UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934

 

For Quarterly Period Ended December 31, 2004

 

Commission File Number 0-14602

 

CYANOTECH CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Check whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).   Yes  o  No  ý

 

Number of common shares outstanding as of January 31, 2005:

 

Title of Class		Shares Outstanding
Common stock - $.005 par value		20,892,140

 

 

CYANOTECH CORPORATION

FORM 10-Q

 

INDEX

 

PART I.    FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets (unaudited) As of December 31, 2004 and March 31, 2004
	Consolidated Statements of Operations (unaudited) For the three and nine month periods ended December 31, 2004 and 2003
	Consolidated Statements of Cash Flows (unaudited) For the nine month periods ended December 31, 2004 and 2003
	Notes to Consolidated Financial Statements (unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.    OTHER INFORMATION
Item 1.	Legal Proceedings
Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES

 

2

 

PART 1.  FINANCIAL INFORMATION

Item 1.  Financial Statements

 

CYANOTECH CORPORATION

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands except per share amounts)

(Unaudited)

 

		December 31, 2004			March 31, 2004
ASSETS
Current assets:
Cash and cash equivalents		$	2,582		$	2,531
Accounts receivable, net		2,414			2,211
Refundable income taxes		14			11
Inventories (see Note 3)		1,476			1,099
Prepaid expenses		126			55
Total current assets		6,612			5,907
Equipment and leasehold improvements, net (see Note 4)		11,393			11,844
Other assets		568			606
Total assets		$	18,573		$	18,357
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt		$	346		$	346
Accounts payable		618			874
Accrued expenses		657			604
Total current liabilities		1,621			1,824
Long-term debt, excluding current maturities		1,838			2,093
Total liabilities		3,459			3,917
Stockholders’ equity:
Common Stock of $0.005 par value, as of December 31, 2004, 30,000,000 shares authorized, 20,840,365 shares issued and outstanding; and as of March 31, 2004, 25,000,000 shares authorized, 20,714,246 shares issues and outstanding		104			104
Additional paid-in capital		27,245			27,141
Accumulated other comprehensive income - foreign currency translation adjustments		40			30
Accumulated deficit		(12,275		)	(12,835		)
Total stockholders’ equity		15,114			14,440
Total liabilities and stockholders’ equity		$	18,573		$	18,357

 

See accompanying Notes to Consolidated Financial Statements.

 

3

 

CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

		Three Months Ended December 31,						Nine Months Ended December 31,
		2004			2003			2004			2003
NET SALES		$	3,180		$	3,024		$	8,885		$	8,292
COST OF PRODUCT SALES		2,017			1,840			5,781			5,543
Gross profit		1,163			1,184			3,104			2,749
OPERATING EXPENSES:
Research and development		38			53			165			117
Sales and marketing		301			298			892			961
General and administrative		506			541			1,395			1,397
Total operating expenses		845			892			2,452			2,475
Income from operations		318			292			652			274
OTHER INCOME (EXPENSE):
Interest income		8			1			25			13
Interest expense		(43		)	(84		)	(122		)	(250		)
Other income, net		37			14			26			17
Total other income (expense)		2			(69		)	(71		)	(220		)
Income before income taxes		320			223			581			54
INCOME TAX EXPENSE (BENEFIT)		(6		)	114			21			96
NET INCOME (LOSS)		$	326		$	109		$	560		$	(42	)
NET INCOME (LOSS) PER SHARE
Basic		$	0.02		$	0.01		$	0.03		$	(0.00	)
Diluted		$	0.02		$	0.01		$	0.03		$	(0.00	)
SHARES USED IN CALCULATION OF NET INCOME (LOSS) PER SHARE:
Basic		20,771			18,777			20,753			18,471
Diluted		20,988			18,934			20,981			18,471
COMPREHENSIVE INCOME (LOSS):
Net income (loss)		$	326		$	109		$	560		$	(42	)
Other comprehensive income		20			9			10			28
		$	346		$	118		$	570		$	(14	)

 

See accompanying Notes to Consolidated Financial Statements.

 

4

 

CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

		Nine Months Ended December 31,
		2004			2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	560		$	(42	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		995			1,013
Issuance of stock in exchange for services		15			—
Issuance of stock options in exchange for services		7			—
Amortization of debt issue costs and other assets		23			55
Allowance for doubtful accounts		30			105
Net (increase) decrease in:
Accounts receivable		(233		)	(128		)
Refundable income taxes		(3		)	6
Inventories		(377		)	(49		)
Prepaid expenses and other assets		(46		)	(104		)
Net increase (decrease) in:
Accounts payable		(256		)	77
Accrued expenses		53			183
Net cash provided by operating activities		768			1,116
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in equipment and leasehold improvements		(544		)	(185		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options		28			1
Proceeds from exercise of warrants (see Note 6)		54			—
Release of restricted cash deposit		—			250
Principal payments on long-term debt		(255		)	(244		)
Net cash provided by (used in) financing activities		(173		)	7
Net increase in cash and cash equivalents		51			938
Cash and cash equivalents at beginning of period		2,531			579
Cash and cash equivalents at end of period		$	2,582		$	1,517
Supplemental disclosure of non-cash financing activities:
Conversion of long-term debt to common stock		$	—		$	1,250
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest		$	98		$	227
Income taxes		$	188		$	11

 

See accompanying Notes to Consolidated Financial Statements.

 

5

 

CYANOTECH CORPORATION

FORM 10-Q

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2004

(Unaudited)

 

1.                                       BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  These consolidated financial statements and notes should be read in conjunction with the Company’s consolidated financial statements contained in the Company’s previously filed report on Form 10-K for the year ended March 31, 2004.

 

The Company consolidates enterprises in which it has a controlling financial interest. The accompanying consolidated financial statements include the accounts of Cyanotech Corporation and its wholly-owned subsidiaries, Nutrex Hawaii, Inc. and Cyanotech Japan YK.  All significant intercompany balances and transactions have been eliminated in consolidation.  While the financial information furnished for the three and nine month periods ended December 31, 2004 is unaudited, the statements in this report reflect all material items which, in the opinion of management, are necessary for a fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the dates of the consolidated balance sheets. The operating results for the interim period presented are not necessarily indicative of the results that may be expected for the year ending March 31, 2005.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of any contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses reported during the reporting period.  Management reviews these estimates and assumptions periodically and reflects the effect of revisions in the period that they are determined to be necessary.  Actual results could differ significantly from those estimates.

 

2.                                       NEW ACCOUNTING PRONOUNCEMENTS

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004) “Share-Based Payment” which is a revision of FASB Statement No. 123 “Accounting for Stock-Based Compensation”.  SFAS No. 123 (Revised 2004) requires an entity to measure the cost of employee services received in exchange for an award.  If an award vests or becomes exercisable based on the achievement of a condition other than service, performance or market condition, the award is liability-classified.  Liability-classified awards are remeasured to fair value at each balance-sheet date until the award is settled.  Equity-classified awards, including grants of employee stock options, are measured at the grant-date fair value of the award and are not subsequently remeasured.  The cost of equity-classified awards is recognized in the income statement over the period during which an employee is required to provide the service in exchange for the award.  Currently the Company accounts for its employee and non-employee director stock options under the intrinsic value provisions of Accounting

 

6

 

Principles Board Opinion No. 25 (See Notes 5 and 7).  The Company is required to adopt the provisions of SFAS No. 123 (Revised 2004) as of the beginning of the first interim or annual reporting period that begins after June 15, 2005, although earlier adoption is permitted.  SFAS No. 123 (Revised 2004) offers several alternatives for implementation.  At this time, management has not made a decision as to the alternative it may select.

 

In November 2004, the FASB issued SFAS No. 151 “Inventory Costs – an amendment of Accounting Research Bulletin No. 43, Chapter 4”.  SFAS No. 151 requires that abnormal amounts of freight, handling costs and wasted material (spoilage) be recognized as current-period charges and fixed production overhead costs be allocated to inventory based on the normal capacity of production facilities.  Normal capacity is defined as “the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.”  Companies will no longer be permitted to capitalize inventory costs on the balance sheet when the production defect rate varies significantly from the expected defect rate.  SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 24, 2004.  The Company has yet to determine the impact, if any, of SFAS No. 151 on its consolidated financial statements.

 

3.                                       INVENTORIES

 

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

 

		December 31, 2004			March 31, 2004
Raw materials		$	170		$	191
Work in process		317			154
Finished goods		873			567
Supplies		116			187
		$	1,476		$	1,099

 

4.                                       EQUIPMENT AND LEASEHOLD IMPROVEMENTS

 

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

 

Equipment		3 to 10 years
Furniture and fixtures		7 years
Leasehold improvements		10 to 21 years

 

7

 

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

 

		December 31, 2004			March 31, 2004
Equipment		$	10,106		$	9,753
Leasehold improvements		14,602			14,326
Furniture and fixtures		84			83
		24,792			24,162
Less accumulated depreciation and amortization		(13,682		)	(12,687		)
Construction in-progress		283			369
Equipment and leasehold improvements, net		$	11,393		$	11,844

 

5.                                       INDEPENDENT DIRECTOR STOCK OPTION AND STOCK GRANT PLAN

 

On August 16, 2004, the stockholders approved the Independent Director Stock Option and Stock Grant Plan (the “2004 Plan”).  300,000 shares of common stock are reserved for issuance under the 2004 Plan.  Under the 2004 Plan, upon election to the Board of Directors, a newly elected non-employee director is granted a ten-year option to purchase 4,000 shares of the Company’s common stock at a fair market value on the date of grant.  In addition, on the date of each Annual Meeting of Stockholders, each non-employee director continuing in office will be automatically granted, without payment, 3,500 shares of common stock, non-transferable for six months following the date of grant.  Concurrently with the 2004 Plan approval, the 1994 Non-Employee Director Stock Option and Stock Grant Plan was terminated except for the outstanding options issued thereunder.

 

The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for its fixed plan stock options issued to employees, including non-employee directors.  As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.  An expense of $25,000 was recognized in connection with common stock grants and issuances of common stock options during the three months ended December 31, 2004.

 

6.                                       WARRANTS

 

In December 2004, a warrant was exercised to acquire 75,000 shares of Common Stock at $0.625 per share.  This warrant had been granted in December 1999 as consideration for services provided by the third party warrant holder.  In May 2004, a warrant was exercised to acquire 7,000 shares of Common Stock at $1.10 per share and warrants to acquire 18,500 shares of Common Stock at $1.10 per share expired.  These warrants had been granted in connection with the extension of the Company’s previously outstanding convertible debentures (see Note 5 of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended March 31, 2004).  As of December 31, 2004, a warrant to acquire 50,000 shares at $1.00 per share and a warrant to acquire 20,000 shares at $2.55 per shares remain outstanding.

 

8

 

7.                                       EARNINGS PER SHARE

 

Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding.  Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding plus the potentially dilutive effect of outstanding stock options and warrants using the “treasury stock” method.

 

Reconciliations between the numerator and the denominator of the basic and diluted earnings per share computations for the three and nine months ended December 31, 2004 and for the three months ended December 31, 2003 are as follows (there were no reconciling items for the nine months ended December 31, 2003) (in thousands, except per share amounts):

 

		Three Months Ended December 31, 2004								Nine Months Ended December 31, 2004
		Net Income			Shares		Per Share Amount			Net Income			Shares		Per Share Amount
		(Numerator)			(Denominator)					(Numerator)			(Denominator)
Basic earnings per share		$	326		20,771		$	0.02		$	560		20,753		$	0.03
Effect of dilutive securities – Common stock options and warrants		—			217					—			228
Dilutive earnings per share		$	326		20,988		$	0.02		$	560		20,981		$	0.03

 

		Three Months Ended December 31, 2003
		Net Income			Shares		Per Share Amount
		(Numerator)			(Denominator)
Basic earnings per share		$	109		18,777		$	0.01
Effect of dilutive securities – Common stock options and warrants		—			157
Dilutive earnings per share		$	109		18,934		$	0.01

 

The following securities were excluded from the calculation of diluted earnings per share because their effect was antidilutive (in thousands):

 

		Three Months Ended December 31,				Nine Months Ended December 31,
		2004		2003		2004		2003
Stock options and warrants		172		990		172		1,298
Convertible debentures		—		1,923		—		1,923

 

8.                                       STOCK-BASED COMPENSATION

 

As allowed by Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, the Company has elected to continue to apply the intrinsic value-based method of accounting for employee stock options and adopted only the disclosure requirements of SFAS No. 123.  The following table illustrates the effect on net income (loss) and net income (loss) per common share if the Company had applied the fair-value method under SFAS No. 123 to its employee stock options (in thousands, except per share amounts):

 

9

 

		Three Months Ended December 31,						Nine Months Ended December 31,
		2004			2003			2004			2003
Net income (loss), as reported		$	326		$	109		$	560		$	(42	)
Less stock-based employee compensation determined under the fair value method		(25		)	(21		)	(67		)	(65		)
Pro-forma net income (loss)		$	301		$	88		$	493		$	(107	)

 

		Three Months Ended December 31,						Nine Months Ended December 31,
		2004			2003			2004			2003
Basic net income (loss) per share:
As reported		$	0.02		$	0.01		$	0.03		$	(0.00	)
Pro-forma		$	0.01		$	0.00		$	0.02		$	(0.01	)
Diluted net income (loss) per share:
As reported		$	0.02		$	0.01		$	0.03		$	(0.00	)
Pro-forma		$	0.01		$	0.00		$	0.02		$	(0.01	)

 

10

 

CYANOTECH CORPORATION

 

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

 

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

 

Overview

 

Selected results for the three and nine months ended December 31, 2004 with comparisons to prior periods follows (dollars in thousands):

 

																														Increase (Decrease) From
			Current Period Ended										Increase (Decrease) From Prior Year Comparable																	Prior Consecutive Quarter Ended
			December 31, 2004										Period Ended December 31, 2003																	September 30, 2004
				3 Months					9 Months					3 Months					%			9 Months					%			3 Months			%
Net sales:
Spirulina products				$	1,810				$	4,985				$	284				19	%		$		564			13		%	$	21		1	%
Natural astaxanthin products				1,324					3,766					(129			)		(9	)%		23					1		%	185			16	%
Other products				46					134					1					2	%		6					5		%	(24		)	(34	)%
				$	3,180				$	8,885				$	156				5	%		$		593			7		%	$	182		6	%
Gross profit				$	1,163				$	3,104				$	(21		)		(2	)%		$		355			13		%	$	109		10	%
Operating income				$	318				$	652				$	26				9	%		$		378			138		%	$	145		84	%

 

The selected data presented above is reported herein and in the Company’s previously filed reports on Form 10-Q for the quarterly period ended September 30, 2004 and on Form 10-K for the year ended March 31, 2004.

 

The Company’s overall net sales in the current periods increased above comparable prior year periods as well as on a sequential quarter to quarter basis.  Compared to units sold in prior periods, Spirulina sales volumes in the current quarter increased in both our bulk sales to certain international customers and our packaged product sales in the United States.  These increases allowed the Company to maintain the level of sales from the second quarter of this year (the second and third quarter’s sales were impacted favorably due to the fulfillment of backlogged orders).  While sales of BioAstin®, our natural astaxanthin product for the human nutrition market increased from the comparable prior fiscal year period, aggregate sales of our natural astaxanthin products for the three months ended December 31, 2004 were lower than comparable prior year period sales.  Sales of NatuRose®, our natural astaxanthin product for the animal nutrition market continue to be impacted by depressed sales volumes from our Japan subsidiary as our customers’ operations continue to recover from the effects of the past summer’s heat wave and typhoons.  Although competition is emerging in the astaxanthin market, we expect our natural astaxanthin sales volumes to rebound in the future to levels consistent with prior year volumes.

 

11

 

Our gross profit margin was 37% and 35% of net sales for the three and nine months ended December 31, 2004, respectively.  The current quarter’s gross profit margin is below the 39% gross profit margin for the comparable prior year period due to lower overall astaxanthin sales which command higher margins.  However, on a consecutive quarter basis for the current fiscal year, the Company has improved on its quarterly gross profit margins (33% for the first quarter, 35% for the second quarter and 37% for the third quarter) achieving increasing economies of scale during a period of pond conversions and shifting market demands.

 

Operating income improved to 10% of net sales for the quarter ended December 31, 2004 compared to 6% for the quarter ended September 30, 2004.  The quarterly improvement favorably impacted year-to-date figures with operating income at 7% for the current fiscal year compared to 3% a year ago.  Higher gross profit margins and a decrease in research and development expenses (due primarily to reduced personnel costs) accounted for the current quarter’s improvement.  The Company is investigating future strategic research and development initiatives.

 

Results of Operations

 

Third Quarter of Fiscal 2005 compared to the Third Quarter of Fiscal 2004

 

Net sales for the three months ended December 31, 2004 were $3,180,000, a 5% increase from the $3,024,000 for the comparable period a year ago.  Sales of Spirulina Pacifica products increased 19% due primarily to continued fulfillment of the backlog orders and increased sales to customers in Asia/Pacific.  The increased spirulina sales were offset in part by a 9% decrease in sales of natural astaxanthin products from the level achieved in the comparable period of the prior fiscal year.  International sales represented 51% of net sales for the three months ended December 31, 2004 compared to 55% for the same period a year ago reflecting lower sales in Japan and Europe.

 

Gross profit represents net sales less cost of goods sold, which includes the cost of materials, manufacturing overhead costs, direct labor expenses and depreciation and amortization.  Gross profit for the three months ended December 31, 2004 was $1,163,000, a decrease of 2% from the comparable period a year ago due primarily to lower sales of higher margin natural astaxanthin products.  As a percent of net sales, the gross profit margin of 37% was a decrease of two percentage points from the same period a year ago.

 

Operating expenses for the third quarter of fiscal 2005 were $845,000, a decrease of $47,000 or 5% from the comparable prior year period.  The decrease in spending is primarily attributable to reductions in research and development and general and administrative expenses, offset in part by a slight increase in sales and marketing expenses.

 

Research and development expenses decreased by 28% from the comparable period of the prior fiscal year due primarily to reduced personnel costs.  The Company expects research and development expenses to increase in the future due to increased costs related to company-sponsored clinical trials and new product development costs.  General and administrative expenses decreased by 6% due primarily to lower accounting and legal expenditures during the period.

 

The Company continues to manage its operating expenses carefully and anticipates increased operating expenses in future periods for scientific clinical trials, expanded sales promotional costs and increased expenses necessary for compliance with the Sarbanes-Oxley Act of 2002.

 

12

 

Net other income was $2,000 for the three months ended December 31, 2004 compared to net other expense of $69,000 recorded in the comparable period of the prior year.  This result was due primarily to reduced interest expense, a result of the conversion of debentures in December 2003 and gain arising from exchange rate fluctuations in the current period on transactions of our Japan subsidiary (whose transactions are denominated in Yen).

 

For the quarter ended December 31, 2004, the Company recorded an income tax benefit of $6,000, compared to income tax expense of $114,000 reported for the comparable period of the prior fiscal year.  This net result is due to lower taxable income in our Japan subsidiary and the effect of net operating loss carryforwards on taxes in the United States.  The Company does not expect any United States income taxes for the current fiscal year due such loss carryforwards.

 

Nine Months Ended December 31, 2004 Compared to Nine Months Ended December 31, 2003

 

Net sales for the nine months ended December 31, 2004 were $8,885,000, an increase of 7% from the comparable period a year ago.  Comparing year-to-year sales by product line, sales of Spirulina Pacifica increased 13%.  The increase in spirulina revenue is attributable to increased sales of powder and tablets in bulk and to higher sales of packaged spirulina, offset in part by lower sales of animal grade product.  While spirulina is an important component of Cyanotech’s business, the Company believes that the market is mature and faces established product and pricing competition.  Sales of all natural astaxanthin increased slightly compared to the comparable period of fiscal 2004 due to increased sales of BioAstin, the Company’s natural astaxanthin product for the human nutrition market.  This increase was offset in large part by decreased sales of NatuRose, the Company’s natural astaxanthin product for the animal nutrition market, due to the issues previously mentioned.  The Company believes that its natural astaxanthin products are positioned in emerging markets and is investing to increase acceptance of its natural astaxanthin worldwide.  International sales represented 48% and 59% of net sales for the nine month periods ended December 31, 2004 and 2003, respectively.  For the nine months ended December 31, 2004, sales to a distributor in the United States accounted for 10% of net sales.  For comparable period of the prior fiscal year, sales to a European distributor accounted for 10% of net sales.

 

Gross profit for the nine months ended December 31, 2004 increased 13% from $2,749,000 reported for the comparable period of the prior fiscal year.  As a percentage of net sales, gross profit margin improved to 35% for the current year period from 33% in the comparable prior year period.  The improvement is primarily attributable to production scale efficiencies achieved during the second and third quarters of the current fiscal year and to increased sales of higher margin BioAstin natural astaxanthin products for the first nine months of the current fiscal year.

 

Operating expenses for the first nine months of fiscal 2005 decreased slightly to $2,452,000, from $2,475,000 for the comparable period of the prior year.  The decrease is primarily attributable to lower sales and marketing expenses, offset in large part by higher research and development expenditures.  The Company continues to carefully monitor its operating expenses and anticipates increased expenditures in the future for scientific clinical trials, new product development, expanded sales promotion and increased expenses necessary for compliance with the Sarbanes-Oxley Act of 2002.

 

Net other expenses amounted to $71,000, a decrease of $149,000 or 68% from the comparable period a year ago primarily due to lower interest expense in the current period resulting from the conversion of debentures in December 2003.

 

13

 

Net income of $560,000 or $0.03 per diluted share was recorded for the nine month period ended December 31, 2004 compared to a net loss of $42,000 or $0.00 per diluted share for the comparable period of the prior fiscal year.  The $602,000 improvement is primarily attributable to improvement in all areas of operation.

 

Variability of Results

 

The Company has experienced significant quarterly fluctuations in operating results and anticipates that these fluctuations may continue in future periods.  Future operating results may fluctuate as a result of changes in sales levels to our largest customers, new product introductions, production difficulties, weather patterns, the mix between sales of bulk products and packaged consumer products, start-up costs associated with new facilities, expansion into new markets, sales promotions, competition, increased energy costs, foreign exchange fluctuations, the announcement or introduction of new products by competitors, changes in our customer mix, overall trends in the market for our products, government regulations and other factors beyond our control.  While a significant portion of our expense levels are relatively fixed and the timing of increases in expense levels is based in large part on forecasts of future sales, if net sales are below expectations in any given period, the adverse impact on results of operations may be magnified by our inability to adjust spending quickly enough to compensate for the sales shortfall.  We may also choose to reduce prices or increase spending in response to market conditions, which may have a material adverse effect on financial condition and results of operations.

 

Liquidity and Capital Resources

 

Working capital for the nine months ended December 31, 2004 increased by $908,000 to $4,991,000 from $4,083,000 at March 31, 2004 primarily due to an increase in inventories and accounts receivables and a decrease in trade accounts payable.  Inventory balances increased as a result of an unexpected change in customer demand for our natural astaxanthin products in both Japan and Europe.

 

The Company generated net income of $560,000 in the nine month period ended December 31, 2004, compared to a net loss of $42,000 for the same period of the prior year.  During the nine months ended December 31, 2004, cash and cash equivalents increased $51,000 to $2,582,000.  The increase in cash balances resulted from cash provided by operations of $768,000, offset by cash used for investment in equipment and leasehold improvements primarily for our natural astaxanthin expansion project and principal payments on long-term debt amounting to $544,000 and $255,000 respectively.

 

Net cash and cash equivalents of $768,000 were provided by operations during the nine months ended December 31, 2004.  Contributing to such result in the current fiscal year were increases in inventory and accounts receivable balances, higher prepaid insurance balances as well as a decrease in accounts payable.

 

Cash used in investing activities (for capital expenditures) amounted to $544,000 for the nine months ended December 31, 2004, primarily due to the Company’s planned equipment upgrades and conversion of ponds.

 

Cash used in financing activities amounted to $173,000 for the nine months ended December 31, 2004, due primarily to principal payments on the Company’s term loan.  This contrasts with cash provided by financing activities of $7,000 for the same period of the prior fiscal year as the result of the release of $250,000 in restricted cash by the Company’s lender in July 2003.

 

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The Company’s contractual obligations and commitments (consisting of a term loan and operating leases) are disclosed in the Company’s previously filed report on Form 10-K for the fiscal year ended March 31, 2004 in the following sections:  Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources; and Item 8. Financial Statements and Supplementary Data – Notes 5 and 6 of Notes to Consolidated Financial Statements.  There have been no significant changes in contractual obligations and commitments from March 31, 2004 to December 31, 2004, other than those reported elsewhere in this Form 10-Q.

 

Critical Accounting Policies

 

Our unaudited financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X.  Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses.  Theses estimates and assumptions are affected by management’s application of accounting policies.  The Company has identified certain policies that require the application of significant judgment by management.  Our most critical accounting policies are those related to inventory valuation, revenue recognition, equipment and leasehold improvements, income taxes and impairment of long-term assets.  These critical accounting policies are discussed in the Notes to Consolidated Financial Statements in the Company’s previously filed report on Form 10-K for the fiscal year ended March 31, 2004.  This discussion and analysis should be read in conjunction with such notes and our consolidated financial statements and related notes included elsewhere in this report.

 

Outlook

 

This outlook section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially. See also the discussion of going concern uncertainty included elsewhere in Item 2.

 

The successful production and marketing of high-value natural products derived from microalgae has been the strategy of Cyanotech Corporation since our inception.  Our current product offerings include Certified Organic and Naturally Cultivated Spirulina Pacifica in powder, flake and tablet form, NatuRose natural astaxanthin powder for the animal nutrition market, BioAstin natural astaxanthin in lipid extract, softgel capsule and micro-encapsulated beadlet form for the human nutrition and cosmetic industries and algae-based Phycobiliproteins for use in medical diagnostics.  Information about our Company and our products can be viewed at www.cyanotech.com, www.nutrex-hawaii.com or www.phycobiliprotein.com.  Consumer products can also be purchased online at www.nutrex-hawaii.com.

 

The results for the quarter ended December 31, 2004 were improved over the prior fiscal quarter and the comparable quarter of the prior year in spite of the disruption of NatuRose sales.  During the third quarter of fiscal 2005, sales of spirulina were consistent with the level achieved during the prior fiscal quarter, amounting to $1,810,000 and $1,789,000 respectively.  Also contributing to such improvement were increased sales of BioAstin.  This increase in sales of higher-margin BioAstin products contributed to achievement of gross profit margin of 37% for the quarter ended December 31, 2004.  Also contributing to this improvement were continued production efficiencies in all product categories.

 

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The Company’s continued to control its operating expenses which amounted to $845,000 for the third quarter of fiscal 2005.  As a result, the Company reported net income of $326,000 or $0.02 per diluted share for the quarter ended December 31, 2004.  This result demonstrates our Company’s ability to maintain efficient production systems, adapt to changing demand in our markets and control overhead expenses in order to sustain and improve profitability.

 

As of December 31, 2004 we have completed the planned upgrade of our natural astaxanthin processing facility and have converted six of the planned ten ponds for such cultivation.  We have decided to defer conversion of the remaining four ponds until we are more certain of the timing of the rebound of our NatuRose sales.  An important fact which we wish to emphasize is that while this project represents an investment of approximately $413,000 during the nine month period ended December 31, 2004, it was funded entirely by cash flows generated from operations.

 

During the final quarter of fiscal 2005, we will be expanding our efforts to accelerate the acceptance of our natural astaxanthin products in both human and animal nutrition markets.  Clinical trials on the benefits of BioAstin are planned to begin in the fourth quarter with results expected in fiscal 2006.  We are continuing our promotional efforts for BioAstin with an advertising campaign aimed at manufacturers of nutritional supplements.  We are confident that sales of BioAstin will continue to improve, that our market for NatuRose will resume its growth and that our Company will be able to capitalize on the increased demand.

 

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

 

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

 

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Item 3.           Quantitative and Qualitative Disclosures About Market Risk

 

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

 

Item 4.           Controls and Procedures

 

Under the supervision and with the participation of management, including the President and Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”) of the Company (the “Certifying Officers”), we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report in accordance with Item 307 of Regulation S-K promulgated by the Securities and Exchange Commission.  As defined under Sections 13a-15(e) and 15d-15(e) issued under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the term “disclosure controls and procedures” refers to controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

Based on that evaluation, the CEO and CFO have concluded that the Company’s disclosure controls and procedures are effective.  There were no changes in our internal controls over financial reporting during the quarter ended December 31, 2004 that have materially affected, or are reasonably like to materially affect, our internal controls over financial reporting.

 

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PART II.		OTHER INFORMATION
Item 1.		Legal Proceedings
		None
Item 6.		Exhibits and Reports on Form 8-K
		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
			99.1	Risk Factors
		b)	Reports on Form 8-K
		A report on Form 8-K dated November 1, 2004 in Item 2.02 - The Company’s press release announcing the financial results for the quarter ended September 30, 2004.
		A report on Form 8-K dated December 6, 2004 included Item 7.01 - An interview with the Company’s President and Chief Executive Officer as published by the Wall Street Transcript in conjunction with the Company’s press release announcing same.
		A report on Form 8-K dated December 14, 2004 included Item 7.01 - A press release providing update on the Company’s pond conversion project.
		A report on Form 8-K dated December 30, 2004 included Item 7.01 - A press release announcing the departure of the Company’s Scientific Director.

 

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SIGNATURES

 

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

CYANOTECH CORPORATION (Registrant)

 

 

February 11, 2005		By:	/s/ Gerald R. Cysewski
(Date)			Gerald R. Cysewski
			Chairman of the Board,
			President and Chief Executive Officer
		By:	/s/ Jeffrey H. Sakamoto
			Jeffrey H. Sakamoto
			Vice President – Finance & Administration
			(Principal Financial and Accounting Officer)

 

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