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 September 30, 2009




 ̈ 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
                  (Registrant’s
      telephone number, including area
code)





Indicate
by check mark whether the registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 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 has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 or Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).


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
November 13, 2009, there were 16,813,133 shares of the registrant’s common
stock, $0.01 par value per share, outstanding.









PACIFIC
BIOMETRICS, INC.





INDEX TO
FORM 10-Q





PagePART
      I - FINANCIAL INFORMATIONITEM
      1 - FINANCIAL STATEMENTSConsolidated
      Balance Sheets as of September 30, 2009 (unaudited) and June 30,
      2009
                
                4Consolidated
      Statements of Operations for the three months ended September 30, 2009 and
      September 30, 2008 (unaudited)
                
                5Consolidated
      Statements of Cash Flows for the three months ended September 30, 2009 and
      September 30, 2008 (unaudited)
                
                6Notes
      to Consolidated Financial Statements (unaudited)
                
                7ITEM
      2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
      RESULTS OF OPERATIONS
                
                15ITEM
      4T - CONTROLS AND PROCEDURES
                
                21PART
      II - OTHER INFORMATIONITEM
      6 - EXHIBITS
                
                22


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 Biomarkers, Inc., PBI Technology,
Inc., and BioQuant, Inc.  During the first quarter of fiscal 2010, we
merged our wholly-owned subsidiary, Pacific Biomarkers, Inc., into our
wholly-owned subsidiary, Pacific Biometrics, Inc. and changed the name of the
surviving company to Pacific Biomarkers, 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
      working capital and cash flows and 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 and revenue
generation,


·
            our
      intentions for the development of new services and products and the
      expansion of the market for our current services and products, including
      our expectations for our clinical biomarker
  services,


·
            our
      goals for implementing aspects of our business plan and strategies,
      and


·
            our
      financing goals and plans





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”, “could”,
“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, 2009. 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, 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





September 30,
                      
                      
                      June 30,2009
                      
                      
                      2009(unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                      
                      $
                      3,233,788
                      
                      
                      $
                      1,365,406Short-term
      investments
                      
                      
                      504,320
                      
                      
                      
                      -Accounts
      receivable, net
                      
                      
                      1,688,386
                      
                      
                      
                      2,238,912Other
      receivable, net
                      
                      
                      6,500
                      
                      
                      
                      9,000Inventory
                      
                      
                      127,679
                      
                      
                      
                      171,885Prepaid
      expenses and other assets
                      
                      
                      183,313
                      
                      
                      
                      230,974Total
      current assets
                      
                      
                      5,743,986
                      
                      
                      
                      4,016,177Property
      and equipment, net
                      
                      
                      814,625
                      
                      
                      
                      813,258Total
      assets
                      
                      $
                      6,558,611
                      
                      
                      $
                      4,829,435LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
                      
                      $
                      511,082
                      
                      
                      $
                      678,818Accrued
      liabilities
                      
                      
                      421,524
                      
                      
                      
                      660,284Advances
      from customers - current portion
                      
                      
                      174,779
                      
                      
                      
                      155,471Capital
      lease obligation - current portion
                      
                      
                      64,896
                      
                      
                      
                      62,709Secured
      note - current portion, net discount of $26,257
                      
                      
                      391,117
                      
                      
                      
                      -Total
      current liabilities
                      
                      
                      1,563,398
                      
                      
                      
                      1,557,282Advances
      from customers - long - term portion
                      
                      
                      272,032
                      
                      
                      
                      272,032Capital
      lease obligations - long - term portion
                      
                      
                      139,239
                      
                      
                      
                      156,309Secured
      note - long - term portion, net discount of $173,510
                      
                      
                      3,409,116
                      
                      
                      
                      -Total
      liabilities
                      
                      
                      5,383,785
                      
                      
                      
                      1,985,623Commitments
      and contingencies
                      
                      
                      -
                      
                      
                      
                      -Stockholders'
      equity:Preferred
      stock, Series A convertible $0.01 par value, 5,000,000 shares authorized,
      0 shares issued and outstanding at September 30, 2009 and June 30,
      2009
                      
                      
                      -
                      
                      
                      
                      -Common
      stock, $0.01 par value, 30,000,000 shares authorized, 19,099,539 shares
      issued and 16,813,133 outstanding at September 30, 2009,
      19,099,539  shares issued and outstanding at June 30,
      2009
                      
                      
                      192,050
                      
                      
                      
                      190,995Additional
      paid-in capital
                      
                      
                      29,193,052
                      
                      
                      
                      29,121,334Accumulated
      deficit
                      
                      
                      (26,741,667
                      )
                      
                      
                      (26,468,517
                      )Treasury
      stock
                      
                      
                      (1,468,609
                      )
                      
                      
                      -Total
      stockholders' equity
                      
                      
                      1,174,826
                      
                      
                      
                      2,843,812Total
      liabilities and stockholders' equity
                      
                      $
                      6,558,611
                      
                      
                      $
                      4,829,435





The
accompanying condensed notes are an integral part of these consolidated
financial statements.


4





PACIFIC
BIOMETRICS, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (unaudited)





Three Months EndedSeptember 30,2009
                  
                  
                  2008Revenues
                  
                  $
                  2,301,375
                  
                  
                  $
                  1,805,042Laboratory
      expenses and cost of sales
                  
                  
                  1,393,700
                  
                  
                  
                  1,103,369Gross
      profit
                  
                  
                  907,675
                  
                  
                  
                  701,673Operating
      expenses:Selling,
      general and administrative
                  
                  
                  1,121,383
                  
                  
                  
                  915,045Operating
      loss
                  
                  
                  (213,708
                  )
                  
                  
                  (213,372
                  )Other
      income (expense):Interest
      expense
                  
                  
                  (53,100
                  )
                  
                  
                  (111,058
                  )Gain
      on adjustment of embedded and freestanding derivatives to fair
      value
                  
                  
                  -
                  
                  
                  
                  332,570Amortization
      of deferred financing costs - secured convertible debt
                  
                  
                  -
                  
                  
                  
                  (18,447
                  )Amortization
      of discount on debt
                  
                  
                  (5,958
                  )
                  
                  
                  -Other
      income (expense)
                  
                  
                  (384
                  )
                  
                  
                  4,570Total
      other income (expense)
                  
                  
                  (59,442
                  )
                  
                  
                  207,635Net
      loss before tax expense
                  
                  
                  (273,150
                  )
                  
                  
                  (5,737
                  )Tax
      expense
                  
                  
                  -
                  
                  
                  
                  -Net
      loss
                  
                  $
                  (273,150
                  )
                  
                  $
                  (5,737
                  )Net
      loss per share:
                  
                  $
                  (0.01
                  )
                  
                  $
                  (0.00
                  )Weighted
      average common shares outstanding, basic and diluted:
                  
                  
                  18,832,061
                  
                  
                  
                  18,920,147





The
accompanying condensed notes are an integral part of these consolidated
financial statements.


5





PACIFIC
BIOMETRICS, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(unaudited)





Three
      Months EndedSeptember 30,2009
                            
                            
                            2008Cash
      flows from operating activities:Net
      loss
                            
                            $
                            (273,150
                            )
                            
                            $
                            (5,737
                            )Reconciliation
      of net loss to net cash provided by operating activities:Depreciation
      and amortization
                            
                            
                            75,609
                            
                            
                            
                            53,469Accretion
      of fair value assigned to conversion feature and warrants
                            
                            
                            -
                            
                            
                            
                            69,044Amortization
      of deferred financing costs on  secured convertible
      note
                            
                            
                            -
                            
                            
                            
                            18,447Gain
      from embedded and freestanding derivative liabilities relating to
      secured  convertible note
                            
                            
                            -
                            
                            
                            
                            (332,570
                            )Amortization
      of fair value assigned to repurchased shares of common
    stock
                            
                            
                            5,958
                            
                            
                            
                            -Net
      losses (gains) on investments
                            
                            
                            1,713
                            
                            
                            
                            -Warrant
      expense for equipment lease and financing
                            
                            
                            -
                            
                            
                            
                            2,956Compensation
      expense  from restricted shares and options
                            
                            
                            72,774
                            
                            
                            
                            6,201Changes in assets and
      liabilities:Accounts
      receivable
                            
                            
                            550,526
                            
                            
                            
                            642,103Other
      receivable
                            
                            
                            2,500
                            
                            
                            
                            451,291Inventory
                            
                            
                            44,206
                            
                            
                            
                            (80,816
                            )Prepaid
      expenses and other assets
                            
                            
                            47,661
                            
                            
                            
                            (58,856
                            )Advances
      from customers
                            
                            
                            19,308
                            
                            
                            
                            121,913Accounts
      payable
                            
                            
                            (167,736
                            )
                            
                            
                            (388,423
                            )Accrued
      liabilities
                            
                            
                            (238,760
                            )
                            
                            
                            (127,387
                            )Net
      cash  provided by operating activities
                            
                            
                            140,609
                            
                            
                            
                            371,635Cash
      flows from investing activities:Purchases
      of capital equipment
                            
                            
                            (76,977
                            )
                            
                            
                            (14,352
                            )Purchases
      of investments
                            
                            
                            (506,033
                            )
                            
                            
                            -Net
      cash used in investing activities
                            
                            
                            (583,010
                            )
                            
                            
                            (14,352
                            )Cash
      flows from financing activities:Payments
      on notes payable
                            
                            
                            -
                            
                            
                            
                            (598,244
                            )Proceeds
      from loan
                            
                            
                            4,000,000
                            
                            
                            
                            -Repurchases
      of common stock
                            
                            
                            (1,674,334
                            )
                            
                            
                            -Payments
      on capital lease obligations
                            
                            
                            (14,883
                            )
                            
                            
                            (11,416
                            )Net
      cash provided by (used in) financing activities
                            
                            
                            2,310,783
                            
                            
                            
                            (609,660
                            )Net
      increase (decrease) in cash and cash equivalents
                            
                            
                            1,868,382
                            
                            
                            
                            (252,377
                            )Cash
      and cash equivalents, beginning of period
                            
                            
                            1,365,406
                            
                            
                            
                            1,196,310Cash
      and cash equivalents, end of period
                            
                            $
                            3,233,788
                            
                            
                            $
                            943,933Supplemental
      Information:Cash
      paid during the period for interest
                            
                            $
                            85,846
                            
                            
                            $
                            42,833Cash
      paid during the period for income taxes
                            
                            $
                            -
                            
                            
                            $
                            -





The
accompanying condensed 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,
biotechnology, and diagnostics industries. Our company was incorporated in
Delaware in May 1996. We conduct our business primarily through our wholly-owned
subsidiary, Pacific Biomarkers, Inc., a Washington corporation. Our two other
wholly-owned subsidiaries are 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-month period
ended September 30, 2009 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, 2009, as previously reported in our annual report on Form 10-K.





2.
            Summary
      of Significant Accounting Policies





There
have been no significant changes in our significant accounting policies during
the three-month period ended September 30, 2009 compared to what was
previously disclosed in the our Annual Report on Form 10-K for the fiscal year
ended June 30, 2009.





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 September 30, 2009, we deemed no account receivable
uncollectible.





Other
accounts receivable consist of non-trade receivables such as state business and
occupation tax refunds, notes receivable and employee advances. 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 September 30, 2009,
we had $6,500 in 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.


7


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.





In
accordance with the guidance of the Financial Accounting Standards Board, 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. As of September 30, 2009 and 2008, no impairment was deemed
necessary.





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.





Treasury
Stock





Shares of
common stock repurchased by us are recorded at cost and are included as a
separate component of Shareholders’ equity. We repurchased 2,391,906 shares of
our common stock having a fair value of $1,468,609 for the three-month period
ended September 30, 2009.





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.




Revenue
Recognition





We
recognize revenue in the period when the related services are performed and
collectability 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
Loss per Share





Basic
loss per share is based upon the weighted average number of our outstanding
common shares. Diluted 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.





The net
loss per common share for the quarters ended September 30, 2009 and 2008 is
based on the weighted average number of shares of common stock outstanding
during the periods. Potentially dilutive securities include 1,288,612 options
and 3,898,027 warrants; however, such securities have not been included in the
calculation of the net loss per common share as their effect would be
antidilutive.


8





The
following table is a reconciliation of the numerator (net loss) and the
denominator (number of shares) used in the basic and diluted EPS calculations
and sets forth potential shares of common stock that are not included in the
diluted net loss per share calculation as the effect is
antidilutive:





Three months endedSeptember 30,2009
                  
                  
                  2008Numerator
      - basic and diluted net loss
                  
                  $
                  (273,150
                  )
                  
                  $
                  (5,737
                  )Denominator
      - basic or diluted weighted average common shares
    outstanding
                  
                  
                  18,832,061
                  
                  
                  
                  18,920,147Net
      loss per share - basic and diluted
                  
                  $
                  (0.01
                  )
                  
                  $
                  (0.00
                  )





During
the quarter ended September 30, 2009, we repurchased 2,391,906 shares,
increasing our treasury stock to 2,661,178 shares.  At September 30,
2009, we had 16,813,133 shares outstanding compared to 19,099,539 shares
outstanding at June 30, 2009. The number of outstanding shares used above
calculation reflects the weighted average number of shares outstanding during
the three-month period in the quarter. For future periods of fiscal 2010, the
per share calculation will be effected by the decrease in outstanding shares
compared to the same periods of fiscal 2009.





Comprehensive
Income





We have
adopted current accounting 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 ended September 30, 2009 and 2008, our comprehensive loss
equaled our net loss. Accordingly, a statement of comprehensive 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.





Accounting
Changes and Recent Accounting Pronouncements





Initial Application of
Accounting Standards





In the
first quarter of fiscal 2010, we adopted the following accounting standards,
none of which had a material impact on our financial position, results of
operations or cash flows:





The
Financial Accounting Standards Board (“FASB”) Accounting Standards Codification
(“Codification”), which is now the source of authoritative U.S. GAAP recognized
by the FASB to be applied for financial statements issued for periods ending
after September 2009. Additionally, we are using the new guidelines
prescribed by the Codification when referring to GAAP, including the elimination
of pre-Codification GAAP references unless accompanied by Codification GAAP
references.





The
accounting standard deferring the effective date of the fair value measurement
standard for disclosures related to nonfinancial assets and nonfinancial
liabilities that are recognized or disclosed at fair value in the financial
statements on a nonrecurring basis. See Note 4 — Fair Value
Measurements-Debt Financingin these Notes to Consolidated Financial
Statements for fair value disclosures required by this
standard.


9





The
accounting standard requiring interim disclosures about fair value of financial
instruments, which extends the annual disclosure requirements about fair value
of financial instruments to interim reporting periods. See Note 4in these Notes to
Consolidated Financial Statements for fair value disclosures required by this
standard.





The
accounting standard updating accounting, presentation and disclosure
requirements for noncontrolling interests in consolidated financial statements,
which requires that noncontrolling interests (previously referred to as minority
interests) be clearly identified and presented as a component of equity,
separate from the parent’s equity. This standard also requires that the amount
of consolidated net income attributable to the parent and to the noncontrolling
interest be clearly identified and presented on the face of the consolidated
statement of income; that changes in ownership interest be accounted for as
equity transactions; and that when a subsidiary is deconsolidated, any retained
noncontrolling equity investment in that subsidiary and the gain or loss on the
deconsolidation of that subsidiary be measured at fair value. The adoption had
no impact on our financial statements.





The
accounting standard for determining whether instruments granted in share-based
payment transactions are participating securities. There was no material change
to our calculations of basic and diluted weighted average shares outstanding for
prior periods.





The
accounting standards for accounting for business combinations, which
significantly change the accounting and reporting requirements related to
business combinations, including the recognition of acquisition-related
transaction and post-acquisition restructuring costs in our results of
operations as incurred. While the adoption of these standards did not have a
material impact on our financial position, results of operations or cash flows
directly in the first quarter of fiscal 2010, it is expected to have a
significant effect on the accounting for any future acquisitions we
make.





Accounting Standards Issued
But Not Yet Effective





In
October 2009, the FASB issued two new accounting standards updates
that:





Revise
accounting and reporting requirements for arrangements with multiple
deliverables. This update allows the use of an estimated selling price to
determine the selling price of a deliverable in cases where neither
vendor-specific objective evidence nor third-party evidence is available, which
is expected to increase the ability for entities to separate deliverables in
multiple-deliverable arrangements and, accordingly, to decrease the amount of
revenue deferred in these cases. Additionally, this update requires the total
selling price of a multiple-deliverable arrangement to be allocated at the
inception of the arrangement to all deliverables based on relative selling
prices.





Clarify
which revenue allocation and measurement guidance should be used for
arrangements that contain both tangible products and software, in cases where
the software is more than incidental to the tangible product as a whole. More
specifically, if the software sold with or embedded within the tangible product
is essential to the functionality of the tangible product, then this software,
as well as undelivered related software elements are excluded from the scope of
existing software revenue guidance, which is expected to decrease the amount of
revenue deferred in these cases.





These
updates are to be applied prospectively for revenue arrangements entered into or
materially modified in fiscal years beginning on or after June 15, 2010,
which for us is our fiscal 2011, and must be adopted at the same time. Early
adoption is permitted, and if these updates are adopted early in other than the
first quarter of our fiscal year, then they must be applied retrospectively to
the beginning of that fiscal year. We are currently evaluating the impact the
adoption of these updates will have on our financial position, results of
operations and cash flows.





In
October 2009, the FASB issued Accounting Standards Update No. 2009-13 (FASB ASU
09-13), “Revenue Recognition (Topic 605): Multiple-Deliverable Revenue
Arrangements (a consensus of the FASB Emerging Issues Task Force).” FASB ASU
09-13 updates the existing multiple-element arrangement guidance currently in
FASB Topic 605-25 (Revenue Recognition – Multiple-Element Arrangements). This
new guidance eliminates the requirement that all undelivered elements have
objective evidence of fair value before a company can recognize the portion of
the overall arrangement fee that is attributable to the items that have already
been delivered. Further, companies will be required to allocate revenue in
arrangements involving multiple deliverables based on the estimated selling
price of each deliverable, even though such deliverables are not sold separately
by either company itself or other vendors. This new guidance also significantly
expands the disclosures required for multiple-element revenue arrangements. The
revised guidance will be effective for the first annual period beginning on or
after June 15, 2010. We may elect to adopt the provisions prospectively to new
or materially modified arrangements beginning on the effective date or
retrospectively for all periods presented. We are currently evaluating the
impact FASB ASU 09-13 will have on our consolidated financial
statements.


10





3.  Concentration
of Credit Risk





Our
largest client in the quarter ended September 30, 2009 accounted for
approximately 21% of our total revenues, while our largest client in the quarter
ended September 30, 2008 accounted for approximately 25% of our total revenues.
As of September 30, 2009 and 2008, approximately 38% and 43% of our accounts
receivable balance was from the 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.





The
majority of our clients are 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 one single client.  For the quarter ended September 30,
2009, 63% of our revenue was derived from Fortune 1000 clients compared to 42%
for the quarter ended September 30, 2008. We believe that our exposure to
concentration of credit risk is very low considering the financial strength of
our clients.





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 $2,733,288 at September 30, 2009 and by $693,933 at September
30, 2008. Management will continue to monitor the creditworthiness of the
financial institutions holding our deposits.  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.





4.  Fair
Value Measurements – Debt Financing





We follow
ASC Topic 820 and 825, (SFAS 157, Fair Value Measurements) which clarify a
number of considerations with respect to fair value measurement objectives for
financial reporting and expand disclosures about the use of fair value
measurements. The guidance regarding fair value measurements is intended to
increase consistency and comparability among fair value estimates used in
financial reporting. The disclosure requirements are intended to provide users
of financial statements with the ability to assess the reliability of an
entity's fair value measurements.





Definition of Fair
Value





Fair
value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date and, therefore, represents an exit price, not an entry price.
We hold or have held fixed maturities, equity securities, derivatives, and
embedded derivatives, which are carried at fair value.





The
degree of judgment utilized in measuring the fair value of financial instruments
is largely dependent on the level to which pricing is based on observable
inputs. Observable inputs reflect market data obtained from independent sources,
while unobservable inputs reflect our view of market assumptions in the absence
of observable market information. Financial instruments with readily available
active quoted prices would be considered to have fair values based on the
highest level of observable inputs, and little judgment would be utilized in
measuring fair value. Financial instruments that rarely trade would be
considered to have fair value based on a lower level of observable
inputs, and more judgment would be utilized in measuring fair
value.


11





Valuation
Hierarchy





A
three-level hierarchy for valuing assets or liabilities at fair value based on
whether inputs are observable or unobservable.





·
            Level
      1 - includes assets and liabilities valued using inputs that are quoted
      prices in active markets for   identical assets or
      liabilities. Our Level 1 assets include exchange traded securities and
      U.S. Treasury securities.





·
            Level
      2 - includes assets and liabilities valued using inputs that are quoted
      prices for similar assets in an active market, quoted prices for identical
      or similar assets in a market that is not active, observable inputs, or
      observable inputs that can be corroborated by market data. Level 2 assets
      and liabilities include those financial instruments that are valued by
      independent pricing services using models or other valuation
      methodologies. These models are primarily industry-standard models that
      consider various inputs such as interest rate, credit spread, reported
      trades, broker/dealer quotes, issuer spreads and other inputs that are
      observable or derived from observable information in the marketplace or
      are supported by observable levels at which transactions are executed in
      the marketplace. Financial instruments in this category primarily include:
      certain public and private corporate fixed maturity securities; certain
      government or agency securities; certain mortgage and asset-backed
      securities; and non-exchange-traded derivatives such as call
      options.





·
            Level
      3 - includes assets and liabilities valued using unobservable inputs that
      are used in model-based valuations that contain management assumptions.
      Level 3 assets and liabilities include those
      financial          instruments
      whose fair value is estimated based on non-binding broker prices or
      internally developed models or methodologies utilizing significant inputs
      not based on, or corroborated by, readily available market information.
      Financial instruments in this category include certain corporate
      securities (primarily private placements), certain mortgage and
      asset-backed securities, and other less liquid
  securities.





At each
reporting date, we classify assets and liabilities into the three input levels
based on the lowest level of input that is significant to the measurement of
fair value for each asset and liability reported at fair value.


This
classification is impacted by a number of factors, including the type of
financial instrument, whether the financial instrument is new to the market and
not yet established, the characteristics specific to the transaction and overall
market conditions. Our assessment of the significance of a particular input to
the fair value measurement and the ultimate classification of each asset and
liability requires judgment.





Debt
Financing





On
September 1, 2009, we obtained $4,000,000 in debt financing from a member of our
Board of Directors, Mr. Terry Giles. Pursuant to the terms of the loan
agreement, we were required to use a portion of the loan proceeds to repurchase
2,391,906 shares of common stock from Mr. Giles and certain other parties
designated by Mr. Giles at a price of $0.70 per share or an aggregate price of
$1,674,334. Concurrent with the financing transaction, Mr. Giles resigned from
the Board of Directors.  We issued a secured note payable bearing
interest at 12% per annum, due on August 31, 2013. The net loan proceeds will be
used for working capital and general corporate purposes.  We received
net loan proceeds of $2,325,666, after payment for stock repurchase of 2,391,906
shares of common stock at a price of $0.70 per share for $1,674,334. We apply
ASC Topic 820 and 825 (SFAS 157, Fair Value Measurements) to assess the fair
value of the repurchased shares of common stock (which were illiquid for a
period of time).





Our
common stock is considered to be thinly traded for the following reasons: a) our
common stock is quoted on the OTCBB; b) the trading volume is less than 100,000
shares per day; c) the trading  volume in dollars is less than
$250,000 per day; d) the Bid/Ask Spread  less than $0.50 per share;
e)  our common stock is traded at less than $1 per share and is
classified as a “penny stock”;  and f) our Market
Capitalization  is less than $50 million.


12





Due to
our stock being thinly traded, we determined that the quoted market price on the
OTCBB of our stock was not the strongest or the leading indicator of fair value
in regards to this stock repurchase transaction.  Our management
performed additional analysis to further analyze the value of the business
(referred to as Level 2 and Level 3 data under ASC Topic 820 and 825, SFAS 157,
Fair Value Measurements).  Since the reported stock price alone was
not considered to be a sufficient measure of fair value, the fair value was
based on factors including the historical market and financial data,
specifically, revenue, earnings, cash on hand to market value (using market
capitalization) and trading volume to value. The fair value estimated for the
shares repurchased are measured using a bid-ask regression model which uses
Level 2 inputs for the determination of fair value, which did take into account
quoted market price of the common stock.





The
2,391,906 shares that were repurchased are treated as treasury stock and we
recorded them on our balance sheet as treasury stock a fair value of $1,468,609
which was determined using a combination of the items noted above.  We
recorded $205,725 on our balance sheet as a discount on the secured note,
representing the difference between the fair value of the common stock
repurchased and the repurchase price. The discount on the Note is being
amortized as interest expense using the effective interest method over the
48-month term of the Note. At September 30, 2009, the unamortized discount on
the Note was approximately $200,000.





Interest
on the Note is payable monthly, with the first 8 months being interest only
($40,000 per month) beginning September 30, 2009, and thereafter 40 monthly
payments of principal and interest ($121,822 each). The Note will mature on
August 31, 2013. Interest on the Note is payable monthly, with the first 8
months being interest only ($40,000 per month) beginning September 30, 2009, and
thereafter 40 monthly payments of principal and interest ($121,822 each). The
Note will mature on August 31, 2013. The Note is redeemable at the option of the
Company, in whole or in part, plus accrued and unpaid interest, if any, to the
date of redemption.





September 30, 2009Amortized
                    
                    
                    Loan
                    
                    
                    EstimatedCost
                    
                    
                    Discount
                    
                    
                    Fair ValueCommon
      stock repurchased
                    
                    $
                    1,674,334
                    
                    
                    $
                    (205,725
                    )
                    
                    $
                    1,468,609





5.  Stock
Based Compensation





We
granted to certain officers and employees 105,500 restricted shares and 151,700
stock options under our stock incentive plan during the three-month period ended
September 30, 2009. We did not grant any equity-based awards in the comparable
period last fiscal year. The fair value of option grants is estimated on the
date of grant using the Black-Scholes option pricing model.





A summary
of option activity from July 1, 2009 through September 30, 2009 is
presented below:





Number of
                  Options
                
                
                Weighted
                  Average Exercise
                  PriceOptions
      outstanding at July 1, 2009
                
                
                1,403,637
                
                
                $
                0.76Granted
                
                
                151,700
                
                
                
                0.60Forfeited
                
                
                -
                
                
                
                -Exercised
                
                
                -
                
                
                
                -Options
      outstanding at September 30, 2009
                
                
                1,555,337
                
                
                
                0.74Exercisable
      outstanding at September 30, 2009
                
                
                1,288,612
                
                
                $
                0.78





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 three-month periods ended September
30:





2009
                  
                  
                  2008Expected
      volatility
                  
                  
                  152
                  %
                  
                  
                  109
                  %Expected
      dividend yield
                  
                  
                  0.00
                  %
                  
                  
                  0.00
                  %Risk-free
      interest rate
                  
                  
                  4
                  %
                  
                  
                  3
                  %Expected
      life
                  
                  10
      years
                  
                  
                  10
      years




13




The
weighted average fair value on the date of the option grant was $74,796 for the
three months ended September 30, 2009.  The total unrecognized
share-based compensation costs related to non-vested stock options outstanding
at September 30, 2009 was $202,711 and is expected to be recognized
over a weighted average period of approximately 5.5 years.





Restricted
Stock





We
granted Restricted Stock, which we refer to as RS, to certain officers and
employees under our stock incentive plan. All RSs vest on the three-year
anniversary of the date of grant. The fair value of our RS is based on the
grant-date fair market value of the common stock, which equals the grant date
market price.




As
of September 30, 2009, all restricted shares are deemed vested by
the Company. As of September 30, 2009, we have no unrecognized compensation
cost.





Compensation
expense for share-based awards was $72,774 and $6,201 for the three months
ending September 30, 2009 and 2008, respectively. Amounts were included in our
consolidated statements of operations as follows:





Three months endedSeptember 30,
                  2009
                
                
                September 30,
                  2008Cost
      of sales
                
                $
                5,614
                
                
                $
                2,231Selling
      and administrative expenses
                
                
                67,160
                
                
                
                3,970Total
      compensation expense
                
                $
                72,774
                
                
                $
                6,201





6.  Short-term
Investments





We
classify our fixed maturity securities into one of three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component
of


shareholders'
equity); (ii) "trading" (which we carry at estimated fair value with changes in
such value recognized as trading income); or (iii) "held to maturity" (which we
carry at amortized cost). We had $504,320 of fixed maturity


securities
classified as held to maturity during the period presented in these financial
statements.


14


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 and our
audited financial statements and related notes for the year ended June 30, 2009,
included in our Annual Report on Form 10-K.





Overview





We
provide specialty 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. Beginning in fiscal 2008, we expanded our service
offering to include clinical biomarker services for novel biomarkers, as well as
custom assay services, to our pharmaceutical and biotechnology clients. Through
our biomarker services, we provide assay development services for novel
biomarkers, as well as custom assay services for immunogenicity testing and
multiplex testing.





Our
company is a Delaware corporation, incorporated in May 1996, and we conduct our
operations primarily through our wholly-owned subsidiary, Pacific Biomarkers,
Inc., a Washington corporation.  During the first quarter of fiscal
2010, we merged our wholly-owned subsidiary, Pacific Biomarkers, Inc., into our
wholly-owned subsidiary, Pacific Biometrics, Inc. and changed the name of the
surviving company to Pacific Biomarkers, Inc.





Critical
Accounting Policies and Estimates





There
have been no material changes to our critical accounting policies and estimates
since the end of our 2009 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, 2009.





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 our Consolidated Financial Statements included in
this Report and Note 2 to our Consolidated Financial Statements included in our
Annual Report on Form 10-K for the fiscal year ended June 30,
2009.


15





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.





Fair
Value Measurements





We follow
ASC Topic 820 and 825, (SFAS 157, Fair Value Measurements)  in determining
the fair value in our recent repurchase of shares of common stock, SFAS 157
clarifies a number of considerations with respect to fair value measurement
objectives for financial reporting and expands disclosures about the use of fair
value measurements.  The degree of judgment utilized in measuring the
fair value of financial instruments is largely dependent on the level to which
pricing is based on observable inputs. Observable inputs reflect market data
obtained from independent sources, while unobservable inputs reflect our view of
market assumptions in the absence of observable market information. See
Note 4 to our Consolidated Financial Statements. In valuing the repurchased
shares from our $4 million debt financing in September 2009, we chose a bid-ask
regression model as the most appropriate method to determine the fair value of
these shares.  We would expect material differences in reporting of
the fair value of these shares, had we chosen other methods in determining the
fair value.  The discount to the Note derived from the fair value of
the shares and interest expense derived from the discount may have been a higher
or lower amount.  For example, a regression model based on
restricted share regression analysis would produce a higher discount amount.
Alternatively, had we chosen the market closing price for fair value, the
discount would have been zero.  However, due to the thin trading
characteristics of our stock within the OTCBB market, the number of shares
repurchased, other observable and unobservable inputs, it was our judgment
that the method utilized in estimating the fair value of these shares was
appropriate for this transaction.





Results
of Operations for Three Months Ended September 30, 2009 and 2008





Revenue:





Three
      months EndedDollars
      in thousands, rounded to nearest
                    
                    September 30,
                    
                    
                    $
                    
                    
                    %thousand
                    
                    2009
                    
                    
                    2008
                    
                    
                    Change
                    
                    
                    ChangeRevenue
                    
                    $
                    2,301
                    
                    
                    $
                    1,805
                    
                    
                    
                    496
                    
                    
                    
                    27





We
generate the majority of our revenue from clinical pharmaceutical trials
testing, clinical biomarker services and diagnostic services. Our revenue
increased approximately 27% to $2,301,000 from $1,805,000 between the comparable
quarters ended September 30, 2009 and 2008. Our revenue fluctuations are due to
the 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. For the quarter ended September 30, 2009, we
benefited from strong levels of testing revenue in the diabetes and rheumatoid
arthritis therapeutic areas as well as an increase in clinical biomarker
services.


16





We
perform services for pharmaceutical and biotech companies, which include our
clinical trials testing and our biomarkers services (“Direct Clinical
Services”), and we also perform services for other large clinical laboratories
that refer specialty laboratory testing to us (“Referral Laboratories”). The
following table provides a breakdown of the percentage of our total revenue
generated from each of our service areas for the comparable quarters ended
September 30, 2009 and 2008:





Direct Clinical ServicesDirect Trials
                    Testing
                  
                  
                  Biomarkers
                  
                  
                  Referral
                    Laboratories
                  
                  
                  Diagnostic
                    ServicesThree
      months EndedSeptember
      30, 2009
                  
                  
                  49
                  %
                  
                  
                  13
                  %
                  
                  
                  37
                  %
                  
                  
                  1
                  %Three
      months EndedSeptember
      30, 2008
                  
                  
                  54
                  %
                  
                  
                  6
                  %
                  
                  
                  39
                  %
                  
                  
                  1
                  %





We
believe that the overall significant increase in revenue for the quarter ended
September 30, 2009 reflects our significant investments in business development
initiatives over several fiscal years, particularly directed towards Direct
Clinical Services.  We have seen growth in our biomarker services and
we expect to see our biomarker services represent a larger portion of our
revenue during fiscal 2010. As discussed in our Annual Report on Form 10-K for
the 2009 fiscal year, we are continuing to monitor and evaluate the shift in the
industry to “adaptive clinical trials” and how this may impact us going
forward.





Our
revenues tend to fluctuate from quarter to quarter, and sometimes these
fluctuations are significant. These fluctuations are typically explained by the
timing of entering into new contracts for clinical studies and our work on
testing and open work orders, and the completion of prior work orders or early
cancellation of studies by our clients.  The studies that we bid on
are uncertain until we have a signed contract. Once our work on a study
commences, the client may cancel the study at any time during the testing phase.
Clients may terminate, delay, or change the scope of a project for a variety of
reasons including unexpected or undesirable clinical results or a decision to
forego a particular study.  Accordingly, our revenues may be
significantly affected by the success or failure of the testing phase and other
factors outside of our control, including a large number of pharmaceutical
companies’ cost reduction announcements and continuing consolidation in the
pharmaceutical market.





Laboratory
Expense and Cost of Goods Sold:





Three months EndedDollars in thousands, rounded to nearest
                  
                  September 30,
                  
                  
                  $
                  
                  
                  %thousand
                  
                  2009
                  
                  
                  2008
                  
                  
                  Change
                  
                  
                  ChangeLaboratory
      Expenses and Cost of Goods Sold
                  
                  $
                  1,394
                  
                  
                  $
                  1,103
                  
                  
                  
                  291
                  
                  
                  
                  26Percentage
      of Revenue
                  
                  
                  61
                  %
                  
                  
                  61
                  %





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 chemical reagents and supplies for analysis ofclinical trialsamples, and
secondarily, of payments to subcontractors for laboratory services, rent,
insurance, business and occupation taxes. The primary expense increases for the
quarter ended September 30, 2009 were from reagents, salaries and employee
benefits, although as a percentage of our total revenue our expenses in this
category remained constant.





Generally,
laboratory expense and cost of goods sold include expense items that are highly
variable due to the mix of services we provide in any given period, the overall
volume of tests performed, the use of new and highly complex assays and the
volume of subcontracted laboratory services. The following table illustrates
changes in laboratory expense and cost of goods sold in fixed and variable
expense categories:


17





Three months EndedSeptember 30,Dollars in thousands, rounded tonearestthousand
                        
                        2009
                        
                        
                        % of
                          revenue
                        
                        
                        2008
                        
                        
                        % of
                          revenue
                        
                        
                        $ change
                        
                        
                        % changeFixed
      Cost DetailRent,
      Utilities, Certain Taxes
                        
                        $
                        164
                        
                        
                        
                        7
                        %
                        
                        $
                        127
                        
                        
                        
                        7
                        %
                        
                        $
                        37
                        
                        
                        
                        29
                        %Variable
      Cost DetailWages,
      Taxes, Benefits
                        
                        
                        628
                        
                        
                        
                        27
                        %
                        
                        
                        507
                        
                        
                        
                        28
                        %
                        
                        
                        121
                        
                        
                        
                        24
                        %Reagent
      Chemicals
                        
                        
                        462
                        
                        
                        
                        20
                        %
                        
                        
                        355
                        
                        
                        
                        20
                        %
                        
                        
                        107
                        
                        
                        
                        30
                        %Other
      Variable Costs
                        
                        
                        140
                        
                        
                        
                        7
                        %
                        
                        
                        114
                        
                        
                        
                        6
                        %
                        
                        
                        26
                        
                        
                        
                        23
                        %Total
                        
                        
                        1,230
                        
                        
                        
                        54
                        %
                        
                        
                        976
                        
                        
                        
                        54
                        %
                        
                        
                        254
                        
                        
                        
                        26
                        %Total
      Cost of Goods Sold
                        
                        $
                        1,394
                        
                        
                        
                        61
                        %
                        
                        $
                        1,103
                        
                        
                        
                        61
                        %
                        
                        $
                        291
                        
                        
                        
                        26
                        %





For the
comparable quarters ended September 30, 2009 and 2008, laboratory expense and
cost of goods sold increased by approximately $291,000, or 26%, to $1,394,000,
up from $1,103,000. Laboratory expense and cost of goods sold as a percentage of
revenue was approximately 61% for both quarters ended September 30, 2009 and
2008. Our increase in laboratory expense and cost of goods sold was due to
increases in variable costs of salaries, related benefits and laboratory
reagents and in fixed costs of our rent.





The
largest component of laboratory expense for the quarter ended September 30, 2009
was salaries and related benefits. Laboratory salaries and related benefits
increased 24% to approximately $628,000 from $507,000 for the quarters ended
September 30, 2009 and 2008 as a result of an increase in staff to accommodate
increases in the complexity and volume of tests performed. These expenses
represented approximately 27% and 28%, respectively, as a percentage of revenue
for the comparable periods.





The other
major component of laboratory expense for the quarter ended September 30, 2009
was the cost of laboratory reagents and supplies for analysis of clinical trial
samples. Over the last three fiscal years, reagent chemicals used 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 September 30, 2009 and 2008, laboratory
reagents and supplies increased by 30% to approximately $462,000 from $355,000
as a result of an increase in the number of tests performed. The cost of
laboratory reagents and supplies as a percentage of revenue was approximately
20% for the comparable quarters ended September 30, 2009 and 2008. This is a
favorable result as we experienced significant reagent cost increases during the
third and fourth quarters of the prior fiscal year (fiscal 2009).





Other
variable costs increased 23% for the comparable quarters, to $140,000 from
$114,000. The increase was primarily due to increases in laboratory repair and
maintenance expense and outside service costs for outsourced
testing.





Fixed
Costs for the quarter ended September 30, 2009 increased 29% compared to the
quarter ended September 30, 2008, to approximately $164,000 from $127,000. This
increase was mainly due to increases in laboratory depreciation and rentfor our new biomarker
services facility.


18





Selling,
General and Administrative Expense:





Three months EndedDollars in thousands, rounded to
                    
                    September 30,
                    
                    
                    $
                    
                    
                    %nearest thousand
                    
                    2009
                    
                    
                    2008
                    
                    
                    Change
                    
                    
                    ChangeSelling,
      General and Administrative Expense
                    
                    $
                    1,121
                    
                    
                    $
                    915
                    
                    
                    
                    206
                    
                    
                    
                    23Percentage
      of Revenue
                    
                    
                    49
                    %
                    
                    
                    51
                    %





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), and secondarily of
share-based compensation, business development expenses, legal, accounting and
public company expenses.





For the
comparable quarters ended September 30, 2009 and 2008, our selling, general and
administrative expense increased 23% to approximately $1,121,000, up from
$915,000. As a percentage of revenue, selling, general and administrative
expense was 49% and 51%, respectively, for the quarters ended September 30, 2009
and 2008. The decrease in selling, general and administrative expense as a
percentage of revenue was the result of the significant increase in our revenues
between the comparable periods.





The
dollar increase in our selling, general and administrative expenses for the
comparable periods is due in large part to increases in legal, accounting and
other public company expense, share-based compensation, and salaries and related
benefits.  Our legal, accounting and other public company expense increased
for the first quarter of fiscal 2010 due to increased legal and accounting fees,
including expenses for our debt financing with Terry Giles, and increases in our
insurance premiums.  Our share-based compensation increased due to our
awards of restricted stock and stock options during the first quarter of fiscal
2010, compared to no such awards in the comparable quarter of fiscal
2009. Our salary and benefit expenses increased due to one addition to the
administration staff and two new hires in our Science and Technology team to
support our clinical biomarkers area. These increases were offset somewhat by
decreases in advertising and marketing expense, consulting expense and travel
expense.





Other
Income (Expense):





Three months EndedDollars in thousands, rounded to
                    
                    September 30,
                    
                    
                    $
                    
                    
                    %nearest thousand
                    
                    2009
                    
                    
                    2008
                    
                    
                    Change
                    
                    
                    ChangeOther
      Income/(Expense)
                    
                    $
                    (59
                    )
                    
                    $
                    208
                    
                    
                    
                    (267
                    )
                    
                    
                    (128
                    )Percentage
      of Revenue
                    
                    
                    (3
                    )%
                    
                    
                    12
                    %





We had
other expense of approximately $59,000 for the quarter ended September 30, 2009,
compared to other income of approximately $208,000 for the quarter ended
September 30, 2008. The main component of other income/expense for the quarter
ended September 30, 2009 was interest expense of approximately $53,000 compared
to approximately $111,000 interest expense in the comparable fiscal period last
year. Interest expense for the quarter ended September 30, 2009 included $40,000
of interest related to our debt financing with Terry M. Giles. We also recorded
$5,958 of expense related to the amortization of the discount on the debt for
the quarter ended September 30, 2009. We had no comparable amortization expense
for the comparable fiscal period last year.





As
previously disclosed, we used a portion of our $4 million debt financing to
repurchase 2,391,906 shares of common stock at a price of $0.70 per
share.  In accordance with SFAS 157 (see Note 4 to our Consolidated
Financial Statements), we are required to assess the “fair value” of the
repurchased shares of common stock.  Although the closing price of the
common stock on September 1, 2009, the closing date of the financing, was $0.95
per share, we could not rely on that measurement alone.  Based on
historical market and financial data (specifically revenue, earnings, cash on
hand to market value (using market capitalization) and trading volume to value),
we determined a fair value of the repurchased shares of $1,468,609 (or
approximately $0.61 per share), representing a discount to the term loan of
approximately $206,000. This loan discount will be amortized over the 48
month-term of the loan as interest expense.  For the quarter ended
September 30, 2009, we recorded $5,958 as amortized interest expense. We had no comparable
amortization expense for the comparable fiscal period last
year.


19





A
significant change between the two comparable quarters is attributable to the
net income we recognized in fiscal 2009 due to the accounting treatment on the
Laurus convertible notes, which were paid in full as of December 31, 2008. Our
“other income” for the first quarter last year included a net gain attributable
to the Laurus convertible notes in the amount of approximately $246,000, due to
adjustments to the value of the embedded derivative, non-cash interest expense
for the intrinsic value of the conversion feature and warrants, and amortization
of deferred financing costs. We had no comparable gain, non-cash interest
expense or amortization costs in the first quarter of the current fiscal
year.





Net
Loss:





Three months EndedDollars in thousands, rounded to nearest
                    
                    September 30,
                    
                    
                    $
                    
                    
                    %thousand
                    
                    2009
                    
                    
                    2008
                    
                    
                    Change
                    
                    
                    ChangeNet
      Loss
                    
                    $
                    (273
                    )
                    
                    $
                    (6
                    )
                    
                    
                    (267
                    )
                    
                    
                    (4450
                    )Percentage
      of Revenue
                    
                    
                    (12
                    )%
                    
                    
                    (0
                    )%





We had a
net loss of approximately $(273,000) for the quarter ended September 30, 2009
compared to a net loss of approximately $(6,000) for the quarter ended September
30, 2008. Although our net loss increased for the first quarter of the current
fiscal year, our gross profit increased 29% to $908,000 from $702,000 compared
to the quarter ended September 30, 2008.





The
primary reason for the change in our net loss between quarters was that fiscal
2009 included a significant net gain due to the accounting treatment for the
Laurus convertible notes (as described above in “Other Income/(Expense)”),
whereas we had no similar non-cash gain in the first quarter of fiscal
2010.  Other changes affecting our net loss are described above under
“Laboratory Expense and Cost of Goods Sold” and “Selling, General and
Administrative Expense.”





Liquidity
and Capital Resources:





At
September 30, 2009 our cash and cash equivalents were approximately $3,234,000,
compared to approximately $1,365,000 at June 30, 2009. At September 30, 2009, we
had approximately $1,688,000 in accounts receivable, compared to approximately
$2,239,000 as of June 30, 2009, reflecting timing of revenues billed and
collected. Our accounts receivable generally reflect our billings, and may
include one or several individually large customer receivables from time to
time. We generally have a high collectibility rate on our accounts receivable,
and our allowance for doubtful trade accounts is approximately $34,000, which we
believe is reasonable based on our past experience.





Total
liabilities recorded on our balance sheet as of September 30, 2009 were
approximately $5,384,000 compared to approximately $1,986,000 as of June 30,
2009. This significant increase in liabilities was the result of our $4 million
debt financing in September 2009 from Terry M. Giles, a former member of our
Board of Directors. We received net loan proceeds of $2,325,666, after payment
for stock repurchase of 2,391,906 shares of common stock at a price of $0.70 per
share for $1,674,334, but excluding our legal and other expenses for the
transaction. We intend to use the net proceeds of the loan to fund our working
capital and growth needs, and in particular development efforts for our
biomarker business. The loan is due and payable over 48 months, with the first 8
months being interest only ($40,000 per month) beginning September 30, 2009, and
thereafter 40 monthly payments of principal and interest ($121,822
each).  During the first 12 months of the term of the loan, we have
the right, in our sole discretion, to obtain an additional $500,000 loan from
Mr. Giles on the same terms. Other than this term loan with Mr. Giles, we do not
have available to us a bank line of credit or other general borrowing
facility.


20





At
September 30, 2009, we had working capital of approximately $4,181,000, compared
to approximately $2,459,000 at June 30, 2009. The increase of approximately
$1,722,000 in our working capital is mainly attributable to a significant
increase in our cash position from net proceeds from debt financing, whereas
only a portion of this loan is recorded as a current liability (affecting
working capital) and the balance is recorded as a long-term liability. Other
changes providing a positive impact in working capital included decreases in
accounts payable, accrued liabilities and capital leases obligations. Changes
providing a negative impact included decreases in accounts receivable, inventory
and prepaid expenses and increases in advances from customers and our secured
note obligation. Other receivable included $451,000 from a state business and
occupation tax refund for fiscal 2008. Net cash from operations has also
improved our working capital position.





Net cash
provided by operating activities was approximately $141,000 for the quarter
ended September 30, 2009 and included the effect of approximately $76,000 in
depreciation and amortization and approximately $73,000 in expense from
share-based compensation. Our investing activities used cash of approximately
$583,000 for the quarter ended September 30, 2009 for the purchase of capital
equipment and investments. Cash flow provided by or used in financing activities
included $4,000,000 provided by gross loan proceeds, approximately $1,674,000
used in common stock repurchase and $15,000 used in payments on capital lease
obligations.





On
September 1, 2009 we repurchased 2,391,906 shares of our outstanding common
stock as condition for obtaining the $4 million debt financing. We did not
repurchase the stock in open market transactions. The funds for the repurchase
came from cash received from the related $4 million debt financing. We have
repurchased the common shares at a cost of approximately
$1,674,334.





We
experienced an increase in our cash and working capital position from operations
during the quarter ended September 30, 2009 and we believe that our cash,
current assets and cash flows from operations will be sufficient to fund current
operations through calendar 2010.





In fiscal
2010, we will continue to actively pursue business development and marketing
activities to broaden our client and revenue base. In particular, we anticipate
making additional capital and human resource investments for our clinical
biomarker services. We may also invest 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.





We will
also continue 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 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.


21





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 and Controller. Based
upon that evaluation, our Chief Executive Officer and Vice President and
Controller concluded that our disclosure controls and procedures are effective
at September 30, 2009.





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
      6.
            EXHIBITS





21.1
                
                Subsidiaries
      of Pacific Biometrics, Inc.31.1
                
                Certification
      of Ronald R. Helm, Chief Executive Officer31.2
                
                Certification
      of John P. Jensen, Vice President and Controller32.1
                
                Certification
      of Ronald R. Helm, Chief Executive Officer and John P. Jensen, Vice
      President 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.


22





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:  November
13, 2009





/s/ Ronald R. HelmRonald
      R. HelmChief
      Executive Officer(principal
      executive officer)/s/ John P. JensenJohn
      P. JensenVice
      President and Controller(principal
      financial and accounting
officer)


23