**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C.  20549**

**FORM 10-Q**

**Quarterly Report UnderSection 13 or 15(d)of the Securities Exchange Act of 1934**

**For Quarterly PeriodEnded June 30, 2006**

**Commission File Number0-14602**

**CYANOTECH CORPORATION**(Exact name of registrant as specified in its charter)

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

 

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

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

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

Yes x No o

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

Large accelerated filer  o          Acceleratedfiler  o          Non-acceleratedfiler  x

Indicate bycheck mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).

Yes  o  No  x

Number ofcommon shares outstanding as of February 12, 2007:

| **Title of Class**              |   | **Shares Outstanding** |
|---------------------------------|--------|------------------------|
| Common stock - $0.020 par value |   | 5,233,543              |

 

 

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CYANOTECHCORPORATION

FORM 10-Q

**Explanatory Note – Restatement of FinancialInformation**

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

The Company isfiling this Form 10-Q for the fiscal quarter ended June 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 months ended June 30, 2005are included in this filing.  The Companywill not file a Form 10-Q/A for the quarterly period ended June 30, 2005, andthe consolidated financial statements and related information contained in thatreport should no longer be relied upon.

On November 3, 2006, the Company implemented a one for four stock splitat which time the share price closed at $0.43 with 20,934,565 common sharesoutstanding.  As the stock split occurredafter the close of the Company’s fiscal quarter and prior to the issuance ofthe financial statements, all share data and per share data in these financialstatements and notes to financial statements reflect the effect of the split asif it occurred prior to the end of the current fiscal quarter.

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

*The Companydid not file Form 10-K/A, for the fiscal years 2005 or 2004, or Form 10-Q/A,for the interim periods affected by the restatement prior to and includingDecember 31, 2005.  The consolidatedfinancial statements and related financial information for such periods aspreviously filed, contain errors and should therefore no longer be relied upon.The related audit reports for the years ended March 31, 2005 and 2004 of KPMGLLP, the Company’s independent registered public accounting firm, with respectto those financial statements 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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CYANOTECHCORPORATION

FORM 10-Q

INDEX
| PART I.  FINANCIAL INFORMATION |                                                                                                                                          |
|------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------|
|                                     |                                                                                                                                          |   |
| Item 1.                                  | Financial Statements                                                                                                                          |   |
|                                     |                                                                                                                                          |   |
|                                     | Consolidated  Balance Sheets (unaudited)  As of June 30, 2006 and March 31, 20 06                                                             |   |
|                                     |                                                                                                                                          |   |
|                                     | Consolidated  Statements of Operations  and Comprehensive Income (Loss) (unaudited)  For the three month periods ended June 30, 2006 and 2005 |   |
|                                     |                                                                                                                                          |   |
|                                     | Consolidated  Statements of Cash Flows (unaudited)  For the three month periods ended June 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 1A.                                 | Risk  Factors                                                                                                                                 |   |
|                                     |                                                                                                                                          |   |
| Item 6.                                  | Exhibits  and Reports on Form 8-K                                                                                                             |   |
|                                     |                                                                                                                                          |   |
| SIGNATURES                               |                                                                                                                                          |

 

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CYANOTECH CORPORATION

CONSOLIDATEDBALANCE SHEETS

(Dollars in thousandsexcept per share amounts)

(Unaudited)
| ** **                                                                                                                                               | ** ** | **June 30,** | ** ** | **March 31,**     | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                               | ** ** | **2006**          | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                               | ** ** | ** **        | ** ** | **(As Restated)** | ** ** |
| ASSETS                                                                                                                                                   |       |              |       |                   |       |
| Current assets:                                                                                                                                          |       |              |       |                   |       |
| Cash and cash equivalents                                                                                                                                |       | $                 | 2,055      |                   | $          | 1,835 |   |
| Short-term investments                                                                                                                                   |       | 700               |       | 700                    |       |
| Accounts receivable, net                                                                                                                                 |       | 1,797             |       | 2,209                  |       |
| Refundable income taxes                                                                                                                                  |       | 20                |       | 17                     |       |
| Inventories (see Note 4)                                                                                                                                 |       | 2,215             |       | 2,056                  |       |
| Prepaid expenses and other                                                                                                                               |       | 130               |       | 99                     |       |
| Total current assets                                                                                                                                     |       | 6,917             |       | 6,916                  |       |
|                                                                                                                                                     |       |              |       |                   |       |
| Equipment and  leasehold improvements, net (see Note 5)                                                                                                  |       | 9,884             |       | 10,164                 |       |
| Other assets                                                                                                                                             |       | 419               |       | 515                    |       |
| Total assets                                                                                                                                             |       | $                 | 17,220     |                   | $          | 17,595 |   |
|                                                                                                                                                     |       |              |       |                   |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                               |       |              |       |                   |       |
| Current  liabilities:                                                                                                                                    |       |              |       |                   |       |
| Current maturities of long-term debt                                                                                                                     |       | $                 | 364        |                   | $          | 364 |   |
| Accounts payable                                                                                                                                         |       | 608               |       | 485                    |       |
| Accrued expenses                                                                                                                                         |       | 351               |       | 420                    |       |
| Total current liabilities                                                                                                                                |       | 1,323             |       | 1,269                  |       |
|                                                                                                                                                     |       |              |       |                   |       |
| Long-term debt,  excluding current maturities (see Note 6)                                                                                               |       | 1,300             |       | 1,387                  |       |
| Total liabilities                                                                                                                                        |       | 2,623             |       | 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 June 30, 2006 and  5,232,066 at March 31, 2006 |       | 105               |       | 105                    |       |
| Additional paid-in capital                                                                                                                               |       | 27,333            |       | 27,330                 |       |
| Accumulated other comprehensive income (loss) -  foreign currency translation adjustments                                                                |       | 1                 |       | (1                     | )          |
| Accumulated deficit                                                                                                                                      |       | (12,842           | )          | (12,495                | )          |
| Total stockholders’ equity                                                                                                                          |       | 14,597            |       | 14,939                 |       |
|                                                                                                                                                     |       |              |       |                   |       |
| Total  liabilities and stockholders’ equity                                                                                                         |       | $                 | 17,220     |                   | $          | 17,595 |   |

 

See accompanying Notes to Consolidated FinancialStatements.

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CYANOTECHCORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

ANDCOMPREHENSIVE INCOME (LOSS)

(Inthousands, except per share amounts)

(Unaudited)
| ** **                                                  | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                  | ** ** | ** **                                          | ** ** | **(As Restated)** | ** ** |
|                                                        |       |                                                |       |   |   |
| NET SALES                                                   |       | $                                                   | 2,444      |   | $ | 3,029 |   |
| COST OF PRODUCT  SALES                                      |       | 1,973                                               |       | 2,024 |   |
| Gross Profit                                                |       | 471                                                 |       | 1,005 |   |
|                                                        |       |                                                |       |   |   |
| OPERATING  EXPENSES:                                        |       |                                                |       |   |   |
| Research and development                                    |       | 30                                                  |       | 44 |   |
| Sales and marketing                                         |       | 290                                                 |       | 328 |   |
| General and administrative                                  |       | 462                                                 |       | 419 |   |
| Total operating expenses                                    |       | 782                                                 |       | 791 |   |
|                                                        |       |                                                |       |   |   |
| Income (loss) from operations                               |       | (311                                                | )          | 214 |   |
|                                                        |       |                                                |       |   |   |
| OTHER INCOME  (EXPENSE):                                    |       |                                                |       |   |   |
| Interest income                                             |       | 9                                                   |       | 15 |   |
| Interest expense                                            |       | (47                                                 | )          | (55 | ) |
| Other expense, net                                          |       | —                                              |       | (10 | ) |
| Total other expense, net                                    |       | (38                                                 | )          | (50 | ) |
|                                                        |       |                                                |       |   |   |
| Income (loss) before income taxes                           |       | (349                                                | )          | 164 |   |
|                                                        |       |                                                |       |   |   |
| INCOME TAX  EXPENSE (BENEFIT)                               |       | (2                                                  | )          | 5 |   |
|                                                        |       |                                                |       |   |   |
| NET INCOME  (LOSS)                                          |       | $                                                   | (347       | ) | $ | 159 |   |
|                                                        |       |                                                |       |   |   |
| NET INCOME  (LOSS) PER SHARE: (See Note 7)                  |       |                                                |       |   |   |
| Basic                                                       |       | $                                                   | (0.07      | ) | $ | 0.03 |   |
| Diluted                                                     |       | $                                                   | (0.07      | ) | $ | 0.03 |   |
|                                                        |       |                                                |       |   |   |
| SHARES USED IN  CALCULATION OF NET INCOME (LOSS) PER SHARE: |       |                                                |       |   |   |
| Basic                                                       |       | 5,232                                               |       | 5,224 |   |
| Diluted                                                     |       | 5,232                                               |       | 5,255 |   |
|                                                        |       |                                                |       |   |   |
| COMPREHENSIVE  INCOME (LOSS):                               |       |                                                |       |   |   |
| Net income (loss)                                           |       | $                                                   | (347       | ) | $ | 159 |   |
| Other comprehensive income (loss)                           |       | 2                                                   |       | (2 | ) |
|                                                        |       | $                                                   | (345       | ) | $ | 157 |   |

 

See accompanying Notes to Consolidated FinancialStatements.

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CYANOTECHCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollarsin thousands)

(Unaudited)
| ** **                                                                                     | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                                     | ** ** | ** **                                          | ** ** | **(As Restated)** | ** ** |
| ** **                                                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                         |       |                                                |       |   |   |
| Net income (loss)                                                                              |       | $                                                   | (347       | ) | $ | 159 |   |
|                                                                                           |       |                                                |       |   |   |
| Adjustment to reconcile net income (loss) to cash  provided by (used in) operating activities: |       |                                                |       |   |   |
| Depreciation                                                                                   |       | 335                                                 |       | 337 |   |
| Amortization of debt issue costs and other assets                                              |       | 9                                                   |       | 8 |   |
| Provision for allowance for doubtful accounts                                                  |       | 4                                                   |       | 13 |   |
| Net (increase) decrease in assets:                                                             |       |                                                |       |   |   |
| Accounts receivable                                                                            |       | 408                                                 |       | (315 | ) |
| Refundable income taxes                                                                        |       | (3                                                  | )          | 46 |   |
| Inventories                                                                                    |       | (159                                                | )          | (30 | ) |
| Prepaid expenses and other assets                                                              |       | 58                                                  |       | (87 | ) |
| Net increase (decrease) in liabilities:                                                        |       |                                                |       |   |   |
| Accounts payable                                                                               |       | 123                                                 |       | (401 | ) |
| Accrued expenses                                                                               |       | (69                                                 | )          | 134 |   |
|                                                                                           |       |                                                |       |   |   |
| Net cash provided by (used in) operating activities                                            |       | 359                                                 |       | (136 | ) |
|                                                                                           |       |                                                |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                         |       |                                                |       |   |   |
| Investment in equipment and leasehold improvements                                             |       | (55                                                 | )          | (40 | ) |
|                                                                                           |       |                                                |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITES:                                                          |       |                                                |       |   |   |
| Proceeds from exercise of stock options                                                        |       | 3                                                   |       | — |   |
| Principal payments on long-term debt                                                           |       | (87                                                 | )          | (86 | ) |
|                                                                                           |       |                                                |       |   |   |
| Net cash used in financing activities                                                          |       | (84                                                 | )          | (86 | ) |
|                                                                                           |       |                                                |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                          |       | 220                                                 |       | (262 | ) |
|                                                                                           |       |                                                |       |   |   |
| Cash and cash  equivalents at beginning of period                                              |       | 1,835                                               |       | 2,005 |   |
|                                                                                           |       |                                                |       |   |   |
| Cash and cash  equivalents at end of period                                                    |       | $                                                   | 2,055      |   | $ | 1,743 |   |
|                                                                                           |       |                                                |       |   |   |
| Supplemental  disclosure of cash flow information:                                             |       |                                                |       |   |   |
| Cash paid during the period for:                                                               |       |                                                |       |   |   |
| Interest                                                                                       |       | $                                                   | 40         |   | $ | 35 |   |
|                                                                                           |       |                                                |       |   |   |
| Income taxes                                                                                   |       | $                                                   | 1          |   | $ | 4 |   |

 

See accompanying Notes to Consolidated FinancialStatements.

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CYANOTECHCORPORATION

FORM 10-Q

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

As of June 30,2006

(Unaudited)

1.                                       BASISOF 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 in consolidation.  While the financial information furnished forthe three month period ended June 30, 2006 is unaudited, the statements in thisreport reflect all material items which, in the opinion of management, arenecessary for a fair presentation of the results of operations for the interim periodscovered and of the financial condition of the Company at the dates of theconsolidated 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 the balancesheet date and the reported amounts of revenues and expenses during the periodreported.  Management reviews thesesestimates and assumptions periodically and reflects the effect of revisions inthe period that they are determined to be necessary.  Actual results could differ from thoseestimates and assumptions.

2.             REVERSE STOCKSPLIT

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 June 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 June 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 exchange for an award.  If an award vests or becomes exercisablebased on the achievement of a condition other than service, performance ormarket condition, the award is liability-classified.  Liability-classified awards are remeasured tofair value at each

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balance sheet date until theaward is settled.  Equity-classifiedawards, including grants of employee stock options, are measured at thegrant-date fair value of the award and are not subsequently remeasured.  The cost of equity-classified awards isrecognized in the income statement over the period during which an employee isrequired to provide the service in exchange for the award.  In the Company’s case, all of the Company’sstock 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 June 30, 2006, 195,000 options remained available for grant under the 2005Plan.  Concurrent with the 2005 Planapproval on August 22, 2005, the 1995 Stock Option Plan was terminated exceptfor the outstanding options issued thereunder.

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

SFAS No. 123R offers several alternatives for implementation, amongthem the Modified Prospective Method of accounting for compensation costsrelated to “Share Based Payments” which the Company has determined toapply.  In the Company’s case, itsemployee incentive stock options are “plain vanilla” as defined by the SEC 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 June 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 totalfuture compensation expense that was avoided by acceleration of vesting was$78,000, before tax, based upon the March 23, 2006 acceleration date. A portionof this amount would have impacted the quarter ended June 30, 2006 had theacceleration not occurred. Nooptions were granted by the Company during the three-month period ending June30, 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.

TheIndependent Director Stock Option and Stock Grant Plan (the “2004 Plan”) has75,000 shares of common stock reserved for issuance.  Under the 2004 Plan, upon election to theBoard of Directors, a newly elected non-employee director is granted a ten-yearoption to purchase 1,000 shares of the Company’s common stock at a fair marketvalue on the date of grant.  All suchoptions are granted at fair market value on the date of grant.  Options granted vest and become exercisable sixmonths from the date of grant.  Inaddition, on the date of each Annual Meeting of Stockholders, each non-employeedirector continuing in office is automatically granted, without payment, 875shares of common stock, non-transferable for six months following the date ofgrant.  As of June 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.

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The followingtable summarizes the post-reverse-split-adjusted weighted averagecharacteristics of outstanding stock options as of June 30, 2006 for variousexercise price ranges:
|                                             | ** ** | **Outstanding Options** | ** ** | **Exercisable Options** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                  | ** ** | **Number of**           | ** ** | **Remaining**                | ** ** | **Weighted** | ** ** | **Number of** | ** ** | **Weighted** | ** ** |
| **Range of Exercise Prices** | ** ** | **Shares**                   | ** ** | **Life (Years)**        | ** ** | **Average Price** | ** ** | **Shares** | ** ** | **Average Price** | ** ** |
| $1.84-$3.08                                 |       | 59,582                       |       | 2.0                          |       | $ | 2.25 |   | 59,066 |   | $ | 2.26 |   |
| $3.88-$6.75                                 |       | 43,568                       |       | 2.2                          |       | 4.38 |   | 41,834 |   | 4.38 |   |
| $14.75-$24.50                               |       | 7,000                        |       | 1.6                          |       | 15.80 |   | 7,000 |   | 15.80 |   |
| Total stock options at  June 30, 2006       |       | 110,150                      |       |                         |       | 3.95 |   | 107,900 |   | 3.96 |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |

 

A summary of option activity under the Company’s stock plans for thequarter ended June 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                      |       | (1,575     | )          | $                                              | 2.15       |                                                        |       |                                |       |   |
| Forfeited or  expired          |       | (5,505     | )          | $                                              | 3.43       |                                                        |       |                                |       |   |
| Outstanding at  June 30, 2006  |       | 110,150    |       | $                                              | 3.95       |                                                        | 2.1 years  |                                | $          | 435,093 |   |
| Exercisable at June 30,  2006  |       | 107,900    |       | $                                              | 3.96       |                                                        | 2.1 years  |                                | $          | 427,284 |   |

 

A summary of non-vested options for the quarter ended June 30, 2006 ispresented below:
| Nonvested Options       | ** ** | **Shares** | ** ** | **Weighted Average  Grant-Date  Fair Value** | ** ** |
|------------------------------|------------|------------|------------|--------------------------------------------------------|------------|
| Nonvested at  March 31, 2006 |       | 2,953      |       | $                                                      | 3.98       |   |
| Granted                      |       | —     |       | —                                                 |       |
| Vested                       |       | (703       | )          | $                                                      | 2.79       |   |
| Forfeited or  expired        |       | —     |       | —                                                 |       |
| Nonvested at June 30,  2006  |       | 2,250      |       | $                                                      | 3.84       |   |

 

Prior to April 1,2006, as allowed by Statement of Financial Accounting Statement No. 123(“SFAS No. 123”), Accounting**for Stock-Based Compensation*,*theCompany elected to apply the intrinsic value-based method of accounting foremployee based stock options and adopted only the disclosure requirements ofSFAS No. 123.  The following tableillustrates the effect on net income and net income per common share as if theCompany had applied the fair-value method under SFAS No. 123 to its employeestock options for the three month comparable period ended June 30, 2005:
|                                                                                                      | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2005**                                            | ** ** |
| ** **                                                                                           | ** ** | **(As Restated)**                              | ** ** |
| Net income  (loss), as reported                                                                      |       | $                                                   | 159        |   |
| Deduct  stock-based employee compensation expense determined under  fair-value method for all awards |       | (20                                                 | )          |
| Pro forma net  income (loss)                                                                         |       | $                                                   | 139        |   |
|                                                                                                 |       |                                                |       |
| Basic net income  (loss) per common share:                                                           |       |                                                |       |
| As reported                                                                                          |       | $                                                   | 0.03       |   |
| Pro forma                                                                                            |       | $                                                   | 0.03       |   |
|                                                                                                 |       |                                                |       |
| Diluted net  income (loss) per common share                                                          |       |                                                |       |
| As reported                                                                                          |       | $                                                   | 0.03       |   |
| Pro forma                                                                                            |       | $                                                   | 0.03       |   |

 

9

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The totalintrinsic value of options exercised during the quarter ending June 30, 2006was $1,000.  The amount of cash receivedfrom option exercises during the quarter ended June 30, 2006 was $3,000.  Because qualified employee incentive optionswere exercised and the Company has significant operating loss carry forwards,there were no tax consequences as a result of option exercises during thequarter ended June 30, 2006.

4.                                       INVENTORIES

Inventories arestated at the lower of cost (which approximates first-in, first-out) ormarket.  Market is defined as sales priceless cost to dispose and a normal profit margin.  Inventories consist of the following (dollarsin thousands):
|                 | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|-----------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **      | ** ** | ** **                  | ** ** | **(As Restated)**       | ** ** |
| Raw materials   |       | $                           | 243        |                         | $          | 240 |   |
| Work in process |       | 268                         |       | 260                          |       |
| Finished goods  |       | 1,567                       |       | 1,432                        |       |
| Supplies        |       | 137                         |       | 124                          |       |
|            |       | $                           | 2,215      |                         | $          | 2,056 |   |

 

5.             EQUIPMENT AND LEASEHOLDIMPROVEMENTS

Equipment andleasehold improvements are stated at cost. Depreciation and amortization areprovided using the straight-line method over the estimated useful lives forequipment and furniture and fixtures, or the shorter of the land lease term orestimated useful lives for leasehold improvements as follows:
| Equipment               |   | 3 to 10 years  |   |
|-------------------------|--------|----------------|--------|
| Furniture and  fixtures |   | 7 years        |   |
| Leasehold improvements  |   | 10 to 20 years |   |

 

Equipment andleasehold improvements consist of the following (dollars in thousands):
|                                                 | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | ** **                  | ** ** | **(As Restated)**       | ** ** |
| Equipment                                       |       | $                           | 10,561     |                         | $          | 10,461 |   |
| Leasehold  improvements                         |       | 14,658                      |       | 14,642                       |       |
| Furniture and  fixtures                         |       | 86                          |       | 86                           |       |
|                                            |       | 25,305                      |       | 25,189                       |       |
| Less accumulated  depreciation and amortization |       | (15,662                     | )          | (15,327                      | )          |
| Construction  in-progress                       |       | 241                         |       | 302                          |       |
| Equipment and leasehold  improvements, net      |       | $                           | 9,884      |                         | $          | 10,164 |   |

 

6.             TERM LOAN AGREEMENT COVENANTSWAIVER

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 Loan containsrestrictive covenants.  The Companyobtained a waiver of the debt covenants that may not be in compliance as aresult 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 (see Note 9).

7.             EARNINGS PER SHARE

Basic earnings pershare is computed on the basis of the weighted average number of common sharesoutstanding.  Diluted earnings per shareis computed on the basis of the weighted average number of common sharesoutstanding plus the potentially dilutive effect of outstanding stock optionsand warrants using the “treasury stock” method and convertible securities usingthe “if-converted” method.

Reconciliationsbetween the numerator and the denominator of the basic and diluted earnings pershare computations for the three

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months ended June30, 2006 and June 30, 2005 are as follows includingpost-reverse-split-adjustments:
|                                       | ** ** | **Three Months Ended June 30, 2006** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                            | ** ** | **Net Loss**                                             | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                            | ** ** | **(Numerator)**                                               | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                            | ** ** | **(in thousands)**                                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Basic loss per  share                 |       | $                                                             | (347       | ) | 5,232 |   | $ | (0.07 | ) |
| Effect of  dilutive securities – |       |                                                          |       |   |   |   |   |
| Common stock options and warrants     |       | —                                                        |       | — |   |   |   |
| Diluted loss per share                |       | $                                                             | (347       | ) | 5,232 |   | $ | (0.07 | ) |

 
|                                       | ** ** | **Three Months Ended June 30, 2006** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                            | ** ** | **Net Income**                                           | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| **(As Restated)**                | ** ** | **(Numerator)**                                               | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                            | ** ** | **(in thousands)**                                       | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Basic earnings  per share             |       | $                                                             | 159        |   | 5,224 |   | $ | 0.03 |   |
| Effect of  dilutive securities – |       |                                                          |       |   |   |   |   |
| Common stock options and warrants     |       | —                                                        |       | — |   |   |   |
| Diluted earnings per  share           |       | $                                                             | 159        |   | 5,255 |   | $ | 0.03 |   |

 

The followingsecurities were excluded from the calculation of diluted earnings per sharebecause their effect was anti-dilutive (in thousands):
|                             | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|
| ** **                  | ** ** | **June 30,**                | ** ** |
| ** **                  | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Stock options  and warrants |       | 115                              |       | 90 |   |

 

8.     NEWACCOUNTING 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. For the three months ended June 30, 2006, production costs ofapproximately $36,000 or $0.01 per diluted share were not inventoried and arereflected in cost of sales as of June 30, 2006. The costs were not inventorieddue 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

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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.

In June 2006, the FASBratified the consensus on Emerging Issues Task Force Issue No. 06-3 (“EITFNo. 06-3”), “How Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement”.  The scope of EITF No. 06-3 includes anytax assessed by a governmental authority that is directly imposed on arevenue-producing transaction between a seller and a customer and may include,but is not limited to, sales, use, value added, Universal Service Fund(USF) contributions and some excise taxes. The Task Force affirmed its conclusion that entities should presentthese taxes in the income statement on either a gross or a net basis based ontheir accounting policy, which should be disclosed pursuant to APB OpinionNo. 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 regardingthe process of quantifying financial statement misstatements.  SAB No. 108 provides guidance on theconsideration of the effects of prior year misstatements (misstatements thatwere not corrected at the end of the prior year) in quantifying current yearmisstatements for the purpose of a materiality assessment.  Common practice in quantifying a misstatementallows for multiple approaches.   Amisstatement can be based on the amount of the error originating in the currentyear income statement or be based on the effects of correcting the misstatementexisting in the balance sheet at the end of the current year, irrespective ofthe misstatement’s year(s) of origination. Therefore, in quantifying the impact of correcting all misstatements,including both the carryover and reversing effects of prior year misstatements,on the current year financial statements, errors should be measured under eachapproach and evaluated for materiality. An adjustment would be required when either approach results inquantifying a misstatement that is material, as defined in FASB ConceptsStatement No. 2, after considering all relevant quantitative and qualitativefactors.  SAB 108 is effective for fiscalyears ended after November 15, 2006. We expect the application of the standard tohave no impact on the Company.

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

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.

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The Company’s Form 10-K/A for the fiscal years ended March 31, 2006 and2005 amended and restated the:

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

(2)   consolidated statements of operations, stockholder’s equity andcomprehensive income (loss) and cash flows for each of the years in the threeyear 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 December31, September 30, and June 30, 2004.

Theerrors or adjustments identified in our previously issued consolidatedfinancial statements are as follows:

(A)      *Wefailed to include as a component of inventory cost certain fixed productioncosts such as depreciation, general insurance and minor compensation cost intoinventory. *Inventories for March 31, 2006, 2005, 2004and 2003, and for the quarterly periods within 2006 and 2005, were restated aswere cost of sales and certain operating expenses as included in theConsolidated Statements of Operations for each of the years in the three yearperiod ended March 31, 2006.  Thisrestatement was a result of the discovery of the error subsequent to the filingwith the SEC of the Original Form 10-K as filed with the SEC.  All inventories, cost of sales and operatingexpense balances, as presented in this Form 10-Q, properly reflect theinventory unit costs which includes these fixed production costs in accordancewith Accounting Research Bulletin No. 43.

(B)        Werecorded certain Hawaii State Tax Credit adjustments which were consideredimmaterial in prior years.  Refundableincome taxes were restated for the year ended March 31, 2005.  Income tax expense (benefit) was restated foreach of the years in the three year period ended March 31, 2006 but had noimpact on net loss for the three months ended June 30, 2006 and 2005.

(C)        Werecorded certain interest income adjustments which were considered immaterialin prior years.  These impacted the yearsended March 31, 2004 and 2003 but had no impact on the three months ended June30, 2005.

(D)       Wereclassified certain certificates of deposit from cash to short-terminvestments in fiscal years 2005 and 2004. These reclassifications had no effect on reported net income (loss) orin cash flows from operations for the years ended March 31, 2005 and 2004.  Cash flows from operations for the threemonths ended June 30, 2005 were restated.

(E)         We recorded certain tax adjustments which were considered immaterial toreports filed in prior periods.  Theseadjustments impacted the years ended March 31, 2005, 2004 and 2003.  Cash flows from operations for the threemonths ended June 30, 2005 were restated.

Quarterly data has beenderived from our unaudited consolidated financial statements that, in ouropinion, reflect all recurring adjustments necessary to fairly present ourfinancial information when read in conjunction with our Consolidated FinancialStatements and Notes.  This quarterlyinformation has been restated for, and as of the end of, all quarters of fiscal2006 and all quarters of fiscal 2005 from previously reported information filedon Forms 10-Q and Forms 10-K, as a result of the restatement of our financialresults as discussed above.  The resultsof operations for any quarter are not necessarily indicative of the results tobe expected for any future period.

The following table setsforth the amounts previously reported in the Company’s consolidated statementof operations for the period ended June 30, 2005 and the effect of therestatement adjustments, and the restated amounts.

13

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| ** **                                                         | ** ** | **Consolidated Statement of Operations** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands, except per share data)** | ** ** | **Three Months  Ended  June 30,  2005**       | ** ** | **Adjustments** | ** ** | **Three Months  Ended  June 30,  2005** | ** ** |
| ** **                                                         | ** ** | **(As reported)**                                  | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| Net sales                                                          |       | $                                                       | 3,029      |   | $ | — |   | $ | 3,029 |   |
| Cost of sales  (A)                                                 |       | 2,004                                                   |       | 20 |   | 2,024 |   |
| Gross profit                                                       |       | 1,025                                                   |       | (20 | ) | 1,005 |   |
| Operating  expenses:                                               |       |                                                    |       |   |   |   |   |
| Research and development (A)                                       |       | 46                                                      |       | (2 | ) | 44 |   |
| Sales and marketing (A)                                            |       | 333                                                     |       | (5 | ) | 328 |   |
| General and administrative (A)                                     |       | 438                                                     |       | (19 | ) | 419 |   |
| Total operating expense                                            |       | 817                                                     |       | (26 | ) | 791 |   |
| Income (loss) from operations                                      |       | 208                                                     |       | 6 |   | 214 |   |
| Other income  (expense):                                           |       |                                                    |       |   |   |   |   |
| Interest income                                                    |       | 15                                                      |       | — |   | 15 |   |
| Interest expense                                                   |       | (55                                                     | )          | — |   | (55 | ) |
| Other expense, net                                                 |       | (10                                                     | )          | — |   | (10 | ) |
| Total other expense, net                                           |       | (50                                                     | )          | — |   | (50 | ) |
| Income (loss) before income taxes                                  |       | 158                                                     |       | 6 |   | 164 |   |
| Income tax expense                                                 |       | 5                                                       |       | — |   | 5 |   |
| Net income (loss)                                                  |       | $                                                       | 153        |   | $ | 6 |   | $ | 159 |   |
| 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                                                            |       | 5,255                                                   |       | — |   | 5,255 |   |

 

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

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

***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. See Item 9A.Controls and Procedures in theCompany’s Form 10-K/A filed on February 14, 2007.   The Company did not file Form 10-K/A, forthe fiscal years 2005 or 2004, or Form 10-Q/A, for the interim periods affectedby the restatement prior to and including December 31, 2005, and suchconsolidated financial statements and related financial information, aspreviously filed, contain errors and should therefore no longer be relied upon.The related audit reports of KPMG LLP, the Company’s independent registeredpublic accounting firm, with respect to those financial statements should alsono longer be relied upon. Prior period comparative information contained inthis form 10-Q has been restated consistent with the Company’s Form 10-K/A andto reflect the Company’s one-for-four reverse stock split as discussed underItem 1A “Risk Factors” sub heading “*Market Price for OurCommon 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** | ** ** | **Three Months Ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**      | ** ** |
| ** **                     | ** ** | ** **                       | ** ** | **(As Restated)**           | ** ** |
| ** **                     | ** ** | **$**                            | ** ** | **$**                            | ** ** | **Change** | ** ** |
| Net sales:                     |       |                             |       |                             |       |   |   |
| Spirulina products             |       | $                                | 1,527      |                             | $          | 1,875 |   | (19 | )% |
| Natural astaxanthin products   |       | 890                              |       | 1,068                            |       | (17 | )% |
| Other products                 |       | 28                               |       | 86                               |       | (53 | )% |
|                           |       | $                                | 2,444      |                             | $          | 3,029 |   | (19 | )% |
| Gross profit                   |       | $                                | 471        |                             | $          | 1,005 |   | (53 | )% |
| Income (loss)  from operations |       | $                                | (311       | )                                | $          | 214 |   | (245 | )% |
| Net income (loss)              |       | $                                | (347       | )                                | $          | 159 |   | (318 | )% |

 

Sales for thefirst quarter of fiscal 2007 ended June 30, 2006 decreased from the comparableprior year period by $585,000 or 19% due primarily to declines in the number ofunits sold across all product lines.

Spirulina salesdeclined 19% from the prior year period due to selling fewer units coupled witha slight decrease in average selling prices.

Naturalastaxanthin product sales decreased 17% from the comparable prior year perioddue to increased competition in the human nutrition market coupled withdecreased sales in the Japan aquaculture market. We expected that warmerseasonal weather in Japan would increase the demand for our NatuRose fish feedastaxanthin product, but the demand did not materialize, and our previousstatements that the shortfall in the Japan aquaculture market would persisthave proven correct.   As such, theCompany is increasing 

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focus on buildingmarket share in the human nutrition market with a major focus ondifferentiating BioAstin, its human nutrition market product, from lowerquality offerings from competitors. The natural astaxanthin product lineoverall experienced an 11% average price decline with NatuRose prices downslightly.

Our gross profitmargin as a percentage of sales decreased to 19% for the three months endedJune, 30, 2006 from 33% for the same period a year ago.  Although sales for the first quarter of FY2007 declined 19% from the comparable prior year period, costs of salesdeclined only 3% for the same respective period.   For the three months ended June 30, 2006,variable production costs increased 13% primarily in labor, chemicals andutility costs.  Approximately $36,000 offixed production overhead cost was not inventoriable during the three monthsended June 30, 2006. In addition, approximately $118,000 and $1,000 of productioncosts associated with the Company’s animal nutrition market products were notinventoriable because such costs would have exceeded the market value for suchinventory during the three months ended June 30, 2006 and 2005, respectively.

As a result of alarger decrease in sales as compared to cost of sales in the current yearperiod, gross profit margins as a percentage of sales decreased to 19% for thethree months ended June 30, 2006 as compared to 33% for the three months endedJune 30, 2005.   Due to above factors, weexpect that the Company’s gross profit margins during fiscal 2007 will continueto be less than the margins reported for comparable prior year periods while actions are currently underway toobtain production at desired capacity and quality levels.

Net income for thefirst quarter of fiscal 2007 decreased $506,000 compared to the comparablequarter. The decrease in net income is primarily due to lower sales and highercost of product sales.

**Resultsof Operations**

# *First Quarter of Fiscal 2007Compared to First Quarter of Fiscal 2006*

Net sales for thefirst quarter of fiscal 2007 declined to $2,444,000, a 19% reduction from the$3,029,000 reported for the comparable period a year ago.  Companysales of Spirulina products for the first quarter of fiscal 2007 were $1,527,000,and declined 19% over the $1,875,000 generated in the first quarter of fiscal2006.  However, as a percentage of salesSpirulina remained at 62% of total sales in the periods presented. Naturalastaxanthin product sales were $890,000 during the first quarter of 2007, a 17%decrease from $1,068,000 in the first quarter of the prior year.  The natural astaxanthin product linesincreased to 36% of total sales from 35% of total sales in the first quarter offiscal 2006.  NatuRose salesdecreased as a result of lower demand in the Japanese aquaculture market. Theastaxanthin product line overall experienced an average 11% price decline withNatuRose prices down slightly. We feel that the Japan aquaculture marketadapted to using less astaxanthin (including NatuRose) in favor of using lesscostly substitutes.  With the sales priceconstraints in the animal nutrition market coupled with rising production costsin labor, nutrient, utility and transportation, profit margins are beinglimited to the point that maintaining a profitable business in the animalnutrition market is becoming difficult.  Other products sales were $28,000 during thefirst quarter of fiscal 2007 and $86,000 during the first quarter of fiscal2006, and represented 1% and 3% of sales in the respective periods.

Internationalsales were 54% of total sales for the first quarter of fiscal 2007, compared to58% a year ago.  Historically, our majorcustomers (sales exceeding 10% of total sales) have been two distributors, onebased in Europe and one in the United States.  For the three months ended June 30, 2006, our European distributoraccounted for 13% of total sales as compared to 11% of total sales for thecomparable period of fiscal 2006.   Salesto the United States distributor for the three months ended June 30, 2006 wereless than 10% of total sales as compared to 10% of total sales for thecomparable period of fiscal 2006.

Gross profit,derived from net sales less the cost of product sales, includes the cost ofmaterials, manufacturing overhead costs, direct labor costs anddepreciation.  Gross profit for the threemonths ended June 30, 2006 was $471,000, with a gross profit margin of 19%.This was a decrease from gross profit of $1,005,000 and gross profit margin of33% reported for the comparable prior year quarter.  Our gross profit margin as a percentage ofsales decreased to 19% for the three months ended June, 30, 2006 from 33% forthe same period a year ago.  Althoughsales for the first quarter of FY 2007 declined 19% from the comparable prioryear period, costs of sales declined only 3% for the same respectiveperiod.   For the three months ended June30, 2006, variable production costs increased 13% primarily in labor, chemicalsand utility costs.   Labor costs wereimpacted by wage increases during the period in response to a competitive labormarket (primarily from the construction industry) in Hawaii and utility costsincreased primarily as a result of rate increases. Chemical costs increased asa result of increased consumption of nutrients used to balance cultivation toestablished parameters. We expect gradual direct cost price increases tocontinue in all areas consistent with the local and national economy.   Approximately $36,000 of fixed productionoverhead cost was not inventoriable during the three months ended June 30,2006. Pursuant to SFAS No. 151, $36,000 of this amount was due to naturalastaxanthin production output below normal capacity.  In addition, approximately $118,000 and $1,000of production costs associated with the Company’s animal nutrition marketproducts 

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was notinventoriable because such costs would have exceeded the market value for suchinventory during the three months ended June 30, 2006 and 2005, respectively

Operating expensesfor three months ended June 30, 2006 were 32% of sales or $782,000, compared to26% of sales or $791,000 for the three months ended June 30, 2005.  The increase in operating expenses as apercentage of sales was the result of general and administrative expenseincreasing by 5% for the three months ended June 30, 2006 compared to the threemonths ended June 30, 2005.  The increasewas due to higher expenses for insurance and regulatory compliance, primarilycustomary audit and legal costs associated with an increasingly complex publicCompany regulatory atmosphere. Research and development expense remainingconstant at 1% of sales over both periods, and comparable sales and marketingexpenses were at 12% and 11% for the three months ended June 30, 2006 and June30, 2005, respectively.

With respect toregulatory compliance in subsequent periods, the Company expects that totaloperating expenses will increase throughout the remainder of the fiscal yeardue to the 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. This is discussed furtherin the Outlook section of this report.

Total other expense, net, was $38,000, a decrease from other expense,net, of $50,000 for the same period a year ago.

For the threemonths ended June 30, 2006, an income tax benefit of $2,000 was recorded forour operations as compared to a provision of $5,000 for the same period a yearago.  The Company does not expect any United States income taxes for thecurrent fiscal year as a result of available net operating loss carry-forwards.

The result of the foregoing was a net loss of$347,000, or ($0.07) per diluted share, for the three months endedJune 30, 2006, in comparison****to net profitof $159,000, or $0.03 per diluted share, for the comparable prior yearquarter.  The net loss was the result oflower net sales and higher relative cost of sales in the current quarter.

### *Variability of Results*

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

**Liquidityand Capital Resources**

For the threemonths ended June 30, 2006, cash and short-term investments increased $220,000 to$2,755,000 from $2,535,000 at March 31, 2006.  However, working capital for the same three month period decreasedslightly by $53,000 to $5,594,000 from $5,647,000 at March 31, 2006 as a resultof an increase in accounts payable in the current year three month period.

The increase incash and short-term investments resulted primarily from cash provided fromoperating activities partly offset by capital expenditures and payments on theCompany’s long-term debt.   Cash providedfrom operating activities for the quarter ended June 30, 2006 was $359,000compared to cash used in operations of $136,000 for the comparable prior yearquarter due to lower accounts receivable partly offset by higher inventorybalances.   Capital expenditures totaled$55,000 for the three months ended June 30, 2006 compared to $40,000 for thecomparable prior year period.   Cash usedin financing activities included repayments of the Company’s long-term debt of$87,000 and $86,000 for the three months ended June 30, 2006 and 2005, respectively.   In addition, the Company received cashproceeds of $3,000 from the exercise of stock options during the current yearperiod.

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 

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FinancialCondition and Results of Operations – Liquidity and Capital Resources, and Item8 Financial Statements and Supplementary Data – Notes 5 and 6 of Notes toConsolidated Financial Statements.  Therewere no significant changes in contractual obligations and commitments fromMarch 31, 2006 to June 30, 2006.

## **Critical Accounting Policies**

Our unauditedfinancial statements and accompanying notes are prepared in accordance withaccounting principles generally accepted in the United States of America forinterim 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.  *Thesecritical accounting policies are stated in the notes to consolidated financialstatements in the Company’s 2006 Annual Report on Form 10-K/A.  This discussion and analysis should beread in conjunction with such notes and in conjunction with our consolidatedfinancial statements and related notes, and in conjunction with the Overview,Results of Operations, and similar discussions included elsewhere in thisreport.*

## **Outlook**

*Thisoutlook section contains a number of forward-looking statements, all of whichare based on current expectations. Actual results may differ materially.*

CyanotechCorporation’s strategic direction is to position itself as a world-leader inthe production and marketing of high-value natural products frommicroalgae.  We are vertically aligned;producing raw materials in the form of microalgae processed at our 90-acrefacility in Hawaii, and integrating those raw materials into finishedproducts.  For fiscal 2007 we are focusedon the business-to-business wholesale market for the products and compoundsthat we produce.  Our current productofferings include Naturally Cultivated Spirulina Pacifica® in powder, flake andtablet form, NatuRose® natural astaxanthin powder for the animal nutritionmarket, BioAstin® natural astaxanthin antioxidant in lipid extract, softgel capletand micro-encapsulated beadlet form for the human nutrition and cosmeticindustries and Phycobiliproteins for use in medical diagnostics.  Information about our Company and ourproducts can be viewed at www.cyanotech.com, www.nutrex-hawaii.com or www.phycobiliprotein.com.  Consumer products can also be purchasedonline at www.nutrex-hawaii.com .

We continue toexperience downward pressure on sales, with unit sales declining during thefirst quarter of fiscal 2007, ended June 30, 2006 as compared to the firstquarter of fiscal year 2006. The most significant impact was due to declines inSpirulina bulk product line. The Company expects Spirulina sales to remainessentially level since the product has reached a mature life cycle stage.However, significant variability between periods and even across severalperiods can be expected based on historical results and it does not necessarilyfollow that decreased unit sales in one period will be followed by increasedunit sales in the next period.

The Company alsocontinues to experience a reduction of NatuRose sales to the worldwideaquaculture market due to reduced Sea Bream sales, growers using less naturalastaxanthin in their feed as a result of pricing competition from syntheticastaxanthin offerings and 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. We feel that these conditions are likely to persist which placessignificant pressure on being able to deliver a profitable natural astaxanthinproduct in the animal nutrition market. In response to this, we are shifting our natural astaxanthin productioninto higher value products such as BioAstin for human consumption until suchtime that animal nutrition markets can be identified that can generatereasonable profitability for the Company.

The Company is exploring options to expand consumer brandawareness and knowledge of its product lines, with particular focus ofBioAstin, the Company’s human natural astaxanthin product line, for which itbelieves full market penetration has not yet been realized. To accomplish theseobjectives the Company, among other initiatives, is actively searching for andwill, within the current fiscal year, base a knowledgeable sales employee onthe US mainland to increase the Company’s outreach to both the US and Europeanmarkets.

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 increaseproduction wages in order to retain key employees and attract qualifiedpersonnel. With competition increasing and higher production costs, pressure isplaced on achieving 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.   

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Additionally, withthe adoption of SFAS 151, the Company recognizes costs associated with abnormalamounts of idle facility expense, freight, handling costs and wasted materials(such as spoilage) as current-period charges in cost of sales.   When production costs exceed historicalaverages, the Company evaluates whether such costs are current-period chargesor can be inventoried.   In addition, theallocation of such fixed production overheads (such as depreciation and generalinsurance) to inventories is determined based on normal productioncapacity.   When the Company’s productionvolumes are below normal capacity limits, certain fixed production overheadcosts cannot be inventoried 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 quarter ended June 30, 2006.  Until the Company is able to prudentlyincrease its level of natural astaxanthin production, the Company believesmargins will continue to be negatively impacted by all of the foregoing costelements, and margins are expected to remain lower than those reported forcomparable previous periods.

The Companyanticipates that future total operating expenses will increase due to the costsof the restatement and the remediation of errors identified by the restatement,including the need to improve the Company’s internal controls.  *Please refer to Part I,Item 4 (a) in this report.*In addition, increased costs are expectedas a result of management’s recommendation and the Company’s Audit Committeeand Board of Directors approval and adoption of a remediation plan whichincludes that policies and procedures will be designed to ensure fullcompliance with GAAP, particularly as it applies to inventory accounting, andwill address key financial reporting risk elements, including the following:(a) ensuring that its disclosures are subject to adequate and rigorous reviewprocess prior to finalizing and releasing financial statements;  (b) continuing to update its inventoryaccounting systems and procedures to properly accommodate specificinventoriable fixed costs in accordance with GAAP; and (c) continuing toidentify resources with the critical skills necessary to ensure full compliancewith GAAP.  Since the process related toerror identification and the subsequent restatement originated after June 30,2006, no related audit, legal, or outside consulting costs, or remediation plancosts have been recorded as of June 30, 2006.

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

The Company’sfuture results of operations and the other forward-looking statements containedin this Outlook, in particular the statements regarding revenues, gross marginand capital spending involve a number of risks and uncertainties.  In addition to the factors discussed above,any of the following could cause actual results to differ materially:  business conditions and growth in the naturalproducts industry and in the general economy; changes in customer orderpatterns; changes in demand for natural products in general; changes in weatherconditions; competitive factors, such as increased production capacity fromcompeting Spirulina and astaxanthin producers and the resulting impact, if any,on world market prices for these products; government actions; shortage ofmanufacturing capacity; and other factors beyond our control.  Risk factors are discussed in detail in Item1A, included in this report.

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

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

We have neverentered into any transactions using derivative financial instruments orderivative commodity instruments and believe that our exposure to market riskassociated with other financial instruments is not material.

We have a termloan agreement that adjusts quarterly based on the prime rate.  As such we are exposed to the interest raterisk whereby a 1% increase in the prime rate would lead to an increase ofapproximately $16,000 in interest expense for the year ending March 31, 2007(based on March 31, 2006 amounts outstanding).

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**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 no changes in Controls and Procedures during the currentquarter. However, there were changes in subsequent quarters of fiscal year2007, as disclosed in the applicable Forms 10-Q, in that, the Company changedand is continuing a process of improving its control policies, procedures, andsystems. This includes restatement of prior periods and correction of the errorin its inventory accounting, and a remediation plan adopted by the Board ofDirectors in November 2006.

As of June 30, 2006, as discussed in the Company’s Form 10-K/A filedFebruary 14, 2007, the Company did not maintain effective controls overaccounting for inventory. Specifically, the Company did not have effectivepolicies and procedures and adequately trained and qualified accountingdepartment staff to ensure that inventory included all inventoriable fixed costcomponents such as depreciation, portions of general insurance costs, andportions of direct labor burden costs in accordance with GAAP. As a result ofthis material weakness, the Company was required to restate its consolidatedfinancial statements of and for fiscal years ended March 31, 2006, 2005, and2004, and quarterly periods within fiscal years 2006 and 2005, and has restatedselected financial data for the years ended March 31, 2004 and 2002 to adjustits inventory balances, cost of goods sold, and restated amounts of income andloss.

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

**PARTII.   OTHER INFORMATION**

**Item 1**.           **LegalProceedings**

None

**Item1A. Risk Factors**

You shouldcarefully consider the risks described below which we believe are significantbut not the only ones we face. Any of the following risks could have a materialadverse effect on our business, financial condition and operating results. Youshould also 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**

Our results of operationsare affected by the business activity of our customers who in turn are affectedby the level of economic activity in the industries and markets that theyserve. A decline in the level of business activity of our clients could have amaterial 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**

We have experienced, andmay in the future continue to experience, fluctuations in our quarterlyoperating results. These fluctuations could reduce the market price of ourCommon Stock. Factors that may cause our quarterly operating results to varyinclude, but are not limited to:

·       thebusiness decisions of our customers regarding orders for our products;

·       increasedenergy costs;

·       increasedraw material costs;

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

·       weather-relatedcultivation difficulties;

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·       contaminationof our cultivation and production facilities;

·       theeffect of weather on customer demand patterns;

·       theintroduction of new products by us or our competitors;

·       changesin our pricing policies or those of our competitors;

·       seasonaltrends in our customers’ buying patterns

·       changesin government regulation, both domestic and foreign;

·       fluctuationin foreign currency exchange rates;

·       globaleconomic and political conditions and related risks, including acts ofterrorism; and

·  customersusing alternative, possibly synthetic, products;

·       aninability to produce or deliver orders;

·       productquality issues which may restrict production or require product recall;

·       otherfactors beyond our control.

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.

**Our Global Operations Expose Us to Complex Management,Foreign Currency, Legal, Tax and Economic Risks, Which We May Not Be Ableto Address Adequately**

We conductbusiness in a number of countries around the world. For the quarter ended June30, 2006, approximately 54% of our net sales were from sales to foreigncustomers. As a result, we are subject to a number of risks which include, butare not limited to:

·       theburden of complying with a wide variety of national and local laws;

·       potentiallylonger payment cycles for foreign sales;

·       multipleand possibly overlapping and conflicting tax laws;

·       coordinatinggeographically separated locations;

·       restrictions(government and otherwise) on the movement of cash;

·       theabsence in some jurisdictions of effective laws protecting our intellectualproperty rights;

·       changesin government regulations, both domestic and foreign;

·       globaleconomic and political conditions and related risks, including acts ofterrorism; and

·       fluctuationsin foreign currency exchange rates.

**Competition in OurIndustry is Intense**

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

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

We have in the past derived, and may continue in thefuture to derive, a significant portion of our revenues from a relativelylimited number of major customers. From quarter to quarter, revenues from oneor more individual customers may

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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.

**IfWe Are Unable to Protect Our Intellectual Property Rights or if We InfringeUpon the Intellectual Property Rights of Others Our Business May Be Harmed**

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

**We May Need to Raise Additional Capital in theFuture Which May Not Be Available**

At June 30, 2006, the Company’s working capital was$5,594,000. Cash equivalents and short-term investments at June 30, 2006 totaled$2,755,000. Our cash requirements will depend on numerous factors, including:demand for products; normal requirements to maintain and upgrade facilities andequipment; whether opportunities emerge in either new markets or in researchand development activities; or, in the event we need to expand or contract ourproduction or distribution infrastructure. We believe our current cash, cashequivalents and short-term investments, and cash provided from operations willbe sufficient to meet our capital requirements for at least the next 12 months.If we need to raise additional funds, we may not be able to secure funding onacceptable terms, or not at all. If we raise additional funds through theissuance of equity or convertible debt securities, the percentage ownership ofour then current stockholders may be reduced. If we raise additional fundsthrough the issuance of convertible debt securities, or through additional debtor similar instruments, such securities, debt, or similar instruments couldhave rights senior to those of our common stockholders and such instrumentscould contain provisions restricting our operations. If adequate funds are notavailable to satisfy either short-term or long-term capital requirements, wemay be required to limit operations with adverse results.

**Our Insurance Liability Coverage is Limited**

In the ordinary course of business, the Companypurchases insurance coverages (e.g., property and liability coverages) toprotect itself against loss of or damage to its properties and claims made bythird parties and employees for property damage or personal injuries. However,the protection provided by such insurance is limited in significant respectsand, in some instances, the Company has no coverage and certain of the Company’sinsurance has substantial “deductibles” or has limits on the maximum amountsthat may be recovered. For example, if a hurricane or other uninsuredcatastrophic natural disaster should occur, the Company may not be able torecover all facility restoration costs and revenues lost from businessinterruption. In addition, the Company maintains product liability insurance inlimited amounts for all of its products involving human consumption; however,broader product liability coverage is prohibitively expensive. Insurers havealso introduced new exclusions or limitations of coverage for claims related tocertain perils including, but not limited to, mold and terrorism. If a seriesof losses occurred, such as from a series of lawsuits in the ordinary course ofbusiness each of which were subject to the deductible amount, or if the maximumlimit of the available insurance were substantially exceeded, the Company couldincur losses in amounts that would have a material adverse effect on its resultof operations and financial condition.

**OurAbility to Develop and Market New Products or Modify Existing Products andProduction Methods May be Adversely Affected If we Lose the Services of orCannot Replace Certain Employees Knowledgeable in Advanced Scientific and OtherFields**

The Company’s products are derived from and depend onproprietary and non-proprietary processes and methods 

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founded on advancedscientific knowledge, skills, and expertise. If the services of employeesknowledgeable in these fields are lost and cannot be replaced in a reasonabletime frame at reasonable costs, the Company’s ability to develop and market newproducts or modify existing products and production methods would be adverselyimpacted. At the same time, regulatory compliance surrounding the Company’sproducts and financial matters generally requires minimum levels of knowledgeand expertise related to production, quality assurance, and financial control.If the Company loses the services or cannot reasonably replace employees whohave the necessary knowledge and expertise the Company’s ability to remain inregulatory compliance could be adversely affected.

**As aResult of Restating the Company’s Form 10-K/A and the Late Filing of Form10-Qs, Additional General and Administrative Expenditures Will Be Required inFuture Periods**

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

**TheCompany Will Incur Additional Sums In the Future in Order to Comply withSecurities and Exchange and Public Company Accounting Oversight RequirementsResulting from the Sarbanes-Oxley Act**

As of the date of filing this Form 10-Q the Company isrequired to have policies, procedures, systems and related documentation infull compliance with Securities and Exchange Commission and Public CompanyAccounting Oversight Board requirements. There is currently no means ofreliably estimating such costs or their duration.

***Potential Delisting from Nasdaq Capital MarketTrading***

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

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

***The Nasdaq Listing 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 has filed an appeal February 20, 2007 with the NasdaqListing and Review Council requesting a further stay of the delisting  until February 28, 2007, but such stay maynot be granted.   See the Company’s Form8-K dated December 18, 2006.  If theCompany’s common stock is delisted, our stockholders could be materially andadversely affected by having less active and efficient market available for thetrading of their stock.***

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

a)                                                              Thefollowing exhibits are furnished with this report:

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

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

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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 Form8-K dated May 24, 2006 included Item 2.02, Results ofOperations and Financial Condition, for the Company’s 4th Quarter and fiscal year ended March 31, 2006,and forward looking statements.

A report on Form8-K dated May 31, 2006 included Item 3.01, Notice ofExtension of Time to Satisfy a Continued Listing Rule.

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SIGNATURES

In accordance with the requirements of the Securities Exchange Act of1934, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                    | CYANOTECH CORPORATION (Registrant) |
|--------------------|------------------------------------|
|               |                               |
| 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 |   |
| (Date)             |                               |   | William R. Maris |
|               |                               |   | Vice President – Finance & Administration, |
|               |                               |   | Chief Financial  Officer |
|               |                               |   | (Principal  Financial and Accounting Officer) |

 

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