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
                                 December 31, 2008     December 31, 2007    % Change
Net sales:
Spirulina products              $             1,650   $             1,095         51 %
Natural astaxanthin products                  1,903                 1,632         17 %
Other products                                    -                    36       (100 )%
Total sales, all products       $             3,553   $             2,763         29 %

Gross profit                    $             1,566   $               353        344 %
Income (loss) from operations   $               556   $              (561 )      199 %
Net income (loss)               $               514   $              (594 )      187 %




                                 Nine Months Ended     Nine Months Ended
                                 December 31, 2008     December 31, 2007    Change
Net sales:
Spirulina products              $             5,344   $             4,033       33 %
Natural astaxanthin products                  5,146                 3,805       35 %
Other products                                   38                   112      (66 )%
Total sales, all products       $            10,528   $             7,950       32 %

Gross profit                    $             4,248   $             1,867      128 %
Income (loss) from operations   $             1,053   $            (1,216 )    187 %
Net income (loss)               $               948   $            (1,320 )    172 %

Sales for the third quarter of fiscal year 2009 increased from the comparable prior year period by $790,000 or 29% due to increases in both spirulina and natural astaxanthin product sales.

Spirulina sales increased 51% over the same period of fiscal year 2008, primarily due to increased units sold of bulk products and price increases in packaged products.

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. Packaged nutrition products increased by 58%. 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 44% for the three months ended December, 31, 2008 from 13% for the same period a year ago. Sales for the third quarter of fiscal year 2009 increased 29% from the comparable prior year period while cost of products sold decreased by 18% for the same respective period, mainly due to the affect of non inventoriable costs recognized in the prior year. Variable production costs increased 15% 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. Recent reductions in fuel prices have not been reflected in local utility rates which resulted in utilities expense 53% above levels one year ago. Management remains diligent in researching methodology to promote and sustain production at desired capacity and quality levels.

The net income of $514,000 for the third quarter of fiscal 2009 represents a positive improvement of $1,108,000 over the comparable quarter of fiscal 2008 which had a net loss of $594,000. The improvement is the result of increased sales volume and improved gross profit margins in the current period coupled with the absence of production issues experienced in the prior fiscal year.

Third Quarter of Fiscal 2009 Compared to Third Quarter of Fiscal 2008

Net sales for the third quarter of fiscal 2009 increased to $3,553,000, a 29% increase from the $2,763,000 reported for the comparable period a year ago. Company sales of Spirulina products for the third quarter of fiscal 2009 were $1,650,000, which is a 51% increase over sales generated in the third quarter of fiscal 2008. As a percentage of sales, Spirulina accounted for 46% of total sales in the third quarter of fiscal 2009, compared to 40% for the comparable quarter of fiscal year 2008. Production problems in fiscal year 2008 resulted in less inventory available to meet bulk sales demands. Current year Spirulina production has been good therefore sales of bulk Spirulina products are up and inventory levels are sufficient to meet current demands.

Natural astaxanthin product sales were $1,903,000 during the third quarter of 2009, a 17% increase from $1,632,000 in the third quarter of the prior year. Although the natural astaxanthin product lines increased in sales dollars, they decreased to 54% of total sales from 60% of total sales in the third quarter of fiscal 2008. This decrease is the result of the increased bulk sales of Spirulina as mentioned above. There were no other products sales during the third quarter of fiscal 2009 and $36,000 during the third quarter of fiscal 2008.

International sales were 53% of total sales for the third quarter of fiscal year 2009 and 41% of sales for the third quarter of fiscal year 2008. Major customers are those equaling or exceeding 10% of the Company's sales for the period. For the third quarter of fiscal 2009, one European distributor accounted for 18% of the Company's total sales. There were no customers exceeding 10% of sales volume in the third 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 third quarter of fiscal 2009 was $1,566,000, with a gross profit margin percentage of 44%. This was an increase from gross profit margin of $353,000 and gross profit margin of 13% reported for the comparable prior year quarter. Sales for the third quarter of fiscal year 2009 increased 29% from the comparable prior year period while costs of products sold decreased 18% for the same respective period, resulting in the substantial improvement in gross profit margin percentage. Variable production costs increased 15% in the current period compared to one year ago. Rising fuel costs have resulted in an increase in electrical rates and freight costs of chemicals and supplies used in production. These increases were partially offset by decreased chemical usage for the current quarter compared to the quarter ended December 31, 2008 due to favorable weather conditions compared to last year. The current period increases were fully inventoriable compared to $604,000 of non-inventoriable period costs associated with production problems in the same period of fiscal year 2008. 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 $18,000 and $121,000 of fixed production overhead cost was not inventoriable during the three months ended December 31, 2008 and 2007, respectively, because such costs would have exceeded the market value of the inventory. There were no such lower of cost or market issues for the third quarter of fiscal year 2009.

Operating expenses for the third quarter of fiscal 2009 were 28% of sales or $1,010,000, compared to 33% of sales or $914,000 for the third quarter of fiscal 2008. This decrease in operating expenses as a percentage of sales in the three months ended December 31, 2008 as compared with the three months ended December 31, 2007 was primarily the result of the increase in sales. Sales and marketing expenses decreased by $93,000 or 24%, offset by a $146,000 or 29% increase in general and administrative expense and a $43,000 or 195% increase in research and development expense for the third quarter of 2009 from the third quarter of 2008. These changes are primarily due to headcount variations in the respective departments as the Company executes its focused operating plan.

Net other expense, which includes interest on the Company's debt, for the three months ended December 31, 2008 increased by 18% to $39,000 from $33,000 for the same prior year period. The current period increase represents interest on the additional long-term debt secured in the fourth quarter of fiscal year 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 period 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.

A $3,000 income tax expense was recorded in the quarter ended December 31, 2008, related to a reduction in expected tax credits for the period. No expense or benefit from income taxes was recorded the quarter ended December 31, 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 $514,000 or $0.10 per basic and diluted share, for the three months ended December 31, 2008 compared to a net loss of $594,000, or ($0.11) per basic and diluted share for the three months ended December 31, 2007.

Nine Months Ended December 31, 2008 Compared to Nine Months Ended December 31, 2007

Net sales for the nine months ended December 31, 2008 were $10,528,000, an increase of 32% from sales of $7,950,000 reported for the comparable period a year ago. The increase in sales over the prior year's nine-month period was largely the result of increased sales of both spirulina and natural astaxanthin products. International sales represented 49% of net sales for the nine months ended December 31, 2008 compared to 42% for the same period a year ago. For the nine months ended December 31, 2008 and December 31, 2007, our European distributors accounted for 24% and 14% of total sales respectively.

For the nine months ended December 31, 2008, cost of sales decreased as a percentage of sales by 17% from the comparable prior year period. Variable production costs increased 13% for the nine months ended December 31, 2008 and were fully inventoriable due to increased production compared with non-inventoriable period costs of approximately $647,000 for the nine months ended December 31, 2007. For the nine months ended December 31, 2008 fixed cost overhead increased 8% due to increases in certain fixed costs such as insurances. Pursuant to SFAS No. 151, $40,000 and $178,000 of fixed overhead costs were not inventoriable during the nine months ended December 31, 2008 and 2007, respectively, because production levels were below normal capacity. In addition, production costs associated with the Company's inventory totaling approximately $141,000 incurred during the nine months ended December 31, 2007 were not inventoriable because such costs would have exceeded the market value for such inventory, no such adjustment was required for the current period end. As a result of the increase in sales and improved production volumes, gross profit margins as a percentage of sales increased to 40% for the nine months ended December 31, 2008 as compared to 23% for the comparable prior year period.

Operating expenses for the nine months ended December 31, 2008 were $3,195,000, an increase of $112,000 or 4% from the comparable prior year period. Sales and marketing expense decreased by $276,000 or 25% as a result of cost reduction measures, including headcount and promotional programs, initiated in the third quarter of fiscal year 2008. General and administrative expense increased $338,000 due to $156,000 of stock related compensation, $100,000 increase in accounting and legal costs to comply with regulatory requirements and inflationary increases, rather than added spending in the nine 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 nine months ended December 31, 2008 increased by 20% to $113,000 from $94,000 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 nine months ended December 31, 2008, the Company recorded an income tax benefit of $8,000 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 $948,000 or $0.18 per basic and diluted share for the nine month period ended December 31, 2008. For the same period a year ago the Company reported a net loss of $1,320,000 or ($0.25) per basic and 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 adjust spending in certain areas meaningfully, or to adjust spending quickly enough, as in personnel and administrative costs. 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 $814,000 or 75% to $276,000 at December 31, 2008, from $1,090,000 million at March 31, 2008. This decrease in cash resulted from cash used in investing activities of $331,000, and cash used in financing activities of $422,000, and cash used in operating activities of $61,000. Cash used in operating activities for the nine months ended December 31, 2008 represents the results of operations adjusted for non-cash depreciation, amortization and share based compensation expenses of $521,000, increases in inventory and accounts receivable of $1,903,000, offset by increases in accounts payable and accrued expenses of $449,000 and other less significant changes. Cash flows used in investing activities reflect capital expenditures during the nine months of fiscal 2009. Cash flows used in financing activities are attributable to debt payments during that period.

As of December 31, 2008, the Company's net accounts receivable increased $412,000 to $2,346,000 from $1,934,000 as of March 31, 2008. The increase in accounts receivable is primarily the result of the increased sales to foreign customers with extended terms. Management believes that its accounts receivable are collectible net of the allowance for doubtful accounts of $15,000 at December 31, 2008.

The Company's net inventory increased $1,499,000 or 94% to $3,100,000 as of December 31, 2008 compared to $1,601,000 as of March 31, 2008. The increase in inventory during the first nine months of fiscal 2009 is primarily due to increased production levels of both spirulina and astaxanthin during the summer months with longer daylight hours and lower rainfall. Management considers this buildup of inventory necessary to respond to our bulk customers fluctuating demands and to cover longer lead times for production of our BioAstin® based health and nutrition products.

Liquidity and Capital Resources

At December 31, 2008, the Company's working capital was $3,772,000, an increase of $680,000 compared to $3,092,000 at March 31, 2008. Cash and cash equivalents at December 31, 2008 totaled $276,000, a decrease of $814,000 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 December 31, 2008 is approximately $1,650,000. The Term Loans have maturity dates of May 1, 2010 as to $665,000 and March 1, 2015 as to $985,000 and are payable in equal monthly principal and interest payments totaling approximately $55,000.

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 3.25% at December 31, 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 December 31, 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 December 31, 2008, the Company had an accumulated deficit of $20,115,000 compared to an accumulated deficit of $21,063,000 at March 31, 2008. The accumulated deficit decreased by $514,000 for the quarter ended December 31, 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.

† 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.

† To conserve liquidity and reduce costs the Company as previously announced, 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. 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, meet debt service requirements, and make 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 $500,000 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 nine months of fiscal 2009 as compared to the first nine 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 insufficient inventory. Accordingly, sales may trend down or remain level in future periods depending on the rate at which orders are backlogged and fulfilled. Significant sales variability between periods and even across several periods can be expected based on historical results.

As discussed in Note 1 to Consolidated Condensed Financial Statements, the Company has discontinued all business activity of its wholly owned Japanese subsidiary CJYK. Management made this decision due to declining sales of approximately 40% in each of the prior two fiscal years. Discontinuance of this . . .