UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM
10-Q




þ
            QUARTERLY REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934


For the
quarterly period ended December 31, 2008





or





 ̈
            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. 001-33407




ISORAY,
INC.


(Exact
name of registrant as specified in its charter)




Minnesota
                      
                      41-1458152(State
      or other jurisdiction of incorporation or
                        organization)
                      
                      (I.R.S.
      Employer
                        Identification
      No.)350 Hills St., Suite
      106, Richland, Washington
                      
                      99354(Address
      of principal executive offices)
                      
                      (Zip
      Code)





Registrant's
      telephone number, including area code: (509)
      375-1202





Indicate by check mark whether the
registrant has (1) 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 the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
YesxNo ̈





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 companyx





Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act):  Yes ̈Nox





Number of
shares outstanding of each of the issuer's classes of common equity as of the
latest practicable date:





Class
              
              Outstanding as of February 6,
      2008Common
      stock, $0.001 par value
              
              22,942,088







ISORAY,
INC.




Table
of Contents





PART
      I
                FINANCIAL
      INFORMATIONItem
      1
                Consolidated
      Unaudited Financial Statements
                1Consolidated
      Balance Sheets
                1Consolidated
      Statements of Operations
                2Consolidated
      Statements of Cash Flows
                3Notes
      to Consolidated Unaudited Financial Statements
                4Item
      2
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                11Item
      3
                Quantitative
      and Qualitative Disclosures About Market Risk
                20Item
      4T
                Controls
      and Procedures
                21PART
      II
                OTHER
      INFORMATIONItem
      1A
                Risk
      Factors
                21Item
      6
                Exhibits
                22Signatures
                
                23







PART
I – FINANCIAL INFORMATION


IsoRay,
Inc. and Subsidiaries


Consolidated
Balance Sheets





December 31,2008
                        
                        
                        June 30,(Unaudited)
                        
                        
                        2008ASSETSCurrent
      assets:Cash
      and cash equivalents
                        
                        $
                        2,483,876
                        
                        
                        $
                        4,820,033Short-term
      investments
                        
                        
                        4,000,000
                        
                        
                        
                        3,726,000Accounts
      receivable, net of allowance for doubtful accounts of $79,110 and $33,031,
      respectively
                        
                        
                        830,108
                        
                        
                        
                        1,016,495Inventory
                        
                        
                        888,270
                        
                        
                        
                        899,964Prepaid
      expenses and other current assets
                        
                        
                        215,558
                        
                        
                        
                        267,001Total
      current assets
                        
                        
                        8,417,812
                        
                        
                        
                        10,729,493Fixed
      assets, net of accumulated depreciation and amortization
                        
                        
                        5,468,386
                        
                        
                        
                        6,040,641Deferred
      financing costs, net of accumulated amortization
                        
                        
                        48,336
                        
                        
                        
                        65,221Licenses,
      net of accumulated amortization
                        
                        
                        6,376
                        
                        
                        
                        455,646Restricted
      cash
                        
                        
                        177,438
                        
                        
                        
                        175,852Other
      assets, net of accumulated amortization
                        
                        
                        349,075
                        
                        
                        
                        345,040Total
      assets
                        
                        $
                        14,467,423
                        
                        
                        $
                        17,811,893LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued liabilities
                        
                        $
                        735,873
                        
                        
                        $
                        751,402Accrued
      payroll and related taxes
                        
                        
                        269,011
                        
                        
                        
                        344,612Notes
      payable, due within one year
                        
                        
                        176,153
                        
                        
                        
                        64,486Capital
      lease obligations, due within one year
                        
                        
                        10,777
                        
                        
                        
                        25,560Total
      current liabilities
                        
                        
                        1,191,814
                        
                        
                        
                        1,186,060Notes
      payable, due after one year
                        
                        
                        203,129
                        
                        
                        
                        344,898Asset
      retirement obligation
                        
                        
                        529,206
                        
                        
                        
                        506,005Total
      liabilities
                        
                        
                        1,924,149
                        
                        
                        
                        2,036,963Shareholders'
      equity:Preferred
      stock, $.001 par value; 6,000,000 shares authorized:Series
      A: 1,000,000 shares allocated; no shares issued and
      outstanding
                        
                        
                        -
                        
                        
                        
                        -Series
      B: 5,000,000 shares allocated; 59,065 shares issued and
      outstanding
                        
                        
                        59
                        
                        
                        
                        59Common
      stock, $.001 par value; 194,000,000 shares authorized;22,942,088
      shares issued and outstanding
                        
                        
                        22,942
                        
                        
                        
                        22,942Treasury
      stock, at cost, 13,200 and 5,000 shares
                        
                        
                        (8,390
                        )
                        
                        
                        (3,655
                        )Additional
      paid-in capital
                        
                        
                        47,664,289
                        
                        
                        
                        47,464,507Accumulated
      deficit
                        
                        
                        (35,135,626
                        )
                        
                        
                        (31,708,923
                        )Total
      shareholders' equity
                        
                        
                        12,543,274
                        
                        
                        
                        15,774,930Total
      liabilities and shareholders' equity
                        
                        $
                        14,467,423
                        
                        
                        $
                        17,811,893





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


1





IsoRay,
Inc. and Subsidiaries


Consolidated
Statements of Operations


(Unaudited)





Three months ended December 31,
                
                
                Six months ended December 31,2008
                
                
                2007
                
                
                2008
                
                
                2007Product
      sales
                
                $
                1,326,703
                
                
                $
                1,758,344
                
                
                $
                2,846,285
                
                
                $
                3,614,063Cost
      of product sales
                
                
                1,724,225
                
                
                
                2,241,795
                
                
                
                3,172,661
                
                
                
                4,247,297Gross
      loss
                
                
                (397,522
                )
                
                
                (483,451
                )
                
                
                (326,376
                )
                
                
                (633,234
                )Operating
      expenses:Research
      and development expenses
                
                
                306,056
                
                
                
                395,545
                
                
                
                524,606
                
                
                
                651,915Sales
      and marketing expenses
                
                
                620,700
                
                
                
                1,142,827
                
                
                
                1,351,474
                
                
                
                2,202,643General
      and administrative expenses
                
                
                758,822
                
                
                
                919,164
                
                
                
                1,538,979
                
                
                
                1,821,189Total
      operating expenses
                
                
                1,685,578
                
                
                
                2,457,536
                
                
                
                3,415,059
                
                
                
                4,675,747Operating
      loss
                
                
                (2,083,100
                )
                
                
                (2,940,987
                )
                
                
                (3,741,435
                )
                
                
                (5,308,981
                )Non-operating
      income (expense):Interest
      income
                
                
                37,562
                
                
                
                179,855
                
                
                
                82,348
                
                
                
                418,551Gain
      on fair value of short-term investments
                
                
                433,200
                
                
                
                -
                
                
                
                274,000
                
                
                
                -Financing
      and interest expense
                
                
                (20,769
                )
                
                
                (25,211
                )
                
                
                (41,616
                )
                
                
                (55,314
                )Non-operating
      income, net
                
                
                449,993
                
                
                
                154,644
                
                
                
                314,732
                
                
                
                363,237Net
      loss
                
                $
                (1,633,107
                )
                
                $
                (2,786,343
                )
                
                $
                (3,426,703
                )
                
                $
                (4,945,744
                )Basic
      and diluted loss per share
                
                $
                (0.07
                )
                
                $
                (0.12
                )
                
                $
                (0.15
                )
                
                $
                (0.21
                )Weighted
      average shares used in computing net loss per share:Basic
      and diluted
                
                
                22,942,088
                
                
                
                23,072,272
                
                
                
                22,942,088
                
                
                
                23,036,657





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


2





IsoRay,
Inc. and Subsidiaries


Consolidated
Statements of Cash Flows


(Unaudited)





Six months ended December 31,2008
                      
                      
                      2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                      
                      $
                      (3,426,703
                      )
                      
                      $
                      (4,945,744
                      )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization of fixed assets
                      
                      
                      604,651
                      
                      
                      
                      586,866Impairment
      of IBt license (see Note 4)
                      
                      
                      425,434
                      
                      
                      
                      -Amortization
      of deferred financing costs and other assets
                      
                      
                      44,144
                      
                      
                      
                      90,541Amortization
      of discount on short-term investments
                      
                      
                      -
                      
                      
                      
                      (119,149
                      )Gain
      on fair value of short-term investments
                      
                      
                      (274,000
                      )
                      
                      
                      -Settlement
      of asset retirement obligation
                      
                      
                      -
                      
                      
                      
                      (135,120
                      )Accretion
      of asset retirement obligation
                      
                      
                      23,201
                      
                      
                      
                      14,703Share-based
      compensation
                      
                      
                      199,782
                      
                      
                      
                      354,613Changes
      in operating assets and liabilities:Accounts
      receivable, net
                      
                      
                      186,387
                      
                      
                      
                      263,007Inventory
                      
                      
                      11,694
                      
                      
                      
                      (114,399
                      )Prepaid
      expenses and other current assets
                      
                      
                      51,443
                      
                      
                      
                      15,130Accounts
      payable and accrued expenses
                      
                      
                      (15,529
                      )
                      
                      
                      (763,203
                      )Accrued
      payroll and related taxes
                      
                      
                      (75,601
                      )
                      
                      
                      49,892Deferred
      revenue
                      
                      
                      -
                      
                      
                      
                      (23,874
                      )Net
      cash used by operating activities
                      
                      
                      (2,245,097
                      )
                      
                      
                      (4,726,737
                      )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of fixed assets
                      
                      
                      (32,396
                      )
                      
                      
                      (2,969,764
                      )Additions
      to licenses and other assets
                      
                      
                      (7,458
                      )
                      
                      
                      (286,733
                      )Change
      in restricted cash
                      
                      
                      (1,586
                      )
                      
                      
                      (172,500
                      )Purchases
      of short-term investments
                      
                      
                      -
                      
                      
                      
                      (10,593,828
                      )Proceeds
      from the sale or maturity of short-term investments
                      
                      
                      -
                      
                      
                      
                      11,975,680Net
      cash used by investing activities
                      
                      
                      (41,440
                      )
                      
                      
                      (2,047,145
                      )CASH
      FLOWS FROM FINANCING ACTIVITIES:Principal
      payments on notes payable
                      
                      
                      (30,102
                      )
                      
                      
                      (25,825
                      )Principal
      payments on capital lease obligations
                      
                      
                      (14,783
                      )
                      
                      
                      (102,157
                      )Proceeds
      from cash sales of common stock, pursuant to exercise of
      warrants
                      
                      
                      -
                      
                      
                      
                      1,010,913Proceeds
      from cash sales of common stock, pursuant to exercise of
      options
                      
                      
                      -
                      
                      
                      
                      11,900Repurchase
      of Company common stock
                      
                      
                      (4,735
                      )
                      
                      
                      -Net
      cash (used) provided by financing activities
                      
                      
                      (49,620
                      )
                      
                      
                      894,831Net
      decrease in cash and cash equivalents
                      
                      
                      (2,336,157
                      )
                      
                      
                      (5,879,051
                      )Cash
      and cash equivalents, beginning of period
                      
                      
                      4,820,033
                      
                      
                      
                      9,355,730CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                      
                      $
                      2,483,876
                      
                      
                      $
                      3,476,679Non-cash
      investing and financing activities:Increase
      in fixed assets related to asset retirement obligation
                      
                      $
                      -
                      
                      
                      $
                      473,096





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


3


IsoRay,
Inc. and Subsidiaries


Notes
to the Consolidated Unaudited Financial Statements
 For
the three and six-month periods ended December 31, 2008 and
2007








1.
            Basis
      of Presentation





The
accompanying consolidated financial statements are those of IsoRay, Inc., and
its wholly-owned subsidiaries (IsoRay or the Company).  All
significant intercompany accounts and transactions have been eliminated in
consolidation.





The
accompanying interim consolidated financial statements have been prepared in
conformity with U.S. generally accepted accounting principles, consistent in all
material respects with those applied in the Company’s Annual Report on Form 10-K
for the fiscal year ended June 30, 2008.  The financial information is
unaudited but reflects all adjustments, consisting only of normal recurring
accruals, which are, in the opinion of the Company’s management, necessary for a
fair statement of the results for the interim periods
presented.  Interim results are not necessarily indicative of results
for a full year.  The information included in this Form 10-Q should be
read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal
year ended June 30, 2008.





Certain
amounts in the prior-year financial statements have been reclassified to conform
to the current year presentation.





2.           Changes
in Accounting Policies





SFAS
157





Effective
July 1, 2008, the Company implemented Statement of Financial Accounting
Standards (SFAS) No. 157, Fair Value
Measurements.  SFAS 157 defines fair value, establishes a
framework for measuring fair value in accordance with accounting principles
generally accepted in the United States, and expands disclosures about fair
value measurements.  The Company elected to implement this Statement
with the one-year deferral permitted by FASB Staff Position (FSP) 157-2 for
nonfinancial assets and nonfinancial liabilities measured at fair value, except
those that are recognized or disclosed on a recurring basis.  This
deferral applies to fixed assets and intangible asset impairment testing and
initial recognition of asset retirement obligations for which fair value is
used.  The Company does not expect any significant impact to our
consolidated financial statements when we implement SFAS 157 for these assets
and liabilities.





SFAS 157
requires disclosures that categorize assets and liabilities measured at fair
value into one of three different levels depending on the observability of the
inputs employed in the measurement.  Level 1 inputs are quoted prices
in active markets for identical assets or liabilities.  Level 2 inputs
are observable inputs other than quoted prices included within Level 1 for the
asset or liability, either directly or indirectly through market-corroborated
inputs.  Level 3 inputs are unobservable inputs for the asset or
liability reflecting significant modifications to observable related market data
or our assumptions about pricing by market participants.





Due to
the uncertainties in the credit markets, the monthly auctions for the Company’s
auction rate securities (ARS) have failed since February 2008 and no longer have
an active market.  These short term securities are valued by our
broker using various assumptions including current interest rates, credit
ratings, the issuer’s financial health, etc.  These are classified as
Level 2.


4





On
October 16, 2008, the Company accepted an offer from UBS AG (UBS) providing the
Company with Auction Rate Securities Rights Series B (Rights) pertaining to our
ARS (see Note 5).  These Rights are a put option for the right to sell
to UBS our ARS at par value.  As the Rights are non-transferable and
cannot be attached to the ARS if they are sold to another entity, the Rights
represent a free-standing instrument between the Company and UBS.  The
Rights were valued using a discounted cash flow model based on the Company’s
estimates and assumptions.





The fair
value hierarchy for our financial assets accounted for at fair value on a
recurring basis at December 31, 2008 was:





Level 1
                    
                    
                    Level 2
                    
                    
                    Level 3Auction
      rate securities
                    
                    $
                    –
                    
                    
                    $
                    3,244,450
                    
                    
                    $
                    –Auction
      rate securities rights – put option
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    755,550$
                    –
                    
                    
                    $
                    3,244,450
                    
                    
                    $
                    755,550





SFAS
159





Effective
July 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities Including an Amendment of FASB Statement No.
115.  The statement allows entities to value many financial
instruments and certain other items at fair value.  SFAS 159 provides
guidance over the election of the fair value option, including the timing of the
election and specific items eligible for the fair value
accounting.  If the fair value option is elected then unrealized gains
and losses are reported in earnings at each subsequent reporting
date.  The Company elected not to measure any additional financial
instruments or other items at fair value as of July 1, 2008 in accordance with
SFAS 159.  Accordingly, the adoption of SFAS 159 did not impact our
consolidated financial statements.  The Company did elect to fair
value its ARS rights that were received in October 2008 in accordance with SFAS
159 (see Note 5).





3.           Loss
per Share





The
Company accounts for its income (loss) per common share according to SFAS No.
128, Earnings Per
Share.  Under the provisions of SFAS 128, primary and fully
diluted earnings per share are replaced with basic and diluted earnings per
share.  Basic earnings per share is calculated by dividing net income
(loss) available to common shareholders by the weighted average number of common
shares outstanding, and does not include the impact of any potentially dilutive
common stock equivalents.  Common stock equivalents, including
warrants and options to purchase the Company's common stock, are excluded from
the calculations when their effect is antidilutive.  At December 31,
2008 and 2007, the calculation of diluted weighted average shares does not
include preferred stock, common stock warrants, or options that are potentially
convertible into common stock as those would be antidilutive due to the
Company’s net loss position.





Securities
not considered in the calculation of diluted weighted average shares, but that
could be dilutive in the future as of December 31, 2008 and 2007 were as
follows:





December
      31,2008
                  
                  
                  2007Preferred
      stock
                  
                  
                  59,065
                  
                  
                  
                  59,065Common
      stock warrants
                  
                  
                  3,245,082
                  
                  
                  
                  3,255,774Common
      stock options
                  
                  
                  2,458,708
                  
                  
                  
                  3,210,981Total
      potential dilutive securities
                  
                  
                  5,762,855
                  
                  
                  
                  6,525,820




5




4.           Impairment
of IBt License





In
December 2008, the Company reevaluated its license agreement with International
Brachytherapy SA (IBt) in connection with an overall review of its present cost
structure and projected market and manufacturing strategies (see Note 9 for
further details on the IBt license agreement).  Management determined
through this review that it does not currently intend to utilize the IBt license
as part of its market strategy due to the cost of revamping its manufacturing
process to incorporate the technology and as there can be no assurance that
physicians would accept this new technology without extensive education and
marketing costs.  However, the Company does not intend to cancel the
license agreement at this time; therefore, the license was reviewed in terms of
an “abandoned asset” for purposes of SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets.As there are no
anticipated future revenues from the license and the Company cannot sell or
transfer the license, it was determined that the entire value should be written
off.  Therefore, the Company recorded an impairment charge of $425,434
that is included in cost of product sales for the three and six months ended
December 31, 2008.





5.           Short-Term
Investments





The
Company’s short-term investments consisted of the following at December 31, 2008
and June 30, 2008:





December 31,
                  
                  
                  June 30,2008
                  
                  
                  2008Auction
      rate securities
                  
                  $
                  3,244,450
                  
                  
                  $
                  3,726,000Auction
      rate securities rights – put option
                  
                  
                  755,550
                  
                  
                  
                  –$
                  4,000,000
                  
                  
                  $
                  3,726,000





Beginning
in February 2008, the uncertainties in the credit markets prevented the Company
from liquidating its ARS (consisting of various student loan
portfolios).  The securities continued to pay interest according to
their stated terms and are all AAA/Aaa rated investments.  Through
September 2008, the Company classified these securities as available-for-sale
and recorded them at fair market value.  The Company recognized a
decline in the fair value of these securities (which has been caused by the
market uncertainties) as other than temporary and recorded the impairment loss
in the statement of operations.





In
October 2008, the Company accepted an offer from UBS to provide the Company with
certain Rights pertaining to our ARS.  The Rights are a put option
allowing the Company to sell its ARS to UBS at par value at any time from
January 2, 2009 to January 4, 2011.  The Rights did not meet the
definition of a derivative under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, as there is no net settlement
method.  The Rights also did not meet the definition of a security
under SFAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities.  The Company
elected to measure the Rights under the fair value option of SFAS No. 159 on the
date they were received (see Note 2) and classified them as short-term
investments.





Also in
October 2008, the Company reclassified its ARS from available-for-sale to
trading and has recorded all changes in fair value to these securities during
the quarter ended December 31, 2008 in the statement of
operations.  The Company felt this reclassification was appropriate
given that it accepted the offer of the Rights, it did not intend to hold these
investments to maturity, and there is no longer an active market to permit their
sale in the normal course of business.


6


6.           Inventory





Inventory
consisted of the following at December 31, 2008 and June 30, 2008:





December 31,
                  
                  
                  June 30,2008
                  
                  
                  2008Raw
      materials
                  
                  $
                  659,138
                  
                  
                  $
                  696,958Work
      in process
                  
                  
                  221,866
                  
                  
                  
                  191,684Finished
      goods
                  
                  
                  7,266
                  
                  
                  
                  11,322$
                  888,270
                  
                  
                  $
                  899,964





7.           Share-Based
Compensation





The
following table presents the share-based compensation expense recognized during
the three and six months ended December 31, 2008 and 2007:





Three months
                    
                    
                    Six monthsended December 31,
                    
                    
                    ended December 31,2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Cost
      of product sales
                    
                    $
                    4,780
                    
                    
                    $
                    36,827
                    
                    
                    $
                    13,910
                    
                    
                    $
                    73,830Research
      and development expenses
                    
                    
                    9,568
                    
                    
                    
                    11,550
                    
                    
                    
                    19,489
                    
                    
                    
                    23,100Sales
      and marketing expenses
                    
                    
                    46,291
                    
                    
                    
                    59,557
                    
                    
                    
                    104,983
                    
                    
                    
                    119,114General
      and administrative expenses
                    
                    
                    30,429
                    
                    
                    
                    59,072
                    
                    
                    
                    61,400
                    
                    
                    
                    138,569Total
      share-based compensation
                    
                    $
                    91,068
                    
                    
                    $
                    167,006
                    
                    
                    $
                    199,782
                    
                    
                    $
                    354,613





As of
December 31, 2008, total unrecognized compensation expense related to
stock-based options was $332,181 and the related weighted-average period over
which it is expected to be recognized is approximately 0.67 years.





The
Company currently provides stock-based compensation under three equity incentive
plans approved by the Board of Directors.  Options granted under each
of the plans have a ten year maximum term, an exercise price equal to at least
the fair market value of the Company’s common stock on the date of the grant,
and varying vesting periods as determined by the Board.  For stock
options with graded vesting terms, the Company recognizes compensation cost on a
straight-line basis over the requisite service period for the entire
award.


7


A summary
of stock options within the Company’s share-based compensation plans as of
December 31, 2008 were as follows:





WeightedWeighted
                    
                    
                    AverageAverage
                    
                    
                    Remaining
                    
                    
                    AggregateNumber
      of
                    
                    
                    Exercise
                    
                    
                    Contractual
                    
                    
                    IntrinsicOptions
                    
                    
                    Price
                    
                    
                    Term
                    
                    
                    ValueOutstanding
      at December 31, 2008
                    
                    
                    2,458,708
                    
                    
                    $
                    2.63
                    
                    
                    
                    7.28
                    
                    
                    $
                    0.00Vested
      and expected to vest at December 31, 2008
                    
                    
                    2,448,164
                    
                    
                    $
                    2.62
                    
                    
                    
                    7.28
                    
                    
                    $
                    0.00Vested
      and exercisable at December 31, 2008
                    
                    
                    2,175,819
                    
                    
                    $
                    2.57
                    
                    
                    
                    7.11
                    
                    
                    $
                    0.00





The
aggregate intrinsic value of options exercised during the six months ended
December 31, 2008 and 2007 was $0 and $25,300, respectively.  The
Company’s current policy is to issue new shares to satisfy option
exercises.





The
weighted average fair value of stock option awards granted and the key
assumptions used in the Black-Scholes valuation model to calculate the fair
value are as follows:





Three months
                      
                      
                      Six monthsended December 31,
                      
                      
                      ended December 31,2008(a)
                      
                      
                      2007(b)
                      
                      
                      2008(c)
                      
                      
                      2007(b)Weighted
      average fair value of options granted
                      
                      $
                      0.25
                      
                      
                      $
                      –
                      
                      
                      $
                      0.37
                      
                      
                      $
                      –Key
      assumptions used in determining fair value:Weighted
      average risk-free interest rate
                      
                      
                      1.99
                      %
                      
                      
                      –
                      %
                      
                      
                      2.63
                      %
                      
                      
                      –
                      %Weighted
      average life of the option (in years)
                      
                      
                      6.00
                      
                      
                      
                      –
                      
                      
                      
                      5.68
                      
                      
                      
                      –Weighted
      average historical stock price volatility
                      
                      
                      252.93
                      %
                      
                      
                      –
                      %
                      
                      
                      191.04
                      %
                      
                      
                      –
                      %Expected
      dividend yield
                      
                      
                      0.00
                      %
                      
                      
                      –
                      %
                      
                      
                      0.00
                      %
                      
                      
                      –
                      %




(a)
            During
      the three months ended December 31, 2008, the Company granted 50,000 stock
      options.


(b)
              During
      the three and six months ended December 31, 2007, the Company did not
      grant any stock options.
 (c)
              During
      the six months ended December 31, 2008, the Company granted 95,000 stock
      options.





The
Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable.  In addition, option valuation models require the input
of highly subjective assumptions, including the expected stock price
volatility.  Although the Company is using the Black-Scholes option
valuation model, management believes that because changes in the subjective
input assumptions can materially affect the fair value estimate, this valuation
model does not necessarily provide a reliable single measure of the fair value
of its stock options.  The risk-free interest rate is based on the
U.S. treasury security rate in effect as of the date of grant.  The
expected option lives, volatility, and forfeiture assumptions are based on
historical data of the Company.


8


8.           UralDial





In
December 2008, the Company entered into an agreement to sell its thirty percent
(30%) interest in UralDial, LLC (UralDial) for a nominal
amount.  UralDial did not have any material assets or liabilities at
the time of the Company’s disposition of its ownership interest.





Also in
December 2008, the Company finalized a contract to purchase cesium-131 from
UralDial.  Under the contract, the Company will purchase cesium-131
from UralDial rather than purchasing cesium-131 directly from its two existing
suppliers in Russia.  UralDial will provide cesium- 131 from at least
two Russian facilities subject to scheduled maintenance shutdowns of the
facilities from time to time.  The contract stabilizes supply
arrangements for the 12 months beginning on December 15, 2008 and ending on
December 31, 2009.





The
Company has an existing distribution agreement with UralDial that allows
UralDial to distribute Proxcelan Cs-131 brachytherapy seeds in
Russia.  The Company expects to begin shipping its brachytherapy seeds
under this agreement once regulatory approval has been obtained in
Russia.





9.           Commitments
and Contingencies





Patent and Know-How Royalty
License Agreement





The
Company is the holder of an exclusive license to use certain “know-how”
developed by one of the founders of a predecessor to the Company and licensed to
the Company by the Lawrence Family Trust, a Company shareholder.  The
terms of this license agreement require the payment of a royalty based on the
Net Factory Sales Price, as defined in the agreement, of licensed product
sales.  Because the licensor’s patent application was ultimately
abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as
defined in the agreement, remains applicable.  To date, management
believes that there have been no product sales incorporating the “know-how” and
therefore no royalty is due pursuant to the terms of the
agreement.  Management believes that ultimately no royalties should be
paid under this agreement as there is no intent to use this “know-how” in the
future.





The
licensor of the “know-how” has disputed management’s contention that it is not
using this “know-how”.  On September 25, 2007 and again on October 31,
2007, the Company participated in nonbinding mediation regarding this matter;
however, no settlement was reached with the Lawrence Family
Trust.  After additional settlement discussions, which ended in April
2008, the parties failed to reach a settlement.  The parties may
demand binding arbitration at any time.





License Agreement with
IBt





In
February 2006, the Company signed a license agreement with IBt covering North
America and providing the Company with access to IBt’s Ink Jet production
process and its proprietary polymer seed technology for use in brachytherapy
procedures using Cs-131.  Under the original agreement royalty
payments were to be paid on net sales revenue incorporating the
technology.





On
October 12, 2007, the Company entered into Amendment No. 1 (the Amendment) to
its License Agreement dated February 2, 2006 with IBt.  The Company
paid license fees of $275,000 (under the original agreement) and $225,000 (under
the Amendment) during fiscal years 2006 and 2008, respectively.  The
Amendment eliminates the previously required royalty payments based on net sales
revenue, and the parties originally intended to negotiate terms for future
payments by the Company for polymer seed components to be purchased at IBt's
cost plus a to-be-determined profit percentage.  In December 2008, the
Company recorded an impairment charge to write down this license based on its
current intentions to not utilize this technology (see Note 4).


9





10.           New
Accounting Pronouncements





In
December 2007, FASB issued SFAS No. 141(R), Business Combinations
(SFAS 141R), which replaces SFAS No. 141, Business Combinations(SFAS 141).  SFAS 141R applies to all transactions
and other events in which one entity obtains control over one or more other
businesses.  The standard requires the fair value of the purchase
price, including the issuance of equity securities, to be determined on the
acquisition date.  SFAS 141R requires an acquirer to recognize
the assets acquired, the liabilities assumed, and any noncontrolling interests
in the acquiree at the acquisition date, measured at their fair values as of
that date, with limited exceptions specified in the
statement.  SFAS 141R requires acquisition costs to be expensed
as incurred and restructuring costs to be expensed in periods after the
acquisition date.  Earn-outs and other forms of contingent
consideration are to be recorded at fair value on the acquisition
date.  Changes in accounting for deferred tax asset valuation
allowances and acquired income tax uncertainties after the measurement period
will be recognized in earnings rather than as an adjustment to the cost of the
acquisition.  SFAS 141R generally applies prospectively to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after
December 15, 2008 with early adoption prohibited.





In
December 2007, the FASB issued statement No. 160, Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No.
51.  The statement requires noncontrolling interests or
minority interests to be treated as a separate component of equity, not as a
liability or other item outside of permanent equity.  Upon a loss of
control, the interest sold, as well as any interest retained, is required to be
measured at fair value, with any gain or loss recognized in
earnings.  Based on SFAS 160, assets and liabilities will not change
for subsequent purchase or sales transactions with noncontrolling interests as
long as control is maintained.  Differences between the fair value of
consideration paid or received and the carrying value of noncontrolling
interests are to be recognized as an adjustment to the parent interest’s
equity.  SFAS 160 is effective for fiscal years beginning on or after
December 15, 2008 and earlier adoption is prohibited.  Due to the sale
of its thirty percent interest in UralDial, the Company does not believe the
implementation of SFAS 160 will have a material effect on its consolidated
financial statements.





In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB
No. 133.  SFAS 161 requires disclosures of the fair value
of derivative instruments and their gains and losses in a tabular format,
provides for enhanced disclosure of an entity’s liquidity by requiring
disclosure of derivative features that are credit-risk related, and requires
cross-referencing within footnotes to enable financial statement users to locate
information about derivative instruments.  This statement is effective
for fiscal years and interim periods beginning after November 15,
2008.  The Company does not believe the adoption of SFAS 161 will have
a material effect on its consolidated financial statements.





11.           Subsequent
Events





Liquidation of
ARS





On
January 2, 2009, the Company exercised its put option with UBS to redeem its ARS
at par value.  The entire $4 million of cash was deposited into the
Company’s account on January 5, 2009.


10


ITEM
2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





Caution
Regarding Forward-Looking Information





In
addition to historical information, this Form 10-Q contains certain
“forward-looking statements” within the meaning of the Private Securities
Litigation Reform Act of 1995 (“PSLRA”).  This statement is included
for the express purpose of availing IsoRay, Inc. of the protections of the safe
harbor provisions of the PSLRA.





All
statements contained in this Form 10-Q, other than statements of historical
facts, that address future activities, events or developments are
forward-looking statements, including, but not limited to, statements containing
the words "believe," "expect," "anticipate," "intends," "estimate," "forecast,"
"project," and similar expressions. All statements other than statements of
historical fact are statements that could be deemed forward-looking statements,
including any statements of the plans, strategies and objectives of management
for future operations; any statements concerning proposed new products,
services, developments or industry rankings; any statements regarding future
economic conditions or performance; any statements of belief; and any statements
of assumptions underlying any of the foregoing.  These statements are
based on certain assumptions and analyses made by us in light of our experience
and our assessment of historical trends, current conditions and expected future
developments as well as other factors we believe are appropriate under the
circumstances. However, whether actual results will conform to the expectations
and predictions of management is subject to a number of risks and uncertainties
described under “Risk Factors” beginning on page 21 below and in the “Risk
Factors” section of our Form 10-K for the fiscal year ended June 30, 2008 that
may cause actual results to differ materially.





Consequently,
all of the forward-looking statements made in this Form 10-Q are qualified by
these cautionary statements and there can be no assurance that the actual
results anticipated by management will be realized or, even if substantially
realized, that they will have the expected consequences to or effects on our
business operations.  Readers are cautioned not to place undue
reliance on such forward-looking statements as they speak only of the Company's
views as of the date the statement was made. The Company undertakes no
obligation to publicly update or revise any forward-looking statements, whether
as a result of new information, future events or otherwise.





Critical Accounting Policies
and Estimates





The
discussion and analysis of the Company’s financial condition and results of
operations are based upon its consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America.  The preparation of these financial
statements requires management to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent liabilities.  On an on-going basis,
management evaluates past judgments and estimates, including those related to
bad debts, inventories, accrued liabilities, and
contingencies.  Management bases its estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the 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.  The
accounting policies and related risks described in the Company’s annual report
on Form 10-K as filed with the Securities and Exchange Commission on September
29, 2008 are those that depend most heavily on these judgments and
estimates.  As of December 31, 2008, there have been no material
changes to any of the critical accounting policies contained therein, except for
the adoption of SFAS 157 and 159 as noted below.


11





Fair Value
Measurements





Effective
July 1, 2008, the Company adopted statement No. 157, Fair Value Measurements
(SFAS 157), which was issued by the FASB in September
2006.  SFAS 157 defines fair value, establishes a framework for
measuring fair value in accordance with accounting principles generally accepted
in the United States, and expands disclosures about fair value
measurements.  Any amounts recognized upon adoption as a cumulative
effect adjustment will be recorded to the opening balance of retained earnings
in the year of adoption.





Fair Value Option for
Financial Assets and Financial Liabilities





Effective
July 1, 2008, the Company adopted statement No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities Including an Amendment of FASB Statement No.
115 (SFAS 159), which was issued by the FASB in February
2007.  The statement allows entities to value financial instruments
and certain other items at fair value.  The statement provides
guidance over the election of the fair value option, including the timing of the
election and specific items eligible for the fair value
accounting.  Changes in fair values would be recorded in
earnings.  The Company elected not to measure any additional financial
instruments or other items at fair value as of July 1, 2008 in accordance with
SFAS 159.  Accordingly, the adoption of SFAS 159 did not impact our
consolidated financial statements.





Results of
Operations




Three
months ended December 31, 2008 compared to three months ended December 31,
2007





Product sales.  The
Company generated sales of $1,326,703 during the three months ended December 31,
2008, compared to sales of $1,758,344 for the three months ended December 31,
2007.  The decrease of $431,641 or 25% is mainly due to decreased
sales volume of the Company’s Proxcelan Cs-131 brachytherapy seed along with a
lower average invoice price due to the expanded use of the Company’s seeds in
dual therapy cases which typically use fewer seeds.  In addition,
about 5% of the decrease is due to physicians ordering less seeds per implant as
they have become more familiar with the isotope and its
characteristics.  The Company does not anticipate the number of seeds
per implant declining any further but will need to increase the total number of
implants to generate higher sales.  Management also believes that
other treatment options with higher reimbursement rates, such as IMRT, put
pressure on Proxcelan Cs-131 seed sales as well as other brachytherapy seed
sales.  During the three months ended December 31, 2008, the Company
sold its Proxcelan seeds to 47 different medical centers as compared to 53
medical centers during the corresponding period of 2007.





Cost of product
sales.  Cost of product sales was $1,724,225 for the three
months ended December 31, 2008 compared to cost of product sales of $2,241,795
during the three months ended December 31, 2007.  The decrease of
$517,570 or 23% is due to reduced sales and more efficient production operations
as the Company has worked to streamline its manufacturing process during the
past year, offset by a one-time impairment of $425,434 related to the Company’s
IBt license.  The major components of the decrease were depreciation,
materials, personnel costs, preload expenses, share-based compensation, and
small tools expense.  Depreciation expenses decreased approximately
$83,000 as the prior year also contained depreciation of both the Company’s new
production facility and the old production facility.  Materials
decreased approximately $362,000 mainly due to ordering and using less isotope
in the three months ended December 31, 2008 compared to the corresponding period
of 2007 and a lower unit price from our primary isotope suppliers in 2008
compared to 2007.  The decrease in pricing came as a result of
negotiations with our main suppliers for the calendar year 2008; however, these
prices increased again in January 2009 although not to the same level as
2007.  Personnel costs, including payroll, benefits, and related
taxes, decreased approximately $158,000 as the number of production personnel
decreased.  Preload expenses decreased by approximately $137,000
mainly due to the lower volume of sales and increased in-house
loading.  Share-based compensation decreased approximately $32,000 due
to the forfeiture of unvested options by the Company’s former
EVP-Operations.  Small tools expenses decreased approximately $25,000
as the prior year quarter contained items that were expensed as part of
equipping the new facility that became operational in September
2007.


12





These
decreases were offset by an impairment of the Company’s IBt license for $425,434
that was recorded in December 2008.  Management completed its review
of the license and associated technology related to this alternative seed
encapsulation process in December 2008 and determined that the adoption of this
process would entail an overhaul of the Company’s existing manufacturing
procedures.  In addition, there is no assurance that physicians would
accept this new technology without extensive education and
marketing.  As there are no anticipated future revenues from the IBt
license and the Company cannot sell or transfer the license, its entire value
was written off in the accompanying financial statements.





In
addition to these changes, the Company also recorded a one-time charge of
$139,043 in the quarter ended December 31, 2007 relating to expenses to
decommission its old production facility.  The Company had an asset
retirement obligation of $135,120 accrued for this facility but total costs
incurred to decommission the facility were $274,163.  This additional
expense incurred in the quarter ended December 31, 2007 was mainly due to
unanticipated construction costs to return the facility to its previous
state.  The Company originally believed that the lessor would retain
many of the leasehold improvements in the building, but the lessor instead
required their removal.





Gross loss.  Gross
loss was $397,522 for the three month period ended December 31,
2008.  This represents a decrease in the Company’s gross loss of
$85,929 or 18% over the corresponding period of 2007’s gross loss of
$483,451.  Included in the gross loss for the three month period ended
December 31, 2008 is the one-time IBt license impairment loss of
$425,434.  Without this impairment loss, the Company’s gross margin
would have been $27,912 or an increase in the gross profit margin of $511,363 or
106% due to the Company’s more efficient manufacturing process, lack of
decommissioning costs in the 2008 period, and lower costs of
supply.





Research and development
expenses.  Research and development expenses for the three
month period ended December 31, 2008 were $306,056 which represents a decrease
of $89,489 or 23% less than the research and development expenses of $395,545
for the three month period ended December 31, 2007.  The decrease is
due to lower personnel, consulting, and travel expenses.  Personnel
costs, including payroll, benefits, and related taxes, decreased approximately
$70,000 due to a reduced headcount in research and
development.  Consulting expenses, which are mainly due to an ongoing
project to increase the efficiency of isotope production, decreased
approximately $62,000 as the project is nearing its final prototype testing
phase.  Travel expenses decreased by approximately
$20,000.  These decreases were partially offset by increased protocol
expenses of approximately $66,000 mainly due to the Company’s dual-therapy study
and its continued monitoring and updating of the mono-therapy
study.





Sales and marketing
expenses.  Sales and marketing expenses were $620,700 for the
three months ended December 31, 2008.  This represents a decrease of
$522,127 or 46% compared to expenditures in the three months ended December 31,
2007 of $1,142,827 for sales and marketing.  Personnel expenses,
including payroll, benefits, and related taxes, decreased approximately $192,000
due to a lower sales headcount and a revised sales compensation plan that was
originally introduced in April 2008 and subsequently amended in October
2008.  Travel expenses decreased approximately $92,000 mainly due to
the decrease in sales force.  Consulting expenses decreased
approximately $79,000 as the Company reduced its reliance on third-parties as
part of its expense reduction initiatives.  Marketing and advertising
decreased approximately $62,000 as during the prior year the Company updated its
marketing literature to incorporate new data published from the protocols,
developed additional websites for patients and doctors, and updated its sales
booth.  Conventions and tradeshows decreased approximately $60,000
mainly due to ASTRO (a large tradeshow) being held in September in 2008 when it
historically has been held in October or November.  Dues and
subscriptions also decreased approximately $21,000 as the Company had purchased
market research reports and subscriptions for US medical residents in the
quarter ended December 31, 2007 but did not do so in the quarter ended December
31, 2008.


13





General and administrative
expenses.  General and administrative expenses for the three
months ended December 31, 2008 were $758,822 compared to general and
administrative expenses of $919,164 for the corresponding period of
2007.  The decrease of $160,342 or 17% is mainly due to decreased
personnel expenses, legal, public company expenses, share-based compensation,
and travel expenses partially offset by increased bad debt allowance and
consulting expenses.  Personnel expenses, including payroll, benefits,
and related taxes, decreased approximately $72,000 owing mainly to the
resignation of the Company’s CEO in February 2008.  Legal expenses
decreased by approximately $47,000 due to costs incurred during 2007 for
contract drafting and review of the Company’s interest in UralDial and the IBt
strategic global alliance agreements and for mediation costs.  These
decreased legal costs were partially offset by legal fees incurred in settling a
lawsuit with a former employee.  Public company expenses, which are
mainly comprised of board compensation, investor relations, and listing and
transfer agent fees, decreased approximately $41,000 due to lower investor
relations costs partially offset by increased board
compensation.  Share-based compensation decreased approximately
$29,000 due to the forfeiture of unvested options by the Company’s former
CEO.  Travel expenses also decreased approximately
$22,000.  These decreases were partially offset by increased expense
related to bad debt allowance of approximately $46,000 and increased consulting
expenses of approximately $36,000 mainly due to compensation paid to the
Company’s interim CEO.





Operating loss.  The
Company continues to focus its resources on improving sales while retaining the
necessary administrative infrastructure to increase the level of demand for the
Company’s product.  These objectives and resulting costs have resulted
in the Company not being profitable and generating operating losses since its
inception.  In the three months ended December 31, 2008, the Company
had an operating loss of $2,083,100 which is a decrease of $857,887 or 29% less
than the operating loss of $2,940,987 for the three months ended December 31,
2007.  Included in the operating loss for the three month period ended
December 31, 2008 is the one-time IBt license impairment loss of
$425,434.  Without this impairment loss, the Company’s operating loss
would have been $1,657,666 or a decrease of $1,283,321 or 44% compared to the
three months ended December 31, 2007.





Interest
income.  Interest income was $37,562 for the three months ended
December 31, 2008.  This represents a decrease of $142,293 or 79%
compared to interest income of $179,855 for the three months ended December 31,
2007.  Interest income is mainly derived from excess funds held in
money market accounts and invested in short-term investments.  The
decrease is due to lower interest rates and lower balances in the Company’s
money market and short-term investment accounts.





Gain on fair value of short-term
investments.  The gain of $433,200 for the three months ended
December 31, 2008 is due to the receipt of auction rate securities rights
(Rights) issued by the Company’s broker in October 2008.  The gain is
calculated as the fair value amount of the Rights as estimated on the date of
receipt plus the changes in their fair value offset by additional realized
losses on the Company’s auction rate securities (ARS).


14





Financing and interest
expense.  Financing and interest expense for the three months
ended December 31, 2008 was $20,769 or a decrease of $4,442 or 18% from
financing  and interest expense of $25,211 for the corresponding
period in 2007.  Included in financing expense is interest expense of
approximately $12,000 and $18,000 for the three months ended December 31, 2008
and 2007, respectively.  The remaining balance of financing expense
represents the amortization of deferred financing costs.





Six
months ended December 31, 2008 compared to six months ended December 31,
2007





Product
sales.  Sales for the six months ended December 31, 2008 were
$2,846,285 compared to sales of $3,614,063 for the six months ended December 31,
2007.  The decrease of $767,778 or 21% was mainly due to decreased
sales volume of the Company’s Proxcelan Cs-131 brachytherapy seeds along with a
lower average invoice price due to the expanded use of the Company’s seeds in
dual therapy cases which typically use fewer seeds.  In addition,
about 4% of the decrease is due to physicians ordering less seeds per implant as
they have become more familiar with the isotope and its
characteristics.  The Company will need to increase the number of
total implants to increase sales.  Management also believes that other
treatment options with higher reimbursement rates, such as IMRT, put pressure on
Proxcelan Cs-131 seed sales as well as other brachytherapy seed
sales.  During the six months ended December 31, 2008 the Company sold
its Cs-131 seeds to 60 different medical centers as compared to 65 centers
during the corresponding period of 2007.





Cost of product
sales.  Cost of product sales was $3,172,661 for the six months
ended December 31, 2008 which represents a decrease of $1,074,636 or 25%
compared to cost of product sales of $4,247,297 during the six months ended
December 31, 2007.  Materials expense decreased approximately $637,000
mainly due to ordering and using less isotope in the six months ended December
31, 2008 compared to the corresponding period of 2007 and a lower unit price
from our primary isotope suppliers.  The decrease in pricing came as a
result of negotiations with our main suppliers for the calendar year 2008;
however, these prices increased again in January 2009 although not to the same
level as 2007.  Personnel expenses, including payroll, benefits, and
related taxes, decreased approximately $325,000 due to a reduction in the
average production headcount levels.  Preload expenses decreased
approximately $244,000 due to lower sales volumes and due to increased in-house
loading.  Small tools expenses decreased approximately $94,000 mainly
due to expensing items in the prior year that were part of equipping the new
facility that became operational in September 2007.  Share-based
compensation decreased approximately $59,000 mainly due to the forfeiture of
unvested options by the Company’s former EVP-Operations.





These
decreases were offset by an impairment of the Company’s IBt license for $425,434
that was recorded in December 2008.  Management completed its review
of the license and associated technology related to this alternative seed
encapsulation process in December 2008 and determined that the adoption of this
process would entail an overhaul of the Company’s existing manufacturing
procedures.  In addition, there is no assurance that physicians would
accept this new technology without extensive education and
marketing.  As there are no anticipated future revenues from the
license and the Company cannot sell or transfer the license, its entire value
was written off in the accompanying financial statements.





During
the six months ended December 31, 2007, the Company removed all radioactive
residuals and tenant improvements from its old production facility and returned
the facility to the lessor.  The Company had an asset retirement
obligation of $135,120 accrued for this facility but total costs incurred to
decommission the facility were $274,163 resulting in an additional expense of
$139,043 that is included in cost of products sold for the six months ended
December 31, 2007.  This additional expense incurred in the six months
ended December 31, 2007 was mainly due to unanticipated construction costs to
return the facility to its previous state.  The Company originally
believed that the lessor would retain many of the leasehold improvements in the
building, but instead required their removal.


15





Gross loss.  Gross
loss was $326,376 for the six month period ended December 31,
2008.  This represents a decrease of $306,858 or 48% over the
corresponding period of 2007’s gross loss of $633,234.  Included in
the gross loss for the six months ended December 31, 2008 is the one-time IBt
license impairment loss of $425,434.  Without this impairment loss,
the Company’s gross margin would have been $99,058 or an increase in the gross
profit margin of $732,292 or 116% due to the Company’s more efficient
manufacturing process, lack of corresponding decommissioning costs in the 2008
period, and lower costs of supply.





Research and development
expenses.  Research and development expenses for the six months
ended December 31, 2008 were $524,606 which represents a decrease of $127,309 or
20% less than the research and development expenses of $651,915 for the
corresponding period of 2007.  The major components of the decrease
were personnel, consulting, and travel expenses.  Personnel expenses,
including payroll, benefits, and related taxes, decreased approximately $111,000
due to lower headcount.  Consulting expenses decreased approximately
$102,000 as the Company’s project to improve the efficiency of isotope
production is nearing its final prototype testing phase.  Travel
expenses decreased approximately $31,000 due to decreased trips to Russia and
Belgium than occurred in the prior year.  These decreases were
partially offset by an increase in protocol expenses of approximately $118,000
mainly due to payments for the Company’s dual-therapy study and its continued
monitoring and updating of the mono-therapy study.





Sales and marketing
expenses.  Sales and marketing expenses were $1,351,474 for the
six months ended December 31, 2008.  This represents a decrease of
$851,169 or 39% compared to expenditures in the six months ended December 31,
2007 of $2,202,643 for sales and marketing.  Personnel expenses,
including payroll, benefits, and related taxes, decreased approximately $433,000
due to a lower sales headcount and a revised sales compensation plan that was
originally introduced in April 2008 and subsequently amended in October
2008.  Travel expenses also decreased approximately $54,000 due to the
decrease in average headcount.  Consulting expenses decreased
approximately $134,000, mainly due to reduced reliance on third-parties as part
of the Company’s expense reduction initiatives.  Marketing and
advertising decreased approximately $162,000 as during the prior year the
Company updated its marketing literature to incorporate new data published from
the protocols, developed additional websites for patients and doctors, and
updated its sales booth.  Dues and subscriptions decreased
approximately $38,000 mainly due to the prior year purchases of market research
reports and subscriptions for US medical residents.  Hiring costs also
decreased approximately $34,000 as during the prior year the Company had paid
third-parties to assist with recruiting new sales associates.





General and administrative
expenses.  General and administrative expenses for the six
months ended December 31, 2008 were $1,538,979 compared to general and
administrative expenses of $1,821,189 for the corresponding period of
2007.  The decrease of $282,210 or 15% is primarily due to a decrease
in personnel costs, public company expenses, share-based compensation, legal
expenses, and travel expenses partially offset by increases in consulting and
bad debt allowance.  Personnel costs decreased approximately $139,000
mainly due to the resignation of the Company’s CEO in February
2008.  Public company expenses decreased approximately $95,000 due to
lower investor relations costs partially offset by increased board
compensation.  Share-based compensation decreased approximately
$77,000 due to the forfeiture of unvested options by the Company’s former
CEO.  Legal expenses decreased by approximately $58,000 as in the six
months ended December 31, 2007 the Company incurred legal fees for contract
drafting and review of the Company’s interest in UralDial and the IBt strategic
global alliance agreements and for mediation costs.  These decreased
legal costs were partially offset by legal fees incurred in settling a lawsuit
with a former employee.  Travel expenses also decreased approximately
$53,000.  These decreases were partially offset by increased expense
related to bad debt allowance of approximately $97,000 and increased consulting
expenses of approximately $84,000 mainly due to compensation paid to the
Company’s interim CEO and the costs of the Company’s ISO 13458 and CE mark audit
that was conducted in July 2008.


16





Operating loss.  The
Company continues to focus its resources on improving sales while retaining the
necessary administrative infrastructure to increase the level of demand for the
Company’s product.  These objectives and resulting costs have resulted
in the Company not being profitable and generating operating losses since its
inception.  In the six months ended December 31, 2008, the Company had
an operating loss of $3,741,435 which is a decrease of $1,567,546 or 30% less
than the operating loss of $5,308,981 for the six months ended December 31,
2007.  Included in the operating loss for the six months ended
December 31, 2008 is the one-time IBt license impairment loss of
$425,434.  Without this impairment loss, the Company’s operating loss
would have been $3,316,001 or a decrease of $1,992,980 or 38% compared to the
six months ended December 31, 2007.





Interest
income.  Interest income was $82,348 for the six months ended
December 31, 2008.  This represents a decrease of $336,203 or 80%
compared to interest income of $418,551 for the six months ended December 31,
2007.  Interest income is mainly derived from excess funds held in
money market accounts and invested in short-term investments.  The
decrease is due to lower interest rates and lower balances in the Company’s
money market and short-term investment accounts.





Gain on fair value of short-term
investments.  The gain of $274,000 for the six months ended
December 31, 2008 is due to the receipt of the Company’s Rights issued by its
broker in October 2008.  The gain is calculated as the fair value
amount of the Rights as estimated on the date of receipt plus the changes in
their fair value offset by additional realized losses on the Company’s
ARS.





Financing and interest
expense.  Financing and interest expense for the six months
ended December 31, 2008 was $41,616 or a decrease of $13,698 or 25% from
financing and interest expense of $55,314 for the corresponding period in
2007.  Included in financing expense is interest expense of
approximately $25,000 and $40,000 for the six months ended December 31, 2008 and
2007, respectively.  The decrease in interest expense is due to the
reduction of the principal balances of the Company’s overall debt and capital
lease balances.  The remaining balance of financing expense represents
the amortization of deferred financing costs.





Liquidity and capital
resources.  The Company has historically financed its
operations through cash investments from shareholders.  During the six
months ended December 31, 2008, the Company primarily used existing cash
reserves to fund its operations and capital expenditures.





Cash
flows from operating activities





Cash used
in operating activities was $2.2 million for the six months ended December 31,
2008 compared to $4.7 million for the six months ended December 31,
2007.  Cash used by operating activities is net loss adjusted for
non-cash items and changes in operating assets and
liabilities.


17


Cash
flows from investing activities





Cash used
in investing activities was approximately $41,000 and $2.0 million for the six
months ended December 31, 2008 and 2007, respectively.  Cash
expenditures for fixed assets were approximately $32,000 and $3.0 million during
the six months ended December 31, 2008 and 2007,
respectively.    The expenditures for fixed assets during
the six months ended December 31, 2007 were related to the construction of the
Company’s new production facility.





Cash
flows from financing activities





Cash used
in financing activities was approximately $50,000 for the six months ended
December 31, 2008 and was used mainly for payments of debt and capital
leases.





Projected
2008 Liquidity and Capital Resources





At
December 31, 2008, cash and cash equivalents amounted to $2,483,876 and
short-term investments amounted to $4,000,000, which includes the Company’s
Rights, compared to $4,820,033 of cash and cash equivalents and $3,726,000 of
short-term investments at June 30, 2008.





The
Company had approximately $5.5 million of cash and $0.5 million of short-term
investments as of February 6, 2009.  As of that date management
believed that the Company’s monthly required cash operating expenditures were
approximately $400,000 excluding capital expenditure requirements.





Assuming
operating costs expand proportionately with revenue increases, other
applications are pursued for seed usage outside the prostate market, protocols
are expanded supporting the integrity of the Company’s product and sales and
marketing expenses continue to increase, management believes the Company will
reach breakeven with revenues of approximately $1.5 million per
month.  Management’s plans to attain breakeven and generate additional
cash flows include increasing revenues from both new and existing customers and
maintaining cost control.  However, there can be no assurance that the
Company will attain profitability or that the Company will be able to attain its
aggressive revenue targets.  If the Company does not experience the
necessary increases in sales or if it experiences unforeseen manufacturing
constraints, the Company may need to obtain additional funding.





In late
November 2008, the Company hired Anthony Pasqualone as Vice President of
Business Development who is responsible for sales.  Mr. Pasqualone has
extensive experience in the brachytherapy industry and the Company believes his
credibility in the industry and extensive sales experience should help
management reverse the trend of sales decreases experienced by the Company
during the past two fiscal quarters.





The
Company expects to finance its future cash needs through the sale of equity
securities and possibly strategic collaborations or debt financing or through
other sources that may be dilutive to existing shareholders.  If the
Company needs to raise additional money to fund its operations, funding may not
be available to it on acceptable terms, or at all. If the Company is unable to
raise additional funds when needed, it may not be able to market its products as
planned or continue development and regulatory approval of its future
products.  If the Company raises additional funds through equity
sales, these sales may be dilutive to existing investors.


18





Long-Term
Debt and Capital Lease Agreements





IsoRay
had two loan facilities in place as of December 31, 2008.  The first
loan is from the Benton-Franklin Economic Development District (BFEDD) in an
original principal amount of $230,000 and was funded in December
2004.  It bears interest at eight percent and has a sixty month term
with a final balloon payment.  As of December 31, 2008, the principal
balance owed was $132,925.  This loan is secured by certain equipment,
materials and inventory of the Company, and also required personal guarantees,
for which the guarantors were issued approximately 70,455 shares of common
stock.  The second loan is from the Hanford Area Economic Investment
Fund Committee (HAEIFC) and was originated in June 2006.  The loan
originally had a total facility of $1,400,000 which was reduced in September
2007 to the amount of the Company’s initial draw of $418,670.  The
loan bears interest at nine percent and the principal balance owed as of
December 31, 2008 was $246,357.  This loan is secured by receivables,
equipment, materials and inventory, and certain life insurance policies and also
required personal guarantees.





The
Company has a capital lease for production equipment that expires in April
2009.  The lease currently calls for total monthly payments of
$2,286.  The total of all capital lease obligations at December 31,
2008 was $10,777.





Other
Commitments and Contingencies





In
February 2006, the Company signed a license agreement with International
Brachytherapy SA (IBt), a Belgian company, covering North America and providing
the Company with access to IBt’s Ink Jet production process and its proprietary
polymer seed technology for use in brachytherapy procedures using
Cs-131.  Under the original agreement royalty payments were to be paid
on net sales revenue incorporating the technology.





On
October 12, 2007, the Company entered into Amendment No. 1 (the Amendment) to
its License Agreement dated February 2, 2006 with IBt.  The Company
paid license fees of $275,000 (under the original agreement) and $225,000 (under
the Amendment) during fiscal years 2006 and 2008, respectively.  The
Amendment eliminates the previously required royalty payments based on net sales
revenue, and the parties originally intended to negotiate terms for future
payments by the Company for polymer seed components to be purchased at IBt's
cost plus a to-be-determined profit percentage.  Management no longer
believes that introducing Cs-131 polymer seeds is a viable strategy due to
concerns regarding physician acceptance and the costs to revamp the Company’s
existing manufacturing procedures to incorporate this technology.  In
December 2008, the Company recorded an impairment charge to write down this
license based on its current intentions to not utilize this
technology.





In
November 2008, a subsidiary of the Company entered into a written contract with
a contractor based in the Ukraine to formalize a research and development
project originally begun over two years ago to develop a proprietary separation
process to manufacture enriched barium.  There is no assurance that
this process can be developed.  The contract calls for an initial
payment of $17,800 and a payment of $56,610 upon completion of a successful
demonstration.  The Company’s initial demonstration has been postponed
until March 2009 due to technical difficulties encountered by the
contractor.





The
Company is subject to various local, state, and federal environmental
regulations and laws due to the isotopes used to produce the Company’s
product.  As part of normal operations, amounts are expended to ensure
that the Company is in compliance with these laws and
regulations.  While there have been no reportable incidents or
compliance issues, the Company believes that if it relocates its current
production facilities then certain decommissioning expenses will be
incurred.  An asset retirement obligation was established in the first
quarter of fiscal year 2008 for the Company’s obligations at its current
production facility.  This asset retirement obligation will be for
obligations to remove any residual radioactive materials and to remove all
leasehold improvements.


19





The
industry that the Company operates in is subject to product liability
litigation.  Through its production and quality assurance procedures,
the Company works to mitigate the risk of any lawsuits concerning its
product.  The Company also carries product liability insurance to help
protect it from this risk.





The
Company has no off-balance sheet arrangements.





New Accounting
Standards





In
December 2007, FASB issued SFAS No. 141(R), Business Combinations
(“SFAS 141R”), which replaces SFAS No. 141, Business Combinations(“SFAS 141”).  SFAS 141R applies to all transactions
and other events in which one entity obtains control over one or more other
businesses.  The standard requires the fair value of the purchase
price, including the issuance of equity securities, to be determined on the
acquisition date.  SFAS 141R requires an acquirer to recognize
the assets acquired, the liabilities assumed, and any noncontrolling interests
in the acquiree at the acquisition date, measured at their fair values as of
that date, with limited exceptions specified in the
statement.  SFAS 141R requires acquisition costs to be expensed
as incurred and restructuring costs to be expensed in periods after the
acquisition date.  Earn-outs and other forms of contingent
consideration are to be recorded at fair value on the acquisition
date.  Changes in accounting for deferred tax asset valuation
allowances and acquired income tax uncertainties after the measurement period
will be recognized in earnings rather than as an adjustment to the cost of the
acquisition.  SFAS 141R generally applies prospectively to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after
December 15, 2008 with early adoption prohibited.





In
December 2007, the FASB issued statement No. 160, Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51 (SFAS
160).  The statement requires noncontrolling interests or minority
interests to be treated as a separate component of equity, not as a liability or
other item outside of permanent equity.  Upon a loss of control, the
interest sold, as well as any interest retained, is required to be measured at
fair value, with any gain or loss recognized in earnings.  Based on
SFAS 160, assets and liabilities will not change for subsequent purchase or
sales transactions with noncontrolling interests as long as control is
maintained.  Differences between the fair value of consideration paid
or received and the carrying value of noncontrolling interests are to be
recognized as an adjustment to the parent interest’s equity.  SFAS 160
is effective for fiscal years beginning on or after December 15, 2008 and
earlier adoption is prohibited.  Due to the sale of its thirty percent
interest in UralDial, LLC, the Company does not believe the implementation of
SFAS 160 will have a material effect on its consolidated financial
statements.





In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB
No. 133.  This Statement expands the annual and interim
disclosure requirements of SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, for derivative instruments within the
scope of that Statement.  The Company does not believe the adoption of
SFAS No. 161 will have a material effect on its consolidated financial
statements.





ITEM
3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





As a
smaller reporting company, the Company is not required to provide Part I, Item 3
disclosure in this Quarterly Report.


20


ITEM
4T – CONTROLS AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





Under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer, we conducted an
evaluation of the design and operation of our disclosure controls and
procedures, as such term is defined under Rules 13a-14(c) and 15d-14(c)
promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), as of December 31, 2008.  Based on that evaluation, our
principal executive officer and our principal financial officer concluded that
the design and operation of our disclosure controls and procedures were
effective in timely alerting them to material information required to be
included in the Company's periodic reports filed with the SEC under the Exchange
Act.  The design of any system of controls is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions, regardless of how remote.  However,
management believes that our system of disclosure controls and procedures is
designed to provide a reasonable level of assurance that the objectives of the
system will be met.





Changes
in Internal Control over Financial Reporting





There
have not been any changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)
during the most recent fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.





PART
II - OTHER INFORMATION





ITEM
1A – RISK FACTORS





There
have been no material changes for the risk factors disclosed in the “Risk
Factors” section of our Annual Report on Form 10-K for the year ended June 30,
2008, except for the addition of the following risk factors:





The risk
factor that immediately follows modifies the risk factors entitled "We Rely
Heavily On A Limited Number Of Suppliers" and "Future Production Increases Will
Depend On Our Ability To Acquire Larger Quantities Of Cs-131 And Hire More
Employees" contained in the Form 10-K for the year ended June 30,
2008.





We Have Entered Into An Agreement
With A Single Distributor For Our Cesium-131 From Russia.  We
previously obtained the majority of our cesium from either the Institute of
Nuclear Materials (INM) or the Russian Research Institute of Atomic Reactors
(RIAR), both of which are located in Russia.  In December 2008, we
entered into an agreement with UralDial, LLC to purchase cesium directly from
UralDial instead of from INM and RIAR.  As a result, we now rely on
UralDial to obtain cesium from Russian sources.  UralDial has agreed
to maintain at least two Russian sources of its cesium, and our agreement with
UralDial has lower minimum purchase requirements than our prior agreements with
INM and RIAR, and these lower minimum purchase requirements are being met at
this time.  Through the UralDial agreement, we have obtained set
pricing for our Russian cesium through the end of 2009.  There can be
no guarantee that UralDial will always be able to supply us with sufficient
cesium, which could be due in part to risks associated with foreign operations
and beyond our and UralDial's control, and if we were unable to obtain supplies
of isotopes from Russia in the future, our overall supply of cesium and barium
would be reduced significantly unless we have a source of enriched barium for
utilization in domestic reactors.


21





Our Reduced Stock Price May
Adversely Affect Our Liquidity.  Our common stock has been
trading at less than $1.00 a share in recent months.  Many market
makers are reluctant to make a market in stock with a trading price of less than
$1.00 per share.  To the extent that we have fewer market makers for
our common stock, our volume and liquidity will likely decline, which could
further depress our stock price.




ITEM
6. EXHIBITS




Exhibits:


31.1
            Rule
      13a-14(a)/15d-14(a) Certification of Principal Executive
      Officer


31.2
            Rule
      13a-14(a)/15d-14(a) Certification of Principal Financial
      Officer


32
            Section
      1350 Certifications




22


SIGNATURES





In
accordance with the requirements of the Exchange Act, the registrant caused this
report to be signed on its behalf by the undersigned, thereunto duly
authorized.




Dated:
      February 17, 2009ISORAY,
      INC., a Minnesota corporationBy
                  /s/ Dwight
      BabcockDwight
      Babcock, Interim Chief Executive
Officer





By
                      /s/ Jonathan
      R. HuntJonathan
      R. Hunt, Chief Financial
Officer




23