**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

**FORM 10-Q**

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

**For Quarterly Period Ended September 30, 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 the registrant is a largeaccelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.

Large accelerated filer  o          Acceleratedfiler  o          Non-acceleratedfiler  x

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

Number of commonshares outstanding as February 12, 2007:

| **Title of Class**              |   | **Shares  Outstanding** |
|---------------------------------|--------|-------------------------|
| Common stock -  $0.02 par value |   | 5,233,543               |

 

 

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CYANOTECH CORPORATION

FORM 10-Q

Explanatory Note —Restatement of Financial Information

On December 1, 2006,Cyanotech Corporation (the “Company”) filed a Current Report on Form 8-K withthe Securities and Exchange Commission (“SEC”) announcing that it would berestating certain consolidated financial statements in amendments to its annualreport on Form 10-K/A for the fiscal year ended March 31, 2006.  As more fully described in Note 13 to theConsolidated Financial Statements in Form 10-K/A filed February 14, 2007, theCompany identified errors in the application of certain accounting practicesand procedures.  The restatement andfiling of Form 10-K/A was primarily the result of the Company’s failure toinclude as a component of inventory cost certain fixed production costs such asdepreciation, general insurance and minor compensation cost.  All inventories, cost of sales and operatingexpense balances, as presented in this Form 10-Q, properly reflect theinclusion of these fixed production costs in accordance with AccountingResearch Bulletin No. 43.  In addition,the restatement and filing of Form 10-K/A also included adjustments for certainHawaii State Tax Credits and interest income for the years ended March 31, 2004and 2003, and tax adjustments for the years ended March 31, 2006, 2005, 2004,and 2003, all of which where considered immaterial in prior years.  In addition, refundable income taxes wererestated for each of the years in the three year period ended March 31, 2006and the reclassification of certain certificates of deposit from cash toshort-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 filingthis Form 10-Q for the fiscal quarter ended September 30, 2006.  Restated amounts from the consolidatedbalance sheet, as of March 31, 2006, and the statement of operations andconsolidated statement of cash flows for the three and six months endedSeptember 30, 2005 are included in this filing. The Company will not file a Form 10-Q/A for the quarterly period endedSeptember 30, 2005, and the consolidated financial statements and relatedinformation contained in that report should no longer be relied upon.

On November 3, 2006, theCompany implemented a one for four stock split at which time the share priceclosed at $0.43 with 20,934,565 common shares outstanding.  As the stock split occurred after the closeof the Company’s fiscal quarter and prior to the issuance of the financialstatements, all share data and per share data in these financial statements andnotes to financial statements reflect the effect of the split as if it occurredprior to the end of the current fiscal quarter.

*This Form 10-Q should be read inconjunction with the Company’s Form 10-K/A for the fiscal year ended March 31,2006 filed February 14, 2007.  Priorperiod comparative information contained in this Form 10-Q has been restatedconsistent with the Company’s Form 10-K/A and to reflect the Company’s one-for-four reverse stock split (see Notes2 and 3 of Notes to Consolidated Financial Statements included in the Form10-Q).*

*The Company did not file Form10-K/A, for the fiscal years 2005 or 2004, or Form 10-Q/A, for the interimperiods affected by the restatement prior to and including December 31,2005.  The consolidated financial statementsand related financial information for such periods as previously filed, containerrors and should therefore no longer be relied upon. The related audit reportsfor the years ended March 31, 2005 and 2004 of KPMG LLP, the Company’sindependent registered public accounting firm, with respect to those financialstatements should also no longer be relied upon.*

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

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CYANOTECH CORPORATION

FORM 10-Q

INDEX
| PART I.FINANCIAL  INFORMATION |
|------------------------------------|
|                               |   |
| Item 1.                            | Financial  Statements |
|                               |   |
|                               | Consolidated Balance Sheets (unaudited)  As of September 30, 2006 and March 31, 2006. |
|                               |   |
|                               | Consolidated  Statements of Operations  (unaudited) For the three and six month  periods ended September 30, 2006 and 2005 |
|                               |   |
|                               | Consolidated Statements of Cash Flows (unaudited)  For the six month periods ended September 30, 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 CORPORATION

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)
| ** **                                                                                                                                                              | ** ** | **September 30,** | ** ** | **March 31,**     | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                              | ** ** | **2006**               | ** ** | **2006 **         | ** ** |
| ** **                                                                                                                                                              | ** ** | ** **             | ** ** | **(As Restated)** | ** ** |
| ASSETS                                                                                                                                                                  |       |                   |       |                   |       |
| Current assets:                                                                                                                                                         |       |                   |       |                   |       |
| Cash and cash equivalents                                                                                                                                               |       | $                      | 1,444      |                   | $          | 1,835 |   |
| Short-term investments                                                                                                                                                  |       | 700                    |       | 700                    |       |
| Accounts receivable, net                                                                                                                                                |       | 1,746                  |       | 2,209                  |       |
| Refundable income taxes                                                                                                                                                 |       | 24                     |       | 17                     |       |
| Inventories (see Note 4)                                                                                                                                                |       | 2,177                  |       | 2,056                  |       |
| Prepaid expenses and other current assets                                                                                                                               |       | 173                    |       | 99                     |       |
| Total current assets                                                                                                                                                    |       | 6,264                  |       | 6,916                  |       |
|                                                                                                                                                                    |       |                   |       |                   |       |
| Equipment and  leasehold improvements, net (see Note 5)                                                                                                                 |       | 9,681                  |       | 10,164                 |       |
| Other assets                                                                                                                                                            |       | 472                    |       | 515                    |       |
| Total assets                                                                                                                                                            |       | $                      | 16,417     |                   | $          | 17,595 |   |
|                                                                                                                                                                    |       |                   |       |                   |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                              |       |                   |       |                   |       |
| Current  liabilities:                                                                                                                                                   |       |                   |       |                   |       |
| Current maturities of long-term debt                                                                                                                                    |       | $                      | 364        |                   | $          | 364 |   |
| Accounts payable                                                                                                                                                        |       | 441                    |       | 485                    |       |
| Accrued expenses                                                                                                                                                        |       | 379                    |       | 420                    |       |
| Total current liabilities                                                                                                                                               |       | 1,184                  |       | 1,269                  |       |
|                                                                                                                                                                    |       |                   |       |                   |       |
| Long-term debt,  excluding current maturities (see Note 6)                                                                                                              |       | 1,210                  |       | 1,387                  |       |
| Total liabilities                                                                                                                                                       |       | 2,394                  |       | 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 September 30, 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                                                                                      |       | (1                     | )          | (1                     | )          |
| Accumulated deficit                                                                                                                                                     |       | (13,414                | )          | (12,495                | )          |
| Total stockholders’ equity                                                                                                                                         |       | 14,023                 |       | 14,939                 |       |
|                                                                                                                                                                    |       |                   |       |                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                        |       | $                      | 16,417     |                   | $          | 17,595 |   |

See accompanyingNotes to Consolidated Financial Statements.

 

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CYANOTECHCORPORATION

CONSOLIDATED STATEMENTS OFOPERATIONS

(In thousands, except per share amounts)

(Unaudited)
| ** **                                         | ** ** | **Three Months Ended   September 30,** | ** ** | **Six Months Ended   September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                   | ** ** | **2005   (As Restated)**                       | ** ** | **2006** | ** ** | **2005  (As Restated)** | ** ** |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| NET SALES                                          |       | $                                                          | 2,475      |                                                     | $          | 2,517 |   | $ | 4,919 |   | $ | 5,546 |   |
| COST OF PRODUCT  SALES                             |       | 2,071                                                      |       | 1,935                                                    |       | 4,044 |   | 3,959 |   |
| Gross profit                                       |       | 404                                                        |       | 582                                                      |       | 875 |   | 1,587 |   |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| OPERATING  EXPENSES:                               |       |                                                       |       |                                                     |       |   |   |   |   |
| Research and development                           |       | 50                                                         |       | 52                                                       |       | 80 |   | 96 |   |
| Sales and marketing                                |       | 325                                                        |       | 300                                                      |       | 615 |   | 628 |   |
| General and administrative                         |       | 571                                                        |       | 504                                                      |       | 1,033 |   | 923 |   |
| Total operating expenses                           |       | 946                                                        |       | 856                                                      |       | 1,728 |   | 1,647 |   |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| Loss from operations                               |       | (542                                                       | )          | (274                                                     | )          | (853 | ) | (60 | ) |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                           |       |                                                       |       |                                                     |       |   |   |   |   |
| Interest income                                    |       | 17                                                         |       | 8                                                        |       | 26 |   | 23 |   |
| Interest expense                                   |       | (47                                                        | )          | (35                                                      | )          | (94 | ) | (90 | ) |
| Other income (expense), net                        |       | (4                                                         | )          | 2                                                        |       | (4 | ) | (8 | ) |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| Total other expense, net                           |       | (34                                                        | )          | (25                                                      | )          | (72 | ) | (75 | ) |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| Loss before income taxes                           |       | (576                                                       | )          | (299                                                     | )          | (925 | ) | (135 | ) |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| INCOME TAX  (BENEFIT) EXPENSE                      |       | (4                                                         | )          | (2                                                       | )          | (6 | ) | 3 |   |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| NET LOSS                                           |       | $                                                          | (572       | )                                                        | $          | (297 | ) | $ | (919 | ) | $ | (138 | ) |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| NET LOSS PER  SHARE (see Note 7)                   |       |                                                       |       |                                                     |       |   |   |   |   |
| Basic                                              |       | $                                                          | (0.11      | )                                                        | $          | (0.06 | ) | $ | (0.18 | ) | $ | (0.03 | ) |
| Diluted                                            |       | $                                                          | (0.11      | )                                                        | $          | (0.06 | ) | $ | (0.18 | ) | $ | (0.03 | ) |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| SHARES USED IN  CALCULATION OF NET LOSS PER SHARE: |       |                                                       |       |                                                     |       |   |   |   |   |
| Basic                                              |       | 5,234                                                      |       | 5,224                                                    |       | 5,233 |   | 5,224 |   |
| Diluted                                            |       | 5,234                                                      |       | 5,224                                                    |       | 5,233 |   | 5,224 |   |
|                                               |       |                                                       |       |                                                     |       |   |   |   |   |
| COMPREHENSIVE  LOSS:                               |       |                                                       |       |                                                     |       |   |   |   |   |
| Net loss                                           |       | $                                                          | (572       | )                                                        | $          | (297 | ) | $ | (919 | ) | $ | (138 | ) |
| Other comprehensive loss                           |       | (2                                                         | )          | (6                                                       | )          | (0 | ) | (8 | ) |
|                                               |       | $                                                          | (574       | )                                                        | $          | (303 | ) | $ | (919 | ) | $ | (146 | ) |

See accompanying Notes to Consolidated Financial Statements.

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OFCASH FLOWS

(Dollars in thousands)

(Unaudited)
| ** **                                                                                 | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                           | ** ** | **2005  (As Restated)** | ** ** |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                     |       |                                               |       |   |   |
| Net loss                                                                                   |       | $                                                  | (919       | ) | $ | (138 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                                               |       |   |   |
| Depreciation                                                                               |       | 650                                                |       | 676 |   |
| Provision for (reduction of) allowance for doubtful  accounts                              |       | 4                                                  |       | (5 | ) |
| Amortization of debt issue costs and other assets                                          |       | 17                                                 |       | 16 |   |
|                                                                                       |       |                                               |       |   |   |
| Net (increase) decrease in:                                                                |       |                                               |       |   |   |
| Accounts receivable                                                                        |       | 459                                                |       | 462 |   |
| Refundable income taxes                                                                    |       | (7                                                 | )          | 46 |   |
| Inventories                                                                                |       | (121                                               | )          | (212 | ) |
| Prepaid expenses and other assets                                                          |       | (48                                                | )          | (76 | ) |
| Net increase (decrease) in:                                                                |       |                                               |       |   |   |
| Accounts payable                                                                           |       | (44                                                | )          | (504 | ) |
| Accrued expenses                                                                           |       | (41                                                | )          | 79 |   |
| Net cash provided by (used in) operating activities                                        |       | (50                                                | )          | 344 |   |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                     |       |                                               |       |   |   |
| Investment in equipment and leasehold improvements                                         |       | (167                                               | )          | (123 | ) |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                     |       |                                               |       |   |   |
| Proceeds from exercise of stock options and warrants                                       |       | 3                                                  |       | 0 |   |
| Principal payments on long-term debt                                                       |       | (177                                               | )          | (172 | ) |
| Net cash used in financing activities                                                      |       | (174                                               | )          | (172 | ) |
|                                                                                       |       |                                               |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                      |       | (391                                               | )          | 49 |   |
|                                                                                       |       |                                               |       |   |   |
| Cash and cash  equivalents at beginning of period                                          |       | 1,835                                              |       | 2,005 |   |
|                                                                                       |       |                                               |       |   |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                  | 1,444      |   | $ | 2,054 |   |
|                                                                                       |       |                                               |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                         |       |                                               |       |   |   |
| Cash paid during  the period for:                                                          |       |                                               |       |   |   |
| Interest                                                                                   |       | $                                                  | 80         |   | $ | 74 |   |
| Income taxes                                                                               |       | $                                                  | 1          |   | $ | 4 |   |

See accompanying Notes to Consolidated Financial Statements.

 

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CYANOTECHCORPORATIONFORM 10-QNOTES TO CONSOLIDATED FINANCIAL STATEMENTSAs of September 30, 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.  *Theseconsolidated financial statements and notes should be read in conjunction withthe Company’s consolidated financial statements contained in the Company’spreviously filed report 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 month and six month period ended September30, 2006 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 31,2007.

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 reviewstheses 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 after the close of the Company’s fiscalquarter ended September 30, 2006 and prior to the issuance of these financialstatements, all share option data and per share data in these financialstatements and notes to financial statements reflect the effects of the stocksplit as if it occurred for all periods presented.  Thenumber of shares used in per share data was determined as if all outstandingshares at September 30, 2006 were exchanged.

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 

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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 grant-date fair value of the awardand are not subsequently remeasured.  Thecost of equity-classified awards is recognized in the income statement over theperiod during which an employee is required to provide the service in exchangefor the award.   In the Company’s case,all of the Company’s stock options are equity-classified awards.

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 September 30, 2006, 195,000 options remained available for grant under the2005 Plan.   Concurrent with the 2005Plan approval on August 22, 2005, the 1995 Stock Option Plan was terminatedexcept for 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 inSAB 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 September 30, 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 six months ended September 30,2006 had the acceleration not occurred. No options weregranted by the Company during the six month period ending September 30,2006.  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 reserved for issuance.  Under the2004 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 September 30, 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.

The followingtable summarizes the weighted average characteristics of outstanding stock optionsas of September 30, 2006 for various exercise price ranges:

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| ** **                                  | ** ** | **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                                 |       | 58,644                       |       | 1.8                          |       | $ | 2.26 |   | 58,207 |   | $ | 2.26 |   |
| $3.88-$6.75                                 |       | 28,393                       |       | 3.0                          |       | 4.51 |   | 26,894 |   | 4.51 |   |
| $14.75-$24.50                               |       | 7,000                        |       | 1.4                          |       | 15.80 |   | 7,000 |   | 15.80 |   |
| Total stock options at  September 30, 2006  |       | 94,037                       |       |                         |       | 3.94 |   | 92,101 |   | 3.95 |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |

 

A summary of option activity under Cyanotech Corporation Stock Plans forthe quarter ended September 30, 2006 is presented below:

 
| **Option Activity**           | ** ** | **Shares** | ** ** | **Weighted Average   Exercise Price** | ** ** | **Weighted Average   Remaining   Contractual Term** | ** ** | **Aggregate Intrinsic   Value** | ** ** |
|------------------------------------|------------|------------|------------|------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| Outstanding at  June 30, 2006      |       | 110,150    |       | $                                                    | 3.95       |                                                                    | 2.1 years  |                                      |       |   |
| Granted                            |       | —     |       | —                                               |       | —                                                                  |       |                                      |       |
| Exercised                          |       | (14,425    | )          | $                                                    | 4.12       |                                                                    |       |                                      |       |   |
| Forfeited or  expired              |       | (1,688     | )          | $                                                    | 3.07       |                                                                    |       |                                      |       |   |
| Outstanding at  September 30, 2006 |       | 94,037     |       | $                                                    | 3.94       |                                                                    | 2.1 years  |                                      | $          | 370,506 |   |
| Exercisable at  September 30, 2006 |       | 92,101     |       | $                                                    | 3.95       |                                                                    | 2.2 years  |                                      | $          | 363,799 |   |
|                                    |            |            |            |                                                      |            |                                                                         |            |                                           |            |  |  |  |

 

A summary of Cyanotech Corporation’s non-vested options for the quarterended September 30, 2006 is presented below:

 
| Nonvested Options           | ** ** | **Shares** | ** ** | **Weighted Average   Grant-Date  Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------------------|------------|
| Nonvested at June  30, 2006      |       | 2,250      |       | $                                                            | 3.84       |   |
| Granted                          |       | —     |       | —                                                       |       |
| Vested                           |       | —     |       | —                                                       |       |
| Forfeited or  expired            |       | (314       | )          | $                                                            | 3.81       |   |
| Nonvested at September  30, 2006 |       | 1,936      |       | $                                                            | 3.85       |   |

 

A summary of option activity under Cyanotech Corporation Stock Plans forthe six months ended September 30, 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                          |       | (16,000            | )          | $                                                    | 4.10       |                                                                    |       |                                      |       |   |
| Forfeited or  expired              |       | (7,193             | )          | $                                                    | 2.96       |                                                                    |       |                                      |       |   |
| Outstanding at  September 30, 2006 |       | 94,037             |       | $                                                    | 3.94       |                                                                    | 2.1 years  |                                      | $          | 370,506 |   |
| Exercisable at  September 30, 2006 |       | 92,101             |       | $                                                    | 3.95       |                                                                    | 2.2 years  |                                      | $          | 363,799 |   |

 

A summary of Cyanotech Corporation’s non-vested options for the sixmonths ended September 30, 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            |       | (1,017     | )          | $                                                            | 4.22       |   |
| Nonvested at September  30, 2006 |       | 1,936      |       | $                                                            | 3.85       |   |

 

9

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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 six month comparable periodended September 30, 2005:

 

|                                                            | ** ** | **Three Months Ended   September 30,** | ** ** | **Six Months Ended   September 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2005  (As Restated)**                               | ** ** | **2005  (As Restated)**                             | ** ** |
|                                                       |       |                                                       |       |                                                     |       |
| Net loss, as  reported                                     |       | $                                                          | (297       | )                                                        | $          | (138 | ) |
| Deduct  stock-based employee compensation                  |       |                                                       |       |                                                     |       |
| Expense determined under fair-value method for all  awards |       | (18                                                        | )          | (39                                                      | )          |
| Pro-forma net  loss                                        |       | $                                                          | (315       | )                                                        | $          | (177 | ) |
| Basic net loss  per common share:                          |       |                                                       |       |                                                     |       |
| As reported                                                |       | $                                                          | (0.06      | )                                                        | $          | (0.03 | ) |
| Pro-forma                                                  |       | $                                                          | (0.06      | )                                                        | $          | (0.03 | ) |
|                                                       |       |                                                       |       |                                                     |       |
| Diluted net loss  per common share:                        |       |                                                       |       |                                                     |       |
| As reported                                                |       | $                                                          | (0.06      | )                                                        | $          | (0.03 | ) |
| Pro-forma                                                  |       | $                                                          | (0.06      | )                                                        | $          | (0.03 | ) |

 

Options wereexercised during the six month period ending September 30, 2006. The intrinsicvalue of options exercised during the six months ended September 30, 2006 was$1,000.  The amount of cash received fromoption exercises during the six months ended September 30, 2006 was$3,000.  Because qualified employeeincentive options were exercised and the Company has significant operating losscarry forwards, there were no tax consequences as a result of option exercisesduring the six months ended September 30, 2006.

4.                                       INVENTORIES

Inventories are stated at the lower of cost (whichapproximates first-in, first-out) or market. Market is defined as sales price less cost to dispose and a normalprofit margin.  Inventories consist ofthe following (dollars in thousands):

 

|                 | ** ** | **September 30, 2006** | ** ** | **March 31, 2006  (As Restated)** | ** ** |
|-----------------|------------|----------------------------------|------------|--------------------------------------------------|------------|
|            |       |                             |       |                                             |       |
| Raw materials   |       | $                                | 237        |                                             | $          | 240 |   |
| Work in process |       | 309                              |       | 260                                              |       |
| Finished goods  |       | 1,507                            |       | 1,432                                            |       |
| Supplies        |       | 124                              |       | 124                                              |       |
|            |       | $                                | 2,177      |                                             | $          | 2,056 |   |

 

5.                                       EQUIPMENTAND LEASEHOLD IMPROVEMENTS

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

 

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

 

10

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Equipmentand leasehold improvements consist of the following (dollars in thousands):

|                                                 | ** ** | **September 30, 2006** | ** ** | **March 31, 2006  (As Restated)** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------------------------|------------|
| Equipment                                       |       | $                                | 10,629     |                                             | $          | 10,461 |   |
| Leasehold  improvements                         |       | 14,666                           |       | 14,642                                           |       |
| Furniture and  fixtures                         |       | 86                               |       | 86                                               |       |
|                                            |       | 25,381                           |       | 25,189                                           |       |
| Less accumulated  depreciation and amortization |       | (15,977                          | )          | (15,327                                          | )          |
| Construction  in-progress                       |       | 277                              |       | 302                                              |       |
| Equipment and leasehold  improvements, net      |       | $                                | 9,681      |                                             | $          | 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 2).

7.                                       EARNINGSPER 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.

Reconciliations between the numerator and thedenominator of the basic and diluted earnings per share computations for thethree months ended September 30, 2006 and 2005 are as follows (inthousands, except per share amounts):

|                                                                         | ** ** | **Three Months Ended September 30, 2006** | ** ** | **Three Months Ended September 30, 2005  (As Restated)** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Loss**                                                  | ** ** | **Shares**                                                                             | ** ** | **Per Share** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                                                    | ** ** | **(Denominator)**                                                                      | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic net loss  per share                                               |       | $                                                                  | (572       | )                                                                                      | 5,234      |   | $ | (0.11 | ) | $ | (297 | ) | 5,224 |   | $ | (0.06 | ) |
| Effect of  dilutive securities — Common stock options and warrants |       | —                                                             |       | —                                                                                 |       | — |   | — |   | — |   | — |   |
| Diluted net loss per  share                                             |       | $                                                                  | (572       | )                                                                                      | 5,234      |   | $ | (0.11 | ) | $ | (297 | ) | 5,224 |   | $ | (0.06 | ) |

 

Reconciliations betweenthe numerator and the denominator of the basic and diluted earnings per sharecomputations for the six months ended September 30, 2006 and 2005 are asfollows (in thousands, except per share amounts):

|                                                                         | ** ** | **Six Months Ended September 30, 2006** | ** ** | **Six Months Ended September 30, 2005   (As Restated)** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Loss**                                                | ** ** | **Shares**                                                                                 | ** ** | **Per Share** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                                                  | ** ** | **(Denominator)**                                                                          | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic net loss  per share                                               |       | $                                                                | (919       | )                                                                                          | 5,233      |   | $ | (0.18 | ) | $ | (138 | ) | 5,224 |   | $ | (0.03 | ) |
| Effect of  dilutive securities — Common stock options and warrants |       | —                                                           |       | —                                                                                     |       | — |   | — |   | — |   | — |   |
| Diluted net loss per  share                                             |       | $                                                                | (919       | )                                                                                          | 5,233      |   | $ | (0.18 | ) | $ | (138 | ) | 5,224 |   | $ | (0.03 | ) |

 

11

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The following securitieswere excluded from the calculation of diluted earnings per share because theireffect was antidilutive (in thousands):

 

|                             | ** ** | **Three Months Ended   September 30,** | ** ** | **Six Months Ended   September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                   | ** ** | **2005**                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Stock options  and warrants |       | 94                                                         |       | 130                                                      |       | 99 |   | 130 |   |

 

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 $59,000 or $0.01 per diluted share were not inventoried for the three monthsended September 30, 2006, and fixed production related costs of $95,000 or $0.02per diluted share were not inventoried for the six months ended September 30,2006. The costs were not inventoried due to production below normal 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 isimpracticable to do so.  In addition,indirect effects of a change in accounting principle should be recognized inthe period of the accounting change.  TheCompany adopted SFAS No. 154 effective April 1, 2006.  Because the impact of adopting the provisionsof SFAS No. 154 will be dependent on future events or circumstances, managementcannot predict such impact.

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 disclosed pursuantto 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 will adopt EITF No. 06-3 on January 1, 2007 and has electedto present these taxes on a gross basis consistent with its accounting policyand historical 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 regarding 

12

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the process ofquantifying financial statement misstatements. SAB No. 108 provides guidance on the consideration of the effects ofprior year misstatements (misstatements that were not corrected at the end ofthe prior year) in quantifying current year misstatements for the purpose of amateriality assessment.  Common practicein quantifying a misstatement allows for multiple approaches.   A misstatement can be based on the amount ofthe error originating in the current year income statement or be based on theeffects of correcting the misstatement existing in the balance sheet at the endof the current year, irrespective of the misstatement’s year(s) oforigination.  Therefore, in quantifyingthe impact of correcting all misstatements, including both the carryover andreversing effects of prior year misstatements, on the current year financialstatements, errors should be measured under each approach and evaluated formateriality.  An adjustment would berequired when either approach results in quantifying a misstatement that ismaterial, as defined in FASB Concepts Statement No. 2, after considering allrelevant quantitative and qualitative factors. SAB No.108 is effective for fiscal years ended after November 15, 2006.Because the impact of adopting the provisions of SAB No. 108 will be dependenton future events or circumstances, management cannot predict such impact.

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 iseffective for financial statements issued for fiscal years beginning afterNovember 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.

9.             LISTING STATUS:RESTATEMENT OF PREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS

On December 1, 2006, Cyanotech Corporation filed a Current Report on Form8-K with the SEC announcing that based on the current findings of itspreviously announced accounting review, it had determined to restate certain ofits previously issued financial statements.  Since that time, we completed our accounting review and determined thatcertain of the errors resulted from deficiencies in our internal control overfinancial reporting.  See Item 4 Controlsand Procedures in this Form 10-Q and Item 9A Controls and Procedures in Form10-K/A filed February 14, 2007.   Due tothe inventory valuation issues involved and the time and effort required forcompletion of the restatement reflected in the Form 10-K/A, the Company isdelinquent in the filing of this Form 10-Q. On December18, 2006, the Company received a Determination Letter (the “Letter”) from theNasdaq 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 theCompany will have until February 20, 2007 to file its late Form 10-Q for thequarter ended June 30, 2006, its Form 10-Q for the quarter ended September 30,2006, and the Form 10-K/A restatement filed February 14, 2007.  The decision represents the full extentof the Panel’s authority to grant an exception pursuant to Marketplace Rule4002(b). The Company has 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.

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 ofMarch 31, 2006 and 2005; (2) consolidated statements ofoperations, stockholder’s equity and comprehensive income (loss) and cash flowsfor 

each of the 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 ended March 31, 2006, 2005,2004, 2003 and 2002; and

(5) certain financial data for the quarterly periods ended March 31,2006, and December 31, September 30, June 30, 

and March 31, 2005 and December 31, September30, and June 30, 2004.

The errors or adjustments identified in ourpreviously issued consolidated financial statements are as follows: (A) *We failed to include as acomponent of inventory cost certain fixed production costs such asdepreciation, general*

*insurance and minor compensation cost into inventory. *Inventories for March 31, 2006, 2005, 2004 and 2003, and 

quarterly periods within the years 2006 and 2005, were restated as werecost of sales and certain operating expenses 

as included in the Consolidated Statements of Operations for each of theyears in the three year period ended March 

31, 2006.   This restatement was aresult of the discovery of the error subsequent to the filing with the SEC ofthe 

Original Form 10-K as filed with the SEC. All inventories, cost of sales and operating expense balances, as 

presented in this Form 10-Q, properly reflect the inventory whichincludes these fixed production costs in 

accordance with Accounting Research Bulletin No. 43.

(B) We recorded certain Hawaii State Tax Credit adjustments which wereconsidered immaterial in prior years.  

Refundable income taxes were restated for the year ended March 31,2005.  Income tax expense (benefit) was 

restated for each of the years in the three year period ended March 31,2006 but had no impact on net loss for the 

three and six months ended September 30, 2006 and 2005.

(C) We recorded certain interest income adjustments which were consideredimmaterial in prior years.  Theseimpacted 

the years ended March 31, 2004 and 2003 but had no impact on the threeand six months ended September 30, 2005 

and 2006.

13

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(D) We reclassified certain certificates of deposit from cash toshort-term investments in fiscal years 2005 and 2004.  

These reclassifications had no effect on reported net income (loss) or incash flows from operations for the years 

ended March 31, 2005 and 2004.  Cash flows from operations for the three and six months ended September30, 

2005 were restated.

(E) We recorded certain tax adjustments which were considered immaterialto reports filed in prior periods.  These 

adjustments impacted the years ended March 31, 2005, 2004 and 2003.   Cash flows from operations for the three 

and six months ended September 30, 2005 wererestated.

Quarterly data has been derived from our unauditedconsolidated financial statements that, in our opinion, reflects 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 previously reported in theCompany’s consolidated statements of operations for the three month periodended September 30, 2005 and the six months ended September 30, 2005 and theeffect of the restatement adjustments, and the restated amounts.

 
| ** **                                                         | ** ** | **Consolidated Statement of Operations** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Three Months  Ended  September 30,  2005**  | ** ** | **Adjustments** | ** ** | **Three Months  Ended  September 30,  2005** | ** ** |
| **(in thousands, except per share data)** | ** ** | **(As reported)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Net sales                                                          |       | $                                                       | 2,517      |   | $ | — |   | $ | 2,517 |   |
| Cost of sales  (A)                                                 |       | 1,936                                                   |       | (1 | ) | 1,935 |   |
| Gross profit                                                       |       | 581                                                     |       | 1 |   | 582 |   |
| Operating  expenses:                                               |       |                                                    |       |   |   |   |   |
| Research and development (A)                                       |       | 53                                                      |       | (1 | ) | 52 |   |
| Sales and marketing (A)                                            |       | 304                                                     |       | (4 | ) | 300 |   |
| General and administrative (A)                                     |       | 522                                                     |       | (18 | ) | 504 |   |
| Total operating expense                                            |       | 879                                                     |       | (23 | ) | 856 |   |
| Income (loss) from operations                                      |       | (298                                                    | )          | 24 |   | (274 | ) |
| Other income  (expense):                                           |       |                                                    |       |   |   |   |   |
| Interest income                                                    |       | 8                                                       |       | — |   | 8 |   |
| Interest expense                                                   |       | (35                                                     | )          | — |   | (35 | ) |
| Other income, net                                                  |       | 2                                                       |       | — |   | 2 |   |
| Total other expense, net                                           |       | (25                                                     | )          | (25 | ) |   |   |
| Income (loss) before income taxes                                  |       | (323                                                    | )          | 24 |   | (299 | ) |
| Income tax benefit                                                 |       | (2                                                      | )          | — |   | (2 | ) |
| Net income (loss)                                                  |       | $                                                       | (321       | ) | $ | 24 |   | $ | (297 | ) |
| Net income  (loss) per share:                                      |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | $                                                       | (0.06      | ) | $ | 0.00 |   | $ | (0.06 | ) |
| Diluted                                                            |       | $                                                       | (0.06      | ) | $ | 0.00 |   | $ | (0.06 | ) |
|  Shares used in calculation of net income  (loss) per share:  |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | 5,224                                                   |       | — |   | 5,224 |   |
| Diluted                                                            |       | 5,224                                                   |       | — |   | 5,224 |   |

 

14

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| ** **                                                         | ** ** | **Consolidated Statement of Operations** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Six Months  Ended  Sept 30,  2005**         | ** ** | **Adjustments** | ** ** | **Six Months  Ended  Sept. 30,  2005** | ** ** |
| **(in thousands, except per share data)** | ** ** | **(As reported)**                                  | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Net sales                                                          |       | $                                                       | 5,546      |   | $ | — |   | $ | 5,546 |   |
| Cost of sales  (A)                                                 |       | 3,940                                                   |       | 19 |   | 3,959 |   |
| Gross profit                                                       |       | 1,606                                                   |       | (19 | ) | 1,587 |   |
| Operating  expenses:                                               |       |                                                    |       |   |   |   |   |
| Research and development (A)                                       |       | 99                                                      |       | (3 | ) | 96 |   |
| Sales and marketing (A)                                            |       | 637                                                     |       | (9 | ) | 628 |   |
| General and administrative (A)                                     |       | 960                                                     |       | (37 | ) | 923 |   |
| Total operating expense                                            |       | 1,696                                                   |       | (49 | ) | 1,647 |   |
| Income (loss) from operations                                      |       | (90                                                     | )          | (30 | ) | (60 | ) |
| Other income  (expense):                                           |       |                                                    |       |   |   |   |   |
| Interest income                                                    |       | 23                                                      |       | — |   | 23 |   |
| Interest expense                                                   |       | (90                                                     | )          | — |   | (90 | ) |
| Other income, net                                                  |       | (8                                                      | )          | — |   | (8 | ) |
| Total other expense, net                                           |       | (75                                                     | )          | — |   | (75 | ) |
| Income (loss) before income taxes                                  |       | (165                                                    | )          | 30 |   | (135 | ) |
| Income tax expense                                                 |       | 3                                                       |       | — |   | 3 |   |
| Net income (loss)                                                  |       | $                                                       | (168       | ) | $ | 30 |   | $ | (138 | ) |
| Net income  (loss) per share:                                      |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | $                                                       | (0.03      | ) | $ | 0.00 |   | $ | (0.03 | ) |
| Diluted                                                            |       | $                                                       | (0.03      | ) | $ | 0.00 |   | $ | (0.03 | ) |
|  Shares used in calculation of net income  (loss) per share:  |       |                                                    |       |   |   |   |   |
| Basic                                                              |       | 5,224                                                   |       | — |   | 5,224 |   |
| Diluted                                                            |       | 5,224                                                   |       | — |   | 5,224 |   |

 

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**CYANOTECHCORPORATION**

**Item 2.****           Management’sDiscussion and Analysis 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 itsreports — except those of which have been designated as no longer to be reliedupon —  on Form 10-K/A, Form 10-K, Form10-Q, Form 8-K, and its proxy materials, contain additional important factorsthat could cause actual results to differ from the Company’s currentexpectations and the forward-looking statements contained herein.*

***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 hasdetermined that certain of the errors resulted from deficiencies in internalcontrol over financial reporting.  SeeItem 9A. Controls and Procedures in the Company’s  Form 10-K/A filed on February 14, 2007. 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, 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**

A comparison of selected consolidated statements of operationsdata as reported herein follows for the periods indicated (dollars inthousands):

 
|                              | ** ** | **Three Months Ended  September 30, 2006** | ** ** | ** Three Months Ended  September 30, 2005  (As Restated)** | ** ** | **Change** | ** ** |
|------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|------------|------------|
| Net sales:                   |       |                                                           |       |                                                                                     |       |       |       |
| Spirulina products           |       | $                                                              | 1,436      |                                                                                     | $          | 1,330      |       | 8 | % |
| Natural astaxanthin products |       | 1,000                                                          |       | 1,131                                                                                    |       | (12        | )%         |
| Other products               |       | 39                                                             |       | 56                                                                                       |       | (30        | )%         |
| Total sales, all  products   |       | $                                                              | 2,475      |                                                                                     | $          | 2,517      |       | (2 | )% |
|                         |       |                                                           |       |                                                                                     |       |       |       |
| Gross profit                 |       | $                                                              | 404        |                                                                                     | $          | 582        |       | (31 | )% |
| Loss from  operations        |       | $                                                              | (542       | )                                                                                        | $          | (274       | )          | 98 | % |
| Net loss                     |       | $                                                              | (572       | )                                                                                        | $          | (297       | )          | 93 | % |
|                         |       |                                                           |       |                                                                                     |       |       |       |

 
|                               | ** ** | **Six Months Ended  September 30, 2006** | ** ** | ** Six Months Ended  September 30, 2005  (As Restated)** | ** ** | **Change** | ** ** | ** ** |
|-------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------|------------|------------|
| Net sales:                    |       |                                                         |       |                                                                                   |       |       |       |       |
| Spirulina  products           |       | $                                                            | 2,962      |                                                                                   | $          | 3,205      |       | (8         | )% |   |
| Natural  astaxanthin products |       | 1,890                                                        |       | 2,199                                                                                  |       | (14        | )%         |       |
| Other products                |       | 67                                                           |       | 142                                                                                    |       | (53        | )%         |       |
| Total sales, all  products    |       | $                                                            | 4,919      |                                                                                   | $          | 5,546      |       | (11        | )% |   |
|                          |       |                                                         |       |                                                                                   |       |       |       |       |
| Gross profit                  |       | $                                                            | 875        |                                                                                   | $          | 1,587      |       | (45        | )% |   |
| Loss from  operations         |       | $                                                            | (853       | )                                                                                      | $          | (60        | )          | n/m        | * |   |
| Net loss                      |       | $                                                            | (919       | )                                                                                      | $          | (138       | )          | 566        | % |   |

----

* notmeaningful

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Sales for thethree and six months ended September 30, 2006 decreased $42,000 or 2% and$627,000 or 11% from the comparable three and six month periods of the prioryear, respectively.  For the three monthperiod, natural astaxanthin sales decreased 12% and Spirulina sales increased8% from the comparable prior year period.  For the six month period, natural astaxanthin sales decreased 14% andSpirulina sales decreased 8% from the comparable prior year period.  The decrease in natural astaxanthin sales forboth the three and six months periods was primarily due to decreased unit salesin the Japan aquaculture market as a result of increased price competition fromsynthetic based astaxanthin products.  Weexpected that warmer seasonal weather in Japan would increase the demand forour NatuRose astaxanthin product but the demand did not materialize and themarket demand shortfall in Japan has persisted. For the three month period, the increase in Spirulina sales resultedprimarily from increased unit sales in our consumer packaged products outsideof the United States. For the six month period, the decrease in Spirulina salesresulted primarily from decreased units and slightly decreased prices whichwere not offset by slightly increased units and slightly increased prices forconsumer packaged products. Price decreases primarily resulted from discountson large volume orders.

For the three andsix month periods ended September 30, 2006 costs of sales increased 7% and 2%,respectively, when compared to the comparable prior year period.   For the three and six months ended September30, 2006, variable production costs increased 12% and 13%, respectively,primarily in labor and chemicals.   Laborcosts were impacted by wage increases during the first quarter of fiscal 2007in response to a competitive labor market (primarily from the constructionindustry) in Hawaii.   Chemical costsincreased as a result of increased consumption of nutrients, some of which weredeemed to be period costs due to abnormal usage which was not effective incorrecting an imbalance in the cultivation process.  Such period costs totaled approximately$143,000 in the second quarter of fiscal 2007 and $149,000 for the six monthsended September 30, 2006.   Pursuant toSFAS No. 151, approximately $59,000 and $95,000 of fixed production overheadcosts was not inventoriable during the three and six months ended September 30,2006 because our natural astaxanthin production output was below normalcapacity for both periods.  In addition,production costs associated with the Company’s animal nutrition market productswere not inventoriable because such costs would have exceeded the market valuefor such inventory:  For the three monthsended September 30, 2006 such costs approximated $127,000, while there were nosuch costs in the prior comparable period; and, for the six months endedSeptember 30, 2006 and 2005, such costs approximated $245,000 and $1,000,respectively.

As a result of thedecrease in sales coupled with the increase in cost of sales in both the threeand six month periods, gross profit margins as a percentage of sales decreasedto 16% for the three months ended September 30, 2006 as compared to 23% for thecomparable prior year quarter and decreased to 18% for the six months endedSeptember 30, 2006 as compared to 29% for the comparable prior year to dateperiod.  Due to above factors, we expectthat the Company’s gross profit margins during fiscal 2007 will continue to beless than the margins reported for comparable prior year periods while actions are currently underway toobtain production at desired capacity and quality levels.

Operatingexpenses, compared to the comparable prior year period, increased $90,000 or11% for the three months and $81,000 or 5% for the nine months ended September30, 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, auditing and contract services.

Lowergross profits and higher operating expenses resulted in a net loss of $572,000for the second quarter of fiscal 2007 compared to net losses of $297,000 forthe second quarter of the prior fiscal year and on a cumulative six monthsbasis, a net loss of $919,000 the fiscal 2007 period compared to $138,000 ayear ago.

**Results of Operations**

*Second Quarter of Fiscal 2007 Compared to SecondQuarter of Fiscal 2006*

Net sales for the three months endedSeptember 30, 2006 were $2,475,000, a 2% decrease from $2,517,000 for thecomparable period a year ago.  Thisdecrease was primarily from reduced sales of natural astaxanthin productspartially offset by increased spirulina sales from the prior comparable period.

Company sales ofspirulina products for the second quarter of fiscal 2007 were $1,436,000, anincrease of 8% over the $1,330,000 generated in the second quarter of fiscal2006.  As a percentage of sales,Spirulina represented 58% of total sales in the current period and 53% of salesin the prior comparable period.  Naturalastaxanthin product sales were $1,000,000 during the second quarter of fiscal2007, a 12% decrease from $1,131,000 in the second quarter of the prioryear.  The natural astaxanthin productlines decreased to 40% of total sales over a 45% of total sales in the secondquarter of fiscal 2006.   NatuRose salescontinued to decrease as a result of lower demand in the Japanese aquaculturemarket and was a significant factor in the decrease in natural astaxanthinsales between 

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the comparativequarters.  Other product sales were$39,000 and $56,000 for the second quarters of fiscal years 2007 and 2006,respectively.

Internationalsales were 41% of total sales for the second quarter of fiscal 2007, comparedto 50% a year ago.  For the three monthsended September 30, 2006, our European distributor accounted for 10% oftotal sales as compared to 12% of total sales for the comparable months prioryear period.  .

For the threemonths ended September 30, 2006 costs of sales increased 7% compared to thecomparable prior year quarter.   For thethree ended September 30, 2006, variable production costs increased 12%primarily in labor and chemicals.   Laborcosts were impacted by wage increases during the first quarter of fiscal 2007in response to a competitive labor market (primarily from the constructionindustry) in Hawaii.   Chemical costsincreased as a result of increased consumption of nutrients, some of which weredeemed to be period costs due to abnormal usage which was not effective incorrecting an imbalance in the cultivation process.  Such period costs totaled approximately$143,000 in three months ended September 30, 2006.   Pursuant to SFAS No. 151, approximately$59,000 of fixed production overhead costs was not inventoriable during thethree months ended September 30, 2006 because our natural astaxanthinproduction output was below normal capacity, and $60,000 of below normalcapacity cost, prior to the adoption of SFAS No. 151, was recorded during thethree months ended September 30, 2005. In addition, production costs associatedwith the Company’s animal nutrition market products totaling approximately$127,000 for the three months ended September 30, 2006 and nil for the threemonths ended September 30, 2005, were not inventoriable because such costswould have exceeded the market value for such inventory.  As a result of the decrease in sales coupledwith the increase in cost of sales, gross profit margins as a percentage ofsales decreased to 16% for the three months ended September 30, 2006 ascompared to 23% for the comparable prior year quarter.

Operating expenses for the three months endedSeptember 30, 2006 were $946,000 or 38% of sales, compared to $856,000 or34% of sales for the three months ended September 30, 2005.  In the second quarter of fiscal 2007, salesand marketing and general and administrative expense were 8% and 13% above thecomparable prior period, respectively, and research and development expensesremained consistent compared to the comparable period of the prior fiscalyear.  The incremental general andadministrative expenses were associated with the prior fiscal year’srestatement and filing of the Company’s Form 10-K/A, late filings of Forms 10-Qfor the first and second quarters of fiscal year 2007, and, to a much lesserextent, the fees associated with the Company’s one for four reverse stock spliton November 3, 2006 (Note 3).  TheCompany expects that total operating expenses will increase throughout theremainder of the fiscal year due to the efforts associated with the restatementand filing process of the Company’s Form 10-K/A as well as late filings ofForms 10-Q and the related fees for accounting, auditing and contract services.In addition, with respect to the reasons underlying the filing of Form 10-K/A,increased costs are expected as a result of management’s recommendation and theCompany’s Audit Committee and Board of Directors approval and adoption of aremediation plan which includes that policies and procedures will be designedto ensure full compliance with Generally Accepted Accounting Principles (GAAP),particularly as it applies to inventory accounting, and will address keyfinancial reporting risk elements, including the following: (a) ensuring thatits disclosures are subject to adequate and rigorous review process prior tofinalizing and releasing financial statements; (b) continuing to update its inventory accounting systems and proceduresto properly accommodate specific inventoriable fixed costs in accordance withGAAP; and (c) continuing to identify resources with the critical skillsnecessary to ensure full compliance with GAAP. The process related to erroridentification and subsequent restatement, originated in the second quarter offiscal 2007.  Related audit, legal,outside consulting costs included in this Form 10-Q for the second quartertotaled $53,000.

Net other expense,which includes interest on the Company’s debt, for the second quarter of fiscal2007 was $34,000, an increase from $25,000 for the same period a year ago.  This increase is primarily attributed tohigher interest rates in the current reporting period on the Company’soutstanding debt.

For the second quarter of fiscal 2007, an income taxbenefit of $4,000 was recorded, compared to an income tax benefit of $2,000 forthe comparable period of the prior fiscal year. The Company does not expect any expense to be recorded for United Statesincome taxes in the current fiscal year as a result of available net operatingloss carry forwards.

The result of the foregoing was a net loss of$572,000, or ($0.11) per diluted share, for the three months endedSeptember 30, 2006, in comparison****to net loss of$297,000, or ($0.06) per diluted share, for the comparable prior yearquarter.  The higher net loss was theresult of lower net sales and lower gross profit in conjunction with higheroperating expenses in the current quarter.

*Six Months Ended September 30, 2006 Comparedto Six Months Ended September 30, 2005*

Net sales for the six months ended September 30,2006 were $4,919,000, a decrease of 11% from sales of $5,546,000 reported forthe comparable period a year ago.  Thereduction in sales over the prior year’s six-month period was largely theresult of decreased sales of bulk products for both spirulina and naturalastaxanthin, offset in part by increased sales in packaged products.  International sales represented 47% of netsales for the six months ended September 30, 2006 compared to 54% for thesame period a year ago due to lower sales in Japan and Europe.  For the six months ended September 30,2006 and September 30, 2005, our European distributor, accounted for 10% oftotal sales, with sales to our United States distributor accounting for lessthan 10% of total sales.

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For the six months endedSeptember 30, 2006 costs of sales increased 2% above the comparable prior yearperiod.   For the three and six monthsended September 30, 2006, variable production costs increased 13% primarily inlabor and chemicals.   Labor costs wereimpacted by wage increases during the first quarter of fiscal 2007 in responseto a competitive labor market (primarily from the construction industry) inHawaii.   Chemical costs increased as aresult of increased consumption of nutrients, some of which were deemed to beperiod costs due to abnormal usage which was not effective in correcting animbalance in the cultivation process. Such period costs totaled approximately $149,000 for the six monthsended September 30, 2006.   Pursuant toSFAS No. 151, approximately $95,000 of fixed production overhead costs was notinventoriable during the six months ended September 30, 2006 because ournatural astaxanthin production output was below normal capacity.  In addition, production costs associated withthe Company’s animal nutrition market products totaling approximately $245,000and $126,000 incurred during the six months ended September 30, 2006 and 2005,respectively, were not inventoriable because such costs would have exceeded themarket value for such inventory.  As aresult of the decrease in sales coupled with the increase in cost of sales,gross profit margins as a percentage of sales decreased to 18% for the sixmonths ended September 30, 2006 as compared to 29% for the comparable prioryear period.

Operating expenses forthe six months ended September 30, 2006 were $1,728,000, an increase of$81,000 or 5% from the comparable prior year period.   The increase in spending reflects highergeneral and administrative expense, which was offset in part by slightly lowersales and marketing and research and development expenses.  Higher general and administrative expensesduring the current six-month period were primarily due to increased time andeffort devoted to the restatement and filing of its 2006 annual report on Form10-K/A.  Lower expenses for sales andmarketing and research and development for the current six-month period reflectthe Company’s efforts to contain expenses where possible.  While it is our goal to contain discretionaryoperating spending in our research and development, sales and marketing, andgeneral and administrative activities, it may become necessary for the companyto selectively increase spending in some or all of these areas to remaincompetitive and to comply with regulatory requirements.

Netother expense, which includes interest on the Company’s debt, for the sixmonths ended September 30, 2006 was comparable to the same period of theprior fiscal year.

For the six months ended September 30, 2006, an income tax benefitof $6,000 was recorded compared to an income tax provision recorded of $3,000for the same period of the prior year. The Company does not expect any United States income taxes for thecurrent fiscal year as a result of available net operating loss carry-forwards.

TheCompany recorded net loss of $919,000 or $0.18 per diluted share for the sixmonth period ended September 30, 2006. For the same period a year ago the Company reported net loss of $138,000or $0.03 per diluted share.  The net lossin the current period is attributable to declining sales in conjunction with anincrease in cost of product sales and higher general and administrativeoperating expenses as compared to the same period a year ago.

*Variabilityof 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 may havea material adverse effect on financial condition and results of operations.

**Liquidityand Capital Resources**

TheCompany’s primary capital requirements are equipment and other leaseholdimprovement purchases, debt service obligation, and working capitalrequirements associated with the Company’s ongoing operations.

Workingcapital at September 30, 2006 decreased by $567,000 to $5,080,000 from$5,647,000 at March 31, 2006 primarily due to 

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reductionsin cash and equivalents of $391,000 and receivables of $463,000, offsetpartially by an increase in inventory of $121,000 and prepaid expenses andother current assets of $48,000.

AtSeptember 30, 2006, cash, cash equivalents and short-term investments was$2,144,000, a decrease from $2,535,000 at the beginning of the fiscalyear.  Net cash of $50,000 was used byoperations for the six months ended September 30, 2006 compared with  $344,000 of net cash provided by operationsfor the comparable prior year period. The net cash used by operations during the six months ended September30, 2006 resulted primarily from the increase in net losses of $919,000 in thecurrent year compared to net losses of $138,000 for the same period a year agoreduced by non-cash transactions, offset in part by higher collections of accountsreceivable.

TheCompany believes that its current cash position in conjunction with theexpectation of future cash provided by operations will be sufficient to meetits working capital and capital expenditure requirements at least the next 12months. However, operating costs and the costs of restatement are placing andwill continue to place an additional burden on the Company’s liquidity. TheCompany expects its future production levels to be in line with future salesdemand in an effort to reduce 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.

Cashused in investing activities (for capital expenditures) for the current sixmonth period was $167,000, an increase from $123,000 in the comparable prioryear period.

Cashused in financing activities amounted to $174,000 and $172,000 for the sixmonths ended September 30, 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 September 30,2006.

## **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 pursuant to Regulation S-X.  Preparing financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenue and expenses. These estimates and assumptions are affected by management’s applicationof accounting policies.  The Company hasidentified certain policies that require the application of significantjudgment by management.  Our mostcritical accounting policies are those related to inventory valuations,valuation of equipment and leasehold improvements and long-lived assets andincome taxes.  These critical accountingpolicies are stated in the notes to consolidated financial statements in theCompany’s previously filed report on Form 10-K, as amended, for the fiscalyear ended March 31, 2006.  Thisdiscussion and analysis should be read in conjunction with such notes and ourconsolidated financial statements and related notes included elsewhere in thisreport.

## **Outlook**

*This outlook section contains anumber of forward-looking statements, all of which are based on currentexpectations.  Actual results may differmaterially.   Also, see the firstparagraph of  Item 2.* “*Management’s Discussion and Analysis of Financial Condition and Resultsof Operation’s*

Cyanotech Corporation’sstrategic direction is to position itself as a world-leader in the productionand 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 the business-to-businesswholesale market for the products and compounds that we produce.  Our current product offerings includeNaturally Cultivated Spirulina Pacifica® in powder, flake and tablet form,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 our 

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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 .

Net sales declined 11%during the six month period ended September 30, 2006 as compared to thecomparable prior year period.  TheCompany continues to experience a reduction of NatuRose sales to the worldwideaquaculture market due to reduced Sea Bream sales, growers using less naturalastaxanthin in their feed, pricing competition from synthetic astaxanthinofferings, and heightened competition from new formulations entering themarkets.  In addition, our costs areincreasing because of complex non-US registration costs and rising labor, nutrient,utility and transportation costs.  Wefeel that these conditions are likely to persist which places significantpressure on being able to maintain a profitable business for our naturalastaxanthin product in the animal nutrition market.  In response to this, we are shifting ournatural astaxanthin production into higher value products such as BioAstin forhuman consumption until such time that animal nutrition markets can beidentified 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 of  BioAstin, the Company’s human naturalastaxanthin product line, for which it believes full market penetration has notyet been realized. To accomplish these objectives the Company, among otherinitiatives, is actively searching for and will, within the current fiscalyear, base a knowledgeable sales employee on the US mainland to increase theCompany’s outreach to both the US and European markets.

Gross profitmargin percentages in fiscal 2007 are expected to remain lower in comparison toprevious periods. The Company has experienced cost increases as certainvariable operating costs for utilities, production labor, and pond nutrientshave increased in comparison to previous periods.  The Company’s utility costs are impacted bythe price of oil, which is used to generate electricity for processing and forwater pumping.  In the face of a robustlocal construction economy, the Company found it necessary to increase productionwages in order to retain key employees and attract qualified personnel. Withcompetition increasing and higher production costs, pressure is placed onachieving a reasonable profit margin. When market value, including a reasonable profit margin, cannot beachieved, production costs exceeding the product’s market value cannot beinventoried and is reflected immediately in cost of sales.   Additionally, with the adoption of SFAS 151,the Company recognizes costs associated with abnormal amounts of idle facilityexpense, freight, handling costs and wasted materials (such as spoilage) ascurrent-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 are below previous periods and normal production levels dueto an imbalance in certain cultivation specifications to established parametersassociated with producing high quality microalgae.  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 six months ended September 30, 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.

The Company anticipatesthat future total operating expenses will increase due to the costs of therestatement and the remediation of errors identified by the restatement,including the need to improve the Company’s internal controls.  *Please refer to Note 2Item 4 (a) in this report.*In addition, increased costs are expectedas a result of managements recommendation and the Company’s Audit Committee andBoard of Directors approval and adoption of a remediation plan which includesthat policies and procedures will be designed to ensure full compliance withGAAP, particularly as it applies to inventory accounting, and will address keyfinancial reporting risk elements, including the following: (a) ensuring thatits disclosures are subject to adequate and rigorous review process prior tofinalizing and releasing financial statements; (b) continuing to update its inventory accounting systems and proceduresto properly accommodate specific inventoriable fixed costs in accordance withGAAP; and (c) continuing to identify resources with the critical skillsnecessary to ensure full compliance with GAAP. Since the process related toerror identification and the subsequent restatement began after June 30, 2006,related audit, legal, outside consulting costs, and remediation plan costs areincluded in and are applicable to this Form 10-Q. For the quarter endedSeptember 30, 2006, such costs are reflected in general and administrativeexpenses.

To effectively manage itscash resources the Company will continue to balance production in light ofsales demand, minimizing the cost associated with build-ups in inventory.  Additionally, the Company has experiencedcash outflows for investing and financing activities, primarily in meeting debtrepayment obligations and may need to utilize cash to meet working capitalneeds 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.

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The Company’s futureresults of operations and the other forward-looking statements contained inthis Outlook, in particular the statements regarding revenues, gross margin andcapital 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.

Cyanotech believes thatit 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 andQualitative Disclosures About Market Risk**

Wehave not entered into any transactions using derivative financial instrumentsor derivative commodity instruments and believe that our exposure to marketrisk associated with other financial instruments is not material.

Wehave a term loan agreement that adjusts quarterly based on the prime rate plus1%.  As such we are exposed to interestrate risk whereby a 1% increase or decrease in the prime rate would lead to anincrease or decrease of approximately $15,000 in interest expense for the yearending March 31, 2007 (based on March 31, 2006 amounts outstanding).

TheCompany may enter into additional foreign countries in the future that mayinvolve similar economic and political risks as well as challenges that aredifferent from those currently encountered by the 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 reports for the second and third quarters offiscal year 2007 beginning in the second quarter of fiscal year 2007 theCompany identified errors in the application of certain accountingpractices and procedures. As a result, during the second and subsequentquarters of fiscal year 2007 theCompany began changing and is continuing a process of changing its controlpolicies, procedures, and systems. This process was and is directly related tothe Company’s February 14, 2007 filing of Form 10-K/A, correction of the errorin its inventory accounting, and also the remediation plan adopted by the Boardof directors in November 2006 as discussed in Form 10-K/A.

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 of and for fiscal years ended March 31, 2006,2005, and quarterly periods within fiscal years 2006 and 2005, and 2004 and hasrestated selected financial data for the years ended March 31, 2004 and 2002 toadjust its inventory balances, cost of goods sold, and restated amounts ofincome 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 resultof illegal acts.

Specific changes in the Company’s disclosure controls and proceduresduring the second quarter of fiscal year 2007 included:

·             Initializing changes in inventory accountingprocedures and systems.

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

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·             Engaging additional professional accountingresources on a consulting basis to assist with error evaluation and correction.

Incorporatedinto the results reported in this Form 10-Q are the above discussed restatementand inventory accounting error corrections which ensure that inventory asreported herein includes all inventoriable fixed cost components such asdepreciation, portions of general insurance costs, and portions of direct laborburden costs in accordance with GAAP.

**PART II.        OTHER INFORMATION6**

**Item 1.**           Legal Proceedings

None

**Item1A. 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 or Prolonged Economic Downturn CouldHave a Material Adverse Effect on Our Results of Operations**

**Ourresults of operations are affected by the business activity of our customerswho in turn are affected by the level of economic activity in the industriesand markets that they serve. A decline in the level of business activity of ourclients could have a material adverse effect on our revenues and profit margin.**

**Our Quarterly Operating Results May Vary FromQuarter to Quarter, Which May Result in Increased Volatility of Our SharePrice**

**Wehave experienced, and may in the future continue to experience, fluctuations inour quarterly operating results. These fluctuations could reduce the marketprice of our Common Stock. Factors that may cause our quarterly operatingresults 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 ourcustomers’ buying patterns

·       changes in governmentregulation, both domestic and foreign;

·       fluctuation in foreigncurrency exchange rates;

·       global economic and politicalconditions 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 Operations Expose Us to ComplexManagement, Foreign Currency, Legal, Tax and Economic Risks, Which WeMay Not Be Able to Address Adequately**

**Weconduct business in a number of countries around the world. For the quarterended September 30, 2006, approximately 41% of our net sales were from sales toforeign customers. As a result, we are subject to a number of risks thatinclude, 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 Our Industry is Intense**

The nutritional productsmarket is highly competitive. In includes international, national, regional andlocal producers and distributors, many of whom have greater resources thanCyanotech and offer a greater variety of products. Increased competition in ourindustry could result in price reductions, reduced gross profit margin or lossof market share, any of which could have a material effect on our business,results of operations and financial condition.

**Our Revenues Could Be Adversely Affected By theLoss of a Significant Customer or the Failure to Collect a Large AccountsReceivable**

We have in the pastderived, and may continue in the future to derive, a significant portion of ourrevenues from a relatively limited number of major customers. From quarter toquarter, revenues from one or more individual customers may exceed 10% of ourrevenues for the quarter. During the year ended March 31, 2006, sales toone customer, a European distributor of natural products, were approximately12% of net sales. If sales to this customer or other such major customerdecrease significantly, this may materially affect our results of operations.In addition, if we fail to collect large accounts receivable from such majorcustomers, we could be subject to significant financial exposure.  For the six months ending September 30, 2006,sales to this European distributor represent 10% of total sales.

**If We Are Unable to Protect Our IntellectualProperty Rights or if We Infringe Upon the Intellectual Property Rights ofOthers Our Business May Be Harmed**

The Company has receivedfive United States patents:  two onaspects of our production 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 a combinationof trade secret, contract, patent, copyright and trademark law to establish andprotect our rights in our products and technology. There can be no assurancethat we will be able to protect our technology adequately or that competitorswill not be able to develop similar technology independently. In addition, thelaws of certain foreign countries may not protect the Company’s intellectualproperty rights to the same extent as the laws of the United States. Litigationin the United States or abroad may be necessary to enforce our patent or otherintellectual property rights, to protect our trade secrets, to determine thevalidity and scope of the proprietary rights of others or to defend againstclaims of infringement. Such litigation, even if successful, could result insubstantial costs and diversion of resources and could have a material adverseeffect on our business, results of operations and financial condition.Additionally, if any such claims are asserted against us, we may seek to obtaina license under the third party’s intellectual property rights. There can be noassurance, however, that a license would be available on terms acceptable orfavorable to us, if at all.

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**We May Need to RaiseAdditional Capital in the Future Which May Not Be Available**

At September 30, 2006,the Company’s working capital was $5,080,000. Cash equivalents and short-terminvestments at September 30, 2006 totaled $2,144,000. Our cash requirementswill depend on numerous factors, including: demand for products; normal requirementsto maintain and upgrade facilities and equipment; whether opportunities emergein either new markets or in research and development activities; or, in theevent we need to expand or contract our production or distributioninfrastructure. We believe our current cash, cash equivalents, short-terminvestments and expected cash provided from operations will be sufficient tomeet our capital requirements for at least the next 12 months. If we need toraise additional funds, we may not be able to secure funding on acceptableterms, if at all. If we raise additional funds through the issuance of equityor convertible debt securities, the percentage ownership of our then currentstockholders may be reduced. If we raise additional funds through the issuanceof convertible debt securities, or through additional debt or similarinstruments, such securities, debt, or similar instruments could have rightssenior to those of our common stockholders and such instruments could containprovisions restricting our operations. If adequate funds are not available tosatisfy either short-term or long-term capital requirements, we may be requiredto limit operations with adverse results.

**Our InsuranceLiability Coverage is Limited**

In the ordinary course ofbusiness, the Company purchases insurance coverages (e.g., property andliability coverages) to protect itself against loss of or damage to itsproperties and claims made by third parties and employees for property damageor personal injuries. However, the protection provided by such insurance islimited in significant respects and, in some instances, the Company has nocoverage and certain of the Company’s insurance has substantial “deductibles”or has limits on the maximum amounts that may be recovered. For example, if ahurricane or other uninsured catastrophic natural disaster should occur, theCompany may not be able to recover all facility restoration costs and revenueslost from business interruption. In addition, the Company maintains productliability insurance in limited amounts for all of its products involving humanconsumption; however, broader product liability coverage is prohibitivelyexpensive. Insurers have also introduced new exclusions or limitations ofcoverage for claims related to certain perils including, but not limited to,mold and terrorism. If a series of losses occurred, such as from a series oflawsuits in the ordinary course of business each of which were subject to thedeductible amount, or if the maximum limit of the available insurance weresubstantially exceeded, the Company could incur losses in amounts that wouldhave a material adverse effect on its result of operations and financialcondition.

**Our Ability to Develop and Market New Products orModify Existing Products and Production Methods May be Adversely AffectedIf we Lose the Services of or Cannot Replace Certain Employees Knowledgeable inAdvanced Scientific and Other Fields**

**TheCompany’s products are derived from and depend on proprietary andnon-proprietary processes and methods founded on advanced scientific knowledge,skills, and expertise. If the services of employees knowledgeable in thesefields are lost and cannot be replaced in a reasonable time frame at reasonablecosts, the Company’s ability to develop and market new products or modifyexisting products and production methods would be adversely impacted. At thesame time, regulatory compliance surrounding the Company’s products andfinancial matters generally requires minimum levels of knowledge and expertiserelated to production, quality assurance, and financial control. If the Companyloses the services or cannot reasonably replace employees who have thenecessary knowledge and expertise the Company’s ability to remain in regulatorycompliance 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 fiscalyear the Company expects to expend significant amounts for independentregistered public accounting, legal, outside consulting, and regulatoryexpenses to address: (a) the previously discussed 10-K/A restatement process,(b) previously disclosed matters dealing with resulting potential delistingfrom the Nasdaq Capital Market, (c) policy, procedure, and initial systemsmodifications required by and attendant to correcting the historical errorwhich lead to the restatement process, and (d) additional costs related to latefiling of the Company’s Forms 10-Q for the first two quarters of fiscal year2007. Also, to accomplish the remediation plan set forth in the 10-K/A underItem 9A “Controls and Procedures” therein. As of the filing date of this Form10-Q the Company has expended approximately $500,000 related to such efforts,and will have to expend additional amounts which cannot now be reliablyestimated.

**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 the date of filingthis Form 10-Q the Company is required to have policies, procedures, systemsand related documentation in full compliance with Securities and ExchangeCommission and Public Company Accounting Oversight Board requirements. There iscurrently no means of reliably estimating such costs or their duration.

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***PotentialDelisting from Nasdaq Capital Market Trading***

*OnDecember 1, 2005 the Company received notice from Nasdaq that the bid price ofthe Company’s stock closed below the minimum $1.00 per share requirement ofNasdaq Marketplace Rule 4310(c)(4).  TheCompany, however, was provided until May 30, 2006, to regain compliance withsuch rule, and was granted by letter dated May 31, 2006 another 180 days to regaincompliance with such rule.  By letterdated August 23, 2006, the Company was notified by Nasdaq of its failure tocomply with Nasdaq Marketplace Rule 4310(c)(14) for not filing its Form 10 Qfor the quarter ended June 30, 2006 and we were notified that the Company’scommon stock would be suspended from trading on September 1, 2006.  The Company appealed this decision and thecommon stock continued to be listed.*

*OnNovember 3, 2006, the Company implemented a one for four reverse stock split ofits common stock as a result of which Nasdaq issued a letter, dated November20, 2006, indicating the closing bid price of our common stock was incompliance with Marketplace Rule 4310(c)(4). This non-compliance matter is now closed.*

***The Nasdaq Listing QualificationsPanel issued its decision on the appeal on December 18, 2006 holding that theCompany is granted an extension until February 20, 2007 to file its Form 10-Qreports. The Company filed on February 20, 2007 an appeal with the NasdaqListing and Review Council requesting a further stay of the delisting untilFebruary 28, 2007, but such stay may not be granted.   See the Company’s Form 8-K dated December18, 2006.  If the Company’s common stockis delisted, our stockholders could be materially and adversely affected byhaving less active and efficient market available for the trading of theirstock.***

**Item 4.**                                                           Submissionof Matters to a Vote of Security Holders —

On August 24,2006, the following matters were submitted and voted by stockholders entitledto vote at the Company’s annual Meeting of Stockholders:

The votes shownbelow are adjusted for the Company’s previously discussed one for four reversestock split.

a)              The followingdirectors were elected to serve until the next Annual Meeting or until theirsuccessors are elected.

 

|                     | ** ** | **For Votes** | ** ** | **Withheld Votes** | ** ** |
|---------------------|------------|--------------------|------------|-------------------------|------------|
| Gerald R.  Cysewski |       | 4,090,676          |       | 145,085                 |       |
| Michael A. Davis    |       | 4,092,214          |       | 143,548                 |       |
| Gregg W.  Robertson |       | 4,095,476          |       | 140,285                 |       |
| David I.  Rosenthal |       | 4,096,064          |       | 139,698                 |       |
| John T. Waldron     |       | 4,096,201          |       | 139,560                 |       |
| Paul C. Yuen        |       | 4,095,476          |       | 140,285                 |       |

 

b)             Ratificationof the selection of KPMG LLP as the Company’s independent Registered PublicAccounting Firm for the fiscal year ending March 31, 2007.  The vote on the ratification was 4,212,289for, 11,692 against and 11,780 abstaining.

**Item 6.****                           Exhibits**

a)                     The following exhibits arefurnished with this report:

31.1                           Certificationby the Chief Executive Officer pursuant to

Rule13a-14(a)/15d-14(a) of the Exchange Act

31.2                           Certificationby the Chief Financial Officer pursuant to

Rule13a-14(a)/15d-14(a) of the Exchange Act

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

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b)                                                            Reportson Form 8-K

A report on****Form 8-K dated August 22, 2006 included item 3.01,Notice of Extension of Time to Satisfy a Continued Listing Rule.

A report on Form 8-Kdated August 24, 2006 included Item 3.01, Notice of DelistingNotice from Nasdaq due to Late Filing of Form 10Q.

A report on Form 8-K dated September 21, 2006 includedItem 3.03  MaterialModification to Rights of Securities Holders

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SIGNATURES

In accordance withthe requirements of the Securities Exchange Act of 1934, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.
|                   | CYANOTECH CORPORATION (Registrant) |                                                |
|-------------------|------------------------------------|-----------------------------------------------------|
|              |                               |                                                |
|              |                               |                                                |
| February 20, 2007 |                               | By:                                                 | /s/ | Gerald R. Cysewski |   |   |
| (Date)            |                               |                                                |   | Gerald R. Cysewski |   |   |   |
|              |                               | Chairman of the Board,                              |   |   |   |
|              |                               | President and Chief Executive Officer               |   |   |
|              |                               |                                                |   |   |   |
|              |                               |                                                |   |   |   |
| February 20, 2007 |                               | By:                                                 | /s/ | William R. Maris |   |   |   |
|              |                               |                                                | William R. Maris |   |   |   |
|              |                               | Vice President — Finance & Administration, |   |   |
|              |                               | Chief Financial Officer                             |   |   |
|              |                               | (Principal Financial and Accounting Officer)        |   |   |
|                   |                                    |                                                     |  |  |  |  |  |  |  |  |

 

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