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 March 31, 2009





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
                  
                  (I.R.S.
      Employerorganization)
                  
                  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: (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 x No 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  ̈     No
 ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer”,
“accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.


Large
accelerated filer 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 o No 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 May 6,
    2009Common
      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 FinancialCondition
      and Results of Operations
                    12Item
      3
                    Quantitative
      and Qualitative Disclosures About Market Risk
                    21Item
      4T
                    Controls
      and Procedures
                    21PART
      II
                    OTHER
      INFORMATIONItem
      1A
                    Risk
      Factors
                    21Item
      4
                    Submission
      of Matters to a Vote of Security Holders
                    22Item
      6
                    Exhibits
                    22Signatures
                    23





PART
I – FINANCIAL INFORMATION


IsoRay,
Inc. and Subsidiaries


Consolidated
Balance Sheets





March 31,2009
                
                
                June 30,(Unaudited)
                
                
                2008ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                5,163,920
                
                
                $
                4,820,033Short-term
      investments
                
                
                479,820
                
                
                
                3,726,000Accounts
      receivable, net of allowance for doubtful accounts   of
      $109,012 and $33,031, respectively
                
                
                864,096
                
                
                
                1,016,495Inventory
                
                
                821,802
                
                
                
                899,964Prepaid
      expenses and other current assets
                
                
                172,933
                
                
                
                267,001Total
      current assets
                
                
                7,502,571
                
                
                
                10,729,493Fixed
      assets, net of accumulated depreciation and amortization
                
                
                5,176,924
                
                
                
                6,040,641Deferred
      financing costs, net of accumulated amortization
                
                
                38,261
                
                
                
                65,221Licenses,
      net of accumulated amortization
                
                
                3,261
                
                
                
                455,646Restricted
      cash
                
                
                178,095
                
                
                
                175,852Other
      assets, net of accumulated amortization
                
                
                276,077
                
                
                
                345,040Total
      assets
                
                $
                13,175,189
                
                
                $
                17,811,893LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued liabilities
                
                $
                883,805
                
                
                $
                751,402Accrued
      payroll and related taxes
                
                
                268,996
                
                
                
                344,612Notes
      payable, due within one year
                
                
                168,554
                
                
                
                64,486Capital
      lease obligations, due within one year
                
                
                2,248
                
                
                
                25,560Total
      current liabilities
                
                
                1,323,603
                
                
                
                1,186,060Notes
      payable, due after one year
                
                
                191,645
                
                
                
                344,898Asset
      retirement obligation
                
                
                541,203
                
                
                
                506,005Total
      liabilities
                
                
                2,056,451
                
                
                
                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
                
                
                47,719,957
                
                
                
                47,464,507Accumulated
      deficit
                
                
                (36,615,830
                )
                
                
                (31,708,923
                )Total
      shareholders' equity
                
                
                11,118,738
                
                
                
                15,774,930Total
      liabilities and shareholders' equity
                
                $
                13,175,189
                
                
                $
                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 March 31,
                
                
                Nine months ended March 31,2009
                
                
                2008
                
                
                2009
                
                
                2008Product
      sales
                
                $
                1,366,289
                
                
                $
                1,783,642
                
                
                $
                4,212,574
                
                
                $
                5,397,705Cost
      of product sales
                
                
                1,351,044
                
                
                
                1,682,981
                
                
                
                4,523,705
                
                
                
                5,930,278Gross
      margin (loss)
                
                
                15,245
                
                
                
                100,661
                
                
                
                (311,131
                )
                
                
                (532,573
                )Operating
      expenses:Research
      and development expenses
                
                
                301,907
                
                
                
                434,418
                
                
                
                826,513
                
                
                
                1,086,333Sales
      and marketing expenses
                
                
                529,349
                
                
                
                888,448
                
                
                
                1,880,823
                
                
                
                3,091,091General
      and administrative expenses
                
                
                666,637
                
                
                
                869,435
                
                
                
                2,205,616
                
                
                
                2,690,624Total
      operating expenses
                
                
                1,497,893
                
                
                
                2,192,301
                
                
                
                4,912,952
                
                
                
                6,868,048Operating
      loss
                
                
                (1,482,648
                )
                
                
                (2,091,640
                )
                
                
                (5,224,083
                )
                
                
                (7,400,621
                )Non-operating
      income (expense):Interest
      income
                
                
                18,722
                
                
                
                131,442
                
                
                
                101,070
                
                
                
                549,993Gain
      (loss) on fair value of short-term investments
                
                
                -
                
                
                
                (187,300
                )
                
                
                274,000
                
                
                
                (187,300
                )Financing
      and interest expense
                
                
                (16,278
                )
                
                
                (22,826
                )
                
                
                (57,894
                )
                
                
                (78,140
                )Non-operating
      income (expense), net
                
                
                2,444
                
                
                
                (78,684
                )
                
                
                317,176
                
                
                
                284,553Net
      loss
                
                $
                (1,480,204
                )
                
                $
                (2,170,324
                )
                
                $
                (4,906,907
                )
                
                $
                (7,116,068
                )Basic
      and diluted loss per share
                
                $
                (0.06
                )
                
                $
                (0.09
                )
                
                $
                (0.21
                )
                
                $
                (0.31
                )Weighted
      average shares used in computing net loss per share:Basic
      and diluted
                
                
                22,942,088
                
                
                
                23,090,200
                
                
                
                22,942,088
                
                
                
                23,054,375





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


2





IsoRay,
Inc. and Subsidiaries


Consolidated
Statements of Cash Flows


(Unaudited)





Nine months ended March 31,2009
                
                
                2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      loss
                
                $
                (4,906,907
                )
                
                $
                (7,116,068
                )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Depreciation
      and amortization of fixed assets
                
                
                905,678
                
                
                
                849,716Impairment
      of IBt license (see Note 4)
                
                
                425,434
                
                
                
                -Write-off
      of certain foreign patents and trademarks (see Note 7)
                
                
                84,671
                
                
                
                -Amortization
      of deferred financing costs and other assets
                
                
                60,448
                
                
                
                61,521Amortization
      of discount on short-term investments
                
                
                -
                
                
                
                (145,165
                )(Gain)
      loss on fair value of short-term investments
                
                
                (274,000
                )
                
                
                187,300Settlement
      of asset retirement obligation
                
                
                -
                
                
                
                (135,120
                )Accretion
      of asset retirement obligation
                
                
                35,198
                
                
                
                25,670Share-based
      compensation
                
                
                255,450
                
                
                
                425,090Changes
      in operating assets and liabilities:Accounts
      receivable, net
                
                
                152,399
                
                
                
                284,252Inventory
                
                
                78,162
                
                
                
                18,395Prepaid
      expenses and other current assets
                
                
                94,068
                
                
                
                58,095Accounts
      payable and accrued liabilities
                
                
                132,403
                
                
                
                (880,599
                )Accrued
      payroll and related taxes
                
                
                (75,616
                )
                
                
                (216,834
                )Deferred
      revenue
                
                
                -
                
                
                
                (23,874
                )Net
      cash used by operating activities
                
                
                (3,032,612
                )
                
                
                (6,607,621
                )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of fixed assets
                
                
                (41,961
                )
                
                
                (3,112,400
                )Additions
      to licenses and other assets
                
                
                (22,245
                )
                
                
                (250,783
                )Change
      in restricted cash
                
                
                (2,243
                )
                
                
                (174,273
                )Purchases
      of short-term investments
                
                
                (479,820
                )
                
                
                (13,273,653
                )Proceeds
      from the sale or maturity of short-term investments
                
                
                4,000,000
                
                
                
                16,667,499Net
      cash provided (used) by investing activities
                
                
                3,453,731
                
                
                
                (143,610
                )CASH
      FLOWS FROM FINANCING ACTIVITIES:Principal
      payments on notes payable
                
                
                (49,185
                )
                
                
                (118,414
                )Principal
      payments on capital lease obligations
                
                
                (23,312
                )
                
                
                (155,603
                )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
                
                
                (77,232
                )
                
                
                748,796Net
      increase (decrease) in cash and cash equivalents
                
                
                343,887
                
                
                
                (6,002,435
                )Cash
      and cash equivalents, beginning of period
                
                
                4,820,033
                
                
                
                9,355,730CASH
      AND CASH EQUIVALENTS, END OF PERIOD
                
                $
                5,163,920
                
                
                $
                3,353,295Non-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 nine-month periods ended March 31, 2009 and
2008





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 auction rate
securities (ARS) failed beginning in February 2008 and did not have an active
market.  These short term securities were valued by our broker using
various assumptions including current interest rates, credit ratings, the
issuer’s financial health, etc.  The Company’s ARS were classified as
Level 2 until their sale on January 5, 2009.


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 were a put option for the right to
sell to UBS our ARS at par value.  As the Rights were non-transferable
and could not be attached to the ARS if they were sold to another entity, the
Rights represented 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 until they were exercised in January
2009.





At March
31, 2009, all of the Company’s financial assets and liabilities are accounted
and reported at fair value using Level 1 inputs.





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 and exercised in January
2009 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 March 31, 2009
and 2008, 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 March 31, 2009 and 2008 were as
follows:





March 31,2009
                  
                  
                  2008Preferred
      stock
                  
                  
                  59,065
                  
                  
                  
                  59,065Common
      stock warrants
                  
                  
                  3,216,644
                  
                  
                  
                  3,250,774Common
      stock options
                  
                  
                  2,430,839
                  
                  
                  
                  2,831,728Total
      potentially dilutive securities
                  
                  
                  5,706,548
                  
                  
                  
                  6,141,567


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 11 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 was
impaired.  Therefore, the Company recorded an impairment charge of
$425,434 in December 2008 that is included in cost of product sales for the nine
months ended March 31, 2009.





5.           Short-Term
Investments





The
Company’s short-term investments consisted of the following at March 31, 2009
and June 30, 2008:





March 31,
                  
                  
                  June 30,2009
                  
                  
                  2008Auction
      rate securities
                  
                  $
                  –
                  
                  
                  $
                  3,726,000Certificates
      of deposit
                  
                  
                  480,005
                  
                  
                  
                  –$
                  480,005
                  
                  
                  $
                  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 were 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 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 were 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 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 recorded all changes in fair value to these securities 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 was no longer an active market to
permit their sale in the normal course of business.





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.


6


6.           Inventory





Inventory
consisted of the following at March 31, 2009 and June 30, 2008:





March 31,
                  
                  
                  June 30,2009
                  
                  
                  2008Raw
      materials
                  
                  $
                  623,860
                  
                  
                  $
                  696,958Work
      in process
                  
                  
                  189,132
                  
                  
                  
                  191,684Finished
      goods
                  
                  
                  8,810
                  
                  
                  
                  11,322$
                  821,802
                  
                  
                  $
                  899,964





7.           Other
Assets





During
the three months ended March 31, 2009, the Company performed a review of its
prepaid legal fees for patents and trademarks that have not been obtained and
are classified within other assets on the consolidated balance
sheet.  The focus of the review was patent and trademark applications
that the Company had been pursuing in foreign countries.  The Company
decided to limit its foreign applications to Canada, Europe, and Russia, as well
as the continued protection of the US patents and trademarks.  This
resulted in the write-off of $80,429 of other patent and trademark application
fees relating to other countries during the quarter ended March
2009.





8.           Share-Based
Compensation





The
following table presents the share-based compensation expense recognized in the
statement of operations during the three and nine months ended March 31, 2009
and 2008:





Three months
                  
                  
                  Nine monthsended March 31,
                  
                  
                  ended March 31,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Cost
      of product sales
                  
                  $
                  3,100
                  
                  
                  $
                  36,029
                  
                  
                  $
                  17,010
                  
                  
                  $
                  109,859Research
      and development expenses
                  
                  
                  4,001
                  
                  
                  
                  10,971
                  
                  
                  
                  23,490
                  
                  
                  
                  34,071Sales
      and marketing expenses
                  
                  
                  18,869
                  
                  
                  
                  59,557
                  
                  
                  
                  123,852
                  
                  
                  
                  178,671General
      and administrative expenses
                  
                  
                  29,698
                  
                  
                  
                  (36,080
                  )
                  
                  
                  91,098
                  
                  
                  
                  102,489Total
      share-based compensation
                  
                  $
                  55,668
                  
                  
                  $
                  70,477
                  
                  
                  $
                  255,450
                  
                  
                  $
                  425,090





Each
quarter the Company reviews its forfeiture assumptions and adjusts its
compensation expense when the actual pre-vesting forfeiture rate differs
materially from the estimate.  During the three months ended March 31,
2008, the Company recognized a credit to compensation expense in general and
administrative expenses due to a significant variation between the estimated
pre-vesting forfeiture rate and the actual pre-vesting forfeiture
rate.





As of
March 31, 2009, total unrecognized compensation expense related to share-based
options was $201,392 and the related weighted-average period over which it is
expected to be recognized is approximately 0.60 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.


7


A summary
of stock options within the Company’s share-based compensation plans as of March
31, 2009 were as follows:





WeightedWeighted
                          
                          
                          AverageAverage
                          
                          
                          Remaining
                          
                          
                          AggregateNumber of
                          
                          
                          Exercise
                          
                          
                          Contractual
                          
                          
                          IntrinsicOptions
                          
                          
                          Price
                          
                          
                          Term
                          
                          
                          ValueOutstanding
      at March 31, 2009
                          
                          
                          2,430,839
                          
                          
                          $
                          2.61
                          
                          
                          
                          7.03
                          
                          
                          $
                          0.00Vested
      and expected to vest atMarch
      31, 2009
                          
                          
                          2,419,937
                          
                          
                          $
                          2.61
                          
                          
                          
                          7.02
                          
                          
                          $
                          0.00Vested
      and exercisable atMarch
      31, 2009
                          
                          
                          2,169,442
                          
                          
                          $
                          2.59
                          
                          
                          
                          6.86
                          
                          
                          $
                          0.00





The
aggregate intrinsic value of options exercised during the nine months ended
March 31, 2009 and 2008 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
                    
                    
                    Nine monthsended March 31,
                    
                    
                    ended March 31,2009(a)
                    
                    
                    2008(b)
                    
                    
                    2009(c)
                    
                    
                    2008(b)Weighted
      average fair value of options granted
                    
                    $
                    –
                    
                    
                    $
                    –
                    
                    
                    $
                    0.37
                    
                    
                    $
                    –Key
      assumptions used in determining fair value:Weighted
      average risk-free interest rate
                    
                    
                    –
                    %
                    
                    
                    –
                    %
                    
                    
                    2.63
                    %
                    
                    
                    –
                    %Weighted
      average life of the option (in years)
                    
                    
                    –
                    
                    
                    
                    –
                    
                    
                    
                    5.68
                    
                    
                    
                    –Weighted
      average historical stock price volatility
                    
                    
                    –
                    %
                    
                    
                    –
                    %
                    
                    
                    191.04
                    %
                    
                    
                    –
                    %Expected
      dividend yield
                    
                    
                    –
                    %
                    
                    
                    –
                    %
                    
                    
                    0.00
                    %
                    
                    
                    –
                    %





(a)
            During
      the three months ended March 31, 2009, the Company did not grant any stock
      options.


(b)
            During
      the three and nine months ended March 31, 2008, the Company did not grant
      any stock options.


(c)
            During
      the nine months ended March 31, 2009, 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 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.


8


9.
            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 the regional healthcare budgets have been
approved.  The Company, through UralDial, has regulatory approval to
sell cesium-131 seeds in Russia.





10.
            Distribution
      Agreement





On
February 18, 2009, the Company entered into an exclusive distribution agreement
with BrachySciences, a division of Biocompatibles International
plc.  The agreement allows BrachySciences to sell the Company’s
Proxcelan cesium-131 brachytherapy seeds throughout the United
States.  The Company did not have any sales under this agreement
during the three months ended March 31, 2009.





11.
            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.


9


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 cesium-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).





12.
            New
      Accounting Pronouncements





In
December 2007, FASB issued SFAS No. 141(R), Business Combinations
(SFAS 141R), which replaces SFAS No. 141, Business Combinations.
 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 SFAS 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.


10


In May
2008, FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles.  SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States.  It was effective November 15, 2008, following the
SEC’s approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, The Meaning of
Present Fairly in Conformity With Generally Accepted Accounting
Principles.  The adoption of this statement is not expected to
have a material effect on the Company’s financial statements.


11


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 March 31, 2009, 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.


12


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.





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 March 31, 2009 compared to three months ended March 31,
2008





Product sales.  The
Company generated sales of $1,366,289 during the three months ended March 31,
2009, compared to sales of $1,783,642 for the three months ended March 31,
2008.  The decrease of $417,353 or 23% 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 2% 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 March 31, 2009, the Company sold
its Proxcelan seeds to 50 different medical centers as compared to 57 medical
centers during the corresponding period of 2008.





Cost of product
sales.  Cost of product sales was $1,351,044 for the three
months ended March 31, 2009 compared to cost of product sales of $1,682,981
during the three months ended March 31, 2008.  The decrease of
$331,937 or 20% is mainly due to reduced sales.  The major components
of the decrease were personnel costs, materials, preload expenses, and
share-based compensation.  Personnel costs, including payroll,
benefits, and related taxes, decreased approximately $154,000 as the number of
production personnel decreased over the past year.  Materials
decreased approximately $100,000 mainly due to ordering and using less isotope
in the three months ended March 31, 2009 compared to the corresponding period of
2008.  Preload expenses decreased by approximately $73,000 mainly due
to the lower volume of sales and increased in-house
loading.  Share-based compensation decreased approximately $33,000 due
to the forfeiture of unvested options by the Company’s former
EVP-Operations.  These decreases were partially offset by an increase
of approximately $29,000 in depreciation expense.





Gross margin.  Gross
margin was $15,245 for the three month period ended March 31,
2009.  This represents a decrease in the Company’s gross margin of
$85,416 or 85% over the corresponding period of 2008’s gross margin of
$100,661.  The decrease in the gross margin is due to the Company’s
lower sales volume.


13


Research and development
expenses.  Research and development expenses for the three
month period ended March 31, 2009 were $301,907 which represents a decrease of
$132,511 or 31% less than the research and development expenses of $434,418 for
the three month period ended March 31, 2008.  The decrease is due to
lower consulting and personnel expenses partially offset by increased protocol
expense and the write-off of certain foreign patent and trademark application
fees.  Consulting expenses, which are mainly due to an ongoing project
to increase the efficiency of isotope production, decreased approximately
$189,000 as the Company has discontinued most funding until the final prototype
testing trial.  Personnel costs, including payroll, benefits, and
related taxes, decreased approximately $52,000 due to a reduced headcount in
research and development.  Protocol expenses increased approximately
$62,000 mainly due to the Company’s dual-therapy study and its continued
monitoring and updating of the mono-therapy study.  Also in the three
months ended March 31, 2009, the Company finalized its on-going strategy
regarding foreign patents and trademarks and wrote-off $80,429 of previously
capitalized costs.  The Company had pursued these patents and
trademarks in various foreign countries including Australia, Japan, and China;
however, the Company no longer believes that pursuing patents and trademarks in
these foreign countries are fundamental to its current business
strategy.





Sales and marketing
expenses.  Sales and marketing expenses were $529,349 for the
three months ended March 31, 2009.  This represents a decrease of
$359,099 or 40% compared to expenditures in the three months ended March 31,
2008 of $888,448 for sales and marketing.  Personnel expenses,
including payroll, benefits, and related taxes, decreased approximately $125,000
due to a lower sales headcount and a revised sales compensation
plan.  Consulting expenses decreased approximately $95,000 as the
Company reduced its reliance on third-parties as part of its expense reduction
initiatives.  Travel expenses decreased approximately $65,000 mainly
due to the decrease in sales force.  Share-based compensation
decreased approximately $41,000 due to the forfeiture of unvested
options.  Marketing and advertising decreased approximately $36,000 as
the Company reduced advertising spending in some trade journals and reduced
spending on the development of websites.





General and administrative
expenses.  General and administrative expenses for the three
months ended March 31, 2009 were $666,637 compared to general and administrative
expenses of $869,435 for the corresponding period of 2008.  The
decrease of $202,798 or 23% is mainly due to decreased personnel and legal
expenses that were partially offset by increased share-based compensation and
consulting expenses.  Personnel expenses, including payroll, benefits,
and related taxes, decreased approximately $222,000 owing mainly to the
resignation of the Company’s CEO in February 2008 and the related severance
payment.  Legal expenses decreased by approximately $79,000 from 2008
as in 2008 the Company incurred legal fees related to negotiation of severance
upon the resignation of the CEO, the annual shareholder meeting, and legal
advice related to various Board meetings.  Share-based compensation
increased by approximately $66,000 as during the prior year period the Company
reversed the expense for unvested and forfeited options of the former
CEO.  Consulting expenses increased by approximately $31,000 due to
payments to the Company’s interim CEO and a computer infrastructure consultant
that was not performing any services during the three months ended March 31,
2008.  Effective March 1, 2009, the interim CEO was converted to
employee status and his wages will no longer be shown in consulting
expenses.





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 March 31, 2009, the Company had
an operating loss of $1,482,648 which is a decrease of $608,992 or 29% less than
the operating loss of $2,091,640 for the three months ended March 31,
2008.


14


Interest
income.  Interest income was $18,722 for the three months ended
March 31, 2009.  This represents a decrease of $112,720 or 86%
compared to interest income of $131,442 for the three months ended March 31,
2008.  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.





Loss on fair value of short-term
investments.  The loss of $187,300 for the three months ended
March 31, 2008 was due to the uncertainties in the credit markets particularly
for certain auction rate securities.  The loss represents the amount
to write-down these securities to their estimated fair market
value.





Financing and interest
expense.  Financing and interest expense for the three months
ended March 31, 2009 was $16,278 or a decrease of $6,548 or 29% from financing
and interest expense of $22,826 for the corresponding period in
2008.  Included in financing expense is interest expense of
approximately $6,000 and $15,000 for the three months ended March 31, 2009 and
2008, respectively.  The remaining balance of financing expense
represents the amortization of deferred financing costs.





Nine
months ended March 31, 2009 compared to nine months ended March 31,
2008





Product
sales.  Sales for the nine months ended March 31, 2009 were
$4,212,574 compared to sales of $5,397,705 for the nine months ended March 31,
2008.  The decrease of $1,185,131 or 22% 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 nine months ended March 31, 2009 the Company sold
its Cs-131 seeds to 68 different medical centers as compared to 79 centers
during the corresponding period of 2008.





Cost of product
sales.  Cost of product sales was $4,523,705 for the nine
months ended March 31, 2009 which represents a decrease of $1,406,573 or 24%
compared to cost of product sales of $5,930,278 during the nine months ended
March 31, 2008.  Materials expense decreased approximately $738,000
mainly due to ordering and using less isotope in the nine months ended March 31,
2009 compared to the corresponding period of 2008.  Personnel
expenses, including payroll, benefits, and related taxes, decreased
approximately $479,000 due to a reduction in the average production headcount
levels.  Preload expenses decreased approximately $317,000 due to
lower sales volumes and due to increased in-house loading.  Small
tools expenses decreased approximately $83,000 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 $92,000 mainly due to the forfeiture of unvested options by the
Company’s former EVP-Operations.


15


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 nine months ended March 31, 2008, 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 nine months ended
March 31, 2008.  This additional expense incurred in the nine months
ended March 31, 2008 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.





Gross loss.  Gross
loss was $311,131 for the nine month period ended March 31,
2009.  This represents a decrease of $221,442 or 42% over the
corresponding period of 2008’s gross loss of $532,573.  Included in
the gross loss for the nine months ended March 31, 2009 is the one-time IBt
license impairment loss of $425,434.  Without this one-time expense,
the Company would have recognized a gross margin of $114,303 for the nine months
ended March 31, 2009.





Research and development
expenses.  Research and development expenses for the nine
months ended March 31, 2009 were $826,513 which represents a decrease of
$259,820 or 24% less than the research and development expenses of $1,086,333
for the corresponding period of 2008.  The major components of the
decrease were personnel, consulting, and travel expenses.  Personnel
expenses, including payroll, benefits, and related taxes, decreased
approximately $163,000 due to lower headcount.  Consulting expenses
decreased approximately $291,000 as the Company’s project to improve the
efficiency of isotope production is nearing its final prototype testing phase
and the Company has discontinued most funding until the final prototype testing
trial.  Travel expenses decreased approximately $41,000 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 $179,000 mainly due to payments for the
Company’s dual-therapy study and its continued monitoring and updating of the
mono-therapy study.  Also in the nine months ended March 31, 2009, the
Company finalized its on-going strategy regarding foreign patents and trademarks
and wrote-off $80,429 of previously capitalized costs.  The Company
had pursued these patents and trademarks in various foreign countries including
Australia, Japan, and China; however, the Company no longer believes that
pursuing patents and trademarks in these foreign countries are fundamental to
its current business strategy.





Sales and marketing
expenses.  Sales and marketing expenses were $1,880,823 for the
nine months ended March 31, 2009.  This represents a decrease of
$1,210,268 or 39% compared to expenditures in the nine months ended March 31,
2008 of $3,091,091 for sales and marketing.  Personnel expenses,
including payroll, benefits, and related taxes, decreased approximately $557,000
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 $119,000 due to
the decrease in average headcount.  Consulting expenses decreased
approximately $228,000, mainly due to reduced reliance on third-parties as part
of the Company’s expense reduction initiatives.  Marketing and
advertising decreased approximately $197,000 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 $41,000 mainly due to the prior year purchases of market research
reports and subscriptions for US medical residents.  Share-based
compensation decreased approximately $55,000 due to the forfeiture of unvested
options and fewer options being granted.


16


General and administrative
expenses.  General and administrative expenses for the nine
months ended March 31, 2009 were $2,205,616 compared to general and
administrative expenses of $2,690,624 for the corresponding period of
2008.  The decrease of $485,008 or 18% 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 $360,000
mainly due to the resignation of the Company’s CEO in February 2008 and lower
headcounts.  Public company expenses decreased approximately $113,000
due to lower investor relations costs partially offset by increased board
compensation.  Legal expenses decreased by approximately $137,000 as
in the nine months ended March 31, 2008 the Company incurred legal fees for
contract drafting and review of the Company’s interest in UralDial, the IBt
strategic global alliance agreements, and settlement agreement 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 $65,000.  These decreases were
partially offset by increased expense related to bad debt allowance of
approximately $76,000 and increased consulting expenses of approximately
$115,000 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.





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 nine months ended March 31, 2009, the Company had
an operating loss of $5,224,083 which is a decrease of $2,176,538 or 29% less
than the operating loss of $7,400,621 for the nine months ended March 31,
2008.  Included in the operating loss for the nine months ended March
31, 2009 is the one-time IBt license impairment loss of
$425,434.  Without this impairment loss, the Company’s operating loss
would have been $4,798,649.





Interest
income.  Interest income was $101,070 for the nine months ended
March 31, 2009.  This represents a decrease of $448,923 or 82%
compared to interest income of $549,993 for the nine months ended March 31,
2008.  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 (loss) on fair value of
short-term investments.  The gain of $274,000 for the nine
months ended March 31, 2009 is due to the receipt of the Company’s rights
related to its auction rate securities (ARS) issued by its broker in October
2008.  The gain is calculated as the fair value amount of the put
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 nine months
ended March 31, 2009 was $57,894 or a decrease of $20,246 or 26% from financing
and interest expense of $78,140 for the corresponding period in
2008.  Included in financing expense is interest expense of
approximately $31,000 and $55,000 for the nine months ended March 31, 2009 and
2008, 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.


17


Liquidity and capital
resources.  The Company has historically financed its
operations through cash investments from shareholders.  During the
nine months ended March 31, 2009, 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 $3.0 million for the nine months ended March 31,
2009 compared to $6.6 million for the nine months ended March 31,
2008.  Cash used by operating activities is net loss adjusted for
non-cash items and changes in operating assets and liabilities.





Cash
flows from investing activities





Cash
provided by investing activities was approximately $3.5 million for the nine
months March 31, 2009 as compared to cash used by investing activities of
$144,000 for the nine months ended March 31, 2008.  Cash expenditures
for fixed assets were approximately $42,000 and $3.1 million during the nine
months ended March 31, 2009 and 2008, respectively.    The
expenditures for fixed assets during the nine months ended March 31, 2008 were
related to the construction of the Company’s new production
facility.  The Company sold its remaining auction rate securities in
January 2009 which generated $4.0 million of cash proceeds.  The
Company reinvested most of these proceeds in money market funds and certificates
of deposit with maturities of less that 3 months which are classified as cash
equivalents on the balance sheet.





Cash
flows from financing activities





Cash used
in financing activities was approximately $77,000 for the nine months ended
March 31, 2009 and was used mainly for payments of debt and capital
leases.





Projected
2008 Liquidity and Capital Resources





At March
31, 2009, cash and cash equivalents amounted to $5,163,920 and short-term
investments amounted to $480,005, 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 $3.5 million of cash and $1.7 million of short-term
investments as of May 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
February 2009, a controversial study was released and widely disseminated by the
popular press claiming that PSA testing was not as important as previously
believed.  Heightened PSA levels did not necessarily correlate to a
greater incidence of prostate cancer, according to this study.  IsoRay
has, as have all brachytherapy companies, relied extensively on PSA testing to
show the patient that he needs treatment.


18


Management
believes that the results of the study and the popularity of the alternative
IMRT procedure, coupled with a very weak economy during the quarter ended March
31, 2009, resulted in fewer procedures than anticipated.  Management
continues to believe that Mr. Pasqualone’s (Vice President of Business
Development) credibility in the industry is important to improve sales but
believes the macroeconomic factors impacting the industry as a whole continue to
make it difficult to reverse negative sales trends.





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.





Long-Term
Debt and Capital Lease Agreements





IsoRay
had two loan facilities in place as of March 31, 2009.  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 due in December 2009.  As of March 31, 2009, the principal
balance owed was $124,360.  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 March
31, 2009 was $235,839.  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 March 31, 2009
was $2,248.





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
cesium-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.


19


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
due to an electrical problem that damaged equipment and due to economic
difficulties in the Ukraine that have protracted the contractor’s
efforts.





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.





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.


20


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.





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 March 31, 2009.  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.


21


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-131 directly
from UralDial instead of from INM and RIAR.  As a result, we now rely
on UralDial to obtain cesium-131 from Russian sources.  UralDial has
agreed to maintain at least two Russian sources of its cesium-131, 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-131 through the end of
2009.  There can be no guarantee that UralDial will always be able to
supply us with sufficient cesium-131, 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-131 would be reduced significantly unless we have a
source of enriched barium for utilization in domestic reactors.





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
4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS





On
February 18, 2009, the Company held its Annual Meeting of Shareholders at which
our shareholders elected four Directors and ratified the appointment of our
independent registered public accounting firm for the fiscal year ending June
30, 2009.





(a)
            Election of
      Directors.  All nominees for election as Directors were
      unopposed and elected as follows:





Director
                  
                  For
                  
                  
                  WithholdDwight
      Babcock
                  
                  
                  14,916,234
                  
                  
                  
                  1,905,529Robert
      R. Kauffman
                  
                  
                  14,901,234
                  
                  
                  
                  1,920,529Thomas
      C. LaVoy
                  
                  
                  14,916,232
                  
                  
                  
                  1,905,531Albert
      Smith
                  
                  
                  14,901,234
                  
                  
                  
                  1,920,529





(b)
            Appointment of our independent
      registered public accounting firm.  Proposal to ratify
      the appointment of DeCoria, Maichel & Teague, P.S. as independent
      registered public accounting firm of the Company for the fiscal year
      ending June 30, 2009 was approved as
follows:





For
                  
                  Against
                  
                  
                  Abstain16,447,339
                  
                  
                  315,756
                  
                  
                  
                  58,668





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:
      May 14, 2009ISORAY,
      INC., a Minnesota corporationBy
                        /s/ Dwight
    BabcockDwight
      Babcock, Chief Executive OfficerBy
                        /s/ Jonathan R.
    HuntJonathan
      R. Hunt, Chief Financial
Officer


23