UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

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

For Quarterly Period Ended September 30, 2006

Commission File Number 0-14602

CYANOTECH CORPORATION

(Exact name of registrant as specified in its charter)

73-4460 Queen Kaahumanu Hwy. #102, Kailua-Kona, HI  96740

(Address of principal executive offices)

(808) 326-1353

(Registrant’s telephone number)

Check whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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  x  No  o

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

Large accelerated filer  o          Accelerated filer  o          Non-accelerated filer  x

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

Number of common shares outstanding as February 12, 2007:

 

CYANOTECH CORPORATION

FORM 10-Q

Explanatory Note — Restatement of Financial Information

On December 1, 2006, Cyanotech Corporation (the “Company”) filed a Current Report on Form 8-K with the Securities and Exchange Commission (“SEC”) announcing that it would be restating certain consolidated financial statements in amendments to its annual report on Form 10-K/A for the fiscal year ended March 31, 2006.  As more fully described in Note 13 to the Consolidated Financial Statements in Form 10-K/A filed February 14, 2007, the Company identified errors in the application of certain accounting practices and procedures.  The restatement and filing of Form 10-K/A was primarily the result of the Company’s failure to include as a component of inventory cost certain fixed production costs such as depreciation, general insurance and minor compensation cost.  All inventories, cost of sales and operating expense balances, as presented in this Form 10-Q, properly reflect the inclusion of these fixed production costs in accordance with Accounting Research Bulletin No. 43.  In addition, the restatement and filing of Form 10-K/A also included adjustments for certain Hawaii State Tax Credits and interest income for the years ended March 31, 2004 and 2003, and tax adjustments for the years ended March 31, 2006, 2005, 2004, and 2003, all of which where considered immaterial in prior years.  In addition, refundable income taxes were restated for each of the years in the three year period ended March 31, 2006 and the reclassification of certain certificates of deposit from cash to short-term investments in fiscal years 2005 and 2004.  These reclassifications had no effect on reported net income (loss) or in cash flow from operations.  The foregoing adjustments and reclassifications are, where appropriate, reflected in the comparative restated information presented in this Form 10-Q.

The Company is filing this Form 10-Q for the fiscal quarter ended September 30, 2006.  Restated amounts from the consolidated balance sheet, as of March 31, 2006, and the statement of operations and consolidated statement of cash flows for the three and six months ended September 30, 2005 are included in this filing.  The Company will not file a Form 10-Q/A for the quarterly period ended September 30, 2005, and the consolidated financial statements and related information contained in that report should no longer be relied upon.

On November 3, 2006, the Company implemented a one for four stock split at which time the share price closed at $0.43 with 20,934,565 common shares outstanding.  As the stock split occurred after the close of the Company’s fiscal quarter and prior to the issuance of the financial statements, all share data and per share data in these financial statements and notes to financial statements reflect the effect of the split as if it occurred prior to the end of the current fiscal quarter.

This Form 10-Q should be read in conjunction with the Company’s Form 10-K/A for the fiscal year ended March 31, 2006 filed February 14, 2007.  Prior period comparative information contained in this Form 10-Q has been restated consistent with the Company’s Form 10-K/A  and to reflect the Company’s one-for-four reverse stock split (see Notes 2 and 3 of Notes to Consolidated Financial Statements included in the Form 10-Q).

The Company did not file Form 10-K/A, for the fiscal years 2005 or 2004, or Form 10-Q/A, for the interim periods affected by the restatement prior to and including December 31, 2005.  The consolidated financial statements and related financial information for such periods as previously filed, contain errors and should therefore no longer be relied upon. The related audit reports for the years ended March 31, 2005 and 2004 of KPMG LLP, the Company’s independent registered public accounting firm, with respect to those financial statements should also no longer be relied upon.

Potential Delisting of Our Common Stock From Nasdaq Capital Market Trading. See Risk Factors – Part II, Item 1A herein.

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CYANOTECH CORPORATION

FORM 10-Q

INDEX

PART I.FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets (unaudited) As of September 30, 2006 and March 31, 2006.
	Consolidated Statements of Operations (unaudited) For the three and six month periods ended September 30, 2006 and 2005
	Consolidated Statements of Cash Flows (unaudited) For the six month periods ended September 30, 2006 and 2005
	Notes to Consolidated Financial Statements (unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures.
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings
Item 1 A.	Risk Factors
Item 4.	Submission of Matters to a Vote of Security Holders
Item 6.	Exhibits and Reports on Form 8-K.
Signatures

 

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PART 1.  FINANCIAL INFORMATION

Item 1.  Financial Statements

CYANOTECH CORPORATION

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

		September 30,			March 31,
		2006			2006
					(As Restated)
ASSETS
Current assets:
Cash and cash equivalents		$	1,444		$	1,835
Short-term investments		700			700
Accounts receivable, net		1,746			2,209
Refundable income taxes		24			17
Inventories (see Note 4)		2,177			2,056
Prepaid expenses and other current assets		173			99
Total current assets		6,264			6,916
Equipment and leasehold improvements, net (see Note 5)		9,681			10,164
Other assets		472			515
Total assets		$	16,417		$	17,595
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt		$	364		$	364
Accounts payable		441			485
Accrued expenses		379			420
Total current liabilities		1,184			1,269
Long-term debt, excluding current maturities (see Note 6)		1,210			1,387
Total liabilities		2,394			2,656
Stockholders’ equity (see Notes 2 and 3):
Common Stock of $0.02 par value; shares authorized 7,500,000; 5,233,543 shares issued and outstanding at September 30, 2006 and 5,232,066 at March 31, 2006		105			105
Additional paid-in capital		27,333			27,330
Accumulated other comprehensive income - foreign currency translation adjustments		(1		)	(1		)
Accumulated deficit		(13,414		)	(12,495		)
Total stockholders’ equity		14,023			14,939
Total liabilities and stockholders’ equity		$	16,417		$	17,595

See accompanying Notes to Consolidated Financial Statements.

 

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

		Three Months Ended  September 30,						Six Months Ended  September 30,
		2006			2005  (As Restated)			2006			2005 (As Restated)
NET SALES		$	2,475		$	2,517		$	4,919		$	5,546
COST OF PRODUCT SALES		2,071			1,935			4,044			3,959
Gross profit		404			582			875			1,587
OPERATING EXPENSES:
Research and development		50			52			80			96
Sales and marketing		325			300			615			628
General and administrative		571			504			1,033			923
Total operating expenses		946			856			1,728			1,647
Loss from operations		(542		)	(274		)	(853		)	(60		)
OTHER INCOME (EXPENSE):
Interest income		17			8			26			23
Interest expense		(47		)	(35		)	(94		)	(90		)
Other income (expense), net		(4		)	2			(4		)	(8		)
Total other expense, net		(34		)	(25		)	(72		)	(75		)
Loss before income taxes		(576		)	(299		)	(925		)	(135		)
INCOME TAX (BENEFIT) EXPENSE		(4		)	(2		)	(6		)	3
NET LOSS		$	(572	)	$	(297	)	$	(919	)	$	(138	)
NET LOSS PER SHARE (see Note 7)
Basic		$	(0.11	)	$	(0.06	)	$	(0.18	)	$	(0.03	)
Diluted		$	(0.11	)	$	(0.06	)	$	(0.18	)	$	(0.03	)
SHARES USED IN CALCULATION OF NET LOSS PER SHARE:
Basic		5,234			5,224			5,233			5,224
Diluted		5,234			5,224			5,233			5,224
COMPREHENSIVE LOSS:
Net loss		$	(572	)	$	(297	)	$	(919	)	$	(138	)
Other comprehensive loss		(2		)	(6		)	(0		)	(8		)
		$	(574	)	$	(303	)	$	(919	)	$	(146	)

See accompanying Notes to Consolidated Financial Statements.

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CYANOTECH CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

		Six Months Ended September 30,
		2006			2005 (As Restated)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(919	)	$	(138	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation		650			676
Provision for (reduction of) allowance for doubtful accounts		4			(5		)
Amortization of debt issue costs and other assets		17			16
Net (increase) decrease in:
Accounts receivable		459			462
Refundable income taxes		(7		)	46
Inventories		(121		)	(212		)
Prepaid expenses and other assets		(48		)	(76		)
Net increase (decrease) in:
Accounts payable		(44		)	(504		)
Accrued expenses		(41		)	79
Net cash provided by (used in) operating activities		(50		)	344
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in equipment and leasehold improvements		(167		)	(123		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and warrants		3			0
Principal payments on long-term debt		(177		)	(172		)
Net cash used in financing activities		(174		)	(172		)
Net increase (decrease) in cash and cash equivalents		(391		)	49
Cash and cash equivalents at beginning of period		1,835			2,005
Cash and cash equivalents at end of period		$	1,444		$	2,054
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest		$	80		$	74
Income taxes		$	1		$	4

See accompanying Notes to Consolidated Financial Statements.

 

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CYANOTECH CORPORATION
FORM 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of September 30, 2006
(Unaudited)

1.                                       BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  These consolidated financial statements and notes should be read in conjunction with the Company’s consolidated financial statements contained in the Company’s previously filed report on Form 10-K/A for the year ended March 31, 2006.

The Company consolidates enterprises in which it has a controlling financial interest. The accompanying consolidated financial statements include the accounts of Cyanotech Corporation and its wholly owned subsidiaries, Nutrex Hawaii, Inc. and Cyanotech Japan YK.  All significant intercompany balances and transactions have been eliminated in consolidation.  While the financial information furnished for the three month and six month period ended September 30, 2006 is unaudited, the statements in this report reflect all material items which, in the opinion of management, are necessary for a fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the dates of the consolidated balance sheets. The operating results for the interim period presented are not necessarily indicative of the results that may be expected for the year ending March 31, 2007.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the period reported.  Management reviews theses estimates and assumptions periodically and reflects the effect of revisions in the period that they are determined to be necessary.  Actual results could differ from those estimates and assumptions.

2.             REVERSE STOCK SPLIT

On September 15, 2006 the Company’s Board of Directors approved a one-for-four reverse stock split on our outstanding common stock and a proportional decrease in the number of common shares authorized from 30,000,000 to 7,500,000.  The reverse stock split was effective on November 3, 2006 at which time the share price closed at $0.43 with 20,934,565 common shares outstanding.  On November 6, 2006, the share price opened at $1.72 with 5,233,641 common shares outstanding resulting from the reverse stock split with the expectation that most stockholders of common stock will not exchange their shares as such exchange is not mandatory and stockholders may keep the originally issued shares for exchanged value.  Fractional shares were paid with cash totaling less than $1,000.  The long term future impact of the reverse stock split on the Company’s stock price is uncertain.

The reverse stock split decision by the Board of Directors was taken to bring the outstanding shares of common stock in line with the Company’s size and value and to bring the price of such stock into compliance with the Nasdaq listing requirement of at least $1.00 per share.   The Company had been notified by Nasdaq that it was subject to delisting for failure of the stock to trade at $1.00 per share or above.  On November 20, 2006, the Company received a letter from Nasdaq indicating the closing bid price of its common stock had been at $1.00 per share or greater for at least 10 consecutive business days.  Accordingly, the Company regained compliance with Marketplace Rule 4310(c)(4).

As the stock split occurred after the close of the Company’s fiscal quarter ended September 30, 2006 and prior to the issuance of these financial statements, all share option data and per share data in these financial statements and notes to financial statements reflect the effects of the stock split as if it occurred for all periods presented.  The number of shares used in per share data was determined as if all outstanding shares at September 30, 2006 were exchanged.

3.       STOCK-BASED COMPENSATION

Effective April 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standard No. 123(R) (“SFAS No. 123R”), “Share-Based Payment,” for its share-based compensation plans, which is a revision of Statement of Financial Accounting Statement No. 123 “Accounting for Stock-Based Compensation”.   On March 29, 2005, the SEC staff issued Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB No. 107), which expressed the SEC staff’s views on SFAS No. 123R, but did not modify any of SFAS No. 123R’s provisions.   SFAS No. 123R requires an entity to measure the cost of employee services received in

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exchange for an award.  If an award vests or becomes exercisable based on the achievement of a condition other than service, performance or market condition, the award is liability-classified.   Liability-classified awards are remeasured to fair value at each balance sheet date until the award is settled.  Equity-classified awards, including grants of employee stock options, are measured at the grant-date fair value of the award and are not subsequently remeasured.  The cost of equity-classified awards is recognized in the income statement over the period during which an employee is required to provide the service in exchange for the award.   In the Company’s case, all of the Company’s stock options are equity-classified awards.

Under the 2005 Stock Option Plan (the “2005 Plan”), 200,000 shares of common stock are reserved for issuance and the plan terminates on August 21, 2015. Under the 2005 Plan, eligible employees and certain independent consultants may be granted options to purchase shares of the Company’s Stock. The shares issuable under the 2005 Plan will either be shares of the Company’s authorized but previously unissued common stock or shares reacquired by the Company, including shares purchased on the open market.  As of September 30, 2006, 195,000 options remained available for grant under the 2005 Plan.   Concurrent with the 2005 Plan approval on August 22, 2005, the 1995 Stock Option Plan was terminated except for the outstanding options issued thereunder.

Options under the 2005 Plan are granted, and are vested and exercisable as determined by the Board of Directors or the Stock Option and Compensation Committee of the Board in accordance with the provisions of the 2005 Stock Option Plan. The number of options granted, vesting, exercise, and other conditions are set forth in a Stock Option Agreement evidencing each grant. No option can have a life in excess of ten (10) years.  All shares granted in the form of options under the 2005 Plan will reduce, on a share for share basis, the number of shares available for subsequent grants. Option grants which forfeit under the terms of the 2005 Plan will return to the pool of reserved shares and be available for subsequent grants under the terms of the 2005 Plan.

SFAS No. 123R offers several alternatives for implementation, among them the Modified Prospective Method of accounting for compensation costs related to “Share Based Payments” which the Company has determined to apply.  In the Company’s case, its employee incentive stock options are “plain vanilla” as defined by the SEC in SAB No. 107, normally vesting over a five year period and exercisable under the terms of the Company’s Stock Plan up to ten years from date of grant.  Because the Company’s future employee incentive stock options are expected to be “plain vanilla”, they will be reflected only in Equity and Compensation Expense accounts.  The Company has determined that a Black-Scholes-Merton model will be most reflective of the fair value of option grants, consistent with the provisions of SFAS No. 123R and SAB No. 107.   Key input and assumptions used to estimate the fair value of stock options include the grant price of the award, the expected option term, volatility of the Company’s stock, risk-free rate and the Company’s dividend yield.   Estimates of fair value are not intended to predict actual future events or the value ultimately realized by employees who receive equity awards and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company.

There is no unrecognized compensation cost related to nonvested stock options as of September 30, 2006. Currently outstanding nonvested options are options that were granted to non-employees and the compensation cost for these options was recognized in prior years operating results.  There are no nonvested employee options because, on March 23, 2006, in response to SFAS No. 123R, the Compensation and Stock Option Committee of the Company’s Board of Directors approved accelerating the vesting of all outstanding unvested employee incentive stock options under the provisions of APB Opinion No. 25, and related interpretations.  Options held by non-employees and directors were not included in the vesting acceleration.  The decision to accelerate vesting of all outstanding unvested employee incentive stock options was made to avoid recognizing, pursuant to the Company’s April 1, 2006 adoption of SFAS No. 123R, the non-cash compensation cost related to unvested employee incentive stock options.  It is estimated that the total future compensation expense that was avoided by accelerating vesting was $78,000, before tax, based upon the March 23, 2006 acceleration date.  A portion of this amount would have impacted the three and six months ended September 30, 2006 had the acceleration not occurred.  No options were granted by the Company during the six month period ending September 30, 2006.  Had any options been granted, related compensation expense under the provisions of SFAS No. 123R would have been reflected in the Consolidated Statements of Operations.

The Independent Director Stock Option and Stock Grant Plan (the “2004 Plan”) has 75,000 shares of common stock reserved for issuance.  Under the 2004 Plan, upon election to the Board of Directors, a newly elected non-employee director is granted a ten-year option to purchase 1,000 shares of the Company’s common stock at a fair market value on the date of grant.  All such options are granted at fair market value on the date of grant.  Options granted vest and become exercisable six months from the date of grant.  In addition, on the date of each Annual Meeting of Stockholders, each non-employee director continuing in office is automatically granted, without payment, 875 shares of common stock, non-transferable for six months following the date of grant.  As of September 30, 2006, 69,500 options remained available for grant under the 2004 Plan.  Concurrent with the 2004 Plan approval on August 16, 2004, the 1994 Non-Employee Director Stock Option and Stock Grant Plan was terminated except for the outstanding options issued thereunder.

The following table summarizes the weighted average characteristics of outstanding stock options as of September 30, 2006 for various exercise price ranges:

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		Outstanding Options							Exercisable Options
		Number of		Remaining		Weighted			Number of		Weighted
Range of Exercise Prices		Shares		Life (Years)		Average Price			Shares		Average Price
$1.84-$3.08		58,644		1.8		$	2.26		58,207		$	2.26
$3.88-$6.75		28,393		3.0		4.51			26,894		4.51
$14.75-$24.50		7,000		1.4		15.80			7,000		15.80
Total stock options at September 30, 2006		94,037				3.94			92,101		3.95

 

A summary of option activity under Cyanotech Corporation Stock Plans for the quarter ended September 30, 2006 is presented below:

 

Option Activity		Shares		Weighted Average  Exercise Price			Weighted Average  Remaining  Contractual Term			Aggregate Intrinsic  Value
Outstanding at June 30, 2006		110,150		$	3.95		2.1 years
Granted		—		—			—
Exercised		(14,425	)	$	4.12
Forfeited or expired		(1,688	)	$	3.07
Outstanding at September 30, 2006		94,037		$	3.94		2.1 years			$	370,506
Exercisable at September 30, 2006		92,101		$	3.95		2.2 years			$	363,799

 

A summary of Cyanotech Corporation’s non-vested options for the quarter ended September 30, 2006 is presented below:

 

Nonvested Options		Shares		Weighted Average  Grant-Date Fair Value
Nonvested at June 30, 2006		2,250		$	3.84
Granted		—		—
Vested		—		—
Forfeited or expired		(314	)	$	3.81
Nonvested at September 30, 2006		1,936		$	3.85

 

A summary of option activity under Cyanotech Corporation Stock Plans for the six months ended September 30, 2006 is presented below:

 

Option Activity		Shares		Weighted Average  Exercise Price			Weighted Average  Remaining  Contractual Term		Aggregate Intrinsic  Value
Outstanding at March 31, 2006		117,230		$	3.91		2.3 years
Granted		—		—			—
Exercised		(16,000	)	$	4.10
Forfeited or expired		(7,193	)	$	2.96
Outstanding at September 30, 2006		94,037		$	3.94		2.1 years		$	370,506
Exercisable at September 30, 2006		92,101		$	3.95		2.2 years		$	363,799

 

A summary of Cyanotech Corporation’s non-vested options for the six months ended September 30, 2006 is presented below:

 

Nonvested Options		Shares		Weighted Average  Grant-Date Fair Value
Nonvested at March 31, 2006		2,953		$	3.98
Granted		—		—
Vested		—		—
Forfeited or expired		(1,017	)	$	4.22
Nonvested at September 30, 2006		1,936		$	3.85

 

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Prior to April 1, 2006, as allowed by Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), Accounting for Stock-Based Compensation, the Company elected to apply the intrinsic value-based method of accounting for employee based stock options and adopted only the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net loss and net (loss) per common share as if the Company had applied the fair-value method under SFAS No. 123 to its employee stock options for the three and six month comparable period ended September 30, 2005:

 

 

Options were exercised during the six month period ending September 30, 2006. The intrinsic value of options exercised during the six months ended September 30, 2006 was $1,000.  The amount of cash received from option exercises during the six months ended September 30, 2006 was $3,000.  Because qualified employee incentive options were exercised and the Company has significant operating loss carry forwards, there were no tax consequences as a result of option exercises during the six months ended September 30, 2006.

4.                                       INVENTORIES

Inventories are stated at the lower of cost (which approximates first-in, first-out) or market.  Market is defined as sales price less cost to dispose and a normal profit margin.  Inventories consist of the following (dollars in thousands):

 

 

5.                                       EQUIPMENT AND LEASEHOLD IMPROVEMENTS

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

 

 

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

 

6.                                       TERM LOAN AGREEMENT COVENANTS WAIVER

The Company’s long-term debt consists of a Term Loan Agreement (“Term Loan”) with a lender providing for $3.5 million in aggregate credit facilities, secured by the Company’s assets.   The Term Loan contains restrictive covenants.   The Company obtained a waiver of the debt covenants that may not be in compliance as a result of the restatement of previously issued financial statements and as related to the untimely submission of its quarterly financial statements for the first quarter ended June, 30, 2006 and the second quarter ended September 30, 2006 (see Note 2).

7.                                       EARNINGS PER SHARE

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

Reconciliations between the numerator and the denominator of the basic and diluted earnings per share computations for the three months ended September 30, 2006 and 2005 are as follows (in thousands, except per share amounts):

 

Reconciliations between the numerator and the denominator of the basic and diluted earnings per share computations for the six months ended September 30, 2006 and 2005 are as follows (in thousands, except per share amounts):

 

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

 

 

8.                                       NEW ACCOUNTING PRONOUNCEMENTS

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 151 (“SFAS No. 151”) “Inventory Costs — an Amendment of Accounting Research Bulletin No. 43, Chapter 4”.  SFAS No. 151 requires that abnormal amounts of freight, handling costs and wasted material (spoilage) be recognized as current-period charges and fixed production overhead costs be allocated to inventory based on the normal capacity of production facilities.  Normal capacity is defined as “the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance”.  Companies will no longer be permitted to capitalize inventory costs on the balance sheet when the production defect rate varies significantly from the expected defect rate.  The Company adopted SFAS No. 151 effective April 1, 2006. In accordance with SFAS No. 151 fixed production related costs of $59,000 or $0.01 per diluted share were not inventoried for the three months ended September 30, 2006, and fixed production related costs of $95,000 or $0.02 per diluted share were not inventoried for the six months ended September 30, 2006. The costs were not inventoried due to production below normal capacity.

In December 2004, the FASB issued SFAS No. 153, “Exchange of Nonmonetary Assets, an amendment of APB Opinion No. 29, “Accounting for Nonmonetary Transactions”.  SFAS No. 153 is based on the principle that exchange of nonmonetary assets should be measured based on the fair market value of the assets exchanged.  SFAS No. 153 eliminates the exception of nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance.  SFAS No. 153 is effective for nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005.  The Company adopted SFAS No. 153 effective April 1, 2006.  Adoption of the provisions of SFAS No. 153 had no material impact on the Company’s financial condition, results of operations, or liquidity.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3”.  SFAS No. 154 requires retrospective application for voluntary changes in accounting principle unless it is impracticable to do so.  In addition, indirect effects of a change in accounting principle should be recognized in the period of the accounting change.  The Company adopted SFAS No. 154 effective April 1, 2006.  Because the impact of adopting the provisions of SFAS No. 154 will be dependent on future events or circumstances, management cannot predict such impact.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN No. 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”.  This interpretation prescribes a “more-likely-than-not” recognition threshold and measurement attribute (the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement with tax authorities) for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006.  The Company will adopt FIN No. 48 on April 1, 2007 and has not yet determined the impact of these provisions on the Company’s results of operations, financial condition or liquidity.

In June 2006, the FASB ratified the consensus on Emerging Issues Task Force Issue No. 06-3 (“EITF No. 06-3”), “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement”.  The scope of EITF No. 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added, Universal Service Fund (USF) contributions and some excise taxes.  The Task Force affirmed its conclusion that entities should present these taxes in the income statement on either a gross or a net basis based on their accounting policy, which should be disclosed pursuant to APB Opinion No. 22, “Disclosure of Accounting Policies.”  If such taxes are significant and are presented on a gross basis, the amounts of those taxes should be disclosed.  The consensus on EITF No. 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006.  The Company will adopt EITF No. 06-3 on January 1, 2007 and has elected to present these taxes on a gross basis consistent with its accounting policy and historical treatment.   For future periods after January 1, 2007, if material, the Company will disclose such taxes.

On September 13, 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB No. 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements of Current Year Financial Statements” which expresses the SEC’s views regarding

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the process of quantifying financial statement misstatements.  SAB No. 108 provides guidance on the consideration of the effects of prior year misstatements (misstatements that were not corrected at the end of the prior year) in quantifying current year misstatements for the purpose of a materiality assessment.  Common practice in quantifying a misstatement allows for multiple approaches.   A misstatement can be based on the amount of the error originating in the current year income statement or be based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of the misstatement’s year(s) of origination.  Therefore, in quantifying the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements, errors should be measured under each approach and evaluated for materiality.  An adjustment would be required when either approach results in quantifying a misstatement that is material, as defined in FASB Concepts Statement No. 2, after considering all relevant quantitative and qualitative factors.  SAB No.108 is effective for fiscal years ended after November 15, 2006. Because the impact of adopting the provisions of SAB No. 108 will be dependent on future events or circumstances, management cannot predict such impact.

On September 15, 2006, the FASB issued SFAS No. 157, Fair Value Measurement (“SFAS 157”).  SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years.  The Company is evaluating the impact of adopting SFAS 157 on the Company’s consolidated financial position, results of operations and cash flows.

9.             LISTING STATUS: RESTATEMENT OF PREVIOUSLY ISSUED CONSOLIDATED FINANCIAL STATEMENTS

On December 1, 2006, Cyanotech Corporation filed a Current Report on Form 8-K with the SEC announcing that based on the current findings of its previously announced accounting review, it had determined to restate certain of its previously issued financial statements.   Since that time, we completed our accounting review and determined that certain of the errors resulted from deficiencies in our internal control over financial reporting.  See Item 4 Controls and Procedures in this Form 10-Q and Item 9A Controls and Procedures in Form 10-K/A filed February 14, 2007.   Due to the inventory valuation issues involved and the time and effort required for completion of the restatement reflected in the Form 10-K/A, the Company is delinquent in the filing of this Form 10-Q.  On December 18, 2006, the Company received a Determination Letter (the “Letter”) from the Nasdaq Listing Qualifications Hearings Panel (the “Panel”).  In its letter, the Panel granted, subject to certain conditions, the Company’s request for continued listing on the Nasdaq Stock Market.   The Panel determined the Company will have until February 20, 2007 to file its late Form 10-Q for the quarter ended June 30, 2006, its Form 10-Q for the quarter ended September 30, 2006, and the Form 10-K/A restatement filed February 14, 2007.  The decision represents the full extent of the Panel’s authority to grant an exception pursuant to Marketplace Rule 4002(b). The Company has filed an appeal on February 20, 2007 with the Nasdaq Listing and Review Council of the Panel’s determination requesting a stay of the delisting of its common stock until February 28, 2007.

The Company’s Form 10-K/A for the fiscal years ended March 31, 2006 and 2005 amended and restated the:
(1) consolidated balance sheets as of March 31, 2006 and 2005;
(2) consolidated statements of operations, stockholder’s equity and comprehensive income (loss) and cash flows for

each of the years in the three year period ended March 31, 2006;

(3) accumulated deficit as of March 31, 2003;

(4) selected financial data for the years ended March 31, 2006, 2005, 2004, 2003 and 2002; and

(5) certain financial data for the quarterly periods ended March 31, 2006, and December 31, September 30, June 30,

and March 31, 2005 and December 31, September 30, and June 30, 2004.

The errors or adjustments identified in our previously issued consolidated financial statements are as follows:
(A) We failed to include as a component of inventory cost certain fixed production costs such as depreciation, general

insurance and minor compensation cost into inventory.  Inventories for March 31, 2006, 2005, 2004 and 2003, and

quarterly periods within the years 2006 and 2005, were restated as were cost of sales and certain operating expenses

as included in the Consolidated Statements of Operations for each of the years in the three year period ended March

31, 2006.   This restatement was a result of the discovery of the error subsequent to the filing with the SEC of the

Original Form 10-K as filed with the SEC.  All inventories, cost of sales and operating expense balances, as

presented in this Form 10-Q, properly reflect the inventory which includes these fixed production costs in

accordance with Accounting Research Bulletin No. 43.

(B) We recorded certain Hawaii State Tax Credit adjustments which were considered immaterial in prior years. 

Refundable income taxes were restated for the year ended March 31, 2005.  Income tax expense (benefit) was

restated for each of the years in the three year period ended March 31, 2006 but had no impact on net loss for the

three and six months ended September 30, 2006 and 2005.

(C) We recorded certain interest income adjustments which were considered immaterial in prior years.  These impacted

the years ended March 31, 2004 and 2003 but had no impact on the three and six months ended September 30, 2005

and 2006.

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(D) We reclassified certain certificates of deposit from cash to short-term investments in fiscal years 2005 and 2004. 

These reclassifications had no effect on reported net income (loss) or in cash flows from operations for the years

ended March 31, 2005 and 2004.   Cash flows from operations for the three and six months ended September 30,

2005 were restated.

(E) We recorded certain tax adjustments which were considered immaterial to reports filed in prior periods.   These

adjustments impacted the years ended March 31, 2005, 2004 and 2003.   Cash flows from operations for the three

and six months ended September 30, 2005 were restated.

Quarterly data has been derived from our unaudited consolidated financial statements that, in our opinion, reflects all recurring adjustments necessary to fairly present our financial information when read in conjunction with our Consolidated Financial Statements and Notes.  This quarterly information has been restated for, and as of the end of, all quarters of fiscal 2006 and all quarters of fiscal 2005 from previously reported information filed on Forms 10-Q and Forms 10-K, as a result of the restatement of our financial results as discussed above.  The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.

The following tables set forth the amounts previously reported in the Company’s consolidated statements of operations for the three month period ended September 30, 2005 and the six months ended September 30, 2005 and the effect of the restatement adjustments, and the restated amounts.

 

		Consolidated Statement of Operations
		Three Months Ended September 30, 2005			Adjustments			Three Months Ended September 30, 2005
(in thousands, except per share data)		(As reported)						(As restated)
Net sales		$	2,517		$	—		$	2,517
Cost of sales (A)		1,936			(1		)	1,935
Gross profit		581			1			582
Operating expenses:
Research and development (A)		53			(1		)	52
Sales and marketing (A)		304			(4		)	300
General and administrative (A)		522			(18		)	504
Total operating expense		879			(23		)	856
Income (loss) from operations		(298		)	24			(274		)
Other income (expense):
Interest income		8			—			8
Interest expense		(35		)	—			(35		)
Other income, net		2			—			2
Total other expense, net		(25		)	(25		)
Income (loss) before income taxes		(323		)	24			(299		)
Income tax benefit		(2		)	—			(2		)
Net income (loss)		$	(321	)	$	24		$	(297	)
Net income (loss) per share:
Basic		$	(0.06	)	$	0.00		$	(0.06	)
Diluted		$	(0.06	)	$	0.00		$	(0.06	)
Shares used in calculation of net income (loss) per share:
Basic		5,224			—			5,224
Diluted		5,224			—			5,224

 

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		Consolidated Statement of Operations
		Six Months Ended Sept 30, 2005			Adjustments			Six Months Ended Sept. 30, 2005
(in thousands, except per share data)		(As reported)						(As restated)
Net sales		$	5,546		$	—		$	5,546
Cost of sales (A)		3,940			19			3,959
Gross profit		1,606			(19		)	1,587
Operating expenses:
Research and development (A)		99			(3		)	96
Sales and marketing (A)		637			(9		)	628
General and administrative (A)		960			(37		)	923
Total operating expense		1,696			(49		)	1,647
Income (loss) from operations		(90		)	(30		)	(60		)
Other income (expense):
Interest income		23			—			23
Interest expense		(90		)	—			(90		)
Other income, net		(8		)	—			(8		)
Total other expense, net		(75		)	—			(75		)
Income (loss) before income taxes		(165		)	30			(135		)
Income tax expense		3			—			3
Net income (loss)		$	(168	)	$	30		$	(138	)
Net income (loss) per share:
Basic		$	(0.03	)	$	0.00		$	(0.03	)
Diluted		$	(0.03	)	$	0.00		$	(0.03	)
Shares used in calculation of net income (loss) per share:
Basic		5,224			—			5,224
Diluted		5,224			—			5,224

 

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CYANOTECH CORPORATION

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

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

Restatement of Previously Issued Consolidated Financial Statements

On December 1, 2006, the Company filed a Current Report on Form 8-K with the SEC in which it announced that based on current findings of its previously announced accounting review it had determined to restate certain of its previously issued financial statements.  Since that time, the Company completed its accounting review and has determined that certain of the errors resulted from deficiencies in internal control over financial reporting.  See Item 9A. Controls and Procedures in the Company’s  Form 10-K/A filed on February 14, 2007. The Company did not file Form 10-K/A, for the fiscal years 2005 or 2004, or Form 10-Q/A, for the interim periods affected by the restatement prior to and including December 31, 2005, and such consolidated financial statements and related financial information, as previously filed, contain errors and should therefore no longer be relied upon. The related audit reports of KPMG LLP, the Company’s independent registered public accounting firm, with respect to those financial statements should also no longer be relied upon. Prior period comparative information contained in this form 10-Q has been restated consistent with the Company’s Form 10-K/A and to reflect the Company’s one-for-four reverse stock split as discussed under Item 1A “Risk Factors” sub heading “Market Price for Our Common Stock…” of the Form 10-K/A..

Overview

A comparison of selected consolidated statements of operations data as reported herein follows for the periods indicated (dollars in thousands):

 

		Three Months Ended September 30, 2006			Three Months Ended September 30, 2005 (As Restated)			Change
Net sales:
Spirulina products		$	1,436		$	1,330		8	%
Natural astaxanthin products		1,000			1,131			(12	)%
Other products		39			56			(30	)%
Total sales, all products		$	2,475		$	2,517		(2	)%
Gross profit		$	404		$	582		(31	)%
Loss from operations		$	(542	)	$	(274	)	98	%
Net loss		$	(572	)	$	(297	)	93	%

 

		Six Months Ended September 30, 2006			Six Months Ended September 30, 2005 (As Restated)			Change
Net sales:
Spirulina products		$	2,962		$	3,205		(8	)%
Natural astaxanthin products		1,890			2,199			(14	)%
Other products		67			142			(53	)%
Total sales, all products		$	4,919		$	5,546		(11	)%
Gross profit		$	875		$	1,587		(45	)%
Loss from operations		$	(853	)	$	(60	)	n/m	*
Net loss		$	(919	)	$	(138	)	566	%

* not meaningful

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Sales for the three and six months ended September 30, 2006 decreased $42,000 or 2% and $627,000 or 11% from the comparable three and six month periods of the prior year, respectively.  For the three month period, natural astaxanthin sales decreased 12% and Spirulina sales increased 8% from the comparable prior year period.   For the six month period, natural astaxanthin sales decreased 14% and Spirulina sales decreased 8% from the comparable prior year period.  The decrease in natural astaxanthin sales for both the three and six months periods was primarily due to decreased unit sales in the Japan aquaculture market as a result of increased price competition from synthetic based astaxanthin products.  We expected that warmer seasonal weather in Japan would increase the demand for our NatuRose astaxanthin product but the demand did not materialize and the market demand shortfall in Japan has persisted.  For the three month period, the increase in Spirulina sales resulted primarily from increased unit sales in our consumer packaged products outside of the United States. For the six month period, the decrease in Spirulina sales resulted primarily from decreased units and slightly decreased prices which were not offset by slightly increased units and slightly increased prices for consumer packaged products. Price decreases primarily resulted from discounts on large volume orders.

For the three and six month periods ended September 30, 2006 costs of sales increased 7% and 2%, respectively, when compared to the comparable prior year period.   For the three and six months ended September 30, 2006, variable production costs increased 12% and 13%, respectively, primarily in labor and chemicals.   Labor costs were impacted by wage increases during the first quarter of fiscal 2007 in response to a competitive labor market (primarily from the construction industry) in Hawaii.   Chemical costs increased as a result of increased consumption of nutrients, some of which were deemed to be period costs due to abnormal usage which was not effective in correcting an imbalance in the cultivation process.  Such period costs totaled approximately $143,000 in the second quarter of fiscal 2007 and $149,000 for the six months ended September 30, 2006.   Pursuant to SFAS No. 151, approximately $59,000 and $95,000 of fixed production overhead costs was not inventoriable during the three and six months ended September 30, 2006 because our natural astaxanthin production output was below normal capacity for both periods.  In addition, production costs associated with the Company’s animal nutrition market products were not inventoriable because such costs would have exceeded the market value for such inventory:  For the three months ended September 30, 2006 such costs approximated $127,000, while there were no such costs in the prior comparable period; and, for the six months ended September 30, 2006 and 2005, such costs approximated $245,000 and $1,000, respectively.

As a result of the decrease in sales coupled with the increase in cost of sales in both the three and six month periods, gross profit margins as a percentage of sales decreased to 16% for the three months ended September 30, 2006 as compared to 23% for the comparable prior year quarter and decreased to 18% for the six months ended September 30, 2006 as compared to 29% for the comparable prior year to date period.  Due to above factors, we expect that the Company’s gross profit margins during fiscal 2007 will continue to be less than the margins reported for comparable prior year periods while actions are currently underway to obtain production at desired capacity and quality levels.

Operating expenses, compared to the comparable prior year period, increased $90,000 or 11% for the three months and $81,000 or 5% for the nine months ended September 30, 2006.   The increase was primarily due to efforts associated with the restatement and filing process of the Company’s Form 10-K/A as well as late filings of Forms 10-Q and the related fees for accounting, auditing and contract services.

Lower gross profits and higher operating expenses resulted in a net loss of $572,000 for the second quarter of fiscal 2007 compared to net losses of $297,000 for the second quarter of the prior fiscal year and on a cumulative six months basis, a net loss of $919,000 the fiscal 2007 period compared to $138,000 a year ago.

Results of Operations

Second Quarter of Fiscal 2007 Compared to Second Quarter of Fiscal 2006

Net sales for the three months ended September 30, 2006 were $2,475,000, a 2% decrease from $2,517,000 for the comparable period a year ago.  This decrease was primarily from reduced sales of natural astaxanthin products partially offset by increased spirulina sales from the prior comparable period.

Company sales of spirulina products for the second quarter of fiscal 2007 were $1,436,000, an increase of 8% over the $1,330,000 generated in the second quarter of fiscal 2006.  As a percentage of sales, Spirulina represented 58% of total sales in the current period and 53% of sales in the prior comparable period.  Natural astaxanthin product sales were $1,000,000 during the second quarter of fiscal 2007, a 12% decrease from $1,131,000 in the second quarter of the prior year.  The natural astaxanthin product lines decreased to 40% of total sales over a 45% of total sales in the second quarter of fiscal 2006.   NatuRose sales continued to decrease as a result of lower demand in the Japanese aquaculture market and was a significant factor in the decrease in natural astaxanthin sales between

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the comparative quarters.  Other product sales were $39,000 and $56,000 for the second quarters of fiscal years 2007 and 2006, respectively.

International sales were 41% of total sales for the second quarter of fiscal 2007, compared to 50% a year ago.  For the three months ended September 30, 2006, our European distributor accounted for 10% of total sales as compared to 12% of total sales for the comparable months prior year period.  .

For the three months ended September 30, 2006 costs of sales increased 7% compared to the comparable prior year quarter.   For the three ended September 30, 2006, variable production costs increased 12% primarily in labor and chemicals.   Labor costs were impacted by wage increases during the first quarter of fiscal 2007 in response to a competitive labor market (primarily from the construction industry) in Hawaii.   Chemical costs increased as a result of increased consumption of nutrients, some of which were deemed to be period costs due to abnormal usage which was not effective in correcting an imbalance in the cultivation process.  Such period costs totaled approximately $143,000 in three months ended September 30, 2006.   Pursuant to SFAS No. 151, approximately $59,000 of fixed production overhead costs was not inventoriable during the three months ended September 30, 2006 because our natural astaxanthin production output was below normal capacity, and $60,000 of below normal capacity cost, prior to the adoption of SFAS No. 151, was recorded during the three months ended September 30, 2005. In addition, production costs associated with the Company’s animal nutrition market products totaling approximately $127,000 for the three months ended September 30, 2006 and nil for the three months ended September 30, 2005, were not inventoriable because such costs would have exceeded the market value for such inventory.  As a result of the decrease in sales coupled with the increase in cost of sales, gross profit margins as a percentage of sales decreased to 16% for the three months ended September 30, 2006 as compared to 23% for the comparable prior year quarter.

Operating expenses for the three months ended September 30, 2006 were $946,000 or 38% of sales, compared to $856,000 or 34% of sales for the three months ended September 30, 2005.  In the second quarter of fiscal 2007, sales and marketing and general and administrative expense were 8% and 13% above the comparable prior period, respectively, and research and development expenses remained consistent compared to the comparable period of the prior fiscal year.  The incremental general and administrative expenses were associated with the prior fiscal year’s restatement and filing of the Company’s Form 10-K/A, late filings of Forms 10-Q for the first and second quarters of fiscal year 2007, and, to a much lesser extent, the fees associated with the Company’s one for four reverse stock split on November 3, 2006 (Note 3).  The Company expects that total operating expenses will increase throughout the remainder of the fiscal year due to the efforts associated with the restatement and filing process of the Company’s Form 10-K/A as well as late filings of Forms 10-Q and the related fees for accounting, auditing and contract services. In addition, with respect to the reasons underlying the filing of Form 10-K/A, increased costs are expected as a result of management’s recommendation and the Company’s Audit Committee and Board of Directors approval and adoption of a remediation plan which includes that policies and procedures will be designed to ensure full compliance with Generally Accepted Accounting Principles (GAAP), particularly as it applies to inventory accounting, and will address key financial reporting risk elements, including the following: (a) ensuring that its disclosures are subject to adequate and rigorous review process prior to finalizing and releasing financial statements;  (b) continuing to update its inventory accounting systems and procedures to properly accommodate specific inventoriable fixed costs in accordance with GAAP; and (c) continuing to identify resources with the critical skills necessary to ensure full compliance with GAAP. The process related to error identification and subsequent restatement, originated in the second quarter of fiscal 2007.  Related audit, legal, outside consulting costs included in this Form 10-Q for the second quarter totaled $53,000.

Net other expense, which includes interest on the Company’s debt, for the second quarter of fiscal 2007 was $34,000, an increase from $25,000 for the same period a year ago.  This increase is primarily attributed to higher interest rates in the current reporting period on the Company’s outstanding debt.

For the second quarter of fiscal 2007, an income tax benefit of $4,000 was recorded, compared to an income tax benefit of $2,000 for the comparable period of the prior fiscal year.  The Company does not expect any expense to be recorded for United States income taxes in the current fiscal year as a result of available net operating loss carry forwards.

The result of the foregoing was a net loss of $572,000, or ($0.11) per diluted share, for the three months ended September 30, 2006, in comparison to net loss of $297,000, or ($0.06) per diluted share, for the comparable prior year quarter.  The higher net loss was the result of lower net sales and lower gross profit in conjunction with higher operating expenses in the current quarter.

Six Months Ended September 30, 2006 Compared to Six Months Ended September 30, 2005

Net sales for the six months ended September 30, 2006 were $4,919,000, a decrease of 11% from sales of $5,546,000 reported for the comparable period a year ago.  The reduction in sales over the prior year’s six-month period was largely the result of decreased sales of bulk products for both spirulina and natural astaxanthin, offset in part by increased sales in packaged products.  International sales represented 47% of net sales for the six months ended September 30, 2006 compared to 54% for the same period a year ago due to lower sales in Japan and Europe.  For the six months ended September 30, 2006 and September 30, 2005, our European distributor, accounted for 10% of total sales, with sales to our United States distributor accounting for less than 10% of total sales.

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