**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

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

 

**ForQuarterly Period Ended December 31, 2007**

 

**CommissionFile Number 0-14602**

 

**CYANOTECH CORPORATION**

(Exact name of registrant as specified in itscharter)

 

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

 

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

 

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

 

Check whether 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 the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  o          Acceleratedfiler  o          Non-acceleratedfiler  x

 

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

 

Number of common shares outstanding as of February 13, 2007:

 

| **Title of Class**              | ** ** | **Shares Outstanding** |
|---------------------------------|------------|------------------------|
| Common stock - $0.02 par  value |       | 5,242,270.

      |

 

 

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CYANOTECH CORPORATIONFORM 10-Q

 

INDEX

 
| ** ** | **PART I.  FINANCIAL  INFORMATION**                                                                                                              | ** ** |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|       | Discussion of  Forward-Looking Statements                                                                                                                       |       |
| Item 1.    | Financial Statements                                                                                                                                            |       |
|       | Consolidated Condensed  Balance Sheets as of December 31, 2007 (unaudited) and March 31,  2007                                                        |       |
|       | Consolidated Condensed  Statements of Operations and Comprehensive Loss (unaudited) For the three and  nine month periods ended December 31, 2007 and 2006 |       |
|       | Consolidated Condensed  Statements of Cash Flows (unaudited) For the nine month periods ended  December 31, 2007 and 2006                                  |       |
|       | Notes to Consolidated  Condensed 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 2.    | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                    |       |
| Item 3.    | Defaults upon Senior  Securities                                                                                                                                |       |
| Item 4.    | Submission of  Matters to a Vote of Security Holders                                                                                                            |       |
| Item 5.    | Other Information                                                                                                                                               |       |
| Item 6.    | Exhibits                                                                                                                                                        |       |
| SIGNATURES |

 

2

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**Discussion of Forward-Looking Statements:**

 

***Important Notice to Investors:***Statements made in this report that relate tofuture plans, events, liquidity, financial results or performance includingstatements relating to cash flows and liquidity, as well as estimatedunrecognized compensation expense, projected capital expenditures, and futurecontractual obligations, are forward-looking statements as defined under thePrivate Securities Litigation Reform Act of 1995.  These statements arebased upon current information and expectations.  Actual results maydiffer materially from those anticipated as a result of certain risks anduncertainties, including delays, difficulties, changed strategies, orunanticipated factors affecting the implementation of the Company’s grossmargin, as well as the general risks and uncertainties applicable to theCompany and its business.  For details concerning these and other risksand uncertainties, see Part I, Item IA, “Risk Factors” of our most recent Form 10-Kas well as the Company’s other reports subsequently filed with the Securitiesand Exchange Commission from time to time.  Investors are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date hereof.  The Company undertakes no obligation to updateforward-looking statements to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events. Investors shouldalso be aware that while the Company from time to time does communicate withsecurities analysts, it is against the Company’s policy to disclose to them anymaterial non-public information or other confidential commercialinformation.  Furthermore, the Company has a policy against distributingor confirming financial forecasts or projections issued by analysts and anyreports issued by such analysts are not the responsibility of theCompany.  Investors should not assume that the Company agrees with anyreport issued by any analyst or with any statements, projections, forecasts oropinions contained in any such report.

 

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PART 1.  FINANCIAL INFORMATION

Item 1.  Financial Statements

 

CYANOTECH CORPORATIONCONSOLIDATED CONDENSED BALANCE SHEETS

(Dollars in thousands except per shareamounts)

 
| ** **                                                                                                                                                | ** ** | **December 31  2007** | ** ** | **March 31,  2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                | ** ** | **(Unaudited)**            | ** ** | ** **               | ** ** |
| ASSETS                                                                                                                                                    |       |                       |       |                     |       |
| Current assets:                                                                                                                                           |       |                       |       |                     |       |
| Cash and cash equivalents                                                                                                                                 |       | $                          | 790        |                     | $          | 1,444 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $23                                                                                       |       | 1,292                      |       | 1,587                    |       |
| Inventories (see Note 4)                                                                                                                                  |       | 1,850                      |       | 1,593                    |       |
| Prepaid expenses and other                                                                                                                                |       | 338                        |       | 141                      |       |
| Total current assets                                                                                                                                      |       | 4,270                      |       | 4,765                    |       |
|                                                                                                                                                      |       |                       |       |                     |       |
| Equipment and leasehold improvements, net                                                                                                                 |       | 4,401                      |       | 4,701                    |       |
| Other assets                                                                                                                                              |       | 510                        |       | 440                      |       |
| Total assets                                                                                                                                              |       | $                          | 9,181      |                     | $          | 9,906 |   |
|                                                                                                                                                      |       |                       |       |                     |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                 |       |                       |       |                     |       |
| Current liabilities:                                                                                                                                      |       |                       |       |                     |       |
| Current maturities of long-term debt                                                                                                                      |       | $                          | 424        |                     | $          | 398 |   |
| Customer deposits                                                                                                                                         |       | 189                        |       | —                   |       |
| Accounts payable                                                                                                                                          |       | 1,167                      |       | 616                      |       |
| Accrued expenses                                                                                                                                          |       | 440                        |       | 390                      |       |
| Total current liabilities                                                                                                                                 |       | 2,220                      |       | 1,404                    |       |
|                                                                                                                                                      |       |                       |       |                     |       |
| Other long-term liabilities                                                                                                                               |       | 100                        |       | —                   |       |
| Long-term debt, excluding current  maturities                                                                                                             |       | 673                        |       | 992                      |       |
| Total liabilities                                                                                                                                         |       | 2,993                      |       | 2,396                    |       |
|                                                                                                                                                      |       |                       |       |                     |       |
| Stockholders’ equity: (see Note 3)                                                                                                                   |       |                       |       |                     |       |
| Common stock of $0.02 par value, shares  authorized 7,500,000; 5,242,270 shares issued and outstanding at  December 31, 2007 and March 31, 2007 |       | 105                        |       | 105                      |       |
| Additional paid-in capital                                                                                                                                |       | 27,333                     |       | 27,333                   |       |
| Accumulated other comprehensive loss –  foreign currency translation adjustments                                                                     |       | (10                        | )          | (8                       | )          |
| Accumulated deficit                                                                                                                                       |       | (21,240                    | )          | (19,920                  | )          |
| Total stockholders’ equity                                                                                                                           |       | 6,188                      |       | 7,510                    |       |
|                                                                                                                                                      |       |                       |       |                     |       |
| Total liabilities and stockholders’ equity                                                                                                           |       | $                          | 9,181      |                     | $          | 9,906 |   |

 

See accompanying Notes to ConsolidatedCondensed Financial Statements.

 

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CYANOTECH CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)(Unaudited)

 
| ** **                                         | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| NET SALES                                          |       | $                                                   | 2,763      |                                               | $          | 2,434 |   | $ | 7,950 |   | $ | 7,353 |   |
| COST OF PRODUCT SALES                              |       | 2,410                                               |       | 2,356                                              |       | 6,083 |   | 6,400 |   |
| Gross profit                                       |       | 353                                                 |       | 78                                                 |       | 1,867 |   | 953 |   |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| OPERATING EXPENSES:                                |       |                                                |       |                                               |       |   |   |   |   |
| Research and development                           |       | 22                                                  |       | 81                                                 |       | 105 |   | 161 |   |
| Sales and marketing                                |       | 391                                                 |       | 327                                                |       | 1,096 |   | 942 |   |
| General and administrative                         |       | 501                                                 |       | 833                                                |       | 1,882 |   | 1,866 |   |
| Total operating expenses                           |       | 914                                                 |       | 1,241                                              |       | 3,083 |   | 2,969 |   |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| Loss from operations                               |       | (561                                                | )          | (1,163                                             | )          | (1,216 | ) | (2,016 | ) |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                            |       |                                                |       |                                               |       |   |   |   |   |
| Interest income                                    |       | 3                                                   |       | 12                                                 |       | 20 |   | 38 |   |
| Interest expense                                   |       | (36                                                 | )          | (46                                                | )          | (115 | ) | (140 | ) |
| Other income (expense), net                        |       | —                                              |       | 7                                                  |       | 1 |   | 3 |   |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| Total other expense, net                           |       | (33                                                 | )          | (27                                                | )          | (94 | ) | (99 | ) |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| Loss before income taxes                           |       | (594                                                | )          | (1,190                                             | )          | (1,310 | ) | (2,115 | ) |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| INCOME TAX (BENEFIT) EXPENSE                       |       | —                                              |       | (3                                                 | )          | 10 |   | (9 | ) |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| NET LOSS                                           |       | $                                                   | (594       | )                                                  | $          | (1,187 | ) | $ | (1,320 | ) | $ | (2,106 | ) |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| NET LOSS PER SHARE (see Note 6)                    |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                              |       | $                                                   | (0.11      | )                                                  | $          | (0.23 | ) | (0.25 | ) | $ | (0.40 | ) |
| Diluted                                            |       | $                                                   | (0.11      | )                                                  | $          | (0.23 | ) | (0.25 | ) | $ | (0.40 | ) |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| SHARES USED IN CALCULATION OF NET LOSS PER  SHARE: |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                              |       | 5,242                                               |       | 5,234                                              |       | 5,242 |   | 5,234 |   |
| Diluted                                            |       | 5,242                                               |       | 5,234                                              |       | 5,242 |   | 5,234 |   |
|                                               |       |                                                |       |                                               |       |   |   |   |   |
| COMPREHENSIVE LOSS:                                |       |                                                |       |                                               |       |   |   |   |   |
| Net loss                                           |       | $                                                   | (594       | )                                                  | $          | (1,187 | ) | (1,320 | ) | $ | (2,106 | ) |
| Other comprehensive loss                           |       | —                                              |       | (8                                                 | )          | (4 | ) | (8 | ) |
|                                               |       | $                                                   | (594       | )                                                  | $          | (1,195 | ) | $ | (1,324 | ) | $ | (2,114 | ) |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

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CYANOTECH CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)(Unaudited)

 
| ** **                                                                                 | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2007**                                           | ** ** | **2006** | ** ** |
| ** **                                                                                 | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |       |                                               |       |   |   |
| Net loss                                                                                   |       | $                                                  | (1,320     | ) | $ | (2,106 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                                               |       |   |   |
| Depreciation and amortization                                                              |       | 380                                                |       | 959 |   |
| Provision for allowance for doubtful  accounts                                             |       | —                                             |       | 4 |   |
| Amortization of debt issue costs and other  assets                                         |       | 27                                                 |       | 27 |   |
| Net (increase) decrease in:                                                                |       |                                               |       |   |   |
| Accounts receivable                                                                        |       | 295                                                |       | 686 |   |
| Refundable income taxes                                                                    |       | 8                                                  |       | (10 | ) |
| Inventories                                                                                |       | (257                                               | )          | 259 |   |
| Prepaid expenses and other assets                                                          |       | (304                                               | )          | (81 | ) |
| Net increase (decrease) in:                                                                |       |                                               |       |   |   |
| Customer deposits                                                                          |       | 289                                                |       | — |   |
| Accounts payable                                                                           |       | 551                                                |       | 153 |   |
| Accrued expenses                                                                           |       | 50                                                 |       | 91 |   |
| Net cash used in operating activities                                                      |       | (281                                               | )          | (18 | ) |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |       |                                               |       |   |   |
| Investment in equipment and leasehold  improvements                                        |       | (80                                                | )          | (246 | ) |
|                                                                                       |       |                                               |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |       |                                               |       |   |   |
| Proceeds from exercise of stock options and  warrants                                      |       | —                                             |       | 3 |   |
| Principal payments on long-term debt                                                       |       | (293                                               | )          | (268 | ) |
| Net cash used in financing activities                                                      |       | (293                                               | )          | (265 | ) |
|                                                                                       |       |                                               |       |   |   |
| Net decrease in cash and cash equivalents                                                  |       | (654                                               | )          | (529 | ) |
|                                                                                       |       |                                               |       |   |   |
| Cash and cash equivalents at beginning of  period                                          |       | 1,444                                              |       | 1,835 |   |
|                                                                                       |       |                                               |       |   |   |
| Cash and cash equivalents at end of period                                                 |       | $                                                  | 790        |   | $ | 1,306 |   |
|                                                                                       |       |                                               |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                         |       |                                               |       |   |   |
| Cash paid during the period for:                                                           |       |                                               |       |   |   |
| Interest                                                                                   |       | $                                                  | 94         |   | $ | 118 |   |
| Income taxes                                                                               |       | $                                                  | 10         |   | $ | 1 |   |

 

See accompanying Notes to ConsolidatedFinancial Statements.

 

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CYANOTECH CORPORATIONFORM 10-QNOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2007(Unaudited)

 

**1.****            ****BASIS OF PRESENTATION**

 

Theaccompanying consolidated condensed financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions to Form 10-Qand Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by Generally Accepted Accounting Principles(GAAP) for complete financial statements.  *These consolidated financial statements and notes should be read inconjunction with the Company’s consolidated financial statements contained inthe Company’s report on Form 10-K for the year ended March 31, 2007filed on August 16, 2007.*

 

The accompanying consolidated condensed financial statements includethe accounts of Cyanotech Corporation and its wholly owned subsidiaries, NutrexHawaii, Inc. (“Nutrex Hawaii” or “Nutrex”) and Cyanotech Japan YK (“CyanotechJapan” or “CJYK”). All significant intercompany balances and transactions havebeen eliminated in consolidation.  On August 31, 2007, the Companydiscontinued the activity of its wholly owned Japanese subsidiary “CJYK.” All aquaculture feed business in Japan was absorbed through the Company’sdomestic operations.  “CJYK” remained a registered Japanese corporationuntil November 30, 2007, at which time it was dissolved.  All “CJYK”assets and liabilities were absorbed into the Company as of September 1,2007, and no significant “CJYK” assets or liabilities existed except for cashof approximately $50,000.  “CJYK” was under no contractual obligations at August 31,2007.  The Company made this decision due to declining sales ofapproximately 40% in each of the prior two fiscal years in addition todeclining gross profit margins of 13% and 4% for fiscal 2007, and the ninemonth period ended December 31, 2007, respectively.  “CJYK” sales forfiscal year 2007 and the nine months ended December 31, 2007, were$482,000 and $45,000, respectively.  We do not expect the dissolution ofthis subsidiary to have a significant impact on our consolidated financialstatements.

 

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

 

2.             **INCOME TAXES**

 

The Company is subject to taxation in the United States and two statejurisdictions. No remaining or future tax liabilities are expected with respectto the dissolution of “CJYK.”  The preparation of tax returns requires theCompany to interpret the applicable tax laws and regulations in effect in suchjurisdictions, which could affect the amount of tax paid by the Company. TheCompany, in consultation with its tax advisors, files its tax returns oninterpretations that are believed to be reasonable under the circumstances. Thetax returns, however, are subject to routine reviews by the various taxingauthorities in the jurisdictions in which the Company files its returns. As part of these reviews, a taxing authority may disagree with respect to thetax positions taken by the Company (“uncertain tax positions”) and thereforerequire the Company to pay additional taxes. As required under applicableaccounting rules, the Company evaluates the requirement for additional taxaccruals, but for the three and nine months ended December 31, 2007, noaccrual was recorded based on this evaluation of potential additional taxliability, including interest and penalties, which the Company could incur as aresult of the ultimate resolution of its uncertain tax positions.  TheCompany reviews and updates the accrual for uncertain tax positions as moredefinitive information becomes available from taxing authorities, completion oftax audits, expiration of statute of limitations, or upon occurrence of otherevents.

 

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In June 2006 the FASB issued FASB Interpretation No. 48 (“FINNo. 48”) “Accounting for Uncertainty in Income Taxes, an interpretation ofFASB 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 interpretationalso provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure and transition. FIN No. 48is effective for fiscal years beginning after December 15, 2006. TheCompany adopted FIN No. 48 on April 1, 2007.

 

As a result of the implementation of FIN 48, the Company did notrecognize a liability for unrecognized tax benefits and, accordingly, was notrequired to record any cumulative effect adjustment to beginning of yearretained earnings.  As of both the date of adoption and December 31,2007, there was no significant liability for income tax associated withunrecognized tax benefits.

 

The Company recognizes interest accrued related to unrecognized taxbenefits as well as any related penalties in interest income or expense in itscondensed consolidated statements of operations, which is consistent with therecognition of these items in prior reporting periods.  As of the date ofadoption and during the three and nine months ended December 31, 2007, theCompany was not required to have an accrual for the payment of interest andpenalties related to uncertain tax positions.  With few exceptions, theCompany is no longer subject to U.S. federal, state and local, or non-U.S.income tax examination by tax authorities for tax years before 2001.

 

**3.**             **SHARE-BASED COMPENSATION**

 

The Company has adopted the provisions of Statement of FinancialAccounting Standard No. 123(R) (“SFAS No. 123R”) “Share-BasedPayment” for its share-based compensation plans.  SFAS No. 123Rrequires an entity to measure the cost of employee services received inexchange for an award.  If an award vests or becomes exercisable based onthe achievement of a condition other than service, performance or marketcondition, the award is liability-classified.   Liability-classifiedawards are remeasured to fair value at each balance sheet date until the awardis settled. The Company currently has no liability-classified awards. Equity-classified awards, including grants of employee stock options, aremeasured at the grant-date fair value of the award and are not subsequentlyremeasured.  The cost of equity-classified awards is recognized in theincome statement over the period during which an employee is required toprovide the service in exchange for the award. All of the Company’s stockoptions are performance based awards and because the Company’s future employeeincentive stock options are “plain vanilla,” as defined by the SEC in StaffAccounting Bulletin No. 107, they are reflected only in Equity andCompensation Expense accounts.

 

***Stock Options***

 

As of December 31, 2007, the Company had the following twoshareholder approved stock plans under which shares were available forequity-based awards: the 2005 Stock Option Plan (the “2005 Plan”) wherein200,000 shares of common stock are reserved for issuance, and the planterminates on August 21, 2015, and the Independent Director Stock Optionand Stock Grant Plan (the “2004 Plan”) wherein 75,000 shares of common stockare reserved for issuance.  Under the 2005 Plan, eligible employees andcertain independent consultants may be granted options to purchase shares ofthe Company’s Stock. The shares issuable under the 2005 Plan will either beshares of the Company’s authorized but previously unissued common stock orshares reacquired by the Company, including shares purchased on the openmarket.  As of December 31, 2007, 195,000 options remained availablefor grant under the 2005 Plan.  Concurrent with the 2005 Plan approval on August 22,2005, the 1995 Stock Option Plan was terminated except for the outstandingoptions issued thereunder.  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 such options are granted at fair marketvalue on the date of grant.  Options granted vest and become exercisablenine months from the date of grant.  In addition, on the date of eachAnnual Meeting of Stockholders, each non-employee director 

 

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continuingin office is automatically granted, without payment, 875 shares of commonstock, non-transferable for nine months following the date of grant.  Asof December 31, 2007, 70,250 options remained available for grant underthe 2004 Plan.  Concurrent with the 2004 Plan approval on August 16,2004, the 1994 Non-Employee Director Stock Option and Stock Grant Plan wasterminated except for the outstanding options issued thereunder.

 

The following table presents shares authorized,available for future grant and outstanding under each of the Company’s plans:

 
| ** ** | ** ** | **As of December 31, 2007** | ** ** |
|------------|------------|-------------------------------------------------|------------|
| ** ** | ** ** | **Authorized**                                  | ** ** | **Available** | ** ** | **Outstanding** | ** ** |
|       |       |                                            |       |   |   |   |   |
| 2005 Plan  |       | 200,000                                         |       | 195,000 |   | 5,000 |   |
| 2004 Plan  |       | 75,000                                          |       | 65,375 |   | 1,000 |   |
| 1995 Plan  |       | —                                          |       | — |   | 55,872 |   |
| 1994 Plan  |       | —                                          |       | — |   | 3,750 |   |
| Total      |       | 275,000                                         |       | 260,375 |   | 65,622 |   |

 

All stock option grants made under the 2005 Plan and the 2004 DirectorsPlan are made at exercise prices no less than the Company’s closing stock priceon the date of grant. Options under the 2005 Plan are granted, and are vestedand exercisable as determined by the Board of Directors or the Stock Option andCompensation Committee of the Board in accordance with the provisions of the2005 Stock Option Plan.  Discussion relative to option granting, vesting,exercising, and other conditions are set forth in a Stock Option Agreementevidencing each grant. No option can have a life in excess of ten (10) years. The Company records compensation expense for employee stock options based onthe estimated fair value of the options on the date of grant using theBlack-Scholes option-pricing model. The model will use various assumptions,including a risk-free interest rate, the expected term of the options, theexpected stock price volatility over the expected term of the options, and theexpected dividend yield. Compensation expense for employee stock options willbe recognized ratably over the vesting term.   There were no stockoptions granted during the three and nine months ended December 31, 2007,or during the three and nine months ended December 31, 2006, thus theaverage fair value assumptions used in the valuation of stock option grants arenot disclosed until the time of such grants.

 

As of December 31, 2007, total unrecognized stock-basedcompensation expense related to unvested stock options was $1,408 which isexpected to be expensed over a weighted-average period of 1.6 years.

 

A summary of option activity under Cyanotech Corporation’s Stock Plansfor the three months ended December 31, 2007 is presented below:

 
| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average**

**Remaining  Contractual  Term in  Years** | ** ** | **Average  Intrinsic  Value** | ** ** |
|------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------------|------------|-------------------------------|------------|
| Balance at September 30, 2007 |       | 67,322                     |       | $                                      | 4.23       |                                                                   | 1.60       |                          | $          | 284,824 |   |
| Granted                            |       | —                     |       | —                                 |       | —                                                                 |       | —                        |       |
| Exercised                          |       | —                     |       | —                                 |       | —                                                                 |       | —                        |       |
| Expired                            |       | (1,000                     | )          | 2.04                                   |       | —                                                                 |       | (2,040                        | )          |
| Forfeited                          |       | (700                       | )          | 4.40                                   |       | —                                                                 |       | (3,080                        | )          |
| Balance at December 31, 2007  |       | 65,622                     |       | $                                      | 4.26       |                                                                   | 1.37       |                          | $          | 279,704 |   |

 

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The following table summarizes the weighted average characteristics ofoutstanding stock options as of December 31, 2007:

 
| ** **                              | ** ** | **Outstanding Options** | ** ** | **Exercisable Options**     | ** ** |
|-----------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  of Shares**   | ** ** | **Remaining  Life (Years)** | ** ** | **Weighted  Average Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Price** | ** ** |
| $1.84 - $2.60                           |       | 33,094                       |       | 1.22                             |       | $ | 2.09 |   | 33,094 |   | $ | 2.09 |   |
| $4.20 - $6.50                           |       | 26,278                       |       | 1.83                             |       | 4.51 |   | 26,278 |   | 4.51 |   |
| $14.75 - $14.75                         |       | 6,250                        |       | 0.28                             |       | 14.75 |   | 6,250 |   | 14.75 |   |
| Total stock options                     |       | 65,622                       |       | 1.37                             |       | 4.26 |   | 65,622 |   | 4.26 |   |
|                                         |            |                              |            |                                  |            |  |  |  |  |  |  |  |  |

 

Asummary of option activity under Cyanotech Corporation’s Stock Plans for thenine months ended December 31, 2007 is presented below:

 
| **Option Activity**              | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------------|------------|------------|------------|------------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at March 31, 2007    |       | 84,172     |       | $                                              | 3.86       |                                                        | 1.77       |                            | $          | 324,904 |   |
| Granted                               |       | —     |       | —                                         |       | —                                                      |       | —                          |       |
| Exercised                             |       | —     |       | $                                              | —     |                                                        | —     |                            | —     |   |
| Forfeited or expired                  |       | (18,550    | )          | $                                              | 2.44       |                                                        | —     |                            | (45,200    | ) |
| Outstanding at December 31, 2007 |       | 65,622     |       | $                                              | 4.26       |                                                        | 1.37 years |                            | $          | 279,704 |   |
| Exercisable at December 31, 2007 |       | 65,622     |       | $                                              | 4.26       |                                                        | 1.37 years |                            | $          | 279,704 |   |

 

Asummary of Cyanotech Corporation’s non-vested options for the nine months endedDecember 31, 2007 is presented below:

 
| **Nonvested Options**          | ** ** | **Shares** | ** ** | **Weighted Average  Grant-Date  Fair Value** | ** ** |
|-------------------------------------|------------|------------|------------|---------------------------------------------------|------------|
| Nonvested at March 31, 2007    |       | 699        |       | $                                                 | 4.40       |   |
| Granted                             |       | —     |       | —                                            |       |
| Vested                              |       | 699        |       | 4.40                                              |       |
| Forfeited or expired                |       | —     |       | —                                            |       |
| Nonvested at December 31, 2007 |       | —     |       | $                                                 | —     |   |

 

***Warrants***

 

The Company had issued warrants which allow the warrant holders rightsto acquire an equivalent number of shares of common stock at a stated exerciseprice. Warrants outstanding during the periods indicated were as follows:

 
| **Warrants issued in connection with:** | ** ** | **Term Loan**                 | ** ** |
|-------------------------------------------------------------|------------|------------------------------------|------------|
| **Grant date:**                                        | ** ** | **April 2000**                | ** ** |
| **Expiration date:**                                   | ** ** | **April 2011**                | ** ** |
| **Exercise price:**                                    | ** ** | **$10.20    ** | ** ** |

 
| Balance at March 31, 2007    |   | 5,000  |   |
|-----------------------------------|--------|--------|--------|
| Exercises                         |   | — |   |
| Expired                           |   | — |   |
| Balance at December 31, 2007 |   | 5,000  |   |

 

See Form 10-K, Note 5 to the Consolidated Financial Statements forthe year ended March 31, 2007 for further discussion relative to warrantsissued in connection with the Term Loan agreement.

 

10

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**4.****            ****INVENTORIES**

 

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

 
| ** **      | ** ** | **December  31, 2007** | ** ** | **March 31, 2007** | ** ** |
|-----------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **      | ** ** | **(in thousands)**     | ** ** |
| Raw materials   |       | $                           | 315        |                         | $          | 246 |   |
| Work in process |       | 139                         |       | 281                          |       |
| Finished goods  |       | 1,232                       |       | 929                          |       |
| Supplies        |       | 164                         |       | 137                          |       |
|            |       | $                           | 1,850      |                         | $          | 1,593 |   |

 

The Company adopted SFAS No. 151 effective April 1, 2006. Inaccordance with SFAS No. 151, fixed production related costs ofapproximately $121,000, and $105,000 were not inventoried for the quarter endedDecember 31, 2007 and December 31, 2006 respectively, and $178,000and $275,000 for the nine months ended December 31, 2007 and December 31,2006 respectively, due to production below normal capacity.

 

During the current quarter, the Company identified and correctederrors to inventory balances which related to previous quarters during fiscal2008.  The impact of these errors andtheir correction in the December 31, 2007 quarter were not material to any ofthe quarterly financialinformation related to fiscal year end March 31, 2008.

 

**5.****            ****EQUIPMENT AND LEASEHOLDIMPROVEMENTS**

 

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

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

 

Equipment and leasehold improvements consist of the following:

 
| ** **                                             | ** ** | **December 31, 2007** | ** ** | **March 31, 2007** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                             | ** ** | **(in thousands)**         | ** ** |
| Equipment                                              |       | $                               | 6,341      |                         | $          | 6,257 |   |
| Leasehold improvements                                 |       | 7,347                           |       | 7,335                        |       |
| Furniture and fixtures                                 |       | 94                              |       | 87                           |       |
|                                                   |       | 13,782                          |       | 13,679                       |       |
| Less accumulated depreciation &  amortization |       | (9,490                          | )          | (9,110                       | )          |
| Construction in-progress                               |       | 109                             |       | 132                          |       |
| Equipment and leasehold improvements, net              |       | $                               | 4,401      |                         | $          | 4,701 |   |

 

At March 31, 2007, the above equipment, leasehold improvements,accumulated depreciation and construction in-progress amounts were reduced by anet $4.5 million impairment charge resulting from management’s analysis underSFAS No. 144, as discussed in Note 3 to the Consolidated FinancialStatements of Form 10-K for the year ended March 31, 2007.

 

TheCompany reviews long-lived assets for impairment whenever events or changes incircumstances indicate that the carrying value of such assets may not berecoverable. Upon such an occurrence, 

 

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recoverabilityof these assets is determined by comparing the forecasted undiscounted net cashflows to which the assets relate, to the carrying amount. If the asset isdetermined to be unable to recover its carrying value, then the carrying valueof the long-lived assets are compared to the asset’s fair value. The Companyhas determined fair value based upon present values of expected future cashflows.  The Company’s SFAS No. 144 analysis for the three and ninemonths ended December 31, 2007, resulted in no asset impairment charge.

 

6.             **CUSTOMER DEPOSITS**

 

                The Company received a restricted securitydeposit of $200,000 cash in connection with a sales contract during thequarter.  The deposit is apportionedbetween current and long-term as follows: $100,000 in “Prepaid expenses and assets” and $100,000 in “Other assets”,offset by $100,000 in “Customer deposits” and $100,000 in “Other long-termliabilities”.  It is uncertain whetherany portion of these funds could eventually become available to the Company, astheir release is dependent on sales volumes with the customer.

 

7.             **EARNINGS PER SHARE**

 

Basic earnings per share is computed on the basis of the weightedaverage number of common shares outstanding.  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 months ended December 31, 2007 and 2006are as follows (in thousands, except per share amounts):

 
| ** **                                                              | ** ** | **Three Months Ended December 31, 2007** | ** ** | **Three Months Ended December 31, 2006** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Loss**                                                 | ** ** | **Shares**                                                        | ** ** | **Per Share** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                                                   | ** ** | **(Denominator)**                                                 | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic net loss per share                                                |       | $                                                                 | (594       | )                                                                 | 5,242      |   | $ | (0.11 | ) | $ | (1,187 | ) | 5,234 |   | $ | (0.23 | ) |
| Effect of dilutive securities — Common  stock options and warrants |       | —                                                            |       | —                                                            |       | — |   | — |   | — |   | — |   |
| Diluted net loss per share                                              |       | $                                                                 | (594       | )                                                                 | 5,242      |   | $ | (0.11 | ) | $ | (1,187 | ) | 5,234 |   | $ | (0.23 | ) |

 

Reconciliationsbetween the numerator and the denominator of the basic and diluted earnings pershare computations for the nine months ended December 31, 2007 and 2006are as follows (in thousands, except per share amounts):

 
| ** **                                                              | ** ** | **Nine Months Ended December 31, 2007** | ** ** | **Nine Months Ended December 31, 2006** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **Net Loss**                                                | ** ** | **Shares**                                                       | ** ** | **Per Share** | ** ** | **Net Loss** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                                                  | ** ** | **(Denominator)**                                                | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic net loss per share                                                |       | $                                                                | (1,320     | )                                                                | 5,242      |   | $ | (0.25 | ) | $ | (2,106 | ) | 5,234 |   | $ | (0.40 | ) |
| Effect of dilutive securities — Common  stock options and warrants |       | —                                                           |       | —                                                           |       | — |   | — |   | — |   | — |   |
| Diluted net loss per share                                              |       | $                                                                | (1,320     | )                                                                | 5,242      |   | $ | (0.25 | ) | $ | (2,106 | ) | 5,234 |   | $ | (0.40 | ) |

 

Basic and diluted earnings per share are the same in periods of a netloss, thus there is no effect of dilutive securities when a net loss isrecorded.  There were approximately 71,000 and 89,000 securities excludedfrom the calculation of diluted loss per share because their effect wasanti-dilutive for the three months ended December 31, 2007 and 2006,respectively.  They were anti-dilutive due to the exercise price beinggreater than the Company’s weighted-average stock price for the period.

 

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

 
| ** **                 | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Stock options and warrants |       | 71                                                  |       | 89                                                 |       | 71 |   | 89 |   |

 

**8.            NEW ACCOUNTING PRONOUNCEMENTS**

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”).This new standard provides guidance for using fair value to measure assets andliabilities and information about the extent to which companies measure assetsand liabilities at fair value, the information used to measure fair value, andthe effect of fair value measurements on earnings. This framework is intendedto provide increased consistency in how fair value determinations are madeunder various existing accounting standards which permit, or in some casesrequire, estimates of fair market value. SFAS No. 157 also expandsfinancial statement disclosure requirements about a company’s use of fair valuemeasurements, including the effect of such measures on earnings. The provisionsof SFAS No. 157 are effective for financial statements issued for fiscalyears beginning after November 15, 2007. While the Company iscurrently evaluating the provisions of SFAS No. 157, the adoption is notexpected to have a material impact on our consolidated financial position orresults of operations.

 

In May 2007,the FASB issued FASB Staff Position (“FSP”) FIN 48-1 Definition of Settlementin FASB Interpretation No. 48 (FSP FIN 48-1). FSP FIN 48-1 providesguidance on how to determine whether a tax position is effectively settled forthe purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1is effective retroactively to January 1, 2007. The implementation of thisstandard did not have a material impact on our consolidated financial positionor results of operations.

 

**CYANOTECH CORPORATION**

 

**Item 2.       Management’s Discussion and Analysis of Financial Conditionand Results of Operations**

 

*Thisreport on Form 10-Q contains forward-looking statements regarding thefuture performance of Cyanotech and future events that involve risks anduncertainties that could cause actual results to differ materially from thestatements contained herein. This document, and the other documents that theCompany files from time to time with the Securities and Exchange Commission,such as its reports — except those of which have been designated as no longerto be relied upon — on Form 10-K/A, Form 10-K, Form 10-Q, Form 8-K,and its proxy materials, contain additional important factors that could causeactual results to differ from the Company’s current expectations and theforward-looking statements contained herein.*

 

**Overview**

 

Comparisons of selectedconsolidated statements of operations data as reported herein follow for theperiods indicated (dollars in thousands):

 
| ** **                   | ** ** | **Three Months Ended  December 31, 2007** | ** ** | **Three Months Ended  December 31, 2006** | ** ** | **Change** | ** ** |
|------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|------------|------------|
| ** **                   | ** ** | ** **                                                    | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Net sales:                   |       |                                                          |       |                                                          |       |       |       |
| Spirulina products           |       | $                                                             | 1,095      |                                                          | $          | 1,475      |       | (26 | )% |
| Natural astaxanthin products |       | 1,632                                                         |       | 950                                                           |       | 72         | %          |
| Other products               |       | 36                                                            |       | 9                                                             |       | 300        | %          |
| Total sales, all products    |       | $                                                             | 2,763      |                                                          | $          | 2,434      |       | 14 | % |

 

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|                 |   | **Three Months Ended  December 31, 2007** |   | **Three Months Ended  December 31, 2006** |   | **Change** |   |
|----------------------|--------|---------------------------------------------------------------|--------|---------------------------------------------------------------|--------|------------|--------|
|                 |   | ** **                                                    |   | ** **                                                    |   | ** ** |   |
| Gross profit    |   | $                                                             | 353    |                                                          | $      |  78   |   | 353 | % |
| Loss from operations |   | $                                                             | (561   | )                                                             | $      | (1,163     | )      | (52 | )% |
| Net loss             |   | $                                                             | (594   | )                                                             | $      | (1,187     | )      | (50 | )% |

 
| ** **                   | ** ** | **Nine Months Ended   December 31, 2007** | ** ** | **Nine Months Ended   December 31, 2006** | ** ** | **Change** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------|------------|
|                         |       |                                                               |       |                                                               |       |       |       |
| Net sales:                   |       |                                                               |       |                                                               |       |       |       |
| Spirulina products           |       | $                                                                  | 4,033      |                                                               | $          | 4,437      |       | (9 | )% |
| Natural astaxanthin products |       | 3,805                                                              |       | 2,840                                                              |       | 34         | %          |
| Other products               |       | 112                                                                |       | 76                                                                 |       | 47         | %          |
| Total sales, all products    |       | $                                                                  | 7,950      |                                                               | $          | 7,353      |       | 8 | % |
|                         |       |                                                               |       |                                                               |       |       |       |
| Gross profit                 |       | $                                                                  | 1,867      |                                                               | $          | 953        |       | 96 | % |
| Loss from operations         |       | $                                                                  | (1,216     | )                                                                  | $          | (2,016     | )          | 40 | % |
| Net loss                     |       | $                                                                  | (1,320     | )                                                                  | $          | (2,106     | )          | 37 | % |

 

Sales for thethird quarter of fiscal 2008 ended December 31, 2007 increased from thecomparable prior year period by $329,000 or 14% due primarily to a 72% increasein natural astaxanthin product sales.

 

Spirulina saleswere $1,095,000, decreasing 26% from the prior year period. The decrease wasprimarily due to a lack of product stemming from previously disclosedproduction problems. These problems have been solved, with the Company devotingsignificant resources to the solution effort during the last half of the thirdquarter ended December 31, 2007. However, the effort itself was hamperedand delayed by flooding due to an abnormal rainstorm during early December.This event was the primary reason the Company recorded non-inventoriable,abnormal period costs totaling approximately $604,000 during the quarter.

 

Naturalastaxanthin total product line sales overall experienced a 72% increase to$1,632,000 in the third quarter of fiscal 2008, increasing by $682,000 comparedto $950,000 in the quarter ended December 31, 2006. The increase primarilydriven by increased natural astaxanthin unit sales. Natural astaxanthin productsales, not including *NatuRose*,increased by 137% compared to the comparable prior period. *NatuRose* product sales decreased by 39%from the comparable prior year period in accordance with the Company’spreviously announced emphasis toward human consumption grade products. Aspreviously discussed, and in light of deemphasizing NatuRose sales, the Companydiscontinued all business activity of its wholly owned Japanese subsidiary “CJYK”.All *NatuRose* aquaculture feed andother business in Japan was absorbed into the Company’s domestic operations.The discontinuance of “CJYK” is not expected to have a significant current orfuture financial impact. In addition, the Company continues to increase itsfocus on building market share in the human nutrition market with a major focuson differentiating *BioAstin* fromlower quality offerings from competitors.

 

Our gross profitmargin as a percentage of sales was 13% for the three months ended December 31,2007 compared to 3% for the same period a year ago. Sales for the three monthsended December 31, 2007 increased 14% from the comparable prior yearperiod, while the cost of sales, including spirulina production abnormal periodcosts, increased 2% to $2,410,000 for the three months ended December 31,2007. The cost of product sales in the comparable quarter ended December 31,2006 was $2,356,000 due to a production imbalance disclosed and discussed forthat quarter. The relatively small 2% cost of products sold increase betweenthe comparable quarters is primarily due to $600,000 of spirulina relatedperiod costs which were not inventoriable in the quarter ended December 31,2007 due to the Company experiencing a 

 

14

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severe interruption in spirulina production caused bydilution and overflow from torrential rains while the company wasre-inoculating its spirulina ponds to improve yield. During the yieldimprovement project the production facility experienced an unprecedented seveninches of rain in three days. The resulting flood significantly harmed there-inoculation process. After the rains subsided, the Company took aggressiveaction to complete the process, correct dilution and overflow problems, andrestore production. The Company returned to full spirulina production in January 2008.However, an abnormal amount of time and material was consumed during thequarter ended December 31, 2007, resulting in $600,000 ofnon-inventoriable spirulina production period cost.

 

During the threeand nine months ended December 31, 2007, as part of cost of sales, theCompany recorded total non-inventoriable costs of approximately $839,000 and$1,299,000, respectively. The three months ended December 31, 2007included $604,000 of period costs resulting from the abnormal production,$121,000 of otherwise inventoriable fixed costs which could not be inventorieddue to production output below normal capacity, and $28,000 of otherwiseinventoriable fixed costs which could not be inventoried because such costswould have exceeded the market value for such inventory. The nine months ended December 31,2007 included $647,000 of period costs resulting from the abnormal production,$178,000 of otherwise inventoriable fixed costs which could not be inventorieddue to production output below normal capacity, and $141,000 of otherwiseinventoriable fixed costs which could not be inventoried because such costswould have exceeded the market value for such inventory.

 

Late in thequarter ended December 31, 2007, the Company announced the lay-off ofapproximately 20% of its workforce in order to conserve working capital and toreduce production costs going forward. Due to timing and minor severance paycosts, the Company experienced only slight third quarter expense reductions dueto the lay-offs. The lay-offs created no liabilities or obligations extendingbeyond the quarter ended December 31, 2007.

 

Operating expensesduring the quarter ended December 31, 2007 were 26% less than during thecomparable quarter ended December 31, 2006. This was primarily due to a40% reduction in general and administrative costs. General and administrativecosts were greater during the quarter ended December 31, 2006 because theCompany was engaged in restating its Form 10-K dated March 31, 2006,preparing to file Form 10-K/A dated March 31, 2006, and preparingresultant delayed Forms 10-Q for the first, second, and third quarters of thefiscal year ended March 31, 2007. The process just discussed requiredsignificant previously disclosed outlays for professional services.Accordingly, total general and administrative costs during the quarter ended December 31,2007 were 40% less than during the quarter ended December 31, 2006, andtotal operating expenses for the quarter ended December 31, 2007 are 26%less than during the quarter ended December 31, 2006.

 

The net loss forthe third quarter of fiscal 2008 decreased to $594,000 compared to a net lossof $1,187,000 in the comparable quarter of fiscal 2007. The decrease in netloss is primarily due to increased sales as noted above, in conjunction withthe above mentioned relatively small increase in the cost of goods sold coupledwith the aforementioned 26% decrease in total operating expenses.

 

*ThirdQuarter of Fiscal 2008 Compared to Third Quarter of Fiscal 2007*

 

Net sales for thethird quarter of fiscal 2008 increased to $2,763,000 compared to $2,434,000 forthe quarter ended December 31, 2006. Sales of spirulina products for thethird quarter of fiscal 2008 were $1,095,000, compared to $1,475,000 in thethird quarter of fiscal 2007. As a percentage of sales, spirulina was 40% oftotal sales in the third quarter of fiscal 2008, compared to 61% for thecomparable period a year ago. The spirulina decrease resulted from the thirdquarter spirulina production shortfall discussed in the Outlook section of thisreport and in the gross profit discussion below. In terms of spirulinaproduction, the three months ended December 31, 2007 experienced aspirulina production decrease to 31 percent of the amount produced during thequarter ended December 31, 2006.

 

Naturalastaxanthin product sales for the third quarter of fiscal 2008 were $1,632,000compared to $950,000 in the third quarter of fiscal 2007 due to increased unitsales. As a percentage of sales, natural astaxanthin product sales including *NatuRose*animal feed astaxanthin were 59%of total sales in the third 

 

15

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quarter of fiscal 2008, compared to 39% for thecomparable period a year ago. With respect to NatuRose sales in particular, aspreviously disclosed the Company has discontinued all business activity of itswholly owned Japanese subsidiary “CJYK”. All aquaculture feed business in Japanhas been absorbed into the Company’s domestic operations. The discontinuance of“CJYK” is not expected to have a significant current or future financialimpact.

 

Other productssales were $36,000 during the third quarter of fiscal 2008 and $9,000 duringthe third quarter of fiscal 2007, and representing 1% or less of sales in bothperiods.

 

International sales were41% of total sales for the third quarter of fiscal 2008, compared to 44% a yearago. Historically, our major customers (sales exceeding 10% of total sales)have been two distributors, one based in Europe and one in the United States. Forthe three months ended December 31, 2007, our European distributoraccounted for 9% of total sales as compared to 10% of total sales for thecomparable period of fiscal 2007. Sales to the United States distributor wereless than 10% of total sales in each of the third quarters of fiscal years 2008and 2007.

 

Gross profit, derivedfrom net sales less the cost of product sales, primarily includes the cost ofmaterials, manufacturing overhead costs, direct labor costs and depreciation. Grossprofit for the three months ended December 31, 2007 was $353,000 with agross profit margin percentage of 13%, increased from gross profit of $78,000and a gross profit margin of 3% reported for the comparable prior year quarter.The gross profit margin improvement was due to a 14% increase in sales for thethird quarter of fiscal year 2008 compared to the same quarter a year ago,partially offset by a 2% increase in cost of sales from the same comparableprior year period. For the three months ended December 31, 2007, cost ofsales includes $604,000 of non-inventoriable period costs primarily related tothe previously discussed spirulina production shortfall. During the currentquarter, the Company experienced a severe interruption in spirulina productioncaused by dilution and overflow from torrential rains while the Company wasre-inoculating its ponds to improve yield. During the yield improvementproject, inclement weather significantly harmed these efforts causing theCompany to consume additional resources and materials in order to restoreproduction.Asdiscussed earlier, in terms of spirulina production, the three months ended December 31,2007 experienced a spirulina production decrease to 31 percent of the amountproduced during the quarter ended December 31, 2006. The Company returnedto typical spirulina production levels in January 2008.

 

Primarily as a result ofthe above discussed spirulina production shortfall, the Company’s cost ofsales, at $2,410,000 for the three months ended December 31, 2007, wasnearly equal to the Company’s cost of sales of $2,356,000 during the threemonths ended December 31, 2006. This is because during the three monthsended December 31, 2006 the Company experienced production problems in itsnatural astaxanthin production due to an imbalance in critical factors whichaffected the biological cultivation process and which resulted innon-inventoriable period costs of $284,000 during the quarter ended December 31,2006. In addition to the foregoing period costs, $121,000 and $105,000 of fixedproduction overhead costs were not inventoriable during the three months ended December 31,2007 and 2006, respectively, due to production output levels below normalcapacity. Also, $28,000 and $65,000 of production costs were not inventoriablebecause such costs would have exceeded the market value for such inventoryduring the three months ended December 31, 2007 and 2006, respectively.

 

Operating expensesfor the three months ended December 31, 2007 were 33% of sales or$914,000, compared to 51% of sales or $1,241,000 for the three months ended December 31,2006. The $327,000 decrease in operating expenses during the three months endedDecember 31, 2007, compared with the three months ended December 31,2006 was primarily due to prior comparable period contractual services andlegal expenses resulting from restating the Company’s Form 10-K for theyear ended March 31, 2006 and filing Form 10-K/A for the same yearend. In addition, and related to filing Form 10-K/A, the Company delayedits filings of Forms 10-Q for the quarters ended June 30, 2007, and September 30,2007. These events have been previously disclosed and discussed. As a result,general and administrative expenses for the three months ended December 31,2007 were less than for the three months ended December 31, 2006. Also,compared to the prior comparable quarter, in December of the currentquarter the Company reduced its workforce by approximately 20%, and a smalloperating expense cost reduction is 

 

16

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reflected in the currentquarter result. In addition, the Company is required to comply with theSarbanes-Oxley Act by March 31, 2008 and costs of $15,000 related to thisrequirement are reflected in current quarter general and administrative expenseresult.

 

In addition to theforegoing, sales and marketing expenses increased 20% in the third quarter offiscal 2008 over prior comparable period amounts driven primarily by spendingon new product introductions. However, the Company plans to reduce new productspending and other sales and marketing expenses, as will be discussed furtherin the Outlook section of this report. Research and development expensedecreased by 73% in the third quarter of fiscal 2008 over the prior periodcomparable amounts due to effort diverted to spirulina production recovery.

 

By March 31,2008, the Company is required to be in full compliance with the Sarbanes-OxleyAct and Rules issued thereunder by the Securities and Exchange Commission,including Section 404 Compliance Standards established by the PublicCompanies Accounting Oversight Board. The cost of attaining and maintainingsuch compliance could materially decrease reported net income or increasereported net losses in future periods. Although the Company had previouslytaken steps toward what is generally referred to as Sarbanes-Oxley Actcompliance, the process of preparing and filing the Company’s Form 10-K/Afor the period ended March 31, 2006 filed February 14, 2007 andsubsequent delayed filings of the Company’s Form 10-K and Forms 10-Q forfiscal year 2007, coupled with the lack of resources discussed in Item 9A of Form 10-Kfor the year ended March 31, 2007, resulted in the recognition of amaterial weakness. These events adversely impacted the Company’s efforts towardimplementing full Sarbanes-Oxley compliance. Such compliance must be achievedby March 31, 2008. This could require significant expenditures and effortover the remaining time to achieve compliance. The costs of compliance withinternational standards (ISO), U.S. food and drug manufacturing practice (GMP),the Sarbanes-Oxley Act, and other regulatory compliance areas may also continueto increase.

 

The end result ofthe foregoing was a net loss of $594,000, or ($0.11) per diluted share, for thethree months ended December 31, 2007, as compared****to a net loss of $1,187,000, or ($0.23)per diluted share, for the comparable prior year quarter.

 

*Ninemonths Ended December 31, 2007 Compared to Nine months Ended December 31,2006*

 

Net sales for thenine months ended December 31, 2007 were $7,950,000, an increase of 8%from sales of $7,353,000 reported for the comparable period a year ago. Theincrease in sales over the prior year’s nine-month period was largely theresult of increased sales volumes of *BioAstin*gelcaps and other *BioAstin*products,offset in part by decreased sales of spirulina products and decreased sales ofastaxanthin *NatuRose* products. Internationalsales represented 42% of net sales for the nine months ended December 31,2007 compared to 46% for the same period a year ago. For the nine months ended December 31,2007 and December 31, 2006, our European distributor accounted for 14% and9% of total sales respectively, with sales to our United States distributoraccounting for less than 10% of total sales.

 

For the nine months endedDecember 31, 2007, gross profit margin as a percentage of sales increasedto 23% from 13% for the comparable prior year period. The gross profit marginimprovement resulted from higher sales which increased 8% from the comparablenine month period a year ago and lower cost of sales which decreased 5% fromthe same period a year ago. Costs of sales was impacted in the nine monthsended December 31, 2007 and 2006 due to separate isolated productionproblems which have been remedied.  Aspreviously discussed, in the nine months ended December 31, 2007, theCompany experienced production problems in its spirulina production due to thedilution and overflow from torrential rains while the Company wasre-inoculating its ponds to improve production yields.  During the nine months ended December 31,2006, the Company experienced production problems in its natural astaxanthinproduction from an imbalance in critical factors which affected the biologicalcultivation process.  As a result of theproduction problems incurred during the current and prior year,non-inventoriable period costs were $647,000 and $434,000 for the nine monthsended December 31, 2007 and 2006, respectively.  In addition, production levels were belownormal capacity, resulting in $178,000 and $275,000 of fixed productionoverhead costs which were not inventoried for the nine months ended December 31,2007 and 2006, respectively.  The Companyalso did not inventory $141,000 and $295,000 

 

17

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of production costs related to certain products because such costswould have exceeded the market value for such inventory for the nine monthsended December 31, 2007 and 2006, respectively.

 

Operating expensesfor the nine months ended December 31, 2007 were $3,083,000, an increaseof $114,000 or 4% from the comparable prior year period.  The increase in such expense reflectsincreased general and administrative expenses, increased sales and marketingexpenses, and decreased research and development expense. Increased general andadministrative expense during the current nine-month period was primarily dueto increased accounting and auditing fees as well as consulting servicesrelated to late filings of Form 10-K for the year ended March 31,2007 and Form 10-Q for the period ended June 30, 2007. Increasedexpenses for sales and marketing were related to advertising campaigns. Decreasedresearch and development expense for the current nine-month period reflects theCompany’s efforts to contain expenses where possible. While it is our goal tocontain discretionary operating spending in our research and development, salesand marketing, and general and administrative activities, it may becomenecessary for the Company to selectively increase spending in some or all of theseareas to remain competitive and to comply with regulatory requirements.

 

Net other expense,which includes interest on the Company’s debt, for the nine months ended December 31,2007, was comparable to the same period of the prior fiscal year.

 

For the ninemonths ended December 31, 2007, an income tax expense of $10,000 wasrecorded compared to an income tax benefit recorded of $9,000 for the sameperiod of the prior year. The Company does not expect any additional UnitedStates income taxes for the current fiscal year as a result of available netoperating loss carry-forwards.

 

The Companyrecorded a net loss of $1,320,000 or ($0.25) per diluted share for the ninemonth period ended December 31, 2007. For the same period a year ago theCompany reported net loss of $2,106,000 or ($0.40) per diluted share.

 

**Variabilityof Results**

 

The Company hasexperienced significant quarterly fluctuations in operating results andanticipates that these fluctuations may continue in future periods.  As described in previous paragraphs, operatingresults have fluctuated as a result of changes in sales levels to ourcustomers, competition (both pricing, new products and other market trends) andproduction difficulties, including non-inventoriable production costs, as discussedearlier in this report, variable production results, and the impact ofoperating in an area where utility costs are sensitive to oil prices. TheCompany has also, during its history, experienced production difficulties as aresult of inclement weather, changes in the mix between sales of bulk andpackaged consumer products and start up costs associated with new productintroductions, new facilities and expansion into new markets.  In addition, future operating results mayfluctuate as a result of factors beyond the Company’s control such as foreignexchange fluctuations, changes in government regulations, and economic changesin the regions it operates in and sells to. 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 expectationsin any given period, the adverse impact on results of operations may bemagnified by our inability to meaningfully adjust spending in certain areas, orthe inability to adjust spending quickly enough, as in personnel andadministrative costs, to compensate for a sales shortfall. We may also chooseto reduce prices or increase spending in response to market conditions, andthese decisions may have a material adverse effect on financial condition andresults of operations.

 

**FinancialCondition**

 

Cash and cashequivalents decreased $654,000 or 45% to $790,000 at December 31,2007, from $1.4 million at March 31, 2007. This decrease in cash resultedfrom cash used in operating activities of $281,000, as well as cash used ininvesting activities of $80,000, and cash used in financing activities of$293,000. Cash used in operating activities for the nine months ended December 31,2007 reflects increases in inventory of $257,000, an increase in prepaid andother assets of $304,000, and offset partially 

 

18

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by a decrease in accounts receivable of $295,000 andan increase in accounts payable of $551,000. Restricted cash of $200,000 wasprovided by a customer and is reflected in “Prepaid expenses and other” and “Otherassets” offset by current and long term liabilities. The Company cannot accessthese funds and deems it uncertain whether or when any portion of these fundscould eventually become available to the Company as their release is dependenton sales volumes with the customer. Any interest earned on the restricted cashwill be accumulated with the funds for the benefit of the Customer, and,accordingly, such interest is not reflected in other income of the Company.

 

Net negativeimpact on cash results from the foregoing items combined with a net loss of$1,320,000 before non-cash adjustments for depreciation and amortization of$407,000. Cash flows used in investing activities reflect capital expendituresduring the first nine months of fiscal 2008. Cash flows used in financingactivities are attributable to debt payments during that period.

 

As of December 31,2007, the Company’s net accounts receivable decreased $295,000 to $1,292,000from $1,587,000 as of March 31, 2007. The decrease in accounts receivableis primarily the result of the timing of collection on the customer’s accounts.The Company believes that its accounts receivable are collectible net of theallowance for doubtful accounts of $23,000 at December 31, 2007.

 

The Company’s netinventory increased $257,000 or 16% to $1,850,000 as of December 31, 2007compared to $1,593,000 as of March 31, 2007. The increase in inventoryduring the first nine months of fiscal 2008 is primarily due to producing moreastaxanthin in the first nine months of fiscal 2008 than in the comparableperiod of fiscal 2007. This is consistent with the Company’s transitionemphasizing human astaxanthin products. During the current quarter, the Companyidentified and corrected errors to inventory balances which related to previousquarters during fiscal 2008. The impact of these errors and their correction inthe December 31, 2007 quarter were not material to any of the quarterlyfinancial information related to fiscal year end March 31, 2008.

 

**Liquidityand Capital Resources**

 

The Company hasapplied to its current senior debt holder for additional funds in the form ofadditional borrowing on its existing senior debt which is under a US Departmentof Agriculture (USDA) Rural Development program. The Company is a significantagricultural employer, producer, and exporter in its headquarters state, andtherefore applied for additional funds under the Company’s existing US Departmentof Agriculture Rural Development loan program. As of the date of this report,the Company has received preliminary senior debt holder and USDA approval foradditional funds of approximately $1 million on terms consistent with itsexisting senior debt. The Company has accepted a commitment letter from thesenior debt holder and has also received preliminary approval documents fromthe US Department of Agriculture. The Company expects to receive the additionalfunds in the fourth quarter of the fiscal year ended March 31, 2008. TheCompany applied for the additional funds primarily in order to partially offsetsignificant one-time spending on administrative matters, particularly spendingrelated to the restatement and filing of Form 10-K/A for the year ended March 31,2006, and spending occasioned by the previously discussed astaxanthinproduction shortfall in the fiscal year ended March 31, 2007, and thespirulina shortfall in the third quarter ended December 31, 2007. Whilethe Company is reasonably confident that the funds will be received, it cannotprovide assurance of such receipt. If such loan should not be funded, theCompany’s financial position could be adversely affected.

 

The Company has, as previously reported, experienced a number of factorsthat have negatively impacted its balance sheet and liquidity, including thefollowing:

 

·      The Company has experienced significantrecurring net losses. At March 31, 2007, the Company had an accumulateddeficit of $19,920,000 compared to an accumulated deficit of $12,495,000 at March 31,2006. This accumulated deficit increased by $1,320,000 for the nine monthsended December 31, 2007. As discussed earlier, and as required underStatement of Financial Accounting Standards (SFAS) No. 144, “Accountingfor the Impairment and Disposal of Long-Lived Assets,” as of March 31,2007 the Company recorded a non-cash impairment charge reducing, by $4.5million, the values of certain production equipment and leasehold improvementassets. *This non-cash charge did not impactliquidity.*

 

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·      The Company’s business has not generatedpositive cash from operating activities in five of the eight quarters duringfiscal years ended March 31, 2007 and 2006, nor during the quarter andyear to date covered by this report.

 

·      Material weaknesses in its internalcontrols, as previously reported, have caused the Company to experience delaysin completing its consolidated financial statements and filing periodic reportswith the U.S. Securities and Exchange Commission (the “SEC”) on a timelybasis. Accordingly, the Company continues to devote substantial additionalinternal resources, and to experience higher than expected fees for auditservices. The Company previously reported the addition of a Controller of Costand Inventory Accounting. However, this employee left the Company during thequarter ended December 31, 2007. The Company has decided that the additionof the employee did not, as intended, enhance internal control or mitigate theaforementioned material weakness. At present the Company has concluded thatmore rigorous emphasis on improving the capabilities of existing systems,procedures, and existing personnel, will correct the material weakness.

 

·      In addition to the foregoing item, toconserve liquidity and reduce costs as previously announced, the Company cutits workforce by approximately 20% in early December 2007. The lay-offshave not had a negative impact on productivity and are not expected to do so.

 

·      Finally, as part of its request to thesenior debt holder for additional funding, the Company has undertaken anaggressive plan to de-emphasize new product introductions and related sales andmarketing expenses, and to aggressively reduce administrative and sales andmarketing expenses in general.

 

***Sources of Liquidity***

 

For the ninemonths ended December 31, 2007, cash decreased $654,000 to $790,000 from$1,444,000 at March 31, 2007. Working capital for the same nine monthperiod decreased by $1,411,000 to $1,950,000 from $3,361,000 at March 31,2007, primarily as a result of decreases in cash and increases to accountspayable and inventory in the current nine month period.

 

The decrease incash resulted primarily from cash used from operating activities, capitalexpenditures, and payments on the Company’s long-term debt. Cash used inoperating activities for the nine month period ended December 31, 2007 was$281,000 compared to cash used in operations of $18,000 for the comparableprior period. Capital expenditures totaled $80,000 for the nine months ended December 31,2007 compared to $246,000 for the comparable prior year period. Cash used infinancing activities included repayments of the Company’s long-term debt of$293,000 and $268,000 for the nine months ended December 31, 2007 and2006, respectively.

 

The Company’scontractual obligations and commitments (consisting of a term loan andoperating leases) are disclosed below and in the Company’s 2007 Annual Reporton Form 10-K in the following sections: Item 7 Management’s Discussion andAnalysis of Financial Condition and Results of Operations–Liquidity and CapitalResources, and Item 8 Financial Statements and Supplementary Data–Notes 5 and 6of Notes to Consolidated Financial Statements. There were no significantchanges in contractual obligations and commitments from March 31, 2007 to December 31,2007 other than the Company has applied to its senior debt holder foradditional funds, and has committed itself to complete the process of securingsuch funds of approximately $1 million and to accept a corresponding increasein its senior debt obligation. While the Company is reasonably confident thatthe funds will be received, it cannot provide assurance of such receipt. Inaddition, to the foregoing and as discussed earlier in this report, the Companyreceived $200,000 restricted cash funds from a customer on a one-time basis. Itis uncertain whether any amount of these funds could eventually becomeavailable to the Company; accordingly, the restricted funds are carried as another asset offset by corresponding liabilities.

 

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***Significant Cash and Contractual Obligations***

 

The followingtable presents the Company’s debt and lease obligations at December 31,2007:

 
| **(in thousands)**       | ** ** | **Less Than   1 Year** | ** ** | **1-3  Years** | ** ** | **4-5   Years** | ** ** | **After 5   Years** | ** ** | **Total** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|----------------|------------|----------------------|------------|-------------------------------|------------|-----------|------------|
| Term Loan                     |       | $                                     | 424        |           | $          | 673                  |       | $                             | —     |      | $          | — |   | $ | 1,097 |   |
| Interest Expense on Term Loan |       | 82                                    |       | 47             |       | —               |       | —                        |       | 129       |       |
| Operating Leases              |       | 186                                   |       | 318            |       | 296                  |       | 1,509                         |       | 2,309     |       |
| Total                         |       | $                                     | 692        |           | $          | 1,038                |       | $                             | 296        |      | $          | 1,509 |   | $ | 3,535 |   |

 

***Sufficiency of Liquidity***

 

Based upon theCompany’s aforementioned preliminarily approved application to its currentsenior debt holder for additional funds of approximately $1 million in the formof additional borrowing on its existing senior debt which is under a USDepartment of Agriculture Rural Development program, the expense reductionmeasures discussed earlier in this report, and analysis of the Company’sconsolidated financial position and projected future results of operations, webelieve that our operating cash flows, cash balances, and working capital,together with the additional funds, will be sufficient to finance currentoperating requirements, debt service, and planned capital expenditures, for thenext 12 months. With total working capital of approximately $2 million, and acurrent ratio of 1.9 as of December 31, 2007, management expects thatliquidity in the remainder of fiscal 2008 to be generated from borrowing,operating cash flows, and working capital will work towards offsetting the$790,000 cash reduction experienced during the nine months ended December 31,2007. Of course, while the Company is reasonably confident that the approximate$1 million of additional funds will be received, it cannot provide assurance ofsuch receipt. If such loan should not be funded, the Company’s financialposition could be adversely affected.

 

***Capital Resources***

 

The Company doesnot currently have any material commitments for capital expenditures. TheCompany expects fiscal 2008 capital expenditures to be under $100,000 which isless than fiscal 2007 by approximately $175,000. This includes capitalexpenditures in support of the Company’s normal operations, and expendituresthat we may incur in conjunction with initiatives to improve gross margins andreduce expenses.

 

**CriticalAccounting Policies and Estimates**

 

There have been nomaterial changes to our critical accounting policies and estimates from theinformation provided in Item 7, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, included in our Form 10-Kfor the fiscal year ended March 31, 2007.

 

In June 2006,the FASB issued FASB Interpretation No. 48 (“FIN No. 48”), “Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”.The Company adopted FIN No. 48 on April 1, 2007. The adoption of thisinterpretation did not have a material impact on its consolidated financialstatements.

 

## **Outlook**

## ** **

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

 

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CyanotechCorporation’s strategic direction is to position itself as a world leader inthe production and marketing of high-value natural products from microalgae. Weare vertically aligned, producing raw materials in the form of microalgaeprocessed at our 90-acre facility in Hawaii, and integrating those rawmaterials into finished products. In fiscal 2008, we will put greater emphasison our Nutrex Hawaii consumer products. To enforce production reliability andmaintain liquidity, we have decided to place less emphasis on new product linedevelopment and introduction and to continue to increase our emphasis on “human”products. Our current product offerings include naturally cultivated SpirulinaPacifica® in powder, flake and tablet form, *BioAstin*®natural astaxanthin antioxidant in lipid extract, softgel caplet andmicro-encapsulated beadlet form for the human nutrition and cosmetic industriesand Phycobiliproteins for use in medical diagnostics. We will continue toproduce and sell *NatuRose*®natural astaxanthin powder for the animal nutrition market as conditions anddemand warrant. Information about our Company and our products can be viewed atwww.cyanotech.com, www.nutrex-hawaii.com or www.phycobiliprotein.com. Consumerproducts can also be purchased online at www.nutrex-hawaii.com.

 

The Company hasapplied to its current senior debt holder for additional funds in the form ofadditional borrowing on its existing senior debt which is under a US Departmentof Agriculture Rural Development program. The Company is a significantagricultural employer, producer, and exporter in its headquarters state, andtherefore applied for additional funds under the Company’s existing USDepartment of Agriculture Rural Development loan program. As of the date ofthis report, the Company has received preliminary approval from the senior debtholder and the USDA for additional funds of approximately $1 million on termsconsistent with its existing senior debt. The Company has accepted a commitmentletter from the senior debt holder and has also received preliminary approvaldocuments from the US Department of Agriculture. The Company expects to receivethe additional funds in the fourth quarter of the fiscal year ended March 31,2008. The Company applied for the additional funds primarily in order topartially offset significant one-time spending on administrative matters,particularly spending related to the restatement and filing of Form 10-K/Afor the year ended March 31, 2006, and spending occasioned by thepreviously discussed astaxanthin production shortfall in the fiscal year ended March 31,2007, and the spirulina shortfall in the third quarter ended December 31,2007. While the Company is reasonably confident that the funds will bereceived, it cannot provide absolute assurance of such receipt.

 

We are currentlyexperiencing an upward trend in sales with unit sales increasing during thethird quarter of fiscal 2008 as compared to the third quarter of fiscal 2007. Themost significant impact was due to an increase in the human astaxanthin bulkproduct line. The Company expects spirulina sales to remain essentially levelsince the product has reached a mature life cycle stage. However, significantvariability between periods and even across several periods can be expectedbased on historical results. The third quarter spirulina production shortfalldiscussed previously in this report has, in management’s opinion, beensuccessfully resolved as evidenced by spirulina production results through thedate of this report.

 

As discussed inNote 1 of “Notes to Consolidated Condensed Financial Statements” the Companyhas discontinued all business activity of its wholly owned Japanese subsidiary “CJYK”.The Company made this decision due to declining sales of approximately 40% ineach of the prior two fiscal years in addition to declining gross profitmargins of 13% and 4% for fiscal 2007, and the nine months ended December 31,2007, respectively. “CJYK” sales for fiscal year 2007 and the nine months endedDecember 31, 2007, were $482,000 and $45,000, respectively. We do notexpect the discontinuance of this subsidiary to have a significant impact onour consolidated financial statements. All sales activity formerly processedthrough CJYK is now being processed through Cyanotech headquarters operations.

 

Overall costs havebeen gradually increasing in part because of increasing utility, chemical, andtransportation costs which reflect and respond to oil prices. We feel thatthese conditions will likely remain, and consequently, we are shifting ournatural astaxanthin production into higher value products such as *BioAstin* for human consumption and we arefocusing our business on “human” products in general.

 

Gross profitmargin percentages in fiscal year 2009 are expected to increase in comparisonto fiscal year 2008 results. We identified and corrected imbalances in astaxanthinproduction in the fourth quarter of fiscal 2006. These imbalances negativelyimpacted fiscal year 2006 gross margins and we expect this imbalance correctionto result in increased gross margins as a percentage of sales during fiscal 

 

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2008. As discussed earlier, we re-inoculated ourspirulina production ponds during the third quarter ended December 31,2007, but this effort, while eventually successful, was severely hampered byunseasonal weather conditions. However, the third quarter spirulina productionshortfall discussed in this report has, in management’s opinion, beensuccessfully resolved as evidenced by spirulina production results through thedate of this report .With competition increasing and higher production costs,though, pressure is placed on achieving production reliability, and achievingreasonable profit margins.

 

With the adoptionof SFAS No. 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 productioncosts exceed historical averages, the Company evaluates whether such costs arecurrent-period charges or are inventoriable. In addition, the allocation offixed production overheads (such as depreciation and general insurance) toinventories is determined based on normal production capacity. When the Company’sproduction volumes are below normal capacity limits, certain fixed productionoverhead costs cannot be inventoried and are recorded immediately in cost ofsales. Currently, the Company’s natural astaxanthin production is approachinglevels experienced prior to fiscal year 2007. Producing the highest qualitymicroalgae is a complex biological process which requires balancing numerousfactors including microalgal strain variation, temperature, acidity, nutrientand other environmental considerations, some of which are not within theCompany’s control.

 

To manage its cashresources effectively, the Company will continue to balance production in lightof sales demand, minimizing the cost associated with build-ups in inventory. TheCompany has experienced other significant cash outflows and may need to utilizeother cash resources to meet working capital needs if prolonged net losses areincurred in future periods. A prolonged downturn in sales could impair theCompany’s ability to generate sufficient cash for operations and minimize theCompany’s ability to attract additional capital investment which could becomenecessary in order to expand into new markets or increase product offerings.

 

The Companyexpects operating expense spending to remain consistent with or to be less incomparison to 2007 levels after the exclusion of the previously mentionednon-cash impairment write-down and SFAS No. 144 related costs. However, byMarch 31, 2008, the Company is required to be in full compliance with theSarbanes-Oxley Act and Rules issued thereunder by the Securities andExchange Commission, including Section 404 Compliance Standardsestablished by the Public Companies Accounting Oversight Board. The cost ofattaining and maintaining such compliance could materially decrease reportednet income or increase reported net losses in future periods.

 

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 additionto the factors discussed above, any of the following could cause actual resultsto differ materially: business conditions and growth in the natural productsindustry and in the general economy; changes in customer order patterns;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 arediscussed in detail in Item 1A in our Form 10-K report for the year ended March 31,2007.

 

Cyanotech believesthat it has the products, facilities, personnel, competitive, and financialresources for improved results, but future revenues, costs, gross margins andprofits are all influenced by a number of factors, as discussed above, all ofwhich are inherently difficult to forecast.

 

**Item 3.     Quantitative and Qualitative Disclosures about 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.

 

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We have a termloan agreement that adjusts quarterly based on the prime rate. As such, we areexposed to the interest rate risk whereby a 1% increase in the prime rate wouldlead to an increase of approximately $12,000 in interest expense for the yearending March 31, 2008 (based on December 31, 2007 amountsoutstanding).

 

**Item 4.    Controls andProcedures**

 

(a) **Disclosure Controls and Procedures**

 

This Form 10-Q should be read in conjunction with Item 9A “Controlsand Procedures” of the Company’s Form 10-K for the fiscal year ended March 31,2007 filed August 16, 2007. There were no material changes in Controls andProcedures during the current quarter, however the Company’s previouslyreported additional accounting employee, the Controller-Inventory and CostAccounting, who began employment on July 9, 2007, left the Company duringthe quarter ended December 31, 2007, so the duties and tasks associatedwith that position were not successfully integrated into the Company’saccounting and internal controls. The Company has since concluded that theaddition of the employee did not, as intended, enhance internal control ormitigate the aforementioned material weakness. At present the Company hasdecided that more rigorous emphasis on improving the capabilities of existingsystems, procedures, and existing personnel, will correct the materialweakness. This effort has been in progress for the last several weeks. Untilthis and other steps are completed, however, the above noted material weaknessin internal control over financial reporting will be deemed to exist. As of December 31,2007, the Company believes its systems and procedures are sufficient toreasonably ensure accurate financial data, but it has concluded that due to alack of adequately trained internal accounting resources, there exists morethan a remote likelihood that a material misstatement to the interim financialstatements could occur and not be detected by procedures and controls over financialreporting on a timely basis. This material weakness in internal control overfinancial reporting has led to an inability to produce timely filings over thepast year.

 

**PART II.      OTHER INFORMATION**

 
| **Item  1.** |   | Legal  Proceedings |
|--------------|--------|--------------------|
|         |   | None               |

 

**Item 1A.  Risk Factors**

 

Certain Factors AffectingCyanotech Corporation

 

The Company has includedin Part I, Item 1A of its Annual Report on Form 10-K for the yearended March 31, 2007, a description of certain risks and uncertaintiesthat could affect the Company’s business, future performance or financialcondition (the “Risk Factors”). There are no material changes from thedisclosure provided in the Form 10-K for the year ended March 31,2007 with respect to the Risk Factors. Investors should consider the RiskFactors prior to making an investment decision with respect to the Company.

 
| **Item 2.** | **Unregistered Sales of Equity Securities and Use of Proceeds** |
|------------------|-----------------------------------------------------------------|

 

None.

 
| **Item 3.** | **Defaults upon Senior Securities** |
|------------------|-------------------------------------|

 

None.

 

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

 

None –

 

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| **Item 5.** | **Other Information** |
|------------------|-----------------------|

 

None.

 

**Item 6.                    Exhibits**

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

 

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SIGNATURES

 

In accordance with the requirements of the SecuritiesExchange Act of 1934, the registrant caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                   |   | CYANOTECH CORPORATION |
|------------------------|--------|-----------------------|
|                   |   | (Registrant)          |
|                   |   |                  |
|                   |   |                  |
| February 13, 2008 |   | By:                   | /s/ Gerald R.  Cysewski |   |
| (Date)                 |   |                  |   | Gerald R. Cysewski |
|                   |   |                  |   | Chairman of the Board,  President and |
|                   |   |                  |   | President and Chief  Executive   Officer |
|                   |   |                  |   |
|                   |   |                  |   |
| February 13, 2008 |   | 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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