UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
  WASHINGTON,
D.C. 20549
  FORM
10-Q
  x  Quarterly
Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934
  For the
quarterly period ended December 31, 2008
   ̈ Transition Report Pursuant to Section
13 or 15(d) of the Securities Exchange Act of 1934
  For the
transition period from ____________ to ____________
  Commission
File No. 0-21537
  Pacific
Biometrics, Inc.
 (Exact
name of registrant as specified in its charter)
 
 Delaware
              93-1211114(State
      or other jurisdiction of incorporation
                or
      organization)
              (I.R.S.
      Employer Identification No.)
 
 220
      West Harrison Street
                Seattle,
      Washington
                (Address
      of principal executive offices)
              98119
                (Zip
      Code)
 
 (206)
298-0068
 (Issuer’s
telephone number, including area code)
 
 Indicate
by check mark whether the issuer: (1) filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the past 12 months (or for such shorter period that the registrant was
required to file for such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes  x  No   ̈
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
 
 Large accelerated filer  ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈
              Smaller
      reporting company x
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
 Yes   ̈  No  x
 
 As of
February 10, 2009, there were 19,099,539 shares of the registrant’s common
stock, $0.01 par value per share, issued and outstanding.
 
  PACIFIC
BIOMETRICS, INC.
 
 INDEX TO
FORM 10-QSB
 
 PagePART
      I - FINANCIAL INFORMATIONITEM
      1 - FINANCIAL STATEMENTSConsolidated
      Balance Sheets as of December 31, 2008 (unaudited) and June 30, 2008
      (audited)
                                  4Consolidated
      Statements of Operations for the three- and six-month periods ended
      December 31, 2008 and 2007 (unaudited)
                                  5Consolidated
      Statements of Cash Flows for the six-month periods ended December 31, 2008
      and 2007 (unaudited)
                                  6Notes
      to Consolidated Financial Statements (unaudited)
                                  7ITEM
      2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
                                  12ITEM
      4T - CONTROLS AND PROCEDURES
                                  19PART
      II - OTHER INFORMATIONITEM
      5 – OTHER INFORMATION
                                  20ITEM
      6 - EXHIBITS
                                  21SIGNATURES
                                  21
  2
  EXPLANATORY
NOTE
 
 Unless
otherwise indicated or the context otherwise requires, all references in this
Report to “we,” “us,” “our,” and the “Company” are to Pacific Biometrics, Inc.
and our wholly-owned subsidiaries Pacific Biometrics, Inc., a Washington
corporation, Pacific Biomarkers, Inc., PBI Technology, Inc., and BioQuant,
Inc.
 
 CAUTIONARY
NOTE REGARDING FORWARD LOOKING STATEMENTS
 
 This
Quarterly Report on Form 10-Q may contain a number of forward-looking
statements, including statements regarding:
 
 ·
              our
      estimates for future revenues and cost of revenues, including sources of
      revenue and anticipated revenue;
 ·
              our
      expectations regarding future expenses, including research and development
      expenses and sales and marketing
expenses;
 ·
              our
      estimates regarding the adequacy of our capital resources, working capital
      and cash flows, as well as our estimates as to how long these funds will
      be sufficient to fund our
operations;
 ·
              our
      business development efforts and our expectations for future work orders
      for laboratory services, referral laboratory services and biomarker
      services;
 ·
              our
      intentions for the development of new services and products and the
      expansion of the market for our current services and products, and our
      expectations for our clinical biomarker
  services;
 ·
              our
      goals for implementing aspects of our business plan and strategies;
      and
 ·
              our
      capital requirements, financing goals and plans, including our prospects
      of raising of additional capital through future equity and debt
      financings, as necessary.
 
 The
forward-looking statements in this Report reflect management’s current views and
expectations with respect to our business, strategies, products, future results
and financial performance. All statements other than statements of historical
fact, including statements addressing projected results of operations or our
future financial position, made in this Quarterly Report on Form 10-Q are
forward looking statements.  In particular, the words “expect,”
“anticipate,” “estimate”, “desire”, “goal”, “ believe”, “may”, “will”, “should”,
“intend”, “objective”, “seek”, “plan”, “strive”, variations of such words, or
similar expressions, or the negatives of these words, are intended to identify
forward-looking statements, but are not the exclusive means of identifying
forward-looking statements.  The absence of these words does not mean
that any particular statement is not a forward-looking statement.
 
 These
forward-looking statements are subject to risks and uncertainties. Our actual
results, performance or achievements could differ materially from historical
results as well as those expressed in, anticipated or implied by these
forward-looking statements.  We expressly disclaim any obligation or
undertaking to release publicly any updates or revisions to any forward-looking
statements contained in this Report to reflect any change in management’s
expectations with regard thereto or any change in events, conditions or
circumstances on which any such statement is based.
 
 For a
discussion of some of the factors that may affect our business, results and
prospects, see  the Risk Factors discussed in our Annual Report on
Form 10-K for the fiscal year ended June 30, 2008.  These risks and
uncertainties include, but are not limited to, the concentration of our business
with large clients, our ability to develop new technology and introduce new
products, competition, fluctuations in general economic conditions, the risk of
bankruptcy, and changes in policies by regulatory agencies.  Readers
are urged to carefully review and consider the various disclosures made by us in
this Report and in our other reports previously filed with the Securities and
Exchange Commission, including our periodic reports on Forms 10-K, 10-Q and 8-K,
and those described from time to time in our press releases and other
communications.
  3
 
 PACIFIC
BIOMETRICS, INC.
 CONSOLIDATED
BALANCE SHEETS
 
 December 31,
                      
                      
                      June 30,2008
                      
                      
                      2008(unaudited)
                      
                      
                      (audited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                      
                      $
                      1,279,633
                      
                      
                      $
                      1,196,310Accounts
      receivable, net
                      
                      
                      2,022,388
                      
                      
                      
                      2,146,080Other
      receivable, net
                      
                      
                      -
                      
                      
                      
                      451,291Inventory
                      
                      
                      246,049
                      
                      
                      
                      197,456Prepaid
      expenses and other assets
                      
                      
                      174,770
                      
                      
                      
                      100,869Deferred
      financing cost on secured convertible note - current
    portion
                      
                      
                      -
                      
                      
                      
                      18,447Total
      current assets
                      
                      
                      3,722,840
                      
                      
                      
                      4,110,453Property
      and equipment, net
                      
                      
                      885,681
                      
                      
                      
                      884,521Total
      assets
                      
                      $
                      4,608,521
                      
                      
                      $
                      4,994,974LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
                      
                      $
                      713,292
                      
                      
                      $
                      818,224Accrued
      liabilities
                      
                      
                      392,484
                      
                      
                      
                      450,788Advances
      from customers
                      
                      
                      723,717
                      
                      
                      
                      643,291Capital
      lease obligation - current portion
                      
                      
                      47,204
                      
                      
                      
                      32,530Secured
      convertible note, net of unaccreted fair value assigned to conversion
      feature and warrants of $0 and $214,771, respectively
                      
                      
                      -
                      
                      
                      
                      678,535Embedded
      derivative liability
                      
                      
                      -
                      
                      
                      
                      642,470Freestanding
      derivative liability
                      
                      
                      -
                      
                      
                      
                      411,545Other
      notes payable - current portion
                      
                      
                      -
                      
                      
                      
                      102,467Total
      current liabilities
                      
                      
                      1,876,697
                      
                      
                      
                      3,779,850Capital
      lease obligations - long - term portion
                      
                      
                      164,126
                      
                      
                      
                      91,109Total
      liabilities
                      
                      
                      2,040,823
                      
                      
                      
                      3,870,959Commitments
      and contingencies
                      
                      
                      -
                      
                      
                      
                      -Stockholders'
      equity:Preferred
      stock, Series A convertible $0.01 par value, 5,000,000 shares authorized,
      0 shares issued and outstanding for 2008
                      
                      
                      -
                      
                      
                      
                      -Common
      stock, $0.01 par value, 30,000,000 shares authorized, 19,099,539 and
      18,720,147  shares issued and outstanding,
      respectively,
                      
                      
                      190,995
                      
                      
                      
                      187,201Additional
      paid-in capital
                      
                      
                      29,110,233
                      
                      
                      
                      28,641,278Accumulated
      deficit
                      
                      
                      (26,733,530
                      )
                      
                      
                      (27,704,464
                      )Total
      stockholders' equity
                      
                      
                      2,567,698
                      
                      
                      
                      1,124,015Total
      liabilities and stockholders' equity
                      
                      $
                      4,608,521
                      
                      
                      $
                      4,994,974
  4
 
 PACIFIC
BIOMETRICS, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (unaudited)
 
 Three
      Months Ended
                  
                  
                  Six
      Months EndedDecember 31,
                  
                  
                  December 31,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Revenues
                  
                  $
                  3,230,913
                  
                  
                  $
                  1,647,535
                  
                  
                  $
                  5,035,955
                  
                  
                  $
                  3,729,197Laboratory
      expenses and cost of sales
                  
                  
                  1,570,235
                  
                  
                  
                  1,145,003
                  
                  
                  
                  2,673,604
                  
                  
                  
                  2,367,683Gross
      profit
                  
                  
                  1,660,678
                  
                  
                  
                  502,532
                  
                  
                  
                  2,362,351
                  
                  
                  
                  1,361,514Operating
      expenses:Selling,
      general and administrative
                  
                  
                  1,106,173
                  
                  
                  
                  1,231,715
                  
                  
                  
                  2,021,218
                  
                  
                  
                  2,146,150Operating
      income (loss)
                  
                  
                  554,505
                  
                  
                  
                  (729,183
                  )
                  
                  
                  341,133
                  
                  
                  
                  (784,636
                  )Other
      income (expense):Interest
      expense
                  
                  
                  (8,868
                  )
                  
                  
                  (59,843
                  )
                  
                  
                  (50,882
                  )
                  
                  
                  (136,377
                  )Interest
      expense from accretion of conversion feature and warrants – secured
      convertible debt
                  
                  
                  (19,760
                  )
                  
                  
                  (183,952
                  )
                  
                  
                  (88,804
                  )
                  
                  
                  (386,935
                  )Gain
      on adjustment of embedded and freestanding derivatives to fair
      value
                  
                  
                  343,121
                  
                  
                  
                  151,632
                  
                  
                  
                  675,691
                  
                  
                  
                  332,860Amortization
      of deferred financing costs - secured convertible debt
                  
                  
                  -
                  
                  
                  
                  (26,792
                  )
                  
                  
                  (18,447
                  )
                  
                  
                  (53,585
                  )Other
      income
                  
                  
                  107,673
                  
                  
                  
                  29,919
                  
                  
                  
                  112,243
                  
                  
                  
                  61,889Total
      other income (expense)
                  
                  
                  422,166
                  
                  
                  
                  (89,036
                  )
                  
                  
                  629,801
                  
                  
                  
                  (182,148
                  )Net
      income (loss) before tax expense
                  
                  
                  976,671
                  
                  
                  
                  (818,219
                  )
                  
                  
                  970,934
                  
                  
                  
                  (966,784
                  )Tax
      expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      income (loss)
                  
                  $
                  976,671
                  
                  
                  $
                  (818,219
                  )
                  
                  $
                  970,934
                  
                  
                  $
                  (966,784
                  )Net
      income (loss) per share
                  
                  $
                  0.05
                  
                  
                  $
                  (0.04
                  )
                  
                  $
                  0.05
                  
                  
                  $
                  (0.05
                  )Weighted
      average common shares outstanding, basic and diluted:
                  
                  
                  19,039,524
                  
                  
                  
                  18,920,147
                  
                  
                  
                  18,964,873
                  
                  
                  
                  18,713,240
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  5
  PACIFIC
BIOMETRICS, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (unaudited)
 
 Six
      Months EndedDecember 31,2008
                    
                    
                    2007Cash
      flows from operating activities:Net
      income (loss)
                    
                    $
                    970,934
                    
                    
                    $
                    (966,784
                    )Reconciliation
      of net loss to net cash provided by operating activities:Depreciation
      and amortization
                    
                    
                    121,940
                    
                    
                    
                    137,345Accretion
      of fair value assigned to conversion feature and warrants
                    
                    
                    88,134
                    
                    
                    
                    386,935Amortization
      of deferred financing costs on  secured convertible
      note
                    
                    
                    18,447
                    
                    
                    
                    53,585Gain
      from embedded and freestanding derivative liabilities relating to
      secured  convertible note
                    
                    
                    (675,691
                    )
                    
                    
                    (332,860
                    )Warrant
      expense for equipment lease and financing
                    
                    
                    3,943
                    
                    
                    
                    5,911Compensation
      expense from restricted shares and options
                    
                    
                    90,485
                    
                    
                    
                    158,402Changes in assets and
      liabilities:Accounts
      receivable
                    
                    
                    123,692
                    
                    
                    
                    331,173Other
      receivable
                    
                    
                    451,291
                    
                    
                    
                    -Inventory
                    
                    
                    (48,593
                    )
                    
                    
                    (38,586
                    )Prepaid
      expenses and other assets
                    
                    
                    (73,901
                    )
                    
                    
                    (105,248
                    )Advances
      from customers
                    
                    
                    80,425
                    
                    
                    
                    (74,382
                    )Accounts
      payable
                    
                    
                    (104,933
                    )
                    
                    
                    48,119Accrued
      liabilities
                    
                    
                    (58,305
                    )
                    
                    
                    (41,406
                    )Net
      cash  provided by (used in) operating activities
                    
                    
                    987,868
                    
                    
                    
                    (437,796
                    )Cash
      flows from investing activities:Purchases
      of capital equipment
                    
                    
                    (14,783
                    )
                    
                    
                    (20,609
                    )Net
      cash used in investing activities
                    
                    
                    (14,783
                    )
                    
                    
                    (20,609
                    )Cash
      flows from financing activities:Payments
      on notes payable
                    
                    
                    (869,136
                    )
                    
                    
                    (854,190
                    )Payments
      on capital lease obligations
                    
                    
                    (20,626
                    )
                    
                    
                    (38,655
                    )Net
      cash used in financing activities
                    
                    
                    (889,762
                    )
                    
                    
                    (892,845
                    )Net
      increase (decrease) in cash and cash equivalents
                    
                    
                    83,323
                    
                    
                    
                    (1,351,251
                    )Cash
      and cash equivalents, beginning of period
                    
                    
                    1,196,310
                    
                    
                    
                    4,219,926Cash
      and cash equivalents, end of period
                    
                    $
                    1,279,633
                    
                    
                    $
                    2,868,675Supplemental
      Information:Cash
      paid during the period for interest
                    
                    $
                    59,505
                    
                    
                    $
                    116,659Non-cash
      investing and financing activities:Capital
      expenditures funded by capital lease borrowings
                    
                    $
                    108,316
                    
                    
                    $
                    -
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
  6
 
 PACIFIC
BIOMETRICS, INC.
 
 CONDENSED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 1.
              Organization
      and Basis of Presentation
 
 We
provide specialty reference laboratory services to the pharmaceutical, biotech,
and diagnostics industries.  Our company was incorporated in Delaware
in May 1996.  We conduct our business primarily through our
wholly-owned subsidiary, Pacific Biometrics, Inc., a Washington
corporation.  Our three other wholly-owned subsidiaries are Pacific
Biomarkers, Inc., a Washington corporation, PBI Technology, Inc., a Washington
corporation, and BioQuant, Inc., a Michigan corporation.  All material
intercompany balances and transactions have been eliminated in the accompanying
consolidated unaudited interim financial statements.
 
 Unaudited
interim financial statements include all adjustments such as normal recurring
accruals that are, in the opinion of management, necessary for a fair statement
of results of interim periods.  Operating results for the three- and
six-month periods ended December 31, 2008 are not necessarily indicative of the
results that may be expected for any future period.  The accompanying
unaudited financial statements and related condensed notes should be read in
conjunction with the audited financial statements and notes thereto, for our
fiscal year ended June 30, 2008, as previously reported in our annual report on
Form 10-K.
 
 2.
              Summary
      of Significant Accounting Policies
 
 Principles
of Consolidation
 
 These
consolidated financial statements include our consolidated financial position,
results of operations, and cash flows.  All material intercompany
balances and transactions have been eliminated in the accompanying consolidated
financial statements.
 
 Cash
and Cash Equivalents
 
 Cash and
cash equivalents consist of highly liquid investments with an original maturity
of three months or less when purchased.
 
 Accounts
Receivable
 
 Trade
accounts receivable are stated at amounts billed to and due from clients, net of
an allowance for doubtful accounts.  Credit is extended based on
evaluation of a client’s financial condition, and collateral is not required. In
determining the adequacy of the allowance, management identifies specific
receivables for which collection is not certain and estimates the potentially
uncollectible amount based on the most recently available information. We write
off accounts receivable when they are determined to be uncollectible, and
payments subsequently received on such receivables are credited to the allowance
for doubtful accounts. At December 31, 2008, we deemed no additional accounts
receivable uncollectible.
 
 Other
accounts receivable consist of non-trade receivables such as state business and
occupation tax refunds, notes receivable and employee accounts
receivable.  These receivables are stated at amounts per invoice or
agreement and due from other parties, net of an allowance for doubtful accounts.
They are evaluated with the same methods as utilized for trade accounts
receivable.  At December 31, 2008, there were no other
receivables.
 
 Inventory
 
 Inventory
is stated the lower of cost or market.  Cost is determined on a first
in, first out (FIFO) basis. Our inventory consists of reagent chemicals used in
our laboratory testing.
 
 Long
–Lived Assets
 
 Property
and equipment are recorded at cost.  Depreciation is provided using
the straight-line method over the useful lives of the related assets, which
range from three to five years. Leasehold improvements are amortized over the
shorter of the estimated useful life of the improvements or the remaining term
of the lease. The cost and related accumulated depreciation of property or
equipment sold or otherwise disposed of are removed from the accounts and the
resulting gains or losses are included in the statement of
operations.
  7
  In
accordance with the Financial Accounting Standards Board’s Statements of
Financial Accounting Standards Statement No. 144 – “Accounting for the Impairment or
Disposal of Long-Lived Assets” (“SFAS 144”), all of our long-lived assets
are reviewed for impairment whenever events or changes in circumstances indicate
the carrying amount may not be recovered.  If the sum of the expected
future cash flows is less than the carrying amount of the asset, a loss is
recognized.
 
 Client
Advances
 
 We
receive advances from certain clients to perform consulting, laboratory
services, and clinical studies. We apply these advances as payments to invoices
as work is completed until the amounts advanced are
exhausted.  Advances are also applied to invoices for setup and
administrative fees, billed upon contract approval. These setup and
administrative fees are deferred as unearned income when billed and amortized
over the life of the project.
 
 Income
Taxes
 
 We
recognize deferred tax assets and liabilities based on differences between the
financial reporting and tax bases of assets and liabilities using the enacted
tax laws and rates that are expected to be in effect when the differences are
expected to be recovered. We provide a valuation allowance for deferred tax
assets due to the uncertainty of realization. We follow SFAS 109, as amended, to
prepare our income tax reporting.
 
 Financial
Instruments
 
 The
carrying amounts of cash, cash equivalents, and accounts receivable approximate
fair value due to the short-term maturities of these instruments.  The
carrying value of our secured convertible note is recorded net of the
unamortized fair value assigned to the conversion feature and warrants,
representing its estimated fair value.  The carrying value of our
other debt approximates their estimated fair values due to the rates of interest
on the debt approximate current interest rates for similar obligations with like
maturities.
 
 Financial
Derivatives – Embedded Features
 
 Embedded
conversion and other features embedded in convertible notes are accounted for in
accordance with Statement of Financial  Accounting Standard (“SFAS)
No. 133 “Accounting for
Derivative Instruments and Hedging Activities” (“SFAS 133”) and EITF
00-19 “Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in a
Company’s Own Stock” (“EITF 00-19”). SFAS 133 generally requires
companies to bifurcate conversion features embedded in convertible notes from
their host instruments and to account for them as freestanding derivative
financial instruments in accordance with EITF 00-19.
 
 Our
convertible notes host conversion features and other features that are deemed to
be embedded derivatives financial instruments or beneficial conversion features
based on the commitment date fair value of the underlying common
stock.  These notes meet the definition of derivative financial
instruments and have, where applicable, been bifurcated from host instruments
and are carried at fair value.  We record the value allocated to
warrants issued with the convertible notes, measured at fair value and
recognized by allocating a portion of the proceeds to derivative liabilities
with an offset to discount on the convertible note. The recorded discount is
accreted as interest expense using the effective interest method over the life
of the debt.
 
 Common
Stock Purchase Warrants and Other Derivative Financial Instruments
 
 We
generally do not use derivative financial instruments to hedge exposures to cash
flow or market risks. We account for the issuance of common stock purchase
warrants issued and other free standing derivative financial instruments in
accordance with the provisions of EITF 00-19. Based on the provisions of EITF
00-19, we classify as equity any contracts that (i) require physical settlement
or net-share settlement or (ii) give us a choice of net-cash settlement or
settlement in its own shares (physical settlement or net-share
settlement).  We classify as assets or liabilities any contracts that
(i) require net-cash settlement (including a requirement to net cash settle the
contract if an event occurs and if that event is outside our control) (ii) give
the counterparty a choice of net-cash settlement or settlement in shares
(physical settlement or net-share settlement).
  8
  Deferred
Debt Issue Cost
 
 The costs
relating to obtaining and securing debt financing are capitalized and expensed
over the term of the debt instrument. In the event of settlement in part or
whole of such debt in advance of the maturity date, an expense is recognized for
the remaining unamortized deferred debt issue cost.
 
 For the
quarters ended December 31, 2008 and 2007, the estimated fair value of our
deferred debt issue cost was zero and $72,032, respectively.
 
 Stock-Based
Compensation
 
 Effective
January 1, 2006, we adopted the provisions of SFAS No. 123(R), “Share-Based Payment”,using
the modified prospective transition method. SFAS No. 123(R) requires companies
to estimate the fair value of equity-based payment awards on the date of grant
using an option-priced model. The value of the portion of the award that is
ultimately expected to vest is recognized as an expense over the requisite
service periods in our consolidated income statements.
 
 We use
the Black-Scholes option-pricing model to estimate the calculated value of our
share-based payments. Stock options are valued as of the date of grant. The
volatility assumption used in the Black-Scholes formula is based on the
volatility of our common stock. We used the following assumptions to compute the
fair value of option grants for the six-month periods ended December
31:
 
 2008
                    
                    
                    2007Expected
      volatility
                    
                    
                    108.76
                    %
                    
                    
                    108.42
                    %Expected
      dividend yield
                    
                    
                    0.00
                    %
                    
                    
                    0.00
                    %Risk-free
      interest rate
                    
                    
                    3.85
                    %
                    
                    
                    4.04
                    %Expected
      life
                    
                    10
      years
                    
                    10
      years
 
 We
granted 371,392 equity-based payment awards under our incentive compensation
plan during the three and six-month periods ended December 31, 2008 and 200,000
equity-based payment awards for the comparable periods of fiscal
2008.
 
 Revenue
Recognition
 
 We
recognize revenue in the period when the related services are performed and
collectibility is reasonably assured.  Currently, we derive
substantially all of our revenues from laboratory services.  Service
contracts generally take the form of fixed-price contracts.  Under
fixed-price contracts, revenue is recognized as services are performed, with
performance generally assessed using output measures, such as units-of-work
performed to date as compared to the total units-of-work
contracted.  Changes in the scope of work generally result in a
renegotiation of contract pricing terms and/or a contract amendment.
Renegotiated amounts are not included in net revenues until earned, and
realization is assured.  Advance payments on service contracts are
treated as a deposit and applied to periodic billing during the contract
period.  Setup and administrative fees are billed upon contract
approval.  Revenues from setup and administrative fees are amortized
over the life of the contract. Historically, costs are not deferred in
anticipation of work on contracts after they are awarded, but instead are
expensed as incurred.  All out-of-pocket costs are included in
expenses.
 
 Net
Income (Loss) per Share
 
 Basic
income (loss) per share is based upon the weighted average number of outstanding
common shares. Diluted income (loss) per share is computed on the basis of the
weighted average number of common shares outstanding plus the effect of
outstanding stock options and warrants using the “treasury stock” method. All
per share calculations exclude treasury shares.
  9
  The net
income (loss) per common share for the three- and six-month periods ended
December 31, 2008 and 2007 is based on the weighted average number of shares of
common stock outstanding during the periods. Potentially dilutive securities
include 1,665,070 options and 4,149,677 warrants; however, such securities have
not been included in the calculation of the net income per share as none of the
shares were “in the money” and not included in the calculation of net loss per
share as their effect would be antidilutive.
 
 Components
of basic and diluted income (loss) per share were as follows for the three- and
six-month periods ended December 31:
 
 Three months Ended
                    
                    
                    Six months EndedDecember 31,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Numerator
      - basic and diluted net income(loss)
                    
                    $
                    976,671
                    
                    
                    $
                    (818,219
                    )
                    
                    $
                    970,934
                    
                    
                    $
                    (966,784
                    )Denominator
      - basic or diluted weighted average common shares
    outstanding
                    
                    
                    19,039,524
                    
                    
                    
                    18,920,147
                    
                    
                    
                    18,964,873
                    
                    
                    
                    18,713,240Net
      income(loss) per share - basic and diluted
                    
                    $
                    0.05
                    
                    
                    $
                    (0.04
                    )
                    
                    $
                    0.05
                    
                    
                    $
                    (0.05
                    )
 
 Reclassification
 
 We
reclassified a portion of our "common stock" account into
our  "additional paid-in capital" account during the quarter ended
December 31, 2008  to reflect common stock shares at par
value. Certain amounts from prior periods have been reclassified to conform
to the current period presentation.  This reclassification has resulted in
no changes to our accumulated deficit or net losses
presented.
 
 Comprehensive
Income
 
 We have
adopted Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive
Income,” which establishes standards for reporting comprehensive income
and its components in the financial statements.  Comprehensive income
consists of net income and other gains and losses affecting stockholders’ equity
that, under generally accepted accounting principles, are excluded from net
income. For the quarters and six month periods ended December 31, 2008 and 2007,
our comprehensive income (loss) equaled our net income (loss). Accordingly, a
statement of comprehensive income (loss) is not presented.
 
 Use
of Estimates
 
 In
preparing financial statements in conformity with U.S. GAAP, management is
required to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
 
 3.  Concentration
of Credit Risk
 
 Our
largest client in the quarter ended December 31, 2008 accounted for
approximately 30% of our total revenues, while our largest client in the quarter
ended December 31, 2007 accounted for approximately 19% of our total revenues.
As of December 31, 2008 and 2007, respectively, approximately 51% and 38% of our
accounts receivable balance were from our two largest clients at that time.
These were different clients in each fiscal period. Component clients included
in the largest client calculation may vary from period to period.
 
 Our
clients are primarily pharmaceutical companies, many of which are on the list of
Fortune 1000 companies. For our revenue calculations, we aggregate revenues we
receive from several divisions within a pharmaceutical company client as a
single client.  For the quarter ended December 31, 2008, 49% of our
revenue was derived from Fortune 1000 clients compared to 44% of revenue derived
from Fortune 1000 clients for the quarter ended December 31, 2007. We believe
that our exposure to concentration of credit risk is very low considering the
financial strength of our clients.
  10
  We
maintain cash in three insured commercial accounts and one uninsured investment
account at major financial institutions. Although the financial institutions are
considered creditworthy and have not experienced any losses on client deposits,
our cash balance exceeded Federal Deposit Insurance Corporation (FDIC) limits
by $779,633 at December 31, 2008 and by $896,310 at June 30, 2008.
FDIC limits were increased from $100,000 per insured account to $250,000 per
insured account effective October 10, 2008.  The new FDIC limits
expire on December 31, 2009.
  11
  ITEM
2.          MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
 
 Investors
should read the following discussion and analysis in conjunction with our
consolidated financial statements and related  notes in this Form
10-Q, our prior period Form 10-Q for the period ended September 30, 2008 and our
audited financial statements and related notes for the fiscal year ended June
30, 2008, included in our Annual Report on Form 10-K.
 
 Overview
 
 We
provide specialty central laboratory services to support pharmaceutical and
laboratory diagnostic manufacturers in the conduct of human clinical research,
for use in their drug and diagnostic product development efforts.  Our
clients include a number of the world’s largest multi-national pharmaceutical,
biotechnology and diagnostic companies.  Our well-recognized specialty
areas include cardiovascular disease (dyslipidemia, atherosclerosis, and
coronary heart disease), diabetes (and obesity), and bone and joint diseases
(osteoporosis as well as osteo and rheumatoid arthritis).  Coupled
with our specialty testing, we also have central laboratory capability and
provide full-service central laboratory support for multi-center clinical
trials, including routine safety lab tests (general chemistry, hematology, and
urinalysis).  We also provide clinical biomarker services for novel
biomarkers, as well as custom assay services, to our pharmaceutical and biotech
clients.Our company
is a Delaware corporation, incorporated in May 1996, and we conduct our
operations primarily through our wholly-owned subsidiary, Pacific Biometrics,
Inc., a Washington corporation.
 
 Critical
Accounting Policies and Estimates
 
 There
have been no material changes to our critical accounting policies and estimates
since the end of our 2008 fiscal year.  For detailed information on
our critical accounting policies and estimates, see our financial statements and
notes thereto included in this Report and our Annual Report on Form 10-Kfor the fiscal year
ended June 30, 2008.
 
 The
discussion and analysis of our financial condition and results of operations is
based upon our consolidated financial statements, which have been prepared in
accordance with U.S. GAAP.  The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenue and expenses, and related disclosure of
contingent assets and liabilities.  On an on-going basis, we evaluate
our estimates including, among others, those affecting revenue, the allowance
for doubtful accounts, and the useful lives of tangible and intangible
assets.  The discussion below is intended as a brief discussion of
some of the judgments and uncertainties that can impact the application of these
policies and the specific dollar amounts reported on our financial
statements.  We base our estimates on historical experience and on
various other assumptions that we believe to be reasonable under the
circumstances, the results of which form our basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources.  Actual results may differ from these estimates under
different assumptions or conditions, or if management made different judgments
or utilized different estimates.  Many of our estimates or judgments
are based on anticipated future events or performance, and as such are
forward-looking in nature, and are subject to many risks and uncertainties,
including those discussed below and elsewhere in this Report.  We do
not undertake any obligation to update or revise this discussion to reflect any
future events or circumstances.
 
 We have
identified below some of our accounting policies that we consider critical to
our business operations and the understanding of our results of
operations.  This is neither a complete list of all of our accounting
policies, nor does it include all the details surrounding the accounting
policies we have identified.  There are other accounting policies that
are significant to our company.  For a more detailed discussion on the
application of these and our other accounting policies, see “Note 2 to the
Consolidated Financial Statements” included in this Report and “Note 2 to
Consolidated Financial Statements” included in our Annual Report on Form 10-K
for the fiscal year ended June 30, 2008.
  12
  Revenue
Recognition
 
 Under
fixed-price contracts, we recognize revenue as services are performed, with
performance generally assessed using output measures, such as units-of-work
performed to date compared to the total units-of-work contracted.  Our
client contracts may be delayed or cancelled at any time.  Uncertainty
surrounding continuation of existing revenues during any period is
high.  We believe that recognizing revenue as services are performed
is the most appropriate method for our business as it directly reflects services
performed in the laboratory.  We would expect material differences in
reporting of our revenues to occur if we changed our assumptions for revenue
recognition from services performed to other methods such as percent complete or
completed contract methods.  While both other methods are allowed
under GAAP, they would introduce more variables and estimates into our revenue
recognition process.  The percent complete method introduces estimated
costs early in the process that may drive revenues higher in early periods, and
in the event that the study is terminated early, previously recognized revenue
would be reversed, net of a cancellation fee, if applicable.  The
completed contract method may recognize revenues in future contract periods,
such as the first quarter after a fiscal year close and subsequent to completion
of the services rendered.
 
 Financial
Derivatives – Conversion, Other Features and Warrants
 
 With
respect to our convertible notes, embedded conversion and other features that
meet the definition of derivative financial instruments have, where applicable,
been bifurcated from host instruments (See Note 2. Summary of significant
accounting policies) and are carried at fair value. We record the value
allocated to warrants issued with the convertible notes, measured at fair value
and recognized by allocating a portion of the proceeds to derivative liabilities
with an offset to discount on the convertible notes. The recorded discount is
accreted as interest expense using the effective interest method over the
remaining life of the debt.
 
 Stock-Based
Compensation Expense
 
 Effective
January 1, 2006, we adopted the provisions of SFAS No. 123(R), “Share-Based
Payment”, using the modified prospective transition method.  This
requires companies to estimate the fair value of equity-based payment awards on
the date of grant using an option-priced model. The value of the portion of the
award that is ultimately expected to vest is recognized as an expense over the
requisite service periods in our consolidated income
statements.  Determining the fair value of equity-based awards at the
grant date requires judgment.  In addition, judgment is also required
in estimating the amount of equity-based awards that are expected to be
forfeited.  If actual results differ significantly from these
estimates, equity-based compensation expense and our results of operations could
be materially impacted. We granted 371,392 equity-based payment awards under our
incentive compensation plans during the three and six-month periods ended
December 31, 2008 and 200,000 options for the comparable periods of
2007.
 
 Results
of Operations for Three- and Six-Month Periods Ended December 31, 2008 and
2007
 
 Revenue:
 
 Three months Ended
                      December 31,
                    
                    
                    
                    
                    
                    
                    
                    
                    Six months Ended
                      December 31,Dollars in thousands, rounded
                      to nearest thousand
                    
                    2008
                    
                    
                    2007
                    
                    
                    $
                      Change
                    
                    
                    %
                      Change
                    
                    
                    2008
                    
                    
                    2007
                    
                    
                    $
                      Change
                    
                    
                    %
                      ChangeRevenue
                    
                    $
                    3,231
                    
                    
                    $
                    1,648
                    
                    
                    
                    1,583
                    
                    
                    
                    96
                    
                    
                    $
                    5,036
                    
                    
                    $
                    3,729
                    
                    
                    
                    1,307
                    
                    
                    
                    35
  13
  Our
revenue is primarily generated from clinical pharmaceutical trials testing,
clinical biomarker services and diagnostic services.  Revenue
increased approximately 96% to $3,231,000 from $1,648,000 between the comparable
quarters ended December 31, 2008 and 2007. Revenue increased by 35% from
$3,729,000 to $5,036,000 between the comparable six-month periods ended December
31, 2008 and 2007. Our revenue fluctuations are primarily explained by
variability in the volume of testing services we perform, and by the timing
between our work on testing and open work orders, and prior work orders having
been completed or terminated. First quarter revenues for fiscal 2009 were below
our expected results due in part to delays in a number of ongoing
studies.  Testing on those studies was completed, and we realized
revenues for those studies, in the second quarter of fiscal 2009.  In
addition, during the quarter ended December 31, 2008, we were engaged to assist
on a study that required a rapid turnaround for laboratory testing to
resolve issues encountered during clinical trial testing by a
different laboratory.  Revenue generated from this study added
nearly $400,000 to the quarter. We also benefited from strong levels
of testing revenue in the diabetes and rheumatoid arthritis therapeutic areas.
We believe that the overall significant increase in revenue reflects our
significant investments in business development initiatives over the last two
fiscal years.
 
 We work
directly with pharmaceutical and biotech companies (“Direct Clinical Services”)
as well as with other large clinical laboratories that refer specialty
laboratory testing to us (“Referral Laboratories”). We experience significant
uncertainty regarding our existing revenues and estimates of future revenues
during any period.  The studies we bid on are uncertain until we have
a signed contract. Once our work on a study commences, the study may be
cancelled by the client at any time during the testing phase. Accordingly, our
revenues may be significantly affected by the success or failure of the testing
phase and other factors outside of our control. In addition, several factors may
adversely affect our future revenues, including a large number of pharmaceutical
companies’ cost reduction announcements and continuing consolidation in the
pharmaceutical market.
 
 During
the quarter ended December 31, 2008, revenue generated from Direct Clinical
Services and services for Referral Laboratories accounted for approximately 53%
and 47% of our total revenue.  During the six-month period ended
December 31, 2008, revenue generated from Direct Clinical Services and services
for Referral Laboratories accounted for approximately 56% and 44% of our total
revenue. There were no diagnostic services revenues for either period. In
contrast, during the quarter ended December 31, 2007, revenue generated from
Direct Clinical Services, services for Referral Laboratories and diagnostic
services accounted for approximately 69%, 30% and 1%, respectively, of our total
revenue.  During the six-month period ended December 31, 2007, revenue
generated from Direct Clinical Services, services for Referral Laboratories and
diagnostic services accounted for approximately 68%, 31% and 1%, respectively,
of our total revenue. One primary component of our business development efforts
has been directed towards Referral Laboratories.  For future periods
of fiscal 2009, we anticipate that revenues from Referral Laboratories will
continue to represent a higher percentage of our total revenues than for the
comparable periods in fiscal 2008.
 
 Laboratory
Expense and Cost of Goods Sold:
 
 Three months Ended
                        December 31,
                      
                      
                      
                      
                      
                      
                      
                      
                      Six months Ended
                        December 31,Dollars in thousands, rounded
                        to nearest thousand
                      
                      2008
                      
                      
                      2007
                      
                      
                      $
                        Change
                      
                      
                      %
                        Change
                      
                      
                      2008
                      
                      
                      2007
                      
                      
                      $
                        Change
                      
                      
                      %
                        ChangeLaboratory Expenses and
                        Cost of Goods Sold
                      
                      $
                      1,570
                      
                      
                      $
                      1,145
                      
                      
                      
                      425
                      
                      
                      
                      37
                      
                      
                      $
                      2,674
                      
                      
                      $
                      2,368
                      
                      
                      
                      306
                      
                      
                      
                      13Percentage
      of Revenue
                      
                      
                      49
                      %
                      
                      
                      70
                      %
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      53
                      %
                      
                      
                      63
                      %
 
 Laboratory
expense and cost of goods sold consist primarily of salaries and related
benefits to employees performing analysis of clinical trial samples and the cost
of reagents and supplies for analysis ofclinical trialsamples, and
secondarily, of payments to subcontractors for laboratory services and other
expenses such as rent, insurance, business and occupation taxes. The relative
decrease in laboratory expense and cost of goods sold as a percentage of revenue
was the result of the significant increase in revenues over the comparable
periods and the effect of fixed costs and other variable costs remaining fixed
or declining.  The higher volume of testing revenues creates
efficiencies in both staffing and variable cost components as both show smaller
cost increases compared to the overall revenue increases for the three and six
month periods.
 
 Laboratory
and cost of goods sold expense items are highly variable due to the mix of
services provided in any given period, overall volume of tests performed, new
and highly complex assays utilized and subcontracted laboratory
services.
  14
  The
following table illustrates changes in Laboratory Expense and Cost of Goods Sold
in fixed and variable expense categories:
 
 Three
      months EndedDecember 31,Dollars in thousands,
                        rounded to nearest thousand
                      
                      2008
                      
                      
                      % of revenue
                      
                      
                      2007
                      
                      
                      % of revenue
                      
                      
                      $
                        Change
                      
                      
                      %
                        ChangeFixed
      Cost DetailRent,
      Utilities, Certain Taxes
                      
                      $
                      120
                      
                      
                      
                      4
                      %
                      
                      $
                      124
                      
                      
                      
                      8
                      %
                      
                      $
                      (4
                      )
                      
                      
                      (3
                      )%Variable
      Cost DetailWages,
      Taxes, Benefits
                      
                      
                      592
                      
                      
                      
                      18
                      %
                      
                      
                      460
                      
                      
                      
                      28
                      %
                      
                      
                      132
                      
                      
                      
                      29Reagent
      Chemicals
                      
                      
                      707
                      
                      
                      
                      22
                      %
                      
                      
                      412
                      
                      
                      
                      25
                      %
                      
                      
                      295
                      
                      
                      
                      72Other
      Variable Costs
                      
                      
                      151
                      
                      
                      
                      5
                      %
                      
                      
                      149
                      
                      
                      
                      9
                      %
                      
                      
                      2
                      
                      
                      
                      1Total
                      
                      
                      1,450
                      
                      
                      
                      45
                      %
                      
                      
                      1,021
                      
                      
                      
                      62
                      %
                      
                      
                      429
                      
                      
                      
                      42Total
      Cost of Goods Sold
                      
                      $
                      1,570
                      
                      
                      
                      49
                      %
                      
                      $
                      1,145
                      
                      
                      
                      70
                      %
                      
                      $
                      425
                      
                      
                      
                      37
                      %
 
 Six
      months EndedDecember 31,Dollars in thousands,
                    rounded to nearest thousand
                  
                  2008
                  
                  
                  % of revenue
                  
                  
                  2007
                  
                  
                  % of revenue
                  
                  
                  $
                    Change
                  
                  
                  %
                    ChangeFixed
      Cost DetailRent,
      Utilities, Certain Taxes
                  
                  $
                  247
                  
                  
                  
                  5
                  %
                  
                  $
                  260
                  
                  
                  
                  7
                  %
                  
                  $
                  (13
                  )
                  
                  
                  (5
                  )%Variable
      Cost DetailWages,
      Taxes, Benefits
                  
                  
                  1,100
                  
                  
                  
                  22
                  %
                  
                  
                  925
                  
                  
                  
                  25
                  %
                  
                  
                  175
                  
                  
                  
                  19Reagent
      Chemicals
                  
                  
                  1,063
                  
                  
                  
                  21
                  %
                  
                  
                  824
                  
                  
                  
                  22
                  %
                  
                  
                  239
                  
                  
                  
                  29Other
      Variable Costs
                  
                  
                  264
                  
                  
                  
                  5
                  %
                  
                  
                  359
                  
                  
                  
                  10
                  %
                  
                  
                  (95
                  )
                  
                  
                  (26
                  )Total
                  
                  
                  2,427
                  
                  
                  
                  48
                  %
                  
                  
                  2,108
                  
                  
                  
                  57
                  %
                  
                  
                  319
                  
                  
                  
                  15Total
      Cost of Goods Sold
                  
                  $
                  2,674
                  
                  
                  
                  53
                  %
                  
                  $
                  2,368
                  
                  
                  
                  63
                  %
                  
                  $
                  306
                  
                  
                  
                  13
                  %
 
 For the
comparable quarters ended December 31, 2008 and 2007, laboratory expense and
cost of goods sold increased by approximately $425,000, or 37%, to $1,570,000,
up from $1,145,000, respectively, and as a percentage of revenue, decreased to
approximately 49%, down from approximately 70%. The increase in laboratory
expense and cost of goods sold were due to increases in salaries and related
benefits, laboratory reagents, depreciation expense and outside services
expense.
 
 The
largest component of laboratory expense for the quarter ended December 31, 2008
was the cost of laboratory reagents and supplies for analysis of clinical trial
samples. Over the last three fiscal years, reagent chemicals that we use in our
laboratory testing have averaged approximately 20% in cost as a percentage of
revenue, but may vary considerably depending on the type of lab testing we are
asked to perform, and constitute a significant expense item for our
business.  During the comparable quarters ended December 31, 2008 and
2007, respectively, laboratory reagents and supplies increased by 72% to
approximately $707,000 from $412,000, following an increase in the number of
tests performed. These reagents and supply costs are highly variable depending
on the type of tests performed. The cost of laboratory reagents and supplies as
a percentage of revenue was approximately 22% and 25% for the comparable
quarters ended December 31, 2008 and 2007.
 
 The other
major component of laboratory expense for the quarter ended December 31, 2008
was salaries and related benefits.  Laboratory salaries and related
benefits increased 29% to approximately $592,000 from $460,000 for the quarters
ended December 31, 2008 and 2007, representing approximately 18% and 28%,
respectively, as a percentage of revenue.  The expense increase was
due primarily to an increase in laboratory staff by 3.5 FTE to perform many new
and more complex assays than were performed in the comparable fiscal period last
year. In addition, we accrued approximately $41,000 of bonuses in the quarter
ended December 31, 2008 based on quarterly results. We did not accrue or pay any
bonuses in the comparable period in the prior fiscal year.
  15
  For the
comparable six-month periods ended December 31, 2008 and 2007, laboratory
expense and cost of goods sold increased approximately 13% to $2,674,000 from
$2,368,000, respectively, and as a percentage of revenue, decreased to
approximately 53% from approximately 63%. The increase in laboratory expense and
cost of goods sold were due to increases in reagent costs and salaries and
related benefits.
 
 Laboratory
salaries and related benefits increased 19% to approximately $1,100,000 from
$925,000 for the six-month periods ended December 31, 2008 and 2007,
respectively, including approximately $41,000 for accrued bonuses for the period
ended December 31, 2008. Salaries and related benefits accounted for
approximately 41% and 39% of total laboratory expense and cost of goods sold for
the six-month periods ended December 31, 2008 and 2007, respectively. On
December 31, 2008 we had 42 FTE in our laboratory services.  This
compares to 39 FTE on December 31, 2007.
 
 Laboratory
reagents and supplies expense increased 29% to approximately $1,063,000 from
$824,000 for the six-month periods ended December 31, 2008 and 2007 due to the
significant increase in testing volume. During the comparable six month periods
ended December 31, 2008 and 2007, respectively, the cost of laboratory reagents
and supplies accounted for approximately 21% and 22% as a percentage of
revenue.
 
 Other
variable costs showed a decrease of 26% for the six month ended December 31,
2008 compared to the six month ended December 31, 2007. The major reason for a
decrease in other variable costs was decrease in outside services and contract
labor costs.  Outside service expense varies with the test content of
studies that may call for routine test services that we do not perform and
prefer to outsource.
 
 Fixed
costs for the quarter ended December 31, 2008 decreased compared to the quarter
ended December 31, 2007, by 3%, from approximately $124,000 to $120,000. Fixed
costs for the six-month period ended December 31, 2008  decreased 5%
from approximately $260,000 to $247,000 compared to the six-month period ended
December 31, 2007. The decrease was attributable to decrease in laboratory
depreciation, other taxes and seminar and training expenses.
 
 Selling,
General and Administrative Expense:
  Three months Ended
                          December 31,
                        
                        
                        
                        
                        
                        
                        
                        
                        Six months Ended
                          December 31,Dollars in thousands, rounded
                          to nearest thousand
                        
                        2008
                        
                        
                        2007
                        
                        
                        $
                          Change
                        
                        
                        %
                          Change
                        
                        
                        2008
                        
                        
                        2007
                        
                        
                        $
                          Change
                        
                        
                        %
                          ChangeSelling,
      General and Administrative Expense
                        
                        $
                        1,106
                        
                        
                        $
                        1,232
                        
                        
                        
                        (126
                        )
                        
                        
                        (10
                        )
                        
                        $
                        2,021
                        
                        
                        $
                        2,146
                        
                        
                        
                        (125
                        )
                        
                        
                        (6
                        )Percentage
      of Revenue
                        
                        
                        34
                        %
                        
                        
                        75
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        40
                        %
                        
                        
                        58
                        %
 
 Our
selling, general and administrative expense consists primarily of compensation
for our executive officers, board members and other selling, general and
administrative personnel (including those in business development, laboratory
administration, and our science and technology department), as well as a major
portion of company share-based compensation, business development expenses, and
legal and accounting fees.
 
 For the
comparable quarters ended December 31, 2008 and 2007, respectively, selling,
general and administrative expense decreased 10% to approximately $1,106,000,
down from $1,232,000.  As a percentage of revenue, selling, general
and administrative expense was 34% and 75%, respectively, for the quarters ended
December 31, 2008 and 2007. For the six-month periods ended December 31, 2008
and 2007, respectively, selling, general and administrative expense decreased 6%
to approximately $2,021,000, down from $2,146,000.  As a percentage of
revenue, selling, general and administrative expense was 40% and 58% for the
six-month periods ended December 31, 2008 and 2007. The decrease in selling,
general and administrative expense as a percentage of revenue was the result of
the significant increase in revenues over the comparable periods and decreases
in our SG&A expenses.
 
  16
  For the
quarter and six-month period ended December 31, 2008, business development
salaries decreased significantly primarily due to the resignation of our Chief
Medical Officer in August 2008.  This decrease in compensation for our
business development staff more than off-set small increases in salaries in our
administrative and laboratory management departments. Overall, salaries and
benefits decreased for the quarter ended December 31, 2008 compared to the
quarter ended December 31, 2007.
 
 Other
factors included in the decrease in selling, general and administrative expense
were decreases in share-based compensation, bad debt, legal and accounting
expenses. The decrease in bad debt expense reflects our $100,000 loan to Saigene
Corporation.  We previously classified this loan as bad debt in
December 2007, after Saigene filed for bankruptcy; however, in December 2008, we
subsequently received payment of the entire principal amount of this debt, plus
some accrued interest, with approval of the Bankruptcy Court.  These
decreases were offset by increases in bonuses accrued, rent expense, consulting
expense, advertising expense and public company expense.
 
 Other
Income (Expense):
  Three months Ended
                            December 31,
                          
                          
                          
                          
                          
                          
                          
                          
                          Six months Ended
                            December 31,Dollars in thousands, rounded
                            to nearest thousand
                          
                          2008
                          
                          
                          2007
                          
                          
                          $
                            Change
                          
                          
                          %
                            Change
                          
                          
                          2008
                          
                          
                          2007
                          
                          
                          $
                            Change
                          
                          
                          %
                            ChangeOther
      Income/(Expense)
                          
                          $
                          422
                          
                          
                          $
                          (89
                          )
                          
                          
                          511
                          
                          
                          
                          574
                          
                          
                          $
                          630
                          
                          
                          $
                          (182
                          )
                          
                          $
                          812
                          
                          
                          
                          446Percentage
      of Revenue
                          
                          
                          13
                          %
                          
                          
                          (5
                          )%
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          13
                          %
                          
                          
                          (5
                          )%
 
 We had
other income of approximately $422,000 for the quarter ended December 31, 2008,
compared to other expense of approximately $89,000 for the quarter ended
December 31, 2007. Total other income for the six-month period ended December
31, 2008 was approximately $630,000, compared to approximately $182,000 other
expense for the six-month period ended December 31, 2007. These improvements in
our other income (expense) are primarily attributable to our convertible notes
payable to Laurus Master Fund Ltd. – reflecting a decrease in interest expense
paid, a decrease in amortization of deferred financial costs, and gain due to
adjustments to the value of the embedded derivative.
 
 During
the quarter ended December 31, 2008, we made our required monthly payments of
principal and accrued interest on the Laurus notes, and we paid in full the
remaining principal balance on December 29, 2008. The reduction in the principal
balance of the Laurus notes is the primary reason that our interest expense
decreased 63% to $51,000 for the six-month period ended December 31, 2008, down
from $136,000 for the six-month period ended December 31, 2007. The gain from
adjustment of embedded and freestanding derivatives to fair value was
approximately $676,000 for the six-month period ended December 31, 2008 compared
to $333,000 for the six-month period ended December 31, 2007. The main component
of the increase in gain on adjustment of embedded and freestanding derivatives
was a reduction in the derivative liability (conversion feature) balance related
to the pay off of the Laurus notes. Another component of other expense for the
six-month period ended December 31, 2008 was approximately $89,000 of non-cash
interest expense that represented the accretion of the intrinsic value of the
conversion feature and warrants, compared to $387,000 of such non-cash interest
expense recorded for six-month period ended December 31, 2007.
 
 We had
approximately $112,000 of other income for the six-month periodended December 31,
2008 compared to approximately $62,000 of other income recorded for the
six-month period ended December 31, 2007. This increase resulted mainly from
collection of $104,000 in December 2008 on a $100,000 loan to Saigene
Corporation, which we previously classified as bad debt in December
2007.
  17
  Net
Income (Loss):
  Three months Ended
                                December 31,
                              
                              
                              
                              
                              
                              
                              
                              
                              Six months Ended
                                December 31,Dollars in thousands, rounded
                                to nearest thousand
                              
                              2008
                              
                              
                              2007
                              
                              
                              $
                                Change
                              
                              
                              %
                                Change
                              
                              
                              2008
                              
                              
                              2007
                              
                              
                              $
                                Change
                              
                              
                              %
                                ChangeNet
      Income (Loss)
                              
                              $
                              977
                              
                              
                              $
                              (818
                              )
                              
                              $
                              1,795
                              
                              
                              
                              222
                              
                              
                              $
                              971
                              
                              
                              $
                              (967
                              )
                              
                              $
                              1,938
                              
                              
                              
                              203Percentage
      of Revenue
                              
                              
                              30
                              %
                              
                              
                              (50
                              )%
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              19
                              %
                              
                              
                              (26
                              )%
 
 We had
net income of approximately $977,000 for the quarter ended December 31, 2008,
compared to a net loss of approximately $818,000 for the quarter ended December
31, 2007. We had net income of approximately $971,000 for the six-month period
ended December 31, 2008, compared to a net loss of approximately $967,000 for
the six-month period ended December 31, 2007. This increase to net income, from
net loss, is principally due to a significant increase in revenue during fiscal
2009 and an increase in other income as described above. Our net income position
was also favorably impacted by a gain on adjustment of derivatives to fair value
of approximately $343,000 for the quarter ended December 31, 2008 and
approximately $676,000 for the six-month period ended December 31,
2008.  The adjustment to fair value of the derivative instruments is
mainly due to a reduction in the derivative liability (conversion feature)
related to the pay off of the Laurus notes.
 
 Liquidity
and Capital Resources:
 
 We had
significant improvement in revenues and net operating income for the quarter and
six-month period ended December 31, 2008, compared to net operating losses for
the quarter and six-month period ended December 31, 2007. While our revenues
increased a record level for the six-month period ended December 31, 2008, we
have been impacted by significant volatility in our revenues over the past
several years.  We experience significant uncertainty regarding
existing revenues and estimates of future revenues, during any
period.  If our revenues decrease significantly in future periods, we
may experience significant losses and our cash and working capital position will
be adversely impacted.  Our operations historically have been funded
through revenues generated from operations and from debt and equity
financings.
 
 At
December 31, 2008, our cash and cash equivalents were approximately $1,280,000
compared to approximately $1,196,000 at June 30, 2008. At December 31, 2008 we
had approximately $2,022,000 in accounts receivable, compared to $2,146,000 as
of June 30, 2008, reflecting timing of revenues billed and
collected.  We had no other accounts receivable, compared to
approximately $451,000 as of June 30, 2008 for a Washington state tax
refund, which we received in August 2008.
 
 Total
liabilities recorded on our balance sheet as of December 31, 2008 were
approximately $2,041,000 compared to approximately $3,871,000 as of June 30,
2008. This significant decrease in liabilities was the result of retiring in the
full both the Laurus debt and the outstanding note balance from Franklin
Funding, which were paid off in December 2008. We paid off the Laurus debt
early, one month prior to maturity, which required approximately $50,000 in
addition to our regular monthly payment. In connection with our payoff of the
Laurus notes, we reduced the remaining balance for embedded derivative liability
to zero by recording gain of approximately $300,000 for the remaining balance of
the derivative liability. We reclassified freestanding derivative liability by
crediting additional paid-in capital for approximately $378,000 for the
remaining balance of the warrants associated with both Laurus notes, which
remain in effect. This reclassification resulted in no changes to our
accumulated deficit or net loss presented.
 
 Our
working capital increased to approximately $1,846,000, compared to working
capital of approximately $331,000 at June 30, 2008. The increase of
approximately $1,515,000 in our working capital is attributable to a significant
decrease in our current liabilities due to Laurus debt payoff and decrease in
other notes payable. Changes providing a positive impact included increases in
inventory, prepaid expenses and decreases in secured convertible debt and
associated derivative liability to the Laurus notes, accounts payable, accrued
liabilities, and other notes payable. Changes providing a negative impact
included decreases in accounts receivable and other receivable and increases in
advances from customers and capital leases obligations.
  18
  Net cash
used by operating activities was approximately $988,000 for
the six-month period ended December 31, 2008.  For the
six-month period ended December 31, 2008, net cash provided by operations
included the effect of approximately $122,000 in depreciation and amortization,
approximately $88,000 of amortization related to the Laurus notes, approximately
$90,000 in expense from share-based compensation and approximately $676,000 in
income from adjustment of the compound embedded derivative liability relating to
the Laurus notes. Our investing activities used cash of approximately $15,000
for the six-month period ended December 31, 2008 for the purchase of capital
equipment.  Cash flows used in financing activities included
approximately $890,000 in payments on notes payable and payments on capital
lease obligations.
 
 We
experienced an increase in our cash and working capital position from operations
during the first six months of fiscal 2009 and we believe that our current cash,
current assets and cash flows from operations will be sufficient to fund
operations through fiscal 2009. Importantly, we paid off the outstanding
principal balance on our convertible notes payable to Laurus and the outstanding
principal balance on our note payable to Franklin Funding.  Aside from
capital leases, we have no other debt obligations as of December 31, 2008. We
are considering new debt financing for fiscal 2009; however, the terms of that
debt are unknown at this time.
 
 In fiscal
2009, we will continue to actively pursue business development and marketing
activities to broaden our client and revenue base, and we anticipate making
additional investments in our biomarker subsidiary, Pacific Biomarkers and from
time to time in our technology infrastructure, operations and other areas of our
business.  These efforts will use significant amounts of time, effort
and funding.  Our efforts to improve our operations and increase
revenue may not be successful.
 
 Any
decreases in future revenue would adversely affect our financial condition, and
we may need to seek additional capital during fiscal 2010. We may not be able to
raise sufficient financing, whether debt or equity, when needed. We are
exploring options for creating a line of credit or other general borrowing
facility. We currently do not have available to us a bank line of credit or
other general borrowing facility.  We have no additional amounts
available to us under our Franklin Funding credit facility and do not have any
other credit facility in place.
 
 We are
also continuing to explore other strategic alternatives, which may include a
merger, asset sale, joint venture or other similar transaction or forming a
joint venture with one or more strategic partners to provide additional capital
resources to fund operations and growth opportunities.
 
 Off-Balance
Sheet Arrangements
 
 We have
no off-balance sheet financing arrangements.
 
 ITEM
4T.        CONTROLS AND
PROCEDURES
 
 We
maintain disclosure controls and procedures designed to ensure that information
required to be disclosed in our reports filed or submitted under the Securities
Exchange Act of 1934 is (a) recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commission’s rules and
forms and (b) accumulated and communicated to management, including our
Chief Executive Officer and Vice President of Finance and Controller, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure.  A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met.  Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues if any, within a company have been
detected.
 
 As of the
end of the period covered by this Report on Form 10-Q, we carried out an
evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Exchange Act Rule 13a-15.  This
evaluation was carried out under the supervision and with the participation of
management, including our Chief Executive Officer and Vice President of Finance
and Controller.  Based upon that evaluation, our Chief Executive
Officer and Vice President of Finance and Controller concluded that our
disclosure controls and procedures are effective at December 31,
2008.
  19
  During
the quarterly period covered by this report, there were no changes in our
internal controls or in other factors that have materially affected, or are
reasonably likely to materially affect our internal controls over financial
reporting.
 
 PART
II – OTHER INFORMATION
 
 ITEM
5.       OTHER INFORMATION
 
 On
October 1, 2008, we formally entered into restricted stock purchase and stock
option agreements with Ronald R. Helm, our Chief Executive Officer, for a share
award of 50,000 shares of restricted common stock and 150,000 stock options,
both effective October 1, 2008.  These awards of restricted stock and
stock options were made pursuant to the third amendment to Mr. Helm's employment
agreement on October 1, 2008.
 
 Also on
October 1, 2008, we granted 113,500 restricted stock awards to other members of
our management team and to our Board of Directors, under our 2005 Stock
Incentive Plan.
 
 The
restricted shares fully vest on the third anniversary of the grant date (October
1, 2011) and are subject to forfeiture under certain conditions if employment or
director appointment is terminated prior to the vesting date.  The
stock options have an exercise price of $0.41 per share (reflecting the closing
trading price for our common stock on October 1, 2008), vest quarterly and will
be fully vested on the third anniversary of the grant date (October 1,
2011).   Otherwise, the terms of the awards are materially
consistent with the forms of restricted stock purchase agreement and stock
option agreement under our 2005 Stock Incentive Plan.
 
 The
restricted stock awards and stock option grants are detailed on the following
table:
 
 Officers and Directors:
                    
                    No. of
                      Shares
                    
                    
                    No. of
                      OptionsTerry
      M. Giles
                    Director
                    
                    
                    12,500Ronald
      R. Helm
                    Chairman
      & CEO
                    
                    
                    50,000
                    
                    
                    
                    150,000John
      P. Jensen
                    VP
      Finance & Controller
                    
                    
                    14,000Paul
      G. Kanan
                    Director
                    
                    
                    12,500Elizabeth
      T. Leary, Ph.D.
                    Chief
      Scientific Officer
                    
                    
                    9,000Michael
      P. Murphy
                    SVP
      Operations
                    
                    
                    14,000Richard
      W. Palfreyman
                    Director
                    
                    
                    12,500Curtis
      J. Scheel
                    Director
                    
                    
                    12,500Stanley
      L. Schloz
                    Director
                    
                    
                    12,500Kenneth
      R. Waters
                    Dir.
      Strategic Planning
                    
                    
                    14,000Total
                    
                    
                    
                    163,500
                    
                    
                    
                    150,000
 
 20
  ITEM
6.           EXHIBITS
 
 31.1
                
                Certification
      of Ronald R. Helm, Chief Executive Officer31.2
                
                Certification
      of John P. Jensen, Vice President of Finance and
  Controller32.1
                
                Certification
      of Ronald R. Helm, Chief Executive Officer and John P. Jensen, Vice
      President of Finance and Controller, of Pacific Biometrics, Inc., pursuant
      to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
 
 SIGNATURES
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
 
 Dated:  February
13, 2009
 
 /s/ Ronald R. HelmRonald
      R. HelmChief
      Executive Officer(principal
      executive officer)/s/ John P. JensenJohn
      P. JensenVice
      President of Finance and Controller(principal
      financial and accounting
officer)
  21