Thursday, December 15, 2011

Cyanotech ( Nasdaq - CYAN ) -- Catches a Wave

Cyanotech (CYAN $8.25) is a leading producer of nutriceutical products used by high performance athletes and other health conscious consumers.  The company's products are derived from algae, which is harvested from a network of growing ponds in a Hawaiian industrial park.  Cyanotech's leading product historically was Spirulina Pacifica, a dietary supplement that provides energy, cardiovascular benefits, and antioxidents that delay the aging process.  That line is a favorite of distance runners and other high endurance athletes to raise performance and enhance recovery.  A second algae based line, BioAstin, was developed more than a decade ago.  That product offers a wider range of benefits including skin, eye, and joint support and reduced inflamation, along with an even greater level of antioxidents.  Demand never gained momentum, however, due to intense competition for shelf space and the lack of a major marketing effort. 

All that changed early in 2011.  BioAstin was featured on the popular Doctor Oz television show.  The segment was repeated two additional times at 2-3 month intervals.  The claim was made that BioAstin was the #2 supplement in the world, right after Vitamin D.  Demand immediately rocketed after the television broadcasts.  And volume has continued to build.  Repeat business has been strong and new consumers continue to try the product.

Most astaxanthin (BioAstin's central ingredient) sales historically were made to bulk buyers.  Part of the output was used by salmon farmers to color the meat like wild fish.  The farmed version comes out white without the additive.  The rest was sold to bigger supplement companies that included astaxanthin in a variety of consumer offerings.  Cyanotech sold some BioAstin directly to retailers in Hawaii, including Costco.  It also landed a few accounts on the mainland, and operated a small direct sales operation.  Prior to the Doctor Oz breakthrough, though, most revenue was generated by the Spirulina Pacifica line.  Overall growth was moderate.  Profitability was okay.  But there wasn't any real excitement in the picture.

Cyanotech kept a low profile during the initial blast-off.  New management had just taken the helm.  And the company wanted to make sure the increase wouldn't be short-lived.  Demand has continued to build, alleviating those concerns.  Measures now are being implemented to capitalize on the burgeoning opportunity.  Physical capacity is being expanded by 33%.  The poor economy has enabled Cyanotech to obtain space inside its existing office park, simplifying logistics.  Productivity at existing ponds is improving, too.  And less output is being directed to bulk purchasers.  New retail distribution is being arranged instead, at higher selling prices.  An advanced processing unit is slated to go on line over the next 18 months, moreover, boosting turnaround time and margins.  A new name for BioAstin is being evaluated, as well, to lift consumer appeal.

Sales advanced 54% in the June period to $5.95 million.  Fully taxed earnings climbed 40% (excluding stock option expense) to $.07 a share. In Q2 (September) sales jumped another 56% to $5.99 million.  Earnings improved 86% to $.13 a share.  Revenues depend on the amount of algae produced.  And that volume typically declines in the winter because there is less sunlight.  In the year ago December quarter Cyanotech had inventory in reserve to keep revenues intact.  This year the shelves are bare due to the surge in demand.  So a less vibrant comparison may be in the cards.  Cyanotech also is beefing up marketing and other business development activities.  So margins also might get compressed by those additional costs.  The company has a lot of scientific talent on hand, though, so output might turn out to be better than historical metrics would suggest.  Astaxanthin prices are rising, moreover, a trend that's likely to continue and reinforce performance in future periods.

We estimate fiscal 2012 (March) earnings will finish around $.30 a share (fully taxed).  Next year $.45 a share represents a realistic target.  A variety of risks will be encountered over the long haul.  BASF and a slew of Chinese chemical producers are developing synthetic versions of astaxanthin.  The initial target is the fish farming industry.  But over time the lower cost (lower quality) competition could affect Cyanotech's consumer operations.  The industry itself is incredibly competitive and flighty.  Dietary supplements come and go all the time.  It's extremely hard to establish a recurring business, and the marketing costs to sustain demand are steep.  Spending increases that coincide with temporary demand decreases are capable of generating dramatic earnings reversals.  Weather vagaries and other logistical issues present a danger, as well.  On top of that new chairman could take over the two Congressional committees that oversee diet supplements.  Those individuals are considered less supportive of the industry, so regulatory hurdles could become more pronounced.

If Cyanotech avoids those pitfalls sales could reach $50 million in 2-3 years.  Earnings could attain $.75 a share.  Applying a P/E multiple of 20x suggests a target price of $15 a share, potential appreciation of 80% from the current quote.

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