Monday, October 6, 2014

Cyanotech ( Nasdaq - CYAN ) - Sees Daylight

Cyanotech (CYAN $4.55) is a Hawaiian based producer of specialty nutritional supplements.  Both of the company's products are strains of algae that thrive in the abundant sunlight that Hawaii provides.  Competitors exist.  But Cyanotech is the market leader in both segments.  Astaxanthin accounts for two-thirds of sales and currently is the faster growing product line.  Demand surged a few years ago after Dr. Oz recommended it on his widely viewed television show.  Sales have continued to advance since that time.  Astaxanthin reduces sunburn, joint pain, and macular degeneration.  It also contains anti-aging properties ("antioxidents").  Spirulina, the company's second product, is popular among serious athletes because it improves recovery time after strenuous workouts.  It also possesses large amounts of antioxidents.

Both lines are cultivated in outdoor growing ponds.  Production rises during the summer and falls in the winter due to the amount of sunshine available.  Cyanotech has developed a repeatable process that generates fairly consistent results.  Last year production was impacted by an unusual series of storms.  But weather conditions usually are excellent in Hawaii.  Technical innovation is helping to increase production at the company's existing facility, moreover.  The Obama Administration, as part of its stimulus package in 2009, spent billions in an attempt to develop algae based biofuels.  That effort fell flat.  But the research generated several new strains of astaxanthin with higher yields than Cyanotech's legacy version.  Last year the company established a relationship with one of those research groups.  Several new strains have been tested.  Three have demonstrated significantly higher yields with the same medicinal benefits.  They now are being introduced into more growing ponds.

Output per acre is expanding, too.  Over the past year Cyanotech reduced the size of a few growing ponds in a pilot program.  The algae concentration remained the same.  Total output was identical.  The company now is modifying more ponds to the shorter format.  Once that's completed it plans to construct additional ponds on the excess land created.  Cyanotech also has an option to lease an adjacent property, which could support further expansion.

Cyanotech has shifted its focus towards the consumer market.  For most of the company's history Cyanotech sold its output to other companies that combined it with additional ingredients.  When new management took the helm three years ago Cyanotech began to emphasize the retail channel, developing its own brand of pure astaxanthin.  Bolstered by the Dr. Oz publicity the company has gained more than 50% of the consumer market.  Most sales currently are made through specialty health food stores and similar internet sites.  Over the past year, though, the company has added larger retailers including Vitamin Shoppe, Whole Foods, and Sprouts to its network.  A test with Costco recently was started, moreover, which could amplify performance further.  Margins and revenue from consumer products are higher than on the old bulk sales.  Results promise to accelerate as the transition continues, reinforced by the larger retail partners.

Earnings were virtually erased over the last two years by costs associated with a patent lawsuit.  Cyanotech declined to settle the case, which would have required it to supply astaxanthin in large quantities at bulk prices.  The tables appear to have turned in Cyanotech's favor as the discovery process continued.  The patent in question hasn't held up under scrutiny.  The company still would prefer to settle the case.  But if it does go to court -- a date is scheduled for next March -- Cyanotech could win a large monetary award, in addition to ending the legal outlays.

Reported earnings promise to surge once the legal expense ends.  We estimate income (fully taxed) could jump to $.60 a share next year and keep advancing at a fast pace beyond.  In 2-3 years earnings could reach $.80-$1.00 a share.  That assumes additional stock will be sold to finance growth.  Applying a P/E multiple of 20x to the midpoint of the range suggests a target price of $18 a share, potential appreciation of 295% from the current quote.

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