**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

** **

**Quarterly Report Under Section 13 or15(d)of the Securities Exchange Act of 1934**

**For Quarterly Period Ended December 31, 2006**

**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) |

 

**73-4460Queen Kaahumanu Hwy. #102, Kailua-Kona, HI 96740**(Address of principal executive offices)

**(808) 326-1353**(Registrant’s telephone number)

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

Yes  x  No  o

Indicate by check mark whether theregistrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  o          Acceleratedfiler  o          Non-acceleratedfiler  x

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

Number of common shares outstanding as of March 1,2007:
| **Title of Class**              | ** ** | **Shares  Outstanding** | ** ** |
|---------------------------------|------------|-------------------------|------------|
| Common stock - $0.02  par value |       | 5,233,543               |       |

 

 

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CYANOTECH CORPORATIONFORM 10-Q

**Explanatory Note — Restatement of FinancialInformation**

On December 1, 2006, Cyanotech Corporation(the “Company”) filed a Current Report on Form 8-K with the Securities andExchange Commission (“SEC”) announcing that it would be restating certainconsolidated financial statements in amendments to its annual report on Form10-K/A for the fiscal year ended March 31, 2006.  As more fully described in Note 13 tothe Consolidated Financial Statements in Form 10-K/A filed February 14, 2007,the Company identified errors in the application of certain accountingpractices and procedures.  Therestatement and filing of Form 10-K/A was primarily the result of the Company’sfailure to include as a component of inventory cost certain fixed productioncosts such as depreciation, general insurance and minor compensation cost.  All inventories, cost of sales and operatingexpense balances, as presented in this****Form 10-Q,properly reflect the inclusion of these fixed production costs in accordancewith Accounting Research Bulletin No. 43. In addition, the restatement and filing of Form 10-K/A also includedadjustments for certain Hawaii State Tax Credits and interest income for theyears ended March 31, 2004 and 2003, and tax adjustments for the years endedMarch 31, 2006, 2005, 2004, and 2003, all of which where considered immaterialin prior years.  In addition, refundableincome taxes were restated for each of the years in the three year period endedMarch 31, 2006 and the reclassification of certain certificates of deposit fromcash to short-term investments in fiscal years 2005 and 2004.  These reclassifications had no effect onreported net income (loss) or in cash flow from operations.  The foregoing adjustments andreclassifications are, where appropriate, reflected in the comparative restatedinformation presented in this Form 10-Q.

The Company is filing this Form 10-Q for the fiscalquarter ended December 31, 2006. Restated amounts from the consolidated balance sheet, as of March 31, 2006,and the statement of operations and consolidated statement of cash flows forthe three and nine  months ended December31, 2005 are included in this filing. The Company will not file a Form 10-Q/A for the quarterly period endedDecember 31, 2005, and the consolidated financial statements and relatedinformation contained in that report should no longer be relied upon.

On November 3, 2006, the Company implemented a one for four stock splitat which time the share price closed at $0.43 with 20,934,565 common sharesoutstanding.  As the stock split occurredduring the fiscal quarter reported by this Form 10-Q, and prior to the issuanceof the financial statements, all share data and per share data in thesefinancial statements and notes to financial statements reflect the effect ofthe split.

*This Form 10-Q should be read in conjunction with the Company’s Form10-K/A for the fiscal year ended March 31, 2006 filed February 14, 2007.  Prior period comparative informationcontained in this Form 10-Q has been restated consistent with the Company’sForm 10-K/A  and to reflect the Company’sone-for-four reverse stock split (see Notes 2 and 3 of Notes to ConsolidatedFinancial Statements included in the Form 10-Q).*

*TheCompany did not file Form 10-K/A, for the fiscal years 2005 or 2004, or Form10-Q/A, for the interim periods affected by the restatement prior to andincluding December 31, 2005.  Theconsolidated financial statements and related financial information for suchperiods as previously filed, contain errors and should therefore no longer berelied upon. The related audit reports for the years ended March 31, 2005 and2004 of KPMG LLP, the Company’s independent registered public accounting firm,with respect to those financial statements should also no longer be reliedupon.*

***PotentialDelisting of Our Common Stock From Nasdaq Capital Market Trading. See RiskFactors — Part II, Item 1A herein.***

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CYANOTECHCORPORATIONFORM 10-Q

INDEX

 
| PART I.  FINANCIAL INFORMATION |                                                                                                                     |
|------------------------------------------|--------------------------------------------------------------------------------------------------------------------------|
|                                     |                                                                                                                     |   |
| Item  1.                                 | Financial  Statements                                                                                                    |   |
|                                     |                                                                                                                     |   |
|                                     | Consolidated  Balance Sheets (unaudited)  As of December 31, 2006 and March 31, 2006.                               |   |
|                                     |                                                                                                                     |   |
|                                     | Consolidated Statements of Operations (unaudited)  For the three and nine month periods ended December 31, 2006 and 2005 |   |
|                                     |                                                                                                                     |   |
|                                     | Consolidated Statements of Cash Flows (unaudited)  For the nine month periods ended December 31, 2006 and 2005           |   |
|                                     |                                                                                                                     |   |
|                                     | Notes to Consolidated Financial Statements (unaudited)                                                                   |   |
|                                     |                                                                                                                     |   |
| Item 2.                                  | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                              |   |
|                                     |                                                                                                                     |   |
| Item 3.                                  | Quantitative and Qualitative Disclosures About Market  Risk                                                              |   |
|                                     |                                                                                                                     |   |
| Item  4.                                 | Controls  and Procedures.                                                                                                |   |
|                                     |                                                                                                                     |   |
| PART II.  OTHER INFORMATION         |                                                                                                                     |
|                                     |                                                                                                                     |   |
| Item 1.                                  | Legal Proceedings                                                                                                        |   |
|                                     |                                                                                                                     |   |
| Item 1 A.                                | Risk Factors                                                                                                             |   |
|                                     |                                                                                                                     |   |
| Item 4.                                  | Submission of Matters to a Vote of Security Holders                                                                      |   |
|                                     |                                                                                                                     |   |
| Item 6.                                  | Exhibits and Reports on Form 8-K.                                                                                   |   |
|                                     |                                                                                                                     |   |
| Signatures                               |                                                                                                                     |

 

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PART 1.  FINANCIAL INFORMATION

Item 1. Financial Statements

CYANOTECH CORPORATIONCONSOLIDATED BALANCE SHEETS(Dollars in thousands)(Unaudited)
| ** **                                                                                                                                                        | ** ** | **December 31,** | ** ** | **March 31,**     | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **2006**              | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                                        | ** ** | ** **            | ** ** | **(As Restated)** | ** ** |
|                                                                                                                                                              |       |                  |       |                   |       |
| ASSETS                                                                                                                                                            |       |                  |       |                   |       |
| Current assets:                                                                                                                                                   |       |                  |       |                   |       |
| Cash and cash  equivalents                                                                                                                                        |       | $                     | 1,306      |                   | $          | 1,835 |   |
| Short-term  investments                                                                                                                                           |       | 700                   |       | 700                    |       |
| Accounts  receivable, net                                                                                                                                         |       | 1,519                 |       | 2,209                  |       |
| Refundable  income taxes                                                                                                                                          |       | 27                    |       | 17                     |       |
| Inventories (see  Note 4)                                                                                                                                         |       | 1,797                 |       | 2,056                  |       |
| Prepaid expenses  and other current assets                                                                                                                        |       | 219                   |       | 99                     |       |
| Total current  assets                                                                                                                                             |       | 5,568                 |       | 6,916                  |       |
|                                                                                                                                                              |       |                  |       |                   |       |
| Equipment and leasehold  improvements, net (see Note 5)                                                                                                           |       | 9,451                 |       | 10,164                 |       |
| Other assets                                                                                                                                                      |       | 441                   |       | 515                    |       |
| Total assets                                                                                                                                                      |       | $                     | 15,460     |                   | $          | 17,595 |   |
|                                                                                                                                                              |       |                  |       |                   |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                        |       |                  |       |                   |       |
| Current liabilities:                                                                                                                                              |       |                  |       |                   |       |
| Current maturities  of long-term debt                                                                                                                             |       | $                     | 364        |                   | $          | 364 |   |
| Accounts payable                                                                                                                                                  |       | 638                   |       | 485                    |       |
| Accrued expenses                                                                                                                                                  |       | 511                   |       | 420                    |       |
| Total current  liabilities                                                                                                                                        |       | 1,513                 |       | 1,269                  |       |
|                                                                                                                                                              |       |                  |       |                   |       |
| Long-term debt,  excluding current maturities (see Note 6)                                                                                                        |       | 1,119                 |       | 1,387                  |       |
| Total  liabilities                                                                                                                                                |       | 2,632                 |       | 2,656                  |       |
|                                                                                                                                                              |       |                  |       |                   |       |
| Stockholders’ equity  (see Notes 2 and 3):                                                                                                                   |       |                  |       |                   |       |
| Common Stock of  $0.02 par value; shares authorized 7,500,000; 5,233,543 shares issued and  outstanding at December 31, 2006 and 5,232,066 at March 31, 2006 |       | 105                   |       | 105                    |       |
| Additional  paid-in capital                                                                                                                                       |       | 27,333                |       | 27,330                 |       |
| Accumulated  other comprehensive income - foreign currency translation adjustments                                                                                |       | (9                    | )          | (1                     | )          |
| Accumulated  deficit                                                                                                                                              |       | (14,601               | )          | (12,495                | )          |
| Total  stockholders’ equity                                                                                                                                  |       | 12,828                |       | 14,939                 |       |
|                                                                                                                                                              |       |                  |       |                   |       |
| Total liabilities and  stockholders’ equity                                                                                                                  |       | $                     | 15,460     |                   | $          | 17,595 |   |

 

See accompanying Notes to Consolidated FinancialStatements.

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CYANOTECHCORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per shareamounts) (Unaudited)
| ** **                                         | ** ** | **Three Months Ended   December 31, ** | ** ** | **Nine Months Ended   December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                        | ** ** | **2005**                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | ** **                                                      | ** ** | **(As Restated)**                                   | ** ** | ** ** | ** ** | **(As Restated)** | ** ** |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| NET SALES                                          |       | $                                                               | 2,434      |                                                     | $          | 2,333 |   | $ | 7,353 |   | $ | 7,879 |   |
| COST OF PRODUCT  SALES                             |       | 2,356                                                           |       | 1,674                                                    |       | 6,400 |   | 5,633 |   |
| Gross profit                                       |       | 78                                                              |       | 659                                                      |       | 953 |   | 2,246 |   |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| OPERATING  EXPENSES:                               |       |                                                            |       |                                                     |       |   |   |   |   |
| Research and development                           |       | 81                                                              |       | 44                                                       |       | 161 |   | 140 |   |
| Sales and marketing                                |       | 327                                                             |       | 347                                                      |       | 942 |   | 975 |   |
| General and administrative                         |       | 833                                                             |       | 444                                                      |       | 1,866 |   | 1,367 |   |
| Total operating expenses                           |       | 1,241                                                           |       | 835                                                      |       | 2,969 |   | 2,482 |   |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| Loss from operations                               |       | (1,163                                                          | )          | (176                                                     | )          | (2,016 | ) | (236 | ) |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                           |       |                                                            |       |                                                     |       |   |   |   |   |
| Interest income                                    |       | 12                                                              |       | 13                                                       |       | 38 |   | 36 |   |
| Interest expense                                   |       | (46                                                             | )          | (46                                                      | )          | (140 | ) | (136 | ) |
| Other income (expense), net                        |       | 7                                                               |       | (2                                                       | )          | 3 |   | (10 | ) |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| Total other expense, net                           |       | (27                                                             | )          | (35                                                      | )          | (99 | ) | (110 | ) |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| Loss before income taxes                           |       | (1,190                                                          | )          | (211                                                     | )          | (2,115 | ) | (346 | ) |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| INCOME TAX  (BENEFIT) EXPENSE                      |       | (3                                                              | )          | (1                                                       | )          | (9 | ) | 2 |   |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| NET LOSS                                           |       | $                                                               | (1,187     | )                                                        | $          | (210 | ) | $ | (2,106 | ) | $ | (348 | ) |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| NET LOSS PER  SHARE (see Note 7)                   |       |                                                            |       |                                                     |       |   |   |   |   |
| Basic                                              |       | $                                                               | (0.23      | )                                                        | $          | (0.04 | ) | (0.40 | ) | $ | (0.07 | ) |
| Diluted                                            |       | $                                                               | (0.23      | )                                                        | $          | (0.04 | ) | (0.40 | ) | $ | (0.07 | ) |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| SHARES USED IN  CALCULATION OF NET LOSS PER SHARE: |       |                                                            |       |                                                     |       |   |   |   |   |
| Basic                                              |       | 5,234                                                           |       | 5,226                                                    |       | 5,234 |   | 5,225 |   |
| Diluted                                            |       | 5,234                                                           |       | 5,226                                                    |       | 5,234 |   | 5,225 |   |
|                                               |       |                                                            |       |                                                     |       |   |   |   |   |
| COMPREHENSIVE  LOSS:                               |       |                                                            |       |                                                     |       |   |   |   |   |
| Net loss                                           |       | $                                                               | (1,187     | )                                                        | $          | (210 | ) | (2,106 | ) | $ | (348 | ) |
| Other comprehensive loss                           |       | (8                                                              | )          | (17                                                      | )          | (8 | ) | (25 | ) |
|                                               |       | $                                                               | (1,195     | )                                                        | $          | (227 | ) | $ | (2,114 | ) | $ | (373 | ) |

 

See accompanying Notes to Consolidated FinancialStatements.

5

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CYANOTECHCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited)
| ** **                                                                                 | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| ** **                                                                                 | ** ** | ** **                                         | ** ** | **(As Restated)** | ** ** |
|                                                                                       |       |                                               | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                     |       |                                               |       |   |   |
| Net loss                                                                                   |       | $                                                  | (2,106     | ) | $ | (348 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                                               |       |   |   |
| Depreciation and amortization                                                              |       | 959                                                |       | 1,019 |   |
| Provision for (reduction of) allowance for doubtful  accounts                              |       | 4                                                  |       | (5 | ) |
| Issuance of stock options in exchange for services                                         |       | —                                             |       | 14 |   |
| Amortization of debt issue costs and other assets                                          |       | 27                                                 |       | 27 |   |
| Net (increase) decrease in:                                                                |       |                                               |       |   |   |
| Accounts receivable                                                                        |       | 686                                                |       | 629 |   |
| Refundable income taxes                                                                    |       | (10                                                | )          | 46 |   |
| Inventories                                                                                |       | 259                                                |       | (536 | ) |
| Prepaid expenses and other assets                                                          |       | (81                                                | )          | (89 | ) |
| Net increase (decrease) in:                                                                |       |                                               |       |   |   |
| Accounts payable                                                                           |       | 153                                                |       | (529 | ) |
| Accrued expenses                                                                           |       | 91                                                 |       | 180 |   |
| Net cash provided by (used in) operating activities                                        |       | (18                                                | )          | 408 |   |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                     |       |                                               |       |   |   |
| Investment in equipment and leasehold improvements                                         |       | (246                                               | )          | (203 | ) |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                     |       |                                               |       |   |   |
| Proceeds from exercise of stock options and warrants                                       |       | 3                                                  |       | — |   |
| Principal payments on long-term debt                                                       |       | (268                                               | )          | (259 | ) |
| Net cash used in financing activities                                                      |       | (265                                               | )          | (259 | ) |
|                                                                                       |       |                                               |       |   |   |
| Net decrease in  cash and cash equivalents                                                 |       | (529                                               | )          | (54 | ) |
|                                                                                       |       |                                               |       |   |   |
| Cash and cash  equivalents at beginning of period                                          |       | 1,835                                              |       | 2,005 |   |
|                                                                                       |       |                                               |       |   |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                  | 1,306      |   | $ | 1,951 |   |
|                                                                                       |       |                                               |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                         |       |                                               |       |   |   |
| Cash paid during  the period for:                                                          |       |                                               |       |   |   |
| Interest                                                                                   |       | $                                                  | 118        |   | $ | 101 |   |
| Income taxes                                                                               |       | $                                                  | 1          |   | $ | 4 |   |

 

See accompanying Notes to Consolidated FinancialStatements.

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CYANOTECHCORPORATIONFORM 10-QNOTES TO CONSOLIDATED FINANCIAL STATEMENTSAs of December 31, 2006(Unaudited)

1.                                       BASIS OF PRESENTATION

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. Generally Accepted Accounting Principles (GAAP) for interim financialinformation and with the instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by GAAP for complete financialstatements.  *These consolidatedfinancial statements and notes should be read in conjunction with the Company’sconsolidated financial statements contained in the Company’s previously filedreport on Form 10-K/A for the year ended March 31, 2006*.

The Companyconsolidates enterprises in which it has a controlling financial interest. Theaccompanying consolidated financial statements include the accounts ofCyanotech Corporation and its wholly owned subsidiaries, Nutrex Hawaii, Inc.and Cyanotech Japan YK.  All significantintercompany balances and transactions have been eliminated inconsolidation.  While the financialinformation furnished for the three and nine month period ended December 31,2006 is unaudited, the statements in this report reflect all material items andadjustments which, in the opinion of management, are necessary for a fairpresentation of the results of operations for the interim periods covered andof the financial condition of the Company at the dates of the consolidatedbalance sheets. The operating results for the interim period presented are notnecessarily indicative of the results that may be expected for the year endingMarch 31, 2007.

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosures of contingent assets and liabilities at thebalance sheet date and the reported amounts of revenues and expenses during theperiod reported.  Management reviewsthese estimates and assumptions periodically and reflects the effect ofrevisions in the period that they are determined to be necessary.  Actual results could differ from thoseestimates and assumptions.

2.             REVERSE STOCK SPLIT

On September 15,2006 the Company’s Board of Directors approved a one-for-four reverse stocksplit on our outstanding common stock and a proportional decrease in the numberof common shares authorized from 30,000,000 to 7,500,000.  The reverse stock split was effective onNovember 3, 2006 at which time the share price closed at $0.43 with 20,934,565common shares outstanding.  On November6, 2006, the share price opened at $1.72 with 5,233,641 common sharesoutstanding resulting from the reverse stock split with the expectation thatmost stockholders of common stock will not exchange their shares as suchexchange is not mandatory and stockholders may keep the originally issuedshares for exchanged value.  Fractionalshares were paid with cash totaling less than $1,000.  The long term future impact of the reversestock split on the Company’s stock price is uncertain.

The reverse stocksplit decision by the Board of Directors was taken to bring the outstandingshares of common stock in line with the Company’s size and value and to bringthe price of such stock into compliance with the Nasdaq listing requirement ofat least $1.00 per share.   The Companyhad been notified by Nasdaq that it was subject to delisting for failure of thestock to trade at $1.00 per share or above. On November 20,2006, the Company received a letter from Nasdaq indicating the closing bidprice of its common stock had been at $1.00 per share or greater for at least10 consecutive business days. Accordingly, the Company regained compliance with Marketplace Rule4310(c)(4).

As the stock split occurred during the current fiscal quarter endedDecember 31, 2006, all share option data and per share data in these financialstatements and notes to the financial statements reflect the effects of thestock split as if it occurred for all periods presented.

3.       STOCK-BASED COMPENSATION

Effective April 1,2006, the Company adopted the provisions of Statement of Financial AccountingStandard No. 123(R) (“SFAS No. 123R”), “Share-Based Payment,” for itsshare-based compensation plans, which is a revision of Statement of FinancialAccounting Statement No. 123 “Accounting for Stock-Based Compensation”.   On March 29, 2005, the SEC staff issued Staff AccountingBulletin No. 107, “Share-Based Payment” (SAB No. 107), whichexpressed the SEC staff’s views on SFAS No. 123R, but did not modify anyof SFAS No. 123R’s provisions.   SFAS No. 123R requires an entity to measurethe cost of employee services received in exchange for an award.  If an award vests or becomes exercisablebased on the achievement of a condition other than service, performance ormarket condition, the award is liability-classified.   Liability-classified awards are remeasuredto fair value at each balance sheet date until the award is settled.  Equity-classified awards, including grants ofemployee stock options, are measured at the 

7

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grant-date fair value of theaward and are not subsequently remeasured. The cost of equity-classified awards is recognized in the incomestatement over the period during which an employee is required to provide theservice in exchange for the award.   Inthe Company’s case, all of the Company’s stock options are equity-classifiedawards.

Underthe 2005 Stock Option Plan (the “2005 Plan”), 200,000 shares of common stockare reserved for issuance and the plan terminates on August 21, 2015. Under the2005 Plan, eligible employees and certain independent consultants may begranted options to purchase shares of the Company’s Stock. The shares issuableunder the 2005 Plan will either be shares of the Company’s authorized butpreviously unissued common stock or shares reacquired by the Company, includingshares purchased on the open market.  Asof December 31, 2006, 195,000 options remained available for grant under the 2005Plan.   Concurrent with the 2005 Planapproval on August 22, 2005, the 1995 Stock Option Plan was terminated exceptfor the outstanding options issued thereunder.

Optionsunder the 2005 Plan are granted, and are vested and exercisable as determinedby the Board of Directors or the Stock Option and Compensation Committee of theBoard in accordance with the provisions of the 2005 Stock Option Plan. Thenumber of options granted, vesting, exercise, and other conditions are setforth in a Stock Option Agreement evidencing each grant. No option can have alife in excess of ten (10) years. All shares granted in the form of options under the 2005 Plan willreduce, on a share for share basis, the number of shares available forsubsequent grants. Option grants which forfeit under the terms of the 2005 Planwill return to the pool of reserved shares and be available for subsequentgrants under the terms of the 2005 Plan.

SFAS No. 123R offers several alternatives for implementation, amongthem the Modified Prospective Method of accounting for compensation costsrelated to “Share Based Payments” which the Company has determined toapply.  In the Company’s case, itsemployee incentive stock options are “plain vanilla” as defined by the SEC isSAB No. 107, normally vesting over a five year period and exercisable under theterms of the Company’s Stock Plan up to ten years from date of grant.  Because the Company’s future employeeincentive stock options are expected to be “plain vanilla”, they will bereflected only in Equity and Compensation Expense accounts.  The Company has determined that aBlack-Scholes-Merton model will be most reflective of the fair value of optiongrants, consistent with the provisions of SFAS No. 123R and SAB No. 107.   Key input and assumptions used to estimatethe fair value of stock options include the grant price of the award, theexpected option term, volatility of the Company’s stock, risk-free rate and theCompany’s dividend yield.   Estimates offair value are not intended to predict actual future events or the valueultimately realized by employees who receive equity awards and subsequentevents are not indicative of the reasonableness of the original estimates offair value made by the Company.

There is no unrecognizedcompensation cost related to nonvested stock options as of December 31, 2006.Currently outstanding nonvested options are options that were granted tonon-employees and the compensation cost for these options was recognized inprior years operating results.  There areno nonvested employee options because, on March 23, 2006, in response toSFAS No. 123R, the Compensation and Stock Option Committee of the Company’sBoard of Directors approved accelerating the vesting of all outstandingunvested employee incentive stock options under the provisions of APB OpinionNo. 25, and related interpretations. Options held by non-employees and directors were not included in thevesting acceleration.  The decision toaccelerate vesting of all outstanding unvested employee incentive stock optionswas made to avoid recognizing, pursuant to the Company’s April 1, 2006adoption of SFAS No. 123R, the non-cash compensation cost related tounvested employee incentive stock options. It is estimated that the total future compensation expense that wasavoided by accelerating vesting was $78,000, before tax, based upon the March23, 2006 acceleration date.  A portion ofthis amount would have impacted the three and nine months ended December 31,2006 had the acceleration not occurred. No options weregranted by the Company during the nine month period ending December 31,2006.  Had any options been granted,related compensation expense under the provisions of SFAS No. 123R wouldhave been reflected in the Consolidated Statements of Operations.

The Independent DirectorStock Option and Stock Grant Plan (the “2004 Plan”) has 75,000 shares of commonstock are reserved for issuance.  Underthe 2004 Plan, upon election to the Board of Directors, a newly electednon-employee director is granted a ten-year option to purchase 1,000 shares ofthe Company’s common stock at a fair market value on the date of grant.  All such options are granted at fair marketvalue on the date of grant.  Optionsgranted vest and become exercisable six months from the date of grant.  In addition, on the date of each AnnualMeeting of Stockholders, each non-employee director continuing in office isautomatically granted, without payment, 875 shares of common stock,non-transferable for six months following the date of grant.  As of December 31, 2006, 69,500 optionsremained available for grant under the 2004 Plan.  Concurrent with the 2004 Plan approval onAugust 16, 2004, the 1994 Non-Employee Director Stock Option and Stock GrantPlan was terminated except for the outstanding options issued thereunder.

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The followingtable summarizes the weighted average characteristics of outstanding stockoptions as of December 31, 2006 for various exercise price ranges:
| ** **                                  | ** ** | **Outstanding Options** | ** ** | **Exercisable Options** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **Number of**           | ** ** | **Remaining**                | ** ** | **Weighted** | ** ** | **Number of** | ** ** | **Weighted** | ** ** |
| **Range of Exercise Prices** | ** ** | **Shares**                   | ** ** | **Life (Years)**        | ** ** | **Average Price** | ** ** | **Shares** | ** ** | **Average Price** | ** ** |
| $1.84-$3.08                                 |       | 50,944                       |       | 1.7                          |       | $ | 2.18 |   | 50,757 |   | $ | 2.18 |   |
| $3.88-$6.75                                 |       | 26,978                       |       | 2.8                          |       | 4.51 |   | 25,978 |   | 4.52 |   |
| $14.75-$24.50                               |       | 7,000                        |       | 1.2                          |       | 15.80 |   | 7,000 |   | 15.80 |   |
| Total stock options at  December 31, 2006   |       | 84,922                       |       |                         |       | 4.04 |   | 83,735 |   | 4.05 |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |

 

A summary of option activity under Cyanotech Corporation Stock Plans forthe quarter ended December 31, 2006 is presented below:
| **Option Activity**           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------|------------|------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  September 30, 2006 |       | 94,037     |       | $                                          | 3.94       |                                                    | 2.1 years  |                            |       |   |
| Granted                            |       | —     |       | —                                     |       |                                                    |       |                            |       |
| Exercised                          |       | —     |       | —                                     |       |                                                    |       |                            |       |
| Forfeited or  expired              |       | (9,115     | )          | $                                          | 3.01       |                                                    |       |                            |       |   |
| Outstanding at  December 31, 2006  |       | 84,922     |       | $                                          | 4.04       |                                                    | 2.0 years  |                            | $          | 343,085 |   |
| Exercisable at December  31, 2006  |       | 83,735     |       | $                                          | 4.05       |                                                    | 2.0 years  |                            | $          | 339,127 |   |

 

A summary of Cyanotech Corporation’s non-vested options for the quarterended December 31, 2006 is presented below:
| **Nonvested Options**       | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------------------------------|------------|
| Nonvested at  September 30, 2006 |       | 1,936      |       | $                                                  | 3.85       |   |
| Granted                          |       | —     |       | —                                             |       |
| Vested                           |       | —     |       | —                                             |       |
| Forfeited or  expired            |       | (749       | )          | $                                                  | 3.61       |   |
| Nonvested at December  31, 2006  |       | 1,187      |       | $                                                  | 4.00       |   |

 

A summary of option activity under Cyanotech Corporation Stock Plans forthe nine months ended December 31, 2006 is presented below:
| **Option Activity**          | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------|------------|------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at March  31, 2006    |       | 117,230    |       | $                                          | 3.91       |                                                    | 2.3 years  |                            |       |   |
| Granted                           |       | —     |       | —                                     |       |                                                    |       |                            |       |
| Exercised                         |       | (1,575     | )          | $                                          | 2.15       |                                                    |       |                            |       |   |
| Forfeited or expired              |       | (30,733    | )          | $                                          | 3.61       |                                                    |       |                            |       |   |
| Outstanding at December  31, 2006 |       | 84,922     |       | $                                          | 4.04       |                                                    | 2.0 years  |                            | $          | 343,085 |   |
| Exercisable at  December 31, 2006 |       | 83,735     |       | $                                          | 4.05       |                                                    | 2.0 years  |                            | $          | 339,125 |   |

 

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A summary of Cyanotech Corporation’s non-vested options for the ninemonths ended December 31, 2006 is presented below:
| **Nonvested Options**      | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|---------------------------------|------------|------------|------------|----------------------------------------------------|------------|
| Nonvested at March 31,  2006    |       | 2,953      |       | $                                                  | 3.98       |   |
| Granted                         |       | —     |       | —                                             |       |
| Vested                          |       | —     |       | —                                             |       |
| Forfeited or expired            |       | (1,766     | )          | $                                                  | 3.96       |   |
| Nonvested at  December 31, 2006 |       | 1,187      |       | $                                                  | 4.00       |   |

 

Prior to April 1,2006, as allowed by Statement of Financial Accounting Standards No. 123 (“SFASNo. 123”), Accounting for Stock-BasedCompensation*,*the Companyelected to apply the intrinsic value-based method of accounting for employeebased stock options and adopted only the disclosure requirements of SFAS No.123. The following table illustrates the effect on net loss and net loss percommon share as if the Company had applied the fair-value method under SFAS No.123 to its employee stock options for the three and nine month comparableperiods ended December 31, 2005:
| ** **                                                 | ** ** | **Three Months  Ended   December 31,** | ** ** | **Nine Months  Ended   December 31,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                                              | ** ** | **2005**                                             | ** ** |
| ** **                                                 | ** ** | **(As Restated)**                                | ** ** | **(As Restated)**                               | ** ** |
|                                                       |       |                                                  |       |                                                 |       |
| Net loss, as  reported                                     |       | $                                                     | (210       | )                                                    | $          | (348 | ) |
| Deduct  stock-based employee compensation                  |       |                                                  |       |                                                 |       |
| Expense determined under fair-value method for all  awards |       | (5                                                    | )          | (44                                                  | )          |
| Pro-forma net  loss                                        |       | $                                                     | (215       | )                                                    | $          | (392 | ) |
| Basic net loss  per common share:                          |       |                                                  |       |                                                 |       |
| As reported                                                |       | $                                                     | (0.04      | )                                                    | $          | (0.07 | ) |
| Pro-forma                                                  |       | $                                                     | (0.04      | )                                                    | $          | (0.08 | ) |
|                                                       |       |                                                  |       |                                                 |       |
| Diluted net loss  per common share:                        |       |                                                  |       |                                                 |       |
| As reported                                                |       | $                                                     | (0.04      | )                                                    | $          | (0.07 | ) |
| Pro-forma                                                  |       | $                                                     | (0.04      | )                                                    | $          | (0.08 | ) |

 

Options wereexercised during the nine month period ending December 31, 2006. The intrinsicvalue of options exercised during the nine months ended December 31, 2006 was$1,000.  The amount of cash received fromoption exercises during the nine months ended December 31, 2006 was $3,000.  Because qualified employee incentive optionswere exercised and the Company has significant operating loss carry forwards,there were no tax consequences as a result of option exercises during the ninemonths ended December 31, 2006.

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4.       INVENTORIES

Inventories are stated atthe lower of cost (which approximates first-in, first-out) or market. Market isdefined as sales price less cost to dispose and a normal profit margin.  Inventories consist of the following (dollarsin thousands):
| ** **      | ** ** | **December 31, 2006** | ** ** | **March 31, 2006** | ** ** |
|-----------------|------------|---------------------------------|------------|------------------------------|------------|
|                 | ** ** | ** **                      | ** ** | **(As Restated)**       | ** ** |
| Raw materials   |       | $                               | 230        |                         | $          | 240 |   |
| Work in process |       | 281                             |       | 260                          |       |
| Finished goods  |       | 1,142                           |       | 1,432                        |       |
| Supplies        |       | 144                             |       | 124                          |       |
|            |       | $                               | 1,797      |                         | $          | 2,056 |   |

 

5.       EQUIPMENT AND LEASEHOLD IMPROVEMENTS

Equipment and leasehold improvements are stated atcost. Depreciation and amortization are provided using the straight-line methodover the estimated useful lives for equipment and furniture and fixtures, orthe shorter of the land lease term or estimated useful lives for leaseholdimprovements as follows:

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

 

Equipment and leasehold improvements consist of thefollowing (dollars in thousands):
| ** **                                      | ** ** | **December 31, 2006** | ** ** | **March 31, 2006** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
|                                                 | ** ** | ** **                      | ** ** | **(As Restated)**       | ** ** |
| Equipment                                       |       | $                               | 10,700     |                         | $          | 10,461 |   |
| Leasehold  improvements                         |       | 14,666                          |       | 14,642                       |       |
| Furniture and  fixtures                         |       | 86                              |       | 86                           |       |
|                                            |       | 25,452                          |       | 25,189                       |       |
| Less accumulated  depreciation and amortization |       | (16,286                         | )          | (15,327                      | )          |
| Construction  in-progress                       |       | 285                             |       | 302                          |       |
| Equipment and leasehold  improvements, net      |       | $                               | 9,451      |                         | $          | 10,164 |   |

 

6.                                       TERMLOAN AGREEMENT COVENANTS WAIVER

The Company’slong-term debt consists of a Term Loan Agreement (“Term Loan”) with a lenderproviding for $3.5 million in aggregate credit facilities, secured by theCompany’s assets.   The Term Loancontains restrictive covenants.   TheCompany obtained a waiver of the debt covenants that may not be in complianceas a result of the restatement of previously issued financial statements and asrelated to the untimely submission of its quarterly financial statements forthe first quarter ended June, 30, 2006 , and the second quarter ended September30, 2006 (see Note 9) and has also obtained a separate waiver of the debtcovenants that may not be in compliance as a result of the untimely submissionof its quarterly financial statements for the third quarter ended December 31,2006.

7.       EARNINGS PER SHARE

Basic earnings per share is computed on the basis ofthe weighted average number of common 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.

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Reconciliations between the numerator and thedenominator of the basic and diluted earnings per share computations for thethree months ended December 31, 2006 and 2005 are as follows (in thousands,except per share amounts):
| ** **                                                                    | ** ** | **Three Months Ended December 31, 2006** | ** ** | **Three Months Ended December 31, 2005  (As Restated)** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **Net Loss**                                                 | ** ** | **Shares**                                                                            | ** ** | **Per Share** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                    | ** ** | **(Numerator)**                                                   | ** ** | **(Denominator)**                                                                     | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic net loss  per share                                                     |       | $                                                                 | (1,187     | )                                                                                     | 5,234      |   | $ | (0.23 | ) | $ | (210 | ) | 5,226 |   | $ | (0.04 | ) |
| Effect of  dilutive securities —  Common stock options and warrants |       | —                                                            |       | —                                                                                |       |   |   | — |   | — |   |   |   |
| Diluted net loss per  share                                                   |       | $                                                                 | (1,187     | )                                                                                     | 5,234      |   | $ | (0.23 | ) | $ | (210 | ) | 5,226 |   | $ | (0.04 | ) |

 

Reconciliationsbetween the numerator and the denominator of the basic and diluted earnings pershare computations for the nine months ended December 31, 2006 and 2005 are asfollows (in thousands, except per share amounts):
| ** **                                                                    | ** ** | **Nine Months Ended December 31, 2006** | ** ** | **Nine Months Ended December 31, 2005  (As Restated)** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **Net Loss**                                                | ** ** | **Shares**                                                                           | ** ** | **Per Share** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                    | ** ** | **(Numerator)**                                                  | ** ** | **(Denominator)**                                                                    | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic net loss  per share                                                     |       | $                                                                | (2,106     | )                                                                                    | 5,234      |   | $ | (0.40 | ) | $ | (348 | ) | 5,225 |   | $ | (0.07 | ) |
| Effect of  dilutive securities —  Common stock options and warrants |       | —                                                           |       | —                                                                               |       |   |   | — |   | — |   |   |   |
| Diluted net loss per  share                                                   |       | $                                                                | (2,106     | )                                                                                    | 5,234      |   | $ | (0.40 | ) | $ | (348 | ) | 5,225 |   | $ | (0.07 | ) |

 

Thefollowing securities were excluded from the calculation of diluted earnings pershare because their effect was antidilutive (in thousands):
| ** **                  | ** ** | **Three Months Ended   December 31,** | ** ** | **Nine Months Ended   December 31,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                  | ** ** | **2005**                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Stock options  and warrants |       | 89                                                        |       | 128                                                      |       | 89 |   | 128 |   |

 

8.                                       NEW ACCOUNTING PRONOUNCEMENTS

In November 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 151 (“SFAS No. 151”) “Inventory Costs — an Amendmentof Accounting Research Bulletin No. 43, Chapter 4”.  SFAS No. 151 requires that abnormal amountsof freight, handling costs and wasted material (spoilage) be recognized ascurrent-period charges and fixed production overhead costs be allocated toinventory based on the normal capacity of production facilities.  Normal capacity is defined as “the productionexpected to be achieved over a number of periods or seasons under normalcircumstances, taking into account the loss of capacity resulting from plannedmaintenance”.  Companies will no longerbe permitted to capitalize inventory costs on the balance sheet when theproduction defect rate varies significantly from the expected defect rate.  The Company adopted SFAS No. 151 effectiveApril 1, 2006. In accordance with SFAS No. 151 fixed production related costsof $181,000 or $0.03 per diluted share were not inventoried for the threemonths ended December 31, 2006, and fixed production related costs of $275,000or $0.05 per diluted share were not inventoried for the nine months endedDecember 31, 2006. The costs were not inventoried due to production belownormal capacity.

In December 2004, the FASBissued SFAS No. 153, “Exchange of Nonmonetary Assets, an amendment of APBOpinion No. 29, “Accounting for Nonmonetary Transactions”.  SFAS No. 153is based on the principle that exchange of nonmonetary assets should bemeasured based on the fair market value of the assets exchanged.  SFAS No.153 eliminates the exception of nonmonetary exchanges of similar productiveassets and replaces it with a general exception for exchanges of nonmonetaryassets that do not have commercial substance.  SFAS No. 153 is effectivefor nonmonetary asset exchanges in fiscal periods beginning after June 15,2005.  The Company adopted SFAS No. 153 effective April 1, 2006.  Adoption of the provisions of SFAS No. 153had no material impact on the Company’s financial condition, results ofoperations, or liquidity.

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections, a replacementof APB Opinion No. 20 and FASB Statement No. 3”.  SFAS No. 154 requires retrospectiveapplication for voluntary changes in accounting principle unless it 

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is impracticable to doso.  In addition, indirect effects of achange in accounting principle should be recognized in the period of theaccounting change.  The Company adoptedSFAS No. 154 effective April 1, 2006. Because the impact of adopting the provisions of SFAS No. 154 will bedependent on future events or circumstances, management cannot predict suchimpact.

In June 2006, the FASBissued FASB Interpretation No. 48 (“FIN No. 48”), “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109”.  This interpretation prescribes a “more-likely-than-not”recognition threshold and measurement attribute (the largest amount of benefitthat is greater than 50% likely of being realized upon ultimate settlement withtax authorities) for the financial statement recognition and measurement of atax position taken or expected to be taken in a tax return.  This interpretation also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN No. 48 is effective for fiscalyears beginning after December 15, 2006. The Company will adopt FIN No. 48 on April 1, 2007 and has notyet determined the impact of these provisions on the Company’s results ofoperations, financial condition or liquidity.

InJune 2006, the FASB ratified the consensus on Emerging Issues Task Force IssueNo. 06-3 (“EITF No. 06-3”), “How Taxes Collected from Customers andRemitted to Governmental Authorities Should Be Presented in the IncomeStatement”.  The scope of EITF No.06-3 includes any tax assessed by a governmental authority that is directlyimposed on a revenue-producing transaction between a seller and a customer andmay include, but is not limited to, sales, use, value added, Universal ServiceFund (USF) contributions and some excise taxes.  The Task Force affirmed its conclusion thatentities should present these taxes in the income statement on either a grossor a net basis based on their accounting policy, which should be disclosedpursuant to APB Opinion No. 22, “Disclosure of Accounting Policies.”  If such taxes are significant and arepresented on a gross basis, the amounts of those taxes should bedisclosed.  The consensus onEITF No. 06-3 will be effective for interim and annual reporting periodsbeginning after December 15, 2006. The Company adopted EITF No. 06-3 on January 1, 2007 and has elected topresent these taxes on a gross basis consistent with its accounting policy andhistorical treatment.   For futureperiods after January 1, 2007, if material, the Company will disclose suchtaxes.

On September 13,2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB No. 108”), “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements ofCurrent Year Financial Statements” which expresses the SEC’s views regardingthe process of quantifying financial statement misstatements.  SAB No. 108 provides guidance on the considerationof the effects of prior year misstatements (misstatements that were notcorrected at the end of the prior year) in quantifying current yearmisstatements for the purpose of a materiality assessment.  Common practice in quantifying a misstatementallows for multiple approaches.   Amisstatement can be based on the amount of the error originating in the currentyear income statement or be based on the effects of correcting the misstatementexisting in the balance sheet at the end of the current year, irrespective ofthe misstatement’s year(s) of origination. Therefore, in quantifying the impact of correcting all misstatements,including both the carryover and reversing effects of prior year misstatements,on the current year financial statements, errors should be measured under eachapproach and evaluated for materiality. An adjustment would be required when either approach results inquantifying a misstatement that is material, as defined in FASB Concepts StatementNo. 2, after considering all relevant quantitative and qualitativefactors.  SAB No. 108 is effective forfiscal years ended after November 15, 2006. Because the impact of adopting the provisions of SAB No. 108 will bedependent on future events or circumstances, management cannot predict suchimpact.

On September 15,2006, the FASB issued SFAS No. 157, FairValue Measurement**(“SFAS157”).  SFAS 157 defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements.  SFAS 157 is effectivefor financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  The Company is evaluating the impact ofadopting SFAS 157 on the Company’s consolidated financial position, results ofoperations and cash flows.

InSeptember 2006 the Financial Accounting Standards Board Issued: Statement No.158, Employers’ Accounting for Defined Benefit Pension and Other PostretirementPlans—an amendment of FASB Statements No. 87, 88, 106, and 132(R). An employerwith publicly traded equity securities is required to initially recognize thefunded status of a defined benefit postretirement plan and to provide therequired disclosures as of the end of the fiscal year ending after December 15,2006. The Company does not maintain any Defined Benefit Pension and OtherPostretirement Plans, and Statement No. 158 is currently not applicable.

In February 2007the Financial Accounting Standards Board issued SFAS No. 159 “The Fair ValueOption for Financial Assets and Financial Liabilities—Including an amendment ofFASB Statement No. 115.” The Statement permits entities to choose to measuremany financial instruments and certain other items at fair value. The objectiveis to improve financial reporting by providing entities with the opportunity tomitigate volatility in reported earnings caused by measuring related assets andliabilities differently without having to apply complex hedge accountingprovisions. The Statement is expected to expand the use of fair valuemeasurement, which is consistent with the Board’s long-term measurementobjectives for accounting for financial instruments. The Statement is effective

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as of thebeginning of an entity’s first fiscal year that begins after November 15, 2007.Early adoption is permitted as of the beginning of a fiscal year that begins onor before November 15, 2007, provided the entity also elects to apply theprovisions of FASB Statement No. 157, Fair Value Measurements. Since CyanotechCorporation is not subject to volatility in its financial instruments, whichconsist only of long term mortgage debt and bank issued certificate ofdeposits, the Statement is not currently applicable to the Company.

9.             RESTATEMENT OFPREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS; LISTING STATUS

On December 1, 2006, Cyanotech Corporationfiled a Current Report on Form 8-K with the SEC announcing that based on thecurrent findings of its previously announced accounting review, it haddetermined to restate certain of its previously issued financialstatements.   Since that time, wecompleted our accounting review and determined that certain of the errorsresulted from deficiencies in our internal control over financial reporting.  See Part I. Item 4 Controls and Procedures inthis Form 10-Q and Item 9A Controls and Procedures in Form 10-K/A filedFebruary 14, 2007.   Due to the inventoryvaluation issues involved and the time and effort required for completion ofthe restatement reflected in the Form 10-K/A, the Company was delinquent in thefiling of its Form 10-Q for the periods ended June 30 and September 30, 2006.

On December 18, 2006, the Company received a Determination Letter (the “Letter”)from the Nasdaq Listing Qualifications Hearings Panel (the “Panel”).  In its letter, the Panel granted, subject tocertain conditions, the Company’s request for continued listing on the NasdaqStock Market.   The Panel determined thatthe Company would have until February 20, 2007 to file its Form 10-Q for thequarter ended June 30, 2006, its Form 10-Q for the quarter ended September 30,2006, and its Form 10-K/A restatement. The Company filed its Form 10-K/A onFebruary 14, 2007, and filed its Forms 10-Q for the periods ended June 30 andSeptember 30, 2006 on February 20, 2007. The Company filed an appeal on February 20, 2007 with the NasdaqListing and Review Council of the Panel’s determination requesting a stay ofthe delisting of its common stock until February 28, 2007. However, afterfiling of the Forms 10-Q, Nasdaq notified the Company that it had satisfied theconditions of the December 18, 2007 Panel Determination. Subsequently,Cyanotech Corporationreceived notice on February21, 2007 from The NASDAQ Stock Market that the Company is not in Compliancewith Nasdaq Marketplace Rule 4310(c)(14 for failure to file its Form 10-Q forthe period ended December 31, 2006 and that such failure is basis for delistingthe Company’s Common Stock from The Nasdaq Stock Market.  The Company was granted until February 28,2007 to present its views to the Nasdaq Listing Qualifications Panel withrespect to the failure to file such Form 10-Q. In its response the Company indicated that it expected to file the Form10-Q report on or before March 14, 2007 and requested continued listing.  On February 28, 2007, based on its responseand request for continued listing submitted by the Company to Nasdaq, theCompany received notice that the Nasdaq Listing Qualifications Panel hasdetermined to grant the Company’s request for continued listing subjectprimarily to the Company’s filing on or before March 14, 2007 its Form 10-Q forthe period ended December 31, 2006. In addition, the Company must be able todemonstrate compliance with all requirements for continued listing. As of thetime of filing this report, the Company believes it meets all of therequirements for continued listing stated in the Listing Qualifications Paneldetermination of February 28, 2007. However, if the Company is incorrect in itsbelief, and the Company’s common stock is delisted, our stockholders could bematerially and adversely affected by having less active and efficient marketavailable for the trading of their stock.

The Company’s Form 10-K/A for the fiscalyears ended March 31, 2006 and 2005 amended and restated the:

(1)             consolidated balance sheets as of March 31,2006 and 2005;

(2)             consolidated statements of operations,stockholder’s equity and comprehensive income (loss) and cash flows for each ofthe years in the three year period ended March 31, 2006;

(3)             accumulated deficit as of March 31, 2003;

(4)             selected financial data for the years endedMarch 31, 2006, 2005, 2004, 2003 and 2002; and

(5)             certain financial data for the quarterlyperiods ended March 31, 2006, and December 31, September 30, June 30, and March31, 2005 and December 31, September 30, and June 30, 2004.

The errors or adjustments identified in our previously issuedconsolidated financial statements are as follows:

(A)         *We failed to include as acomponent of inventory cost certain fixed production costs such as depreciation,general insurance and minor compensation cost into inventory. *Inventories for March 31, 2006, 2005, 2004 and 2003, and quarterlyperiods within the years 2006 and 2005, were restated as were cost of sales andcertain operating expenses as included in the Consolidated Statements ofOperations for each of the years in the three year period ended March 31,2006.   This restatement was a result ofthe discovery of the error subsequent to the filing with the SEC of the OriginalForm 10-K as filed with the SEC.  Allinventories, cost of sales and operating expense balances, as presented in thisForm 10-Q, properly reflect the inventory which includes these fixed productioncosts in accordance with Accounting Research Bulletin No. 43.

(B)           We recorded certain Hawaii State Tax Creditadjustments which were considered immaterial in prior years.  Refundable income taxes were restated for theyear ended March 31, 2005.  Income taxexpense (benefit) was restated for each of the years in the three year periodended March 31, 2006 but had no impact on net loss for the three and ninemonths ended December 31, 2006 and 2005.

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(C)           We recorded certain interest incomeadjustments which were considered immaterial in prior years.  These impacted the years ended March 31, 2004and 2003 but had no impact on the three and nine months ended December 31, 2006and 2005.

(D)          We reclassified certain certificates ofdeposit from cash to short-term investments in fiscal years 2005 and 2004.  These reclassifications had no effect onreported net income (loss) or in cash flows from operations for the years endedMarch 31, 2005 and 2004.   Cash flowsfrom operations for the three and nine months ended December 31, 2005 wererestated.

(E)            We recorded certain tax adjustments whichwere considered immaterial to reports filed in prior periods.   These adjustments impacted the years endedMarch 31, 2005, 2004 and 2003.   Cashflows from operations for the three and nine months ended December 31, 2005were restated.

Quarterly data has been derived from our unauditedconsolidated financial statements that, in our opinion, reflect all recurringadjustments necessary to fairly present our financial information when read inconjunction with our Consolidated Financial Statements and Notes.  This quarterly information has been restatedfor, and as of the end of, all quarters of fiscal 2006 and all quarters offiscal 2005 from previously reported information filed on Forms 10-Q and Forms10-K, as a result of the restatement of our financial results as discussedabove.  The results of operations for anyquarter are not necessarily indicative of the results to be expected for anyfuture period.

The following tables set forth the amounts previouslyreported in the Company’s consolidated statements of operations for the threemonth period ended December 31, 2005 and the nine month period ended December31, 2005 and the effect of the restatement adjustments, and the restatedamounts.

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| ** **                                                         | ** ** | **Consolidated Statement of Operations** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands, except per share data)** | ** ** | **Three Months  Ended  December 31,  2005**   | ** ** | **Adjustments** | ** ** | **Three Months  Ended  December 31,  2005** | ** ** |
| ** **                                                         | ** ** | **(As reported)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Net sales                                                          |       | $                                                       | 2,333      |   | $ | — |   | $ | 2,333 |   |
| Cost of sales  (A)                                                 |       | 1,712                                                   |       | (38 | ) | 1,674 |   |
| Gross profit                                                       |       | 621                                                     |       | 38 |   | 659 |   |
| Operating  expenses:                                               |       |                                                    |       |   |   |   |   |
| Research and development (A)                                       |       | 45                                                      |       | (1 | ) | 44 |   |
| Sales and marketing (A)                                            |       | 351                                                     |       | (4 | ) | 347 |   |
| General and administrative (A)                                     |       | 461                                                     |       | (17 | ) | 444 |   |
| Total operating expense                                            |       | 857                                                     |       | (22 | ) | 835 |   |
| Income (loss) from operations                                      |       | (236                                                    | )          | 60 |   | (176 | ) |
| Other income  (expense):                                           |       |                                                    |       |   |   |   |   |
| Interest income                                                    |       | 13                                                      |       | — |   | 13 |   |
| Interest expense                                                   |       | (46                                                     | )          | — |   | (46 | ) |
| Other income, net                                                  |       | (2                                                      | )          | — |   | (2 | ) |
| Total other expense, net                                           |       | (35                                                     | )          |   |   | (35 | ) |
| Income (loss) before income taxes                                  |       | (271                                                    | )          | 60 |   | (211 | ) |
| Income tax expense (benefit) (B, E)                                |       | 23                                                      |       | (24 | ) | (1 | ) |
| Net income (loss)                                                  |       | $                                                       | (294       | ) | $ | 84 |   | $ | (210 | ) |
| Net income  (loss) per share:                                      |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | $                                                       | (0.06      | ) | $ | 0.02 |   | $ | (0.04 | ) |
| Diluted                                                            |       | $                                                       | (0.06      | ) | $ | 0.02 |   | $ | (0.04 | ) |
| Shares used in  calculation of net income (loss) per share:        |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | 5,226                                                   |       | — |   | 5,226 |   |
| Diluted                                                            |       | 5,226                                                   |       | — |   | 5,226 |   |

 

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| ** **                                                         | ** ** | **Consolidated Statement of Operations** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands, except per share data)** | ** ** | **Nine Months  Ended  December 31,  2005**    | ** ** | **Adjustments** | ** ** | **Nine Months  Ended  December 31,  2005** | ** ** |
| ** **                                                         | ** ** | **(As reported)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Net sales                                                          |       | $                                                       | 7,879      |   | $ | — |   | $ | 7,879 |   |
| Cost of sales  (A)                                                 |       | 5,652                                                   |       | (19 | ) | 5,633 |   |
| Gross profit                                                       |       | 2,227                                                   |       | 19 |   | 2,246 |   |
| Operating  expenses:                                               |       |                                                    |       |   |   |   |   |
| Research and development (A)                                       |       | 144                                                     |       | (4 | ) | 140 |   |
| Sales and marketing (A)                                            |       | 988                                                     |       | (13 | ) | 975 |   |
| General and administrative (A)                                     |       | 1,421                                                   |       | (54 | ) | 1,367 |   |
| Total operating expense                                            |       | 2,553                                                   |       | (71 | ) | 2,482 |   |
| Income (loss) from operations                                      |       | (326                                                    | )          | 90 |   | (236 | ) |
| Other income  (expense):                                           |       |                                                    |       |   |   |   |   |
| Interest income                                                    |       | 36                                                      |       | — |   | 36 |   |
| Interest expense                                                   |       | (136                                                    | )          | — |   | (136 | ) |
| Other income, net                                                  |       | (10                                                     | )          | — |   | (10 | ) |
| Total other expense, net                                           |       | (110                                                    | )          | — |   | (110 | ) |
| Income (loss) before income taxes                                  |       | (436                                                    | )          | 90 |   | (346 | ) |
| Income tax expense (benefit) (B, E)                                |       | 26                                                      |       | (24 | ) | 2 |   |
| Net income (loss)                                                  |       | $                                                       | (462       | ) | $ | 114 |   | $ | (348 | ) |
| Net income  (loss) per share:                                      |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | $                                                       | (0.09      | ) | $ | 0.02 |   | $ | (0.07 | ) |
| Diluted                                                            |       | $                                                       | (0.09      | ) | $ | 0.02 |   | $ | (0.07 | ) |
| Shares used in  calculation of net income (loss) per share:        |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | 5,225                                                   |       | — |   | 5,225 |   |
| Diluted                                                            |       | 5,225                                                   |       | — |   | 5,225 |   |

 

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**CYANOTECHCORPORATION**

**Item 2.****          ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

*Thisreport on Form 10-Q contains forward-looking statements regarding the futureperformance of Cyanotech and future events that involve risks and uncertaintiesthat could cause actual results to differ materially from the statementscontained herein. This document, and the other documents that the Company filesfrom time to time with the Securities and Exchange Commission, such as its reports— except those of which have been designated as no longer to be relied upon — onForm 10-K/A, Form 10-K, Form 10-Q, Form 8-K, and its proxy materials, containadditional important factors that could cause actual results to differ from theCompany’s current expectations and the forward-looking statements containedherein.*

***Restatement of Previously Issued Consolidated FinancialStatements***

*On December 1, 2006, the Company filed a CurrentReport on Form 8-K****with the SECin which it announced that based on current findings of its previouslyannounced accounting review it had determined to restate certain of itspreviously issued financial statements. Since that time, the Company completed its accounting review and has determinedthat certain of the errors resulted from deficiencies in internal control overfinancial reporting.  See Item 9A.Controls and Procedures in the Company’s Form 10-K/A filed on February 14,2007. The Company did not file Form 10-K/A, for the fiscal years 2005 or 2004,or Form 10-Q/A, for the interim periods affected by the restatement prior toand including December 31, 2005, and such consolidated financial statements andrelated financial information, as previously filed, contain errors and shouldtherefore no longer be relied upon. The related audit reports of KPMG LLP, theCompany’s independent registered public accounting firm, with respect to thosefinancial statements should also no longer be relied upon. Prior periodcomparative information contained in this form 10-Q has been restatedconsistent with the Company’s Form 10-K/A and to reflect the Company’sone-for-four reverse stock split as discussed under Item 1A “Risk Factors” subheading “*Market Price for Our Common Stock...”*of the Form 10-K/A..*

**Overview**

Comparisons of selected consolidatedstatements of operations data as reported herein follow for the periodsindicated (dollars in thousands):
| ** **                   | ** ** | **Three Months Ended  December 31, 2006** | ** ** | **Three Months Ended  December 31, 2005** | ** ** | **Change** | ** ** |
|------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|------------|------------|
| ** **                   | ** ** | ** **                                                    | ** ** | **(As Restated)**                                        | ** ** | ** ** | ** ** |
| Net sales:                   |       |                                                          |       |                                                          |       |       |       |
| Spirulina products           |       | $                                                             | 1,475      |                                                          | $          | 1,307      |       | 13 | % |
| Natural astaxanthin products |       | 950                                                           |       | 994                                                           |       | (4         | )%         |
| Other products               |       | 9                                                             |       | 32                                                            |       | (72        | )%         |
| Total sales, all  products   |       | $                                                             | 2,434      |                                                          | $          | 2,333      |       | 4 | % |
|                         |       |                                                          |       |                                                          |       |       |       |
| Gross profit                 |       | $                                                             | 78         |                                                          | $          | 659        |       | (88 | )% |
| Loss from  operations        |       | $                                                             | (1,163     | )                                                             | $          | (176       | )          | 561 | % |
| Net loss                     |       | $                                                             | (1,187     | )                                                             | $          | (210       | )          | 465 | % |
|                         |       |                                                          |       |                                                          |       |       |       |
| Net sales:                   |       |                                                          |       |                                                          |       |       |       |
| Spirulina products           |       | $                                                             | 4,437      |                                                          | $          | 4,512      |       | (2 | )% |
| Natural astaxanthin products |       | 2,840                                                         |       | 3,193                                                         |       | (11        | )%         |
| Other products               |       | 76                                                            |       | 174                                                           |       | (56        | )%         |
| Total sales, all  products   |       | $                                                             | 7,353      |                                                          | $          | 7,879      |       | (7 | )% |
|                         |       |                                                          |       |                                                          |       |       |       |
| Gross profit                 |       | $                                                             | 953        |                                                          | $          | 2,246      |       | (58 | )% |
| Loss from  operations        |       | $                                                             | (2,016     | )                                                             | $          | (236       | )          | 754 | % |
| Net loss                     |       | $                                                             | (2,106     | )                                                             | $          | (348       | )          | 505 | % |

 

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Sales for thethree and nine months ended December 31, 2006 increased $101,000 or 4% anddecreased $526,000 or 7% from the comparable three and nine month periods ofthe prior year, respectively.  For thethree month period, Spirulina sales increased 13% above the comparable prioryear period due to increased unit sales of bulk products to larger customers.Natural astaxanthin sales decreased 4% from the comparable prior year periodwith increased packaged product unit sales offset by decreased astaxanthinprices resulting from volume discounts and competitive pricing requirements.

For the nine monthperiod ended December 31, 2006, natural astaxanthin sales decreased $353,000 or11% and Spirulina sales decreased $75,000 or 2% from the comparable nine monthprior year period. The decrease in natural astaxanthin sales for the nine monthperiod was primarily due to decreased bulk product, including NatuRose, unitsales, and decreased average bulk selling prices.  Both of these overshadowed increased packagedastaxanthin and spirulina unit sales and prices.

For the three andnine months ended December 31, 2006, the Company’s cost of sales increased$682,000 or 41% and $767,000 or 14%, with respect to the prior comparableperiods, Total cost of sales for the three and nine months ended December 31,2006 was 97% and 87% of net sales, compared to 72% and 71%, with respect to theprior comparable periods. Correspondingly, for the three and nine month periodsended December 31, 2006 gross profit decreased to 3% and 13% from 28% and 29%in the comparable prior year periods.

The cost of salesincrease for the three months ended December 31, 2006, relative to the priorcomparable period, was primarily due to labor and chemical costs, some of whichwere deemed to be period costs resulting from an abnormal usage of nutrientswhich, coupled with other efforts, were not effective in correcting an imbalancein the multiple factors affecting the Company’s biological cultivationprocess.  Comparable period labor costsincreased due to hourly wage rate increases in the first quarter of the year,and also due to the additional effort required in light of the just mentionedimbalance.  The imbalance also requiredthe Company to incur additional utility costs relative to the level of productproduced. In general, the forgoing elements combined to significantly increasethe cost of sales, and correspondingly reduce gross profit for the three monthsended December 31, 2006 relative to the prior comparable period. The cost ofsales increase for the nine months ended December 31, 2006 relative to theprior comparable nine months was mainly due to the aforementioned factors, withimbalance in the cultivation process, and attendant additional efforts andcosts, more of a factor in the third quarter. The impact of the imbalance isdiscussed, in part, below, and in more detail later in this *Overview.*

During the threeand nine months ended December 31, 2006, as part of cost of sales, the Companyrecorded non inventoriable costs of approximately $513,000 and $1,276,000respectively. Comparable non-inventoriable costs recognized in the three andnine months ended December 31, 2005 were $193,000 and 471,000, respectively,with non-inventoriable costs increasing $320,000 and $805,000 for the three andnine month periods ended December 31, 2006. The three months ended December 31,2006 included an increase of $284,000 of period costs resulting from theabnormal chemical, labor, and utility usage discussed above, and $105,000wherein a portion of otherwise inventoriable fixed costs could not beinventoried due to natural astaxanthin production output below normal capacity.The nine months ended December 31, 2006 included an increase of $434,000 ofperiod costs due to abnormal chemical, labor, and utility usage. In addition,during the nine month period there was an increase of $295,000 in productioncosts associated with the Company’s animal nutrition market products which werenot inventoriable because such costs would have exceeded the market value forsuch inventory. Additional information on these costs is provided later in thisreport.

We expect that theCompany’s gross profit margins during fiscal 2007, and during the first quarterof fiscal 2008, will continue to be less than the margins reported forcomparable prior year periods. This is primarily due to increased operatingcosts, the need to price 

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competitively, andactions underway to bring production to desired capacity and quality levels. Asnoted earlier, the Company has recognized period costs resulting from anabnormal usage of nutrients coupled with other efforts which were not effectivein correcting an imbalance in the cultivation process. Producing the highestquality microalgae is a complex biological process which requires the tenuousbalancing of numerous factors including microalgal strain variations,temperature, acidity, nutrient and other environmental considerations, some ofwhich is not in the Company’s control.  As a result, especially for natural astaxanthin cultivation, it isdifficult and time consuming to adjust, improve or correct the productionprocess when quality levels fall below specifications, and, while the Companypossesses the scientific knowledge and resources to correct its productionprocesses, there are too many variables involved for the Company to makereliable projections concerning such efforts.

Operatingexpenses, compared to the comparable prior year period, increased $406,000 or49% for the three months and $487,000 or 20% for the nine months ended December31, 2006.   The increase was primarilydue to efforts associated with the restatement and filing process of theCompany’s Form 10-K/A as well as late filings of Forms 10-Q and the relatedfees for accounting, legal,  auditing andcontract services. $427,000 of such costs were incurred during the three monthsended December 31, 2006, and $480,000 of such costs were incurred during thenine months then ended.

Otherexpenses decreased slightly comparing both the three and nine month periodsended December 31, 2006 and 2005.

The loss in gross profit and higher operating expensesresulted in a net loss of $1,187,000 for the third quarter of fiscal 2007,compared to a net loss of $210,000 for the third quarter of the prior fiscalyear, and a loss of $2,106,000 for the nine months ended December 31, 2006compared to a loss of $348,000 for the nine months ended December 31, 2005.

**Results of Operations**

***Third Quarter of Fiscal 2007Compared to Third Quarter of Fiscal 2006***

Net sales for thethree months ended December 31, 2006 were $2,434,000, a 4% increase from$2,333,000 for the comparable period a year ago.  The increase was primarily from increasedsales of spirulina products partially offset by decreased natural astaxanthinsales in comparison to the prior comparable period.  Sales of spirulina products for the thirdquarter of fiscal 2007 were $1,475,000, an increase of 13% over the $1,307,000generated in the third quarter of fiscal 2006. As a percentage of sales, Spirulina represented 61% of total sales inthe current period and 56% of sales in the prior comparable period.  Natural astaxanthin product sales were$950,000 during the third quarter of fiscal 2007, a 4% decrease from $994,000in the third quarter of the prior year. Natural astaxanthin product lines decreased to 39% of total salescompared to 43% of total sales in the third quarter of fiscal 2006.  Natural astaxanthin sales continued todecrease both as a result of a shortage of natural astaxanthin production anddue to continued lower NatuRose demand in the Japanese aquaculture market. Hadproduction been at levels consistent with prior consecutive quarters, theCompany believes it could have would have generated additional sales in allnatural astaxanthin products. This belief, however, is not based on a firmlycontracted backlog since the Company’s customers may at any time forgopurchases or seek alternative sources.

Other product sales, primarily phycobilli proteins,were $9,000 and $32,000 for the third quarter of fiscal years 2007 and 2006,respectively, and represented 0.4% and 1% of sales in the respective periods.

International sales were 44% of total sales for thethird quarter of fiscal 2007 and the comparable third quarter of fiscal2006.  Historically, our major customers(sales exceeding 10% of total sales) have been two distributors, one based inEurope and one in the United States.  Forthe three months ended December 31, 2006, neither distributor accounted formore than 10% of total sales.  For thethree months ended December 31, 2005, sales to the United States distributorwere 12% of total sales.

For the threemonths ended December 31, 2006, the Company’s cost of sales increased $682,000or 41% with respect to the prior comparable period. The cost of sales increasewas primarily due to increased chemical and labor costs. For the three monthsended December 31, 2006, total variable production costs increased 3%, andunits produced decreased 35%, resulting in higher costs per unit of production.Chemical costs increased as a result of increased consumption of nutrients someof which were deemed to be period costs resulting from an abnormal usage ofnutrients coupled with other efforts which were not effective in correcting animbalance in the cultivation process. Labor costs were impacted by wageincreases during the first quarter of fiscal 2007 in response to a competitivelabor market (primarily from the construction industry) in Hawaii.

The foregoing costincreases, coupled with the 35% decrease in units produced, contributed to theCompany recording additional otherwise inventoriable costs as expenses in thecurrent period.  Such costs totaled approximately$529,000 in three months ended December 31, 2006 compared to $90,000 for thethree months ended December 31, 2005. These included $284,000 of period costsas 

20

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explained in the *Overview*. Also, $181,000 of fixed production overhead costwas not inventoriable during the three months ended December 31, 2006 becauseour natural astaxanthin production output was below normal capacity, comparedto $76,000 of below normal capacity cost recorded during the three months endedDecember 31, 2005. Finally, production costs associated with the Company’sanimal nutrition market products totaling approximately $65,000 for the threemonths ended December 31, 2006 compared to $14,000 for the three months endedDecember 31, 2005, were not inventoriable because such costs would have exceededthe market value for such inventory.

As a result of the decrease in sales coupled with theincrease in cost of sales, the gross profit margin as a percentage of salesdecreased to 3% for the three months ended December 31, 2006 as compared to 28%for the comparable prior year quarter. Gross profit represents net sales lessthe cost of product sales, which includes the cost of materials, manufacturingoverhead costs, direct labor costs and depreciation and amortization.  Gross profit for the three months endedDecember 31, 2006 was $78,000.  Incontrast, gross profit for the comparable period of the prior fiscal year was$659,000.  Gross profit was significantlyreduced in the current period by the Company recording additional otherwiseinventoriable costs as expenses, as noted and discussed earlier. Explainingfurther, the Company judged certain production cultivation costs to be abovehistorical averages and recognizable as current-period charges resulting fromunusually low production volumes in astaxanthin and, to some extent,spirulina.  These costs consistedprimarily of labor, chemicals and also utility costs which were incurred inresponse to balancing cultivation specifications to established parameters associatedwith producing high quality microalgae. In addition, due to the low production volumes, certain fixed productionoverhead costs could not be inventoried as of December 31, 2006 becauseproduction output was below normal capacity and the inventorying of such fixedcosts would have exceeded the market value for such inventory.  Lastly, gross margins were impacted by marketpricing constraints on the Company’s animal nutrition product which limited theamount of production costs to be reflected in inventory because the costsexceeded the market value for such inventory.

Operating expenses for the three months ended December31, 2006 and 2005 were $1,241,000 or 51% of sales and $835,000, or 36% of salesrespectively, resulting in an increase of $406,000, or 49%.  Research and development expenses increased$37,000 over the comparable period of the prior fiscal year while sales andmarketing expenses declined $20,000. General and administrative expenses increased $389,000, primarily due toexpenses that were associated with the prior fiscal year’s restatement andfiling of the Company’s Form 10-K/A, late filings of Forms 10-Q for the firstand second and third quarters of fiscal year 2007, and, to a much lesserextent, other expenses associated with the Company’s one for four reverse stocksplit on November 3, 2006. (See Note 2 to the Consolidated FinancialStatements).   The Company expects thattotal operating expenses will increase throughout the remainder of the fiscalyear due to additional efforts associated with the aforementioned restatement,late filings of Forms 10-Q and costs stemming from a remediation plan whichrequires that policies and procedures be designed to ensure full compliancewith Generally Accepted Accounting Principles (GAAP) as it applies to inventoryaccounting, and to: (a) ensure that the Company’s disclosures are subject toadequate and rigorous review process prior to finalizing and releasingfinancial statements;  (b) continue toupdate inventory accounting systems and procedures to properly accommodate specificinventoriable fixed costs in accordance with GAAP; and (c) continue to identifyresources with the critical skills necessary to ensure full compliance withGAAP.  Approximately $427,000 of relatedaudit, legal, outside consulting costs, remediation plan costs, and minor  costs related to the Company’s one for fourreverse stock split, are included in general and administrative expenses forthe current period, and these expenses were partially offset by a cumulativenet reduction in several minor General and Administrative expense categories.

Net other expense for the third quarter of fiscal 2007was $27,000, a decrease from $35,000 for the same period a year ago, with thedifference primarily due to realized transaction losses with our Japanese subsidiary.

For the third quarter of fiscal 2007, an income taxbenefit of $3,000 was recorded, compared to an income tax benefit of $1,000reported for the comparable period of the prior fiscal year. The benefits ariseprimarily from state tax credits related to investment in property andequipment. The Company does not expect any expense to be recorded for UnitedStates income taxes in the current fiscal year as a result of available netoperating loss carry forwards.

The result of the foregoing was a net loss of$1,187,000, or ($0.23) per diluted share, for the three months ended December31, 2006, in comparison****to net loss of$210,000, or ($0.04) per diluted share, for the comparable prior yearquarter.  The net loss occurred becauseof lower net sales and lower gross profit in conjunction with higher operatingexpenses for the current quarter.

***Nine Months Ended December 31,2006 Compared to Nine Months Ended December 31, 2005***

Net sales for thenine months ended December 31, 2006 were $7,353,000, a decrease of 7% fromsales of $7,879,000 reported for the comparable period a year ago.  The reduction in sales over the nine monthperiod was the largely the result of decreased sales of bulk naturalastaxanthin, including NatuRose, units sold coupled with decreased Spirulinaand astaxanthin bulk prices. Although spirulina bulk units sold increased andthere were increases in packaged astaxanthin and spirulina unit sales andprices, these increases were offset by the decreases just discussed. Pricedecreases for bulk astaxanthin product were due to volume discounts andcompetitive pricing decisions. We expect price competition to continue forcertain astaxanthin bulk products. The impact of volume discounts andcompetitive 

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pricing depends onorder levels and timing, both of which we have historically been unable topredict with any degree of certainty. For the nine month period, the decreasein Spirulina sales resulted primarily from a net increase in units sold offsetby a decrease in average bulk selling prices due to discounts on large volumeorders.

International sales represented 46% of net sales forthe nine months ended December 31, 2006 compared to 52% for the same period ayear ago due to lower sales in Japan, the Asia Pacific region, and Europe.  For the nine months ended December 31, 2006and 2005, our European distributor, Spirulina International, accounted for 9%and 10% of total sales, respectively.

For the ninemonths ended December 31, 2006 cost of sales increased by $767,000 or 14% abovethe comparable prior year period.   Also,for the nine months ended December 31, 2006, variable production costsincreased 10% primarily in labor and chemicals.   Labor costs were impacted by wage increasesduring the first quarter of fiscal 2007 in response to a competitive labormarket (primarily from the construction industry) in Hawaii.   Chemical costs increased as a result ofincreased consumption of nutrients and other efforts, some of which were deemedto be period costs due to abnormal usage which, particularly in the thirdquarter, were not effective in correcting an imbalance in the cultivationprocess.  The foregoing cost increases,coupled with a 16% overall decrease in units produced, contributed to theCompany recording additional otherwise inventoriable costs as expenses in thecurrent period.  Such costs totaledapproximately $1,276,000 in nine months ended December 31, 2006 compared to$471,000 for the nine months ended December 31, 2006. These included $434,000of period costs due primarily to the imbalance discussed above. Also, $275,000of fixed production overhead cost was not inventoriable during the nine monthsended December 31, 2006 because our natural astaxanthin production output wasbelow normal capacity, compared to $203,000 of below normal capacity cost.being recorded during the nine months ended December 31, 2005. Finally,production costs associated with the Company’s animal nutrition market productstotaling approximately $309,000 for the nine months ended December 31, 2006compared to $14,000 for the nine months ended December 31, 2005, were notinventoriable because such costs would have exceeded the market value for suchinventory.

Our gross profit marginas a percentage of sales decreased to 13% for the nine months ended December,31, 2006 from 29% for the same period a year ago.  Gross margins were significantly impacted inkeeping with the forgoing cost of sales discussion. With respect to theproduction imbalance previously discussed, which , for the current period, hasbecome the primary reason for the Company’s gross margin decrease, it is againimportant to note that producing the highest quality microalgae is a complexbiological process which requires the tenuous balancing of numerous factorsincluding microalgal strain variations, temperature, acidity, nutrient andother environmental considerations, some of which is not in the Company’scontrol.   As a result, especially fornatural astaxanthin cultivation, it is difficult and time consuming to adjust,improve or correct the production process when quality levels fall belowspecifications. Until this imbalance, which primarily impacts astaxanthin, iscorrected we expect production volumes to remain low and we expect our grossprofit margins to remain lower than those experienced in prior comparableperiods.

Operating expensesfor the nine months ended December 31, 2006 were $2,969,000, an increase of$487,000 or 20% from the comparable prior year period.   The increase in spending reflects highergeneral and administrative expense.  During the current nine-month period, theCompany has recorded expenses of $480,000 associated with completing therestatement of the Company’s 2006 annual report on Form 10-K/A, and due to latefiscal year Form 10-Q filings, and other associated matters.  Sales and marketing expenses for the ninemonths slightly decreased while research and development expenses slightlyincreased   While it is our goal tocontain discretionary operating spending in our research and development, salesand marketing, and general and administrative activities, it may becomenecessary for the company to selectively increase spending in some or all ofthese areas to remain competitive and to meet and, in certain areas exceed,increasing regulatory requirements. In particular, it will be necessary for theCompany to incur additional general and administrative expenses due to effortsassociated with the aforementioned restatement, late filings of Forms 10-Q andcosts stemming from a remediation plan which requires that policies andprocedures be designed to ensure full compliance with Generally AcceptedAccounting Principles (GAAP) as it applies to inventory accounting, and to: (a)ensure that the Company’s disclosures are subject to adequate and rigorousreview process prior to finalizing and releasing financial statements;  (b) continue to update inventory accountingsystems and procedures to properly accommodate specific inventoriable fixedcosts in accordance with GAAP; and (c) continue to identify resources with thecritical skills necessary to ensure full compliance with GAAP.

Netother expense of $99,000 for the nine months ended December 31, 2006 wascomparable to the same period of the prior fiscal year at $110,000, with thedecrease due primarily to realized transaction losses with our Japanesesubsidiary.

For the nine months ended December 31, 2006, an income tax benefit of$9,000 was recorded compared to an income tax provision of $2,000 for thecomparable prior year period.  TheCompany does not expect any United States income taxes for the current fiscalyear as a result of available net operating loss carry-forwards.  For income taxes, the Company records a valuationallowance to reduce its deferred tax assets to the amount that it believes ismore likely than not to be realized. Judgment is required in assessing the need for the valuationallowance.  The ultimate realization ofdeferred tax assets is dependent upon the generation of future taxable incomeduring the periods in which those temporary differences become deductible.  In assessing the realizability of deferredtax assets, 

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managementconsiders whether it is more likely than not that some portion or all of thedeferred tax assets will not be realized. The ultimate realization of deferredtax assets is dependent upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Managementconsiders the scheduled reversal of deferred tax liabilities, projected futuretaxable income and tax planning strategies in making this assessment. Basedupon the level of historical taxable income and projections for future taxableincome over the periods in which net deferred tax assets are deductible,management does not believe it is more likely than not the Company will realizea portion of its gross deferred tax assets, and has thus established avaluation allowance to reflect its estimated realizability. The amount of thedeferred tax assets considered realizable, however, could change in the nearterm if estimates of future taxable income during the carryforward periodchange.

The Company recorded net loss of $2,106,000 or ($0.40)per diluted share for the nine month period ended December 31, 2006.  For the same period a year ago the Companyreported net loss of $348,000 or ($0.07) per diluted share.  The net loss in the current period isprimarily attributable to decreased sales in conjunction with an increase incost of sales and higher operating expenses as compared to the same period ayear ago.

*Variability of Results*

The Company hasexperienced significant quarterly fluctuations in operating results andanticipates that these fluctuations may continue in future periods.   As described in previous paragraphs,operating results have fluctuated as a result of changes in sales levels to ourcustomers, competition (both pricing, new products and other market trends) andproduction difficulties including increased production costs.   The Company has also during its historyexperienced production difficulties as a result of inclement weather, changesin the mix between sales of bulk and packaged consumer products and start upcosts associated with new product introductions, new facilities and expansioninto new markets.    In addition, futureoperating results may fluctuate as a result of factors beyond the Company’scontrol such as foreign exchange fluctuations, changes in governmentregulations and economic changes in the regions it operates in and sellsto.  A portion of our operating expensesare relatively fixed and the timing of increases in expense levels is based inlarge part on forecasts of future sales.  Therefore, if net sales are below expectations in any given period, theadverse impact on results of operations may be magnified by our inability tomeaningfully adjust spending in areas such as depreciation, or the inability toadjust spending quickly enough, as in personnel and administrative costs, tocompensate for a sales shortfall. We may also choose to reduce prices orincrease spending in response to market conditions, and these decisions mayhave a material adverse effect on financial condition and results ofoperations.

**Liquidity and Capital Resources**

The Company’s primary capital requirements areequipment and other leasehold improvement purchases, debt service obligation,and working capital requirements associated with the Company’s ongoingoperations.

Working capital at December 31, 2006 decreased by$1,592,000 to $4,055,000 from $5,647,000 at March 31, 2006 primarily dueto significant reductions in cash and equivalents of $529,000, receivables of$690,000, and inventory of $259,000, offset partially by an increase in prepaidexpenses and other current assets of $120,000.

At December 31, 2006, cash, cash equivalents andshort-term investments was $2,006,000, a decrease from $2,535,000 at thebeginning of the fiscal year.  Net cashof $18,000 was used by operations for the nine months ended December 31, 2006compared with $408,000 of net cash provided by operations for the comparableprior year period.  The net cash used byoperations during the nine months ended December 31, 2006 resulted primarilyfrom a $1,758,000 increase in net loss in the current year compared to a netlosses of $348,000 for the same period a year ago reduced by non-cashtransactions. Large factors in minimizing the cash used in operations for thecurrent period were a $686,000 reduction of accounts receivable, a $259,000inventory decrease, and an increase of $153,000 in accounts payable.

The Company believes that its current cash position inconjunction with the expectation of future cash provided by operations will besufficient to meet its working capital and capital expenditure requirements forat least the next 12 months. However, operating costs and the costs ofrestatement are placing and will continue to place an additional burden on theCompany’s liquidity. Once the previously discussed production imbalance iscorrected the Company expects that its future production levels will be in linewith future sales demand and that this will continue to allow the Company tominimize its investment in inventory held for sale.  The Company continues to consider sources ofcapital to strengthen its financial position and liquidity should its liquidityposition worsen significantly.  There canbe no assurance that such financing alternatives or other sources of capitalwill be available under favorable terms, if at all.

Cash used in investing activities (for capitalexpenditures) for the current nine month period was $246,000, an increase from $203,000

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in the comparable prior year period.

Cash used in financing activities amounted to $265,000and $259,000 for the nine months ended December 31, 2006 and 2005,respectively.

The Company’scontractual obligations and commitments (consisting of a term loan andoperating leases) are disclosed in the Company’s 2006 Annual Report on Form10-K/A in the following sections: Item 7 Management’s Discussion and Analysisof Financial Condition and Results of Operations — Liquidity and CapitalResources, and Item 8 Financial Statements and Supplementary Data — Notes 5 and6 of Notes to Consolidated Financial Statements.  There were no significant changes incontractual obligations and commitments from March 31, 2006 to December 31,2006.

CriticalAccounting Policies

Our unaudited financialstatements and accompanying notes are prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information pursuant to Regulation S-X.  The Company’s discussion and analysis of itsfinancial condition and results of operations are based upon the Company’sconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof financial statements in conformity with those accounting principles requiresmanagement to make judgments and estimates that affect the amounts reported inthe consolidated financial statements and accompanying notes. Actual resultscould differ from those estimates. The Company regularly re-evaluates itsjudgments and estimates which are based upon historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances. The Company believes that of its significant accountingpolicies, policies that may involve a higher degree of judgment and complexityare inventory valuations, valuation of equipment and leasehold improvements andlong-lived assets, and income taxes. These critical accounting policies arestated in the notes to consolidated financial statements in the Company’spreviously filed report on Form  10-K/A, for the fiscal year endedMarch 31, 2006.  This discussion andanalysis should be read in conjunction with such notes and our consolidatedfinancial statements and related notes included elsewhere in this report.

## **Outlook**

*Thisoutlook section contains a number of forward-looking statements, all of whichare based on current expectations. Actual results may differ materially.  Also, see the first paragraph of Item 2.* “*Management’s Discussion and Analysis of Financial Condition and Resultsof Operation’s*

CyanotechCorporation’s strategic direction is to position itself as a world-leader inthe production and marketing of high-value natural products from microalgae.  We are vertically aligned; producing rawmaterials in the form of microalgae processed at our 90-acre facility inHawaii, and integrating those raw materials into finished products.  For fiscal 2007 we are focused on thebusiness-to-business wholesale market for the products and compounds that weproduce.  Our current product offeringsinclude Naturally Cultivated Spirulina Pacifica® in powder, flake and tabletform, NatuRose® natural astaxanthin powder for the animal nutrition market,BioAstin® natural astaxanthin antioxidant in lipid extract, softgel caplet andmicro-encapsulated beadlet form for the human nutrition and cosmetic industriesand Phycobiliproteins for use in medical diagnostics.  Information about our Company and ourproducts can be viewed at www.cyanotech.com, www.nutrex-hawaii.com orwww.phycobiliprotein.com.  Consumerproducts can also be purchased online at www.nutrex-hawaii.com .

Currently, the Company’snatural astaxanthin production levels are below previous periods due to animbalance in certain cultivation specifications compared to establishedparameters associated with producing high quality microalgae.   Some natural astaxanthin orders for both theanimal nutrition and the human market were backlogged as of December 31, 2006due to the lower production volumes in the current year. However, customers arenot obligated to purchased backlogged product and may seek alternatives orforgo purchases.  While the Company isactively working to address the imbalance situation, it might take many weeksor months to restore production to normal capacity volumes. Natural astaxanthincultivation is a complex biological process which requires the tenuousbalancing of numerous factors including microalgal strain variations,temperature, acidity, nutrient and other environmental considerations, some ofwhich is not in the Company’s control.  As a result, especially for natural astaxanthin cultivation, it isdifficult and time consuming to adjust, improve or correct the productionprocess when quality levels fall below specifications, and, while the Companypossesses the scientific knowledge and resources to correct its productionprocesses, there are too many variables involved for the Company to makereliable projections concerning such efforts.

In addition, forthe current fiscal year, the Company has been unable to inventory the full costof producing its natural astaxanthin product for the animal nutrition marketdue to lower of cost or market constraints. As a result, we are shifting ournatural astaxanthin 

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production towardhigher valued products such as BioAstin for human consumption until and if suchtime that profitable animal nutrition markets or other astaxanthin markets canbe identified that can generate reasonable profitability for the Company.

The Company is exploring options to expand consumer brandawareness and knowledge of its product lines, with particular focus ofBioAstin, the Company’s human natural astaxanthin product line, for which itbelieves full market penetration has not yet been realized. To accomplish theseobjectives the Company, among other initiatives, has, as of the date of filingthis report, based a knowledgeable sales employee on the US mainland toincrease the Company’s outreach to both the US and European markets.

Gross profitmargin percentages in fiscal 2007, and early next fiscal year, are expected toremain lower in comparison to previous periods. This is primarily due to theaforementioned production imbalance. In addition, the Company has experiencedcost increases as certain variable operating costs for utilities, productionlabor, and pond nutrients have increased in comparison to previousperiods.  The Company’s utility costs areimpacted by the price of oil, which is used to generate electricity forprocessing and for water pumping.  In theface of a robust local construction economy, the Company found it necessary toincrease production wages in order to retain key employees and attractqualified personnel. With competition increasing and higher production costs,pressure is placed on achieving a reasonable profit margin.  When market value, including a reasonableprofit margin, cannot be achieved, production costs exceeding the product’smarket value cannot be inventoried and is reflected immediately in cost ofsales.   Additionally, with the adoptionof SFAS 151, the Company recognizes costs associated with abnormal amounts ofidle facility expense, freight, handling costs and wasted materials (such as spoilage)as current-period charges in cost of sales.  When production costs exceed historical averages, the Company evaluateswhether such costs are current-period charges or can be inventoried.   In addition, the allocation of such fixedproduction overheads (such as depreciation and general insurance) toinventories is determined based on normal production capacity.   When the Company’s production volumes arebelow normal capacity limits, certain fixed production overhead costs cannot beinventoried and are recorded immediately in cost of sales.   Currently, the Company’s natural astaxanthinproduction levels (and to a much lesser extent Spirulina production levelsduring the period ended December 31, 2006) are below previous periods andnormal production levels due to an imbalance in certain cultivationspecifications in comparison to parameters associated with producing highquality microalgae. Again, producing the highest quality microalgae is acomplex biological process which requires balancing numerous factors includingmicroalgal strain variations, temperature, acidity, nutrient and otherenvironmental considerations, some of which are not within the Company’scontrol.   It is difficult and timeconsuming to adjust, improve or correct the production process when qualitylevels fall below specifications.   As aresult, we experienced a production shortfall in our natural astaxanthinproducts during the three and nine months ended December 31, 2006.  These shortfalls likely resulted in decreasedsales since customers are able to secure alternative products or are able toforgo purchases. Until the Company is able to prudently increase its level ofnatural astaxanthin production, the Company believes margins will continue tobe negatively impacted by all of the foregoing cost elements, and margins areexpected to remain lower than those reported for comparable previous periods.

TheCompany anticipates that future total operating expenses will increase due tothe costs of the restatement and the remediation of errors identified by therestatement, including the need to improve the Company’s internalcontrols.  *Please referto Part II, Item 4 (a) in this report.*In addition, increased costsare expected as a result of management’s recommendation and the Company’s AuditCommittee and Board of Directors approval and adoption of a remediation planwhich includes that policies and procedures will be designed to ensure fullcompliance with GAAP, particularly as it applies to inventory accounting, andwill address key financial reporting risk elements, including the following:(a) ensuring that its disclosures are subject to an adequate review processprior to finalizing and releasing financial statements;  (b) continuing to update its inventoryaccounting systems and procedures to properly accommodate specificinventoriable fixed costs in accordance with GAAP; and (c) continuing toidentify resources with the critical skills necessary to ensure full compliancewith GAAP. Since the process related to error identification and the subsequentrestatement began after June 30, 2006, much of the related audit, legal,outside consulting costs, and remediation plan costs are included in and areapplicable to this Form 10-Q. For the quarter ended December 31, 2006, $428,000of such costs are reflected in general and administrative expenses, and for thenine months ended December 31, 2007, $480,000 of such costs are reflected.

To effectivelymanage its cash resources the Company will continue to balance production inlight of sales demand, minimizing the cost associated with build-ups ininventory.  Additionally, the Company hasexperienced cash outflows for investing and financing activities, primarily inmeeting debt repayment obligations and may need to utilize cash to meet workingcapital needs if prolonged net losses are incurred in future periods.  A prolonged downturn in sales could impairthe Company’s ability to generate sufficient cash for operations and minimizethe Company’s ability to attract additional capital investments which may benecessary in order to expand into new markets or increase product offerings.

The Company’sfuture 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 addition to the factors discussed above,any of the following could cause actual results to differ materially:  business conditions and growth in the naturalproducts industry and in the general economy; changes in customer orderpatterns; changes in demand for natural products in general; changes in weatherconditions; competitive factors, such as increased production capacity fromcompeting Spirulina and astaxanthin producers and the resulting impact, if any,on world market prices for these products; government actions; shortage ofmanufacturing capacity; and other factors beyond our control.  Risk factors are discussed in detail in Item1A, included in this report.

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Cyanotech believesthat it has the product offerings, facilities, personnel, and competitive andfinancial resources for improved results, but future revenues, costs, marginsand profits are all influenced by a number of factors, as discussed above, allof which are inherently difficult to forecast.

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

We have not entered into any transactions usingderivative financial instruments or derivative commodity instruments andbelieve that our exposure to market risk associated with other financialinstruments is not material.

We have a term loan agreement which adjusts quarterlybased on the prime rate plus 1%.  As suchwe are exposed to interest rate risk whereby a 1% increase or decrease in theprime rate would lead to an increase or decrease of approximately $15,000 ininterest expense for the year ending March 31, 2007 (based onMarch 31, 2006 amounts outstanding).

The Company may enter into additional foreigncountries in the future which may involve similar economic and political risksas well as challenges that are different from those currently encountered bythe Company.

**Item4.  Controls and Procedures**

**(a)Disclosure Controls and Procedures**

*This Form 10-Q should be read in conjunction with Item 9A “Controls andProcedures” of the Company’s Form 10-K/A for the fiscal year ended March 31,2006 filed February 14, 2007, which is incorporated herein by reference.*

There were changes in Controls and Procedures during the current quarter.As disclosed in the Form 10-Q report for the second quarter of fiscal year2007, beginning in that quarter the Company identified errors in theapplication of certain accounting practices and procedures. As a result, duringthe second and third quarters of fiscalyear 2007 the Company began changing and is continuing the process of improvingits control policies, procedures, and systems. This process was and is directlyrelated to the Company’s February 14, 2007 filing of Form 10-K/A, correction ofthe error in its inventory accounting, and also a remediation plan adopted bythe Board of Directors in November 2006 as discussed in Form 10-K/A, especiallyNote 13 to the Consolidated Financial Statements therein.

Because the aforementioned error was discovered by the Company on August7, 2006, it is clear that as of June 30, 2006 the Company did not maintaineffective controls over accounting for inventory. Specifically, errors resultedbecause the Company did not have effective policies and procedures andadequately trained and qualified accounting department staff to ensure thatinventory included all inventoriable fixed cost components such asdepreciation, portions of general insurance costs, and portions of direct laborburden costs in accordance with GAAP. As a result of this weakness, which waslater determined by the Company to be material, the Company restated itsconsolidated financial statements as of and for the fiscal years ended March31, 2006, 2005, and quarterly periods within fiscal years 2006, 2005, and 2004and has restated selected financial data for the years ended March 31, 2003 and2002 to adjust its inventory balances, cost of goods sold, and related amountsof income and loss. The restatement is reflected in the Company’s Form 10-K/Afiled February 14, 2007, and is reflected in restated prior period comparableinformation contained in this Form 10-Q.

The process of investigating and rectifying the aforementioned errors hasresulted in the Company enhancing and continuing to enhance its accountingpolicies and procedures to assure that inventoriable fixed cost components suchas depreciation, portions of general insurance costs, and portions of directlabor burden costs are reflected in the Company’s financial statements inaccordance with GAAP. Because of the nature of and circumstances surroundingthe errors, the Company’s management, Board of Directors, and Audit Committeeof the Board of Directors concluded that the errors were not the result ofillegal acts.

Specific changes in the Company’s internal control over financialreporting during the third quarter of fiscal year 2007 included:

—             Additional improvements in inventoryaccounting procedures and systems.

—             Heightening enterprise level review andevaluation of inventory accounting policies, procedures, and systems.

—             Engaging additional professional accountingresources on a consulting basis to assist with error evaluation and correction,and taking specific steps to find and hire additional professional accountingemployees to bolster both financial reporting and inventory accounting in-housecapabilities. As of this filing, we are still seeking additional suitableprofessional accounting employees.

Incorporated into the results reported in this Form 10-Q are the abovediscussed restatement and inventory accounting error corrections which ensurethat inventory as reported herein includes all inventoriable fixed costcomponents such as depreciation, portions of general insurance costs, andportions of direct labor burden costs in accordance with GAAP.

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**PART II.   OTHER INFORMATION6**

**Item 1.**                                                           LegalProceedingsNone

**Item 1A. Risk Factors**

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

**A Significant orProlonged Economic Downturn Could Have a Material Adverse Effect on Our Resultsof Operations**

**Our results of operations are affected by the businessactivity of our customers who in turn are affected by the level of economicactivity in the industries and markets that they serve. A decline in the levelof business activity of our clients could have a material adverse effect on ourrevenues and profit margin.**

**Our Quarterly OperatingResults May Vary From Quarter to Quarter, Which May Result inIncreased Volatility of Our Share Price**

**We have experienced, and may in the future continue toexperience, fluctuations in our quarterly operating results. These fluctuationscould reduce the market price of our Common Stock. Factors that may cause ourquarterly operating results to vary include, but are not limited to:**

·       the business decisions ofour customers regarding orders for our products;

·       increased energy costs;

·       increased raw materialcosts;

·       production difficulties,especially CO2 interruption,which could shut down production;

·       weather-related cultivationdifficulties;

·       contamination of ourcultivation and production facilities;

·       the effect of weather oncustomer demand patterns;

·       the introduction of newproducts by us or our competitors;

·       changes in our pricingpolicies or those of our competitors;

·       seasonal trends in our customers’buying patterns

·       changes in governmentregulation, both domestic and foreign;

·       fluctuation in foreigncurrency exchange rates;

·       global economic andpolitical conditions and related risks, including acts of terrorism; and

·  customersusing alternative, possibly synthetic, products;

·       an inability to produce ordeliver orders;

·       product quality issueswhich may restrict production or require product recall;

·       other factors beyond ourcontrol.

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

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**Our Global OperationsExpose Us to Complex Management, Foreign Currency, Legal, Tax and EconomicRisks, Which We May Not Be Able to Address Adequately**

**We conduct business in a number of countries around theworld. For the quarter ended December 31, 2006, approximately 44% of our netsales were from sales to foreign customers. As a result, we are subject to anumber of risks that include, but are not limited to:**

·       the burden of complyingwith a wide variety of national and local laws;

·       potentially longer paymentcycles for foreign sales;

·       multiple and possiblyoverlapping and conflicting tax laws;

·       coordinating geographicallyseparated locations;

·       restrictions (governmentand otherwise) on the movement of cash;

·       the absence in somejurisdictions of effective laws protecting our intellectual property rights;

·       changes in governmentregulations, both domestic and foreign;

·       global economic andpolitical conditions and related risks, including acts of terrorism; and

·       fluctuations in foreigncurrency exchange rates.

**Competition in OurIndustry is Intense**

The nutritional products market is highly competitive.In includes international, national, regional and local producers anddistributors, many of whom have greater resources than Cyanotech and offer agreater variety of products. Increased competition in our industry could resultin price reductions, reduced gross profit margin or loss of market share, anyof which could have a material effect on our business, results of operationsand financial condition.

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

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

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

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

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**WeMay Need to Raise Additional Capital in the Future Which May Not BeAvailable**

**At December 31, 2006, the Company’s working capital was$4,055,000. Cash equivalents and short-term investments at December 31, 2006totaled $2,066,000. Our cash requirements will depend on numerous factors,including: demand for products; normal requirements to maintain and upgradefacilities and equipment; whether opportunities emerge in either new markets orin research and development activities; or, in the event we need to expand orcontract our production or distribution infrastructure. We believe our currentcash, cash equivalents, short-term investments and expected cash provided fromoperations will be sufficient to meet our capital requirements for at least thenext 12 months. If we need to raise additional funds, we may not be able tosecure funding on acceptable terms, if at all. If we raise additional fundsthrough the issuance of equity or convertible debt securities, the percentage ownershipof our then current stockholders may be reduced. If we raise additional fundsthrough the issuance of convertible debt securities, or through additional debtor similar instruments, such securities, debt, or similar instruments couldhave rights senior to those of our common stockholders and such instrumentscould contain provisions restricting our operations. If adequate funds are notavailable to satisfy either short-term or long-term capital requirements, wemay be required to limit operations with adverse results.**

**OurInsurance Liability Coverage is Limited**

**In the ordinary course of business, the Company purchasesinsurance coverages (e.g., property and liability coverages) to protect itselfagainst loss of or damage to its properties and claims made by third partiesand employees for property damage or personal injuries. However, the protectionprovided by such insurance is limited in significant respects and, in someinstances, the Company has no coverage and certain of the Company’s insurance hassubstantial “deductibles” or has limits on the maximum amounts that may berecovered. For example, if a hurricane or other uninsured catastrophic naturaldisaster should occur, the Company may not be able to recover all facilityrestoration costs and revenues lost from business interruption. In addition,the Company maintains product liability insurance in limited amounts for all ofits products involving human consumption; however, broader product liabilitycoverage is prohibitively expensive. Insurers have also introduced newexclusions or limitations of coverage for claims related to certain perilsincluding, but not limited to, mold and terrorism. If a series of lossesoccurred, such as from a series of lawsuits in the ordinary course of businesseach of which were subject to the deductible amount, or if the maximum limit ofthe available insurance were substantially exceeded, the Company could incurlosses in amounts that would have a material adverse effect on its result ofoperations and financial condition.**

**Our Ability to Developand Market New Products or Modify Existing Products and Production MethodsMay be Adversely Affected If we Lose the Services of or Cannot ReplaceCertain Employees Knowledgeable in Advanced Scientific and Other Fields**

**The Company’s products are derived from and depend onproprietary and non-proprietary processes and methods founded on advancedscientific knowledge, skills, and expertise. If the services of employeesknowledgeable in these fields are lost and cannot be replaced in a reasonabletime frame at reasonable costs, the Company’s ability to develop and market newproducts or modify existing products and production methods would be adverselyimpacted. At the same time, regulatory compliance surrounding the Company’s productsand financial matters generally requires minimum levels of knowledge andexpertise related to production, quality assurance, and financial control. Ifthe Company loses the services or cannot reasonably replace employees who havethe necessary knowledge and expertise the Company’s ability to remain inregulatory compliance could be adversely affected.**

**As a Result of Restating the Company’s Form 10-K/A andthe Late Filing of Form 10-Qs, Additional General and AdministrativeExpenditures Will Be Required in Future Periods**

During the current fiscal year the Company expects toexpend significant amounts for independent registered public accounting, legal,outside consulting, and regulatory expenses to address: (a) the previouslydiscussed 10-K/A restatement process, (b) previously disclosed matters dealingwith resulting potential delisting from the Nasdaq Capital Market, (c) policy,procedure, and initial systems modifications required by and attendant tocorrecting the historical error which lead to the restatement process, and (d)additional costs related to late filing of the Company’s Forms 10-Q for thefirst two quarters of fiscal year 2007. Also, to accomplish the remediationplan set forth in the 10-K/A under Item 9A “Controls and Procedures” therein.As of the filing date of this Form 10-Q the Company has expended approximately$500,000 related to such efforts, and will have to expend additional amountswhich cannot now be reliably estimated.

**The Company Will Incur Additional Sums In the Futurein Order to Comply with Securities and Exchange and Public Company AccountingOversight Requirements Resulting from the Sarbanes-Oxley Act**

As of March 31, 2008, the Company is required to haveadditional policies, procedures, systems and related documentation incompliance with Securities and Exchange Commission and Public CompanyAccounting Oversight Board requirements. There is currently no means ofreliably estimating the costs of such additional compliance.

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***Potential Delisting from Nasdaq Capital Market Trading***

*On December 1, 2005 the Company received noticefrom Nasdaq that the bid price of the Company’s stock closed below the minimum$1.00 per share requirement of Nasdaq Marketplace Rule 4310(c)(4).  The Company, however, was provided until May30, 2006, to regain compliance with such rule, and was granted by letter datedMay 31, 2006 another 180 days to regain compliance with such rule.  By letter dated August 23, 2006, the Companywas notified by Nasdaq of its failure to comply with Nasdaq Marketplace Rule4310(c)(14) for not filing its Form 10 Q for the quarter ended June 30, 2006and we were notified that the Company’s common stock would be suspended fromtrading on September 1, 2006.  TheCompany appealed this decision and the common stock continued to be listed.*

*On November 3, 2006, the Company implemented a onefor four reverse stock split of its common stock as a result of which Nasdaqissued a letter, dated November 20, 2006, indicating the closing bid price ofour common stock was in compliance with Marketplace Rule 4310(c)(4).  This non-compliance matter is now closed.*

*The Nasdaq Listing Qualifications Panel issued itsdecision on the appeal on December 18, 2006 holding that the Company is grantedan extension until February 20, 2007 to file its Form 10-Q reports. See theCompany’s Form 8-K dated December 18, 2006.*

*Subsequently,on February 14, 2007 the Company filed Form 10-K/A amending and restating itsForm 10-K for the year ended March 31, 2006. Also, on February 20, 2007 theCompany filed Forms 10-Q for the quarters ended June 30 and September 30, 2006,in compliance with the December 18, 2006 extension discussed above. CyanotechCorporation received notice on February 21, 2007 from The NASDAQ Stock Marketthat the Company is not in Compliance with Nasdaq Marketplace Rule 4310(c)(14)for failure to file its Form 10-Q for the period ended December 31, 2006 andthat such failure is basis for delisting the Company’s Common Stock from TheNasdaq Stock Market.  The Company wasgranted until February 28, 2007 to present its views to the Nasdaq ListingQualifications Panel with respect to the failure to file such Form 10-Q.  In its response the Company indicated that itexpected to file the Form 10-Q report on or before March 14, 2007 and requestedcontinued listing. On February 28, 2007, based on its supplemental response andrequest for continued listing submitted by the Company to Nasdaq, the Companyreceived notice that the Nasdaq Listing Qualifications Panel has determined togrant the Company’s request for continued listing subject primarily to theCompany’s filing on or before March 14, 2007 its Form 10-Q for the period endedDecember 31, 2006. In addition, the Company must be able to demonstratecompliance with all requirements for continued listing. As of the time offiling this report, the Company believes it meets all of the requirements forcontinued listing stated in the Listing Qualifications Panel determination ofFebruary 28, 2007. However, if the Company is incorrect in its belief, and the Company’scommon stock is delisted, our stockholders could be materially and adverselyaffected by having less active and efficient market available for the tradingof their stock.*

**Item 4.**       Submission of Matters to a Vote ofSecurity Holders

None -

**Item 6.                    Exhibits**
| a)     | The following exhibits are furnished with this  report: |
|--------|---------------------------------------------------------|
|   |                                                    |
|   | 31.1                                                    | Certification by the Chief Executive Officer  pursuant to |
|   |                                                    | Rule 13a-14(a)/15d-14(a) of the Exchange Act |
|   |                                                    |   |
|   | 31.2                                                    | Certification by the Chief Financial Officer  pursuant to |
|   |                                                    | Rule 13a-14(a)/15d-14(a) of the Exchange Act |
|   |                                                    |   |
|   | 32.1                                                    | Certification by the Chief Executive Officer  pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 |
|   |                                                    |   |
|   | 32.2                                                    | Certification by the Chief Financial Officer  pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 |

 

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| b)     | Reports on Form 8-K                                                                                                                                                     |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated October 16, 2006 included  Item 3.03, Material Modification of Rights of Securities  Holders.                                                |
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated November 14, 2006  included Item 3.01, Notice of Delisting or Failure to  Satisfy a Continued Listing Rule or Standard; Transfer of Listing. |
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated November 14, 2006  included Item 3.03, Material Modification to Rights of  Securities Holders.                                               |
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated November 14, 2006  included Item 8.01, Other Events.                                                                                         |
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated November 28, 2006  included Item 2.02, Results of Operations and  Financial Condition.                                                  |
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated November 28, 2006  included Item 4.02, Results of Operations and  Financial Condition.                                                  |
|   |                                                                                                                                                                    |
|   | A report on Form 8-K dated December 18, 2006  included Item 8.01, Other Events:                                                                                    |

 

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SIGNATURES

In accordance with therequirements of the Securities Exchange Act of 1934, the registrant caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.
|                |   | CYANOTECH CORPORATION (Registrant) |                                                             |   |
|----------------|--------|------------------------------------|------------------------------------------------------------------|--------|
|           |   |                               |                                                             |   |
|           |   |                               |                                                             |   |
|           |   |                               |                                                             |   |
| March 13, 2007 |   | By:                                | /s/ Gerald R. Cysewski                                      |   |   |
| (Date)         |   |                               | Gerald R.  Cysewski                                              |   |   |
|           |   |                               | Chairman of the  Board, President and                            |   |   |
|           |   |                               | President and  Chief Executive Officer                           |   |   |
|           |   |                               |                                                             |   |   |
|           |   |                               |                                                             |   |   |
| March 13, 2007 |   | By:                                | /s/  William R. Maris                                       |   |
| (Date)         |   |                               |   William  R. Maris                                    |   |   |
|           |   |                               |   Vice  President — Finance & Administration, |   |
|           |   |                               |   Chief  Financial Officer                             |   |   |
|           |   |                               |   (Principal  Financial and Accounting Officer)        |   |
|                |        |                                    |                                                                  |        |  |  |

 

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