UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





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




For the
quarterly period ended September 30, 2010





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


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


Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period the registrant was required to
file such reports), and (2) has been subject to such filing requirements for the
past 90 days.
 Yes xNo o
  Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or such shorter period that the
registrant was required to submit and post such files).
 Yes xNo  ̈
  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 o       Accelerated
filer o       Non-accelerated
filer o
 Smaller
reporting company x
  Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act):
 Yes oNo x




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




Class
            Outstanding as of
      November 10, 2010Common
      stock, $0.001 par value
            23,566,825









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
              
              
              8Item
      3
              Quantitative
      and Qualitative Disclosures About Market Risk
              
              
              13Item
      4
              Controls
      and Procedures
              
              
              13PART
      II
              OTHER
      INFORMATIONItem
      1A
              Risk
      Factors
              
              
              14Item
      2
              Unregistered
      Sales of Equity Securities and Use of Proceeds
              
              
              14Item
      6
              Exhibits
              
              
              15Signatures
              
              
              
              16









PART
I – FINANCIAL INFORMATION




IsoRay, Inc. and
Subsidiaries


Consolidated
Balance Sheets






(Unaudited)September
      30,
              
              
              June
      30,2010
              
              
              2010ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              1,024,569
              
              
              $
              1,678,869Accounts
      receivable, net of allowance for doubtful accountsof
      $32,068 and $36,390, respectively
              
              
              833,343
              
              
              
              896,266Inventory
              
              
              678,588
              
              
              
              681,677Prepaid
      expenses and other current assets
              
              
              305,495
              
              
              
              259,975Total
      current assets
              
              
              2,841,995
              
              
              
              3,516,787Fixed
      assets, net of accumulated depreciation and amortization
              
              
              3,737,347
              
              
              
              3,959,983Deferred
      financing costs, net of accumulated amortization
              
              
              12,724
              
              
              
              13,277Restricted
      cash
              
              
              180,368
              
              
              
              180,154Other
      assets, net of accumulated amortization
              
              
              269,997
              
              
              
              272,594Total
      assets
              
              $
              7,042,431
              
              
              $
              7,942,795LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued liabilities
              
              $
              426,961
              
              
              $
              404,401Accrued
      protocol expense
              
              
              212,331
              
              
              
              242,029Accrued
      radioactive waste disposal
              
              
              72,060
              
              
              
              60,060Accrued
      payroll and related taxes
              
              
              125,016
              
              
              
              186,513Accrued
      vacation
              
              
              70,281
              
              
              
              68,525Notes
      payable, due within one year
              
              
              50,575
              
              
              
              49,445Total
      current liabilities
              
              
              957,224
              
              
              
              1,010,973Notes
      payable, due after one year
              
              
              117,501
              
              
              
              130,550Asset
      retirement obligation
              
              
              619,115
              
              
              
              605,391Total
      liabilities
              
              
              1,693,840
              
              
              
              1,746,914Commitments
      and contingencies (Note 6)Shareholders'
      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;23,048,754
      shares issued and outstanding
              
              
              23,049
              
              
              
              23,049Treasury
      stock, at cost, 13,200 shares
              
              
              (8,390
              )
              
              
              (8,390
              )Additional
      paid-in capital
              
              
              48,109,375
              
              
              
              48,084,783Accumulated
      deficit
              
              
              (42,775,502
              )
              
              
              (41,903,620
              )Total
      shareholders' equity
              
              
              5,348,591
              
              
              
              6,195,881Total
      liabilities and shareholders' equity
              
              $
              7,042,431
              
              
              $
              7,942,795




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




1




IsoRay, Inc. and
Subsidiaries


Consolidated
Statements of Operations


(Unaudited)




Three
      months ended
                September
      30,2010
              
              
              2009Product
      sales
              
              $
              1,327,127
              
              
              $
              1,379,087Cost
      of product sales
              
              
              1,111,527
              
              
              
              1,160,089Gross
      margin
              
              
              215,600
              
              
              
              218,998Operating
      expenses:Research
      and development expenses
              
              
              114,522
              
              
              
              68,882Sales
      and marketing expenses
              
              
              373,425
              
              
              
              442,899General
      and administrative expenses
              
              
              596,133
              
              
              
              602,431Total
      operating expenses
              
              
              1,084,080
              
              
              
              1,114,212Operating
      loss
              
              
              (868,480
              )
              
              
              (895,214
              )Non-operating
      income (expense):Interest
      income
              
              
              1,061
              
              
              
              5,867Financing
      and interest expense
              
              
              (4,463
              )
              
              
              (17,361
              )Non-operating
      income (expense), net
              
              
              (3,402
              )
              
              
              (11,494
              )Net
      loss
              
              
              (871,882
              )
              
              
              (906,708
              )Preferred
      stock dividends
              
              
              (2,658
              )
              
              
              (2,658
              )Net
      loss applicable to common shareholders
              
              $
              (874,540
              )
              
              $
              (909,366
              )Basic
      and diluted loss per share
              
              $
              (0.04
              )
              
              $
              (0.04
              )Weighted
      average shares used in computing net loss per share:Basic
      and diluted
              
              
              23,048,754
              
              
              
              22,942,088




The
accompanying notes are an integral part of these consolidated financial
statements.
  2




IsoRay, Inc. and
Subsidiaries


Consolidated
Statements of Cash Flows


(Unaudited)




Three
      months ended
                September
      30,2010
              
              
              2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
              
              $
              (871,882
              )
              
              $
              (906,708
              )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization of fixed assets
              
              
              224,528
              
              
              
              242,904Amortization
      of deferred financing costs and other assets
              
              
              7,262
              
              
              
              18,191Amortization
      of discount on short-term investments
              
              
              -
              
              
              
              9Accretion
      of asset retirement obligation
              
              
              13,724
              
              
              
              12,547Share-based
      compensation
              
              
              24,592
              
              
              
              57,927Changes
      in operating assets and liabilities:Accounts
      receivable, net
              
              
              62,923
              
              
              
              (52,868
              )Inventory
              
              
              3,089
              
              
              
              68,260Prepaid
      expenses, other current assets and other assets
              
              
              (49,632
              )
              
              
              (25,183
              )Accounts
      payable and accrued liabilities
              
              
              22,560
              
              
              
              10,875Accrued
      protocol expense
              
              
              (29,698
              )Accrued
      radioactive waste disposal
              
              
              12,000Accrued
      payroll and related taxes
              
              
              (61,497
              )
              
              
              58,449Accrued
      vacation
              
              
              1,756Net
      cash used by operating activities
              
              
              (640,275
              )
              
              
              (515,597
              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of fixed assets
              
              
              (1,892
              )
              
              
              (8,000
              )Change
      in restricted cash
              
              
              (214
              )
              
              
              (536
              )Proceeds
      from the sale or maturity of short-term investments
              
              
              -
              
              
              
              720,000Net
      cash provided (used) by investing activities
              
              
              (2,106
              )
              
              
              711,464CASH
      FLOWS FROM FINANCING ACTIVITIES:Principal
      payments on notes payable
              
              
              (11,919
              )
              
              
              (17,235
              )Net
      cash used by financing activities
              
              
              (11,919
              )
              
              
              (17,235
              )Net
      increase (decrease) in cash and cash equivalents
              
              
              (654,300
              )
              
              
              178,632Cash
      and cash equivalents, beginning of period
              
              
              1,678,869
              
              
              
              2,990,744CASH
      AND CASH EQUIVALENTS, END OF PERIOD
              
              $
              1,024,569
              
              
              $
              3,169,376




The
accompanying notes are an integral part of these consolidated financial
statements.
  3




IsoRay,
Inc. and Subsidiaries




Notes
to the Unaudited Consolidated Financial Statements
 For
the three month periods ended September 30, 2010 and
2009




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, 2010.  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, 2010.





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





2.           New
Accounting Pronouncements





From time
to time, new accounting pronouncements are issued by the Financial Accounting
Standards Board (the “FASB”) or other standards setting bodies that are adopted
by us as of the specified effective date. Unless otherwise discussed, we believe
the impact of recently issued standards that are not yet effective will not have
a material impact on our consolidated financial position, results of operations
and cash flows upon adoption.





3.           Loss
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 anti-dilutive.  At September 30, 2010 and 2009, 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 anti-dilutive 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 September 30, 2010 and 2009 were as
follows:




September
      30,2010
              
              
              2009Preferred
      stock
              
              
              59,065
              
              
              
              59,065Common
      stock warrants
              
              
              3,165,768
              
              
              
              3,216,644Common
      stock options
              
              
              2,151,372
              
              
              
              2,606,769Total
      potentially dilutive securities
              
              
              5,376,205
              
              
              
              5,882,478




4




4.           Inventory





Inventory
consisted of the following at September 30, 2010 and June 30, 2010:




September
      30,
                2010
              
              
              June
      30,
                2010Raw
      materials
              
              $
              514,913
              
              
              $
              546,080Work
      in process
              
              
              129,903
              
              
              
              130,840Finished
      goods
              
              
              6,772
              
              
              
              4,757$
              678,588
              
              
              $
              681,677




5.           Share-Based
Compensation





The
following table presents the share-based compensation expense recognized in the
statement of operations during the three months ended September 30, 2010 and
2009:




Three
      monthsended
                September
      30,2010
              
              
              2009Cost
      of product sales
              
              $
              8,470
              
              
              $
              5,897Research
      and development expenses
              
              
              5,410
              
              
              
              162Sales
      and marketing expenses
              
              
              3,847
              
              
              
              23,625General
      and administrative expenses
              
              
              6,865
              
              
              
              28,243Total
      share-based compensation
              
              $
              24,592
              
              
              $
              57,927




As of
September 30, 2010, total unrecognized compensation expense related to
share-based options was $223,901 and the related weighted-average period over
which it is expected to be recognized is approximately 1.24 years.





The
Company currently provides share-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.




5





A summary
of stock options within the Company’s share-based compensation plans as of
September 30, 2010 was as follows:





Number
      of
                Options
              
              
              Weighted
                Average
                Exercise
                Price
              
              
              Weighted
                Average
                Remaining
                Contractual
                Term
              
              
              Aggregate
                Intrinsic
                ValueOutstanding
      at September 30, 2010
              
              
              2,151,372
              
              
              $
              1.87
              
              
              
              7.01
              
              
              $
              754,362Vested
      and expected to vest at September 30, 2010
              
              
              2,064,046
              
              
              $
              1.93
              
              
              
              6.94
              
              
              $
              687,668Vested
      and exercisable at September 30, 2010
              
              
              1,614,293
              
              
              $
              2.27
              
              
              
              6.54
              
              
              $
              477,588




There
were no options exercised during the three months ended September 30, 2010 and
2009, 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 ended
                September
      30,2010(a)
              
              
              2009(b)Weighted
      average fair value of options granted
              
              $
              –
              
              
              $
              0.51Key
      assumptions used in determining fair value:Weighted
      average risk-free interest rate
              
              
              –
              %
              
              
              2.50
              %Weighted
      average life of the option (in years)
              
              
              –
              
              
              
              4.00Weighted
      average historical stock price volatility
              
              
              –
              %
              
              
              132.21
              %Expected
      dividend yield
              
              
              –
              %
              
              
              –
              %







(a)
            During
      the three months ended September 30, 2010, the Company granted no stock
      options.


(b)
            During
      the three months ended September 30, 2009, the Company granted 10,000
      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 with an equivalent term in effect as of the date of
grant.  The expected option lives, volatility, and forfeiture
assumptions are based on historical data of the Company.





6.           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.




6





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.





7.           Preferred
Dividends





Cumulative
preferred dividends outstanding through December 31, 2009 of $36,679 were paid
as of that date.  As of September 30, 2010, there are cumulative
preferred dividends outstanding of $7,974.





8.           Subsequent
Events





On
October 1, 2010, the Company issued a placement notice with C.K. Cooper &
Company, Inc. to begin selling shares under the “at the market” sales agreement
between the two parties dated April 22, 2010 and as amended on July 29,
2010.  Under the placement notice additional cash of approximately
$360,000 has been raised through sales of common stock at market prices through
November 10, 2010.





Beginning
on October 20, 2010, the Company revised the exercise price of certain
outstanding warrants to $0.95 per share.  The election to exercise the
common stock warrants at the reduced strike price of $.95 per share of common
stock was required to be postmarked on or before October 30, 2010, after which
time the warrants reverted to their original exercise
prices.  Exercise of warrants at the reduced exercise price has
generated approximately $200,000 in cash as of November 10, 2010.





On
October 29, 2010 the Company received notification from the U.S. Department of
Health and Human Services and the Internal Revenue Service regarding the receipt
of grants for three qualifying therapeutic discovery projects in the total
amount of $526,510.  The initial grant award amount payable for the
year ended June 30, 2010 to the Company in the amount of $109,316 is to be
funded on or before November 16, 2010.  The remaining grant award of
$417,194 is to be paid to the Company after the completion of the fiscal year on
June 30, 2011 and prior to July 30, 2011.




7





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 14 below and in the “Risk
Factors” section of our Form 10-K for the fiscal year ended June 30, 2010 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
28, 2010 are those that depend most heavily on these judgments and
estimates.  As of September 30, 2010, there have been no material
changes to any of the critical accounting policies contained
therein.
  8





Results of
Operations





Three
months ended September 30, 2010 compared to three months ended September 30,
2009





Product sales.  The
Company generated revenue of $1,327,127 during the three months ended September
30, 2010 compared to revenue of $1,379,087 during the three months ended
September 30, 2009.  The decrease of $51,960 or 4% in revenue is the
result of an overall reduction in the quantity of seeds sold which was partially
offset by a 4% increase in the average price per seed sold.  Revenue
from new modalities increased to approximately $95,064 in the three months ended
September 30, 2010 as compared to approximately $32,500 in the three months
ended September 30, 2009, or approximately 193%. Management believes that the
overall market for prostate brachytherapy continues to receive increased
pressure from other treatment modalities with higher reimbursement rates such as
Intensity-Modulated Radiation Therapy (IMRT) and
Robotics.





Cost of product
sales.  Cost of product sales was $1,111,527 for the three
months ended September 30, 2010 compared to cost of product sales of $1,160,089
during the three months ended September 30, 2009.  The decrease in
cost of product sales of $48,562 or 4% directly relates to the reduction in
product sales.  The major components of the net decrease of cost of
product sales in the amount of $48,562 were comprised of personnel costs of
approximately $41,000, preload expenses of approximately $16,000, and
depreciation and amortization expense of approximately $10,000, that were
partially offset by an increase in materials cost of approximately
$19,000.





The cost
savings achieved in the three months ended September 30, 2010 compared to three
months ended September 20, 2009 represent continued management achievement of
cost reductions achieved in the prior fiscal year in line with current levels of
revenue.  The savings achieved in the prior year that have been
maintained include improved production processes, improved utilization of labor,
continuation of a reduced reliance on consultants along with an increase in
utilizing the Company's in-house  loading services.





Gross margin.  Gross
margin was $215,600 for the three month period ended September 30, 2010 as
compared to $218,998 for the three months ended September 30,
2009.  This represents a decrease in the Company’s gross margin of
$3,398 or approximately 2%.  The decrease in the gross margin is the
result of a decrease in product sales which exceeded the increase in cost
savings for the three months ended September 30, 2010 when compared to the three
months ended September 30, 2009 and resulted in an increase in the gross margin
percentage from 15.9% for the three months ended September 30, 2009 to 16.2% for
the three months ended September 30, 2010.





Research and development
expenses.  Research and development expenses for the three
month period ended September 30, 2010 were $114,522 which represents an increase
of $45,640 or 66% more than the research and development expenses of $68,882 for
the three month period ended September 30, 2009.  The major components
of the net increase in Research and Development costs were comprised of a
continued reduction in protocol expense of approximately $13,000 and consulting
expense of approximately $12,000 that was offset by an increase in payroll and
benefits of approximately $60,000 and travel expense of approximately
$12,000.





The net
increase in Research and Development expense is the result of an increase in
payroll and benefits cost related to the addition of a Vice President of R&D
and an increase in labor expenditures related to the development efforts for
treatments of brain, breast and lung cancers along with additional travel
costs.  These increases were partially offset by a continued effort by
Company management to reduce consulting costs and minimize protocol
expenses.




9





Sales and marketing
expenses.  Sales and marketing expenses were $373,425 for the
three months ended September 30, 2010.  This represents a decrease of
$69,474 or 16% compared to expenditures in the three months ended September 30,
2009 of $442,899 for sales and marketing.





The net
cost savings of $69,474 was a direct result of a reduction in conventions and
tradeshow expense of approximately $19,000, marketing and advertising of
approximately $31,000, and approximately $20,000 in share-based
compensation.  These savings are the result of active management of
convention and tradeshow activities, marketing and advertising expenses and a
reduction of share-based compensation.





General and administrative
expenses.  General and administrative expenses for the three
months ended September 30, 2010 were $596,133.  This represents a
decrease of $6,298 or approximately 1% compared to general and administrative
expenses of $602,431 for the three months ended September 30, 2009.





The net
cost savings of $6,298 were the result of reductions in share-based compensation
of approximately $21,000 and legal expenses of approximately $18,000, that were
offset partially by increases in Audit, SOX and tax expenses of approximately
$13,000, office equipment and supplies of approximately $5,000 and other
expenses of approximately $14,000.





Operating loss.  The
Company continues to focus its resources on improving sales while continuing to
retain the necessary administrative and production infrastructure to meet the
demands for the Company’s products as sales levels change.  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 September 30, 2010, the Company had an operating loss of $868,480
which is a decrease of $26,734 or 3% less than the operating loss of $895,214
for the three months ended September 30, 2009.





Interest
income.  Interest income was $1,061 for the three months ended
September 30, 2010.  This represents a decrease of $4,806 or 82%
compared to interest income of $5,867 for the three months ended September 30,
2009.  Interest income is primarily derived from excess funds held in
money market accounts.  The decrease in interest income of $4,806 is
due to lower interest rates and lower balances in the Company’s money market
account.





Financing and interest
expense.  Financing and interest expense for the three months
ended September 30, 2010 was $4,463 or a decrease of $12,898 or 74% from
financing and interest expense of $17,361 for the three months ended September
30, 2009.  Included in financing expense is interest expense of
approximately $4,000 for the three months ended September 30, 2010 and
approximately $7,000 for the three months ended September 30,
2009.  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 three months ended September 30, 2010, the
Company primarily used existing cash reserves to fund its operations and capital
expenditures.





Cash
flows from operating activities





Cash used
in operating activities increased approximately $124,678 to approximately
$640,275 for the three months ended September 30, 2010 compared to approximately
$515,597 for the three months ended September 30, 2009.  Cash used by
operating activities is net loss adjusted for non-cash items and changes in
operating assets and liabilities.




10





Cash
flows from investing activities





Cash used
by investing activities increased approximately $713,570 to approximately $2,106
for the three months September 30, 2010 as compared to cash provided by
investing activities of approximately $711,464 for the three months ended
September 30, 2009.  The primary influence in the change in cash used
in financing activities in the three months ended September 30, 2010 to
September 30, 2009 is the maturation of short-term investments in the three
months ended September 30, 2009 in the amount of $720,000.  Cash
expenditures for fixed assets were approximately $2,000 and $8,000 during the
three months ended September 30, 2010 and 2009, respectively.





Cash
flows from financing activities





Cash used
in financing activities was approximately $12,000 and $17,000 for the three
months ended September 30, 2010 and 2009, respectively, and was used primarily
for payment of debt during the three months ended September 30, 2010 and 2009,
respectively.





Projected
2011 Liquidity and Capital Resources





At
September 30, 2010, cash and cash equivalents amounted to $1,024,569 compared to
$1,678,869 of cash and cash equivalents at September 30, 2009.





The
Company had approximately $1,323,532 of cash and no short-term investments as of
November 10, 2010.  The Company’s monthly required cash operating
expenditures were approximately $215,000 in the three months ended September 30,
2010, which represents a 5% decrease or approximately $10,000 from average
monthly cash operating expenditures in fiscal year 2010 of approximately
$225,000. This reduction is primarily the result of continued improvements in
operating performance during fiscal year 2011.  Management believes
that less than $100,000 will be spent on capital expenditures for fiscal year
2011 outside of any research and development, but there is no assurance that
unanticipated needs for capital equipment may not arise.





The
Company has a single remaining loan facility outstanding with the Hanford Area
Economic Investment Fund Committee (HAEIFC), with a principal balance of
approximately $168,000 of which approximately $51,000 will be due in the next
twelve months.





The
Company intends to continue its existing protocol studies and to begin new
protocol studies on lung cancer treatment using Cesium-131.  The
Company continues to believe that approximately $100,000 in expense will be
incurred during fiscal year 2011 related to protocol expenses relating to lung
cancer and dual therapy and mono therapy prostate protocols.





Based on
the foregoing assumptions, management believes cash, cash equivalents, and
short-term investments on hand at September 30, 2010 will not be sufficient to
meet our anticipated cash requirements for operations, debt service, and capital
expenditure requirements through the next twelve months but will fund operations
through February 28, 2011.





Management
plans to attain breakeven and generate additional cash flows by
increasing  revenues from both new and existing customers (through our
direct sales channels and through our distributors), expanding into other market
applications which initially will include head and neck, colorectal and lung
implants while maintaining the Company's focus on cost
control.  Company management continues to believe that theCompany will reach
breakeven with revenues of approximately $750,000 per month with cash flow
breakeven from operations being reached at approximately $700,000. However,
there can be no assurance that the Company will attain profitability or that the
Company will be able to attain its revenue targets. Sales in the prostate market
have not shown the increases necessary to breakeven during the past three fiscal
years and did not improve during the three months ended September 30, 2010. As
management is now focused on expanding into head and neck, colorectal, lung and
brain applications, management believes the Company will need to raise
additional capital for protocols, marketing staff, production staff and
production equipment as it attempts to gain market share. As the Company does
not meet the minimum stockholder’s equity listing requirement for NYSE AMEX,
management plans to sell equity and/or debt at a possible discount to the market
price to seek to raise $2 to $5 million on or before December 31, 2010, but we
do not have any agreements in place to do so other than our existing “at the
market” sales agreement.  Through October 31, 2010, the Company has
raised approximately $564,000 through “at the market” offerings and through the
solicitation of warrants at a reduced exercise price.




11





The
Company expects to finance its future cash needs through sales of equity,
possible strategic collaborations, debt financing or through other sources that
may be dilutive to existing shareholders but as the Company now has insufficient
capital to fund operations through the end of the current fiscal year, it may
need to offer substantial discounts from the market price of our common
stock.  Management anticipates that if it raises additional financing
that it will be at a discount to the market price and it will be dilutive to
shareholders. Of course, funding may not be available to it on acceptable terms,
or at all. If the Company is unable to raise additional funds, it will have to
discontinue or significantly curtail operations.





Long-Term
Debt and Capital Lease Agreements





IsoRay
has a single loan facility in place as of September 30, 2010.  This
loan facility is from the 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 September 30, 2010 was $168,076.  This loan is
secured by receivables, equipment, materials and inventory, and certain life
insurance policies and also required personal guarantees.  This loan
facility was modified effective October 1, 2010 by the lender to reflect a
reduction in the interest rate from nine percent to five and one-half percent
with all other terms remaining unchanged.





Other
Commitments and Contingencies





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.





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.




12




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.





ITEM
4 – 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 September 30, 2010.  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. 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.





The
Company is continuing the process of developing and implementing the remediation
plan to address the material weakness and significant deficiency identified in
its Form 10-K for the fiscal year ended June 30, 2010.  This plan is
as follows-





·
            The
      Company continues to assess opportunities to further segregate duties
      within a limited staff.


·
            The
      staff is utilizing continuing professional education opportunities to
      enhance their knowledge.


·
            Management
      is conducting ongoing reviews of all significant and non-routine
      transactions.





As a
result of the ongoing reviews of all significant and non-routine transactions,
management believes that there are no material inaccuracies or omissions of
material fact and to the best of its knowledge, believes that the consolidated
financial statements for the quarter ended September 30, 2010 fairly present in
all material respects the financial condition and results of operations for the
Company in conformity with U.S. generally accepted accounting
principles.




13




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,
2010, except for the changes to the following risk factor that was included in
the Form 10-K:





Failure to Comply with NYSE Amex
Listing Standards And Any Resulting Delisting Could Adversely Affect The Market
For Our Common Stock.  Our common stock is presently listed on
the NYSE Amex. The NYSE Amex will consider delisting a company's securities if,
among other things, the company fails to maintain minimum stockholder's equity
or the company has sustained losses which are so substantial in relation to its
overall operations or its existing financial resources, or its financial
condition has become so impaired that it appears questionable, in the opinion of
the NYSE Amex, as to whether such issuer will be able to continue operations
and/or meet its obligations as they mature. As of the quarter ended September
30, 2010, IsoRay fell below the minimum stockholder’s equity requirement of $6
million needed to maintain its listing.  Management is actively
pursuing a capital raise to increase its  stockholder’s equity above
$6 million.  There can be no assurance that we will be able to raise
sufficient capital to maintain our listing on the NYSE Amex. In the event that
our common stock is delisted from the NYSE Amex, trading, if any, in the common
stock would be conducted in the over-the-counter market. As a result, our
shareholders would likely find it more difficult to dispose of, or to obtain
accurate quotations as to the market value of, our common stock.




ITEM
2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS





Use
of Proceeds from Registered Securities





On
October 27, 2009, we filed a registration statement on Form S-3 to register
securities up to $15 million in value for future issuance in our capital raising
activities.  The registration statement became effective on November
13, 2009, and we filed a prospectus supplement relating to the Sales Agreement
described below on April 23, 2010.  The Commission file number
assigned to the registration statement is 333-162694.





On April
22, 2010, we entered into a Sales Agreement (the "Agreement") with C. K. Cooper
& Company, Inc. ("CKCC").  Pursuant to the terms of the Agreement,
the Company may offer and sell (the "Offering") from time to time through CKCC,
as the Company's sales agent, up to $4 million of shares of the Company's common
stock, par value $0.001 per share (the "Shares").  CKCC is not
required to sell any specific number or dollar amount of Shares but will use its
commercially reasonable efforts, as the Company's agent and subject to the terms
of the Agreement, to sell the Shares offered, as instructed by the Company.
Sales of the Shares, if any, may be made by means of ordinary brokers'
transactions on the NYSE AMEX at market prices and such other sales as agreed to
by the Company and CKCC. CKCC will receive from us a commission of 2.0% based on
the gross sales price per share for any Shares sold through it as agent under
the Agreement. Net proceeds from the sale of the Shares will be used for general
corporate purposes. The Company has also agreed to reimburse CKCC for certain
expenses incurred in connection with entering into the Agreement and has
provided CKCC with customary indemnification rights.





On July
29, 2010, we entered into an amendment (the "Amendment") to the
Agreement.  The purpose of the Amendment is to extend the term of the
offering of Shares by CKCC as the Company's sales agent pursuant to the
Agreement.  The offering of Shares pursuant to the Agreement, as
amended by the Amendment, will terminate upon the earliest of (i) December 31,
2010, (ii) the sale of all Shares subject to the Agreement or (iii) the
termination of the Agreement by the Company or CKCC.  The other terms
of the Agreement remain in effect and have not been changed by the
Amendment.




CKCC was
instructed by the Company to commence the Offering on October 1, 2010 via a
placement notice permitting "at the market" sales of common stock through
October 31, 2010.  As of October 31, 2010, CKCC had sold 304,227
shares of common stock for gross proceeds of $368,781.  As sales
occurred subsequent to the end of the most recent completed fiscal quarter,
expense and use of proceeds information for these sales will be provided in the
Company's Form 10-Q filing for the fiscal quarter ending December 31,
2010.




14




ITEM
6 – EXHIBITS




Exhibits:


31.1
            Rule
      13a-14(a)/15d-14(a) Certification of Principal Executive
      Officer31.2
            Rule
      13a-14(a)/15d-14(a) Certification of Principal Financial
  Officer32
            Section
      1350 Certifications





15




SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




ISORAY,
      INC., a Minnesota corporationDated:
      November 15, 2010
              By
              /s/ Dwight
      BabcockDwight
      Babcock, Chief Executive Officer(Principal
      Executive Officer)






By
                /s/ Brien
      RagleBrien
      Ragle, Controller(Principal
      Financial and Accounting Officer)


16