CYANOTECH CORP - Annual Report: 2003 (Form 10-K)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

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

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

(808) 326-1353
(Registrant's telephone number)

Securities registered pursuant to Section 12(b) of the Exchange Act:
NONE

Securities registered pursuant to Section 12(g) of the Exchange Act:

Title of class
Common Stock, Par value $.005 per share

        Indicate by check mark whether the registrant (1) has 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 o    No ý

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ý

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

        At September 30, 2002, the aggregate market value of the registrant's Common Stock held by non-affiliates of the registrant was approximately $9,557,000.

        At June 26, 2003, the number of shares outstanding of Registrant's Common Stock was 18,316,701.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the Registrant's Definitive Proxy Statement for its 2003 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission on or prior to July 18, 2003 and to be used in connection with the Annual Meeting of Stockholders expected to be held on August 21, 2003, are incorporated by reference in Part III of this Form 10-K.

Cyanotech Corporation
Annual Report on Form 10-K for the Fiscal Year Ended March 31, 2003

TABLE OF CONTENTS

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PART I

Item 1. Business

        Except for historical information contained in this document, the matters discussed in this report contain forward-looking statements that involve risks and uncertainties. These future risks and uncertainties could cause actual results to differ materially.

General

        Cyanotech Corporation is a worldwide leader in the development and commercialization of high value natural products derived from microalgae. Microalgae are a diverse group of over 30,000 species of microscopic plants which have a wide range of physiological and biochemical characteristics and naturally contain high levels of proteins, amino acids, vitamins, pigments and enzymes. Since 1983, we have designed, developed and implemented proprietary production and harvesting technologies, systems and processes which eliminate many of the stability and contamination problems frequently encountered in the production of microalgae. We believe that our technology, systems, processes and favorable growing location permit year-round harvesting of our microalgal products in a cost-effective manner. We currently produce natural products from microalgae for the nutritional supplement, aquaculture feed, animal nutrition, and immunological diagnostics markets.

        Since 1985, Cyanotech has been producing microalgae-based "spirulina" products for the vitamin and supplement market. Spirulina Pacifica®, which is our principal source of revenue, is a unique strain of spirulina microalga developed by us which provides a vegetable-based, highly absorbable source of natural beta-carotene, mixed carotenoids, B vitamins, gamma linolenic acid ("GLA"), protein, essential amino acids and other phytonutrients. We currently market our spirulina products in more than eighteen countries through a combination of retail, wholesale, and private label channels.

        In early 1997, we introduced NatuRose® to the worldwide aquaculture industry. NatuRose is the brand name of our natural astaxanthin (pronounced "as-tah-zan-thin") product for the animal nutrition market which we produce from the microalga, Haematococcus pluvialis ("Haematococcus"). Astaxanthin is a red pigment used in aquaculture to impart a pink to red color to pen-raised fish and shrimp. The worldwide astaxanthin market for animal pigmentation is estimated at more than $200 million in annual sales. NatuRose competes in this marketplace with astaxanthin synthesized from petrochemicals and derived from other sources.

        In March of 1999, we announced the development of BioAstin®, our natural astaxanthin product for the human nutrition market. A growing body of scientific literature is demonstrating that the beneficial antioxidant properties of natural astaxanthin surpass many of the antioxidant properties of vitamin C, vitamin E, beta-carotene and other carotenoids. In August 1999, the United States Food and Drug Administration ("FDA"), completed its review of our application to sell BioAstin without objection, allowing us to offer our new product for sale and use as a human nutritional supplement in the United States. The total market that human astaxanthin products potentially could address is estimated to exceed $5 billion annually.

        Cyanotech Corporation was incorporated in Nevada in 1983. Our principal executive offices are located at 73-4460 Queen Kaahumanu Highway, Suite 102, Kailua-Kona, Hawaii 96740, and our telephone number is (808) 326-1353. Unless otherwise indicated, all references in this report to the "Company," "we," "us," "our," and "Cyanotech" refer to Cyanotech Corporation, a Nevada corporation, and its wholly owned subsidiaries, Nutrex Hawaii, Inc. ("Nutrex Hawaii", "Nutrex"), a Hawaii corporation and Cyanotech Japan YK ("Cyanotech Japan", "CJYK"), a Japan corporation.

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Industry Background

        Microalgae are a diverse group of microscopic plants that have a wide range of physiological and biochemical characteristics and contain, among other things, high levels of natural proteins, amino acids, vitamins, pigments and enzymes. Microalgae have the following properties that make commercial production attractive: (1) microalgae grow much faster than land grown plants, often up to 100 times faster; (2) microalgae have a uniform cell structure with no bark, stems, branches or leaves, permitting easier extraction of products and higher utilization of the microalgae cells; (3) the cellular uniformity of microalgae makes it practical to manipulate and control growing conditions in order to optimize a particular cell characteristic; (4) microalgae contain a wide array of vitamins and other important nutrients; (5) microalgae contain natural pigments; and (6) microalgae are a potential source of medical products.

        Current commercial applications for these microscopic plants include nutritional products, diagnostic products, aquaculture feed and pigments, natural food colorings and research grade chemicals. We believe that microalgae could potentially be used for other commercial applications, including nutraceuticals, polyunsaturated fatty acids, and pharmaceuticals. The most significant microalgae products produced today are algae utilized as food supplements.

        While many unique compounds have been identified in microalgae, the efficient and cost-effective commercial production of microalgae is elusive. Many microalgae culture systems over the last 25 years have failed. Because microalgae produced for food supplements are typically cultivated and harvested outdoors, production is significantly affected by climate, weather conditions and the chemical composition of the culture media. Without consistent sunlight, warm temperature, low rainfall and proper chemical balance, microalgae will not grow quickly, resulting in longer harvesting cycles, decreased pond utilization and increased cost. Furthermore, microalgal growth requires a very nutrient rich environment. The high nutrient levels in the ponds promote the growth of unwanted organisms, or "weeds," when the chemical composition of the ponds changes from its required balance. Once contamination occurs, a pond must be emptied, cleaned and refilled, a process that further decreases pond utilization and increases production costs.

Cyanotech's Technology

        Since 1983, our scientists have designed, developed and implemented proprietary production and harvesting technologies, systems and processes which reduce many of the stability and contamination problems frequently encountered in the production of microalgae. We believe we were the first spirulina producer to have its products and processes certified organic and we were the first microalgae producer to have its quality system registered under the ISO 9002-94 standards. Our proprietary production system is known as Integrated Culture Biology Management ("ICBM"). Through the application of this technology, our spirulina culture ponds can be productive year-round without any significant loss in productivity due to contamination. We believe that such an accomplishment remains unique to Cyanotech.

        In addition to the advantages of our ICBM technology, we have developed a patented system for the recovery of carbon dioxide from our drying system exhaust gas, called Ocean-Chill Drying™. Since microalgae are essentially microscopic plants, they require sunlight, water, carbon dioxide and nutrients for optimal growth. By recovering carbon dioxide from the drying system that would otherwise be released into the atmosphere, we can divert the recovered carbon dioxide back to the algae cultures. This process provides us with another significant cost advantage over other microalgae producers who must purchase carbon dioxide. Moreover, Ocean-Chill Drying dries microalgal products in a low oxygen environment, which protects oxygen sensitive nutrients. In addition, we have developed an automated spirulina processing system, which enables a single operator to harvest and dry the spirulina powder.

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        Our efforts in commercial production of our natural astaxanthin products have resulted in an improved, large-scale photobioreactor system referred to as the PhytoDome Closed Culture System, or PhytoDome CCS™. To date, this improved technology has resulted in reduced production costs, increased control of product purity and has had a positive effect on production yield compared to other photobioreactor systems previously employed.

        Another major advantage for us is the location of our production facility at the Hawaii Ocean Science and Technology ("HOST") Park at Keahole Point, Hawaii. We believe that the combination of consistent warm temperature, abundant sunlight, and low rainfall at this facility makes this a highly favorable location for the economical, large-scale cultivation of microalgae. In contrast to our facility, microalgae producers in other regions of the world lacking these favorable characteristics stop producing for up to four months a year because of less favorable climate or weather conditions. At the HOST Park, we have access to cold, clean, deep sea water that is pumped from a depth of 2,000 feet. This sea water is used both as a source of nutrients for microalga culture and as a cooling agent in the Ocean-Chill Drying process. Additionally, our facility has access to a complete industrial infrastructure and is located 30 miles from a deep water port and is adjacent to an international airport.

        Applying our experience in cultivating and harvesting spirulina, we began commercial production of our first natural astaxanthin product, NatuRose, during the fourth quarter of fiscal 1997. By the end of fiscal 1999, our experience with NatuRose processing resulted in the development of its companion product, BioAstin.

        Our primary business objective is to be the leading developer and producer of high-value microalgal products in our existing and future markets. We believe that the combination of our ICBM technology, our PhytoDome CCS technology, our Ocean-Chill Drying process, our automated processing system and a favorable growing location with year-round production capabilities, can be successfully applied to the commercial cultivation of many other species of microalgae.

Products

Spirulina

        Our principal product, accounting for 67% and 74% of net sales for the years ended March 31, 2003 and 2002, respectively, is a nutritional microalgae marketed as Spirulina Pacifica. Developed by us and sold worldwide to the health and natural foods market, Spirulina Pacifica is a unique strain of microalgae that is a highly absorbable source of natural beta carotene, mixed carotenoids, B vitamins, GLA, protein, essential amino acids and other phytonutrients. Since 1994, we have produced two grades of Spirulina Pacifica; an all-natural grade cultivated by using conventional agricultural fertilizers and an organic grade that is cultivated using only organic fertilizers. Although this product constitutes a substantial portion of our net sales, we have concluded that the market for spirulina is mature with slow growth expected in future periods. As one of the world's largest producers of spirulina, our challenge is to increase our market share among customers who seek the high-quality product we produce while concurrently adjusting our product mix to meet our revenue targets.

        Cyanotech produces Spirulina Pacifica in three forms: powder, flake and tablets. Powder is used as an ingredient in nutritional supplements and health food drinks while flakes are used as a seasoning on various foods. Tablets are consumed as a daily dietary supplement. All three forms of our Spirulina Pacifica are sold in bulk quantities as a raw material to manufacturers and as a packaged consumer product through our wholly-owned subsidiary, Nutrex Hawaii, Inc. We also produce and market a blended nutritional supplement product in packaged form under the Hawaiian Energizer name. Hawaiian Energizer tablets contain Spirulina Pacifica, Bee Pollen and Siberian Ginseng.

        We anticipate that sales of our Spirulina Pacifica products will continue to constitute a substantial portion of net sales during fiscal 2004. However, as mentioned earlier we believe that the market for

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this product is essentially mature with slow growth expected in future periods. Any material decrease in the overall level of sales of, or the prices for, our Spirulina Pacifica products, whether as a result of competition, change in consumer demand, increased worldwide supply of spirulina or other factors beyond our control, would have a material adverse effect on our business, financial condition and results of operations.

Natural Astaxanthin

        The year ended March 31, 2003 was the sixth year of commercial production of NatuRose, our natural astaxanthin product for the animal nutrition market, and the fourth year of commercial production of BioAstin, our natural astaxanthin product for the human nutrition market. Astaxanthin is a red pigment used primarily in the aquaculture industry to impart pink color to the flesh of pen-raised fish and shrimp. Since its introduction six years ago, dozens of feeding trials have been performed by our customers and potential customers which prove the efficacy of NatuRose as an alternative to the petrochemical-based synthetic astaxanthin presently used by most aquaculture companies. The appeal of our product is that it is derived from a natural source and produces results which are comparable, or in some cases superior, to synthetic astaxanthin. As a result of continued growth in the world aquaculture industry, the world market for astaxanthin pigment is currently estimated to exceed $200 million per year. We therefore believe that sales of NatuRose may increase in future periods.

        BioAstin, our natural astaxanthin product for the human nutrition market has been in commercial production since March 1999 and has been available for sale since we received notice from the FDA in August 1999 that it had completed review of our application to sell BioAstin without objection. In January 2000, our wholly-owned subsidiary, Nutrex Hawaii, Inc., began selling BioAstin gelcaps in packaged consumer form. A growing body of scientific literature is demonstrating that the beneficial antioxidant properties of natural astaxanthin surpass many of the antioxidant properties of vitamin C, vitamin E, beta-carotene and other carotenoids, with independent scientific studies indicating that natural astaxanthin has up to 550 times the antioxidant activity of vitamin E and 10 times the antioxidant activity of beta-carotene. We believe that sales of BioAstin, in bulk, packaged consumer form, or as a component of a formulated product, may increase and may ultimately constitute a significant portion of total sales in future periods.

        We have sponsored several scientific clinical trials since introducing this product with results from some of these trials announced during fiscal 2002 and 2003. Among these results, some of the more promising findings are:

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A clinical trial linked BioAstin with preventing knee soreness after strenuous leg exercises and showed a significantly stronger immune system response compared to the control group after exercise activity.



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A clinical study of BioAstin showed improvement in the condition of patients with Carpal Tunnel Syndrome ("CTS"), with patients using BioAstin reporting a reduction in both severity and duration of pain. The Occupational Safety and Health Administration ("OSHA") estimates that three million Americans suffer from CTS. Prior to receiving the results of this trial, Cyanotech was awarded U.S. Patent 6,258,855 "Method of Retarding and Ameliorating Carpal Tunnel Syndrome," based on the protective properties of BioAstin.



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In May 2002, we reported results from another clinical trial testing the benefit of BioAstin on subjects suffering from rheumatoid arthritis. Results from this trial show that BioAstin reduced joint pain significantly and improved overall physical performance in the subjects. Rheumatoid arthritis is a chronic destructive disorder that is the most common form of inflammatory arthritis. According to the Arthritis Foundation, over two million Americans suffer from rheumatoid arthritis with an estimated cost to the U.S. economy of $65 billion per year in medical care and indirect expenses for this and similar musculoskeletal conditions.

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Early in fiscal 2003 we received positive results from a clinical evaluation of BioAstin to measure its effectiveness in providing sun screen protection from ultraviolet light ("UV"). The study concluded that daily ingestion of BioAstin for a two week period significantly increased the amount of UV energy required to produce skin reddening. On August 13, 2002, the United States Patent and Trademark Office ("USPTO") awarded Cyanotech U.S. Patent 6,433,025 "Method for Retarding and Preventing Sunburn by UV Light," based on the protective properties of our natural astaxanthin. This patent covers the use of astaxanthin as a single active ingredient to retard and prevent sunburn in both oral and topical applications.

Phycobiliproteins

        Cyanotech also produces phycobiliproteins which are sold to the medical and biotechnology research industry. Phycobiliproteins are highly fluorescent pigments purified from microalgae. Their spectral properties make them useful as tags or markers in many kinds of biological assays, such as flow cytometry, fluorescence immunoassays and fluorescence microscopy. We do not anticipate that phycobiliproteins will represent a significant component of total sales in future periods.

        The Company maintains product liability insurance in limited amounts for all of its products involving human consumption. In the opinion of management, broader product liability insurance coverage is prohibitively expensive at this time.

Research & Development Expenses

        Cyanotech Corporation's expertise is in the development of efficient, stable and cost-effective production systems for microalgal products. Our researchers investigate specific microalga identified in scientific literature for potentially marketable products and then strive to develop the technology to grow such microalgae on a commercial scale.

        The Company's current research and development efforts are primarily directed at validating the anecdotal indications of BioAstin through clinical evaluations and trials. In March 2002 we concluded a feeding trial aimed at further validation of the efficacy of NatuRose as an alternative to synthetic pigments in both aquaculture and avian feed markets. We performed fewer scientific clinical trials during fiscal 2003 as part of our cost containment efforts. This reduction resulted in research and development expenses of $217,000, down 37% from the prior fiscal year's expenditures of $343,000. Future expenditures for clinical trials area will depend on available liquidity. The Company continues to investigate new products and prioritizes its research and development activities to focus on projects that we believe will have the greatest market acceptance and achieve the highest return on the Company's investment. Successful microalgal product development is highly uncertain and is dependent on numerous factors, many of which are beyond the Company's control. Products that appear promising in early phases of development may be found to be ineffective, may be uneconomical because of manufacturing costs or other factors, may be precluded from commercialization due to the proprietary rights of other companies, or may fail to receive necessary regulatory approvals.

Manufacturing

        Cyanotech cultivates and processes its microalgae products at a 90-acre production facility on the Kona coast of the island of Hawaii. We have a total of 68 large oval culture ponds, 1 media recycling lake and 17 smaller auxiliary culture ponds totaling approximately 200,000 square meters, all of which are currently available for production. Each of the large ponds has an average surface area of 30,408 square feet (2,825 square meters) and each contain approximately 132,000 gallons (500,000 liters) of culture media. In addition, we have in production eight large-scale photobioreactors, each with a capacity of approximately 12,000 gallons (45,000 liters). Also located at this facility are two processing

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plants, our spirulina tableting plant, our research and quality control laboratories and three administration buildings.

Spirulina Pacifica

        Cyanotech began culturing Spirulina Pacifica in 1985 at its present facility at the HOST Park. Since 1994, we have produced two grades of Spirulina Pacifica; an all-natural grade cultivated by using conventional agricultural fertilizers and an organic grade that is cultivated using only organic fertilizers. Our organic Spirulina Pacifica is grown and processed in accordance with the National Organic Program ("NOP") of the United States Department of Agriculture ("USDA") which came into effect in October 2002. Previously our organic Spirulina Pacifica was grown and processed in compliance with the California Organic Food Act of 1990. The organic cultivation and processing methods we use are certified annually by Quality Assurance International, a leading third-party agency. Both grades of Spirulina Pacifica are certified Kosher and are cultivated without the use of herbicides or pesticides. Since 1996, our Company's spirulina process has also been certified under the ISO 9002-94 international quality standards.

        Our Spirulina Pacifica is cultivated in a combination of fresh water and a metered amount of nutrient-rich deep ocean water (containing ninety-six trace elements), drawn from a depth of 2,000 feet below sea level. This water is supplemented with the other major required nutrients such as sodium bicarbonate (baking soda) and infused with carbon dioxide. The spirulina crop in each pond is circulated by paddlewheels to keep an even blend of nutrients in suspension and a uniform exposure of the algae to sunlight, the other major component of cultivation. Our ponds are engineered to maintain the right media depth for sunlight to permeate each crop completely, facilitating rapid growth. Our system promotes efficient growing conditions, allowing the Spirulina Pacifica algae to reproduce rapidly. Each pond can be harvested, on average, in six days.

        Once ready for harvest, 70% of the spirulina culture is pumped from a pond through underground pipes to our processing building where the crop is separated from the culture medium by stainless steel screens. The remaining 30% serves as an innoculum for the next growth cycle. Harvested spirulina is washed with fresh water three times and vacuum filtered before moving to the drying stage. Culture media removed in processing is recycled. Recycled media is treated, tested for nutrient content and, if necessary, fortified with nutrients before being returned to the culture ponds for another cycle of cultivation. Our ICBM technology for microalgae cultivation has proven to be a reliable and stable operating environment, allowing us to grow and harvest spirulina without significant contamination by unwanted algae and associated loss of productivity. We believe that such an accomplishment remains unique to Cyanotech.

        Spirulina Pacifica for use in powder and tablets is dried by our patented low-oxygen Ocean-Chill Drying process which preserves high levels of antioxidant carotenoids. This provides a significant quality edge over competing products. The drying process takes about six seconds and results in a dark green powder. We also employ an alternate proprietary drying method to produce Spirulina Pacifica in the flake form. Bulk spirulina powder, tablets and flakes are vacuum-sealed in oxygen-barrier foil laminate bags along with a packet of oxygen absorbent. This packaging ensures product freshness and extends the shelf life of bulk Spirulina Pacifica products to three years. Another significant benefit of the Ocean-Chill Drying system is our ability to recover the carbon dioxide produced in the drying process. The recovered carbon dioxide is a major required nutrient for algal culture growth.

        Each production lot of spirulina is sampled and subjected to thorough quality assurance which includes testing for bulk density, moisture, particulate matter, color and taste, among others. In addition, each lot of our Spirulina Pacifica undergoes a prescribed set of microbiological food product tests, including total aerobic bacteria, coliform bacteria and E. coli. All of our Spirulina Pacifica powder is certified free of pesticides and herbicides, and certified Kosher.

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        Spirulina powder is difficult to form into tablets. Most tablet manufacturers either add high amounts (from 10% to 30%) of inert substances to "glue" the tablet together or use a heat granulation process that destroys nutrients. In contrast, our Spirulina Pacifica tablets contain a maximum of 2% of such substances and are produced in cold press compression tablet-making machines. Our Spirulina Pacifica flakes are produced by combining freshly harvested Spirulina Pacifica with food-grade lecithin and drying this blend in a proprietary system. The Company's packaged consumer products are bottled and labeled by a subcontractor in California. This subcontractor is a current Good Manufacturing Practices ("cGMP") certified manufacturer with organic and Kosher certifications, subject to regular government inspections.

Natural Astaxanthin

        The Haematococcus microalgae which produce natural astaxanthin grow in fresh water supplemented with nutrients. As such, it is extremely susceptible to contamination by unwanted algae, protozoa, and amoeba. Cyanotech has developed a proprietary system to overcome this problem known as our PhytoDome Closed Culture System or PhytoDome CCS. Using this large-scale photobioreactor, we are able to consistently grow large volumes of contaminant-free Haematococcus cultures.

        For the final stage of culture, the Haematococcus algae is transferred to open ponds. There, an environmental stress is applied causing spores to form which accumulate high levels of astaxanthin. The media containing these spores is transported through underground pipes to our astaxanthin processing building where the culture media and algal spores are separated. Fresh water recovered from this stage of processing is tested and treated using a proprietary water treatment system. It is then recycled for use in the next production cycle. The algal spores are dried to a fine powder using the low-oxygen Ocean-Chill Drying system. During processing, the spores are cracked in a proprietary system to assure high bioavailability of astaxanthin. Finally the bulk powder in vacuum-sealed in oxygen-barrier foil laminate bags along with a packet of oxygen absorbent.

        Unlike spirulina, astaxanthin is produced in a batch-mode and each cultivation pond must be thoroughly cleaned between cycles. While the entire astaxanthin production cycle takes a total of four weeks, each stage of the four-step process is staggered and continuously feeds the next stage of cultivation. As a result, we are able to produce a new crop of astaxanthin from each of our fifteen 500,000 liter culture ponds approximately once a week.

        Natural astaxanthin for human consumption is processed further utilizing a high-pressure extraction process. Cyanotech utilizes the services of two contractors for this process. The resulting product is a liquid lipid extract which is used by our customers for production of gelcaps. This product can also be micro-encapsulated into "beadlets" which our customers use in other formulations. All natural astaxanthin products destined for human consumption undergo a prescribed set of microbiological food product tests to ensure safety and quality.

Distribution and International Sales

        The majority of our bulk Spirulina sales are to health food manufacturers and health food formulators with their own spirulina product lines, many of whom identify and promote Cyanotech's Hawaiian Spirulina Pacifica in their products. Our packaged consumer products are sold through an established health food distribution network in the domestic market and shipped through one of our wholesale distributors under the Nutrex Hawaii label. In selected foreign markets, we have exclusive sales distributors for both our bulk and packaged consumer products. During fiscal 2003, our Spirulina Pacifica products were sold in 22 foreign countries and the United States.

        Our natural astaxanthin product, NatuRose, is presently being sold through a network of agents and distributors directly to aquaculture farmers, aquaculture feed manufacturers, poultry feed formulators, vitamin premix suppliers and other end users in 19 foreign countries and the United States

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for use in aquaculture feed, poultry feed and pet feed industries. During fiscal 2002, Japan emerged as one of our primary markets for the application of NatuRose in aquaculture. Feeding trials in Japan have proven that NatuRose produces superior results in pen-raised Sea Bream ("Tai") and Yellowtail; both major products in that market. Using NatuRose, pen-raised Sea Bream and Yellowtail develop an appearance closer to fish caught in the open ocean than cultivated fish fed synthetic astaxanthin. In addition to the more desirable natural coloration, a lower volume of NatuRose is required compared to synthetic astaxanthin. The increased demand for NatuRose in Japan was a major factor in our decision to establish Cyanotech Japan YK as a new channel of distribution in January 2002. At present, CJYK sells our feed spirulina and NatuRose products to several large Japanese aquaculture feed manufacturers.

        In addition to aquaculture, NatuRose is also being used to pigment the yolk of chicken eggs in Scandinavia and Japan and is being used by commercial tropical fish breeders to produce higher-value tropical fish with more desirable coloration. As NatuRose is one of the few non-synthetic astaxanthin feed ingredients available, many feed formulators identify NatuRose and Cyanotech as the source of this component in their feed to capitalize on the appeal of an all-natural feed/cultivation process.

        We began fiscal 2003 with BioAstin sales coming mostly from nutritional supplement manufacturers, health food formulators and sales of our Nutrex Hawaii packaged product. During fiscal 2003, sales of our BioAstin products improved by 45% compared to fiscal 2002, with increased interest from supplement manufacturers and cosmetic formulators. The increase in sales is due primarily to higher sales of bulk BioAstin products. We expect interest in BioAstin to continue to increase as more manufacturers begin using this powerful antioxidant in their new product offerings. In turn this will support sales of our packaged consumer products as more consumers become aware of its benefits as a human dietary supplement. As part of our expansion of sales channels, several customers of bulk quantities of BioAstin have introduced product formulations containing our natural astaxanthin. Such customers include Twin Laboratories ("Twinlab"), Solgar Vitamins ("Solgar") and more recently, Rexall Sundown, the Capsugel division of Pfizer Pharmaceuticals and Mac Cosmetics, a division of Estee Lauder. During fiscal 2003 revenue from our packaged BioAstin gelcaps was slightly lower compared to the prior fiscal year due in large part to our Company's decision to reduce expenditures on advertising. Revenue derived from BioAstin packaged product during fiscal 2003 was primarily from sales made to natural products distributors, to retailers and directly to consumers using our toll-free order line (1-888-922-2107) and our internet e-commerce website, www.nutrex-hawaii.com.

        In October 2001, in our effort to increase the revenue potential of our packaged consumer product we began development of a national television marketing campaign to promote Nutrex Hawaii's BioAstin in the mass market. This campaign revolved around a 30-minute television infomercial which was tested in several markets throughout fiscal 2003. Sales from the infomercial, however, were less than anticipated and due to the high cost of television air time the Company decided to discontinue the effort. The Company retains all rights to the contents of the infomercial and has incorporated portions of video footage into it's internet website, www.nutrex-hawaii.com. In accordance with accounting principles generally accepted in the United States, all costs related to production and airing of this infomercial effort were fully expensed during fiscal 2003.

        In the years ended March 31, 2003, 2002 and 2001, international sales accounted for approximately 54%, 47% and 54%, respectively, of our net sales. We expect that international sales will continue to represent a significant portion of our net sales in future periods. Our business, financial condition and results of operations may be materially adversely affected by any difficulties associated with managing accounts receivable from international customers, tariff regulations, imposition of governmental controls, political and economic instability or other trade restrictions. Through December 2001 all of our international sales were denominated in United States dollars which exposed us to a measure of risk resulting from fluctuations in currency exchange rates. Such fluctuations could cause our products to become relatively more expensive to customers in the affected country, leading to a reduction in

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sales in that country. To address this issue in one of our major markets, we formed the Japanese business unit, Cyanotech Japan in January 2002. Through this subsidiary, we are better able to service our increasing customer base in Japan, economize on shipping costs, provide more timely delivery and can allow these customers to conduct transactions in Japanese Yen rather than US Dollars. Assets and liabilities of this subsidiary are translated at the period-end exchange rate and resulting translation gains or losses are accounted for in a stockholder's equity account entitled "accumulated other comprehensive loss—foreign currency translation adjustments." Operating results of this subsidiary are translated at average exchange rates during the period.

Customers

Spirulina

        We market and sell our spirulina products to a variety of customers, which range in size from manufacturers with $500 million in annual sales to small retail stores. Several of our major customers are businesses that were established exclusively to market and sell spirulina products.

        Approximately $1,546,000, or 17% of our net sales for the year ended March 31, 2003 was to a single customer, Spirulina International B. V. ("Spirulina International"), a spirulina marketing and distribution company based in the Netherlands. Sales to this customer for fiscal 2002 and 2001 were $1,031,000 (13%) and $1,533,000 (19%), respectively. We believe that sales to this customer will continue to represent a significant portion of total net sales in future periods. Any changes in demand from this customer could have a material adverse effect on our business, financial condition and results of operations.

        We market and sell our spirulina products to a variety of other customers, including:

        Health Food Manufacturers.    Health food manufacturers often use Cyanotech's Spirulina Pacifica products as a key ingredient in their spirulina-based products, or as an ingredient in their health food formulations. These customers purchase bulk powder or bulk tablets and package the products under their brand label for sale to the health and natural food markets. Many of the products produced by these customers are often marketed and sold domestically in direct competition with our Nutrex Hawaii line of retail consumer products.

        Private Label Customers.    We currently provide private label retail consumer products to seven international customers. Products for these customers are manufactured only upon receipt of an order and no finished product inventories are maintained.

        Retail Distributors.    Retail distributors act as product wholesalers to independent and chain retailers. The majority of domestic Nutrex Hawaii sales in the year ended March 31, 2003 were to 29 distributors.

        Raw Materials Suppliers.    In the year ended March 31, 2003, we sold bulk spirulina products to fifteen domestic and ten foreign customers engaged in the business of distributing natural raw materials to health and natural food manufacturers. These distributors provide their customers with standardized quality control, warehousing and distribution services, and charge a mark up on the products for providing these services. These distributors may differentiate the products they sell, but they generally treat the products as commodities, with price being the major determining factor in their purchasing decision.

Natural Astaxanthin

        NatuRose is presently being sold through a network of agents and distributors directly to aquaculture farmers, aquaculture feed manufacturers, poultry feed formulators, vitamin premix suppliers and other end users in the United states and in 19 foreign countries. As mentioned earlier, in

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fiscal 2002 and also in 2003 our major market for NatuRose was aquaculture customers in Japan. In addition to our aquaculture customers, NatuRose is also being sold to poultry feed formulators to naturally pigment the yolk of chicken eggs and to pet feed formulators for commercial breeders of high-value tropical fish. As our product is a natural astaxanthin derived from microalgae, many of these formulators identify NatuRose and Cyanotech as the source of this component in their feed.

        BioAstin is presently being sold as a raw ingredient to dietary supplement manufacturers, health food formulators and cosmetic manufacturers, as well as a packaged consumer product through our wholly-owned subsidiary, Nutrex Hawaii, Inc. During fiscal 2003, BioAstin product revenues were derived primarily from increased sale of bulk product to manufacturers who are using BioAstin in their own product formulations and sales of our packaged consumer product made directly to natural product distributors, retailers and consumers using our toll-free order line (1-888-922-2107) and our internet e-commerce website, www.nutrex-hawaii.com.

Competition

Spirulina

        Our Spirulina Pacifica products compete with a variety of vitamins, dietary supplements, other algal products and similar nutritional products available to consumers. The nutritional products market is highly competitive. It includes international, national, regional and local producers and distributors, many of whom have greater resources than Cyanotech, and many of whom offer a greater variety of products. Our direct competition in the spirulina market is currently from Dainippon Ink and Chemical Company's Earthrise facility in California and several farms in China. To a lesser extent, we compete with numerous smaller farms in China, India, Thailand, Taiwan, Cuba and South Africa. Packaged consumer products marketed under our Nutrex Hawaii brand also compete with products marketed by health food manufacturing customers of Cyanotech who purchase bulk spirulina from us and package it for retail sales. A decision by another company to focus on Cyanotech's existing or target markets or a substantial increase in the overall supply of spirulina could have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that we will not experience competitive pressure, particularly with respect to pricing, that could adversely affect us.

Natural Astaxanthin

        Our natural astaxanthin product for the animal nutrition market, NatuRose, competes directly with the synthetic astaxanthin products produced and marketed for the commercial feed and aquaculture industry worldwide by Hoffmann-LaRoche and BASF. The animal nutrition market for astaxanthin is currently dominated by a single producer, Hoffmann-LaRoche, who produces synthetic astaxanthin from petrochemicals. Hoffmann-LaRoche currently sells astaxanthin synthesized from petrochemicals to the aquaculture industry at approximately $2,400 per pure kilogram, on average. To a lesser extent, our NatuRose also competes in the marketplace with natural astaxanthin derived from other natural sources.

        In August 2000, the FDA affirmed our development work by approving NatuRose for use as a color additive in the feed of salmon and trout grown worldwide and sold in the United States. During fiscal 2001, two additional producers, Archer Daniels Midland and Igene Biotechnology, Inc., entered the market with natural astaxanthin products derived from Phaffia yeast. Several other companies have announced plans to produce commercial quantities of natural astaxanthin but we believe that these companies are presently producing only small quantities for test purposes.

        Although synthetic astaxanthin has widespread use as a pigmentation source in commercial aquaculture, independent scientific analysis has shown that the molecular structure of the astaxanthin derived from the Haematococcus microalga more closely resembles the astaxanthin obtained naturally by fish in the wild. As mentioned earlier in this report, this characteristic has shown significant positive

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results in feeding trials done in Japan on Sea Bream. The results from these feeding trials affirm our belief that there is an international market demand for pen raised seafood whose diet consists of nutrients derived from natural sources. We believe there is commercial demand for a natural astaxanthin pigment for animal feed and that our NatuRose product can compete against such other products on the basis of performance and price.

        BioAstin, our natural astaxanthin product for the human nutrition market, was the first natural astaxanthin product for human consumption to be reviewed without exception by the FDA. Presently, BioAstin competes directly with similar products marketed by other manufacturers which include Mera Pharmaceuticals ("Mera" formerly "Aquasearch") in the United States, Fuji Chemicals in Japan and AstaCarotene AB in certain portions of the European market. In the general category of nutritional supplements, BioAstin also competes with a variety of vitamins, dietary supplements and other antioxidant products available to consumers. The nutritional products market is highly competitive. It includes international, national, regional and local producers and distributors, many of whom have greater resources than Cyanotech, and many of whom offer a greater variety of products.

Phycobiliproteins

        Three major competitors manufacture phycobiliprotein products for sale, including Molecular Probes, Inc., Prozyme, Inc. and Serologicals, Inc. (formerly Intergen). Cyanotech competes with these companies on the basis of price and quality. New synthetic fluorescent compounds have been developed which are superior to phycobiliproteins in some applications. The advantage of the synthetic compounds is their lower molecular weight and, in some cases, their lower cost. While our phycobiliprotein products may not be able to compete effectively against synthetic compounds in some applications, Cyanotech's phycobiliproteins have gained a reputation for high quality at a competitive price.

Government Regulation

        Cyanotech's products, potential products and its manufacturing and research activities are subject to varying degrees of regulation by a number of government authorities in the United States and in other countries, including the United States Food and Drug Administration pursuant to the Federal Food, Drug and Cosmetic Act. The FDA regulates, to varying degrees and in different ways, dietary supplements, other food products, diagnostic medical devices and pharmaceutical products, including their manufacture, testing, exportation, labeling, and, in some cases, advertising.

        Cyanotech is also subject to other federal, state and foreign laws, regulations and policies with respect to labeling of its products, importation of organisms, environmental protection, and occupational safety laws, among others. Federal, state and foreign laws, regulations and policies are always subject to change and depend heavily on administrative policies and interpretations. We work with foreign distributors to ensure our compliance with foreign laws, regulations and policies. There can be no assurance that any changes with respect to federal, state and foreign laws, regulations and policies, and, particularly with respect to the FDA or other such regulatory bodies, with possible retroactive effect, will not have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that any of our potential products will satisfy applicable regulatory requirements.

        The Federal Dietary Supplement Health and Education Act ("DSHEA") regulates the use and marketing of dietary supplements, including vitamin products. The DSHEA covers only dietary supplements and contains a number of provisions that differentiate dietary supplements from other foods. The DSHEA also sets forth standards for adulteration of dietary supplements or ingredients and provides detailed requirements for the labeling of dietary supplements, including nutrition and ingredient labeling. Compliance with relevant requirements can be onerous and time consuming, and

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there can be no assurance that Cyanotech can continue to meet relevant FDA manufacturing requirements for existing products or meet such requirements for any future products. Ongoing compliance with applicable regulatory requirements are monitored through periodic inspections by state and federal agencies, including the FDA, the Hawaii Department of Health and comparable agencies in other countries. Our processing facility is also inspected annually for organic certification by Quality Assurance International and for Kosher certification by Organized Kashrus Laboratories.

        In October 2002, all United States products labeled "Organic" became subject to guidelines promulgated under the United States Department of Agriculture's ("USDA") National Organic Program ("NOP"). These regulations are primarily directed at soil-based agriculture, a method of cultivation quite different from the aquaculture methodology used to produce microalgae. We petitioned the USDA National Organic Standards Board to amend their proposed regulations to include exemptions based on the unique aspects of spirulina cultivation. As a result, our Company received an extension of time to comply fully with the USDA regulations until October 21, 2005. In order to comply with the proposed regulations we may encounter significant increases in organic spirulina production costs which in turn may affect our decision to produce "Certified Organic" spirulina for sale in large quantities.

        In August 2000, we received notice that our natural astaxanthin product for the animal nutrition market, NatuRose, had been approved by the FDA for use as a color additive in the feed of salmon and trout. The FDA approval of NatuRose adds to the clearances we had already received in Japan and Canada and organic registration for use in feed in New Zealand. With FDA approval, we are able to sell NatuRose to US salmon and trout producers as well as to foreign producers whose products are destined for the US market. The process of obtaining clearances for a new color additive is expensive and time consuming. Extensive information is required on the toxicity of the additive, including carcinogenicity studies and other animal testing. No assurances can be given that any of our proposed products intended for use as feed additives will be approved on a timely basis for use in countries other than those mentioned above, if at all.

        As in vitro diagnostic medical device components, phycobiliprotein products do not currently require pre-market clearances by the FDA. However, as a component of a medical device, they can be subject to other various medical device requirements, including cGMP requirements.

Patents, Licenses and Trademarks

        Cyanotech has received five United States patents; two on aspects of our production methods and three for use of our BioAstin products; a) in treatment of Carpal Tunnel Syndrome ("CTS"), b) in treatment of Canker/Cold sores, and c) for use as a topical and oral sun screen. Although we regard our proprietary technology, trade secrets, trademarks and similar intellectual property as critical to our success, we rely on a combination of trade secret, contract, patent, copyright and trademark law to establish and protect our rights in our products and technology. There can be no assurance that we will be able to protect our technology adequately or that competitors will not be able to develop similar technology independently. In addition, the laws of certain foreign countries may not protect the Company's intellectual property rights to the same extent as the laws of the United States.

        Litigation in the United States or abroad may be necessary to enforce our patent or other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. Such litigation, even if successful, could result in substantial costs and diversion of resources and could have a material adverse effect on our business, results of operations and financial condition. Additionally, if any such claims are asserted against us, we may seek to obtain a license under the third party's intellectual property rights. There can be no assurance, however, that a license would be available on terms acceptable or favorable to us, if at all.

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Associates

        Cyanotech employed 60 full-time associates as of March 31, 2003 Approximately 39 associates are involved in the harvesting and production process, 3 are involved in research and product development, and the remainder are involved in sales, administration and support. Management believes that its relations with its associates are good. We have not experienced difficulty in attracting personnel and none of our associates are represented by a labor union.

Industry Segments and Export Sales

        The Company's business consists of one industry segment, the production of microalgae products, and is grouped into six geographic areas: United States, Canada/South America, the Netherlands, Europe, excluding the Netherlands, Japan, and Asia/Pacific, excluding Japan. In January 2002, the Company established Cyanotech Japan, a new subsidiary with an office in Tokyo. The following table (dollars in thousands) summarizes the product sales revenues from unaffiliated customers in each of the six geographic regions:

        The Company believes that its profit margin on export sales is not significantly different from that realized on sales in the United States. For the purposes of our consolidated financial reports, sales made through Cyanotech Japan are denominated in Japanese Yen and converted to US Dollars at an average exchange rate in effect during the period in which the sales were recorded.

Item 2. Properties

        Cyanotech Corporation's production facility, manufacturing plant and executive offices are located in Kailua-Kona, Hawaii, at the HOST Park. The HOST Park facility consists of approximately 90 leased acres. All 90 acres have been fully developed and contain production ponds, a processing facility, a laboratory, and administrative offices. All products are produced at this facility. The property is leased from the State of Hawaii under a 30-year commercial lease expiring in 2025. The Company also rents 3,200 square feet of warehouse space in a light industrial area located approximately four miles from the HOST Park.

        During 1997, we reached a preliminary agreement with the State of Hawaii to lease an additional 93 acres at the HOST Park, which would increase the total acreage under lease to 183 acres. The State of Hawaii agreed to allow the Company to lease this additional 93 acres on a year-to-year basis, until such time that the Company determined the need for a longer lease term. The construction work performed on this expansion acreage was the subject of the asset impairment charge of $2,796,000 recorded during fiscal 2000. Due, in large part, to improvements made in our astaxanthin cultivation techniques during fiscal 2002 and 2003 we concluded that our existing 90 acre facility would be sufficient for near future projections and terminated our lease on the entire 93 acre expansion parcel during the first quarter of fiscal 2003. In the event we need to expand beyond our current 90 acre facility there is sufficient available land at the HOST Park to meet our currently planned needs.

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Item 3. Legal Proceedings

        There were no material legal matters addressed during fiscal 2003.

Item 4. Submission of Matters to a Vote of Security Holders

        No matters were submitted to a vote of the stockholders during the fourth quarter of fiscal 2003.

Part II

Item 5. Market for Common Equity and Related Stockholder Matters

        During fiscal 2002, the Company's Common Stock was traded on the NASDAQ National Market. On June 17, 2002 the Company received a delisting warning letter from NASDAQ for failure to comply with the $1.00 per share minimum bid price. Cyanotech had 90 calendar days, or until September 16, 2002, to regain compliance. The Company was unable to regain compliance prior to September 16, 2002, and subsequently applied for, and received listing for its common stock on the NASDAQ SmallCap Market.

        Listing on the NASDAQ SmallCap market made available a 180 calendar day SmallCap Market grace period, or until December 16, 2002 to regain compliance. The Company failed to regain compliance before the end of this grace period but was eligible for an additional 180 calendar day grace period, or until June 12, 2003 to demonstrate compliance, provided that it met NASDAQ listing criteria for the SmallCap Market. The Company was unable to attain the $1.00 per share value prior to June 12, 2003 but met the other listing criteria for the SmallCap Market. However, on June 13, 2003, the Company received notification from NASDAQ that under Marketplace Rule 4210(c)(2)(A), the compliance period for listing on the SmallCap Market was extended from 360 to 450 calendar days for companies which met certain heightened criteria. The Company met the initial listing requirements and in accordance with Marketplace Rule 4310(c)(8)(D), has been provided an additional 90 calendar days, or until September 10, 2003 to regain compliance with the $1.00 per share minimum bid price requirement.

        As a result, as of the date of this report, the Company's common stock continues to be listed on the NASDAQ SmallCap Market under symbol "CYAN". If at anytime before September 10, 2003, the bid price of the Company's common stock closes at $1.00 per share or more for a minimum of 10 consecutive trading days, NASDAQ Staff will provide written notification that the Company complies with listing requirements under Marketplace Rule 4450(a)(5). Under certain circumstances, to ensure that Company can sustain long-term compliance, NASDAQ Staff may require that the closing bid price equals $1.00 per share or greater for more than 10 consecutive business days, but, generally, not more than 20 consecutive business days before determining that the Company complies. If compliance with this rule cannot be demonstrated by September 10, 2003, NASDAQ Staff will provide written notification that the Company's securities will be delisted from the SmallCap Market and begin trading on the NASDAQ Over-The-Counter Bulletin Boards. In such case common stock of the Company will be traded on a less active market to the possible detriment of the stockholders. At that time, the Company may appeal the NASDAQ Staff's determination to a Listing Qualifications Panel.

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        The following table sets forth the high and low selling prices as reported by the NASDAQ Stock Market for the periods indicated. Cyanotech's Common Stock is currently traded on the NASDAQ SmallCap Market under the symbol "CYAN."

(a)

NASDAQ Small-Cap Market listing, September 23, 2002 to March 31, 2003.

(b)

NASDAQ National Market listing, April 1, 2001 to September 22, 2002.

        Cyanotech has never declared or paid cash dividends on its Common Stock. We currently intend to retain all of our earnings for use in the business and do not anticipate paying any cash dividends Common Stock in the foreseeable future.

        The approximate number of record holders of outstanding Common Stock of the Company as of June 26, 2003 was 1,360. On this date the reported closing bid price was $0.50 per share.

Item 6. Selected Financial Data

(a)

Loss from operations, net loss and net loss per common share for the year ended March 31, 2000 reflect the effect of an asset impairment charge of $2,796.

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(b)

Gross profit, loss from operations, net loss and net loss per common share for the year ended March 31, 2002 reflect the effect of a finished goods inventory adjustment totaling $454. For further detail, see the section "Results of Operations—Fiscal 2002 Compared to Fiscal 2001—Gross Profit" in Management's Discussion and Analysis of Financial Condition and Results of Operations set forth in Item 7 of this report.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

        The following discussion is intended to assist in the understanding of Cyanotech Corporation's financial position and results of its operations for the three years ended March 31, 2003. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes To Consolidated Financial Statements included in this report. The financial section of the Cyanotech 2003 Annual Report to Stockholders consisting of this Management's Discussion and Analysis of Financial Condition and Results of Operations, the Consolidated Financial Statements have been prepared using accounting principles generally accepted in the United States of America ("GAAP").

        The Company's Consolidated Financial Statements have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and liquidation of liabilities in the ordinary course of business. During the years ended March 31, 2003, 2002 and 2001, the Company incurred losses of $1,775,000, $2,589,000 and $1,067,000, respectively. The Company's working capital at March 31, 2003 was $2,352,000 with cash balances amounting to $579,000. Net cash and cash equivalents used in operating activities for the years ended March 31, 2003 and 2002 amounted to $502,000 and $567,000, respectively. Accordingly this causes substantial doubt as to the ability of the Company to continue as a going concern. The Company's continuation as a going concern is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis, to comply with the terms of its financing agreements, to obtain additional financing or refinancing as may be required, to attain profitability, or a combination thereof. There can be no assurance that these efforts will be successful or that the Company will return to generating profit on either a quarterly or annual basis.

Company Overview and Critical Accounting Policies and Estimates

        Cyanotech Corporation is a worldwide leader in the development and commercialization of high value natural products derived from microalgae, a diverse group of over 30,000 species of microscopic plants which have a wide range of physiological and biochemical characteristics and naturally contain high levels of proteins, amino acids, vitamins, pigments and enzymes. Since 1983, we have designed, developed and implemented proprietary production and harvesting technologies, systems and processes which eliminate many of the stability and contamination problems frequently encountered in the production of microalgae. We believe that our technology, systems, processes and favorable growing location permit year-round harvesting of our microalgal products in a cost-effective manner. Currently, Cyanotech operates as a single segment, producing and selling natural products from microalgae for the nutritional supplement, aquaculture feed, animal nutrition, and immunological diagnostics markets. In response to SEC Release No. 33-8040, "Cautionary Advice Regarding Disclosure About Critical Accounting Policies," the Company has identified certain of its policies as being of particular importance to the understanding of its financial position and results of operations and which require the application of significant judgement by Cyanotech management.

        Inventory Valuation—Inventories are stated at the lower of cost (which approximates first-in, first-out) or market. Market is determined by net realizable value.

        Revenue Recognition—The Company recognizes revenue when goods are shipped and when significant risks and benefits of ownership are transferred. Amounts received in advance under sales and distribution agreements for the right to sell and distribute the Company's products are recognized as revenues on a straight-line basis over the term of such agreements.

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        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, and the shorter of the lease terms or estimated useful lives for leasehold improvements as described in the section "Notes To Consolidated Financial Statements" included in this report.

        Income Taxes—Income taxes are accounted for under the asset and liability method. Deferred tax assets are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

        Impairment of Long-Lived Assets—The Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 144 provides a single accounting model for long-lived assets to be disposed of. SFAS No. 144 also changes the criteria for classifying an asset as held for sale; and broadens the scope of businesses to be disposed of that qualify for reporting as discontinued operations and changes the timing of recognizing losses on such operations. The Company adopted SFAS No. 144 on April 1, 2002. The adoption of SFAS No. 144 did not affect the Company's consolidated financial statements.

        In accordance with SFAS No. 144, long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

        Goodwill and intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair value.

        Prior to the adoption of SFAS No. 144, the Company accounted for long-lived assets in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of."

        Use of Estimates—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 disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates.

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Contractual Obligations

        The following table presents the Company's contractual obligations at March 31, 2003:

RESULTS OF OPERATIONS

        The following table sets forth certain consolidated statement of operations data as a percentage of net sales for the periods indicated.

Fiscal 2003 Compared to Fiscal 2002

Net Sales

        Net sales for the year ended March 31, 2003 amounted to $8,951,000, an increase of 8.7% from net sales reported for the prior fiscal year, primarily due to increased sales of bulk and packaged BioAstin (up 45%), higher sales of bulk NatuRose (up 30%) and bulk Spirulina Pacifica tablets (up 33%), offset in part by decreased sales of bulk Spirulina Pacifica powder (down 17%). Net sales for the prior fiscal year includes $204,000 of non-recurring product distribution license fees. If the effect of these fees are omitted for comparison purposes, net sales for fiscal 2003 increased by $920,000 or 11.5% over the prior fiscal year.

        International sales increased slightly to 54% of total net sales for the year ended March 31, 2003, up from 47% reported for the prior fiscal year. This increase was primarily due to increased sales in

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Japan through our wholly-owned subsidiary Cyanotech Japan and higher sales to our largest customer, Spirulina International. Sales to this customer amounted to $1,546,000 or 17% of net sales for the year ended March 31, 2003, an increase of $515,000 from this customer's purchases during the prior fiscal year.

Gross Profit

        Gross profit represents net sales less the cost of goods sold, which includes the cost of materials, manufacturing overhead costs, direct labor expenses and depreciation and amortization. Gross profit for the year ended March 31, 2003 improved significantly to $2,895,000, an increase of 85% from that reported for the prior fiscal year, with the gross profit margin increasing to 32.3% from 19.0% of net sales. This increase in gross profit from the prior year is primarily attributable to operating at more optimal production levels and from increased sales of higher profit natural astaxanthin products. Results for the prior fiscal year include the offsetting effect of finished goods inventory adjustments of $454,000, and income from a non-recurring settlement related to product distribution license fees of $204,000. Our gross profit margin is dependent on multiple factors which include, but are not limited to, product mix, production levels, weather-seasonality, raw material, supply and shipping costs, and other factors beyond our control. Changes in any combination of these factors may result in fluctuation in gross profit in future periods.

Operating Expenses

        Total operating expenses for the year ended March 31, 2003 amounted to $4,105,000, an increase of 9.6% from operating expenses reported for the prior fiscal year primarily due to higher sales and marketing expenses and increased general and administrative expenses, offset in part by lower research and development expenses. In fiscal 2004 we expect operating expenses to remain at, or below, that reported for fiscal 2003 due to continued cost containment and discontinuation of the television infomercial advertising campaign during fiscal 2003.

        Research and Development    For the year ended March 31, 2003, expenditures for research and development amounted to $217,000, a decrease of 36.7% from the $343,000 reported for the prior fiscal year. This decrease is primarily attributable to reduced outside service expenses related to scientific clinical studies on BioAstin.

        General and Administrative    For the year ended March 31, 2003, general and administrative expenses increased 24.7% to $2,061,000 from the amount reported for the prior fiscal year. This increase is primarily due to writeoff of the discontinued television infomercial project, higher consulting service expense, higher corporate insurance, write-down of a capital expenditure warehouse project, a one-time NASDAQ fee associated with the change in the trading of the Company's common stock on the National Market to the Small Cap Market and increased bad debt expense.

        Sales and Marketing    For the year ended March 31, 2003, sales and marketing expenses increased slightly to $1,827,000, an increase of 4.3% from the amount reported for the prior fiscal year. This increase is primarily attributable to higher personnel and commission expense for all products.

Other Expense

        Other expense for the year ended March 31, 2003 increased by 39.0% to $574,000. The increase from the prior year is due to decreased interest income on lower cash balances and higher other expenses of approximately $236,000 related to extension of the convertible debentures which were retired in October 2002, partially offset by lower prime rate interest expense on the Term Loan.

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Income Tax Benefit

        The income tax benefit of $9,000 for each of the years ended March 31, 2003 and 2002 represents current state tax refunds.

Net Loss

        The Company recorded a net loss of $1,775,000 for the year ended March 31, 2003, an improvement in result of $814,000 or 31% from that reported for the prior fiscal year. This improvement can be primarily attributed to lower production costs and the subsequent effect on gross profit resulting from operating at more optimal levels, offset in part by increased sales and marketing and general and administrative operating and other expenses.

Fiscal 2002 Compared to Fiscal 2001

Net Sales

        Net sales for the year ended March 31, 2002 increased by 2.4% from net sales of $8,043,000 for the year ended March 31, 2001, primarily due to increased sales of packaged spirulina consumer products (an increase of $417,000, or 35%) and higher sales of all BioAstin products (an increase of $682,000, or 292%), offset in part by lower sales of bulk Spirulina Pacifica products (a decrease of $544,000, or 11%) and bulk NatuRose products (a decrease of $354,000, or 26%).

        International sales decreased slightly to 47% of total net sales for the year ended March 31, 2002, down from 54% for the year ended March 31, 2001. This decrease was primarily due to increased domestic sales and lower international sales. Sales of bulk spirulina products to our largest customer, Spirulina International, amounted to $1,031,000 or 13% of net sales for the year ended March 31, 2002, a decrease from $1,533,000 or 19% of net sales recorded for the year ended March 31, 2001.

Gross Profit

        Gross profit for the year ended March 31, 2002 decreased $783,000 or 33% compared to the prior year, with the gross profit margin decreasing to 19.0% from 29.2% of net sales. This decrease in gross profit from the prior year is primarily attributable to higher production costs in all products resulting from operating at lower than optimal production levels and the effects of inventory adjustments and a finished goods write off of $454,000 made during the third quarter of fiscal 2002, offset in part by increased sales of higher margin packaged consumer products.

Operating Expenses

        Total operating expenses for the year ended March 31, 2002 amounted to $3,747,000, an increase of 22.7% from the $3,053,000 of operating expenses reported for the prior fiscal year primarily due to the significantly increased sales and marketing expenses attributable to expanded advertising and promotion costs. Also contributing to the increase in operating costs were higher research and development expenses of approximately $78,000 related primarily to scientific clinical trials. Increases in both of these functional areas were slightly offset by a 2.8% reduction in general and administrative expenses, primarily due to lower legal expenses.

        Research and Development    Expenditures for research and development increased 29.4% to $343,000 for the year ended March 31, 2002, from $265,000 for the year ended March 31, 2001. The increase from the prior year resulted primarily from increased outside service expenses due to continuing clinical studies for BioAstin.

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        General and Administrative    General and administrative expenses decreased by $47,000 to $1,653,000 for the year ended March 31, 2002, from $1,700,000 for the year ended March 31, 2001. The decrease from the prior year is primarily due to lower legal expenses.

        Sales and Marketing    Sales and marketing expenses increased significantly due to expanded advertising and promotional expenses for all products. Sales and marketing expenses for the year ended March 31, 2002, amounted to $1,751,000, an increase of 60.9% from $1,088,000 recorded for the prior year.

Other Expense

        Other expense for the year ended March 31, 2002 increased by 12.5% to $413,000. The increase from the prior year is due to decreased other income and lower interest income, partially offset by lower interest expense.

Income Tax Benefit

        The income tax benefit of $9,000 and $8,000 for the years ended March 31, 2002 and 2001 respectively, represent current state tax refunds.

Net Loss

        The Company recorded a net loss of $2,589,000 for the year ended March 31, 2002 compared to a loss of $1,067,000 for the year ended March 31, 2001. This increased loss can be primarily attributed to higher production costs, inventory adjustments and the subsequent effect on gross profit resulting from operating at lower than optimal levels, combined with increased operating expenses in research and development and sales and marketing and, to a lesser extent, lower other income.

VARIABILITY OF RESULTS

        Cyanotech Corporation was formed in 1983 and did not become profitable on an annual basis until fiscal 1992 (the twelve month period ended December 31, 1992). From fiscal 1992 through fiscal 1997, the Company had total net sales of $29,401,000 and total net income of $7,931,000. From fiscal 1998 through fiscal 2003, the Company had total net sales of $46,992,000 and net losses totaling $12,773,000. As of March 31, 2003, our accumulated deficit is $13,234,000. There can be no assurance that we will return to generating profits on either a quarterly or an annual basis.

        We have experienced significant quarterly fluctuations in operating results and anticipate that these fluctuations may continue in future periods. Future operating results may fluctuate as a result of changes in sales 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 our 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 our 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 the Company's financial condition, results of operations and liquidity. The Company's continuation as a going concern is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis, to comply with the terms of its financing agreements, to obtain additional financing or refinancing as may be required, to attain

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profitability, or a combination thereof. There can be no assurance that these efforts will be successful or that the Company will return to generating profit on either a quarterly or annual basis.

NEW ACCOUNTING PRONOUNCEMENTS

        Accounting for Asset Retirement Obligations—In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs would be capitalized as a part of the carrying amount of the long-lived asset and depreciated over the life of the asset. The liability is accreted at the end of each period through charges to operating expense. If the obligation is settled for other than the carrying amount of the liability, the Company will recognize a gain or loss on settlement. The provisions of SFAS No. 143 are effective for fiscal years beginning after June 15, 2002. Adoption of SFAS No. 143 is not expected to have a material effect on the Company's financial condition, results of operations or liquidity.

        Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity—In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." SFAS No. 150 requires issuers to classify as liabilities (or assets in some circumstances) three classes of freestanding financial instruments that embody obligations for the issuer. Generally, SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of SFAS No. 150 is not expected to have a material effect on the Company's financial condition, results of operations or liquidity.

        Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others—In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN No. 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN No. 45 did not have a material effect on the Company's financial condition, results of operations or liquidity.

        Consolidation of Variable Interest Entities—In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities," which addresses the consolidation of variable interest entities ("VIE") as defined. FIN No. 46 applies immediately to variable interests in VIEs created after January 31, 2003, and to variable interests in VIEs obtained after January 31, 2003. For a variable interest in a VIE acquired before February 1, 2003, FIN No. 46 is to be applied no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003. The adoption of FIN No. 46 did not have a material effect on the Company's financial condition, results of operations or liquidity.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flows—Fiscal 2003

        Our working capital at March 31, 2003 amounted to $2,352,000, an increase of $1,344,000 from working capital at March 31, 2002, but cash and cash equivalents decreased by $472,000 to $579,000. This decrease in cash and cash equivalents is primarily because of cash flows used in operating

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activities and for investment in equipment and leasehold improvements totaling $752,000, offset in part by cash provided by financing activities of $280,000.

        Cash flows used in operating activities for the year ended March 31, 2003 amounted to $502,000, $67,000 less than cash flows used in operating activities reported for the prior fiscal year. The cash flows used in operating activities for fiscal 2003 is primarily due to the net loss of $1,775,000 offset in part by depreciation and amortization charges of $1,324,000.

        Cash flows used in investing activities (capital equipment purchases and leasehold improvements) for the year ended March 31, 2003 decreased by $132,000 to $250,000 from the amount recorded for the prior fiscal year. The Company expects to invest similar amounts in fiscal 2004 for capital equipment and leasehold improvements.

        Cash flows provided by financing activities amounted to $280,000, compared to cash flows used in financing activities of $269,000 for the prior fiscal year. This result is attributable to net proceeds from the issuance of long-term debt of $1,250,000 and common stock of $630,000, offset in part by repayment of long-term debt of $1,541,000.

Cash Flows—Fiscal 2002

        Cash flows used in operating activities for the year ended March 31, 2002 amounted to $567,000, a decrease from cash flows provided by operating activities of $243,000 for the year ended March 31, 2001. The decrease in cash flows from operating activities is due primarily to the net loss of $2,589,000 offset in part by depreciation and amortization charges of $1,312,000 and reduction in inventories of $1,010,000.

        Cash flows used in investing activities for the year ended March 31, 2002 decreased slightly to $382,000 from $437,000 recorded for the prior fiscal year.

        Cash flows used in financing activities amounted to $269,000 compared to cash provided by financing activities of $2,058,000 for the prior fiscal year, primarily as a result of the prior year's term loan and convertible debenture financings.

Term Loan Agreement

        On April 21, 2000, the Company executed a Term Loan Agreement ("Term Loan") with a lender which provided for $3.5 million in aggregate credit facilities, secured by substantially all the assets of the Company. The Term Loan has a maturity date of May 1, 2010 and is payable in 120 equal monthly principal and interest payments of approximately $40,000, commencing June 1, 2000 ($39,000 at March 31, 2003 and 2002). The interest rate under this Term Loan, in the absence of a default under the agreement, is the prime rate in effect as of the close of business on the first day of each calendar quarter, plus 1% (at March 31, 2003 and 2002, the prime rate was 4.25% and 4.75%, respectively). Interest is calculated on the unpaid balance of principal based on a straight-line amortization schedule commencing May 1, 2000. Of the loan proceeds, $500,000 has been deposited in an interest-bearing restricted cash account per the terms of the loan, with such amount included in other assets in the consolidated balance sheets at March 31, 2003 and 2002. A warrant to purchase 20,000 shares of the Company's common stock was issued in conjunction with this Term Loan agreement. The warrant expires in April 2011 and has an exercise price of $2.55 per share. The warrant may only be exercised after the Company has repaid the Term Loan in full.

        The Term Loan contains restrictive covenants which included, among others, maintenance of an annual minimum debt service coverage ratio. The Company failed to meet this covenant requirement for the year ended March 31, 2002 but received from the lender a waiver of the covenant violation until the year ending March 31, 2003. In October 2002, this covenant was deleted from the Term Loan

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by the lender. At March 31, 2003 the Company was in compliance with all restrictive covenants of the Term Loan.

        In connection with the Term Loan, the Company is prohibited from declaring common stock dividends without the lender's prior written consent.

Convertible Debentures due April 30, 2002

        On May 2, 2000, the Company completed a private placement of $1,250,000 principal amount 6% convertible subordinated debentures ("Debentures") due April 30, 2002, with net proceeds to the Company of approximately $1.1 million. Interest on these Debentures was to be paid quarterly, in arrears, at a rate of 6% per annum. The Debentures were convertible into shares of the Company's common stock at a conversion price of $1.50 per share, the market price of the Company's common stock at the date of issuance. Warrants to purchase 83,334 shares of the Company's common stock were issued to the placement agent of the Debentures, exercisable for five years from the issue date, at $1.80 per share. At March 31, 2002 and 2001, the outstanding principal amount of these debentures were $1,238,000 and $1,250,000 respectively.

        In May 2002, the Company reached an agreement with the holders of the Debentures to extend the maturity date by six months to October 31, 2002. In exchange for the extension, the Company agreed to: 1) reduce the conversion price from $1.50 per share to $1.00 per share (the approximate market value at date of issuance); 2) increase the interest rate during the remaining period the Debentures are outstanding from 6% to 10%; 3) issue two-year warrants to the Debenture holders to purchase additional shares of common stock of Cyanotech in an amount equal to thirty percent (30%) of the shares into which the Debentures are convertible at $1.10 per share; and 4) reduce the forced conversion price at which the Company can require the conversion of the Debentures from $3.00 per share to $1.50 per share. The terms of the aforementioned warrant issued to the placement agent in conjunction with the initial placement were also revised in this extension agreement. Under the terms of the extension, the warrant exercise price was reduced to $1.10 per share and the expiration date was accelerated to May 2004. As a result of this renegotiation of debt, the Company recorded a charge of approximately $236,000 during the year ended March 31, 2003, of which approximately $223,000 was a non-cash charge. These Debentures were retired in their entirety in October 2002.

Convertible Debentures due September 30, 2004

        In October 2002, the Company issued in a private placement (a) $1,250,000 principal amount of 10% convertible subordinated debentures, due September 30, 2004, convertible into shares of the Company's common stock at a price of $0.65 per share and (b) 750,000 shares of common stock with proceeds to the Company of $300,000. Proceeds from the 10% convertible subordinated debentures issued in October were used to retire convertible debentures of $1,238,000 which were due to mature on October 31, 2002. The remaining net proceeds from the issuance of common stock are to be used for working capital purposes. Subsequent to the transaction the investor was elected to the Company's Board of Directors.

Common Stock Listing

        During fiscal 2002, the Company's Common Stock was traded on the NASDAQ National Market. On June 17, 2002 the Company received a delisting warning letter from NASDAQ for failure to comply with the $1.00 per share minimum bid price. Cyanotech had 90 calendar days, or until September 16, 2002, to regain compliance. The Company was unable to regain compliance prior to September 16, 2002, and subsequently applied for, and received listing for its common stock on the NASDAQ SmallCap Market.

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        Listing on the NASDAQ SmallCap market provided the Company a 180 calendar day grace period, or until December 16, 2002 to regain compliance. The Company failed to regain compliance before the end of this grace period but was eligible for an additional 180 calendar day grace period, or until June 12, 2003 to demonstrate compliance, provided that it met NASDAQ listing criteria for the SmallCap Market. The Company was unable to attain the $1.00 per share value prior to June 12, 2003 but met the other listing criteria for the SmallCap Market. However, on June 13, 2003, the Company received notification from NASDAQ that under Marketplace Rule 4210(c)(2)(A), the compliance period for listing on the SmallCap Market was extended from 360 to 450 calendar days for companies which met certain heightened criteria. The Company met the initial listing requirements and in accordance with Marketplace Rule 4310(c)(8)(D), has been provided an additional 90 calendar days, or until September 10, 2003 to regain compliance with the $1.00 per share minimum bid price requirement.

        As a result, as of the date of this report, the Company's common stock continues to be listed on the NASDAQ SmallCap Market under symbol "CYAN". If at anytime before September 10, 2003, the bid price of the Company's common stock closes at $1.00 per share or more for a minimum of 10 consecutive trading days, NASDAQ Staff will provide written notification that the Company complies with listing requirements under Marketplace Rule 4450(a)(5). Under certain circumstances, to ensure that Company can sustain long-term compliance, NASDAQ Staff may require that the closing bid price equals $1.00 per share or greater for more than 10 consecutive business days, but, generally, not more than 20 consecutive business days before determining that the Company complies. If compliance with this rule cannot be demonstrated by September 10, 2003, NASDAQ Staff will provide written notification that the Company's securities will be delisted from the SmallCap Market and begin trading on the NASDAQ Over-The-Counter Bulletin Boards. In such case common stock of the Company will be traded on a less active market to the possible detriment of the stockholders. At that time, the Company may appeal the NASDAQ Staff's determination to a Listing Qualifications Panel.

        The accompanying consolidated financial statements have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and liquidation of liabilities in the ordinary course of business. During the years ended March 31, 2003, 2002 and 2001, the Company incurred losses of $1,775,000, $2,589,000 and $1,067,000, respectively. The Company's working capital at March 31, 2003 was $2,352,000 with cash balances amounting to $579,000. Net cash and cash equivalents used in operating activities for the years ended March 31, 2003 and 2002 amounted to $502,000 and $567,000, respectively. Accordingly, this causes substantial doubt as to the ability of the Company to continue as a going concern. The Company's continuation as a going concern is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis, to comply with the terms of its financing agreements, to obtain additional financing or refinancing as may be required, to attain profitability, or a combination thereof. The Company is pursuing several sources of additional financing but there can be no assurance that these efforts will be successful or that the Company will return to generating profit on either a quarterly or annual basis.

Item 7a. 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.

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Item 8. Consolidated Financial Statements and Supplementary Data

Independent Auditor's Report

The Board of Directors
Cyanotech Corporation:

        We have audited the accompanying consolidated balance sheets of Cyanotech Corporation and subsidiaries as of March 31, 2003 and 2002, and the related consolidated statements of operations, stockholders' equity and comprehensive loss, and cash flows for the years in the three-year period ended March 31, 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cyanotech Corporation and subsidiaries as of March 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 2003 in conformity with accounting principles generally accepted in the United States of America.

        The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in note 15 to the consolidated financial statements, the Company has suffered recurring losses from operations and has limited sources of additional liquidity to enable it to sufficiently liquidate its debts as they become due that raise substantial doubt about its ability to continue as a going concern. Management's plans in regards to these matters are also described in note 15. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ KPMG LLP
Honolulu, Hawaii
May 2, 2003

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CONSOLIDATED BALANCE SHEETS

March 31, 2003 and 2002

See accompanying notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS

Years ended March 31, 2003, 2002 and 2001

See accompanying notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS

Years ended March 31, 2003, 2002 and 2001

See accompanying notes to consolidated financial statements.

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CONSOLIDATED STATEMENT OF CASH FLOWS

Years ended March 31, 2003, 2002 and 2001