## **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

## **Washington,D.C.  20549**

 

**FORM 10-QSB**

 
| **ý**                                 | **Quarterly report pursuant to section 13 or 15(d) of  the Securities Exchange Act of 1934.**                                                                                       |
|--------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                       | **For the quarterly  period ending December 31, 2003.**                                                                                                                             |
|                                       |                                                                                                                                                                                     |
|                                       | **or**                                                                                                                                                                                   |
|                                       |                                                                                                                                                                                     |
| **o**                                      | **Transition report pursuant to Section 13 or 15(d) of  the Securities Exchange Act of 1934.**                                                                                      |
|                                       | **For the transition  period from              to            .** |
|                                       |                                                                                                                                                                                     |
| **Commission file number  000-25839** |

 

**IMPLANTSCIENCES CORPORATION**

(Exact name of registrant as specified in itscharter)

 
| **Massachusetts**                                                                    |   | **04-2837126**                        |
|--------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization)                      |   | (IRS Employer  Identification number) |
|                                                                                 |   |                                  |
| **107 Audubon Road, #5**                                                             |   | **Wakefield, MA  01880**         |
|                                                                                 |   |                                  |
| **781-246-0700**                                                                     |
| (Issuers telephone number)                                                           |
|                                                                                 |   |                                  |
| **Not Applicable**                                                                   |
| (Former name, former address and former  fiscal year, if changed since last report.) |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject to suchfiling requirements for the past 90 days.

YES   ý            NO  o

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common equity, as of the latest practicable date:

 

| **Class**                    |   | **Outstanding  at January 31, 2004** |
|------------------------------|--------|-------------------------------------------|
| Common Stock, $.10 par value |   | 7,330,824                                 |

 

Transitional small business disclosure format(check one):

| YES   o |   | NO  ý |
|--------------|--------|-----------------|

 

 

----

 

**IMPLANTSCIENCES CORPORATION**

 

**INDEX**

 
| PART I.   FINANCIAL INFORMATION |                                                                                                               |
|--------------------------------------|--------------------------------------------------------------------------------------------------------------------|
|                                 |                                                                                                               |   |
| Item 1.                              | Financial Statements:                                                                                              |   |
|                                 |                                                                                                               |   |
|                                 | Condensed Balance Sheets as of  December 31, 2003 and June 30, 2003 (unaudited)                          |   |
|                                 |                                                                                                               |   |
|                                 | Condensed Statements of Operations for the  Three and Six Months Ended December 31, 2003 and 2002 (unaudited) |   |
|                                 |                                                                                                               |   |
|                                 | Condensed Statements of Cash Flows for the  Six Months Ended December 31, 2003 and 2002 (unaudited)           |   |
|                                 |                                                                                                               |   |
|                                 | Notes to Condensed Financial Statements  (unaudited)                                                               |   |
|                                 |                                                                                                               |   |
| Item 2.                              | Management’s Discussion and Analysis of  Financial Condition  and Results of  Operations                 |   |
| Item 3.                              | Controls and Procedures                                                                                            |   |
|                                 |                                                                                                               |   |
| PART II.  OTHER INFORMATION     |                                                                                                               |
|                                 |                                                                                                               |   |
|                                 |                                                                                                               |   |
| Item 1.                              | Legal Proceedings                                                                                                  |   |
|                                 |                                                                                                               |   |
| Item 2.                              | Changes in Securities and Use of Proceeds                                                                          |   |
|                                 |                                                                                                               |   |
| Item 3.                              | Defaults Upon Senior Securities                                                                                    |   |
|                                 |                                                                                                               |   |
| Item 4.                              | Submission of Matters to a Vote of  Security-Holders                                                               |   |
|                                 |                                                                                                               |   |
| Item 5.                              | Other Information                                                                                                  |   |
|                                 |                                                                                                               |   |
| Item 6.                              | Exhibits and Reports on Form 8-K                                                                                   |   |
|                                 |                                                                                                               |   |
|                                 | Signatures                                                                                                         |   |

 

1

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDBALANCE SHEETS**

**(Unaudited)**

 
|                                                                                                                                                                            |   | **December 31  2003** |       | **June 30,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|------------|-------------------------|--------|
| **ASSETS**                                                                                                                                                                      |   |                       |       |                    |   |
| Current  assets:                                                                                                                                                                |   |                       |       |                    |   |
| Cash  and cash equivalents                                                                                                                                                      |   | $                          | 2,879,000  |                    | $      | 959,000 |   |
| Accounts  receivable, net                                                                                                                                                       |   | 907,000                    |       | 778,000                 |   |
| Inventories                                                                                                                                                                     |   | 527,000                    |       | 473,000                 |   |
| Investments  - available for sale securities                                                                                                                                    |   | 324,000                    |       | 177,000                 |   |
| Prepaid  expenses and other current assets                                                                                                                                      |   | 50,000                     |       | 33,000                  |   |
| Total  current assets                                                                                                                                                           |   | 4,687,000                  |       | 2,420,000               |   |
|                                                                                                                                                                            |   |                       |       |                    |   |
| Property  and equipment, net                                                                                                                                                    |   | 4,507,000                  |       | 4,741,000               |   |
| Amoritzable  intangible assets, net (Note 10)                                                                                                                                   |   | 833,000                    |       | —                  |   |
| Other  non-current assets, net                                                                                                                                                  |   | 179,000                    |       | 136,000                 |   |
|                                                                                                                                                                            |   |                       |       |                    |   |
| Total  assets                                                                                                                                                                   |   | $                          | 10,206,000 |                    | $      | 7,297,000 |   |
|                                                                                                                                                                            |   |                       |       |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                   |   |                       |       |                    |   |
| Current  liabilities:                                                                                                                                                           |   |                       |       |                    |   |
| Accounts  payable                                                                                                                                                               |   | $                          | 579,000    |                    | $      | 749,000 |   |
| Accrued  expenses                                                                                                                                                               |   | 661,000                    |       | 669,000                 |   |
| Current  portion of long-term debt                                                                                                                                              |   | 945,000                    |       | 1,269,000               |   |
| Obligations  under capital leases                                                                                                                                               |   | 4,000                      |       | 5,000                   |   |
| Total  current liabilities                                                                                                                                                      |   | 2,189,000                  |       | 2,692,000               |   |
|                                                                                                                                                                            |   |                       |       |                    |   |
| Long-term  liabilities:                                                                                                                                                         |   |                       |       |                    |   |
| Noncurrent  obligations under capital lease                                                                                                                                     |   | 8,000                      |       | 11,000                  |   |
| Long-term  debt                                                                                                                                                                 |   | 414,000                    |       | —                  |   |
| Total  liabilities                                                                                                                                                              |   | 2,611,000                  |       | 2,703,000               |   |
|                                                                                                                                                                            |   |                       |       |                    |   |
| Convertible  preferred stock:  5,000,000 shares  authorized:                                                                                                               |   |                       |       |                    |   |
| 7%  Series A Cumulative Convertible Preferred Stock, $10 stated value; 250,000  shares designated; 150,000 shares issued and outstanding at June 30,  2003                 |   | —                     |       | 966,000                 |   |
| 5%  Series B Cumulative Convertible Preferred Stock, $10 stated value; 200,000  shares designated; 145,000 issued and outstanding at December 31, 2003                     |   | 670,000                    |       | —                  |   |
| 5%  Series C Cumulative Convertible Preferred Stock, $10 stated value; 250,000  shares designated; 250,000 shares issued and outstanding at December 31,  2003             |   | 1,544,000                  |       | —                  |   |
| Stockholders’  equity:                                                                                                                                                     |   |                       |       |                    |   |
| Common  stock, $.10 par value; 20,000,000 shares authorized; 7,121,599 and 6,650,156  issued and outstanding as of December 31, 2003 and June 30, 2003,  respectively |   | 712,000                    |       | 665,000                 |   |
| Additional  paid-in capital                                                                                                                                                     |   | 20,920,000                 |       | 16,064,000              |   |
| Accumulated  deficit                                                                                                                                                            |   | (15,823,000                | )          | (12,988,000             | )      |
| Deferred  compensation                                                                                                                                                          |   | (568,000                   | )          | (7,000                  | )      |
| Accumulated  other comprehensive income                                                                                                                                         |   | 224,000                    |       | 117,000                 |   |
| Notes  receivable from employees                                                                                                                                                |   | (84,000                    | )          | (223,000                | )      |
|                                                                                                                                                                            |   |                       |       |                    |   |
| Total  stockholders’ equity                                                                                                                                                |   | 5,381,000                  |       | 3,628,000               |   |
|                                                                                                                                                                            |   |                       |       |                    |   |
| Total  liabilities and stockholders’ equity                                                                                                                                |   | $                          | 10,206,000 |                    | $      | 7,297,000 |   |

 

Theaccompanying notes are an integral part of these condensed financialstatements.

 

2

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                          |   | **Three Months Ended  December 31,** |       | **Six Months Ended  December 31,** |   |
|---------------------------------------------------------------|--------|-------------------------------------------|------------|-----------------------------------------|--------|
|                                                          |   | **2003**                                  |       | **2002**                                |   | **2003** |   | **2002** |   |
| Revenues:                                                     |   |                                      |       |                                    |   |   |   |   |   |
| Product  and contract research:                               |   |                                      |       |                                    |   |   |   |   |   |
| Medical                                                       |   | $                                         | 1,030,000  |                                    | $      | 1,138,000 |   | $ | 2,044,000 |   | $ | 2,332,000 |   |
| Semiconductor                                                 |   | 208,000                                   |       | 188,000                                 |   | 467,000 |   | 397,000 |   |
| Government  contracts and other                               |   | 651,000                                   |       | 400,000                                 |   | 1,015,000 |   | 572,000 |   |
| Total  revenues                                               |   | 1,889,000                                 |       | 1,726,000                               |   | 3,526,000 |   | 3,301,000 |   |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Costs  and expenses:                                          |   |                                      |       |                                    |   |   |   |   |   |
| Cost  of product and contract research revenues               |   | 1,009,000                                 |       | 942,000                                 |   | 1,979,000 |   | 1,997,000 |   |
| Cost  of government contracts                                 |   | 497,000                                   |       | 357,000                                 |   | 687,000 |   | 529,000 |   |
| Total  costs and expenses                                     |   | 1,506,000                                 |       | 1,299,000                               |   | 2,666,000 |   | 2,526,000 |   |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Gross  margin                                                 |   | 383,000                                   |       | 427,000                                 |   | 860,000 |   | 775,000 |   |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Operating  expenses:                                          |   |                                      |       |                                    |   |   |   |   |   |
| Research  and development                                     |   | 464,000                                   |       | 452,000                                 |   | 893,000 |   | 868,000 |   |
| Selling,  general and administrative                          |   | 990,000                                   |       | 632,000                                 |   | 1,750,000 |   | 1,154,000 |   |
| Total  operating expenses                                     |   | 1,454,000                                 |       | 1,084,000                               |   | 2,643,000 |   | 2,022,000 |   |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Loss  from operations                                         |   | (1,071,000                                | )          | (657,000                                | )      | (1,783,000 | ) | (1,247,000 | ) |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Other  income (expense)                                       |   |                                      |       |                                    |   |   |   |   |   |
| Interest  income                                              |   | 3,000                                     |       | 11,000                                  |   | 7,000 |   | 15,000 |   |
| Interest  expense                                             |   | (36,000                                   | )          | (6,000                                  | )      | (78,000 | ) | (11,000 | ) |
| Equity  loss in Epsilon Medical                               |   | (3,000                                    | )          | —                                  |   | (7,000 | ) | — |   |
| Total  other income (expense)                                 |   | (36,000                                   | )          | 5,000                                   |   | (78,000 | ) | 4,000 |   |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Net  loss                                                     |   | (1,107,000                                | )          | (652,000                                | )      | (1,861,000 | ) | (1,243,000 | ) |
| Preferred  distribution, dividends and accretion (Note 8)     |   | (530,000                                  | )          | (201,000                                | )      | (973,000 | ) | (201,000 | ) |
| Net  loss applicable to common shareholders                   |   | $                                         | (1,637,000 | )                                       | $      | (853,000 | ) | $ | (2,834,000 | ) | $ | (1,444,000 | ) |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Net  loss per share                                           |   |                                      |       |                                    |   |   |   |   |   |
| Per  share - basic and diluted                                |   |                                      |       |                                    |   |   |   |   |   |
| Net  loss                                                     |   | $                                         | (0.16      | )                                       | $      | (0.10 | ) | $ | (0.27 | ) | $ | (0.20 | ) |
| Preferred  distribution                                       |   | (0.08                                     | )          | (0.03                                   | )      | (0.14 | ) | (0.03 | ) |
| Net  loss per share applicable to common shareholders         |   | $                                         | (0.23      | )                                       | $      | (0.14 | ) | $ | (0.41 | ) | $ | (0.23 | ) |
|                                                          |   |                                      |       |                                    |   |   |   |   |   |
| Weighted  average common shares outstanding basic and diluted |   | 7,029,911                                 |       | 6,229,413                               |   | 6,912,070 |   | 6,222,747 |   |

 

The accompanying notes are an integral partof these condensed financial statements

 

3

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                                                     |   | **Six Months Ended  December 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|------------|
|                                                                                                                     |   | **2003**                                |       | **2002** |   |
| **Cash flows  from operating activities**                                                                                |   |                                    |       |   |   |
| Net  loss                                                                                                                |   | $                                       | (1,861,000 | ) | $ | (1,243,000 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                                             |   |                                    |       |   |   |
| Depreciation  and amortization                                                                                           |   | 564,000                                 |       | 409,000 |   |
| Stock-based  compensation expense                                                                                        |   | 520,000                                 |       | 55,000 |   |
| Equity  in loss in Epsilon Medical                                                                                       |   | 7,000                                   |       | — |   |
| Changes  in assets and liabilities:                                                                                      |   |                                    |       |   |   |
| Accounts  receivable                                                                                                     |   | (129,000                                | )          | (12,000 | ) |
| Inventories                                                                                                              |   | (54,000                                 | )          | (308,000 | ) |
| Prepaid  and other current assets                                                                                        |   | (17,000                                 | )          | (27,000 | ) |
| Accounts  payable                                                                                                        |   | (170,000                                | )          | 317,000 |   |
| Accrued  expenses                                                                                                        |   | (52,000                                 | )          | (149,000 | ) |
| Net  cash used in operating activities                                                                                   |   | (1,192,000                              | )          | (958,000 | ) |
|                                                                                                                     |   |                                    |       |   |   |
| **Cash flows from investing activities**                                                                                 |   |                                    |       |   |   |
| Purchase  of property and equipment                                                                                      |   | (155,000                                | )          | (201,000 | ) |
| Investment  in for sale securities                                                                                       |   | (40,000                                 | )          | — |   |
| Other  non-current assets                                                                                                |   | (52,000                                 | )          | (8,000 | ) |
| Net  cash used in investing activities                                                                                   |   | (247,000                                | )          | (209,000 | ) |
|                                                                                                                     |   |                                    |       |   |   |
| **Cash flows from financing activities**                                                                                 |   |                                    |       |   |   |
| Proceeds  from common stock                                                                                              |   | 172,000                                 |       | 90,000 |   |
| Proceeds  from issuance of Series A preferred stock, net of issuance costs                                               |   | —                                  |       | 2,099,000 |   |
| Proceeds  from issuance of Series B preferred stock, net of issuance costs                                               |   | 1,818,000                               |       | — |   |
| Proceeds  from issuance of Series C preferred stock, net of issuance costs                                               |   | 2,289,000                               |       | — |   |
| Repayments  of long-term debt                                                                                            |   | (218,000                                | )          | (240,000 | ) |
| Repayments  of capital lease obligations                                                                                 |   | (3,000                                  | )          | — |   |
| Repayments  of equipment financing                                                                                       |   | (699,000                                | )          | — |   |
| Net  cash provided by financing activities                                                                               |   | 3,359,000                               |       | 1,949,000 |   |
|                                                                                                                     |   |                                    |       |   |   |
| Net  increase in cash and cash equivalents                                                                               |   | 1,920,000                               |       | 782,000 |   |
| Cash  and cash equivalents, beginning                                                                                    |   | 959,000                                 |       | 1,014,000 |   |
| Cash  and cash equivalents, ending                                                                                       |   | $                                       | 2,879,000  |   | $ | 1,796,000 |   |
|                                                                                                                     |   |                                    |       |   |   |
| **Noncash Investing and Financing Activity:**                                                                            |   |                                    |       |   |   |
| Issuance  of Series A warrants                                                                                           |   | $                                       | —     |   | $ | 128,000 |   |
| Noncash  beneficial conversion feature - Series A                                                                        |   | $                                       | —     |   | $ | 537,000 |   |
| Issuance  of Series B warrants                                                                                           |   | $                                       | 125,000    |   | $ | — |   |
| Noncash  beneficial conversion feature - Series B                                                                        |   | $                                       | 767,000    |   | $ | — |   |
| Issuance  of Series C warrants                                                                                           |   | $                                       | 210,000    |   | $ | — |   |
| Noncash  beneficial conversion feature - Series C                                                                        |   | $                                       | 605,000    |   | $ | — |   |
| Conversion  of Series A Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |   | $                                       | 1,500,000  |   | $ | — |   |
| Conversion  of Series B Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |   | $                                       | 550,000    |   | $ | — |   |
| Value  of amortizable intangible asset acquired in exchange for long term note  payable                                  |   | $                                       | 1,007,000  |   | $ | — |   |
| Accretion  of 7% Series A Cumulative Convertible Preferresd Stock dividends, beneficial  conversion feature and warrants |   | $                                       | 556,000    |   | $ | 201,000 |   |
| Accretion  of 5% Series B Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants  |   | $                                       | 294,000    |   | $ | — |   |
| Accretion  of 5% Series C Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants  |   | $                                       | 69,000     |   | $ | — |   |

 

Theaccompanying notes are an integral part of these condensed financialstatements.

 

4

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**IMPLANT SCIENCES CORPORATION**

**NOTES TO CONDENSED FINANCIAL STATEMENTS**

**December 31, 2003**

**(Unaudited)**

 

**1.****              Description of Business**

 

Implant Sciences Corporation (the “Company”)develops products for the medical device and explosives detection industryusing ion implantation and thin film coatings of radioactive andnon-radioactive materials.  The Companyhas received Food and Drug Administration 510(k) clearance to market itsI-Plantä Iodine-125radioactive seed for the treatment of prostate cancer.  The Company also has under development interventionalcardiology devices and temporary coronary brachytherapy systems for theprevention of restenosis (reclosure of the artery after balloonangioplasty).  In addition, the Companymodifies the surface characteristics of orthopedic joint implants to reducepolyethylene wear and thereby increasing the life of the implant and providesion implantation of electronic dopants for the semiconductor industry.  Additionally, the Company is developing anexplosives detection device to be used in the detection of trace residues ofexplosives.

 

**2.****              Interim Financial Statements**

 

The financial information for the three andsix months ending December 31, 2003 and 2002 is unaudited but includes alladjustments (consisting only of normal recurring adjustments) which we considernecessary for a fair presentation of the financial position at such date and ofthe operating results and cash flows for these periods.  The result of operations and cash flows forthe three and six months ended December 31, 2003 are not necessarilyindicative of results that may be expected for the entire year.  The information contained in this Form10-QSB should be read in conjunction with our audited financial statements,included in our Form 10-KSB/A No. 1 as of and for the year ending June 30,2003 filed with the Securities and Exchange Commission on October 1, 2003.

 

**3.****              Stock-basedCompensation**

 

The Company accounts for its employee stockbased compensation arrangements under the provisions of Accounting PrincipalBoard (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, ratherthan the alternative fair value accounting method provided for under SFAS No.123, “Accounting for Stock-Based Compensation.”  Under APB 25, when the exercise price of options granted toemployees and non-employee directors under these plans equals the market priceof the underlying stock on the date of the grant, no compensation expense isrecorded.

 

The Company has elected to use the disclosure-onlyprovisions of SFAS No. 123 and SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure.” Had compensation expense for stock option grants to employees beendetermined based on the fair value method at the grant dates for awards underthe stock option plans consistent with the method prescribed by SFAS No. 123,the Company’s net loss would have increased to the pro forma amounts indicatedas follows:

 

5

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|                                                                                                                                   |   | **Three Months Ended  December 31,** |       | **Six Months Ended  December 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|-----------------------------------------|--------|
|                                                                                                                                   |   | **2003**                                  |       | **2002**                                |   | **2003** |   | **2002** |   |
|                                                                                                                                   |   |                                      |       |                                    |   |   |   |   |   |
| Net  loss applicable to common shareholders, as reported                                                                               |   | $                                         | (1,637,000 | )                                       | $      | (853,000 | ) | $ | (2,834,000 | ) | $ | (1,444,000 | ) |
| Add:  Stock-based employee compensation expense  included in reported net loss applicable to common shareholders, net of tax      |   | 371,000                                   |       | 55,000                                  |   | 520,000 |   | 55,000 |   |
| Deduct:  Total stock-based employee compensation  expense determined under the fair value based method of all awards, net of  tax |   | (302,000                                  | )          | (195,000                                | )      | (452,000 | ) | (230,010 | ) |
|                                                                                                                                   |   |                                      |       |                                    |   |   |   |   |   |
| Pro  forma net loss applicable to common shareholders                                                                                  |   | $                                         | (1,568,000 | )                                       | $      | (993,000 | ) | $ | (2,766,000 | ) | $ | (1,619,010 | ) |
|                                                                                                                                   |   |                                      |       |                                    |   |   |   |   |   |
| Net  loss applicable to common shareholders per basic and dilutive shares:                                                             |   |                                      |       |                                    |   |   |   |   |   |
| As  reported                                                                                                                           |   | $                                         | (0.23      | )                                       | $      | (0.14 | ) | $ | (0.41 | ) | $ | (0.23 | ) |
| Pro  forma                                                                                                                             |   | $                                         | (0.22      | )                                       | $      | (0.16 | ) | $ | (0.40 | ) | $ | (0.26 | ) |
|                                                                                                                                   |   |                                      |       |                                    |   |   |   |   |   |
| Weighted  average common shares outstanding basic and diluted                                                                          |   | 7,029,911                                 |       | 6,229,413                               |   | 6,912,070 |   | 6,222,747 |   |

 

In August 2003, the Company issued45,550 shares of restricted common stock to employees in lieu of cashraises.  These shares of restrictedstock were subject to forfeiture if the employee’s employment with the Companyceased prior to January 2, 2004. Additionally the shares may not be sold, transferred or assigned untilAugust 2004.  The Company recordeddeferred compensation of $265,000 related to this transaction.  This amount is being amortized over the fourmonth vesting period.  During the threeand six months ended December 31 2003, the Company recorded $130,000 and$263,000 in compensation expense reduced by $2,000 of stock compensation related to forfeitures due to employmentterminations.

 

The Company recorded additional deferredcompensation of $739,000 relating to stock options issued below fair marketvalue.  This amount is being amortizedover the vesting period of the options which averages 10 years.  During the quarter ended December 31,2003, the Company recorded $176,000 in compensation expense related to thistransaction.

 

During the three months endedDecember 31, 2003, the Company granted certain officers a bonus in theform of common stock.  The Companyissued 5,500 shares of common stock and recognized approximately $43,000 incompensation expense.

 

During the three months endedDecember 31, 2003, the Company issued 4,000 shares of restricted commonstock to a consultant in exchange for services.  The company recognized approximately $29,000 in expenseassociated with the stock granted to this consultant.

 

The Company granted 1,000 options to purchasecommon stock to a consultant in exchange for services during the three monthsended December 31, 2003.  TheCompany recorded approximately $3,000 in expense associated with thisissuance.  The Company estimated thefair value of the common stock options using the Black-Scholes option-pricingmodel.  The Company estimated the fairvalue of the options using the following input assumptions:

 

6

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| Volatility               |   | 67.80    | %      |
|--------------------------|--------|----------|--------|
| Divident                 |   | 0        | %      |
| Risk-free  interest rate |   | 3.18     | %      |
| Expected  lives          |   | 5  years |   |

 

**4.****              Earnings Per Share**

 

Basic earnings per share is computed basedonly on the weighted average number of common shares outstanding during theperiod.  Diluted earnings per share iscomputed by using the weighted average number of common shares outstandingduring the period, plus the dilutive effects of shares issuable through theexercise of stock options (common stock equivalents) unless their inclusionwould be antidilutive.

 

**5.****              Comprehensive Income**

 

The Company has accumulated other comprehensiveincome resulting from the unrealized gain on an investment in marketable equitysecurities of CardioTech International Inc. (Note 9) which is recorded in thestockholders’ equity section of the balance sheet.  Comprehensive income is summarized below:

 
|                        |   | **Three Months Ended  December 31,** |       | **Six Months Ended  December 31,** |       |
|-----------------------------|--------|-------------------------------------------|------------|-----------------------------------------|------------|
|                        |   | **2003**                                  |       | **2002**                                |       | **2003** |   | **2002** |   |
|                        |   |                                      | ** ** |                                    | ** ** |   | ** ** |   | ** ** |
| Net  Loss                   |   | $                                         | (1,107,000 | )                                       | $          | (652,000 | ) | $ | (1,861,000 | ) | $ | (1,243,000 | ) |
| Other  Comprehensive Income |   | 80,000                                    |       | (3,000                                  | )          | 107,000 |   | (24,000 | ) |
|                        |   |                                      |       |                                    |       |   |   |   |   |
| Comprehensive  Loss         |   | $                                         | (1,027,000 | )                                       | $          | (655,000 | ) | $ | (1,754,000 | ) | $ | (1,267,000 | ) |

 

**6.****              Accounts Receivable**

 

Contract revenue under cost sharing researchand development agreements is recognized as eligible expenses areincurred.  Invoicing of research anddevelopment contracts occurs in accordance with the terms of the contract.  Revenue recognized but unbilled is recordedas unbilled accounts receivable.  AtDecember 31, 2003 and June 30, 2003, unbilled accounts receivablerepresented approximately 24% and 10% of total accounts receivable,respectively.  Generally, there are noprerequisites necessary to bill.

 

**7.****              Credit Arrangements**

 

In June, 2003, the Company purchased a MC3,mass-analyzed ion implanter and wafer handling end-station (the “System”) fromAxcelis Technologies, Inc. (“Axcelis”) for a price of $1,300,000.  The Company had financed the System withAxcelis via monthly installments of approximately $43,000 beginningJuly 2003 and continuing through December 31, 2003.  Interest is being calculated at prime plus6.25%.  In December 2003, theCompany made a lump sum payment of approximately $571,000.  The remaining balance of $571,000 has beenfinanced by Axcelis and is due via monthly installments of approximately$98,000 beginning January 2004 and continuing through June 30,2004.  Title for the equipment shallremain with Axcelis until the system is paid in full.  Should the Company fail to pay the balance in full, Axcelis hasthe right to recover the system from the Company.  The value of the equipment is included in property andequipment.  As of December 31,2003, the unpaid balance on this equipment is approximately $571,000, all ofwhich is classified as current.

 

**8.****              Private Placement**

 

On October 7, 2002, the Company issued250,000 shares of Series A 7% Cumulative Convertible Preferred Stock (“SeriesA”) having a stated value of $10 per share, pursuant to a Securities PurchaseAgreement executed

 

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on October 7, 2002 with the Laurus Master Fund, Ltd.  The Company received $2,500,000 in grossproceeds, less a management and placement agent fee of approximately $300,000,and related transaction costs of approximately $101,000.  The terms of the Series A provide forrepayment of outstanding principal and accrued dividends in either cash or withshares of the Company’s common stock, at the Company’s option, over a 14 monthperiod beginning February 1, 2003. If the Company elects to convert into shares of the Company’s commonstock, the common stock will be valued at $5.19 per share.  However, if the closing price of theCompany’s common stock for any of the 11 trading days prior to a monthlyrepayment date is less than $5.70, the common stock will be valued at thegreater of 83% of the average of the three lowest closing prices during the 30trading days immediately preceding the repayment date or $2.02 and LaurusMaster Fund, Ltd. will be permitted to convert such part of the monthlypayment, up to the amount the Company elected to repay, into shares of commonstock.  Any part of the monthly amountnot converted into common stock shall be paid in cash on the following monthlyrepayment date.  The Company also grantedthe investor a security interest in substantially all of the Company’s assets.  In connection with the issuance of theSeries A, the investor received a warrant to purchase 55,000 shares of theCompany’s common stock.  The commonstock purchase warrant may be exercised at any time and is valid for five yearsfrom the date of issuance at an exercise price of $6.23 per share.

 

In accordance with the provisions of EmergingIssues Task Force (EITF) Issue 00-27, “Application of EITF Issue No. 98-5‘Accounting for Convertible Securities with Beneficial Conversion Features ofContingently Adjustable Conversion Ratios’, to Certain Convertible Securities”,which became effective in November 2000, the allocated value of the SeriesA contained a beneficial conversion feature calculated based on the differencebetween the effective conversion price of the proceeds allocated to the SeriesA and the fair market value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $537,000. The discount is being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of April 7, 2004 or the actual conversion date, whicheveris earlier.

 

The Company valued the Series A at issuanceat $1,434,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $2,099,000 ($401,000of issuance costs incurred), amount allocated to warrants of $128,000, and theamount of the discount related to the value of beneficial conversion feature of$537,000.  The Company was accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,500,000 at April 7, 2004, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period of accretion.  During the three months endedDecember 31, 2003, approximately $193,000 was amortized.  As of December 31, 2003, all amountswere fully amortized.

 

During the three months endedDecember 31, 2003, Laurus converted 45,125 shares of Series A into 89,643shares of the Company’s common stock at conversion price of $5.19 pershare.  As of December 31, 2003,the principal balance of the Series A has been paid in full.  The conversion of accrued interest intocommon stock resulted in additional dividends of $6,000 and $3,000 during thethree and six months ended December 31, 2003, in excess of 7% statedinterest rate.  As of December 31,2003, all Series A shares had been converted into 672,458 shares of commonstock

 

OnAugust 28, 2003, the Company issued 200,000 shares of SeriesB 5% Cumulative Convertible Preferred Stock (“Series B”) having a stated valueof $10 per share, pursuant to a Securities Purchase Agreement executed onAugust 28, 2003 with the Laurus Master Fund, Ltd.  The Company received $2,000,000 in grossproceeds, less a management and placement agent fee of approximately $108,000,and related transaction costs of approximately $70,000.  The terms of the Series B provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries B commenced on December 1, 2003. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both.  However, if the closing price for any of the 11 trading dayspreceding a repayment date is less than $6.00, the Company would be required topay such monthly amount in cash at 105% of the monthly obligation.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $5.50.  The Company

 

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also issued to Laurus a warrant to purchase 25,000 shares of commonstock at $6.88 per share and 45,000 shares of common stock at $8.25 pershare.  The Securities PurchaseAgreement also provides for a security interest in substantially all of theCompany’s assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by the Company in order to subordinate its rightsunder the Series B to the subsequent financier.  The Company will utilize the proceeds of this financing tocommercialize its explosives detection system and for general working capitalpurposes.

 

In accordance with the provisions of EmergingIssues Task Force (EITF) Issue 00-27, “Application of EITF Issue No. 98-5‘Accounting for Convertible Securities with Beneficial Conversion Features ofContingently Adjustable Conversion Ratios’, to Certain Convertible Securities”,which became effective in November 2000, the allocated value of the SeriesB contained a beneficial conversion feature calculated based on the differencebetween the effective conversion price of the proceeds allocated to the SeriesB and the fair market value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $768,000. The discount is being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of March 1, 2005, or the actual conversion date, whicheveris earlier.

 

The Company valued the Series B at issuanceto be $929,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $1,822,000 ($178,000of issuance costs incurred), amount allocated to warrants of $125,000, and theamount of the discount related to the value of beneficial conversion feature of$768,000.  The Company is accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,000,000 at March 1, 2005, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.  During the period endedDecember 31, 2003 approximately $222,000 was amortized.

 

During the three months endedDecember 31, 2003, Laurus converted 55,000 shares of Series B into 100,000shares of the Company’s common stock, at a conversion price of $5.50 pershare.  As of December 31, 2003,the principal balance outstanding of the Series B was approximately$1,450,000.  For the three months endedDecember 31, 2003, the Company accrued approximately $24,000 of dividends.

 

OnNovember 25, 2003, the Company issued 250,000 shares ofSeries C 5% Cumulative Convertible Preferred Stock (“Series B”) having a statedvalue of $10 per share, pursuant to a Securities Purchase Agreement executed onNovember 25, 2003 with the Laurus Master Fund, Ltd.  The Company received $2,500,000 in grossproceeds, less a management and placement agent fee of approximately $125,000,and related transaction costs of approximately $86,000.  The terms of the Series C provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries C commences on March 31, 2004. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both.  If the payment of the monthly amount is made in common stock, thefixed conversion price is $6.75.  TheCompany also issued to Laurus a warrant to purchase 50,000 shares of commonstock at $8.44 per share and 50,000 shares of common stock at $10.13 pershare.  The Securities PurchaseAgreement also provides for a security interest in substantially all of theCompany’s assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by the Company in order to subordinate its rightsunder the Series C to the subsequent financier.  The Company will utilize the proceeds of this financing topurchase an ion implanter and for general working capital purposes.

 

In accordance with the provisions of EmergingIssues Task Force (EITF) Issue 00-27, “Application of EITF Issue No. 98-5‘Accounting for Convertible Securities with Beneficial Conversion Features ofContingently Adjustable Conversion Ratios’, to Certain Convertible Securities”,which became effective in November 2000, the allocated value of the SeriesC contained a beneficial conversion feature calculated based on the differencebetween the effective conversion price of the proceeds allocated to the SeriesC and the fair market value of the

 

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common stock at the date of issuance. The discount arising from the beneficial conversion feature aggregated$605,000.  The discount is being amortizedand recorded as a preferred dividend during the period from the issuance of thepreferred stock to the mandatory redemption date of June 1, 2005, or theactual conversion date, whichever is earlier using the effective interestmethod.

 

The Company valued the Series C at issuanceto be $1,523,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $2,289,000 ($211,000of issuance costs incurred), the amount allocated to warrants of $210,000, andthe amount of the discount related to the value of beneficial conversionfeature of $605,000.  The Company isaccreting these discounts on the carrying value of the preferred stock to itsredemption value of $2,500,000 at June 1, 2005, or the actual conversiondate, whichever is earlier.  Theaccretion of these amounts is being recorded as a preferred dividend in theperiod of accretion.  During the periodended December 31, 2003 approximately $69,000 was amortized.  As of December 31, 2003, theoutstanding principal of the Series C was $2,500,000.  For the three months ended December 31, 2003, the Companyaccrued approximately $12,000 of dividends.

 

**9.****              Related PartyTransactions**

 

SFAS No. 57, “Related Party Disclosures,”specifies the nature of information that should be disclosed in financialstatements regarding related party transactions.  CardioTech, a public company, is a related party with the Companyby virtue of its significant business relationships.

 

Certain directors of the Company holdpositions as directors of CardioTech. The CEO and Chairman of the Board of Directors of the Company is also adirector of CardioTech.  The CEO andChairman of the Board of Directors of CardioTech is also a director of theCompany.

 

Accounts receivable from related parties asof September 30, 2003 consisted of a loan of $138,000 to the Company’schief executive officer, which was used to exercise options for 50,000 sharesof the Company’s common stock on December 9, 1997.  This loan has been paid in full as ofDecember 31, 2003.

 

In March 2000, the Company entered intoa joint research agreement with CardioTech to develop a proprietary porouspolymer biocompatible coating technology as a platform for the Company’sproprietary radioactive brachytherapy technology.  In consideration for this agreement, the Company agreed to pay$150,000 in cash and purchase 100,000 shares of CardioTech stock at a price of$1.00 per share.  The final cash paymentof $35,000 was made in quarter ended December 31, 2003.  In the three month period endedDecember 31, 2003, the Company acquired an additional 40,000 shares ofcommon stock of CardioTech at a price of $1.00 per share, for a total of100,000 shares.  As of December 31,2003, the fair market value of the CardioTech shares held as investment is$540,000.  CardioTech is a publiclytraded company whose common stock trades under the symbol CTE on the AmericanStock Exchange.

 

**10.****       MED-TEC**

 

On July 31, 2003, the Company enteredinto an agreement with its former exclusive distributor of prostate seeds, torelease each other from further obligations under the 2000 Agreement.  The new agreement conveys to the Companydirect marketing and sales capabilities to sell its I-Plant Seed brachytherapyseeds for use in the treatment of prostate cancer.  In connection with this, the Company’s former exclusivedistributor will work cooperatively to transition customers and marketingmaterials directly to the Company.  Thedistributor also agreed not to compete with the Company for a period of threeyears.  The Company will pay thedistributor an average of approximately $39,000 per month over the 28 months,beginning September 1, 2003.  As ofDecember 31, 2003, the outstanding principal balance is approximately$788,000.  For the three months endedDecember 31, 2003, the Company recorded approximately $23,000 of interestexpense relating to this transaction.

 

The present value of this asset was recordedas approximately $1,007,000, using a rate of 10.24%, and is being amortizedover its estimated useful life of 29 months. As of December 31, 2003, approximately $174,000 of amortizationexpense was recognized.

 

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**Item2.****           Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

The following management discussion and analysis should be read inconjunction with the financial statements and notes thereto as filed in ourForm 10-KSB/A No. 1 for the year ended June 30, 2003.  In addition to historical information, thisForm 10-QSB contains forward-looking statements.  The forward-looking statements are subject to certain risks anduncertainties that could cause actual results to differ materially from thosereflected in such forward-looking statements. Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s opinions only as of thedate hereof.  We undertake no obligationto revise or publicly release the results of any revision to theseforward-looking statements.  Readersshould carefully review documents that we file from time to time with theSecurities and Exchange Commission, including our Quarterly Reports and AnnualReports filed by us in fiscal 2003 and 2004.

 

Implant Sciences Corporation, incorporated in 1984, operates out of a43,000 square foot leased facility in Wakefield, Massachusetts.  The Company has approximately 70 employeesand runs three shifts.  The Company  generates revenues from the sale of ionimplantation services which include, semiconductor wafer processing, and  medical and industrial coatings, combined withradioactive prostate seed manufacturing and the performance of governmentresearch and development contracts.  TheCompany continues to make a significant financial commitment to the developmentof its trace explosives detection device, currently being evaluated by variousgovernment agencies.

 

**Results of Operations**

 

*Comparison for the three months endedDecember 31, 2003 and 2002*

 

*Revenues. *Total revenues for the three months endedDecember 31, 2003 were $1,889,000 as compared to $1,726,000 for the comparableprior year period, an increase of $163,000 or 9%.  The increase is primarily attributable to the revenue recognizedfrom new government contracts to develop applications and products using ourLaser Ion Mobility Spectrometry (“IMS”) technology.  Our Laser IMS technology is the platform technology used in ourexplosives detection devices. Government contracts revenues increased by $213,000 or 53% for thequarter ended December 31, 2003, as compared with the same period lastyear.  Our grant revenues, principallySmall Business Innovative Research (SBIR) programs, fluctuate due to: (a) ourdesire to obtain external funding for its research and development efforts; (b)the availability of government funding; and (c) the time required to obtainapproval of a grant application.  Wehave been successful in obtaining SBIR grants in fiscal 2004 and 2003. Weexpect to continue to seek continuation or replacement of our existing SBIRgrants during fiscal 2004 and beyond

 

In the three months ended December 31, 2003, we recognized $38,000representing a portion of the revenue relating to the issuance of an exclusiveoption to license our technology withInVision Technologies, Inc.  Thisagreement is to jointly evaluate the capabilities of the Company’s non-contacttrace explosives detection technology for future incorporation in an automatedexplosives detection system for airport checkpoint screening of passengersand/or carry-on bags.  The agreementgives InVision an exclusive option during the limited evaluation period, toenter into a definitive agreement for exclusive distribution rights to theCompany’s technology for aviation security.

 

Revenues from semiconductors for the three months endedDecember 31, 2003 were $208,000 as compared to $188,000 for the comparableprior year period, an increase of $20,000 or 11%.  The increase is primarily attributable to the revenue generatedfrom the Company’s new MC3 mass analyzed ion implanters.  We believe that revenue from theseimplanters will continue to increase as our customer’s production needs growand we identify new customers requiring the larger wafer implants that thisequipment can accommodate.  We believefluctuations in sales in our semiconductor business from quarter-to-quarter arenormal occurrences, however we believe that growth will continue to beachieved.

 

These increases in revenue were offset by a decrease in medicalrevenues from the sales of medical and industrial coatings and I-PlantTM  prostate seeds.  For the three months ended December 31, 2003, revenue formedical and industrial coatings was $385,000 as compared to $475,000 for thecomparable prior year period, a decrease of $90,000 or 19%.  The decrease in revenues is due primarily toa $41,000 decrease in industrial coating sales resulting from certain customerspursuing different product processes not requiring radiopacity.  This decrease was further influenced by a$54,000 decrease in sales to our major medical coating customer.  We anticipate a continued decline in medicalcoatings revenue due to the introduction of a new product in our customer’sline not requiring ion implantation.

 

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Revenue of the I-PlantTM prostate seed for the three monthsended December 31, 2003 was approximately $644,000 as compared to $663,000for the comparable prior year period, a decrease of $19,000 or 3%.  The decrease in prostate seed revenues wasdue to a 22% reduction in seed sales volume. The decrease in seed volume is the result of a reduction in the numberof procedures performed by our largest customer.  Additionally, we continue to build our direct sales force as theCompany transitions from a distributorship. Two  regional salesrepresentatives were hired in the quarter ended December 31, 2003.  These new hires may facilitate an increasein the volume of seeds sold in future periods. This decline in seed volume was offset by an increase of 37% in theaverage seed price.  This increase inaverage seed price is the direct result of the value added items offered to ourcustomers.  Additionally, changes inseed reimbursement policies by insurance companies has impacted the number ofprocedures being performed industrywide. Effective January 1, 2004, Medicare again changed the reimbursementpolicy and we have yet to see what this may do to seed sales volumes.

 

In the fourth quarter of fiscal 2003, management hired a new directorof national sales in order to open new channels of distribution for sales ofour prostate seeds and to assist our current distributors in growing the volumeof seeds sold.  In the first quarter offiscal 2004, the Company entered into a new agreement with MED-TEC, our formerexclusive distributor of I-Plant prostate seeds to replace the originalDistributor Agreement, which had expired. This new agreement outlines an orderly transition of the direct salesresponsibilities for the I-Plant prostate seed to the Company.  Management believes this direct marketingand sales program will put the sales process in the complete control of the Companyand will enable the Company to expand distribution channels targeting theradiation oncology market.  As a result,MED-TEC will work cooperatively with the Company to transition its customersand marketing materials directly to Implant Sciences and MED-TEC also agreednot to compete with the Company for a period of three years.  Implant Sciences is paying MED-TEC anaverage of approximately $39,000 per month over a period of 29 months,beginning September 1, 2003.  As ofDecember 31, 2003, the outstanding principal balance is approximately$788,000.

 

Combined sales to our two major customers, the Howmedica/OsteonicsDivision of Stryker Corporation and MED-TEC Iowa, our former exclusivedistributor of prostate seeds, accounted for 34% and 62% of revenue for thethree months ended December 31, 2003 and 2002, respectively.  As a result of the non-compete agreementwith MED-TEC, sales to this customer ended in December 2003, as we beganto direct bill our prostate seed customers. Government contract and grant revenue accounted for 32% and 23% ofrevenue for the three months ended December 31, 2003 and 2002,respectively.  Government contract andgrant revenue as a percentage of total revenues increased as a result of ourreceiving several new grants and contracts, primarily related to our Laser IMStechnology

 

*Cost of Sales*.  Cost of sales for the three months ended December 31, 2003was $1,506,000 as compared to $1,299,000 for the comparable prior year period,an increase of $207,000 or 16%. Included in the costs for period ended December 31, 2003, isapproximately $43,000 of non-cash stock-based compensation.  Cost of government contracts for the threemonth period ended December 31, 2003 was $497,000 as compared to $357,000for the comparable prior year period, an increase of $140,000 or 39%.  As a percentage of product revenues, thecost of medical and semiconductor product revenues increased to 82% for thethree months ended December 31, 2003 as compared to 71% for the comparableprior year period.  This increase is aresult of the increased non-cash expenses in the second quarter of fiscal2004.  During the fiscal quarters endedDecember 31, 2003 and 2002, we utilized Small Business Innovative Researchgrants as a source of funding for our research and development efforts.  Our obligation with respect to these grantsis to perform the research on a best-efforts basis.

 

*Research and Development*.  Research and development expenses for thethree months ended December 31, 2003 was $464,000 as compared to $452,000for the comparable prior year period, an increase of f $12,000 or 3%.  This slight increase is a result of theincrease government contracts subsidizing our research and development work inthe areas of explosives and toxic substance detection.  Research and development expenses included$132,000 and $16,000 of noncash stock-based compensation recorded in connectionwith the issuance of stock and stock options to employees in the three monthsended December 31, 2003 and 2002 respectively.

 

*Selling, General and Administrative*.  Selling, general and administrative expensesfor the three months ended December 31, 2003 were $990,000 as compared to$632,000 for the comparable prior year period, an increase of $358,000 or 57%.  Selling, general and administrative expensesincluded $195,000 and $39,000 of noncash stock-based compensation recorded inconnection with the issuance of stock and stock options to employees andwarrants to an outside agent in the three months ended December 31, 2003and 2002 respectively.  In the threemonth period

 

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ended December 31, 2003, depreciation and amortization expenseswere $126,000, relating to the amortization of the Med-tec noncompleteagreement, and depreciation expenses totaled $30,000 in the respective prioryear perioed.  Net of the noncashstock-based compensation, and depreciation and amortization, general andadministrative expenses increased by $106,000 or 19%.  This increase reflects our addition of sales personnel needed tosupport our continued growth and increased travel and trade show costs relatingto the marketing our products.  However,management continues to exercise strict cost containment measures to ensure controlover our administrative spending.

 

*Other Income and Expenses, Net.*  For the three month period endedDecember 31, 2003, we recorded other expense, net of $36,000 as comparedto other income, net of $5,000 in the comparable prior year period.  The increase in other expenses is a resultof increased interest expense relating to the financing of the new ionimplanters with Axcelis Corporation and the Med-tec non-compete payments in theperiod ended December 31, 2003.

 

*Net Loss.*  Net loss for the three months endedDecember 31, 2003 was $1,107,000 as compared to $652,000 for thecomparable prior year period, an increase of $455,000 or 70%.  Net loss for three months endedDecember 31, 2003 includes an approximate charge of $371,000 related tostock based compensation as compared to $55,000 in the comparable prior yearperiod.  Accordingly, the net loss forthe period ended December 31, 2003, before giving effect to the charge forstock-based compensation is $736,000 as compared to $597,000 for the comparableprior year period, an increase of $139,000 or 23%.

 

Additionally, during the period ended December 31, 2003, accretionof dividends, the beneficial conversion feature and amortization of warrants inthe amount of $202,000, $246,000 and $82,000 relating to the Series A, B, andC, respectively was recognized as a preferred distribution, as compared with$201,000 for the prior year period.  Theeffect of these transactions had no overall effect on stockholders’ equity orcash, but increased net loss per share applicable to common shareholders by $0.08per share.  The basic and diluted netloss per share applicable to common shares for the period endedDecember 31, 2003 was ($0.23) per share as compared to ($0.14) per sharefor the comparable prior year period, an increase in net loss applicable to commonshares per share of $0.09 or 64%.

 

*Comparison for the six months endedDecember 31, 2003 and 2002*

 

*Revenues. *Total revenues for the six months endedDecember 31, 2003 were $3,526,000 as compared to $3,301,000 for thecomparable prior year period, an increase of $225,000 or 7%.  The increase is primarily attributable torevenue recognized from new government contracts to develop new applicationsand products using our Laser IMS technology. Our Laser IMS technology is the platform technology used in ourexplosives detection devices. Government contracts revenues increased by $405,000 or 71% as comparedwith the same period last year. Revenues from semiconductors for the six months ended December 31,2003 were $467,000 as compared to $397,000 for the comparable prior yearperiod, an increase of $70,000 or 18%. This increase was due to the addition of two new ion implanters, thusincreasing our production capacity and enabling us to service new customersrequiring the larger wafer implants this machinery can accommodate.

 

These increases in revenue were offset by a decrease in medicalrevenues from the sales of medical and industrial coatings and I-PlantTM  prostate seeds.  Sales of the  I-PlantTM  prostate seeds for the six month periodended December 30, 2003 were $1,275,000 as compared to $1,361,000 for thecomparable prior year period, a decrease of $86,000 or 6%.  Seed volume decreased by 17% in the periodended December 30, 2003 as compared with the comparable prior yearperiod.  The decrease in seed volume wasaffected by the Company’s transition from a distributorship to a direct salesforce.  This decrease was furthercompounded by an industry wide reduction in the number of prostate implantprocedures, as a result of a change to the Medicare reimbursement policy andalternative treatments.  Thisreimbursement policy changed on January 1, 2004 whereby reimbursement will be made on a per seedbasis versus a flat per procedure charge. This could have a positive impact on the number of procedures beingperformed.  Management believes that thesevere pricing pressure being experienced throughout the industry may continueto have a negative effect on seed revenue through the remainder of fiscal 2004.

 

Revenues from medical and industrial coatings for the six months endedDecember 31, 2002 were $775,000 as compared to $971,000 for the comparableprior year period, a decrease of $196,000 or 20%.  The decrease in revenues from coatings is due to a $114,000 decreasein industrial coating sales resulting from the completion of a large researchand development project with a certain customer in the six months endedDecember 31, 2002 and a reduction of $81,000 or 10% in the area of medicalcoatings in the six month period ended December 2003 as compared with theprior year period.

 

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Combined sales to our two major customers, the Howmedica/OsteonicsDivision of Stryker Corporation and MED-TEC Iowa, our exclusive distributor ofprostate seeds, accounted for 46% and 66% of revenue for the six months endedDecember 31, 2003 and 2002.  Ourgovernment contract and grant revenue accounted for 28% and 17% of revenue forthe six months ended December 31, 2003 and 2002, respectively.  Government contract and grant revenue as apercentage of total revenues increased as a result of our receiving several newgrants and contracts, primarily related to our Laser IMS technology.  Grant revenues, principally Small BusinessInnovative Research (SBIR) programs, fluctuate due to: (a) our desire to obtainexternal funding for its research and development efforts; (b) the availabilityof government funding; and (c) the time required to obtain approval of a grantapplication.  We have been successful inobtaining SBIR grants in fiscal 2004 and 2003 and expect to continue to seekcontinuation or replacement of its existing SBIR grants during the remainder offiscal 2004 and beyond.

 

*Cost ofSales*.  Cost of salesfor the six months ended December 31, 2003 were $2,666,000 as compared to$2,526,000 for the comparable prior year period, an increase of $140,000 or6%.  The increases are, in general,attributable to the costs associated with the increase in government contractactivities combined with the $89,000 of stock-based compensation.  As a percentage of revenues, the cost ofmedical and semiconductor revenues increased to 79% for the six months endedDecember 31, 2003 as compared to 73% for the comparable prior yearperiod.  This increase in costs inmedical and semiconductor revenues as a percentage of revenues is attributableto the stock-based compensation. Management is continually evaluating and implementing strategies toimprove the cost of materials to produce prostate seeds, developing new productsrelated to the delivery of seeds in prostate procedures, and assessingadditional channels of distribution that could increase seed sales volume.  During fiscal 2004 and 2003, we utilizedSBIR grants as a significant source of funding for our research and developmentefforts.  We will continue to use SBIRgrants as a source of funding for our research and development efforts infiscal 2004.  Our obligation withrespect to these grants is to perform the research on a best-efforts basis.  Periodically, we may continue our researchand development efforts related to these projects at its own expense.  This cost is considered company-fundedresearch and development.

 

*Research and Development*.  Research and development expense for the sixmonths ended December 31, 2003 was $893,000 as compared to $868,000 forthe comparable prior year period.  Theaward of new government contracts subsidized certain of our research anddevelopment expenses for the period ended December 31, 2003.  The Company continues to work in the areasof explosives and toxic substance detection, temporary brachytherapy andradioactive prostate seed product compliments. Costs incurred in connection with our explosives and toxic substancedetection device was approximately $164,000 for the six months endedDecember 31, 2003 as compared to $256,000 for the comparable prior yearperiod.  We anticipate increases infuture expenditures resulting from these and new product developmentplans.  We will continue to use SBIRgrants as a source of funding for our research and development efforts infiscal 2004.

 

*Selling, General and Administrative*.  Selling, general and administrative expensesfor the six months ended December 31, 2003 were $1,750,000 as compared to$1,154,000 for the comparable prior year period, an increase of $596,000 or52%.  The increase is primarilyattributable to a $259,000 charge for noncash stock-based compensation ascompared with $55,000 in the comparable prior year period and $174,000 ofamortization expense relating to the amortization of the Med-Tec non-competeagreement, which is being amortized over a 29 month period beginningJuly 31, 2003.  Net of the noncashstock based compensation and amortization expenses, selling, general andadministrative expenses increased by $218,000 or 20%.  This increase reflects our addition of certain administrativepersonnel necessary to support our continued growth.  However, management continues to exercise strict cost containmentmeasures to ensure control over our administrative spending.

 

*Other Income, Net.*  For the six month period endedDecember 31, 2003, we recorded other expense, net, of $78,000, as comparedto other income of $4,000 for the comparable prior year period, an increase inother expenses net of $82,000.  The increasein other expense, net, is attributable to the interest expense relating to thefinancing of the mass analyzed ion implanters with Axcelis Technologies (Note7) and Med-tec non-compete agreement (Note 10)..

 

*Net Loss.*  Net loss for the six month period endedDecember 31, 2003 was $1,861,000 as compared to $1,243,000 for thecomparable prior year period, an increase of $618,000 or 50%.  This increase in net loss is primarily aresult of the decrease in revenues from the sale of I-PlantTMprostate seeds and medical and industrial coating services combined with thecosts associated with noncash stock-based compensation and amortizationexpenses.  Additionally, this increasein net loss is attributable, in part, to the marked increase in government

 

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contract expenses in the areas of explosives and toxic substancedetection and temporary brachytherapy.

 

Additionally, during the six months ended December 31, 2003,accretion of dividends, the beneficial conversion feature and amortization ofwarrants in the amounts of $565,000, $327,000 and $83,000 for the Series A, B,and C, respectively, was recognized as a preferred distribution in the sixmonth period ended December 31, 2003, as compared with $201,000 in thecomparable prior year period relating to the Series A only.  The effect of these transactions had nooverall effect on stockholders’ equity or cash, but increased net loss pershare applicable to common shareholders by $0.14 and $.03 per share for the sixmonth period ended December 31, 2003 and 2002 respectively.  The basic and diluted net loss per shareapplicable to common shares for the period ended December 31, 2003 was($0.41) per share as compared to ($0.23) per share for the comparable prior yearperiod, an increase in net loss applicable to common shares per share of $0.18or 78%.

 

**Liquidity and Capital Resources**

 

As of December 31, 2003, we had approximately $2,879,000 in cashin the form of cash and cash equivalents. During the six months ended December 31, 2003, operating activitiesused cash of approximately $1,192,000. Net cash used by operating activities primarily reflects the net loss of$1,861,000, a $54,000 increase in inventory, a $17,000 increase in prepaid andother current assets, a $170,000 decrease in accounts payable, a $52,000decrease in accrued expenses and a $129,000 increase in accounts receivable;offset by depreciation and amortization of $564,000 and stock-basedcompensation expense of $520,000.  As aresult of the decrease in seed sales volume, our inventory balance andassociated expenses increased. Additionally, the payment of government contract related expenses in thesix month period ended December 31, 2003, reduced the accounts payablebalance and a significant accrual relating to a required payment to the Company’s401(k) plan was paid during the six months ended December 31, 2003.  These items combined with the increase inA/R relating to government contract revenues has increased the Company’s netcash used in operating activities as compared with the same prior year period.

 

During the six months ended December 31, 2003, investingactivities used cash of approximately $247,000, primarily attributable to thepurchase of property and equipment, seed demonstration equipment and thepurchase of 40,000 shares of Cardio-Tech International stock (Note 9),  These shares are unregistered and subject tothe Securities Act of 1933.

 

During the six months ended December 31, 2003, financingactivities provided approximately $3,359,000 in cash.  Net cash provided by financing activities primarily includes netproceeds from the Series B and Series C preferred stock and the exercise ofstock options offset by payments on our capital lease, non-compete agreementand equipment financing.

 

On August 28, 2003, theCompany issued 200,000 shares of Series B 5% Cumulative Convertible PreferredStock (“Series B”) having a stated value of $10 per share, pursuant to aSecurities Purchase Agreement executed on August 28, 2003 with the LaurusMaster Fund, Ltd.  The Company received$2,000,000 in gross proceeds, less a management and placement agent fee ofapproximately $108,000, and related transaction costs of approximately$70,000.  The terms of the Series Bprovide for repayment with shares of the Company’s common stock or in cash, pursuantto an amortization schedule.  Repaymentof the Series B commenced on December 1, 2003.  The Company has the sole option to determine whether to satisfypayment of the monthly amount in full on each repayment date either in cash orin shares of common stock, or a combination of both.  However, if the closing price for any of the 11 trading dayspreceding a repayment date is less than $6.00, the Company would be required topay such monthly amount in cash at 105% of the monthly obligation.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $5.50.  The Company also issued to Laurus a warrant to purchase 25,000shares of common stock at $6.88 per share and 45,000 shares of common stock at$8.25 per share.  The SecuritiesPurchase Agreement also provides for a security interest in substantially allof the Company’s assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by the Company in order to subordinate its rightsunder the Series B to the subsequent financier.  The Company will utilize the proceeds of this financing tocommercialize its explosives detection system and for general working capitalpurposes.

 

In accordance with the provisions of Emerging Issues Task Force (EITF)Issue 00-27, “Application of EITF Issue No. 98-5 ‘Accounting for ConvertibleSecurities with Beneficial Conversion Features of Contingently

 

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Adjustable Conversion Ratios’, to Certain Convertible Securities”,which became effective in November 2000, the allocated value of the SeriesB contained a beneficial conversion feature calculated based on the differencebetween the effective conversion price of the proceeds allocated to the SeriesB and the fair market value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $768,000. The discount is being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of March 1, 2005 or the actual conversion date, whicheveris earlier.

 

The Company valued the Series B at issuance to be $929,000 based on therelative fair market values of the financial instruments issued in connectionwith this placement, net of offering costs and the beneficial conversionfeature.  The amounts recorded in thefinancial statements represent the amounts attributed to the sale of thepreferred stock, net cash proceeds of $1,822,000 ($178,000 of issuance costsincurred), amount allocated to warrants of $125,000, and the amount of thediscount related to the value of beneficial conversion feature of$768,000.  The Company is accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,000,000 at March 1, 2005 or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.  During the period endedDecember 31, 2003 approximately $222,000 was amortized.

 

During the three months ended December 31, 2003, Laurus converted55,000 shares of Series B into 100,000 shares of the Company’s common stock, ata conversion price of $5.50 per share. As of December 31, 2003, the principal balance outstanding of theSeries B was approximately $1,450,000. For the three months ended December 31, 2003, the Company accruedapproximately $24,000 of dividends.

 

On November 25, 2003, theCompany issued 250,000 shares of Series C 5% Cumulative Convertible PreferredStock (“Series B”) having a stated value of $10 per share, pursuant to aSecurities Purchase Agreement executed on November 25, 2003 with theLaurus Master Fund, Ltd.  The Companyreceived $2,500,000 in gross proceeds, less a management and placement agentfee of approximately $125,000, and related transaction costs of approximately$86,000.  The terms of the Series Cprovide for repayment with shares of the Company’s common stock or in cash,pursuant to an amortization schedule. Repayment of the Series C commences on March 31, 2004.  The Company has the sole option to determinewhether to satisfy payment of the monthly amount in full on each repayment dateeither in cash or in shares of common stock, or a combination of both.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $6.75.  The Company also issued to Laurus a warrant to purchase 50,000shares of common stock at $8.44 per share and 50,000 shares of common stock at$10.13 per share.  The SecuritiesPurchase Agreement also provides for a security interest in substantially allof the Company’s assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by the Company in order to subordinate its rightsunder the Series C to the subsequent financier.  The Company will utilize the proceeds of this financing topurchase an ion implanter and for general working capital purposes.

 

In accordance with the provisions of Emerging Issues Task Force (EITF)Issue 00-27, “Application of EITF Issue No. 98-5 ‘Accounting for ConvertibleSecurities with Beneficial Conversion Features of Contingently AdjustableConversion Ratios’, to Certain Convertible Securities”, which became effectivein November 2000, the allocated value of the Series C contained abeneficial conversion feature calculated based on the difference between theeffective conversion price of the proceeds allocated to the Series C and thefair market value of the common stock at the date of issuance.  The discount arising from the beneficialconversion feature aggregated $605,000. The discount is being amortized and recorded as a preferred dividendduring the period from the issuance of the preferred stock to the mandatoryredemption date of June 1, 2005, or the actual conversion date, whicheveris earlier, using the effective interest method.

 

The Company valued the Series C at issuance to be $1,523,000 based onthe relative fair market values of the financial instruments issued inconnection with this placement, net of offering costs and the beneficialconversion feature.  The amountsrecorded in the financial statements represent the amounts attributed to thesale of the preferred stock, net cash proceeds of $2,289,000 ($211,000 ofissuance costs incurred), the amount allocated to warrants of $210,000, and theamount of the discount related to the value of beneficial conversion feature of$605,000.  The Company is accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,500,000 at June 1, 2005, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.

 

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During the period ended December 31, 2003 approximately $69,000was amortized.  As of December 31,2003, the outstanding principal of the Series C was $2,500,000.  For the three months ended December 31,2003, the Company accrued approximately $12,000 of dividends.

 

We are developing several explosive detection systems that could beused in airports, public and government buildings, and sporting eventfacilities.  The systems use ourproprietary Laser IMS technology, which includes the use of laser beams incombination with ion mobility spectrometry, to electronically detect minutequantities of explosive vapor molecules in the air.  This project has been ongoing since approximately May 1999.

 

This research is currently being undertaken by both our internalscientists and certain outside contractors. The development of new applications is typically funded throughgovernment grants or internal funding. Originally, we funded a research and development program for theelectronic detection system to produce enough data to write grant proposals forthe Department of Defense to detect unexploded bombs and mines.  Since March 2000, we have receivedeleven contracts totaling approximately $5,500,000 for detection of toxicchemicals or explosives from agencies such as the Departments of the Army, AirForce, Marine Corps and Navy; as well as the National Institutes of Health.

 

In June 2000, we developed our first generation device, which demonstratedsensitivity to the explosive TNT.  InJune 2001, we developed a second generation prototype with increasedsensitivity and selectivity.  Thisdevice can detect and specify an increasing number of compounds within variousexplosive materials.  The explosivesthat have been tested to date are TNT, RDX, PETN, EGDN, and DNT.  RDX is the primary component of C3 and C4explosives, such as Datasheet and Semtex, as well as certain types of blackpowder explosives.  We believe theseexplosives represent the majority of the explosives presently used in terroristactivities.  After the attack on theWorld Trade Center occurred on September 11, 2001, management made thedecision to continue the internal funding of the project rather than awaitfunding through government grants.  Ourelectronic detection system has been subjected to controlled testing by thirdparties and successfully detected C4. As a result of the successful demonstration, we believed it wasappropriate to further pursue the commercial development of our electronicdetection system device

 

In November 2001, we developed a portable prototype and inDecember 2001 we demonstrated it to the U.S. Department ofTransportation.  Following thisdemonstration, we decided to pursue the technology.  At present, we are developing both portable and bench-top systemsfor use in airports and Department of Defense facilities.  Prototype units have been transported to theDepartment of Defense and Department of Homeland Security (DHS) fordemonstration and evaluation.  OnAugust 12, 2002, we signed a Cooperative Research and DevelopmentAgreement (CRDA) with an agency of the Department of Transportation (nowHomeland Security) which will permit us and the government to exchange criticaltest data and for us to deliver a certain number of units to the TransportationSecurity Administration  (TSA) forindependent evaluation and field testing. The TSA tested the breadboard system at their technical center inAtlantic City and as a result of these tests funded the CRDA with $1,000,000 todevelop a bench-top explosives detection system.  As of December 31, 2003, $600,000 has been released to theCompany

 

We are developing several versions of our explosives detection systems,including: (i) a table-top unit, which can be used to screen passengers andcarry-on baggage in airports; and (ii) a portable system, which can be used toreplace bomb-sniffing dogs to clear buildings, aircrafts, or ships where hiddenbombs are believed to exist.  Wereceived $600,000 from the U.S. Navy in November 2002 for furtherdevelopment of the portable device. This device was delivered to the U.S. Navy for testing in May 2003.  The U.S. Navy tested the unit in simulatedoutdoor conditions and their engineers were satisfied with the results of thetests.  There can be no guaranteehowever, that the final production model will pass the government tests or thatthe government will purchase any equipment from the Company.  In December 2003, we received a$1,700,000 contract to deliver three production ready handheld units.  We plan to first market these systems toU.S. government agencies for use in airports, government buildings andfacilities.

 

Consistent with our policy to protect our proprietary technologies, wehave submitted twenty patent applications to the United States Patent andTrademark Office.  These patentapplications will cover specific design configurations that are responsible forour improved vapor detection sensitivity.

 

Although our operations and spending continue to focus on the sales ofour semiconductor, medical coatings and prostate seed products, we arecurrently expending significant resources in the development of our

 

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explosives detection devices. We continue to fund as much research and development as possible throughgovernment grants in accordance with the provisions of the respective grantawards.  We will require additionalfunding in order to advance the commercial development of the explosivesdetection system.  We will attempt toobtain such financing by: (i) government grants, (ii) the exercise of theredeemable common stock purchase warrants, (iii) private financing, or (iv)strategic partnerships.  However, therecan be no assurance that we will be successful in our attempts to raise suchadditional financing.

 

We will require substantial funds for further research and development,future pre-clinical and clinical trials, regulatory approvals, continuedexpansion of commercial-scale manufacturing capabilities, and the marketing ofour products.  Our capital requirementsdepend on numerous factors, including but not limited to, the progress of ourresearch and development programs; the progress of pre-clinical and clinicaltesting; the time and costs involved in obtaining regulatory approvals; thecost of filing, prosecuting, defending and enforcing any intellectual propertyrights; competing technological and market developments; changes in ourdevelopment of commercialization activities and arrangements; and the purchaseof additional facilities and capital equipment.

 

As of December 31, 2003, we were conducting our operations withapproximately $2,900,000 in cash and cash equivalents.  We estimate such amounts combined with ourcash flow from operations will be sufficient to fund our working capital in thenext twelve months.  Future expendituresfor research and product development, especially relating to outside testingand clinical trials, are discretionary and, accordingly, can be adjusted, ascan certain selling, general and administrative expenses, based on theavailability of cash.

 

The Company’s future minimum payments under contractual obligationsrelated to capital leases, operating leases and term notes as ofDecember 31, 2003, are as follows:

 
|                       |   | **Capital  Lease** |   | **Operating********Leases** |   | **Axcelis  Technologies,  Inc.** |   | **MED-TEC** |    | **Total** |   |
|----------------------------|--------|--------------------|--------|-----------------------------|--------|----------------------------------|--------|-------------|---------|-----------|--------|
| Year  ending June 30: |   |               |   |                        |   |                             |   |        |    |      |   |
| 2004                       |   | $                  | 4,000  |                        | $      | 228,000                          |   | $           | 571,000 |      | $      | 182,000 |   | $ | 985,000 |   |
| 2005                       |   | 5,000              |   | 531,000                     |   |                             |   | 394,000     |    | 930,000   |   |
| 2006                       |   | 3,000              |   | 568,000                     |   |                             |   | 212,000     |    | 783,000   |   |
| 2007                       |   | —             |   | 569,000                     |   |                             |   |        |    | 569,000   |   |
| 2008                       |   | —             |   | 570,000                     |   |                             |   |        |    | 570,000   |   |
| Thereafter                 |   | —             |   | 285,000                     |   |                             |   |        |    | 285,000   |   |
| Total                      |   | $                  | 12,000 |                        | $      | 2,751,000                        |   | $           | 571,000 |      | $      | 788,000 |   | $ | 4,122,000 |   |

 

*Critical Accounting Policies*

 

Our significant accounting policies are described in Note 1 to thefinancial statements included in Item 7 of our Form 10-KSB/A No. 1 as ofJune 30, 2003.  Our discussion andanalysis of our financial condition and results of operations are based uponthe financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those relatedto bad debts, product returns, inventories, investments, intangible assets andwarranty obligations.  We base ourestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  In the past, actual results have not beenmaterially different from our estimates. However, results may differ from these estimates under differentassumptions or conditions.  There hasbeen no change to our critical accounting policies during the quarter endingDecember 31, 2003.

 

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**Item 3.****           Controls and Procedures**

 

Based on  an evaluation of ourdisclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c)under the Securities Exchange Act of 1934), the chief executive officer andchief financial officer have concluded that our disclosure controls andprocedures as of the end of the three months ended December 31, 2003, aredesigned to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms and are operating in an effective manner.

 

There were not significant changes in our internal controls or in otherfactors that could significantly affect these controls and subsequent to thedate of their most recent evaluation.

 

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PART II:  OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

Not Applicable

 

Item 2.  Changes in Securities and Use of Proceeds

 

OnAugust 28, 2003, the Company issued 200,000 shares of SeriesB 5% Cumulative Convertible Preferred Stock (“Series B”) having a stated valueof $10 per share, pursuant to a Securities Purchase Agreement executed onAugust 28, 2003 with the Laurus Master Fund, Ltd.  The Company received $2,000,000 in grossproceeds, less a management and placement agent fee of approximately $108,000,and related transaction costs of approximately $70,000.  The terms of the Series B provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries B commenced on December 1, 2003. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both.  However, if the closing price for any of the 11 trading days precedinga repayment date is less than $6.00, the Company would be required to pay suchmonthly amount in cash at 105% of the monthly obligation.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $5.50.  The Company also issued to Laurus a warrant to purchase 25,000shares of common stock at $6.88 per share and 45,000 shares of common stock at$8.25 per share.  The SecuritiesPurchase Agreement also provides for a security interest in substantially allof the Company’s assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term. In the event Laurus declines to exercise its right of first refusal, ithereby agrees to enter into such documentation as shall be reasonable requestedby the Company in order to subordinate its rights under the Series B to thesubsequent financier.  The Company willutilize the proceeds of this financing to commercialize its explosivesdetection system and for general working capital purposes.

 

During the three months endedDecember 31, 2003, Laurus converted 55,000 shares of Series B into 100,000shares of the Company’s common stock, at a conversion price of $5.50 pershare.  As of December 31, 2003, theprincipal balance outstanding of the Series B was approximately $1,450,000.

 

OnNovember 25, 2003, the Company issued 250,000 shares ofSeries C 5% Cumulative Convertible Preferred Stock (“Series B”) having a statedvalue of $10 per share, pursuant to a Securities Purchase Agreement executed onNovember 25, 2003 with the Laurus Master Fund, Ltd.  The Company received $2,500,000 in grossproceeds, less a management and placement agent fee of approximately $125,000,and related transaction costs of approximately $86,000.  The terms of the Series C provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries C commences on March 31, 2004. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both.  If the payment of the monthly amount is made in common stock, thefixed conversion price is $6.75.  TheCompany also issued to Laurus a warrant to purchase 50,000 shares of commonstock at $8.44 per share and 50,000 shares of common stock at $10.13 pershare.  The Securities PurchaseAgreement also provides for a security interest in substantially all of theCompany’s assets and provides Laurus a right of first refusal on futurefinancing arrangements during the Term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by the Company in order to subordinate its rightsunder the Series C to the subsequent financier.  The Company will utilize the proceeds of this financing topurchase an ion implanter and for general working capital purposes.

 

As of December 31, 2003, the outstandingprincipal of the Series C was $2,500,000.

 

 

Item 3.  Defaults Upon Senior Securities

 

Not Applicable

 

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Item 4.  Submission of Matters of a Vote toSecurity-Holders

 

We held our annual shareholders meeting onDecember 11, 2003.  Anthony Armini,Stephen Bunker, Shaun Cave, David Eisenhaure and Michael Szycher were electedas directors of the Company to hold office until the 2004 annual meeting of theshareholders.  The results for thisproposal were as follows:

 

| **NAME**         |   | **FOR**   |   | **WITHHELD** |   |
|------------------|--------|-----------|--------|--------------|--------|
|             |   |      |   |         |   |
| Anthony Armini   |   | 5,800,861 |   | 127,436      |   |
| Stephen Bunker   |   | 5,804,461 |   | 123,836      |   |
| Shaun Cave       |   | 5,818,490 |   | 109,807      |   |
| David Eisenhaure |   | 5,782,990 |   | 145,307      |   |
| Michael Szycher  |   | 5,812,290 |   | 116,007      |   |

 

Proposal No. 2 was an amendment to the Company’s2002 Incentive and Nonqualified Stock Option Plan.  The results for this proposal were as follows:

 

| **FOR**   |   | **AGAINST** |   | **WITHHELD** |   |
|-----------|--------|-------------|--------|--------------|--------|
| 4,641,741 |   | 240,785     |   | 24,570       |   |

 

Item 5.  Other Information

 

**Certifications Under Sarbanes-Oxley Act**

Our chief executive officer and chief financial officer have furnishedto the SEC the certification with respect to this Report that is required bySection 906 of the Sarbanes-Oxley Act of 2002.

 

Item 6.  Listof Exhibits and Reports on Form 8-K

 

(a)            The following exhibits, required by Item601 of Regulation S-B, are filed as part of this Quarterly Report on Form10-QSB.  Exhibit numbers, whereapplicable, in the left hand column correspond to those of Item 601 ofRegulation S-B.

 
| **Exhibit No.** |   | **Description**                                                                                                                   |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                              |
| *3.7            |   | Certificate of Vote of Directors  establishing Series C 5% Cumulative Convertible Preferred Stock, dated  November 25, 2003. |
| *10.75          |   | Securities Purchase Agreement between  Implant Sciences Corporation and Laurus Master Fund, Ltd, Dated  November 25, 2003.   |
| *10.76          |   | Security Agreement between Implant Sciences  Corporation and Laurus Master Fund, Ltd. Dated November 25, 2003.               |
| *10.77          |   | Common Stock Purchase Warrant for 100,000  shares issued to Laurus Master Fund, Ltd. Dated November 25, 2003.                |
|            | 32.1   |                                                                                                                              | Certification of the Chief Executive Officer Pursuant to 18 U.S.C.  1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
|            | 32.2   |                                                                                                                              | Certification of the Chief Financial Officer Pursuant to 18 U.S.C.  1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

 

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*   Previously filed on Form 8-K on December 12,2003, and is incorporated herein by reference

 

(b)           Current Report on Form 8K datedDecember 10, 2003 regarding the issuance of 250,000 shares of  Series C 5% Cumulative Convertible PreferredStock.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities and Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 
|                         | Implant Sciences Corporation |
|------------------------------|------------------------------|
|                         |                         |
| Date: February 12, 2004 | /s/ Anthony J. Armini        |   |
|                         | Anthony J. Armini            |
|                         | President and CEO            |
|                         |                         |
|                         |                         |
| Date: February 12, 2004 | /s/ Diane J. Ryan            |   |
|                         | Diane J. Ryan                |
|                         | Chief Financial Officer      |
|                              |                              |  |  |

 

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