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Cyanotech (NASDAQ:CYAN) reported lower-than-expected Q1 (June) results. The stock price fell $0.50, from $6.00 to $5.50, in the week after earnings were released on Aug. 10. The company is a leading producer of dietary supplements that are derived from algae. Production is based in Hawaii to take advantage of the abundant sunshine there. Cyanotech also pipes in cold water from the bottom of the Pacific Ocean to treat the algae after it's harvested, to boost potency. Until recently Spirulina was the company's key product. Athletes use it to enhance recovery after workouts and for a wide range of other health benefits. Demand for Spirulina is growing at a 5%-10% annual rate. Astaxanthin is a newer product that now has become Cyanotech's hottest selling line. Astaxanthin contains high levels of antioxidants and provides an even broader range of health benefits than Spirulina. Demand for Astaxanthin is burgeoning, and that trend appears likely to continue.

June quarter results were affected by production shortages. Sales rose 9% to $6.51 million. Backlog increased due to the inability to meet demand. Earnings (fully taxed) were flat year to year at $.07 a share. Cyanotech increased growing capacity by 33% in April. The new ponds all were devoted to Astaxanthin. They were rolled out throughout the quarter, though, so the incremental production built up over time. That material is shipped out to third parties, which perform an intermediate step called extraction. So the impact of the new ponds was limited. The Astaxanthin side of the business now is getting into full swing. A stronger contribution is likely in upcoming periods.

The Spirulina operation has become a drag. Abnormal costs impacted income by $0.02 a share in the June period. Output was below target as well, which affected sales. Measures have been implemented to contain the damage, but Spirulina probably will remain below potential at least for another quarter or two.

Legal costs are likely to affect margins, too. A bulk customer is trying to force Cyanotech to keep selling it a low margin version of Astaxanthin. Cyanotech has rebuffed the effort so far. The dispute is headed to court. A settlement appears achievable, but until a resolution is reached legal costs could impair income in future quarters.

New marketing efforts promise to reinforce growth. Cyanotech traditionally has sold most output in a bulk format to companies that combine it with other ingredients for sale to consumers. The company has beefed up marketing to address that higher margin opportunity directly. Those costs could impact profitability in the near term. But sales of packaged goods already are climbing. And that trend promises to support expanded margins despite the rising marketing, legal, and production costs Cyanotech is facing.

We have reduced our earnings estimate to $0.50 a share to reflect the rising expense levels. Next year, $0.65 a share represents a realistic target as more output heads directly into the retail channel. Major new retail accounts are being cultivated. Growth could be sustained at above average levels well into the decade.

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Disclosure: I am long CYAN.

Source: Cyanotech Gets Drilled