Cyanotech ( Nasdaq - CYAN ) -- Cranks it Up

Cyanotech (CYAN $8.25) reported excellent Q3 (Dec.) results, above our expectation.  Earnings (fully taxed) leaped to $.15 a share versus a breakeven performance the year before.  Sales advanced 71% to $6.71 million.  The company shifted a little of its astaxanthin output to higher margin retail customers.  But a big chunk was shipped to longstanding bulk buyers.  The transition to retail generally lifts per-pound selling prices by 100%-200%.  As more product moves into retail distribution revenues and margins promise to benefit directly.  Most of the period's revenue was derived from algae that was grown in earlier periods.  That material is sent out for processing at a variety of third party locations.  New production was pretty good, under the circumstances.  Volume was robust in October, fueled by abundant sunshine and technology enhancements.  November and December were unusually cloudy, though.  So there might be a drop-off  in upcoming periods as Q3 output goes into circulation.

The trend towards higher margin sales promises to keep profitability on a rising slope.  Cyantotech is gradually weaning its bulk buyers away from its astaxanthin production.  That output currently is being redirected to U.S. mainland specialty retailers.  Those stores typically are run by knowledgeable proprietors who are up to date on all the latest nutriceuticals.  The wave of publicity that cast Cyanotech into the limelight in 2011 still is resonating with that group.  The company also is drumming up business in Europe.  And demand is being reinforced with a significant investment in social media marketing.

The Costco relationship might expand.  Cyanotech has supplied astaxanthin to Costco stores in Hawaii for several years.  One of the chain's specialties is nutriceuticals.  Test marketing on the mainland could begin this year.  That test marketing alone could exert a noticable impact on Cyanotech's financial performance.  If the results are good and the rollout goes national substantial further leverage could emerge.

Cyanotech is tooling up to meet rising levels of demand.  A 33% expansion in growing capacity is nearing completion.  Those new ponds won't all produce at 100% right off the bat.  It might take six months to make all the necessary adjustments.  Still, unit volume should improve as the additional capacity starts to come on line in the June quarter.  Cyanotech also plans to expand its processing capacity so it won't have to send the raw algae out for extraction.  That build-up probably will take 18 months to complete.  Once in place turnaround time should improve, along with profit margins.

We are raising our fiscal 2012 (March) earnings estimate by a dime to $.40 a share (fully taxed).  Next year $.55 a share represents a realistic target.  The transition from bulk to retail distribution is likely to sustain growth at above average rates well into the decade.  More growing ponds could be added, supplying additional impetus.  Astaxanthin is believed to be one of the few nutriceuticals now on the market which produce genuine health benefits.  Cyanotech will have to maintain an effective marketing effort to keep that message in front of consumers.  Re-order rates always have been remarkably high by industry standards, though.  Once new customers are added those recurring revenue streams tend to stay in place.  In 2-3 years fully taxed earnings could reach $.75 a share.  Applying a P/E multiple of 20x suggests a target price of $15 a share.

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