**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**QuarterlyReport Under Section 13 or 15(d)**

**of theSecurities Exchange Act of 1934**

 

**For Quarterly Period Ended December 31,2005**

 

**Commission File Number 0-14602**

 

**CYANOTECHCORPORATION**

(Exact name of registrantas specified in its charter)

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

 

Check whether the registrant (1) filed allreports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes ýNo o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.

 

Large accelerated filer  o          Acceleratedfiler  o          Non-acceleratedfiler  ý

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act. Yes  o  No  ý

 

Numberof common shares outstanding as of February 8, 2006:

 
| **Title of Class**               | ** ** | **Shares Outstanding** |
|----------------------------------|------------|------------------------|
| Common stock - $0.005  par value |       | 20,913,765             |

 

 

----

 

CYANOTECH CORPORATION

FORM 10-Q

 

INDEX

 
| PART I.  FINANCIAL INFORMATION |                                                                                        |
|-------------------------------------|---------------------------------------------------------------------------------------------|
|                                |                                                                                        |   |
| Item 1.                             | Financial  Statements                                                                       |   |
|                                |                                                                                        |   |
|                                | Consolidated  Balance Sheets (unaudited)                                                    |   |
|                                |                                                                                        | As of  December 31, 2005 and March 31, 2005 |   |
|                                |                                                                                        |   |
|                                | Consolidated  Statements of Operations (unaudited)                                          |   |
|                                |                                                                                        | For  the three and nine month periods ended |   |
|                                |                                                                                        | December 31, 2005 and  2004 |   |
|                                |                                                                                        |   |
|                                | Consolidated  Statements of Cash Flows (unaudited)                                          |   |
|                                |                                                                                        | For  the nine month periods ended |   |
|                                |                                                                                        | December 31, 2005 and  2004 |   |
|                                |                                                                                        |   |
|                                | 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  4.                            | Submission of Matters to a  Vote of Security Holders                                        |   |
|                                |                                                                                        |   |
| Item  6.                            | Exhibits and Reports on  Form 8-K                                                      |   |
|                                |                                                                                        |   |
| SIGNATURES                          |                                                                                        |

 

2

----

 

PART 1.  FINANCIAL INFORMATION

Item 1.  Financial Statements

 

CYANOTECH CORPORATION

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

 
| ** **                                                                                                                                                                  | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
|                                                                                                                                                                        |       |                        |       |                     |       |
| ASSETS                                                                                                                                                                      |       |                        |       |                     |       |
| Current assets:                                                                                                                                                             |       |                        |       |                     |       |
| Cash and cash  equivalents                                                                                                                                                  |       | $                           | 1,951      |                     | $          | 2,005 |   |
| Short-term  investments                                                                                                                                                     |       | 1,000                       |       | 1,000                    |       |
| Accounts  receivable, net                                                                                                                                                   |       | 1,445                       |       | 2,069                    |       |
| Refundable  income taxes                                                                                                                                                    |       | 27                          |       | 97                       |       |
| Inventories (see  Note 3)                                                                                                                                                   |       | 2,011                       |       | 1,565                    |       |
| Prepaid expenses                                                                                                                                                            |       | 131                         |       | 85                       |       |
| Total current  assets                                                                                                                                                       |       | 6,565                       |       | 6,821                    |       |
|                                                                                                                                                                        |       |                        |       |                     |       |
| Equipment and leasehold improvements, net (see Note  4)                                                                                                                     |       | 10,358                      |       | 11,174                   |       |
| Other assets                                                                                                                                                                |       | 538                         |       | 547                      |       |
| Total assets                                                                                                                                                                |       | $                           | 17,461     |                     | $          | 18,542 |   |
|                                                                                                                                                                        |       |                        |       |                     |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                  |       |                        |       |                     |       |
| Current liabilities:                                                                                                                                                        |       |                        |       |                     |       |
| Current  maturities of long-term debt                                                                                                                                       |       | $                           | 354        |                     | $          | 355 |   |
| Accounts payable                                                                                                                                                            |       | 448                         |       | 977                      |       |
| Accrued expenses                                                                                                                                                            |       | 567                         |       | 387                      |       |
| Total current  liabilities                                                                                                                                                  |       | 1,369                       |       | 1,719                    |       |
|                                                                                                                                                                        |       |                        |       |                     |       |
| Long-term debt,  excluding current maturities                                                                                                                               |       | 1,485                       |       | 1,743                    |       |
| Total  liabilities                                                                                                                                                          |       | 2,854                       |       | 3,462                    |       |
|                                                                                                                                                                        |       |                        |       |                     |       |
| Stockholders’  equity:                                                                                                                                                 |       |                        |       |                     |       |
| Common Stock of  $0.005 par value; shares authorized 30,000,000; 20,913,765 shares issued and outstanding  at December 31, 2005, and 20,896,265 at March 31, 2005 |       | 104                         |       | 104                      |       |
| Additional  paid-in capital                                                                                                                                                 |       | 27,312                      |       | 27,298                   |       |
| Accumulated  other comprehensive income - foreign currency translation adjustments                                                                                          |       | 2                           |       | 27                       |       |
| Accumulated deficit                                                                                                                                                         |       | (12,811                     | )          | (12,349                  | )          |
| Total  stockholders’ equity                                                                                                                                            |       | 14,607                      |       | 15,080                   |       |
|                                                                                                                                                                        |       |                        |       |                     |       |
| Total  liabilities and stockholders’ equity                                                                                                                            |       | $                           | 17,461     |                     | $          | 18,542 |   |

 

See accompanying Notes toConsolidated Financial Statements.

 

3

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CYANOTECH CORPORATION

CONSOLIDATEDSTATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 
| ** **                                                  | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |   |   |   |
| NET SALES                                                   |       | $                                         | 2,333      |                                     | $          | 3,180 |   | 7,879 |   | $ | 8,885 |   |
| COST OF PRODUCT  SALES                                      |       | 1,712                                     |       | 2,017                                    |       | 5,652 |   | 5,781 |   |
| Gross profit                                                |       | 621                                       |       | 1,163                                    |       | 2,227 |   | 3,104 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| OPERATING  EXPENSES:                                        |       |                                      |       |                                     |       |   |   |   |   |
| Research and  development                                   |       | 45                                        |       | 38                                       |       | 144 |   | 165 |   |
| Sales and  marketing                                        |       | 351                                       |       | 301                                      |       | 988 |   | 892 |   |
| General and  administrative                                 |       | 461                                       |       | 506                                      |       | 1,421 |   | 1,395 |   |
| Total operating  expenses                                   |       | 857                                       |       | 845                                      |       | 2,553 |   | 2,452 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Income (loss)  from operations                              |       | (236                                      | )          | 318                                      |       | (326 | ) | 652 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                    |       |                                      |       |                                     |       |   |   |   |   |
| Interest income                                             |       | 13                                        |       | 8                                        |       | 36 |   | 25 |   |
| Interest expense                                            |       | (46                                       | )          | (43                                      | )          | (136 | ) | (122 | ) |
| Other income  (expense), net                                |       | (2                                        | )          | 37                                       |       | (10 | ) | 26 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Total other  income (expense), net                          |       | (35                                       | )          | 2                                        |       | (110 | ) | (71 | ) |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Income (loss)  before income taxes                          |       | (271                                      | )          | 320                                      |       | (436 | ) | 581 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| INCOME TAX  EXPENSE (BENEFIT)                               |       | 23                                        |       | (6                                       | )          | 26 |   | 21 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| NET INCOME  (LOSS)                                          |       | $                                         | (294       | )                                        | $          | 326 |   | $ | (462 | ) | $ | 560 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| NET INCOME  (LOSS) PER SHARE                                |       |                                      |       |                                     |       |   |   |   |   |
| Basic                                                       |       | $                                         | (0.01      | )                                        | $          | 0.02 |   | $ | (0.02 | ) | $ | 0.03 |   |
| Diluted                                                     |       | $                                         | (0.01      | )                                        | $          | 0.02 |   | $ | (0.02 | ) | $ | 0.03 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| SHARES USED IN  CALCULATION OF NET INCOME (LOSS) PER SHARE: |       |                                      |       |                                     |       |   |   |   |   |
| Basic                                                       |       | 20,906                                    |       | 20,771                                   |       | 20,900 |   | 20,753 |   |
| Diluted                                                     |       | 20,906                                    |       | 20,988                                   |       | 20,900 |   | 20,981 |   |
|                                                        |       |                                      |       |                                     |       |   |   |   |   |
| COMPREHENSIVE  INCOME (LOSS):                               |       |                                      |       |                                     |       |   |   |   |   |
| Net income  (loss)                                          |       | $                                         | (294       | )                                        | $          | 326 |   | $ | (462 | ) | $ | 560 |   |
| Other  comprehensive income (loss)                          |       | (17                                       | )          | 20                                       |       | (25 | ) | 10 |   |
|                                                        |       | $                                         | (311       | )                                        | $          | 346 |   | $ | (487 | ) | $ | 570 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

 

4

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CYANOTECH CORPORATION

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 
| ** **                                                                                | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
|                                                                                      |       |                                     |       |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                                     |       |   |   |
| Net income (loss)                                                                         |       | $                                        | (462       | ) | $ | 560 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                     |       |   |   |
| Depreciation and  amortization                                                            |       | 1,024                                    |       | 995 |   |
| Issuance of  stock in exchange for services                                               |       | 14                                       |       | 15 |   |
| Issuance of  stock options in exchange for services                                       |       | —                                   |       | 7 |   |
| Amortization of  debt issue costs and other assets                                        |       | 23                                       |       | 23 |   |
| Allowance for  doubtful accounts                                                          |       | (5                                       | )          | 30 |   |
| Net (increase)  decrease in:                                                              |       |                                     |       |   |   |
| Accounts  receivable                                                                      |       | 629                                      |       | (233 | ) |
| Refundable  income taxes                                                                  |       | 70                                       |       | (3 | ) |
| Inventories                                                                               |       | (446                                     | )          | (377 | ) |
| Prepaid expenses  and other assets                                                        |       | (90                                      | )          | (46 | ) |
| Net increase  (decrease) in:                                                              |       |                                     |       |   |   |
| Accounts payable                                                                          |       | (529                                     | )          | (256 | ) |
| Accrued expenses                                                                          |       | 180                                      |       | 53 |   |
| Net cash  provided by operating activities                                                |       | 408                                      |       | 768 |   |
|                                                                                      |       |                                     |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                                     |       |   |   |
| Investment in  equipment and leasehold improvements                                       |       | (203                                     | )          | (544 | ) |
|                                                                                      |       |                                     |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |                                     |       |   |   |
| Proceeds from  exercise of stock options                                                  |       | —                                   |       | 28 |   |
| Proceeds from  exercise of warrants                                                       |       | —                                   |       | 54 |   |
| Principal  payments on long-term debt                                                     |       | (259                                     | )          | (255 | ) |
| Net cash  provided by (used in) financing activities                                      |       | (259                                     | )          | (173 | ) |
|                                                                                      |       |                                     |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                     |       | (54                                      | )          | 51 |   |
|                                                                                      |       |                                     |       |   |   |
| Cash and cash  equivalents at beginning of period                                         |       | 2,005                                    |       | 2,531 |   |
|                                                                                      |       |                                     |       |   |   |
| Cash and cash  equivalents at end of period                                               |       | $                                        | 1,951      |   | $ | 2,582 |   |
|                                                                                      |       |                                     |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                        |       |                                     |       |   |   |
| Cash paid during  the period for:                                                         |       |                                     |       |   |   |
| Interest                                                                                  |       | $                                        | 101        |   | $ | 98 |   |
| Income taxes                                                                              |       | $                                        | 4          |   | $ | 188 |   |

 

See accompanyingNotes to Consolidated Financial Statements.

 

5

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CYANOTECH CORPORATION

FORM 10-Q

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

As of December 31, 2005

(Unaudited)

 

1.       BASIS OFPRESENTATION

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions to Form 10-Qand Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  These consolidated financial statements andnotes should be read in conjunction with the Company’s consolidated financialstatements contained in the Company’s previously filed report on Form 10-K for the year ended March 31, 2005.

 

The Company consolidatesenterprises in which it has a controlling financial interest. The accompanyingconsolidated financial statements include the accounts of Cyanotech Corporationand its wholly-owned subsidiaries, Nutrex Hawaii, Inc. and Cyanotech JapanYK.  All significant intercompanybalances and transactions have been eliminated in consolidation. While thefinancial information furnished for the three and nine month periods ended December 31,2005 is unaudited, the statements in this report reflect all material itemswhich, in the opinion of management, are necessary for a fair presentation ofthe results of operations for the interim periods covered and of the financialcondition of the Company at the dates of the consolidated balance sheets. Theoperating results for the interim period presented are not necessarilyindicative of the results that may be expected for the year ending March 31,2006.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities and thedisclosure of any contingent assets and liabilities as of the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period.  Management reviewsthese estimates and assumptions periodically and reflects the effect of revisionsin the period that they are determined to be necessary.  Actual results could differ significantlyfrom those estimates.

 

2.       STOCK-BASED COMPENSATION

 

As allowed by Statementof Financial Accounting Standards (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation*, the Company has elected to continue toapply the intrinsic value-based method of accounting for employee based stockoptions and adopted only the disclosure requirements of SFAS No.123.  The following table illustrates the effect onnet income and net income per common share if the Company had applied thefair-value method under SFAS No. 123 to its employee stock option plans:

 
| ** **                                                 | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                       |       |                                      |       |                                     |       |   |   |   |   |
| Net income  (loss), as reported                            |       | $                                         | (294       | )                                        | $          | 326 |   | $ | (462 | ) | $ | 560 |   |
| Deduct  stock-based employee compensation                  |       |                                      |       |                                     |       |   |   |   |   |
| Expense  determined under fair-value method for all awards |       | (5                                        | )          | (25                                      | )          | (44 | ) | (67 | ) |
| Pro-forma net  income (loss)                               |       | $                                         | (299       | )                                        | $          | 301 |   | $ | (506 | ) | $ | 493 |   |
|                                                       |       |                                      |       |                                     |       |   |   |   |   |
| Basic net income  (loss) per common share:                 |       |                                      |       |                                     |       |   |   |   |   |
| As reported                                                |       | $                                         | (0.01      | )                                        | $          | 0.02 |   | $ | (0.02 | ) | $ | 0.03 |   |
| Pro-forma                                                  |       | $                                         | (0.01      | )                                        | $          | 0.01 |   | $ | (0.02 | ) | $ | 0.02 |   |
|                                                       |       |                                      |       |                                     |       |   |   |   |   |
| Diluted net  income (loss) per common share:               |       |                                      |       |                                     |       |   |   |   |   |
| As reported                                                |       | $                                         | (0.01      | )                                        | $          | 0.02 |   | $ | (0.02 | ) | $ | 0.03 |   |
| Pro-forma                                                  |       | $                                         | (0.01      | )                                        | $          | 0.01 |   | $ | (0.02 | ) | $ | 0.02 |   |

 

6

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3.       INVENTORIES

 

Inventories are stated atthe lower of cost (which approximates first-in, first-out) or market andconsist of the following (dollars in thousands):

 
| ** **      | ** ** | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|-----------------|------------|----------------------------|------------|-------------------------|------------|
|            |       |                       |       |                    |       |
| Raw materials   |       | $                          | 218        |                    | $          | 246 |   |
| Work in process |       | 296                        |       | 243                     |       |
| Finished goods  |       | 1,377                      |       | 957                     |       |
| Supplies        |       | 120                        |       | 119                     |       |
|            |       | $                          | 2,011      |                    | $          | 1,565 |   |

 

4.       EQUIPMENT AND LEASEHOLD IMPROVEMENTS

 

Equipment and leaseholdimprovements are stated at cost. Depreciation and amortization are providedusing the straight-line method over the estimated useful lives for equipmentand furniture and fixtures, or the shorter of the land lease term or estimateduseful lives for leasehold improvements as follows:

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

 

Equipment and leaseholdimprovements consist of the following (dollars in thousands):

 
| ** **                                      | ** ** | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|
| Equipment                                       |       | $                          | 10,440     |                    | 10,241     |   |
| Leasehold  improvements                         |       | 14,613                     |       | 14,603                  |       |
| Furniture and  fixtures                         |       | 86                         |       | 86                      |       |
|                                            |       | 25,139                     |       | 24,930                  |       |
| Less accumulated  depreciation and amortization |       | (15,025                    | )          | (14,006                 | )          |
| Construction  in-progress                       |       | 244                        |       | 250                     |       |
| Equipment and  leasehold improvements, net      |       | $                          | 10,358     |                    | $          | 11,174 |   |
|                                                 |            |                            |            |                         |            |  |  |

 

5.       EARNINGS PER SHARE

 

Basic earnings per shareis computed on the basis of the 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.

 

Reconciliations betweenthe numerator and the denominator of the basic and diluted earnings per sharecomputations for the three months ended December 31, 2005 and 2004 are asfollows (in thousands, except per share amounts):

 

7

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| ** **                                                              | ** ** | **Three Months Ended December 31, 2005** | ** ** | **Three Months Ended December 31, 2004** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Income,**                               | ** ** | ** **                                    | ** ** | ** ** | ** ** | **Net Income,** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                              | ** ** | **(Loss)**                                    | ** ** | **Shares**                                    | ** ** | **Per Share** | ** ** | **(Loss)** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                               | ** ** | **(Denominator)**                             | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic earnings  (loss) per share                                        |       | $                                             | (294       | )                                             | 20,906     |   | $ | (0.01 | ) | $ | 326 |   | 20,771 |   | $ | 0.02 |   |
| Effect of  dilutive securities – Common stock options and warrants |       | —                                        |       | —                                        |       |   |   | — |   | 217 |   |   |   |
| Dilutive  earnings per share                                            |       | $                                             | (294       | )                                             | 20,906     |   | $ | (0.01 | ) | $ | 326 |   | 20,988 |   | $ | 0.02 |   |

 

Reconciliations betweenthe numerator and the denominator of the basic and diluted earnings per sharecomputations for the nine months ended December 31, 2005 and 2004 are asfollows (in thousands, except per share amounts):

 
| ** **                                                              | ** ** | **Nine Months Ended December 31, 2005** | ** ** | **Nine Months Ended December 31, 2004** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Income,**                              | ** ** | ** **                                   | ** ** | ** ** | ** ** | **Net Income,** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                              | ** ** | **(Loss)**                                   | ** ** | **Shares**                                   | ** ** | **Per Share** | ** ** | **(Loss)** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                              | ** ** | **(Denominator)**                            | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic earnings  (loss) per share                                        |       | $                                            | (462       | )                                            | 20,900     |   | $ | (0.02 | ) | $ | 560 |   | 20,753 |   | $ | 0.03 |   |
| Effect of  dilutive securities – Common stock options and warrants |       | —                                       |       | —                                       |       |   |   | — |   | 228 |   |   |   |
| Dilutive  earnings per share                                            |       | $                                            | (462       | )                                            | 20,900     |   | $ | (0.02 | ) | $ | 560 |   | 20,981 |   | $ | 0.03 |   |

 

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,** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Stock options  and warrants |       | 512                                       |       | 172                                      |       | 512 |   | 172 |   |

 

Sincedilutive securities reduce loss per share amounts, they are disregarded whennet losses are reported. In this context, the disregarded securities are describedas being “anti-dilutive”.

 

6.       NEW ACCOUNTING PRONOUNCEMENTS

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (Revised2004) “Share-Based Payment” which is a revision of FASB Statement No. 123 “Accountingfor Stock-Based Compensation.”  SFAS No. 123(Revised 2004) (Statement No. 123R) requires an entity to measure the cost ofemployee 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 remeasured tofair value at each balance sheet date until the award is settled.  Equity –classified awards, including grantsof employee stock options, are measured at the 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. Currently the Company accounts for its employee and non-employeedirector stock options under the intrinsic value provision of APB Opinion No. 25.   The Company is required to adopt theprovisions for SFAS No. 123 (Revised 2004) as of the beginning of thefirst annual reporting period that begins after June 15, 2005, althoughearlier adoption is permitted.   SFAS No. 123(Revised 2004) offers several alternatives for implementation.  At this time, management has not made adecision as to the alternative it may select.

 

8

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In November 2004, theFASB issued SFAS No. 151 “Inventory Costs – an amendment of AccountingResearch Bulletin No. 43, Chapter 4”. SFAS No. 151 requires that abnormal amounts of freight, handlingcosts and wasted material (spoilage) be recognized as current-period chargesand fixed production overhead costs be allocated to inventory based on thenormal capacity of production facilities. Normal capacity is defined as “the production expected to be achievedover a number of periods or seasons under normal circumstances, taking intoaccount the loss of capacity resulting from planned maintenance.”  Companies will no longer be permitted tocapitalize inventory costs on the balance sheet when the production defect ratevaries significantly from the expected defect rate.  SFAS No. 151 is effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.   Earlier application is permitted forinventory costs incurred during fiscal years beginning after November 24,2004.  The Company has yet to determinethe impact, if any, of SFAS No. 151 on its consolidated financialstatements.

 

In December 2004, the FASB issued SFAS No. 153,“Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29, ‘Accountingfor Nonmonetary Transactions.’”  SFAS No. 153 is based on theprinciple that exchange of nonmonetary assets should be measured based on thefair market value of the assets exchanged.  SFAS No. 153 eliminatesthe exception of nonmonetary exchanges of similar productive assets andreplaces it with a general exception for exchanges of nonmonetary assets thatdo not have commercial substance.  SFAS No. 153 is effective fornonmonetary asset exchanges in fiscal periods beginning after June 15,2005.  Adoption of the provisions of SFAS No. 153 is not expected tohave a material impact on the Company’s financial condition, results ofoperations, or liquidity.

 

In March 2005, the FASB issued FASBInterpretation No. 47 (“FIN 47”), “Accounting for Conditional AssetRetirement Obligations — an interpretation of FASB Statement No. 143.” FIN 47 clarifies that the term “conditional asset retirement obligation” asused in FASB Statement No. 143, “Accounting for Asset RetirementObligations,” refers to a legal obligation to perform an asset retirementactivity in which the timing and (or) method of settlement are conditional on afuture event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair valueof a conditional asset retirement obligation if the fair value of the liabilitycan be reasonably estimated.  FIN 47 is effective for fiscal years endingafter December 15, 2005.  The Company adopted the provisions of FIN47 effective April 2005.    Adoptionof the provisions of FIN 47 had no material impact on the Company’s financialcondition, results of operations or liquidity.

 

On March 29, 2005, the Securities and ExchangeCommission (SEC) staff issued Staff Accounting Bulletin No. 107, “Share-BasedPayment” (SAB No. 107), which expressed the SEC staff’s views on StatementNo. 123R, but did not modify any of Statement No. 123R’s provisions.The Company is evaluating the views expressed by the SEC in SAB No. 107 inconjunction with its assessment of Statement No. 123R’s impact to theCompany.

 

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20 andFASB Statement No. 3.”  SFAS No. 154requires retrospective application for voluntary changes in accountingprinciple unless it is impracticable to do so. In addition, indirect effects of a change in accounting principle shouldbe recognized in the period of the accounting change. SFAS No. 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005.

 

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**CYANOTECHCORPORATION**

 

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

 

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

 

**Overview**

 

Acomparison of selected consolidated statements of operations data asreported herein and in the Company’s previously filed reports on Form 10-Qfor the quarterly period ended September 30, 2005 and on Form 10-K for the year ended March 31,2005 follows for the periods indicated (dollars in thousands):

 
| ** **                     | ** ** | **(A)**                                                                     | ** ** | **(B)**                                                                        | ** ** | **(C)**                                                                     | ** ** |
|--------------------------------|------------|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Current Year  Third Quarter  Three Months Ended  December 31, 2005** | ** ** | **Prior Year Comparable  Quarter  Three Months Ended  December 31, 2004** | ** ** | **Prior Consecutive  Quarter  Three Months Ended  September 30, 2005** | ** ** |
| Net sales:                     |       |                                                                        |       |                                                                           |       |                                                                        |       |
| Spirulina  products            |       | $                                                                           | 1,289      |                                                                           | $          | 1,810                                                                       |       | $ | 1,377 |   |
| Natural  astaxanthin products  |       | 1,011                                                                       |       | 1,324                                                                          |       | 1,084                                                                       |       |
| Other products                 |       | 33                                                                          |       | 46                                                                             |       | 56                                                                          |       |
| Total sales, all  products     |       | $                                                                           | 2,333      |                                                                           | $          | 3,180                                                                       |       | $ | 2,517 |   |
|                           |       |                                                                        |       |                                                                           |       |                                                                        |       |
| Gross profit                   |       | $                                                                           | 621        |                                                                           | $          | 1,163                                                                       |       | $ | 581 |   |
| Income (loss)  from operations |       | $                                                                           | (236       | )                                                                              | $          | 318                                                                         |       | $ | (298 | ) |
| Net income  (loss)             |       | $                                                                           | (294       | )                                                                              | $          | 326                                                                         |       | $ | (321 | ) |

 

| ** **                    | ** ** | **Year to Year  Comparison,  Three Month  Comparable Period  Percentage Change  (A) – (B) / (B)** | ** ** | **Sequential Quarter  Comparison,  Three Month  Prior Sequential Period  Percentage Change  (A) – (C) / (C)** | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|
| Net sales:                    |       |                                                                                                             |       |                                                                                                                         |       |
| Spirulina products            |       | (29                                                                                                              | )%         | (6                                                                                                                           | )%         |
| Natural  astaxanthin products |       | (24                                                                                                              | )%         | (7                                                                                                                           | )%         |
| Other products                |       | (28                                                                                                              | )%         | (41                                                                                                                          | )%         |
| Total sales, all  products    |       | (27                                                                                                              | )%         | (7                                                                                                                           | )%         |

 

Decreased sales for thecurrent year third quarter compared to the prior year comparable quarter areattributable primarily to lower order levels of Spirulina products and reduceddemand for NatuRose® from the Japan aquaculture market. Decreased salescompared to the prior consecutive quarter are primarily attributable tocontinuing reduced demand for NatuRose® from the Japan aquaculture market withslight reductions in some Spirulina product sales offset in part by increasedsales of BioAstin® and private label products.

 

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Gross profit of $621,000 forthe third quarter of fiscal 2006 was 47% or $542,000 less than reported for theprior year comparable quarter, and 7% or $40,000 more in comparison to the priorconsecutive quarter. Comparing the third quarter of the current fiscal year tothe prior year comparable quarter, decreased gross profit was primarilyattributable to decreased sales coupled with increased natural astaxanthin perunit production cost increases which resulted from a decision to reduce naturalastaxanthin production in response to lower order levels. The per unit costincrease reflects continuing fixed overhead costs of our operations. Inaddition, certain raw material, utility, and freight costs increased, alsoincreasing the total per unit cost. Comparing the third quarter of the currentfiscal year to the prior consecutive quarter, the increase in gross profit of$40,000, from $581,000 to $621,000, was due to the foregoing, and in addition,gross profit is also impacted because the company’s various products naturallyhave different costs. As the mix as well as the volume of product sales variesbetween comparable periods the cost of sales varies and the resulting grossmargin also varies.

 

Comparing the thirdquarter of the current fiscal year to the prior year comparable quarter, salesand marketing expenses have increased 17% or $50,000. Likewise, comparing thethird quarter of the current fiscal year to the prior consecutive quarter,sales and marketing expenses have increased $47,000 or 16%. Both of theseincreases are consistent with our plan to increase marketing activity with theobjective of increasing product sales.

 

Comparing the thirdquarter of the current fiscal year to the prior year comparable quarter,general and administrative expenses have decreased 9% or $45,000. Likewise,comparing the third quarter of the current fiscal year to the prior consecutivequarter, general and administrative expenses have decreased $61,000 or 12%.Both of these decreases are consistent with the company’s on-going costcontainment efforts. Comparing the third quarter of the current fiscal year tothe prior year comparable quarter, and comparing the third quarter of thecurrent fiscal year to the prior consecutive quarter, total operating expenseof $857,000 for the current quarter is nearly level with the amounts reportedfor the comparable periods just noted, the reason being that sales andmarketing expense increases were basically offset by general and administrativeexpense decreases.

 

Total other expenseincreased in comparison to both the third quarter of the previous fiscal yearand compared to the second quarter of the current fiscal year. The increase wasprimarily due to period to period foreign currency translation adjustments.

 

The company’s net loss of$294,000 for the third quarter of fiscal 2006 reflected a decrease of $620,000 incomparison to the prior year comparable quarter income of $326,000, but thethird quarter current fiscal year net loss was $27,000 less than the net lossof $321,000 reported for the prior consecutive quarter. Because operatingexpenses, as discussed above, and other income/expense and tax provisionsremained somewhat level, the net loss for the quarter, when compared to both theprior year comparable quarter and the prior consecutive quarter, was primarily dueto lower sales and the previously discussed decline in gross margin.

 

**Resultsof Operations**

 

*ThirdQuarter of Fiscal 2006 Compared to Third Quarter of Fiscal 2005*

 

Net sales for the threemonths ended December 31, 2005 were $2,333,000, a 27% decrease from $3,180,000for the comparable period a year ago.  Sales of spirulina products decreased 29% primarily due to lower

 

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tablet sales volumes. Salesof natural astaxanthin products decreased by 24% due primarily to reduceddemand for NatuRose from the Japan aquaculture market.   Sales of private label products doubled, butthis increase only slightly offset reduced spirulina and astaxanthin salesoverall.  International sales were 44% oftotal sales for the third quarter of fiscal 2006, compared to 51% a yearago.  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, 2005, our European distributoraccounted for 7% of total sales as compared to 11% of total sales for thecomparable prior year period.  Sales tothe major United States distributor accounted for 12% of total sales for thethree months ended December 31, 2005 and 6% of total sales for the threemonths ended December 31, 2004. Increases and decreases in percentage salesto the two distributors reflect overall sales volumes and historic variabilityin the order patterns of these customers.

 

Gross profit representsnet sales less the cost of product sales, which includes the cost of materials,manufacturing overhead costs, direct labor costs, depreciation andamortization.  Gross profit for the threemonths ended December 31, 2005 was $621,000, with a gross profit margin of27%.  In contrast, gross profit for thecomparable period of the prior fiscal year was $1,163,000 with a gross profitmargin of 37%. As discussed in the preceding overview, comparing the thirdquarter of the current fiscal year to the prior year comparable quarter,decreased gross profit was primarily attributable to decreased sales coupledwith increased natural astaxanthin per unit production cost increases whichresulted from a decision to reduce natural astaxanthin production in responseto lower order levels. In addition, in comparison to the third quarter of theprevious fiscal year, for the three months ended December 31, 2005,certain raw material, utility, and freight costs increased, and the companyabsorbed production support costs, such as depreciation and utilities, acrossreduced production and sales volumes, resulting in higher per unit costs. Inaddition to the foregoing, gross profit is also impacted because the company’svarious products naturally have different costs. As the mix as well as the volumeof product sales varies between comparable periods, the cost of sales variesand the resulting gross margin also varies.

 

Operating expenses forthe three months ended December 31, 2005 and 2004 were $857,000 and $845,000,respectively.  As a percentage of netsales, operating expenses for the third quarter of fiscal 2006 were 37%,compared to 27% for the comparable prior year quarter, with the percentagechange due primarily to lower net sales in the current year period.   Increased sales and marketing expenses inthe current period were offset by decreased general and administrative expenses. Sales and marketing expense increases werefocused on emerging BioAstin markets and in response to declining sales.

 

Total other expense, netfor the third quarter of fiscal 2006 was $35,000, compared with net other incomeof $2,000 for the same period a year ago. The change was primarily due to foreign currency translation losses fromtransactions with our Japanese subsidiary. Also, for the quarter ended December 31,2005, a change in a previous estimate of a state tax accrual resulted in a $23,000estimated tax expense for the quarter. This compares to a $6,000 tax benefit recordedfor the comparable period of the prior fiscal year.  The Company does not expect any United Statesincome taxes for the current fiscal year as a result of available net operatingloss carry forwards.

 

The result of theforegoing is a net loss of $294,000, or ($0.01) per diluted share, for thethree months ended December 31, 2005, in contrast to net income of $326,000,or $0.02 per diluted share, for the comparable prior year quarter.  The net loss stemmed primarily from overalllower net sales and reduced gross margin, as previously discussed.

 

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* *

*NineMonths Ended December 31, 2005 Compared to Nine Months Ended December 31,2004*

 

Net sales for the ninemonths ended December 31, 2005 were $7,879,000, a decrease of 11% fromsales of $8,885,000 reported for the comparable period a year ago.  This decrease during the current year periodis primarily attributable to lower sales of most natural astaxanthin and spirulinaproducts. These reductions are somewhat offset by increased sales of phycobiliproteins,BioAstin, and private label products as compared to the comparable period ofthe prior fiscal year.  Internationalsales represented 52% of net sales for the nine months ended December 31,2005 compared to 48% for the same period a year ago with reduced Japan and Asiasales offset by increased European, Canadian, and New Zealand sales.  For the nine months ended December 31,2005, our European distributor accounted for 10% of total sales as compared to 9%of total sales for the comparable prior year period.  Sales to the major United States distributorwere less than 10% of total sales for the nine months ended December 31,2005 and 2004. Increases and decreases in percentage sales to the twodistributors reflect overall sales volumes and historic variability in theorder patterns of these customers.

 

Gross profit for the ninemonths ended December 31, 2005 was $2,227,000 with a gross profit marginof 28%, compared to gross profit of $3,104,000 and gross profit margin of 35%for the comparable period of the prior fiscal year.   Asdiscussed in the preceding overview, comparing the first nine months of thecurrent fiscal year to the prior year comparable nine months, decreased grossprofit was primarily attributable to decreased sales coupled with increasednatural astaxanthin per unit production cost increases which resulted from adecision to reduce natural astaxanthin production in response to lower orderlevels. In addition, in comparison to the comparable nine months of theprevious fiscal year, for the nine months ended December 31, 2005, certainraw material, utility, and freight costs increased, and the company absorbedproduction support costs, such as depreciation and utilities, across reducedproduction and sales volumes, resulting in higher per unit costs. In additionto the foregoing, gross profit is also impacted because the company’s variousproducts naturally have different costs. As the mix as well as the volume ofproduct sales varies between comparable periods the cost of sales varies andthe resulting gross margin also varies.

 

Operating expenses forthe nine months ended December 31, 2005 were $2,553,000, an increase of $101,000or 4% versus the comparable prior year period.  The expense increase reflects a combination of reduced general and administrativeand research and development expenses year to date coupled with increased salesand marketing expenses.  As notedearlier, sales and marketing expense were increased in an effort to generateadditional sales.

 

Net other expense increased55% or $39,000 over the prior year comparable period.  Current year’s interest expense increased dueto increases in the prime rate, the basis for term loan interest.  Interest income on short-term investments increasedslightly. The nine month comparable period ended December 31, 2004 includedother income of $26,000 while the current nine month period reflects otherexpense of $10,000, the net $36,000 difference comprises the bulk of the$39,000 increase in net other expense which is primarily related to foreigncurrency translation expense stemming from transactions with our Japanesesubsidiary.

 

Forthe nine months ended December 31, 2005, a tax provision of $26,000 hasbeen recorded primarily reflecting a $23,000 change in a previous estimate of astate tax accrual compared to a tax provision of $21,000 recorded for the sameperiod of the prior year.   The Companydoes not expect any United States income taxes for the current fiscal year as aresult of available net operating loss carry forwards.

 

The Company recorded a netloss of $462,000 or ($0.02) per diluted share for the nine month period ended December 31, 2005.  For the same period a year ago the Companyreported net income of $560,000 or earnings of $0.03 per diluted share.  The $1,022,000 net income difference betweenthe comparable periods is primarily due to sales decreasing 11% or $1,006,000while total cost of goods sold decreased 2% or

 

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$129,000. This resultedin a period to period gross margin decrease of $877,000 or 28%. As discussedearlier, increased per unit production costs stemming from decisions to reduceproduction levels coupled with certain material and support cost increases resultedin the gross margin decrease between the comparable periods. In addition togross margin, total operating expense increased $101,000 or 4% when comparingthe nine month period ended December 31, 2005 as compared to the ninemonths ended December 31, 2004. The operating expense increase wasprimarily due to increased sales and marketing expenses as previously discussed.The remainder of the comparative difference between the periods was due toincreased other expenses, primarily related to foreign currency translation andtax provision expenses.

 

*Variabilityof Results*

 

The Company hasexperienced significant quarterly fluctuations in operating results andanticipates that these fluctuations may continue in future periods. Futureoperating results may fluctuate as a result of changes in sales levels to ourlargest customers, new product introductions, production difficulties, weatherpatterns, the mix between sales of bulk products and packaged consumerproducts, start-up costs associated with new facilities, expansion into newmarkets, sales promotions, competition, increased energy costs, foreignexchange fluctuations, the announcement or introduction of new products bycompetitors, changes in our customer mix, overall trends in the market for ourproducts, government regulations and other factors beyond our control.  While a significant portion of our expenselevels are relatively fixed and the timing of increases in expense levels isbased in large part on 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 spending quickly enough tocompensate for the sales shortfall. We may also choose to reduce prices orincrease spending in response to market conditions, which may have a materialadverse effect on financial condition and results of operations.

 

**Liquidityand Capital Resources**

 

Working capital for thenine months ended December 31, 2005 increased by $94,000 to $5,196,000from $5,102,000 at March 31, 2005 primarily due to a reduction in tradeaccounts payable, offset by lower accounts receivable balances.  At December 31, 2005 inventory increasedto $2,011,000 an increase of $446,000 from $1,565,000 at the beginning of thefiscal year. The inventory increase was primarily due to accumulating specificinventory in order to satisfy existing bulk shipment commitments and ordinary timingdifferences between production levels and sales volumes.

 

Despite the net loss of$462,000 for the nine month period ended December 31, 2005 versus $560,000net income for the same period a year ago, overall cash and equivalents remainednearly the same, decreasing $54,000 from $2,005,000 to $1,951,000. Cash wasprimarily generated by collection of receivables and mainly used for payment oftrade payables.

 

Cash used in investingactivities (for capital expenditures) was $341,000 less for the nine monthsended December 31, 2005 versus the same period a year ago, reflecting reducedcapital spending after the completion of the natural astaxanthin project in theprior fiscal year.

 

Cash used in financing activitiestotaled $259,000 for the nine months ended December 31, 2005 compared tocash used in financing activities of $173,000 for the comparable prior yearperiod.  For the current period and forthe comparable prior year period, cash used in financing went to principalpayments on debt, remaining effectively level period to period. In the priorcomparable period cash was also generated from stock option and warrant exerciseproceeds.

 

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There have been no significantchanges in contractual obligations and commitments from March 31, 2005 to December 31,2005 other than those reported elsewhere in this Form 10-Q. The Company’scontractual obligations and commitments (consisting of a term loan andoperating leases) are disclosed in the Company’s previously filed report on Form 10-Kfor the fiscal year ended March 31, 2005 in the following sections: Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Liquidity and Capital Resources, and Item 8. Financial Statementsand Supplementary Data – Notes 5 and 6 of Notes to Consolidated FinancialStatements.

 

**CriticalAccounting Policies**

 

Ourunaudited financial statements and accompanying notes are prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions to Form 10-Qand Regulation S-X.  Preparing financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenue and expenses.  These estimates and assumptions are affectedby management’s application of accounting policies.  The Company has identified certain policiesthat require the application of significant judgment by management.  Our most critical accounting policies arethose related to inventory valuation, revenue recognition, equipment and leaseholdimprovements, income taxes and impairment of long-lived assets.  These critical accounting policies are discussedin the Notes to Consolidated Financial Statements in the Company’s previouslyfiled report on Form 10-K for the fiscal year ended March 31, 2005.  This discussion and analysis should be readin conjunction with such notes and our consolidated financial statements andrelated notes included elsewhere in this report.

 

**Outlook**

 

*Thisoutlook section contains a number of forward-looking statements, all ofwhich are based on current expectations. Actual results may differ materially.See first paragraph of this Item 2.*

 

Thegoal of Cyanotech Corporation is based on its strategy to be a world-leader inthe production and marketing of high-value natural products from microalgae.For fiscal 2006 we have refined this strategy with a heightened focus on thebusiness-to-business wholesale market for the products and compounds that weextract from the microalgae processed at our 90 acre facility in Hawaii. Ourcurrent product offerings include “All Natural” Spirulina Pacifica®in powder, flake, and tablet form, NatuRose®  natural astaxanthin powder for the animalnutrition market, BioAstin® natural astaxanthin antioxidant in lipidextract, softgel caplet and micro-encapsulated beadlet form for the humannutrition and cosmetic industries, and Phycobiliproteins for use in medical diagnostics.Information about our Company and our products can be viewed atwww.cyanotech.com, www.nutrex-hawaii.com or www.phycobiliprotein.com.  Consumer products can also be purchasedonline at www.nutrex-hawaii.com.

 

Ournet sales for the third quarter of fiscal 2006 (the quarter ended December 31,2005) of $2,333,000 were 7% or $184,000 less than the $2,517,000 reported forthe prior sequential quarter ended September 30, 2005. Compared to theprior sequential quarter, increased sales of BioAstin and private labelproducts partially offset decreases in other product sales. Third quarterfiscal 2006 net sales were $847,000 or 27% less than reported for the thirdquarter of the prior fiscal year. Compared to the third quarter ended December 31,2004, sales of all but private label products were either comparable or down.In general, sales decreases were attributable to lower orders for spirulina andNatuRose®  products offset partlyby the aforementioned

 

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increasesin BioAstin and private label sales.

 

BioAstinis the company’s natural Astaxanthin product for the human nutraceuticalmarket. We remain concerned about the recovery of our largest market forNatuRose (fish coloration in Japan aquaculture) and continue taking action toimprove sales of this product through feeding trials aimed at enhancing thisproduct’s appeal for use as animal nutrition. At the same time, the Companyrecognizes that the general market for spirulina is maturing.

 

Withthe foregoing in mind, we continue to believe that it is important to useCompany resources for advertising and promotion aimed at generating highersales of our BioAstin® products. In addition company resources willbe used for research and development aimed at new or improved products,product uses, production methods, and product trials. We believe that our product mix may changewith increases in sales of BioAstin® as more manufacturers expandtheir product offerings to incorporate this anti-inflammatory carotenoid. Therecan be no assurance as to whether or when advertising, changes in products orproduct mix, promotion, or research and development will bear results.

 

TheCompany will continue to restrain discretionary operating spending while deployingCompany resources as discussed in the preceding paragraphs.

 

TheCompany’s future results of operations and the other forward-looking statementscontained in this Outlook, in particular any statements regarding revenues,gross margin, expenses and spending involve a number of risks anduncertainties.  In addition to thefactors discussed above that could cause actual results to differ materiallyare the following:  business conditionsand growth in the natural products industry and in the general economy, changesin customer order patterns, changes in demand for natural products in general,changes in weather conditions, competitive factors, such as competing spirulinaand astaxanthin producers increasing their production capacity and the resultingimpact, if any, on world market prices for these products, government actions,shortage of manufacturing capacity, and other factors beyond our control.  Risk factors are discussed in detail in Exhibit 99.1,included in this report.

 

Cyanotechbelieves that it has the product offerings, facilities, personnel, andcompetitive and financial resources for improved results, but future revenues,costs, margins and profits are all influenced by a number of factors, asdiscussed above, all of which are inherently difficult to forecast.

 

**Item 3.       Quantitative and Qualitative DisclosuresAbout Market Risk**

 

We have not entered intoany transactions using derivative financial instruments or derivative commodityinstruments and believe that our exposure to market risk associated with otherfinancial instruments is not material.

 

**Item 4.  Controls and Procedures**

 

Under the supervision and with the participation of management,including the President and Chief Executive Officer (“CEO”) and the ChiefFinancial Officer (“CFO”) of the Company (the “Certifying Officers”), we haveevaluated the effectiveness of the Company’s disclosure controls and proceduresas of the end of the period covered by this report in accordance with Item 307of Regulation S-K promulgated by the Securities and Exchange Commission.  As defined under Rules 13a-15(e) or15d-15(e) issued under the Securities Exchange Act of 1934, as amended(the “Exchange Act”), the term “disclosure controls and

 

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procedures” refers to controls and other procedures of an issuer thatare designed to ensure that information required to be disclosed by the issuerin the reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theCommission’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed byan issuer in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the issuer’s management, including itsprincipal executive officer or officers and principal financial officer orofficers, or persons performing similar functions, as appropriate to allowtimely decisions regarding required disclosure.

 

Based on that evaluation, the CEO and CFO have concluded that theCompany’s disclosure controls and procedures are effective. There were nochanges in our internal controls over financial reporting during the quarterended December 31, 2005 that have materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting.

 

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** **

**PART II.   OTHER INFORMATION**

 

Item 1.                    LegalProceedings

None

 

Item 4.                    Submissionof Matters to a Vote of Security Holders

 

On August 22, 2005, the following matters weresubmitted and voted by stockholders entitled to vote at the Company’s AnnualMeeting of Stockholders:

 

a)              Thefollowing directors were elected to serve until the next Annual Meeting oruntil their successors are elected:

 

| ** **          | ** ** | **For Votes** | ** ** | **Withheld Votes** | ** ** |
|---------------------|------------|---------------|------------|--------------------|------------|
|                |       |          |       |               |       |
| Gerald R.  Cysewski |       | 15,030,894    |       | 88,383             |       |
| Michael A. Davis    |       | 14,988,998    |       | 130,279            |       |
| Gregg W.  Robertson |       | 14,976,594    |       | 142,683            |       |
| David I.  Rosenthal |       | 14,984,644    |       | 144,633            |       |
| John T. Waldron     |       | 14,994,694    |       | 124,583            |       |
| Paul C. Yuen        |       | 15,005,194    |       | 114,083            |       |

 

b)             Approvalof the 2005 Stock Option Plan (the “2005 Plan”), reserving a total of 800,000authorized shares of common stock of the Company for issuance of options underthe 2004 Plan.   The vote was 4,043,292for, 423,236 against, 40,851 abstaining and 10,611,898 broker not voted.

 

d)             Ratificationof the selection of KPMG LLP as the Company’s independent Registered Public AccountingFirm for the fiscal year ending March 31, 2006.  The vote on the ratification was 15,062,416for, 23,736 against and 32,955 abstaining.

 

Item 6.                                                             Exhibitsand Reports on Form 8-K

 

a)     The followingexhibits are furnished with this report:

 

31.1         Certificationby the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) ofthe Exchange Act

 

31.2         Certificationby the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) ofthe Exchange Act

 

32.1         Certificationby the Chief Executive Officer pursuant to 18 U. S. C. Section 1350, asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2         Certificationby the Chief Financial Officer pursuant to 18 U. S. C. Section 1350, asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

99.1         RiskFactors

 

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b)             Reportson Form 8-K

 

Areport on Form 8-K dated October 19, 2005 included Item 8.01, OtherEvents, in conjunction with the Company’s press release dated October 19,2005, announcing the resignation of Chief Financial Officer, Jeffery H.Sakamoto.

 

Areport on Form 8-K dated October 28, 2005 included Item 5.04,Temporary Suspension of Trading Under Registrant’s Employee Benefit Plans, inconjunctions with issuance of a notice dated October 24, 2005, to allparticipants of such plan.

 

Areport on Form 8-K dated October 28, 2005 included Item 8.01, OtherEvents, in conjunction with the Company’s press release dated October 24,2005, announcing the date of its earnings release and investor conference callfor the quarter ended September 30, 2005.

 

Areport on Form 8-K dated November 4, 2005 included Item 2.02, Resultsof Operations and Financial Condition, in conjunction with the Company’s pressrelease dated October 24, 2005, announcing the financial results for theQuarter ended September 30, 2005.

 

Areport on Form 8-K dated November 21, 2005 included Item 5.04,Temporary Suspension of Trading Under Registrant’s Employee Benefit Plans, inconjunctions with issuance of a revised blackout period notice to allparticipants in the Company’s 401(k) Plan.

 

Areport on Form 8-K dated December 6, 2005 included Item 3.01, Noticeof Failure to Satisfy a Continued Listing Rule, in conjunction with issuance ofa press release dated December 6, 2005, announcing notification from theNasdaq Stock Market Listing Qualifications Department that for the previous 30consecutive business days the Company’s common stock has closed below theminimum $1.00 per share requirement for continued inclusion under Marketplace Rule 4310(c)(4).(See additional discussion under Risk Factors.)

 

Areport on Form 8-K dated December 19, 2005 included Item 5.02,Departure of Directors or Principal Officers; Election of Directors;Appointment of Principal Officers, in conjunction with a press release dated December 12,2005 announcing the election of William R. Maris, age 56, as Chief FinancialOfficer and Vice President of Finance and Administration, effective January 1,2006. The same Form 8-K also included Item 5.05 Amendments to theRegistrant’s Code of Ethics, or Waiver of a Provision of the Code of Ethics,with Cyanotech Corporation Corporate Code of Conduct attached as an Exhibit,such that, on December 9, 2005 the Board of Directors of CyanotechCorporation amended the Corporate Code of Conduct and Ethics, strengthening itscommitment to honest and ethical behavior and the highest standards of businessconduct, and further emphasizing corporate and individual accountability whileencouraging individuals to come forward with information about possiblemisconduct and assuring them of protection from retaliation.

 

Areport on Form 8-K datedFebruary 9, 2006 included Item 2.02, Results of Operations and FinancialCondition, in conjunction with the Company’s press release dated February 8,2006, and transcript of the web-cast and Vcall announcing the financial resultsfor the Quarter ended December 31, 2005.

 

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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) |
|-----------------------|-------------------------------------|
|                  |                                |   |
|                  |                                |   |
| February 8, 2006 |                                | By: |   | /s/ Gerald R.  Cysewski |   |
| (Date)                |                                |   | Gerald R. Cysewski |
|                  |                                | Chairman of the  Board, |
|                  |                                | President and  Chief Executive Officer |
|                  |                                |
|                  |                                |
|                  |                                | By: |   | /s/ William R.  Maris |   |
|                  |                                | William R. Maris |
|                  |                                | Vice President –  Finance & Administration |
|                  |                                | (Principal  Financial and Accounting Officer) |
|                       |                                     |  |  |  |  |  |  |  |  |  |

 

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