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** **

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

** **

**x  Quarterly Report Pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934**

** **

**For Quarterly Period Ended September 30, 2010**

** **

**Or**

** **

**o  TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

 

**For the Transition Period From             to**

 

**Commission File Number 0-14602**

 

**CYANOTECH CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **NEVADA**                        | ** ** | **91-1206026**         |
|-----------------------------------|------------|------------------------|
| (State or other jurisdiction      |       | (IRS Employer          |
| of incorporation or organization) |       | Identification Number) |

 

**73-4460 Queen Kaahumanu Hwy.#102, Kailua-Kona, HI 96740**

(Address of principal executive offices)

 

**(808) 326-1353**

(Registrant’s telephone number)

 

**Not Applicable**

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

 

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

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes x No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 
| Large accelerated filer o                |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                  |   | Smaller reporting company x |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o   No x

 

Numberof common shares outstanding as of November 10, 2010:

 
| **Title of  Class**            | ** ** | **Shares  Outstanding** |
|--------------------------------|------------|-------------------------|
| Common stock - $0.02 par value |       | 5,391,968               |

 

 

 

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CYANOTECHCORPORATION

 

FORM 10-Q

 

INDEX

 
| **PART I.  FINANCIAL INFORMATION** |
|--------------------------------------------------------|
| ** **                                             | ** ** | ** ** |
| Item 1.                                                | Financial  Statements (unaudited) | 3 |
|                                                   | Condensed Consolidated Balance Sheets as of  September 30, 2010 and March 31, 2010 | 3 |
|                                                   | Condensed Consolidated Statements of Operations for  the three and six month periods ended September 30, 2010 and 2009 | 4 |
|                                                   | Condensed Consolidated Statements of Cash Flows for  the six month periods ended September 30, 2010 and 2009 | 5 |
|                                                   | Notes to  Consolidated Condensed Financial Statements | 6 |
| Item 2.                                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 14 |
| Item 3.                                                | Quantitative  and Qualitative Disclosures About Market Risk | 19 |
| Item 4.                                                | Controls and  Procedures | 19 |
| ** **                                             | **PART II.  OTHER  INFORMATION** | ** ** |
| ** **                                             | ** ** | ** ** |
| Item 1.                                                | Legal Proceedings | 20 |
| Item 2.                                                | Unregistered  Sales of Equity Securities and Use of Proceeds | 20 |
| Item 3.                                                | Defaults upon Senior  Securities | 20 |
| Item 5.                                                | Other Information | 20 |
| Item 6.                                                | Exhibits | 20 |
| SIGNATURES                                             | 21 |

 

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**PART I.  FINANCIALINFORMATION**

 

**Item 1.  Financial Statements** (Unaudited)

 

CYANOTECH CORPORATION

CONDENSED CONSOLIDATEDBALANCE SHEETS

(Dollars in thousands except par value and number of shares)

(Unaudited)

 
| ** **                                                                                                                                                                               | ** ** | **September 30,  2010** | ** ** | **March 31,  2010** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|
| ASSETS                                                                                                                                                                                   |       |                         |       |                     |       |
| Current assets:                                                                                                                                                                          |       |                         |       |                     |       |
| Cash and cash equivalents                                                                                                                                                                |       | $                            | 783        |                     | $          | 817 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $10 at September 30, 2010 and March 31,  2010                                                   |       | 2,130                        |       | 2,064                    |       |
| Inventories, net                                                                                                                                                                         |       | 4,613                        |       | 3,933                    |       |
| Prepaid expenses and other assets                                                                                                                                                        |       | 155                          |       | 400                      |       |
| Total current assets                                                                                                                                                                     |       | 7,681                        |       | 7,214                    |       |
|                                                                                                                                                                                     |       |                         |       |                     |       |
| Equipment and leasehold improvements, net                                                                                                                                                |       | 4,709                        |       | 4,681                    |       |
| Other assets                                                                                                                                                                             |       | 263                          |       | 253                      |       |
| Total assets                                                                                                                                                                             |       | $                            | 12,653     |                     | $          | 12,148 |   |
|                                                                                                                                                                                     |       |                         |       |                     |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                |       |                         |       |                     |       |
| Current liabilities:                                                                                                                                                                     |       |                         |       |                     |       |
| Current maturities of long-term debt                                                                                                                                                     |       | $                            | 200        |                     | $          | 276 |   |
| Line of credit                                                                                                                                                                           |       | 150                          |       | 150                      |       |
| Customer deposits                                                                                                                                                                        |       | 10                           |       | —                   |       |
| Accounts payable                                                                                                                                                                         |       | 688                          |       | 1,125                    |       |
| Accrued expenses                                                                                                                                                                         |       | 683                          |       | 721                      |       |
| Total current liabilities                                                                                                                                                                |       | 1,731                        |       | 2,272                    |       |
|                                                                                                                                                                                     |       |                         |       |                     |       |
| Long-term debt, less current maturities                                                                                                                                                  |       | 656                          |       | 756                      |       |
| Total liabilities                                                                                                                                                                        |       | 2,387                        |       | 3,028                    |       |
|                                                                                                                                                                                     |       |                         |       |                     |       |
| Commitments and contingencies                                                                                                                                                            |       |                         |       |                     |       |
|                                                                                                                                                                                     |       |                         |       |                     |       |
| Stockholders’ equity:                                                                                                                                                               |       |                         |       |                     |       |
| Common stock of $0.02 par value, shares authorized  7,500,000; 5,391,968 shares issued and outstanding at  September 30, 2010 and 5,252,572 shares at March 31, 2010 |       | 108                          |       | 105                      |       |
| Additional paid-in capital                                                                                                                                                               |       | 27,763                       |       | 27,545                   |       |
| Accumulated deficit                                                                                                                                                                      |       | (17,605                      | )          | (18,530                  | )          |
| Total stockholders’ equity                                                                                                                                                          |       | 10,266                       |       | 9,120                    |       |
|                                                                                                                                                                                     |       |                         |       |                     |       |
| Total liabilities and stockholders’ equity                                                                                                                                          |       | $                            | 12,653     |                     | $          | 12,148 |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CYANOTECH CORPORATION

CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(Dollars in thousands, except per share amounts)

(Unaudited)

 
| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                           | ** ** | **2010**                                             | ** ** | **2009**                                           | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| NET SALES                                            |       | $                                                    | 3,834      |                                               | $          | 3,925 |   | $ | 7,690 |   | $ | 7,946 |   |
| COST OF PRODUCT SALES                                |       | 2,182                                                |       | 2,163                                              |       | 4,379 |   | 4,451 |   |
| Gross profit                                         |       | 1,652                                                |       | 1,762                                              |       | 3,311 |   | 3,495 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| OPERATING EXPENSES:                                  |       |                                                 |       |                                               |       |   |   |   |   |
| General and administrative                           |       | 643                                                  |       | 778                                                |       | 1,406 |   | 1,674 |   |
| Sales and marketing                                  |       | 393                                                  |       | 303                                                |       | 776 |   | 624 |   |
| Research and development                             |       | 62                                                   |       | 42                                                 |       | 146 |   | 123 |   |
| Total operating expenses                             |       | 1,098                                                |       | 1,123                                              |       | 2,328 |   | 2,421 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| Income from operations                               |       | 554                                                  |       | 639                                                |       | 983 |   | 1,074 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                              |       |                                                 |       |                                               |       |   |   |   |   |
| Interest expense, net                                |       | (18                                                  | )          | (28                                                | )          | (39 | ) | (57 | ) |
| Other income, net                                    |       | —                                               |       | —                                             |       | 1 |   | 17 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| Total other expense, net                             |       | (18                                                  | )          | (28                                                | )          | (38 | ) | (40 | ) |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| Income before provision for income taxes        |       | 536                                                  |       | 611                                                |       | 945 |   | 1,034 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| PROVISION FOR INCOME TAXES                           |       | 10                                                   |       | 12                                                 |       | 20 |   | 22 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| NET INCOME                                           |       | $                                                    | 526        |                                               | $          | 599 |   | $ | 925 |   | $ | 1,012 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| NET INCOME PER SHARE:                                |       |                                                 |       |                                               |       |   |   |   |   |
| Basic                                                |       | $                                                    | .10        |                                               | $          | .11 |   | $ | .17 |   | $ | .19 |   |
| Diluted                                              |       | $                                                    | .10        |                                               | $          | .11 |   | $ | .17 |   | $ | .19 |   |
|                                                 |       |                                                 |       |                                               |       |   |   |   |   |
| SHARES USED IN CALCULATION OF NET INCOME PER  SHARE: |       |                                                 |       |                                               |       |   |   |   |   |
| Basic                                                |       | 5,374                                                |       | 5,247                                              |       | 5,314 |   | 5,246 |   |
| Diluted                                              |       | 5,390                                                |       | 5,308                                              |       | 5,333 |   | 5,300 |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CYANOTECH CORPORATION

CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(Dollars in thousands)(Unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2010**                                           | ** ** | **2009** | ** ** |
| ** **                                                                         | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                              |       |                                               |       |   |   |
| Net income                                                                         |       | $                                                  | 925        |   | $ | 1,012 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                               |       |   |   |
| Depreciation and amortization                                                      |       | 279                                                |       | 242 |   |
| Amortization of debt issue costs and other assets                                  |       | 14                                                 |       | 29 |   |
| Issuance of common stock for services                                              |       | 21                                                 |       | 10 |   |
| Stock based compensation expense                                                   |       | 15                                                 |       | 138 |   |
| Net (increase) decrease in assets:                                                 |       |                                               |       |   |   |
| Accounts receivable                                                                |       | (66                                                | )          | (45 | ) |
| Inventories                                                                        |       | (680                                               | )          | (397 | ) |
| Prepaid expenses and other assets                                                  |       | (30                                                | )          | (93 | ) |
| Net increase (decrease) in liabilities:                                            |       |                                               |       |   |   |
| Customer deposits                                                                  |       | 10                                                 |       | 2 |   |
| Accounts payable                                                                   |       | (436                                               | )          | (269 | ) |
| Accrued expenses                                                                   |       | (38                                                | )          | 309 |   |
| Net cash provided by operating activities                                          |       | 14                                                 |       | 938 |   |
|                                                                               |       |                                               |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                              |       |                                               |       |   |   |
| Investment in equipment and leasehold improvements                                 |       | (307                                               | )          | (509 | ) |
| Proceeds from return of restricted cash                                            |       | 250                                                |       | — |   |
| Net cash used in investing activities                                              |       | (57                                                | )          | (509 | ) |
|                                                                               |       |                                               |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                              |       |                                               |       |   |   |
| Principal payments on long-term debt                                               |       | (176                                               | )          | (306 | ) |
| Stock options exercised                                                            |       | 185                                                |       | — |   |
| Net cash provided by (used in) financing  activities                               |       | 9                                                  |       | (306 | ) |
|                                                                               |       |                                               |       |   |   |
| Net (decrease) increase in cash and cash  equivalents                              |       | (34                                                | )          | 123 |   |
|                                                                               |       |                                               |       |   |   |
| Cash and cash equivalents at beginning of period                                   |       | 817                                                |       | 977 |   |
|                                                                               |       |                                               |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                                                  | 783        |   | $ | 1,100 |   |
|                                                                               |       |                                               |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                  |       |                                               |       |   |   |
| Cash paid during the period for:                                                   |       |                                               |       |   |   |
| Interest                                                                           |       | $                                                  | 25         |   | $ | 35 |   |
| Income taxes                                                                       |       | $                                                  | 12         |   | $ | 30 |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CYANOTECH CORPORATION

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2010(Unaudited)

 

**1.****                                     ****BASISOF PRESENTATION**

 

Theaccompanying condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”) for interim financial information and with the instructionsto Form 10-Q and Regulation S-X.  Accordingly, they do not includeall of the information and footnotes required by GAAP for complete financialstatements. The condensed consolidated balance sheet as of March 31, 2010was derived from the audited financial statements. These consolidated condensed financial statements and notes should beread in conjunction with the Company’s consolidated financial statements forthe year ended March 31, 2010, contained in the Company’s report onForm 10-K as filed on June 24, 2010.

 

Theaccompanying consolidated condensed financial statements include the accountsof Cyanotech Corporation and its wholly owned subsidiary, NutrexHawaii, Inc. (“Nutrex Hawaii” or “Nutrex”). All significant intercompanybalances and transactions have been eliminated in consolidation.

 

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and the disclosures of contingent assets and liabilities at thebalance sheet date and the reported amounts of revenues and expenses during theperiod reported.  Management reviews these estimates and assumptionsperiodically and reflects the effect of revisions in the period that they aredetermined to be necessary.  Actual results could differ from thoseestimates and assumptions.

 

**2.**                                      **INVENTORIES**

 

Inventoriesare stated at the lower of cost (which approximates first-in, first-out) ormarket. Market is defined as sales price less cost to dispose and a normalprofit margin.  Inventories consist of the following:

 
| ** **        | ** ** | **September 30, 2010** | ** ** | **March 31, 2010** | ** ** |
|-------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **        | ** ** | **(in thousands)**          | ** ** |
| Raw materials     |       | $                                | 389        |                         | $          | 392 |   |
| Work in process   |       | 291                              |       | 303                          |       |
| Finished goods(1) |       | 3,780                            |       | 3,062                        |       |
| Supplies          |       | 153                              |       | 176                          |       |
|              |       | $                                | 4,613      |                         | $          | 3,933 |   |

 

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(1)          Net of reserve forobsolescence of $85,000 at September 30, 2010 and $54,000 atMarch 31, 2010.

 

TheCompany recognizes abnormal production costs including fixed cost variancesfrom normal production capacity as an expense in the period incurred. No fixedproduction related costs were charged to cost of sales for the three and sixmonths ended September 30, 2010 and 2009, respectively.

 

**3.****                                     ****EQUIPMENTAND LEASEHOLD IMPROVEMENTS**

 

Equipmentand leasehold improvements are stated at cost. Depreciation and amortization areprovided using the straight-line method over the estimated useful lives forequipment and furniture and fixtures, or the shorter of the land lease term orestimated useful lives for leasehold improvements as follows:

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

 

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Equipmentand leasehold improvements consist of the following:

 
| ** **                                     | ** ** | **September 30, 2010** | ** ** | **March 31, 2010** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | **(in thousands)**          | ** ** |
| Equipment(1)                                   |       | $                                | 6,634      |                         | $          | 6,350 |   |
| Leasehold improvements                         |       | 7,386                            |       | 7,298                        |       |
| Furniture and fixtures                         |       | 83                               |       | 88                           |       |
|                                           |       | 14,103                           |       | 13,736                       |       |
| Less accumulated depreciation and amortization |       | (9,522                           | )          | (9,243                       | )          |
| Construction-in-progress                       |       | 128                              |       | 188                          |       |
| Equipment and leasehold improvements, net      |       | $                                | 4,709      |                         | $          | 4,681 |   |

 

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(1)          Includes $97,000 of equipment under capital leasewith accumulated depreciation of $10,000 and $0 at September 30, 2010 andMarch 31, 2010, respectively. (See note 6)

 

Managementreviews long-lived assets for impairment whenever events or changes incircumstances indicate that the carrying value of such assets may not berecoverable. Recoverability of these assets is measured by a comparison of thecarrying amount to forecasted undiscounted future cash flows expected to begenerated by the asset. If the carrying amount exceeds its estimated futurecash flows, then an impairment charge is recognized to the extent that thecarrying amount exceeds the asset’s fair value. Management has determined noasset impairment existed as of September 30, 2010.

 

**4.             ACCRUEDEXPENSES**

 

Accrued expenses consist of the following:

 
| ** **                       | ** ** | **September 30, 2010** | ** ** | **March 31, 2010** | ** ** |
|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **(in thousands)**          | ** ** |
| Wages, commissions and royalties |       | $                                | 335        |                         | $          | 334 |   |
| Customer rebates                 |       | 115                              |       | —                       |       |
| Bonuses                          |       | 61                               |       | 140                          |       |
| Other accrued expenses           |       | 172                              |       | 247                          |       |
|                             |       | $                                | 683        |                         | $          | 721 |   |

 

**5.             LINEOF CREDIT**

 

The Company has a line of credit agreement with First Hawaiian Bank inthe amount of $350,000 for a term of one year. The amount of the line was increased from $150,000 on March 25,2010, the date that the line of credit agreement was renewed.  The obligation is secured by the Company’sU.S. accounts receivable and bears a variable interest rate based on prime(3.25% at September 30, 2010) plus 2%. The outstanding balance as ofSeptember 30, 2010 and March 31, 2010 was $150,000. The creditagreement requires the Company to meet certain financial covenants. The Companywas in compliance with these financial covenants at September 30,2010.  The line of credit balance of$150,000 was paid in full on October 7, 2010.

 

**6.**                                      **LONG-TERMDEBT**

 

Long-term debt consists ofthe following:

 
| ** **                                   | ** ** | **September 31, 2010** | ** ** | **March 31, 2010** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **(in thousands)**          | ** ** |
| Term loans                                   |       | $                                | 856        |                         | $          | 1,032 |   |
| Less current maturities                      |       | (200                             | )          | (276                         | )          |
| Long-term debt, excluding current maturities |       | $                                | 656        |                         | $          | 756 |   |

 

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*Term Loan Agreement*

 

In April 2000, the Company executed a Term Loan Agreement (“TermLoan A”) with a lender providing for $3.5 million in aggregate creditfacilities, secured by the Company’s assets. Term Loan A had a maturity date ofMay 1, 2010. The balance under this loan was $0 and $80,000 at September 30,2010 and March 31, 2010, respectively. A warrant to purchase 5,000 sharesof the Company’s common stock was issued in conjunction with this Term Loan.The warrant expires in April 2011 and has an exercise price of $10.20 pershare. The warrant may only be exercised after the Company has repaid the TermLoan in full. A $250,000 restricted cash deposit was held to secure these loansand was released to the Company in May 2010 upon maturity of Term Loan A.The $250,000 restricted cash deposit is included in other current assets in theaccompanying consolidated condensed balance sheet at March 31, 2010.

 

In February 2008, the Company executed a Term Loan Agreement (“TermLoan B”) with the same lender providing for $1.1 million in aggregatecredit facilities, secured by the Company’s assets. Term Loan B has a maturitydate of March 1, 2015 and is payable in 84 equal monthly principalpayments plus interest. The interest rate under Term Loan B, in the absence ofa default under the agreement, is the prime rate in effect as of the close ofbusiness on the first day of each calendar quarter, plus 1%. As ofSeptember 30, 2010, the prime rate was 3.25%. The balance under this loanwas $735,000 and $808,000 at September 30, 2010 and March 31, 2010,respectively. The Company is prohibited from declaring any common stockdividends without the lender’s prior written consent. The credit agreementrequires the Company to meet certain financial covenants. The Company was incompliance with these financial covenants at September 30, 2010.

 

In March 2009, the Company executed a Term Loan Agreement withJohn Deere credit providing for $29,340 in equipment, secured by the equipmentfinanced. The Term Loan has a maturity date of March 25, 2013 and ispayable in 48 equal monthly principal payments. The interest rate under thisTerm Loan is 0%.  Imputed interest at arate of 2% (cash discount offered by seller) has been recorded and will beamortized as interest over the term of the loan. The face value of the termloan is reported in the balance sheets at $18,000, less the unamortizeddiscount of $1,000 at September 30, 2010 and $22,000, less the unamortizeddiscount of $2,000 at March 31, 2010.

 

In January 2010, the Company executed a Term Loan Agreement withJohn Deere credit providing for $27,217 in equipment, secured by the equipmentfinanced. The Term Loan has a maturity date of December 28, 2012 and ispayable in 36 equal monthly principal payments. The interest rate under thisTerm Loan is 0%. Imputed interest at a rate of 2% (cash discount offered byseller) has been recorded and will be amortized as interest over the term ofthe loan. The face value of the term loan is reported in the balance sheets at$22,000, less the unamortized discount of $1,000 at September 30, 2010 and$27,000, less the unamortized discount of $2,000 at March 31, 2010.

 

In March 2010, the Company executed a capital lease agreement withThermo Fisher Financial providing for $97,000 in equipment, secured by theequipment financed. The capital lease has a maturity date of March 2013and is payable in 36 equal monthly payments. The interest rate under thiscapital lease is 6.6%. The balance under this lease was $82,000 atSeptember 30, 2010 and $97,000 at March 31, 2010.

 

Future principal payments under the term loan agreements as ofSeptember 30, 2010 are as follows:

 
| **Payments Due**    | ** ** | **(in  thousands)** | ** ** |
|--------------------------|------------|---------------------|------------|
| Next 12 Months           |       | $                   | 200        |   |
| Year 2                   |       | 208                 |       |
| Year 3                   |       | 188                 |       |
| Year 4                   |       | 172                 |       |
| Year 5                   |       | 88                  |       |
| Thereafter through 2015  |       | —              |       |
| Total principal payments |       | $                   | 856        |   |

 

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**7.****                                     ****LEASES**

 

TheCompany leases facilities, equipment and land under operating leases expiringbetween 2010 and 2026.  The land leaseprovides for contingent rental in excess of minimum rental commitments based ona percentage of the Company’s sales. Management has accrued for the estimatedcontingent rent as of September 30, 2010.

 

Futureminimum lease payments under all non-cancelable operation leases atSeptember 30, 2010 are as follows:

 
| **Payments Due**        | ** ** | **(in  thousands)** | ** ** |
|------------------------------|------------|---------------------|------------|
| Next 12 Months               |       | $                   | 162        |   |
| Year 2                       |       | 157                 |       |
| Year 3                       |       | 157                 |       |
| Year 4                       |       | 157                 |       |
| Year 5                       |       | 152                 |       |
| Thereafter through 2026      |       | 1,517               |       |
| Total minimum lease payments |       | $                   | 2,302      |   |

 

**8.**                                      **SHARE-BASEDCOMPENSATION**

 

TheCompany accounts for transactions under share based payment arrangements withemployees based on fair value. If an award vests or becomes exercisable basedon the achievement of a condition other than service, such as for meetingcertain performance or market condition, the award is classified as aliability.  Liability-classified awards are remeasured to fair value ateach balance sheet date until the award is settled. The Company currently hasno liability-classified awards.  Equity-classified awards, including grantsof employee stock options, are measured at the grant-date fair value of theaward and are not subsequently remeasured unless an award is modified. The cost of equity-classified awards is recognized in the income statement overthe period during which an employee is required to provide the service inexchange for the award. All of the Company’s stock options areservice-based awards, and because the Company’s stock options are “plainvanilla,” as defined by the U. S. Securities and Exchange Commission in StaffAccounting Bulletin No. 107, they are reflected only in Stockholders’Equity and Compensation Expense accounts.

 

***Stock Options***

 

Asof September 30, 2010, the Company had the following two shareholderapproved stock plans under which shares were available for equity based awards:The 2005 Stock Option Plan (the “2005 Plan”) wherein 700,000 shares of commonstock are reserved for issuance until the Plan terminates on August 21,2015, and; The Independent Director Stock Option and Stock Grant Plan (the “2004Directors Plan”) wherein 75,000 shares of common stock are reserved forissuance until the plan terminates in 2014.

 

Underthe 2005 Plan, eligible employees and certain independent consultants may begranted options to purchase shares of the Company’s common stock. The sharesissuable under the 2005 Plan will either be shares of the Company’s authorizedbut previously unissued common stock or shares reacquired by the Company,including shares purchased on the open market.  As of September 30,2010, 371,204 options remain available for grant under the 2005 Plan.

 

Underthe 2004 Directors Plan, upon election to the Board of Directors, a newlyelected non-employee director is granted a ten-year option to purchase 1,000shares of the Company’s common stock. Options granted vest and becomeexercisable six months from the date of grant.  In addition, on the dateof each Annual Meeting of Stockholders, each non-employee director continuingin office is automatically issued 875 shares of common stock, non-transferablefor nine months following the date of grant. The 2004 Directors Plan wasamended effective March 24, 2010, to increase the number of shares ofcommon stock issued to each non-employee director to 2,000 shares and anadditional 2,000 shares to the director serving as Chairman of the Board. As ofSeptember 30, 2010, 39,123 options remain available for grant under the2004 Directors Plan.

 

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Thefollowing table presents shares authorized, available for future grant andoutstanding under each of the Company’s plans:

 
| ** **          | ** ** | **As of September 30, 2010** | ** ** |
|---------------------|------------|--------------------------------------------------|------------|
| ** **          | ** ** | **Authorized**                                   | ** ** | **Available** | ** ** | **Outstanding** | ** ** |
|                |       |                                             |       |   |   |   |   |
| 2005 Plan           |       | 700,000                                          |       | 371,204 |   | 197,350 |   |
| 2004 Directors Plan |       | 75,000                                           |       | 39,123 |   | 1,000 |   |
| 1994 Plan           |       | —                                           |       | — |   | 2,250 |   |
| Total               |       | 775,000                                          |       | 410,327 |   | 200,600 |   |

 

Allstock option grants made under the 2005 Plan and the 2004 Directors Plan wereat exercise prices no less than the Company’s closing stock price on the dateof grant. Options under the 2005 Plan and 2004 Directors Plan were determinedby the Board of Directors or the Stock Option and Compensation Committee of theBoard in accordance with the provisions of the respective plans.  Theterms of each option grant include vesting, exercise, and other conditions areset forth in a Stock Option Agreement evidencing each grant. No option can havea life in excess of ten (10) years.  The Company records compensationexpense for employee stock options based on the estimated fair value of theoptions on the date of grant using the Black-Scholes option-pricing model. Themodel requires various assumptions, including a risk-free interest rate, theexpected term of the options, the expected stock price volatility over theexpected term of the options, and the expected dividend yield. Compensationexpense for employee stock options is recognized ratably over the vesting term.Compensation expense recognized for options issued under the 2005 Plan was $7,000and $15,000 for the three and six months ended September 30, 2010,respectively.  Compensation expenserecognized for options issued under the 2005 Plan was $61,000 and $138,000 forthe three and six months ended September 30, 2009, respectively. IndependentDirector compensation expense of $21,000 and $9,000 was recognized under the2004 Directors Plan for the three and six months ended September 30, 2010and 2009, respectively. All stock-based compensation has been classified asGeneral and Administrative expense.

 

Asummary of option activity under the Company’s stock plans for the six monthsended September 30, 2010 is presented below:

 
| **Option Activity**               | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at March 31, 2010     |       | 333,606    |       | $                                              | 1.69       |                                                        | 8.4 years  |                            | $          | 555,281 |   |
| Granted                                |       | —     |       | —                                         |       | —                                                      |       | —                          |       |
| Exercised                              |       | (131,396   | )          | $                                              | 1.41       |                                                        | —     |                            | —     |   |
| Forfeited or expired                   |       | (1,610     | )          | $                                              | 1.87       |                                                        | —     |                            | —     |   |
| Outstanding at September 30, 2010 |       | 200,600    |       | $                                              | 1.86       |                                                        | 8.2 years  |                            | $          | 109,536 |   |
| Exercisable at September 30, 2010 |       | 30,955     |       | $                                              | 1.93       |                                                        | 4.5 years  |                            | $          | 14,964 |   |

 

Theaggregate intrinsic value in the table above is before applicable income taxesand represents the amount optionees would have received if all options had beenexercised on the last business day of the period indicated, based on theCompany’s closing stock price of $2.41 for such day.

 

Asummary of the Company’s non-vested options for the six months endedSeptember 30, 2010 is presented below:

 
| **Nonvested Options**           | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------------------|------------|
| Nonvested at March 31, 2010     |       | 181,955    |       | $                                                  | .62        |   |
| Granted                              |       | —     |       | —                                             |       |
| Vested                               |       | (10,850    | )          | .65                                                |       |
| Forfeited or expired                 |       | (1,460     | )          | 1.90                                               |       |
| Nonvested at September 30, 2010 |       | 169,645    |       | $                                                  | .62        |   |

 

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Thefollowing table summarizes the weighted average characteristics of outstandingstock options as of September 30, 2010:

 
| ** **                              | ** ** | **Outstanding Options** | ** ** | **Exercisable Options**     | ** ** |
|-----------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  of Shares**   | ** ** | **Remaining  Life (Years)** | ** ** | **Weighted  Average Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Price** | ** ** |
| $ 1.41 - $2.60                     |       | 198,850                      |       | 8.2                              |       | $ | 1.84 |   | 29,205 |   | $ | 1.78 |   |
| $ 4.20 - $4.40                     |       | 1,750                        |       | 2.6                              |       | 4.31 |   | 1,750 |   | 4.31 |   |
| Total stock options                     |       | 200,600                      |       | 8.2                              |       | $ | 1.86 |   | 30,955 |   | $ | 1.93 |   |

 

Therewere no stock options granted during the three and six months endedSeptember 30, 2010. There were 113,000 stock options granted during thesix months ended September 30, 2009. The fair value assumptions related tooptions granted during the six months ended September 30 were as follows:

 
| ** **       | ** ** | **2009**   | ** ** |
|------------------|------------|------------|------------|
| Exercise Price:  |       | $          | 2.08       |   |
| Volatility:      |       | 88.9       | %          |
| Risk Free Rate:  |       | 3.13       | %          |
| Vesting Period:  |       | 4 years    |       |
| Forfeiture Rate: |       | 20         | %          |
| Expected Life    |       | 6.25 years |       |
| Dividend Rate    |       | 0          | %          |
|                  |            |            |            |  |

 

Asof September 30 2010, total unrecognized stock-based compensation expenserelated to all unvested stock options was $72,506, which is expected to beexpensed over a weighted average period of 2.2 years.

 

***Warrant***

 

AtSeptember 30, 2010 and 2009, the Company had a single warrant outstandingwhich allows the warrant holder rights to acquire 5,000 shares of the Company’scommon stock.  The warrant was valued atthe date of grant and was amortized as premium, but was subsequently deemed tohave no value as a result of a reverse split which occurred in a prioryear.  Accordingly, no expense wasrecognized in the three and six months ended September 30, 2010 or 2009.  The warrant expires in April 2011 andhas an exercise price of $10.20 per share.

 

**9.            ****INCOMETAXES**

 

TheCompany is subject to taxation in the United States and two statejurisdictions.  The preparation of taxreturns requires management to interpret the applicable tax laws andregulations in effect in such jurisdictions, which could affect the amount oftax paid by the Company. Management, in consultation with its tax advisors,files its tax returns on interpretations that are believed to be reasonableunder the circumstances. The income tax returns, however, are subject toroutine reviews by the various taxing authorities in the jurisdictions in whichthe Company files its returns.  As part of these reviews, a taxingauthority may disagree with respect to the tax positions taken by management (“uncertaintax positions”) and therefore may require the Company to pay additional taxes.Management evaluates the requirement for additional tax accruals, includinginterest and penalties, which the Company could incur as a result of theultimate resolution of its uncertain tax positions. Management reviews andupdates the accrual for uncertain tax positions as more definitive informationbecomes available from taxing authorities, completion of tax audits, expirationof statute of limitations, or upon occurrence of other events.

 

Asof September 30, 2010, there was no significant liability for income taxassociated with unrecognized tax benefits. The Company recognizes accruedinterest related to unrecognized tax benefits as well as any related penaltiesin interest income or expense in its consolidated condensed statements ofoperations, which is consistent with the recognition of these items in priorreporting periods.

 

Incometaxes are provided on the earnings in the consolidated financial statements.The provision is based on the current quarter activity of the legal entitiesand jurisdictions in which the Company operates. Tax credits, such as Hawaiicapital goods excise tax credits, are recognized as a reduction to income taxesin the year the credits are earned.  Accordingly,the effective tax rate may vary from the customary relationship between incometax expense (benefit) and pre-tax income. The effective tax rate for the three months ended September 30,2010 differs from the statutory rate due to utilization of net operating losscarryforwards that have been fully reserved due to the Company’s inconsistenttaxable income in recent years and uncertainty about taxable income in futureyears.

 

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Withfew exceptions, the Company is no longer subject to U.S. federal, state andlocal, and non-U.S. income tax examination by tax authorities for tax yearsbefore 2002.

 

**10.**          **EARNINGSPER SHARE**

 

Basicearnings per share is computed on the basis of the weighted average number ofcommon shares outstanding.  Diluted earnings per share is computed on thebasis of the weighted average number of common shares outstanding plus thepotentially dilutive effect of outstanding stock options and warrants using the“treasury stock” method and convertible securities using the “if-converted”method.

 

Reconciliationsbetween the numerator and the denominator of the basic and diluted earnings pershare computations for the three months ended September 30, 2010 and September 30,2009 are as follows:

 
| ** **                                              | ** ** | **Three Months Ended September 30, 2010** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **Net Income**                                                | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                              | ** ** | **(Numerator)**                                                    | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                              | ** ** | **(in thousands)**                                            | ** ** | ** ** | ** ** |
| Basic income per share                                  |       | $                                                                  | 526        |   | 5,374 |   | $ | 0.10 |   |
| Effect of dilutive securities—Common stock options |       | —                                                             |       | 16 |   | — |   |
| Diluted income per share                                |       | $                                                                  | 526        |   | 5,390 |   | $ | 0.10 |   |

 
| ** **                                                 | ** ** | **Three Months Ended September 30, 2009** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **Net Income**                                                | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                 | ** ** | **(Numerator)**                                                    | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                                 | ** ** | **(in thousands)**                                            | ** ** | ** ** | ** ** |
| Basic income per share                                     |       | $                                                                  | 599        |   | 5,247 |   | $ | 0.11 |   |
| Effect of dilutive securities — Common stock  options |       | —                                                             |       | 61 |   | — |   |
| Diluted income per share                                   |       | $                                                                  | 599        |   | 5,308 |   | $ | 0.11 |   |

 

Reconciliationsbetween the numerator and the denominator of the basic and diluted earnings pershare computations for the six months ended September 30, 2010 and September 30,2009 are as follows:

 
| ** **                                               | ** ** | **Six Months Ended September 30, 2010** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                               | ** ** | **Net Income**                                              | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                               | ** ** | **(Numerator)**                                                  | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                               | ** ** | **(in thousands)**                                               | ** ** | ** ** | ** ** |
| Basic income per share                                   |       | $                                                                | 925        |   | 5,314 |   | $ | 0.17 |   |
| Effect of dilutive  securities—Common stock options |       | —                                                           |       | 19 |   | — |   |
| Diluted income per share                                 |       | $                                                                | 925        |   | 5,333 |   | $ | 0.17 |   |

 
| ** **                                                 | ** ** | **Six Months Ended September 30, 2009** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **Net Income**                                              | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                 | ** ** | **(Numerator)**                                                  | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                                 | ** ** | **(in thousands)**                                               | ** ** | ** ** | ** ** |
| Basic income per share                                     |       | $                                                                | 1,012      |   | 5,246 |   | $ | 0.19 |   |
| Effect of dilutive securities — Common stock  options |       | —                                                           |       | 54 |   | — |   |
| Diluted income per share                                   |       | $                                                                | 1,012      |   | 5,300 |   | $ | 0.19 |   |

 

Diluted earnings per sharedoes not include the impact of common stock options totaling 114,750 and382,362 for the three months ended September 30, 2010 and 2009,respectively, and 114,917 and 474,221 for the six months ended September 30,2010 and 2009, respectively, as the effect of their inclusion would beanti-dilutive.

 

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**11.          NEW ACCOUNTINGPRONOUNCEMENTS**

 

In January 2010, the Financial Accounting Standards Board (“FASB”)issued Accounting Standards Update (“ASU”) No. 2010-06, “ImprovingDisclosures about Fair Value Measurements,” an amendment to AccountingStandards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures.”The standard requires disclosure for transfers in and out of Level 1 andLevel 2, as well as the disclosure of Level 3 activity on a gross,rather than net, basis. The guidance also requires enhancements to certainexisting disclosures. The amendments are effective as of the beginning of ourfiscal year 2011, or April 1, 2010, except for the new requirementsregarding Level 3 activity, which is deferred until the beginning offiscal year 2012. The guidance is not expected to have an impact on the Company’sconsolidated financial statements.

 

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

 

**FORWARD LOOKING STATEMENTS**

 

This Report and other presentations made by Cyanotech Corporation (“CYAN”)and its subsidiaries contain “forward-looking statements,” which includestatements that are predictive in nature, depend upon or refer to future eventsor conditions, and usually include words such as “expects,” “anticipates,” “intends,”“plan,” “believes,” “predicts”, “estimates” or similar expressions. Inaddition, any statement concerning future financial performance, ongoingbusiness strategies or prospects and possible future actions are alsoforward-looking statements. Forward-looking statements are based upon currentexpectations and projections about future events and are subject to risks,uncertainties and the accuracy of assumptions concerning CYAN and itssubsidiaries (collectively, the “Company”), the performance of the industry inwhich CYAN does business, and economic and market factors, among other things. **These forward-looking statements are not guarantees offuture performance.**

 

Forward-looking statements speak only as of the date of the Report,presentation or filing in which they are made. Except to the extent required bythe Federal Securities Laws, the Company undertakes no obligation to publiclyupdate or revise any forward-looking statements, whether as a result of newinformation, future events or otherwise. Our forward-looking statements in thisReport include, but are not limited to:

 

·                  Statements relating to ourbusiness strategy;

 

·                  Statements relating to ourbusiness objectives; and

 

·                  Expectations concerningfuture operations, profitability, liquidity and financial resources.

 

These forward-looking statements are subject to risk, uncertainties andassumptions about us and our operations that are subject to change based onvarious important factors, some of which are beyond our control. The followingfactors, among others, could cause our financial performance to differsignificantly from the goals, plans, objectives, intentions and expectationsexpressed in our forward-looking statements:

 

·                  The added risks associatedwith the current local, national and world economic crisis, including but notlimited to, the volatility of crude oil prices and currency fluctuations;

 

·                  The effects of competition,including locations of competitors and operating and market competition;

 

·                  Demand for the company’sproducts, the quantities and qualities thereof available for sale and levels ofcustomer satisfaction;

 

·                  Changes in domestic and/orforeign laws, regulations or standards, affecting nutraceutical products or theCompany’s methods of operation;

 

·                  Environmental restrictions,soil and water conditions, variations in daylight hours and seasonal weatherpatterns, particularly heavy rain, wind and other hazards;

 

·                  Access to available andreasonable financing on a timely basis;

 

·                  Changes in laws, includingnew corporate governance requirements and increased tax rates, regulations oraccounting standards, and decisions of courts, regulators and governmentalbodies;

 

·                  Our dependence on theexperience and competence of our executive officers and other key employees;

 

·                  The risk associated with thegeographic concentration of the company’s business;

 

·                  Acts of war, terroristincidents or natural disasters; and

 

·                  Other risks oruncertainties described elsewhere in this Report and in other periodic reportspreviously and subsequently filed by the Company with the Securities andExchange Commission.

 

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**Overview**

 

Comparisonsof selected consolidated statements of operations data as reported hereinfollow for the periods indicated (dollars in thousands):

 
| ** **                   | ** ** | **Three Months Ended** | ** ** | ** **                       | ** ** |
|------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                   | ** ** | **September 30, 2010** | ** ** | **September 30, 2009** | ** ** | **Change** | ** ** |
| Net sales:                   |       |                             |       |                             |       |   |   |
| Spirulina products           |       | $                                | 1,868      |                             | $          | 1,958 |   | (5 | )% |
| Natural astaxanthin products |       | 1,965                            |       | 1,956                            |       | 0 | % |
| Other products               |       | 1                                |       | 11                               |       | (91 | )% |
| Total sales, all products    |       | $                                | 3,834      |                             | $          | 3,925 |   | (2 | )% |
|                         |       |                             |       |                             |       |   |   |
| Gross profit            |       | $                                | 1,652      |                             | $          | 1,762 |   | (6 | )% |
| Income from operations       |       | $                                | 554        |                             | $          | 639 |   | (13 | )% |
| Net income                   |       | $                                | 526        |                             | $          | 599 |   | (12 | )% |

 
| ** **                   | ** ** | **Six Months Ended**   | ** ** | ** **                       | ** ** |
|------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                   | ** ** | **September 30, 2010** | ** ** | **September 30, 2009** | ** ** | **Change** | ** ** |
| Net sales:                   |       |                             |       |                             |       |   |   |
| Spirulina products           |       | $                                | 3,821      |                             | $          | 3,876 |   | (1 | )% |
| Natural astaxanthin products |       | 3,865                            |       | 4,057                            |       | (5 | )% |
| Other products               |       | 4                                |       | 13                               |       | (69 | )% |
| Total sales, all products    |       | $                                | 7,690      |                             | $          | 7,946 |   | (3 | )% |
|                         |       |                             |       |                             |       |   |   |   |   |
| Gross profit            |       | $                                | 3,311      |                             | $          | 3,495 |   | (5 | )% |
| Income from operations       |       | $                                | 983        |                             | $          | 1,074 |   | (8 | )% |
| Net income                   |       | $                                | 925        |                             | $          | 1,012 |   | (9 | )% |

 

**Results of Operations**

 

*Second Quarter of Fiscal 2011 Compared to SecondQuarter of Fiscal 2010*

 

Netsales for the second quarter of fiscal 2011 were $3,834,000, a 2% decrease fromthe $3,925,000 reported for the comparable period a year ago.  Spirulinasales decreased overall in the current quarter compared to last year due to adecrease in bulk product sales offset by increases in packaged product sales.As a percentage of sales, Spirulina accounted for 49% of total sales in thesecond quarter of fiscal 2011, compared to 50% for the comparable period a yearago.

 

Naturalastaxanthin product sales increased slightly over the second quarter of theprior year due to an increase in bulk product sales offset by a decrease inpackaged product sales. Packaged astaxanthin sales decreased primarily due toreduced sales to foreign private label customers as compare to prior year.Natural astaxanthin product sales increased to 51% of total sales from 50% oftotal sales in the second quarter of fiscal 2010.

 

Internationalsales were 41% of total sales for the second quarter of fiscal year 2011 and37% in the second quarter of 2010. The increase in international sales as apercentage of total sales is due to an increase of $118,000 in internationalsales, offset by a decrease of $ 207,000 in domestic sales from the same periodin the prior year.  Major customers arethose equaling or exceeding 10% of our sales for the period. For the secondquarter of fiscal 2011 there were no customers who had sales equal to orgreater than 10% of our total sales for the quarter.  For the second quarter of fiscal 2010, onecustomer had sales equal to or greater than 10% of our total sales for thequarter.

 

Grossprofit, derived from net sales less the cost of product sales, includes thecost of materials, direct labor, manufacturing overhead and depreciation. Grossprofit for the three months ended September 30, 2010 and 2009 was$1,652,000 and $1,762,000, respectively. The decrease of $110,000 is the direct result of reduced sales, lowerproduction and increase in the inventory reserve. Gross profit margin, as apercentage of sales, was 43% for the three months ended September 30,2010, compared to 45% for the comparable period in the prior year.

 

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Variableproduction costs decreased by 7% in the current period compared to one yearago. Increases in supplies and repair and maintenance costs were offset bydecreases in nutrients and packaging expenses. Fixed costs have increased approximately 2% primarily due todepreciation expense associated with additions to production equipment.Spirulina production decreased 14% and astaxanthin production decreased 16%over the same quarter one year ago reflecting planned production yields. Totalvariable and fixed costs spread over decreased production units raised theindividual unit production costs over the same period last year

 

Operatingexpenses were $1,098,000 in the three months ended September 30, 2010compared to $1,123,000 in the quarter ended September 30, 2009, a decreaseof $25,000. As a percentage of sales, operating expenses were 29% in thequarters ended September 30, 2010 and 2009.

 

Thedecrease in operating expenses in the three months ended September 30,2010 as compared with the three months ended September 30, 2009, wasprimarily the result of reduced general and administrative expense offset byincreases in both sales and marketing expense and research and developmentexpense.  General and administrativeexpense for the second quarter 2011 decreased by $135,000, down 17% from thesecond quarter of 2010. The decrease is primarily the result of reduced bonus,stock option and other compensation expenses associated with not having apermanent CEO. Sales and marketing expense for the second quarter of 2011increased by $90,000 or 30% over the second quarter of 2010. The increase isdue primarily to the initiation of broker training and new marketing programsfor packaged products. Research and development expense for the second quarterof 2011 increased by $20,000, up 48% from the second quarter of 2010. Theincrease is due primarily to increased employee compensation and lab supplies.

 

Werecorded an income tax expense of $10,000 related to federal and statealternative minimum tax for the three months ended September 30, 2010compared to $12,000 for the three months ended September 30, 2009.  We do not expect any material U.S. federal orstate income taxes to be recorded for the current fiscal year because ofavailable net operating loss carry-forwards.

 

Insummary, we reported net income of $526,000 or $0.10 per diluted share for thethree months ended September 30, 2010 compared****to net income of $599,000 or $0.11 per diluted share for thethree months ended September 30, 2009. The decrease is the result ofreduced sales, reduced gross profit margin percentage and increase in ourinventory reserve.

 

*Six Months Ended September 30, 2010 Compared toSix Months Ended September 30, 2009*

 

Netsales for the six months ended September 30, 2010 were $7,690,000, adecrease of 3% from sales of $7,946,000 reported for the comparable period ayear ago.  The decrease in sales over the prior year’s six-month periodwas the result of decreased sales of both spirulina, (1% decrease) and naturalastaxanthin products (5% decrease).  Spirulina bulk sales decreased 6%while packaged spirulina products increased 5%. Astaxanthin bulk sales decreased 1% while packaged astaxanthin productsales decreased 14%, primarily the result of reduced private label sales.

 

Internationalsales represented 44% of net sales for the six months ended September 30,2010 compared to 43% for the same period a year ago.  For the six months ended September 30,2010 and September 30, 2009, one customer had sales equal to or greaterthan 10% of our total sales.

 

Grossprofit for the six months ended September 30, 2010 and September 30,2009 was $3,311,000 and $3,495,000 respectively. The decrease of $184,000 isthe direct result of reduced sales, reduced profit margin and increase in theinventory reserve.

 

Forthe six months ended September 30, 2010, variable production costsdecreased 6%. Increases in supplies and utilities costs were offset bydecreases in nutrients, packaging and repairs and maintenance expenses. For thesix months ended September 30, 2010, fixed cost overhead increased 1%primarily due to depreciation expense associated with additions to productionequipment. Spirulina and astaxanthin production remained consistent over thesame six month period one year ago.

 

Operatingexpenses for the six months ended September 30, 2010 were $2,328,000, adecrease of $93,000 or 4% from the comparable prior year period.   General and administrative expense decreased$268,000 or 16%. The decrease is primarily the result of reduced bonus, stockoption and other compensation expenses associated with not having a permanentCEO. Sales and marketing expense increased by $152,000 or 24% as a result ofthe initiation of broker training and new marketing programs for packagedproducts to expand consumer awareness. Research and development expenseincreased $23,000 or 19% from the comparable prior period, primarily due to increasedemployee compensation and lab supplies. While it is our goal to contain discretionary operating spending, it maybecome necessary for us to selectively increase spending in some or all ofthese areas to remain competitive and to comply with regulatory requirements.

 

Forthe six months ended September 30, 2010, we recorded income tax expense of$20,000 related to Federal and state alternative minimum tax, compared to$22,000 for the six months ended September 30, 2009.  We do notexpect any material United States income taxes for the current fiscal year as aresult of available net operating loss carry-forwards.

 

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Werecorded net income of $925,000 or $0.17 per diluted share for the six monthperiod ended September 30, 2010. For the same period a year ago wereported net income of $1,012,000 or $0.19 per diluted share.

 

**Variability of Results**

 

Wehave experienced significant quarterly fluctuations in operating results andsuch fluctuations could occur in future periods. We have, during our history,experienced fluctuations in operating results due to the following:  changes in sales levels to our customers; competitionincluding pricing, new products and shifts in market trends; productiondifficulties from increased production costs and variable production resultsdue to inclement weather; and start up costs associated with new productintroductions, new facilities and expansion into new markets. In addition,future operating results may fluctuate as a result of factors beyond the ourcontrol such as foreign exchange fluctuations, changes in governmentregulations, and economic changes in the regions it operates in and sells to. Aportion of our operating expenses are relatively fixed and the timing ofincreases in expense levels is based in large part on forecasts of futuresales. Therefore, if net sales are below expectations in any given period, theadverse impact on results of operations may be magnified by our inability toeffectively adjust spending in certain areas, or to adjust spending in a timelymanner, as in personnel and administrative costs. We may also choose to reduceprices or increase spending in response to market conditions, and thesedecisions may have a material adverse effect on financial condition and resultsof operations.

 

**Financial Condition**

 

Cashand cash equivalents remained fairly consistent with levels at March 31,2010 decreasing $34,000, or 4%, to $783,000 at September 30, 2010. Cashprovided by operating activities of $14,000 decreased $924,000 from the samesix month period of last fiscal year. The decrease is due to the decrease innet income of $87,000, plus the decrease of non-cash expenses of $90,000 andthe net changes in current assets and liabilities using cash of $747,000 overthe same six month period of last fiscal year. The net change in current assets and liabilities was largely due toincreased inventory and reduced payables and accrued expenses.  Net cash used in investing activitiesdecreased by $452,000 over the same six month period of last fiscal year mainlydue to the return of restricted cash in the amount of $250,000 and $202,000decrease in investment in capital projects.

 

Asof September 30, 2010, our accounts receivable, net increased $66,000 to$2,130,000 from $2,064,000 as of March 31, 2010. The increase in accountsreceivable is primarily the result of some extended payment terms on sales forthe quarter. Management believes that its accounts receivable are collectible,net of the allowance for doubtful accounts of $10,000, at September 30,2010.

 

Ournet inventory increased $680,000 or 17% to $4,613,000 as of September 30,2010 compared to $3,933,000 as of March 31, 2010. The increase ininventory during the first six months of fiscal 2011 is primarily due toincreased production as the hours of daylight increase in the summer months andslightly reduced sales.

 

Cashflows used in investing activities reflect capital expenditures which totaled$307,000 during the first six months of fiscal 2011 compared to $509,000 oneyear ago. Cash flows used in financing activities are attributable to debtpayments during that period which were $176,000 and $306,000 for the first sixmonths of fiscal 2011 and 2010, respectively.

 

**Liquidity and Capital Resources**

 

At September 30, 2010, our working capital was $5,950,000, anincrease of $1,008,000 compared to $4,942,000 at March 31, 2010. Theincrease in working capital is primarily due to the increase in inventory andreduction of liabilities. Cash and cash equivalents at September 30, 2010totaled $783,000, a decrease of $34,000 from $817,000 at March 31, 2010.

 

We had two Term Loan Agreements (“Term Loans”) with a lender. Theseprovided up to $4.6 million in combined credit facilities which aresecured by substantially all the assets of the Company. One of the Term Loanswas paid in full on its maturity date of May 1, 2010. The outstandingbalance under the remaining Term Loan as of September 30, 2010 isapproximately $735,000 with a maturity date of March 1, 2015 and ispayable in equal monthly principal payments plus interest totalingapproximately $15,000. The interest rate under the Term Loan, in absence of adefault under the agreement, is the prime rate, as defined, in effect as of theclose of business on the first day of each calendar quarter, plus 1% (the primerate was 3.25% at September 30, 2010). We are prohibited by the Term Loanfrom declaring any cash dividends without the lender’s prior written consent.

 

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We have a line of credit agreement with First Hawaiian Bank in theamount of $350,000 for a term of one year. The amount of the line was increased from $150,000 on March 25,2010, the date that the line of credit agreement was renewed.  The obligation is secured by the Company’sU.S. accounts receivable and bears a variable interest rate based on prime,(3.25% at September 30, 2010), plus 2%. The outstanding balance as ofSeptember 30, 2010 and March 31, 2010 was $150,000, respectively. Thecredit agreement requires the Company to meet certain financial covenants. TheCompany was in compliance with these financial covenants at September 30,2010. The line of credit balance of $150,000 was paid in full on October 7,2010.

 

We have, as previously reported, experienced a number of factors thathave negatively impacted our balance sheet and liquidity. At September 30,2010, we had an accumulated deficit of $17,605,000 compared to an accumulateddeficit of $18,530,000 at March 31, 2010. The accumulated deficitdecreased by $925,000 for the six months ended September 30, 2010.

 

***Sufficiency of Liquidity***

 

Basedupon our current operating plan, analysis of our consolidated financialposition and projected future results of operations, we believe that ouroperating cash flows, cash balances, and working capital, together with amoderate amount of additional borrowing, will be sufficient to finance currentoperating requirements, debt service requirements, and planned capitalexpenditures, for the next twelve (12) months. We expect liquidity in theremainder of fiscal 2011 to be generated from operating cash flows.

 

**CapitalResources**

 

Weexpect fiscal 2011 capital expenditures to be approximately $900,000 and to befunded from operating cash flows. This includes capital expenditures in supportof our normal operations, and expenditures that we may incur in conjunctionwith initiatives to improve gross margins and reduce expenses.

 

**Outlook**

 

*This outlook section contains a number offorward-looking statements, all of which are based on current expectations.Actual results may differ materially.*

 

Ourstrategic direction has been to position the Company as a world leader in theproduction and marketing of high-value natural products from microalgae. We arevertically aligned, producing raw materials in the form of microalgae processedat our 90-acre facility in Hawaii, and integrating those raw materials intofinished products. In fiscal 2011, we are putting increased emphasis on ourNutrex Hawaii consumer products to introduce them to a broader consumer marketthan in prior years. Our focus going forward will continue to be to leverageour experience and reputation for quality, building nutritional brands whichpromote health and well-being. The foundation of our nutritional products isnaturally cultivated Spirulina Pacifica® in powder, flake and tablet form; and *BioAstin*® natural astaxanthin antioxidantin extract, softgel caplet and micro-encapsulated beadlet form. Informationabout our Company and our products can be viewed at www.cyanotech.com andwww.nutrex-hawaii.com. Consumer products can also be purchased online atwww.nutrex-hawaii.com.

 

Weare focused on sustainability of its production levels in order to promotegrowth in its astaxanthin product line. In fiscal year 2010 we expanded ourBioAstin based MD Formulas Hawaii line in order to provide all vegetariancondition specific alternatives to consumers. Our introduction of Spirulina Pacifica Multivitamins in fiscal year2010, is expected to allow spirulina sales to increase even though spirulinahas reached a mature life cycle stage. We will continue to promote thenutritional superiority of Hawaiian grown spirulina to maintain and expandmarket share. Significant sales variability between periods and even acrossseveral periods can be expected based on historical results.

 

Risingcrude oil prices in prior years resulted in increased nutrient, utility andtransportation costs which reflect and respond to oil prices. We feel thatthese conditions are likely to occur again in the near or distant future, andconsequently, we are putting greater focus on prudent cost controls and expenseavoidance.

 

Grossprofit margin percentages going forward will be impacted by continued pressureon input costs and greater competition in the market place. This could causemargins to decline in future periods. We will continue to focus on health andwell-being, promoting higher gross margin items. We are dedicated to continuousimprovements in process and production methods to stabilize and increaseproduction levels for the future.

 

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Producingthe highest quality microalgae is a complex biological process which requiresbalancing numerous factors including microalgal strain variation, temperature,acidity, nutrient and other environmental considerations, some of which are notwithin our control. An imbalance or unexpected event can occur resulting inproduction levels below normal capacity. The allocation of fixed productionoverheads (such as depreciation and general insurance) to inventories isdetermined based on normal production capacity. When our production volumes arebelow normal capacity limits, certain fixed production overhead costs cannot beinventoried and are recorded immediately in cost of sales. In addition, whenproduction costs exceed historical averages, we evaluate whether such costs areone-time-period charges or an ongoing component of inventory cost.

 

Tomanage our cash resources effectively, we will continue to balance productionin light of sales demand, minimizing the cost associated with build-ups ininventory when appropriate. We could experience unplanned cash outflows and mayneed to utilize other cash resources to meet working capital needs. A prolongeddownturn in sales could impair our ability to generate sufficient cash foroperations and minimize our ability to attract additional capital investmentwhich could become necessary in order to expand into new markets or maintainoptimal production levels.

 

Ourfuture results of operations and the other forward-looking statements containedin this Outlook, in particular the statements regarding revenues, gross marginand capital spending, involve a number of risks and uncertainties. In additionto the factors discussed above, any of the following could cause actual resultsto differ materially: business conditions and growth in the natural productsindustry and in the general economy; changes in customer order patterns; changesin demand for natural products in general; changes in weather conditions;competitive factors, such as increased production capacity from competingspirulina and astaxanthin producers and the resulting impact, if any, on worldmarket prices for these products; government actions and increased regulationsboth domestic and foreign; shortage of manufacturing capacity; and otherfactors beyond our control. Risk factors are discussed in detail in Item 1A inour Form 10-K report for the year ended March 31, 2010.

 

Webelieve that our technology, systems, processes and favorable growing locationgenerally permit year-round harvest of our microalgal products in acost-effective manner. However, previously experienced imbalances in the highlycomplex biological production systems, together with volatile energy costs andrapidly changing world markets, suggest a need for continuing caution withrespect to variables beyond our reasonable control. Therefore, we cannot, anddo not attempt to, provide any definitive assurance with regard to ourtechnology, systems, processes, location, or cost-effectiveness.

 

**Item 3.   Quantitative and Qualitative Disclosures about Market Risk**

 

We do not enter 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.

 

We have one term loan which adjusts quarterly based on the prime rate,and one revolving line of credit which adjust upon change of the primerate.  As such, we are exposed to theinterest rate risk whereby a 1% increase in the prime rate would lead to anincrease of approximately $9,000 in interest expense for the year endingMarch 31, 2011 (based on September 30, 2010 amounts outstanding).

 

**Item 4.   Controls and Procedures**

 

(a) **Disclosure Controls and Procedures**

 

Wemaintain disclosure controls and procedures (as defined inRules 13a-15(e) and 15 (d)-15(e) under the Exchange Act that aredesigned to ensure that information required to be disclosed in our reportsfiled or submitted under the Exchange Act is recorded, processed, summarizedand reported, within the time periods specified in the Security and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow for timely decisions regardingrequired disclosure.

 

ThisForm 10-Q should be read in conjunction with Item 9A “Controls andProcedures” of the Company’s Form 10-K for the fiscal year endedMarch 31, 2010, filed June 24, 2010. There were no material changesin controls and procedures during the current quarter. As of September 30,2010, management believes systems and procedures were in place to reasonablyensure accurate financial data.

 

As noted in prior years’ Forms 10-K, errors were identified in thecalculations and applications of certain accounting practices relating to thecarrying value of inventory. Accordingly, the Company has taken measures overthe past few years to correct the identified weakness: (1) The Companyengaged the services of qualified independent consultants to advise the Companyon improvements to internal controls and procedures; (2) the Company addedto its staff of educated and experienced accounting personnel; and(3) consultants independent from those who assisted with improvements andprocedures have tested the Company’s internal controls over financial reportingconcurrent with this Form 10-Q. Based on these measures, managementbelieves systems and procedures are in place to reasonably ensure accuratefinancial data. However, these controls and procedures continue to rely heavilyon manual transfers of data, manual calculations and supervisory review of thework product. It is not practical to believe that such manual activities willeliminate the possibility of a material misstatement of the annual or interimfinancial statements.

 

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(b) **Changes to Internal Control Over Financial Reporting**

 

There was no change in our internal control over financial reportingduring the current quarter that has materially affected or is reasonably likelyto materially affect, our internal control over financial reporting. We haveundertaken to upgrade our resource management software to provide a singlesource for all financial data; establish access controls to data andtransactions; and to automate allocations, calculations and periodicreports.  All critical manual processesare expected to be automated prior to March 31, 2011.  Additional functionality will continue to beadded to our resource management system throughout fiscal 2012 in order toprovide additional assurances of the accuracy of our financial reporting.

 

**PART II.      OTHER INFORMATION**

 
| **Item 1.** | **Legal Proceedings**                                       |
|------------------|------------------------------------------------------------------|
| ** **       | ** **                                                       |
| ** **       | None.                                                            |
|             |                                                             |   |
| **Item 2.** | **Unregistered  Sales of Equity Securities and Use of Proceeds** |
| ** **       | ** **                                                       |
|             | None.                                                            |
|             |                                                             |   |
| **Item 3.** | **Defaults  upon Senior Securities**                             |
| ** **       | ** **                                                       |
|             | None.                                                            |
|             |                                                             |   |
| **Item 5.** | **Other  Information**                                           |
| ** **       | ** **                                                       |
|             | None.                                                            |

 

**Item 6.  Exhibits**

** **

a)           The followingexhibits are furnished with this report:

 
| 10.1   |   | Amended,  Reformed and Restated 2004 Independent Director Stock Option and Restricted  Stock Grant Plan adopted November 5, 2010.                                       |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                         |
| 10.2   |   | Restated  2005 Stock Option Plan adopted November 5, 2010.                                                                                                              |
|   |   |                                                                                                                                                                         |
| 31.1   |   | Certifications  of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 signed as of November 10, 2010.                              |
|   |   |                                                                                                                                                                         |
| 31.2   |   | Certifications  of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 signed as of November 10, 2010.                              |
|   |   |                                                                                                                                                                         |
| 32     |   | Certifications  of Chief Executive Officer and Chief Financial Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 signed as of  November 10, 2010. |

 

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SIGNATURES

 

Inaccordance with the requirements of the Securities Exchange Act of 1934, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                   |     | CYANOTECH  CORPORATION |
|------------------------|----------|------------------------|
|                   |     | (Registrant)           |
|                   |     |                   |
|                   |     |                   |
| November 10, 2010 |     | By:                    | /s/ David I. Rosenthal |
| (Date)                 |     | * *               | David I. Rosenthal |
| * *               | * * | * *               | *Interim President and Chief Executive Officer and  Director* |
| * *               | * * |                   | *(Performing the Functions of Principal Executive  Officer)* |
|                   |     |                   |
| November 10, 2010 |     | By:                    | /s/ Deanna L. Spooner |
| (Date)                 |     | * *               | Deanna L. Spooner |
| * *               | * * | * *               | *Vice President — Finance &  Administration and CFO* |
| * *               | * * | * *               | *(Principal Financial and Accounting Officer)* |

 

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EXHIBIT INDEX

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                              |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                    |       | Amended,  Reformed and Restated 2004 Independent Director Stock Option and Restricted  Stock Grant Plan adopted November 5, 2010.                                       |
|                    |       |                                                                                                                                                                         |
| 10.2                    |       | Restated  2005 Stock Option Plan adopted November 5, 2010.                                                                                                              |
|                    |       |                                                                                                                                                                         |
| 31.1                    |       | Certifications  of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 signed as of November 10, 2010                               |
|                    |       |                                                                                                                                                                         |
| 31.2                    |       | Certifications  of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 signed as of November 10, 2010.                              |
|                    |       |                                                                                                                                                                         |
| 32                      |       | Certifications  of Chief Executive Officer and Chief Financial Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 signed as of  November 10, 2010. |

 

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