This Report on Form 10-Q and other presentations made by Cyanotech Corporation ("CYAN") and its subsidiaries contain "forward-looking statements," which include statements that are predictive in nature, depend upon or refer to future events or conditions, and usually include words such as "expects," "anticipates," "intends," "plan," "believes," "predicts," "estimates" or similar expressions. In addition, any statement concerning future financial performance, ongoing business strategies or prospects and possible future actions are also forward-looking statements. Forward-looking statements are based upon current expectations and projections about future events and are subject to risks, uncertainties and the accuracy of assumptions concerning CYAN and its subsidiaries (collectively, the "Company"), the performance of the industry in which they do business and economic and market factors, among other things. These forward-looking statements are not guarantees of future performance.

Forward-looking statements speak only as of the date of the Report, presentation or filing in which they are made or were made. Investors are cautioned not to place undue reliance on forward looking statements. Except to the extent required by the Federal Securities Laws, the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Our forward-looking statements in this Report include, but are not limited to:

† statements relating to our business strategy;

† statements relating to our business objectives; and,

† expectations concerning future operations, profitability, liquidity and financial resources.

These forward-looking statements are subject to risk, uncertainties and assumptions about us and our operations that are subject to change based on various important factors, some of which are beyond our control. The following factors, among others, could cause our financial performance to differ significantly from the goals, plans, objectives, intentions and expectations expressed in our forward-looking statements:

† the effects of competition, including locations of competitors and operating and market competition;

† worldwide economic conditions and their effects on costs, pricing and descretionary spending on health products;

† environmental restrictions, soil and water conditions, weather and other hazards;

†          access to available and reasonable financing on a timely basis;



†          changes in laws, including increased tax rates, regulations or
accounting standards, and decisions of courts, regulators and governmental
bodies;

† demand for the company's products, the quantities and qualities thereof available for sale and levels of customer satisfaction;

† changes to capital markets and access to sufficient capital on satisfactory terms;

† our dependence on the experience and competence of our executive officers and other key employees;

† the risk associated with the geographic concentration of the company's business;

† acts of war, terrorists incidents or natural disasters; and,

† other risks or uncertainties described elsewhere in this Report in our most recent annual report on Form 10-K and in other periodic reports previously and subsequently filed by the Company with the Securities and Exchange Commission.

Overview



Comparisons of selected consolidated statements of operations data as reported
herein follow for the periods indicated (dollars in thousands):



                                Three Months Ended    Three Months Ended
                                September 30, 2008    September 30, 2007    Change
Net sales:
Spirulina products              $             1,644   $             1,407       17 %
Natural astaxanthin products                  1,621                 1,176       38 %
Other products                                    9                    21      (57 )%
Total sales, all products       $             3,274   $             2,604       26 %

Gross profit                    $             1,378   $               768       79 %
Income (loss) from operations   $               205   $              (314 )      -
Net income (loss)               $               163   $              (344 )      -




                                 Six Months Ended      Six Months Ended
                                September 30, 2008    September 30, 2007    Change
Net sales:
Spirulina products              $             3,684   $             2,938       25 %
Natural astaxanthin products                  3,242                 2,173       49 %
Other products                                   49                    76      (36 )%
Total sales, all products       $             6,975   $             5,187       35 %

Gross profit                    $             2,682   $             1,514       77 %
Income (loss) from operations   $               497   $              (655 )      -
Net income (loss)               $               434   $              (726 )      -

Sales for the second quarter of fiscal year 2009 increased from the comparable prior year period by $670,000 or 26% due to increases in both spirulina and natural astaxanthin product sales.

Spirulina sales increased 17% over the same period of fiscal year 2008, primarily due to increased pricing of both bulk and packages products while units remained level.

Natural astaxanthin product sales increased as well over the comparable prior year period due to an increase in sales of both bulk and packaged astaxanthin products. Bulk products sales increased by 90% while packaged nutrition products increased by 50%. The Company is now focused on building market share based on nutritional brands which promote health and well-being.

Gross profit margin as a percentage of sales increased to 42% for the three months ended September, 30, 2008 from 29% for the same period a year ago. Sales for the second quarter of fiscal year 2009 increased 26% from the comparable prior year period while cost of products sold increased only 3% for the same respective period. Variable production costs increased 18% in the current period compared to one year ago primarily as a result of the impact of rising fuel costs on electrical rates and on the shipping costs of chemicals used in production. Fixed costs have declined by 16% compared to one year ago primarily due to reduced related headcount and production equipment becoming fully depreciated. We expect continued pressure on input costs going forward and this could cause gross margins to decline in future periods. Management is consistently researching methodology to promote and sustain production at desired capacity and quality levels.

The net income of $163,000 for the second quarter of fiscal 2009 represents a positive improvement of $507,000 over the comparable quarter of fiscal 2008 which had a net loss of $344,000. The improvement is the result of increased sales volume, improved gross profit and an 8% reduction in operating expenses as a percentage of sales due to reduced sales and marketing expenses.

Second Quarter of Fiscal 2009 Compared to Second Quarter of Fiscal 2008

Net sales for the second quarter of fiscal 2009 increased to $3,274,000 a 26% increase from the $2,604,000 reported for the comparable period a year ago. Company sales of Spirulina products for the second quarter of fiscal 2009 were $1,644,000, which is a 17% increase over sales generated in the second quarter of fiscal 2008. As a percentage of sales, Spirulina accounted for 50% of total sales in the second quarter of fiscal 2008, compared to 54% for the comparable period a year ago. Spirulina sales have declined as a percentage of total sales due to greater emphasis on sales of Natural Astaxanthin products, producing a favorable margin impact.

Natural astaxanthin product sales were $1,622,000 during the second quarter of 2009, a 38% increase from $1,176,000 in the second quarter of the prior year. The natural astaxanthin product lines increased to 50% of total sales from 46% of total sales in the second quarter of fiscal 2008. This increase is the result of the Company focusing its products to build nutritional brands which promote health and well-being. During fiscal year 2008, the Company closed it's wholly owned Japan subsidiary CJYK, which sold to the aquaculture market, and discontinued its NatuRose animal nutrition product. The aquaculture and animal nutrition market had been experiencing declines in both demand and profit margins. Other products sales were $9,000 during the second quarter of fiscal 2009 and $21,000 during the second quarter of fiscal 2008, and represented less than 1% in both periods.

International sales were 52% of total sales for the second quarter of fiscal year 2009 and 44% of sales for the second quarter of fiscal year 2008. Major customers are those equaling or exceeding 10% of the Company's sales for the period. For the second quarter of fiscal 2009, two European distributors each had sales equal to 10% of the Company's total sales for the quarter. Only one distributor, with 12% of sales for the period, met or exceeded major customer sales volume in the second quarter of fiscal year 2008.

Gross profit, derived from net sales less the cost of product sales, includes the cost of materials, direct labor, manufacturing overhead and depreciation. Gross profit for the second quarter of fiscal 2009 was $1,378,000, with a gross profit margin percentage of 42%. This was an increase from gross profit margin of $768,000 and gross profit margin of 30% reported for the comparable prior year quarter. Sales for the second quarter of fiscal year 2009 increased 26% from the comparable prior year period while costs of products sold increased 3% for the same respective period, resulting in the 12% improvement in gross profit margin percentage. Variable production costs increased 5% in the current period compared to one year ago. Rising fuel costs have resulted in an increase in electrical rates, freight costs and the cost of chemicals used in production. These increases were partially offset by decreased labor costs of 12% for the current quarter compared to the quarter ended September 30, 2008 due to maintaining reduced work force levels implemented in the third quarter of fiscal year 2008. Fixed costs have declined by 15% primarily due to reduced headcount compared to the quarter prior and production equipment becoming fully depreciated. Direct cost increases are expected to continue in all areas consistent with the local and national economy.

Pursuant to SFAS No. 151, "Inventory Costs - an amendment of ARB No. 43, Chapter 4," all fixed production overhead costs were inventoriable for the current quarter. Approximately $34,000 of fixed production overhead cost was not inventoriable during the three months ended September 30, 2007. Additionally $126,000 of production cost was not inventoriable in the second quarter of fiscal year 2008 because such costs would have exceeded the market value of the inventory. There were no such lower of cost or market issues for the second quarter of fiscal year 2009.

Operating expenses for the second quarter of fiscal 2009 were 36% of sales or $1,173,000, compared to 42% of sales or $1,082,000 for the second quarter of fiscal 2008. This decrease in operating expenses as a percentage of sales in the three months ended September 30, 2008 as compared with the three months ended September 30, 2007, was primarily the result of sales and marketing expense reductions of $82,000 or 24% offset by an $154,000 or 22% increase in general and administrative expense and an $18,000 or 50% increase in research and development expense for the second quarter of 2009 from the second quarter of 2008.

Income taxes are provided on the earnings in the consolidated financial statements. The provision is based on the current quarter activity of the legal entities and jurisdictions in which the Company operates. Tax credits such as Hawaii capital goods excise tax credits are recognized as a reduction to income taxes in the year the credits are earned. Accordingly, the effective tax rate may vary from the customary relationship between income tax expense (benefit) and pre-tax income (loss). The Company's effective tax rate is reconciled to consider the tax effect of net operating losses incurred in prior periods.

No expense or benefit from income taxes was recorded in the quarter ended September 30, 2008 or 2007. The Company does not expect any U.S. Federal or state income taxes to be recorded for the current fiscal year because of available net operating loss carry-forwards.

The Company had net income of $163,000 or $0.03 per diluted share, for the three months ended September 30, 2008 compared to a net loss of $344,000, or ($0.07) per diluted share for the three months ended September 30, 2007.

Six Months Ended September 30, 2008 Compared to Six Months Ended September 30, 2007

Net sales for the six months ended September 30, 2008 were $6,975,000, an increase of 35% from sales of $5,187,000 reported for the comparable period a year ago. The increase in sales over the prior year's six-month period was largely the result of increased sales of both spirulina and natural astaxanthin products. International sales represented 46% of net sales for the six months ended September 30, 2008 compared to 43% for the same period a year ago. For the six months ended September 30, 2008 and September 30, 2007, our European distributors accounted for 13% and 11% of total sales respectively.

For the six months ended September 30, 2008, cost of sales decreased as a percentage of sales by 13% from the comparable prior year period. For the six months ended September 30, 2008, variable production costs increased 12% and were fully inventoriable due to increased production compared with non-inventoriable period costs of approximately $43,000 for the six months ended September 30, 2007. For the six months ended September 30, 2008 fixed cost overhead increased 8%. Pursuant to SFAS No. 151, $20,000 and $57,000 of fixed overhead costs were not inventoriable during the six months ended September 30, 2008 and 2007 respectively because production levels were below normal capacity. No market value adjustment was required for inventory at September 30, 2008. However, production costs associated with the Company's inventory totaling approximately $156,000 incurred during the six months ended September 30, 2007 were not inventoriable because such costs would have exceeded the market value for such inventory. As a result of the increase in sales and improved production volumes, gross profit margins as a percentage of sales increased to 38% for the six months ended September 30, 2008 as compared to 29% for the comparable prior year period.

Operating expenses for the six months ended September 30, 2008 were $2,185,000, an increase of $16,000 or 1% from the comparable prior year period. Sales and marketing expense decreased by $183,000 or 26% as a result of cost reduction measures taken in the third quarter of fiscal year 2008. General and administrative expense increased $192,000 due to $66,000 of stock related compensation and inflationary increases rather than additional spending in the six month period. While it is our goal to contain discretionary operating spending it may become necessary for the Company to selectively increase spending in some or all of these areas to remain competitive and to comply with regulatory requirements.

Net other expense, which includes interest on the Company's debt, for the six months ended September 30, 2008 increased by 21% to $74,000 from $61,000 for the same prior year period. The current year increase represents interest on the additional long-term debt secured in the fourth quarter of fiscal year 2008.

For the six months ended September 30, 2008, the Company recorded an income tax receivable of $11,000 related to Federal and state tax credits. An income tax expense of $10,000 was recorded for the same period of the prior year. The Company does not expect any additional United States income taxes for the current fiscal year as a result of available net operating loss carry-forwards.

The Company recorded net income of $434,000 or $0.08 per diluted share for the six month period ended September 30, 2008. For the same period a year ago the Company reported a net loss of $726,000 or ($0.14) per diluted share.

Variability of Results

The Company has experienced significant quarterly fluctuations in operating results and anticipates that these fluctuations may continue in future periods. As described in previous paragraphs, operating results have fluctuated as a result of changes in sales levels to our customers, competition (both pricing, new products and other market trends) and production difficulties, including increased production costs and variable production results. The Company has also, during its history, experienced production difficulties as a result of inclement weather, changes in the mix between sales of bulk and packaged consumer products and start up costs associated with new product introductions, new facilities and expansion into new markets. In addition, future operating results may fluctuate as a result of factors beyond the Company's control such as

foreign exchange fluctuations, changes in government regulations, and economic changes in the regions it operates in and sells to. A portion of our operating expenses are relatively fixed and the timing of increases in expense levels is based in large part on forecasts of future sales. Therefore, if net sales are below expectations in any given period, the adverse impact on results of operations may be magnified by our inability to meaningfully adjust spending in certain areas, or the inability to adjust spending quickly enough, as in personnel and administrative costs, to compensate for a sales shortfall. We may also choose to reduce prices or increase spending in response to market conditions, and these decisions may have a material adverse effect on financial condition and results of operations.

Financial Condition

Cash and cash equivalents decreased $101,000 or 9% to $989,000 at September 30, 2008, from $1.1 million at March 31, 2008. This decrease in cash resulted from cash used in investing activities of $151,000, and cash used in financing activities of $279,000 offset by cash provided by operating activities of $329,000. Cash provided by operating activities for the six months ended September 30, 2008 represents the results of operations adjusted for non-cash depreciation, amortization 2nd stock option compensation expenses of $309,000, increases in accounts payable and accrued expenses of $534,000 offset by increases in inventory of $1,012,000 and other less significant changes. Cash flows used in investing activities reflect capital expenditures during the second six months of fiscal 2008. Cash flows used in financing activities are attributable to debt payments during that period.

As of September 30, 2008, the Company's net accounts receivable increased $110,000 to $2,052,000 from $1,934,000 as of March 31, 2008. The increase in accounts receivable is primarily the result of the timing of sales and collections on the customer's accounts. Management believes that its accounts receivable are collectible net of the allowance for doubtful accounts of $15,000 at September 30, 2008.

The Company's net inventory increased $1,012,000 or 63% to $2,613,000 as of September 30, 2008 compared to $1,601,000 as of March 31, 2008. The increase in inventory during the first six months of fiscal 2008 is primarily due to increased production levels of both spirulina and astaxanthin during the six months with little or no rainfall and longer daylight hours. Management considers this buildup of inventory prudent entering the winter quarters with historically lower production resulting from fewer daylight hours and seasonal rain. Spirulina production was 14% higher in the six months ending September 30, 2008 as compared to the six months ended March 31, 2008. Astaxanthin production was 140% higher in the six months ending September 30, 2008 as compared to the six months ended March 31, 2008. The increase is the result of the Company's focus on astaxanthin production in order to expand its BioAstin® based health and nutrition products.

Liquidity and Capital Resources

At September 30, 2008, the Company's working capital was $3,381,000, an increase of $289,000 compared to $3,092,000 at March 31, 2008. Cash and cash equivalents at September 30, 2008 totaled $989,000, a decrease of $101,000 from $1,090,000 at March 31, 2008.

The Company has two Term Loan Agreements ("Term Loans") with a lender. These provided up to $4.6 million in combined credit facilities and are secured by substantially all the assets of the Company. The outstanding combined balance under the Term Loans as of September 30, 2008 is approximately $1,793,000. The Term Loans have maturity dates of May 1, 2010 as to $777,000 and March 1, 2015 as to $1,017,000 and are payable in equal monthly principal and interest payments of totaling approximately $57,000.

The interest rate under the Term Loans, in absence of a default under the agreement, is the prime rate, as defined, in effect as of the close of business on the first day of each calendar quarter, plus 1% (the prime rate was 5.00% at September 30, 2008). The Company is prohibited by the Term Loan from declaring any cash dividends without the lender's prior written consent. A $250,000 restricted cash deposit is held in an interest-bearing restricted cash account per the terms of the Term Loan and is included in other assets in the consolidated balance sheet at September 30, 2008.

The Company has, as previously reported, experienced a number of factors that have negatively impacted its balance sheet and liquidity, including the following:

† The Company has experienced significant recurring net losses. At September 30, 2008, the Company had an accumulated deficit of $20,629,000 compared to an accumulated deficit of $21,063,000 at March 31, 2008. The accumulated deficit decreased by $163,000 for the quarter ended September 30, 2008. As discussed earlier, and as required under SFAS No. 144, "Accounting for the Impairment and Disposal of Long-Lived Assets," as of March 31, 2007 the Company recorded a non-cash impairment charge reducing, by $4.5 million, the values of certain production equipment and leasehold improvement assets. This non-cash charge did not impact liquidity.

† The Company's business did not generate positive cash from operating activities in seven of the eight quarters during fiscal years ended March 31, 2008 and 2007. The first two quarters of the fiscal year ended March 31, 2009 did generate positive cash from operating activities.

† Material weaknesses in its internal controls, as previously reported, have caused the Company to experience delays in completing its consolidated financial statements and filing periodic reports with the SEC on a timely basis. Accordingly, the Company continues to devote substantial additional internal resources, and to experience higher than expected fees for audit services. At present the Company has concluded that more rigorous emphasis on improving the capabilities of existing systems, procedures, and existing personnel, will correct the material weakness.

† In addition to the foregoing item, to conserve liquidity and reduce costs as previously announced, the Company cut its workforce by approximately 20% in early December 2007. The lay-offs have not had a negative impact on productivity and are not expected to do so. However, to achieve and sustain improved sales and enhanced production efficiency and effectiveness, it has been necessary for the Company to increase its operations workforce in subsequent quarters.

† Finally, as part of its request to the senior debt holder for additional funding, the Company has undertaken an aggressive plan to de-emphasize new product introductions and related sales and marketing expenses, and to aggressively reduce administrative and sales and marketing expenses in general. However, to achieve and sustain improved sales and enhanced production efficiency and effectiveness, it may be necessary to increase such expenses in future quarters.

Sufficiency of Liquidity

Based upon our current operating plan, analysis of our consolidated financial position and projected future results of operations, we believe that our operating cash flows, cash balances, and working capital, together with a moderate amount of additional borrowing, will be sufficient to finance current operating requirements, debt service, and planned capital expenditures, for the next 12 months. Management expects liquidity in the remainder of fiscal 2009 to be generated from operating cash flows.

Capital Resources

The Company does not currently have any material commitments for capital expenditures. The Company expects fiscal 2009 capital expenditures to be under $250,000 and to be funded by operating cash flows. This includes capital expenditures in support of the Company's normal operations, and expenditures that we may incur in conjunction with initiatives to improve gross margins and reduce expenses.

Outlook

This outlook section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially.

Cyanotech Corporation's strategic direction has always been to position itself as a world leader in the production and marketing of high-value natural products from microalgae. We are vertically aligned, producing raw materials in the form of microalgae processed at our 90-acre facility in Hawaii, and integrating those raw materials into finished products. In fiscal 2009, we will put greater emphasis on our Nutrex Hawaii consumer products. Our focus going forward will be to leverage our experience and reputation for quality, building nutritional brands which promote health and well-being. The foundation of our nutritional products is naturally cultivated Spirulina Pacifica® in powder, flake and tablet form; and BioAstin® natural astaxanthin antioxidant in extract, softgel caplet and micro-encapsulated beadlet form. Information about our Company and our products can be viewed at www.cyanotech.com, www.nutrex-hawaii.com. Consumer products can also be purchased online at www.nutrex-hawaii.com.

We are currently experiencing an upward trend in sales with unit sales increasing during the first six months of fiscal 2009 as compared to the first six months of fiscal 2008. The most significant impact was due to an increase in the astaxanthin bulk product line. The Company expects spirulina sales to remain essentially level since the product has reached a mature life cycle stage. A portion of the upward trend in sales is attributable to filling orders we could not fill during the third and fourth quarters of fiscal year 2008 due to . . .