Cyanotech ( Nasdaq - CYAN ) -- Demand Accelerates

Cyanotech (CYAN $4.70) appears on track to produce reasonably good Q4 (March) results.  The company is the leading producer of algae used in natural supplements used by high endurance athletes and other health conscious consumers.  Over the years Cyanotech was scientifically focused.  Resources were devoted to enhancing quality and production.  Marketing was given short shrift.  Until the current management arrived on the scene most output was sold in bulk quantities to other nutrition companies that combined it with additional ingredients, and resold it at a big mark-up.  The new management team took the scientific side of the business and put their efforts into developing Cyanotech's own direct sales channels.  That project is working.  The company's branded products have gained the leading market share in the independent health store channel.  That percentage is over 33% and it's continuing to rise.  New products are being developed to expand that penetration.  New brand names are in the works to allow the company to move into the high volume chain store segment without disrupting the specialty business.

Last year the scientists let the company down.  Production snafus curtailed production.  That in turn affected margins.  And it all took place at a time when marketing costs were accelerating.  That was a dangerous combination that sliced the stock price in half.  The damage was contained because a rising percentage of sales were shifting from low margin bulk customers to higher priced retail channels.  The retail initiative remains in an early stage of development, though.  Only 33% of the company's physical output is sold at those higher prices currently.  The rest is still sold to bulk customers.  But the future was uncertain because of the production problems.  They had to be resolved before Cyanotech could put the pedal to the metal on the marketing front.

It looks like the setback has been fixed.  Output has blossomed over the past month.  And there appears to be a logical explanation for the problem, and the solution.  Fourth quarter performance will be impacted by the temporary slowdown in production.  It takes several months to turn around an algae crop.  But output promises to rise in upcoming months as the changes are implemented and more sunshine lifts output further. 

The long term outlook remains bright.  Cyanotech has two products with leading market shares in high growth segments.  The natural products industry continues to expand overall.  The areas targeted by the company are growing 10%-20% a year.  And pricing to the retail channel brings Cyanotech 2x-3x the revenue it garners from bulk sales.  As the 67% of output now devoted to bulk converts to retail pricing both revenue and margins promise to expand.  Production capacity might be expanded, as well. 

We estimate sales will improve 10%-20% in the coming fiscal year to $30-$33 million.  Demand already is outstripping supply.  Cyanotech's high octane marketing program is poised to deliver further impetus.  Production probably will be the limiting factor.  That's a complete reversal from past years.  Our single point estimate assumes some lingering effects.  Earnings should climb nonetheless on the strength of expanding gross margins.  Overhead costs are likely to be constrained, moreover, until the rebound in output demonstrates greater certainty.  Income could reach $.50 a share.  In 2-3 years sales could attain $50 million to provide income of $.75 a share.  That figure assumes the sale of an additional 2 million shares to support growth.

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