## ** **

## **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **Quarterly  report pursuant to section 13 or 15(d) of the Securities Exchange  Act of 1934.**                                                                                                                                                                                                                      |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                                                    |
|       |       | **For the quarterly period ending  December 31, 2005.**                                                                                                                                                                                                                                                                  |
|       |       |                                                                                                                                                                                                                                                                                                                          |
| **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**

 

**IMPLANT SCIENCES CORPORATION**

(Exact name ofregistrant as specified in its charter)

 
| **Massachusetts**                                                | ** ** | **04-2837126**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |       | (IRS Employer  Identification number) |
|                                                             |       |                                  |
| **107  Audubon Road, #5 Wakefield, MA**                          | ** ** | **01880**                             |
| (Address of  Principal Executive Offices)                        |       | (Zip Code)                            |

** **

**781-246-0700**

(Registrant’s Telephone Number, Including Area Code)

 

Securities registeredpursuant to Section 12(b) of the Act:

 
| **Title of Each Class**      | ** ** | **Name of Each Exchange on Which Registered** |
|------------------------------|------------|-----------------------------------------------|
| Common Stock, $.10 par value |       | American Stock  Exchange                      |
| Warrants                     |       | American Stock  Exchange                      |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for thepast 90 days.

YES  ý         NO  o

 

Indicate bycheckmark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer.  Seedefintion of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):

 
| Large Accelerated filer  o |   | Accelerated filer  o |   | Non-accelerated filer  ý |
|--------------------------------------|--------|--------------------------------|--------|-----------------------------------------|

 

Indicate by checkmarkwhether the Registrant is a shell company (as defined in Rule 12B-2 of theExchange Act)

YES  o         NO  ý

 

State issuer’s revenuesfor its most recent fiscal year: **$12,286,000**

 

The aggregate marketvalue of the voting stock held by non-affiliates of the registrant wasapproximately $40,186,000 as of January 31, 2006 (based on the closingprice for such stock as of January 31, 2006).

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock:

 
| **Class**                     | ** ** | **Outstanding at January 31, 2006** |
|-------------------------------|------------|------------------------------------------|
| Common Stock,  $.10 par value |       | 11,457,126                               |

 

 

----

 

**IMPLANTSCIENCES CORPORATION**

 

**INDEX**

 
|    | PART I.  FINANCIAL INFORMATION                                                                                  |   |
|---------|----------------------------------------------------------------------------------------------------------------------|--------|
|    |                                                                                                                 |   |
| Item 1. | Financial Statements (unaudited):                                                                                    |   |
|    |                                                                                                                 |   |
|    | Condensed Consolidated  Balance Sheets as of December 31, 2005 and June 30, 2005                           |   |
|    |                                                                                                                 |   |
|    | Condensed Consolidated  Statements of Operations for the Three and Six Months Ended December 31,  2005 and 2004 |   |
|    |                                                                                                                 |   |
|    | Condensed Consolidated  Statements of Cash Flows for the Six Months Ended December 31, 2005 and  2004           |   |
|    |                                                                                                                 |   |
|    | Notes to Condensed Consolidated  Financial Statements                                                                |   |
|    |                                                                                                                 |   |
| Item 2. | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                          |   |
|    |                                                                                                                 |   |
| Item 3. | Quantitative  and Qualitative Disclosure About Market Risk                                                           |   |
|    |                                                                                                                 |   |
| Item 4. | Controls and  Procedures                                                                                             |   |
|    |                                                                                                                 |   |
|    | PART II. OTHER  INFORMATION                                                                                     |   |
|    |                                                                                                                 |   |
| Item 1. | Legal Proceedings                                                                                                    |   |
|    |                                                                                                                 |   |
| Item 2. | Unregistered  Sales of Equity Securities                                                                             |   |
|    |                                                                                                                 |   |
| 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                                                                                                           |   |

 

2

----

 

**IMPLANTSCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                                                                         | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                         | ** ** | **2005**              | ** ** | **2005**          | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                         |       |                  |       |              |       |
| Current assets:                                                                                                                                                                                                                                                                                                                                    |       |                  |       |              |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                                                                         |       | $                     | 1,868,000  |              | $          | 1,549,000 |   |
| Accounts  receivable, less allowance of $121,000 and $147,000, respectively                                                                                                                                                                                                                                                                        |       | 3,649,000             |       | 3,003,000         |       |
| Accounts  receivable, unbilled                                                                                                                                                                                                                                                                                                                     |       | 400,000               |       | 298,000           |       |
| Inventories  (Note 3)                                                                                                                                                                                                                                                                                                                              |       | 1,802,000             |       | 1,204,000         |       |
| Investments -  available for sale securities                                                                                                                                                                                                                                                                                                       |       | 256,000               |       | 204,000           |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                                                                                                         |       | 323,000               |       | 224,000           |       |
| Total current  assets                                                                                                                                                                                                                                                                                                                              |       | 8,298,000             |       | 6,482,000         |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| Property and equipment, net (Note 4)                                                                                                                                                                                                                                                                                                               |       | 9,704,000             |       | 10,434,000        |       |
| Amortizable intangible assets, net (Note 11)                                                                                                                                                                                                                                                                                                       |       | 1,643,000             |       | 2,057,000         |       |
| Investment in unconsolidated subsidiary (Note 5)                                                                                                                                                                                                                                                                                                   |       | 429,000               |       | 531,000           |       |
| Other non-current assets                                                                                                                                                                                                                                                                                                                           |       | 488,000               |       | 511,000           |       |
| Goodwill (Note 11)                                                                                                                                                                                                                                                                                                                                 |       | 12,123,000            |       | 12,213,000        |       |
| Total assets                                                                                                                                                                                                                                                                                                                                       |       | $                     | 32,685,000 |              | $          | 32,228,000 |   |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                      |       |                  |       |              |       |
| Current liabilities:                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| Current  maturities of long-term debt and obligations under capital lease                                                                                                                                                                                                                                                                          |       | $                     | 394,000    |              | $          | 2,052,000 |   |
| Payable to  Med-Tec                                                                                                                                                                                                                                                                                                                                |       | 268,000               |       | 348,000           |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                   |       | 2,045,000             |       | 2,445,000         |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                   |       | 2,147,000             |       | 1,526,000         |       |
| Current portion  of long term lease liability                                                                                                                                                                                                                                                                                                      |       | 102,000               |       | 102,000           |       |
| Current portion  of Series D redemption                                                                                                                                                                                                                                                                                                       |       | 304,000               |       | —            |       |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                   |       | 874,000               |       | 773,000           |       |
| Total current  liabilities                                                                                                                                                                                                                                                                                                                         |       | 6,134,000             |       | 7,246,000         |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| Long-term liabilities:                                                                                                                                                                                                                                                                                                                             |       |                  |       |              |       |
| Long-term debt  and obligations under capital lease, net of current maturities                                                                                                                                                                                                                                                                     |       | 739,000               |       | 897,000           |       |
| Long-term lease  liability                                                                                                                                                                                                                                                                                                                         |       | 653,000               |       | 701,000           |       |
| Beneficial  conversion feature of Series D preferred stock                                                                                                                                                                                                                                                                                    |       | 506,000               |       | —            |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                                                 |       | 8,032,000             |       | 8,844,000         |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| Series D  Cumulative Convertible Preferred Stock; $10 stated value; 5,000,000 shares  authorized; 500,000 and 0 shares issued and outstanding, respectively, net of  $1,786,000 attributible to warrants and beneficial conversion feature (Note  8) and currently redeemable portion. (liquidation preference of $5,000,000  plus dividends) |       | 2,639,000             |       | —            |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                                                                                         |       |                  |       |              |       |
| Common stock,  $0.10 par value; 50,000,000 shares authorized; 11,379,274 and 10,734,393  shares issued and outstanding, respectively                                                                                                                                                                                                               |       | 1,140,000             |       | 1,075,000         |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                        |       | 52,852,000            |       | 50,995,000        |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                               |       | (31,804,000           | )          | (28,115,000       | )          |
| Deferred  compensation                                                                                                                                                                                                                                                                                                                             |       | (26,000               | )          | (349,000          | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                                                                                                                                                     |       | 69,000                |       | (5,000            | )          |
| Treasury stock,  22,449 common shares, at cost                                                                                                                                                                                                                                                                                                     |       | (217,000              | )          | (217,000          | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                                   |       | 22,014,000            |       | 23,384,000        |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |       |              |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                                                                   |       | $                     | 32,685,000 |              | $          | 32,228,000 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements

 

3

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**IMPLANTSCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**

 
| ** **                                                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                                                      |       |                                      |       |                                    |       |   |   |   |   |
| Medical                                                                                        |       | $                                         | 991,000    |                                    | $          | 933,000 |   | $ | 2,140,000 |   | $ | 1,893,000 |   |
| Semiconductor                                                                                  |       | 3,334,000                                 |       | 1,288,000                               |       | 6,456,000 |   | 1,622,000 |   |
| Explosives  detection                                                                          |       | 3,215,000                                 |       | 320,000                                 |       | 3,616,000 |   | 1,300,000 |   |
| Total revenues                                                                                 |       | 7,540,000                                 |       | 2,541,000                               |       | 12,212,000 |   | 4,815,000 |   |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Cost of revenues:                                                                              |       |                                      |       |                                    |       |   |   |   |   |
| Cost of medical  revenues                                                                      |       | 829,000                                   |       | 1,002,000                               |       | 1,788,000 |   | 1,799,000 |   |
| Cost of  semiconductor revenues                                                                |       | 2,940,000                                 |       | 1,536,000                               |       | 5,637,000 |   | 1,913,000 |   |
| Cost of  explosives detection revenues                                                         |       | 2,297,000                                 |       | 442,000                                 |       | 3,319,000 |   | 1,080,000 |   |
| Total cost of  revenues                                                                        |       | 6,066,000                                 |       | 2,980,000                               |       | 10,744,000 |   | 4,792,000 |   |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Gross margin                                                                                   |       | 1,474,000                                 |       | (439,000                                | )          | 1,468,000 |   | 23,000 |   |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Operating expenses:                                                                            |       |                                      |       |                                    |       |   |   |   |   |
| Research and  development                                                                      |       | 492,000                                   |       | 282,000                                 |       | 808,000 |   | 868,000 |   |
| Selling, general  and administrative                                                           |       | 2,665,000                                 |       | 1,276,000                               |       | 4,590,000 |   | 2,330,000 |   |
| Total operating expenses                                                                       |       | 3,157,000                                 |       | 1,558,000                               |       | 5,398,000 |   | 3,198,000 |   |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Loss from operations                                                                           |       | (1,683,000                                | )          | (1,997,000                              | )          | (3,930,000 | ) | (3,175,000 | ) |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Other income (expenses):                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| Interest income                                                                                |       | 17,000                                    |       | 15,000                                  |       | 28,000 |   | 31,000 |   |
| Interest expense                                                                               |       | (74,000                                   | )          | (29,000                                 | )          | (166,000 | ) | (47,000 | ) |
| Equity losses in  unconsolidated subsidiaries                                                  |       | (84,000                                   | )          | (17,000                                 | )          | (124,000 | ) | (28,000 | ) |
| Mark to market  of beneficial conversion feature                                               |       | 891,000                                   |       | —                                  |       | 891,000 |   | — |   |
| Total other  expense, net                                                                      |       | 750,000                                   |       | (31,000                                 | )          | 629,000 |   | (44,000 | ) |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Net loss                                                                                       |       | (933,000                                  | )          | (2,028,000                              | )          | (3,301,000 | ) | (3,219,000 | ) |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Preferred distribution, dividends and accretion                                                |       | (387,000                                  | )          | (283,000                                | )          | (387,000 | ) | (567,000 | ) |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Net loss applicable to common shareholders                                                     |       | $                                         | (1,320,000 | )                                       | $          | (2,311,000 | ) | $ | (3,688,000 | ) | $ | (3,786,000 | ) |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Net loss per  share applicable to common shareholders, basic and diluted                       |       | $                                         | (0.12      | )                                       | $          | (0.26 | ) | $ | (0.33 | ) | $ | (0.44 | ) |
|                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Weighted average  common shares outstanding used in computing basic and diluted loss per share |       | 11,379,275                                |       | 8,882,786                               |       | 11,170,989 |   | 8,674,673 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

4

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**IMPLANTSCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                  | ** ** | **Six Months Ended  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| **Cash flows from operating activities:**                                                   |       |                                    |       |   |   |
| Net loss                                                                                    |       | $                                       | (3,301,000 | ) | $ | (3,219,000 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                |       |                                    |       |   |   |
| Depreciation and  amortization                                                              |       | 1,168,000                               |       | 783,000 |   |
| Amortization of  intangible assets                                                          |       | 414,000                                 |       | — |   |
| Stock-based  compensation expense                                                           |       | 1,458,000                               |       | 153,000 |   |
| Equity loss in  unconsolidated subsidiaries                                                 |       | 124,000                                 |       | 28,000 |   |
| Loss on  equipment sale or write down                                                       |       | 43,000                                  |       | 6,000 |   |
| Accretion of  Series D interest                                                             |       | 40,000                                  |       |   |   |
| Gain on mark to  market of beneficial conversion feature                                    |       | (891,000                                | )          | — |   |
| Changes in  operating assets and liabilities:                                               |       |                                    |       |   |   |
| Accounts  receivable                                                                        |       | (749,000                                | )          | (52,000 | ) |
| Inventories                                                                                 |       | (597,000                                | )          | (31,000 | ) |
| Prepaid expenses  and other current assets                                                  |       | (99,000                                 | )          | 68,000 |   |
| Deferred revenue                                                                            |       | 111,000                                 |       | — |   |
| Accounts payable                                                                            |       | 621,000                                 |       | 237,000 |   |
| Accrued expenses                                                                            |       | (521,000                                | )          | 282,000 |   |
| Net cash used in  operating activities                                                      |       | (2,179,000                              | )          | (1,745,000 | ) |
|                                                                                        |       |                                    |       |   |   |
| **Cash flows from investing activities:**                                                   |       |                                    |       |   |   |
| Purchase of  property and equipment                                                         |       | (380,000                                | )          | (359,000 | ) |
| Investment in  unconsolidated subsidiary                                                    |       | —                                  |       | 60,000 |   |
| Investment in  Core Systems                                                                 |       | (9,000                                  | )          | (2,597,000 | ) |
| Investment in  Accurel Systems International                                                |       | (2,000                                  | )          | — |   |
| Increase in  other non-current assets                                                       |       | (47,000                                 | )          | (103,000 | ) |
| Net cash used in  investing activities                                                      |       | (438,000                                | )          | (2,999,000 | ) |
|                                                                                        |       |                                    |       |   |   |
| **Cash flows from financing activities:**                                                   |       |                                    |       |   |   |
| Proceeds from  issuance of common stock                                                     |       | —                                  |       | 831,000 |   |
| Proceeds from  exercise of employee options and stock purchase plan                         |       | 29,000                                  |       | — |   |
| Proceeds from  exercise of warrants and non-employee options                                |       | 69,000                                  |       | 66,000 |   |
| Payments of  additional issuance costs related to private placement of common stock         |       | (31,000                                 | )          | (25,000 | ) |
| Proceeds from  issuance of Series D Convertible Preferred Stock, net of issuance costs |       | 4,728,000                               |       | — |   |
| Proceeds from  capital lease obligations                                                    |       | —                                  |       | 61,000 |   |
| Repayments of  long-term debt and capital lease obligations                                 |       | (1,859,000                              | )          | (861,000 | ) |
| Acqusition of  treasury shares                                                              |       | —                                  |       | (54,000 | ) |
| Net cash  provided by financing activities                                                  |       | 2,936,000                               |       | 18,000 |   |
|                                                                                        |       |                                    |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                       |       | 319,000                                 |       | (4,726,000 | ) |
| Cash and cash  equivalents, beginning                                                       |       | 1,549,000                               |       | 6,906,000 |   |
| Cash and cash  equivalents, ending                                                          |       | $                                       | 1,868,000  |   | $ | 2,180,000 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

5

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| ** **                                                                                                                   | ** ** | **Six Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| ** **                                                                                                                   | ** ** | ** **                              | ** ** | ** ** | ** ** |
| **Supplemental Disclosure of Cash Flow  Information:**                                                                       |       |                                    |       |   |   |
| Interest paid in cash                                                                                                        |       | $                                       | 136,000    |   | $ | 47,000 |   |
|                                                                                                                         |       |                                    |       |   |   |
| **Noncash Investing and Financing Activity:**                                                                                |       |                                    |       |   |   |
| Conversion of 5%  Series C Cumulative Convertible Preferred Stock and accrued dividends  into common stock              |       | $                                       | —     |   | $ | 1,141,000 |   |
|                                                                                                                         |       |                                    |       |   |   |   |   |
| Accretion of 5%  Series C Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants |       | $                                       | —     |   | $ | 567,000 |   |
|                                                                                                                         |       |                                    |       |   |   |
| Accrued dividends on Series D Preferred Stock                                                                           |       | $                                       | 102,000    |   | $ | — |   |
|                                                                                                                         |       |                                    |       |   |   |
| Accretion of Series D Preferred Stock,  beneficial conversion and warrants                                              |       | $                                       | 285,000    |   | $ | — |   |
|                                                                                                                         |       |                                    |       |   |   |
| Capital equipment acquired under capital lease                                                                               |       | $                                       | 42,000     |   | $ | — |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

6

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**IMPLANTSCIENCES CORPORATION**

**NOTESTO CONDENSED FINANCIAL STATEMENTS**

**December 31,2005**

**(Unaudited)**

 

**1.****                                Descriptionof Business and Basis of Presentation**

 

Implant SciencesCorporation (the “Company”) develops products for the medical device andexplosives detection industry and provides services to the semiconductorindustry.  Its core technology involves ionimplantation and thin film coatings of radioactive and non-radioactivematerials.  The Company has received Foodand Drug Administration 510(k) clearance to market radioactive seeds for thetreatment of prostate cancer and breast cancer. The Company also modifies the surface characteristics of orthopedicjoint implants to reduce polyethylene wear, thereby increasing the life of theimplant.  The Company also provides ionimplantation, analytical services and equipment to the semiconductorindustry.  The Company manufactures traceexplosives detection equipment while continuing to make significant investmentsin developing new applications of its explosives detection technologies.

 

These condensedconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. For the three and six month periods ended December 31, 2005 theCompany had net losses of $933,000 and $3,301,000 respectively.  The Company also had cash and cashequivalents of $1,868,000 and net working capital of $2,164,000 on December 31,2005.  The Company continually reviewsits operating plans to determine if it has adequate cash flows to fund itsoperations and achieve its operating plans. Although the Company believes it can achieve these plans there can be noassurances that it will.  If the Companyfails to achieve its revenue and gross margin goals, it would have to undertakeadditional steps to fund operations. These steps may include: obtaining additional financing, entering intostrategic agreements to fund the development of our products and/or cuttingcosts and expenses.

 

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

 

The accompanyingcondensed consolidated financial statements of the Company have been preparedin accordance with the accounting principles generally accepted in the UnitedStates of America. In the opinion of management, the accompanying condensedconsolidated financials statements includes all adjustments (consisting only ofnormal recurring adjustments), which the Company considers necessary for a fairpresentation of the financial position at such date and of the operatingresults and cash flows for these periods. The result of operations and cash flows for the three and six monthperiods ended December 31, 2005 may not necessarily be indicative ofresults that may be expected for any succeeding quarter or for the entire fiscalyear.  The information contained in this Form 10-Qshould be read in conjunction with the Company’s audited financial statements,included in our Form 10-KSB as of and for the year ended June 30,2005 filed with the Securities and Exchange Commission on October 13,2005.

 

The accompanyingconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries.  Allintercompany balances have been eliminated in consolidation.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States (“U.S. GAAP”) requires management to makeestimates and judgments, which are evaluated on an on-going basis, that affectthe amounts reported in the Company’s condensed consolidated financialstatements and accompanying notes. Management bases its estimates on historical experience and on variousother assumptions that it believes are reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities and the amounts of revenues and expenses that are notreadily apparent from other sources. Actual results could differ from those estimates and judgments,  In particular, significant estimates andjudgments include those related to revenue recognition, allowance for doubtfulaccounts, useful lives of property and equipment, inventory reserves, businesscombinations, valuation for goodwill and acquired intangible assets, instrumentswhich contain features of both equity and debt instruments, derivatives,share-based compensation and warranty reserves.

 

7

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**3.****                                Inventories**

 

Inventoriesconsist of the following:

 
| ** **       | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|------------------|------------|-----------------------|------------|-------------------|------------|
| ** **       | ** ** | **2005**              | ** ** | **2005**          | ** ** |
| Raw materials    |       | $                     | 1,027,000  |              | $          | 548,000 |   |
| Work-in-progress |       | 392,000               |       | 416,000           |       |
| Finished goods   |       | 383,000               |       | 240,000           |       |
|             |       |                  |       |              |       |
|             |       | $                     | 1,802,000  |              | $          | 1,204,000 |   |

 

**4.****                                Propertyand Equipment**

 

Property and equipment consists of the following**:**

 
| ** **                                      | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2005**          | ** ** |
| Total property and equipment                    |       | 15,994,000            |       | 15,624,000        |       |
| Less: accumulated depreciation and amortization |       | (6,290,000            | )          | (5,190,000        | )          |
|                                            |       |                  |       |              |       |
| Property and equipment, net                     |       | $                     | 9,704,000  |              | $          | 10,434,000 |   |
|                                                 |            |                       |            |                   |            |  |  |

 

 

**5.****                                RelatedParty Transactions**

 

Statement of Financial Accounting Standard (“SFAS”) No. 57, “RelatedParty Disclosures,” specifies the nature of information that should bedisclosed in financial statements regarding related party transactions.  CardioTech, a publicly traded company whosecommon stock trades under the symbol CTE on the American Stock Exchange, is arelated party with the Company by virtue of its significant businessrelationships.

 

Certain directors of the Company hold positions as directors ofCardioTech.  The CEO and Chairman of theBoard of Directors of the Company is also a director of CardioTech.  The CEO and Chairman of the Board ofDirectors of CardioTech is also a director of the Company.

 

In March 2000, the Company entered into a joint research agreementwith CardioTech to develop a proprietary porous polymer biocompatible coatingtechnology as a platform for the Company’s proprietary radioactivebrachytherapy technology.  Inconsideration for this agreement, the Company agreed to pay $150,000 in cashand purchase 100,000 shares of CardioTech stock at a price of $1.00 pershare.  As of December 31, 2005, theCompany has purchased these shares, the fair market value of which is $230,000and is recorded as investments in available for sale securities in theaccompanying consolidated balance sheet. The unrealized holding gains and losses are recorded as accumulatedother comprehensive income (loss) within stockholders’ equity.

 

In March 2004 the Company entered into an Exchange &Venture Agreement with CardioTech and CorNova. The Company’s CEO and the Company’s Chairman of the Nominating Committeeare also on the Board of Directors of CorNova.

 

8

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**6.****                                EmployeeStock-Based Compensation**

 

On December 16, 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 123 (Revised 2004) (“SFAS 123R”), “Share-Based Payments,”which is a revision of SFAS No. 123, “Accounting for Stock-BasedCompensation.”  SFAS 123R supersedesAccounting Principal Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.”  Generally, the approach in SFAS 123R issimilar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees,including grants of employee stock options and stock issued from certainemployee stock purchase plans, to be recognized in the income statement basedon their fair values.  Pro formadisclosure is no longer an alternative.

 

Prior to July 1, 2005, as was permitted under SFAS No. 123,the Company accounted for stock-based awards using the intrinsic value methodunder APB No. 25.  Under APB No. 25,when the exercise price of options granted to employees and non-employeedirectors under these plans equals the market price of the underlying stock onthe date of the grant, no compensation expense was recorded.

 

Effective July 1, 2005, the Company adopted SFAS 123R.  The Company selected the modified prospectivemethod of adoption in which compensation cost is recognized beginning with theeffective date for all share-based payments to employees after June 30,2005 and any unvested share-based payments to employees as of the effectivedate.  In accordance with the modifiedprospective method of adoption, the Company’s results of operations for priorperiods have not been restated.

 

The Company has refined certain estimates used previously based uponthe guidance provided under SFAS 123R, specifically the expected life of theoption and estimated forfeitures.   The calculation of the fair value of theawards for quarters ended September 30, 2005 and thereafter has beenadjusted to reflect these refined assumptions.

 

The following table illustrates the effect on net loss applicable tocommon shareholders and net loss per share applicable to common shareholders asif the fair value method had been applied to all outstanding and unvestedawards in the prior period:

 
| ** **                                                                                                                                               | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                                                               | ** ** | **2004**                                  | ** ** | **2004**                                | ** ** |
|                                                                                                                                                     |       |                                      |       |                                    |       |
| Net loss  applicable to common shareholders as reported.                                                                                                 |       | $                                         | (2,311,000 | )                                       | $          | (3,786,000 | ) |
| Add:  share-based employee compensation expense  included in proforma net loss and reported net loss applicable to common  shareholders, net of tax |       | 77,000                                    |       | 136,000                                 |       |
|                                                                                                                                                     |       |                                      |       |                                    |       |
| Deduct:  total share-based employee compensation  expense determined under the fair value based method of all awards, net of  tax                   |       | (651,000                                  | )          | (864,000                                | )          |
|                                                                                                                                                     |       |                                      |       |                                    |       |
| Proforma net  loss, for the periods applicable to common shareholders after adopting SFAS  123R                                                          |       | $                                         | (2,885,000 | )                                       | $          | (4,514,000 | ) |
|                                                                                                                                                     |       |                                      |       |                                    |       |
| Net loss per  share applicable to common shareholders, basic and diluted:                                                                                |       |                                      |       |                                    |       |
| As reported                                                                                                                                              |       | $                                         | (0.26      | )                                       | $          | (0.44 | ) |
| Pro forma                                                                                                                                                |       | $                                         | (0.32      | )                                       | $          | (0.52 | ) |

 

9

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Under the provisions of SFAS 123R the Company recorded$1,028,000 and $1,413,000 of stock based compensation on its condensedconsolidated statement of operations for the three and six month periods ended December 31,2005, which includes $29,000 of compensation expense attributable to itsEmployee Stock Purchase Plan for the three and six month periods.  The stock based compensation is included inthe following expense categories:

 
| ** **                          | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended**       | ** ** |
|-------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | **December 31, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** **                          | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Cost of revenues                    |       | $                          | 94,000     |                       | $          | 176,000 |   |
| Research and development            |       | $                          | 210,000    |                       | $          | 278,000 |   |
| Selling, general and administrative |       | $                          | 724,000    |                       | $          | 959,000 |   |
|                                |       |                       |       |                       |       |
| Total FAS123R compensation expense  |       | $                          | 1,028,000  |                       | $          | 1,413,000 |   |

 

The Company also had $20,000 and $45,000 ofcompensation expense attributable to non-employee options and warrants, for thethree month and six month periods respectively.

 

The fair value of each option award is estimated on the date of grantusing the Black-Scholes option pricing model using the assumptions noted in thefollowing table.  Expected volatilitiesare based on historical volatility of the Company’s stock options.  The Company uses historical data to estimateoption forfeitures within the valuation model. The expected term of optionsgranted is calculated using the “Simplified Method” as outlined SFAS 123R andreflects the period of time that options granted are expected to beoutstanding.  The risk-free rate forperiods within the contractual life of the option is based on the U.S Treasuryyield curve in effect at the time of grant.

 
| ** **               | ** ** | **Stock Option Plans** | ** ** | **Stock Purchase Plan** | ** ** |
|--------------------------|------------|------------------------|------------|-------------------------|------------|
|                     |       |                   |       |                    |       |
| Risk free interest rate  |       | 3.34% - 4.48%          |       | 4.33%                   |       |
| Expected dividend yield  |       | 0%                     |       | 0%                      |       |
| Expected lives (years)   |       | 2.5 - 6 years(1)       |       | 6 months                |       |
| Expected volatility      |       | 57% - 80%              |       | 61%                     |       |
| Expected forfeiture rate |       | 4%                     |       | 0%                      |       |
| Contractual term         |       | 5 – 10 years      |       | 6 months                |       |

 

----

(1)          The estimate of anoption’s expected life has been updated and revised for all grants outstandingprior to adoption based upon guidance provided under SFAS 123R and theSecurities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) Topic 107.The estimate of expected life was revised to use the “simplified method” todetermine the expected life of an option versus the contractual life aspreviously used.

 

**7.****                         ****Share-basedCompensation Plans**

 

The Company has two types of shared based compensation plans, a StockOption Plan and an Employee Stock Purchase Plan.

 

10

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*StockOption Plans*

 

In September 1998,the Company adopted the 1998 Stock Option Plan (the “1998 Plan”).  The 1998 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equal 100% of the fair market value on the date of the grant or 110% ofthe fair market value for greater than 10% beneficial owners of the Companystock.  Options expire between five and tenyears from the date of the option grant and have various vesting periods.

 

In December 2000,the Company adopted the 2000 Incentive and Non Qualified Stock Option Plan (the“2000 Plan”).  The 2000 Plan provides forthe grant of incentive stock options and nonqualified stock options toemployees and affiliates.  The exerciseprice of the options equal 100% of the fair market value on the date of thegrant or 110% of the fair market value for greater than 10% beneficial ownersof the Company stock.  Options expirebetween five and ten years from the date of the option grant and have various vestingperiods.

 

In December 2004,the Company adopted the 2004 Stock Option Plan (the “2004 Plan”).  The 2004 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equal 100% of the fair market value on the date of the grant or 110% ofthe fair market value for greater than 10% beneficial owners of the Companystock.  Options expire between five andten years from the date of the option grant and have various vesting periods.  At the December 2005 annual meeting theshareholders voted to increase the shares available for issuance under the 2004Plan by 500,000 to 1,000,000 shares.

 

A summary ofoption activity under the plans as of and for the period December 31, 2005are as follows: 

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding at June 30, 2005      | ** ** | 1,908,331  | ** ** | $                                      | 5.66       | ** ** |
|                                   |       |       |       |                                   |       |
| Granted                                |       | 88,000     |       | 6.72                                   |       |
| Exercised                              |       | (2,500     | )          | 2.10                                   |       |
| Canceled                               |       | (184,440   | )          | 6.30                                   |       |
|                                   |       |       |       |                                   |       |
| Outstanding at September 30, 2005 |       | 1,809,391  |       | $                                      | 5.65       |   |
|                                   |       |       |       |                                   |       |
| Granted                                |       | 365,250    |       | 4.07                                   |       |
| Exercised                              |       | —     |       | 0                                      |       |
| Canceled                               |       | (82,754    | )          | 0.42                                   |       |
|                                   |       |       |       |                                   |       |
| Outstanding at December 31, 2005  |       | 2,091,887  |       | 5.58                                   |       |

 

A summary of theunvested option activity under the plans as of and during the six month periodended December 31, 2005 is as follows:

 

11

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| **Unvested Options**                | ** ** | **Shares** | ** ** | **Weighted-  Average  Fair Value** | ** ** |
|-------------------------------------|------------|------------|------------|------------------------------------|------------|
| Unvested at at June 30, 2005   |       | 891,969    |       | $                                  | 4.79       |   |
|                                |       |       |       |                               |       |
| Granted                             |       | 88,000     |       | 4.79                               |       |
| Vested                              |       | (138,450   | )          | 5.47                               |       |
| Forfeited                           |       | (62,216    | )          | 5.71                               |       |
|                                |       |       |       |                               |       |
| Unvested at September 30, 2005 |       | 779,302    |       |                               |       |   |
|                                |       |       |       |                               |       |
| Granted                             |       | 124,000    |       | 3.84                               |       |
| Vested                              |       | (67,235    | )          | 7.16                               |       |
| Forfeited                           |       | (2,000     | )          | 6.00                               |       |
|                                |       |       |       |                               |       |
| Unvested at December 31, 2005  |       | 834,067    |       |                               |       |

 

As of December 31,2005 there was $2,564,000 of total unrecognized compensation expense related tounvested share based compensation arrangements under the various share-basedcompensation plans.  This expense isexpected to be recognized as follows:

 
| **Year  ending June 30:** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| 2006                           |       | $          | 891,000    |   |
| 2007                           |       | 1,129,000  |       |
| 2008                           |       | 506,000    |       |
| 2009                           |       | 38,000     |       |
|                           |       |       |       |
| Total                          |       | $          | 2,564,000  |   |

 

*EmployeeStock Purchase Plan*

 

In September 1998,the Company adopted the 1998 Employee Stock Purchase Plan (the “ESPP Plan”).  The Plan provides a method whereby employeesof the Company will have an opportunity to acquire an ownership interest in theCompany through the purchase of shares of common stock of the Company throughpayroll deductions.  After 12 months ofemployment, an employee is eligible to participate and can defer up to 10% oftheir wages into this ESPP Plan, with a maximum of $25,000 in any calendaryear.  The purchase price of the commonstock is calculated at the lower of 85% of the closing price of the stock onthe first day of the plan period or the last day of the ESPP plan period.  The periods are January 1 to June 30and July 1 to December 31. Fractional shares are not issued. Participants may withdraw at any time by giving written notice to theCompany and will be credited the amounts of deferrals in their account.  The maximum number of shares eligible to beissued under the ESPP Plan is 141,000. As of December 31, 2005, a total of 78,163 shares are available forissuance under the ESPP Plan.   Compensationexpense under the plan for the period ended December 31, 2005 is $29,000.

 

**8.****                                SecuredTerm Note and Series D Financing**

 

On July 6, 2005,the Company executed a $3.0 million secured term note payable to Laurus MasterFund, Ltd. (“Laurus”).   The Companyreceived $3,000,000 in gross proceeds, less a management fee of $135,000 andrelated transaction costs of approximately $32,000.  The term note was collateralized by

 

12

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substantially all of theCompany’s assets, had a 4-month term and bore interest at a rate equal to the primerate plus once percent (1%).  Inconnection with the financing, on September 30, 2005, the Company issuedLaurus a warrant to purchase up to 250,000 shares of the Company’s common stockat a price equal to $3.75 per share.  Netproceeds from the financing were used for increasing the capacity of the QuantumSnifferTM production line, increasing unit inventories and the repayment ofcertain indebtedness due and owing by the Company to the former shareholders ofAccurel Systems International in connection with the acquisition of thiswholly-owned subsidiary.

 

On September 30, 2005, the Company issued 500,000 shares of Series DConvertible Preferred Stock (“Series D”) having a stated value of $10 pershare, pursuant to a Securities Purchase Agreement with Laurus Master Fund,Ltd.  The Company received $5,000,000 ingross proceeds, less a management and placement agent fee of approximately$90,000, and related transaction costs of approximately $27,000.  The Series D has a dividend equal to theprime rate plus one percent (1%)  (8.25%as of December 31, 2005) and provides for redemption over a thirty-sixmonth period pursuant to an amortization schedule.  The monthly redemption amount ofapproximately $152,000 may be paid in cash or common shares at the option ofthe Company, subject to certain restrictions, commencing on January 1,2006.  If the payment of the monthlyamount is made in common stock, the fixed conversion price is $6.80 per commonshare.  The following table reflects therequired redemption of the Series D preferred stock:

 
| **Year ending June 30:** | ** ** | **Preferred Stock  Repayment  Schedule** | ** ** |
|-------------------------------|------------|------------------------------------------|------------|
| 2006                          |       | $                                        | 912,000    |   |
| 2007                          |       | 1,824,000                                |       |
| 2008                          |       | 1,824,000                                |       |
| 2009                          |       | 440,000                                  |       |
| Total                         |       | $                                        | 5,000,000  |   |

 

The Company alsoissued to Laurus a warrant to purchase up to 50,000 shares of the Company’s commonstock at a price equal to $10.20 per share. The Securities Purchase Agreement provides for a security interest insubstantially all of the Company’s assets and provides Laurus a right of firstrefusal on future financing arrangements during the term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it agreed to enter into such documentation as shall bereasonably requested by the Company in order to subordinate its rights underthe Series D to the subsequent financier. The Company utilized the proceeds to repay the $3 million term note withLaurus dated July 6, 2005, plus accrued interest, and for working capital.

 

In order tocorrect an error, during the quarter ended December 31, 2005, the Companyre-reviewed guidance and interpretations provided by the SEC relating to theconversion feature of the Series D and concluded that the convertiblepreferred stock was not “conventional preferred” as the number of shares to beissued upon conversion are not fixed, as there is the possibility that theconversion price may be reset under certain conditions.  In accordance with the provisions of EmergingIssues Task Force (“EITF”) Issue 00-19, “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, theSeries D contained a beneficial conversion feature which was valued atfair value using the Black Scholes option pricing model.  The following assumptions were used in thiscalculation: volatility 80%, expected life 1.5 years, interest rate of 3.96%.  The value of the beneficial conversionfeature aggregated to $1,397,000 on September 30, 2005 and is recorded asa liability on the balance sheet and marked to market each reporting periodwith changes in its value flowing through the statement of operations inaccordance with SFAS 133. Accordingly, primarily due to the decline in the fair market value ofthe Company’s common stock at December 31, 2005, the fair value of thebeneficial conversion feature decreased to $506,000 whereby the Company recorded$891,000 in other income for the three and six months ended December 31,2005.

 

The Company valuedthe Series D at issuance at its residual value of $2,700 based on the fairvalues of the financial instruments issued in connection with this preferred stockfinancing, including the warrants, the beneficial conversion feature andoffering costs.  The amounts recorded inthe financial statements represent the amounts attributed to the sale of thepreferred stock, the amount allocated to warrants of $632, (which includes the unamortizedportion of the warrants issued in connection with the term note as well asthose issued with the preferred stock), the amount of the discount related tothe value of beneficial conversion feature of $1,397,000 and $271,000 ofissuance costs (including $154,000 of unamortized costs

 

13

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of the July 6, 2005term note).  The Company is accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $5,000,000 at September 1, 2008, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.  As of December 31, 2005,$285,000 has been accreted and no preferred shares have been converted.  The Company also accreted $40,000 as interestexpense during the six months ended December 31, 2005.  Net cash proceeds were $1,851,000 (whichincluded repayments of $3,032,000 of principal and interest related to the July 6,2005 term note and $117,000 of issuance costs).

 

The accounting forthe Series D financing is currently under review by the SEC and is subjectto change based on the SEC’s final interpretation and review of the Company’saccounting.

 

**9.****                                Loss Per Share**

 

Basicloss per share is computed based only on the weighted average number of commonshares outstanding during the period. Diluted earnings per share is computed by using the weighted averagenumber of common shares outstanding during the period, plus the dilutiveeffects of shares issuable through the exercise of stock options and warrants(common stock equivalents) unless their inclusion would be antidilutive.  The shares underlying the preferred stockhave not been included in the earnings per share calculation.  The Series D preferred stock, ifconverted at December 31, 2005 would result in an additional 735,294shares of common stock.

 

**10.****                         FinancialInformation by Segment**

 

UnderSFAS No. 131, “Disclosures aboutSegments of an Enterprise and Related Information,” operating segmentsare defined as components of an enterprise about which separate financialinformation is available that is evaluated regularly by the chief operatingdecision maker, or decision making group, in deciding how to allocate resourcesand in assessing performance.  TheCompany’s chief operating decision making group is composed of the chiefexecutive officer and members of senior management. The Company’s reportablesegments are:  Medical, Semiconductor andExplosives.

 

Grossmargin is the measure that management uses when evaluating the Company’s segments;therefore, operating expenses are excluded from the financial informationbelow.

 

The revenues andexpenses related to these segments for the three months and six months ended December 31,2005 and 2004 are:

 

14

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| ** **   | ** ** | **Three Months Ended December 31, 2005** | ** ** |
|--------------|------------|-----------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                             | 991,000    |   | $ | 3,334,000 |   | $ | 3,215,000 |   | $ | 7,540,000 |   |
| COGS         |       | (829,000                                      | )          | (2,940,000 | ) | (2,297,000 | ) | (6,066,000 | ) |
| Gross Margin |       | $                                             | 162,000    |   | $ | 394,000 |   | $ | 918,000 |   | $ | 1,474,000 |   |

 
| ** **   | ** ** | **Three Months Ended December 31, 2004** | ** ** |
|--------------|------------|-----------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                             | 933,000    |   | $ | 1,288,000 |   | $ | 320,000 |   | $ | 2,541,000 |   |
| COGS         |       | (1,002,000                                    | )          | (1,536,000 | ) | (442,000 | ) | (2,980,000 | ) |
| Gross Margin |       | $                                             | (69,000    | ) | $ | (248,000 | ) | $ | (122,000 | ) | $ | (439,000 | ) |

 
| ** **   | ** ** | **Six Months Ended December 31, 2005** | ** ** |
|--------------|------------|---------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                           | 2,140,000  |   | $ | 6,456,000 |   | $ | 3,616,000 |   | $ | 12,212,000 |   |
| COGS         |       | (1,788,000                                  | )          | (5,637,000 | ) | (3,319,000 | ) | (10,744,000 | ) |
| Gross Margin |       | $                                           | 352,000    |   | $ | 819,000 |   | $ | 297,000 |   | $ | 1,468,000 |   |

 
| ** **   | ** ** | **Six Months Ended December 31, 2004** | ** ** |
|--------------|------------|---------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                           | 1,893,000  |   | $ | 1,622,000 |   | $ | 1,300,000 |   | $ | 4,815,000 |   |
| COGS         |       | (1,799,000                                  | )          | (1,913,000 | ) | (1,080,000 | ) | (4,792,000 | ) |
| Gross Margin |       | $                                           | 94,000     |   | $ | (291,000 | ) | $ | 220,000 |   | $ | 23,000 |   |

 

**11.****                        ****Goodwill and Other IntangibleAssets**

 

At December 31,2005, the Company had goodwill and intangible assets of $13,766.  SFAS No. 142, “Goodwill and OtherIntangible Assets”, requires that goodwill and intangible assets withindefinite lives no longer be amortized but instead be measured for impairmentat least annually or whenever events indicate that there may be animpairment.  The Company has four reporting units, medical, explosivesdetection, semiconductor wafer processing and semiconductor analyticalservices. All of the Company’s goodwill is allocated to the semiconductor waferprocessing and the semiconductor analytical services reporting units.  Determining the reporting unit’s fair valuerequires management to make estimates based on market conditions andoperational performance. Absent an event that indicates a specific impairmentmay exist, management has selected August 31as the date of performing theannual goodwill impairment test.  In order to determine ifimpairment exists, management continually estimates the reporting unit’s fairvalue based on market conditions and operational performance.  The Company may employ the work ofindependent appraisers in making its determination.  As of August 31, 2005, goodwill existedin two of our reporting units, our semiconductor wafer processing andsemiconductor analytical services units. The Company, in conjunction with areport from an independent appraiser made its annual assessment of goodwillattributable to its semiconductor wafer processing reporting unit on August 31,2005 and determined that the reporting unit’s goodwill is not impaired.  In addition, management conducted an internalassessment of the semiconductor analytical services reporting unit’s goodwilland concluded that these assets were not impaired as well.

 

15

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Thefollowing table summarizes the Company’s goodwill assets as of December 31,2005 and June 30, 2005:

 
| **Reporting Unit**                 | ** ** | **December 31, 2005** | ** ** | **June 30, 2005** | ** ** |
|------------------------------------|------------|----------------------------|------------|------------------------|------------|
|                               |       |                       |       |                   |       |
| Semiconductor  Wafer Processing    |       | $                          | 4,548,000  |                   | $          | 4,647,000 |   |
|                               |       |                       |       |                   |       |
| Semiconductor  Analytical Services |       | 7,575,000                  |       | 7,566,000              |       |
|                               |       |                       |       |                   |       |
| Total Goodwill                     |       | $                          | 12,123,000 |                   | $          | 12,213,000 |   |

 

Thechange in the value of the goodwill assets primarily reflect the satisfactionof a $112,000 liability in the semiconductor wafer processing segment offset byadditional acquisition related expenses.

 

Intangibleassets with finite lives are valued according to the future cash flows they areestimated to produce.  These assignedvalues are amortized over the period of time those cash flows are estimated tobe produced.  Management continuallyevaluates whether events or circumstances have occurred that indicate that theestimated remaining useful life or the carrying value of these assets has beenimpaired. As of December 31, 2005 management believes no impairmentexists.

 

Futureevents could cause management to conclude that impairment indicators exist andthat goodwill and intangible assets with indefinite lives associated with theCompany’s acquired businesses are impaired. Any resulting impairment loss could have a material adverse impact onthe Company’s financial condition and results of operations.

 

Thefollowing table summarizes the Company’s intangible assets as of December 31,2005 and June 30, 2005:

 
| ** **       | ** ** | ** **       | ** ** | **December 31, 2005**  | ** ** | **June 30, 2005**        | ** ** |
|------------------|------------|------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **       | ** ** | **Useful  Life** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|             |       |             |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Non-Compete      |       | 18-36 mo.        |       | $                           | 1,057,000  |                          | $          | 1,035,000 |   | $ | 22,000 |   | $ | 1,057,000 |   | $ | 809,000 |   | $ | 248,000 |   |
|             |       |             |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Name Recognition |       | 60-84 mo.        |       | 200,000                     |       | 23,000                        |       | 177,000 |   | 200,000 |   | 9,000 |   | 191,000 |   |
|             |       |             |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Customer Base    |       | 60 mo.           |       | 1,630,000                   |       | 281,000                       |       | 1,349,000 |   | 1,630,000 |   | 119,000 |   | 1,511,000 |   |
|             |       |             |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Technology       |       | 60 mo.           |       | 125,000                     |       | 30,000                        |       | 95,000 |   | 125,000 |   | 18,000 |   | 107,000 |   |
|             |       |             |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Total            |       |             |       | $                           | 3,012,000  |                          | $          | 1,369,000 |   | $ | 1,643,000 |   | $ | 3,012,000 |   | $ | 955,000 |   | $ | 2,057,000 |   |

 

Estimated future amortization expense for intangible assets with finitelives as of December 31, 2005 is as follows:

 

16

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| Remainder of  fiscal year | 2006       |   | $       | 207,000   |   |
|---------------------------|------------|--------|---------|-----------|--------|
|                      | 2007       |   | 387,000 |      |
|                      | 2008       |   | 380,000 |      |
|                      | 2009       |   | 380,000 |      |
|                      | 2010       |   | 244,000 |      |
|                      | thereafter |   | 45,000  |      |
|                      |       |   | $       | 1,643,000 |   |

 

**12.****                         CreditArrangements**

 

At the time of itsacquisition, Accurel Systems had a $1,400,000 fixed rate installment note witha bank with terms providing for monthly payments of $29,000 plus interest at arate of 6.84%, through September 1, 2008, (“the Accurel note”).  The bank has consented to continue the Accurelnote under the same terms after the acquisition. As of December 31, 2005,the Accurel note balance is $991,000. The Accurel note is collateralized by substantially all assets ofAccurel.

 

The Accurel note requiresAccurel to report monthly financial results to the bank and for Accurel tocomply with certain financial covenants including cash flow and tangible networth ratios and net income. As of December 31, 2005, Accurel was incompliance with the covenants.

 

On June 8, 2005, the Company executeda revolving credit facility for $1,500,000 with Silicon Valley based BridgeBank, N.A.  The revolving credit facilityhas a one year term, provides for advances of up to eighty percent (80%) of theCompany’s eligible accounts receivable, bears interest at the prime rate plusone-half percent (1/2%) (8.25% as of December 31, 2005), and is collateralizedby certain assets of the Company and is subject to certain covenants, includingquick ratio and tangible net worth.  Asof December 31, 2005, the company has not drawn down any funds on thecredit facility.

 

**13.        Proforma Financial Information**

 

Thefollowing table presents selected unaudited financial information of theCompany including Core Systems Incorporated and Accurel Systems InternationalCorporation as if the acquisition had occurred on July 1, 2004.  The unaudited proforma results are notnecessarily indicative of the results that would have occurred had the acquisitionof Core Systems and Accurel been consumated on July 1, 2004, or of futureresults.

 

**IMPLANTSCIENCES CORPORATION**

**PROFORMACONSOLIDATED STATEMENT OF OPERATIONS**

(Unaudited)

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                         | ** ** | **December 31,**       | ** ** | **December 31,**     | ** ** |
| ** **                                                         | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**                                                        |       | $                      | 7,540,000  |                 | $          | 4,626,000 |   | $ | 12,212,000 |   | $ | 10,077,000 |   |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| **Net  Loss Before Taxes**                                         |       | (933,000               | )          | (2,350,000           | )          | (3,301,000 | ) | (3,556,000 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| **Preferred  distribution, dividends**                             |       | (432,000               | )          | (283,000             | )          | (432,000 | ) | (567,000 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| **Net  Loss**                                                      |       | $                      | (1,325,000 | )                    | $          | (2,633,000 | ) | $ | (3,733,000 | ) | $ | (4,123,000 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| **Net  loss per share applicable to common shareholders**          |       | $                      | (0.12      | )                    | $          | (0.26 | ) | $ | (0.33 | ) | $ | (0.40 | ) |
|                                                               |       |                   |       |                 |       |   |   |   |   |
| **Weighted  average common shares outstanding, basic and diluted** |       | 11,379,000             |       | 10,318,000           |       | 11,171,000 |   | 10,165,673 |   |

 

**14.****                         SubsequentEvents**

 

On January 24,2006 the Company drew $500,000 on its credit facility with Bridge Bank.

 

On February 14,2006 Laurus Master Fund, LLP waived the monthly redemptions for the period January 1,2006 through March 1, 2006.

 

17

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**ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following managementdiscussion and analysis should be read in conjunction with the financialstatements and notes thereto as filed in our Form 10-KSB for the yearended June 30, 2005.  In addition tohistorical information, this Form 10-Q contains forward-lookingstatements.  The forward-lookingstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from those reflected in suchforward-looking statements.  Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s opinions only as of the date hereof.  We undertake no obligation to revise orpublicly release the results of any revision to these forward-lookingstatements.  Readers should carefullyreview documents that we file from time to time with the Securities andExchange Commission, including our Quarterly Reports and Annual Reports filedby us in fiscal 2005 and 2004.

 

Implant SciencesCorporation, incorporated in 1984, has three locations.  It operates out of a 51,000 square footleased facility in Wakefield, Massachusetts. Since October 15, 2004, Implant also operates out of a 35,000square foot leased facility in Sunnyvale, California and since March 9,2005, out of a 20,000 square foot leased facility also in Sunnyvale,California.  The Company hasapproximately 155 employees and runs three shifts in Wakefield and two shiftsin Sunnyvale.  The Company generatesrevenues from the sale of ion implantation and analytical services for thesemiconductor industry, radioactive prostate seeds and medical coatings,explosives trace detection equipment and government research and developmentcontracts for both medical products and explosives detection segments.Semiconductor products and services are conducted in both the Wakefield andSunnyvale facilities.  Medical andindustrial coatings, radioactive prostate seed manufacturing, explosivesdetection equipment manufacturing and research and development programs areconducted in Wakefield.

 

The three months and sixmonths ended December 31, 2005 includes revenues from Core Systems whichwas acquired by the Company on October 15, 2004, and Accurel Systems whichwas acquired on March 9, 2005. These acquisitions contributed revenues of $3.0 million in the quarterout of total revenues of $7.5 million and $6.0 million for the six months outof total of $12.2 million. Core and Accurel are included in the semiconductorsegment.  Revenues from our explosivesdetection segment, during the three months and six months ended December 31,2005, were $3.2 million and $3.6 million respectively.  These revenues reflect the first significantshipments of our explosives detection product during the quarter, includingmost of a previously announced order from China.

 

As a result of theacquisition of Core and Accurel on October 15, 2004 and March 9,2005, respectively, and the Company’s presentation of consolidated financialstatements, it should be noted that the fiscal 2006 versus fiscal 2005comparative information may not be meaningful.

 

On July 1, 2005, theCompany adopted SFAS 123R, “Share-Based Payments,” which is a revision of SFAS No. 123,“Accounting for Stock-Based Compensation,” using the modified prospectivemethod.  Prior to this the Company hadelected to use the disclosure-only provisions of SFAS No. 123. The Companywas required to adopt on July 1, 2005 because it no longer qualifies as a “smallbusiness” filer for SEC reporting purposes as of that date. Under SFAS 123R,the Company is required to account for all options granted to employees after July 1,2005 and any unvested portion of options outstanding as to the effective date,using the fair value method. The Company previously accounted for its employeestock-based compensation arrangements under the provisions of AccountingPrincipal Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” rather than the alternative fair value accounting method providedfor under SFAS No. 123. Previously under APB 25, when the exercise priceof options granted to employees and non-employee directors under these plansequals the market price of the underlying stock on the date of the grant, nocompensation expense is recorded. Because of the adoption of SFAS 123R comparisons with previous periodsmay not be meaningful.

 

**RESULTSOF OPERATIONS**

 

The following is adiscussion and analysis of the financial condition and results of operation ofthe Company for the three month period and six month period ended December 31,2005 and December 31, 2004.  Itshould be read in conjunction with the condensed consolidated financialstatements and notes thereto appearing elsewhere herein.

 

18

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*ThreeMonth Period Ended December 31, 2005 vs. December 31, 2004*

 

*Revenues.* Total revenues for the three month period ended December 31,2005 were $7,540,000 as compared to $2,541,000 for the comparable prior yearperiod, an increase of $4,999,000 or 197%.   Our revenues by business segment are asfollows:

 
| **Three Months Ended December 31, 2005** | ** ** |
|-----------------------------------------------|------------|
| **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Revenues** | ** ** |
|                                          |       |   |   |   |   |   |   |
| $                                             | 991,000    |   | $ | 3,334,000 |   | $ | 3,215,000 |   | $ | 7,540,000 |   |
|                                               |            |  |  |  |  |  |  |  |  |  |  |

 
| **Three Months Ended Decmber 31, 2004** | ** ** |
|-----------------------------------------|------------|
| **Medical**                             | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Revenues** | ** ** |
|                                    |       |   |   |   |   |   |   |
| $                                       | 933,000    |   | $ | 1,288,000 |   | $ | 320,000 |   | $ | 2,541,000 |   |
|                                         |            |  |  |  |  |  |  |  |  |  |  |

 

The overall increase in revenues isattributable to revenues from Explosives Detection products, Core Systems andAccurel Systems. Explosives detection included significant shipments of theCompany’s explosives detection equipment to a customer in China. The Companyhas been making a significant investment in the development and manufacturingcapability for its explosives detection products. The quarter ended December 31,2005 marks the first time a commercially viable explosives product wasavailable in significant quantities.   Inaddition the Company also recognized revenues from its previously announceddevelopment contract with the Transportation Security Administration.

 

Core was acquired on October 15, 2004 andits revenues are included since that date. Accurel was acquired on March 9, 2005 and its results were notincluded in the previous year period.   Revenuesfrom Core and Accurel totaled approximately $2,952,000 and are included in oursemiconductor segment.  Semiconductorrevenues were $3,334,000 as compared to $1,288,000 in the comparable prior yearperiod, an increase of $2,046,000 or 159%.  Since the acquisition of Core on October 15,2004 the Company has transitioned some semiconductor work from Wakefield toSunnyvale to take advantage of operating efficiencies.

 

Medical revenues were $991,000 as compared to$933,000 for the comparable prior year period, an increase of $58,000 or 6%.  The increase in medical revenues was due primarilyfrom a new non-orthopedic related coatings customer.  After a lengthy period of decline, managementbelieves seed volumes have now stabilized, and has taken steps to achieveincreasing seed volumes in the coming year including the benefits of sellingour recently acquired treatment planning software.  This product provides an opportunity tointroduce our seed product to a new set of customers – software users, and viceversa, leading to new revenue growth opportunities.  The treatmentplanning software is a proprietary treatment planning technology marketed as “I-PlantTPS”TM. In its latest version, a new module aids the physicianin making 2 and 3 dimensional maps of stage, grade and location of cancerwithin the prostate gland. This “Pathology Mapping Module”TM is inaddition to the standard treatment planning function used for prostateBrachytherapy and will provide for image guided, focal treatment of thedisease.

 

Revenues from the Company’s explosivesdetection business increased to $3,215,000 as compared to $320,000 for the comparableprior year period, an increase of $2,895,000 or 905%.  This increase is attributable to the firstsignificant shipments of its explosives detection equipment during thequarter.  The Company has beentransitioning the explosives business from primarily a contracts/developmentbusiness to a product sales business.  Tothat extent, we have established strategic sales and distribution relationshipsboth domestically and internationally.

 

*Cost ofRevenues*.  Cost ofrevenues for the three months ended December 31, 2005 was $6,066,000 ascompared to $2,980,000 for the comparable prior year period, an increase of $3,086,000or 104%.  The cost of revenues bybusiness segment is as follows:

 

19

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| **Three Months Ended December 31, 2005** | ** ** |
|-----------------------------------------------|------------|
| **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Cost of  Revenues** | ** ** |
|                                          |       |   |   |   |   |   |   |
| $                                             | 829,000    |   | $ | 2,940,000 |   | $ | 2,297,000 |   | $ | 6,066,000 |   |
|                                               |            |  |  |  |  |  |  |  |  |  |  |

 
| **Three Months Ended December 31, 2004** | ** ** |
|-----------------------------------------------|------------|
| **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Cost of  Revenues** | ** ** |
|                                          |       |   |   |   |   |   |   |
| $                                             | 1,002,000  |   | $ | 1,536,000 |   | $ | 442,000 |   | $ | 2,980,000 |   |
|                                               |            |  |  |  |  |  |  |  |  |  |  |

 

The overall increase incost of revenues is primarily a result of costs attributable to product costsof explosives detection equipment, and costs associated with the operations of Coreand Accurel.  The cost of our explosivesdetection revenues were $2,297,000 compared to $442,000 in the comparable prioryear period, an increase of $1,855,000 or 420%. This increase is directlyattributable to the cost of product shipped during the period.  Core and Accurel were acquired on October 15,2004 and March 9, 2005, respectively, and their results were not includedin the entire comparable prior year period. Cost of revenues at Core and Accurel totaled $2,460,000 for the period andare included in our semiconductor segment. Medical products costs were $829,000as compared to $1,002,000 in the comparable prior year period, a decrease of $173,000or 17%.  This decrease is primarily dueto scaling back seed production to align with lower volumes of seed sales.   Includedin cost of sales for the period ended December 31, 2005, is $94,000 ofshare-based compensation as required by SFAS 123R.

 

*GrossMargins*.  Overall grossmargins were 20% of revenues in the three month period ended December 31,2005 as compared to a gross margin loss of 17% of revenues in the comparable prioryear period.  The increase in the grossmargin percentage is attributable to the volume of explosives detectionequipment built and shipped during the period. The result of this transitionwas a gross margin of $918,000 or 29% of sales for the explosives detectionsegment for the three months ended December 31, 2005, as compared to grossmargin losses of $1,222,000 or 38% in the comparable prior year period. Alsocontributing were margins on explosives development contracts.   Semiconductormargins were 13% of revenues as compared to a gross margin loss of 19% in the comparableprior year period. This turnaround is attributable to Accurel.  Accurel was acquired on March 9, 2005and its results are not included in the comparable prior year period.  Medical margins improved to 16% of revenuesfrom a loss of 7% in the prior year period. This improvement is attributable to scaling back our seeds manufacturingcapacity to be more in line with the lower revenue levels as well as anincrease in our higher margin coatings business.  Gross margins by business segment are asfollows:

 
| **Three Months Ended December 31, 2005** | ** ** |
|-----------------------------------------------|------------|
| **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Gross  Margin** | ** ** |
| 16                                            | %          | 13 | % | 29 | % | 20 | % |

 
| **Three Months Ended December 31, 2004** | ** ** |
|-----------------------------------------------|------------|
| **Medical**                                   | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Gross  Margin** | ** ** |
| -7                                            | %          | -19 | % | -38 | % | -17 | % |

 

20

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*Researchand Development*. Research and development expense for the three month period ended December 31,2005 was $492,000 as compared to $282,000 for the comparable prior year period,an increase of $210,000 or 43%.  Includedin research and development costs for the period ended December 31, 2005,is $210,000 of share-based compensation as required by SFAS 123R. The Companycontinues to expend funds to further the development of new products in theareas of explosives and toxic substance detection and temporary brachytherapyareas.

 

*Selling,General and Administrative*. Selling, general and administrative expenses for the three month periodended December 31, 2005 were $2,665,000 as compared to $1,276,000 for thecomparable prior year period, an increase of $1,389,000 or 109%.  Included in selling, general andadministrative costs for the period ended December 31, 2005, is $724,000of share-based compensation as required by SFAS 123R.  Other factors contributing to the increaseare $426,000 of additional selling, general and administrative expensesincurred due to the acquisition of Accurel, which were not in the previous year’snumbers.  Core and Accurel were acquiredon October 15, 2004 and March 9, 2005, respectively, and theirresults were not included in the comparable prior year period prior to thosedates.  Selling expense associated withour treatment planning software line was $90,000 in the three month periodended December 31, 2005 as compared to $0 for the comparable prior yearperiod.

 

*OtherIncome and Expenses, Net*. For the three months ended December 31, 2005, the Company recordedother income,  net, of $750,000 ascompared to other expense, net, of $31,000, in the comparable prior yearperiod. Other income includes $891,000 of income attributable to marking tomarket the beneficial conversion feature associated with the Series Dpreferred stock.  The Company booked$40,000 of interest expense due to accretion of values ascribed to warrantsissued with the Series D.  Equitylosses in unconsolidated subsidiaries increased by $67,000 in the currentfiscal year period due to the Company’s share of losses at CorNova.

 

*Net Loss.*  Net loss for the three month period ended December 31,2005 was $933,000 as compared with $2,028,000 for the comparable prior yearperiod, a decrease in net loss of $1,095,000 or 54%.  The decrease in net loss is primarily due toan increased margin contribution from our explosives detection segment of $1,040,000,a $642,000 improvement from our semiconductor segment, a $231,000 improvementfrom our medical segment and $891,000 of income attributable to marking tomarket the beneficial conversion feature associated with the Series Dpreferred stock.  These improvements ingross margin were offset by $1,599,000 of increased operating expenses.   The increase in operating expense is attributableto $378,000 from Accurel, which was not included in the prior year numbers and$1,028,000 of non-cash compensation due to FAS123R.   The acquisition of Core Systems on October 15,2004 was expected to have a positive impact on earnings because of expectedoperating efficiencies and increased revenues when combined with the Company’sexisting semiconductor operations.  Thesebenefits have been slow to develop and Core has experienced losses since it wasacquired.  Management continues to focuson opportunities for Core that could have significant profit potential. TheCompany continually reviews its goodwill assets for potential impairment.  The Company has four reporting units formeasuring goodwill and intangible assets, medical, explosives detection,semiconductor wafer processing and semiconductor analytical services. All ofthe Company’s goodwill is allocated to the semiconductor wafer processing and thesemiconductor analytical services reporting units.  Determining the reporting unit’s fair valuerequires management to make estimates based on market conditions andoperational performance. Absent an event that indicates a specific impairmentmay exist, management has selected August 31 as the date of performing theannual goodwill impairment test. The results of this assessment, based onmanagement forecasts, conclude that the goodwill is not impaired.  However, if events should occur and animpairment charge is warranted it could have a significant impact on theCompany’s financial results for the period then reported.

 

Preferred distribution,dividends and accretion were $388 in the three month period ended December 31,2005 as compared to $283,000 in the period ended December 31, 2004.

 

*Six MonthPeriod Ended December 31, 2005 vs. December 31, 2004*

 

*Revenues.* Total revenues for the six month period ended December 31,2005 were $12,212,000 as compared to $4,815,000 for the comparable prior yearperiod, an increase of $7,397,000 or 154%.  Our revenues by business segment are as follows:

 

21

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| **Six Months Ended December 31, 2005** | ** ** |
|---------------------------------------------|------------|
| **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Revenues** | ** ** |
|                                        |       |   |   |   |   |   |   |
| $                                           | 2,140,000  |   | $ | 6,456,000 |   | $ | 3,616,000 |   | $ | 12,212,000 |   |
|                                             |            |  |  |  |  |  |  |  |  |  |  |

 
| **Six Months Ended Decmber 31, 2004** | ** ** |
|---------------------------------------|------------|
| **Medical**                           | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Revenues** | ** ** |
|                                  |       |   |   |   |   |   |   |
| $                                     | 1,893,000  |   | $ | 1,622,000 |   | $ | 1,300,000 |   | $ | 4,815,000 |   |
|                                       |            |  |  |  |  |  |  |  |  |  |  |

 

The overall increase in revenues isattributable primarily to revenues from Core Systems and Accurel Systems. Corewas acquired on October 15, 2004 and its results are included in theprevious year period from that day. Accurel was acquired on March 9, 2005 and its results were not includedin the previous year period.   Revenuesfrom Core and Accurel totaled approximately $6,035,000 and are included in oursemiconductor segment.  Semiconductorrevenues were $6,456,000 as compared to $1,622,000 in the comparable prior yearperiod, an increase of $4,834,000 or 298%. Since the acquisition of Core on October 15, 2004 the Company hastransitioned some semiconductor work and equipment from Wakefield to Sunnyvale,to take advantage of operating efficiencies.

 

Medical revenues were $2,140,000 as comparedto $1,893,000 for the comparable prior year period, an increase of $247,000 or13%.  The increase in medical revenueswas due primarily from a new non-orthopedic related coatings customer.  After a lengthy period of decline, managementbelieves seed volumes have now stabilized, and has taken steps to achieveincreasing seed volumes in the coming year, including the benefits of sellingour treatment planning software to our customers. The treatment planning software is a proprietary treatmentplanning technology marketed as “I-PlantTPS”TM. In itslatest version, a new module aids the physician in making two and three dimensionalmaps of stage, grade and location of cancer within the prostate gland. This “PathologyMapping Module”TM is in addition to the standard treatment planningfunction used for prostate brachytherapy and will provide for image guided,focal treatment of the disease.

 

Revenues from the Company’s explosivesdetection business increased to $3,616,000 as compared to $1,300,000 for the comparableprior year period, an increase of $2,316,000 or 178%.  This increase is attributable to shipments ofthe Company’s explosives detection equipment. The Company has beentransitioning the explosives business from primarily a contracts/developmentbusiness to a product sales business.  Tothat extent, we have established strategic sales and distribution relationshipsboth domestically and internationally. The Company had previously announced a major order for its explosivesdetection product from its distributor in China and shipped most of that orderduring the second quarter of fiscal 2006.

 

*Cost ofRevenues*.  Cost ofrevenues for the six months ended December 31, 2005 was $10,744,000 ascompared to $4,792,000 for the comparable prior year period, an increase of$5,952,000 or 124%.  The cost of revenuesby business segment is as follows:

 

22

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| **Six Months Ended December 31, 2005** | ** ** |
|---------------------------------------------|------------|
| **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Cost of  Revenues** | ** ** |
|                                        |       |   |   |   |   |   |   |
| $                                           | 1,788,000  |   | $ | 5,637,000 |   | $ | 3,319,000 |   | $ | 10,744,000 |   |
|                                             |            |  |  |  |  |  |  |  |  |  |  |

 
| **Six Months Ended December 31, 2004** | ** ** |
|---------------------------------------------|------------|
| **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Cost of  Revenues** | ** ** |
|                                        |       |   |   |   |   |   |   |
| $                                           | 1,799,000  |   | $ | 1,913,000 |   | $ | 1,080,000 |   | $ | 4,792,000 |   |
|                                             |            |  |  |  |  |  |  |  |  |  |  |

 

The overall increase incost of revenues is primarily a result of costs attributable to Core andAccurel.  Core was acquired on October 15,2004 and its results are included from that day.  Accurel was acquired on March 9, 2005,and its results were not included in the comparable prior year period.  Cost of revenues at Core and Accurel totaled$4,795,000 and are included in our semiconductor segment.  In addition, our cost of revenues alsoincreased due to higher volumes of product sales related to the explosivesdetection equipment.  The cost of ourexplosives detection revenues were $3,319,000 compared to $1,080,000 in thecomparable prior year period, an increase of $2,239,000 or 207%. Medicalproducts costs decreased to $1,788,000 as compared to $1,799,000 in the comparableprior year period, a decrease of $11,000 or 1%.  Included in cost of sales for the six month periodended December 31, 2005, is $176,000 of share-based compensation asrequired by SFAS 123R.

 

            *Gross Margins*.  Overall gross margins were 12% of revenues inthe six month period ended December 31, 2005 as compared to 1% of revenuesin the comparable prior year period.    Semiconductor margins were 13% of revenues ascompared to a gross margin loss of 18% in the comparable prior year period.This turnaround is attributable to Accurel. Accurel was acquired on March 9, 2005 and its results are notincluded in the comparable prior year period. Management expects continued semiconductor gross margin improvements asvolumes continue to increase and operating efficiencies at Core are realized. Medicalmargins reflect an increase in our coatings business.  Explosives Detection gross margins are 8% ofrevenues as compared to 17% in the comparable prior year period.  Most of the explosives detection revenues andmargin came in the final months of the six month period with losses experiencedin the first quarter.  Gross margins bybusiness segment are as follows:

 
| **Six Months Ended December 31, 2005** | ** ** |
|---------------------------------------------|------------|
| **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Gross  Margin** | ** ** |
| 16                                          | %          | 13 | % | 8 | % | 12 | % |

 
| **Six Months Ended December 31, 2004** | ** ** |
|---------------------------------------------|------------|
| **Medical**                                 | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Gross  Margin** | ** ** |
| 5                                           | %          | -18 | % | 17 | % | 1 | % |

 

*Researchand Development*. Research and development expense for the six month period ended December 31,2005 was $808,000 as compared to $868,000 for the comparable prior year period,a decrease of $60,000 or 7%.  In the sixmonth period ended December 31, 2005, certain of the Company’s R&Dresources were temporarily transferred to explosives detection productmanufacturing team to assist with order fulfillment of our handheld explosivesdetectors.  However, the Companycontinues to expend funds to further the development of new products in theareas of explosives and toxic substance detection and in applications for temporarybrachytherapy.  Included

 

23

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in research anddevelopment costs for the period ended December 31, 2005, is $278,000 ofshare-based compensation as required by SFAS 123R.

 

*Selling,General and Administrative*. Selling, general and administrative expenses for the six month period endedDecember 31, 2005 were $4,590,000 as compared to $2,330,000 for thecomparable prior year period, an increase of $2,260,000 or 97%.   This increase is primarily related to $787,000of additional selling, general and administrative expenses incurred due to theacquisition of Accurel.  Accurel wasacquired March 9, 2005, and Core was acquired on October 15, 2004,their results were not included in the entire comparable prior yearperiod.  Selling expense associated withour treatment planning software line were $187,000 in the six month periodended December 31, 2005 as compared to $0 for comparable prior yearperiod.  Included in selling, general andadministrative costs for the period ended December 31, 2005 is $959,000 ofshare-based compensation as required by SFAS 123R.

 

*OtherIncome and Expenses, Net*. For the six months ended December 31, 2005, we recorded other income,net, of $629,000 as compared to other expense, net, of $44,000, in the comparableprior year period.  This increase includesinterest expense of $166,000, primarily due to the Laurus financing in July of2005 and debt held by Accurel as compared to interest expense of $47,000 in thecomparable prior year period.    Inaddition, equity losses in unconsolidated subsidiaries increased by $96,000 inthe current fiscal year period. Other income also includes $891,000 of incomeattributable to marking to market the beneficial conversion feature associatedwith the Series D preferred stock.

 

*Net Loss.*  Net loss for the six month period ended December 31,2005 was $3,301,000 as compared with $3,219,000 for the comparable prior yearperiod, an increase in net loss of $82,000 or 3%.  The increase in net loss is primarily due to $1,413,000of non-cash compensation expense as required by FAS123R.  Previous year results do not included FAS123Rcompensation expense.  The current yearincludes $891,000 of income attributable to marking to market the beneficialconversion feature associated with the Series D preferred stock. Theacquisition of Core Systems on October 15, 2004 was expected to have apositive impact on earnings because of expected operating efficiencies andincreased revenues when combined with the Company’s existing semiconductoroperations.  These benefits have beenslow to develop and Core has experienced losses since it was acquired.  Management continues to focus onopportunities for Core that could have significant profit potential. TheCompany continually reviews its goodwill assets for potential impairment.  The Company has four reporting units,medical, explosives detection, semiconductor wafer processing and semiconductoranalytical services. All of the Company’s goodwill is allocated to thesemiconductor wafer processing and the semiconductor analytical servicesreporting units.  Determining thereporting unit’s fair value requires management to make estimates based onmarket conditions and operational performance. Absent an event that indicates aspecific impairment may exist, management has selected August 31 as thedate of performing the annual goodwill impairment test. The results of thisassessment, based on management forecasts, conclude that the goodwill is notimpaired.  However, if events shouldoccur and an impairment charge is warranted it could have a significant impacton the Company’s financial results for the period then reported.

 

Preferred distribution,dividends and accretion were $388 in the six month period ended December 31,2005 as compared to $567,000 in the period ended December 31, 2004.  In addition, the Company recorded a $891,000gain due to marking to market its liability due to the beneficial conversionfeature of the Series D preferred stock.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

The Company continually reviewsits operating plans to determine if it has adequate cash flows to fund itsoperations and achieve its operating plans. Although the Company believes it can achieve these plans there can be noassurances that it will.  If the Companyfails to achieve its revenue and gross margin goals, it would have to undertakeadditional steps to fund operations. These steps may include: obtaining additional financing, entering intostrategic agreements to fund the development of our products and/or cutting costsand expenses.

 

24

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As of December 31,2005, the Company had approximately $1,868,000 in the form of cash and cashequivalents and net working capital of $2,164,000.  During the six month period ended December 31,2005, operating activities used cash of approximately $2,179,000.  Net cash used by operating activitiesprimarily reflects the $3,301,000 net loss offset by $3,247,000 in depreciation,amortization and other non-cash expenses and $891,000 of income attributable tomarking to market the beneficial conversion feature associated with the Series Dpreferred stock.

 

In addition the Companyinvested $597,000 in inventory as it continues its production of our explosivesdetection products.  The Company’s accountsreceivables increased $749,000 due to shipments of its explosives detectionproduct late in the quarter, and unbilled government contracts.  It is expected that these receivables will becollected in the Company’s third quarter.  During the six months ended December 31,****2005, investing activities used cash of approximately $438,000which was primarily attributable to $380,000 used for additions to property andequipment.  The additions were primarilyused to increase production capacity at Core and for explosives detectionproducts production in Wakefield.  Duringthe six month period ended December 31, 2005, financing activitiesprovided approximately $2,936,000 in cash.

 

On July 6, 2005, the Company executed a $3.0 millionsecured term note from Laurus Master Fund, Ltd.   The Company received $3,000,000 in grossproceeds, less a management fee of $135,000 and related transaction costs ofapproximately $32,000.  The term note wascollateralized by substantially all of the Company’s assets, had a 4-month termand bore interest at a rate equal to the prime rate plus one percent (1%).  In connection with the financing, on September 30,2005, the Company issued Laurus a warrant to purchase up to 250,000 shares ofthe Company’s common stock at a price equal to $3.75 per share.  Net proceeds from the financing were used forincreasing the capacity of the Quantum SnifferTM production line, increasingunit inventories and the repayment of certain indebtedness due and owing by theCompany to the former shareholders of Accurel Systems International.

 

On July 8, 2005,the Company paid in full the principal and interest due on the notes payable tothe former Accurel Shareholders.  Allliens on the Company’s assets in regards to this transaction have been removed.

 

OnSeptember 30, 2005, the Company issued 500,000 shares of Series DConvertible Preferred Stock (“Series D”) having a stated value of $10 pershare, pursuant to a Securities Purchase Agreement with Laurus Master Fund,Ltd.  The Company received $5,000,000 ingross proceeds, less a management and placement agent fee of approximately$90,000, and related transaction costs of approximately $27,000.  The Series D has a dividend equal to theprime rate plus one percent (1%)  (8.25%as of December 31, 2005) and provides for redemption over a thirty-sixmonth period pursuant to an amortization schedule.  The monthly redemption amount ofapproximately $152,000 may be paid in cash or common shares at the option ofthe Company, subject to certain restrictions, commencing on January 1,2006.  If the payment of the monthlyamount is made in common stock, the fixed conversion price is $6.80 per commonshare.

 

The Company also issuedto Laurus a warrant to purchase up to 50,000 shares of the Company’s commonstock at a price equal to $10.20 per share. The Securities Purchase Agreement provides for a security interest insubstantially all of the Company’s assets and provides Laurus a right of firstrefusal on future financing arrangements during the term of the agreement.  In the event Laurus declines to exercise itsright of first refusal, it agreed to enter into such documentation as shall bereasonably requested by the Company in order to subordinate its rights underthe Series D to the subsequent financier. The Company utilized the proceeds to repay the $3 million term note withLaurus dated July 6, 2005, plus accrued interest, and for working capital.

 

In order to correct anerror, during the quarter ended December 31, 2005, the Company re-reviewedguidance and interpretations provided by the SEC relating to the conversionfeature of the Series D and concluded that the convertible preferred stockwas not “conventional preferred” as the number of shares to be issued uponconversion are not fixed, as there is the possibility that the conversion pricemay be reset under certain conditions. This conversion feature was also determined to be a liability as it maybe required to be repaid in cash, cannot be paid in unregistered shares and hascertain penalties.  These conditions definethe conversion feature is an embedded derivation which must be reported at fairvalue pursuant to SFAS 133.

 

25

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In accordance with theprovisions of Emerging Issues Task Force (“EITF”) Issue 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”, the Series D contained a beneficial conversionfeature which was valued at fair value using the Black Scholes option pricingmodel.  The following assumptions wereused in this calculation: volatility 80%, expected life 1.5 years, interestrate of 3.96%.  The value of thebeneficial conversion feature aggregated to $1,397,000 on September 30,2005 and is recorded as a liability on the balance sheet and marked to marketeach reporting period with changes in its value flowing through the statementof operations.  Accordingly, primarilydue to the decline in the fair market value of the Company’s common stock at December 31,2005, the fair value of the beneficial conversion feature decreased to $506,000whereby the Company recorded $891,000 in other income for the three and sixmonths ended December 31, 2005.

 

The Company valued the Series Dat issuance at its residual value of $2,659,000 based on the fair values of thefinancial instruments issued in connection with this preferred stock financing,including the warrants, the beneficial conversion feature and offeringcosts.  The amounts recorded in thefinancial statements represent the amounts attributed to the sale of thepreferred stock, the amount allocated to warrants of $673,000, (which includesthe value of the warrants issued in connection with the term note as well asthose issued with the preferred stock), the amount of the discount related to thevalue of beneficial conversion feature of $1,397,000 and $271,000 of issuancecosts (including $154,000 of unamortized costs of the July 6, 2005 termnote).  The Company is accreting thesediscounts on the carrying value of the preferred stock to its redemption valueof $5,000,000 at September 1, 2008, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.  As of December 31, 2005,$330,000 has been accreted and no preferred shares have been converted. Netcash proceeds were $1,851,000 (which included repayments of $3,032,000 ofprincipal and interest related to the July 6, 2005 term note and $117,000of issuance costs).

 

The accounting for the Series Dfinancing is currently under review by the SEC and is subject to change basedon the SEC’s final interpretation and review of the Company’s accounting.

 

The Series Dpreferred stock is redeemable in common stock or cash, at the option of theCompany if certain conditions are met. If the Company’s common stock trades atless than 110% of $6.80 for the five trading days prior to a requiredredemption, the payment must be made in cash.  The following table reflects therequired redemption of the Series D preferred stock:

 

| ** **                | ** ** | **Preferred Stock  Repayment  Schedule** | ** ** |
|---------------------------|------------|------------------------------------------|------------|
| Year ending June 30: |       |                                     |       |
| 2006                      |       | $                                        | 912,000    |   |
| 2007                      |       | 1,824,000                                |       |
| 2008                      |       | 1,824,000                                |       |
| 2009                      |       | 440,000                                  |       |
| Total                     |       | $                                        | 5,000,000  |   |

 

Although we continue tofund as much research and development as possible through government grants andcontracts in accordance with the provisions of the respective grant awards, wewill require additional funding in order to continue the advancement of thecommercial development and manufacturing of the explosives detectionsystem.  We will attempt to obtain suchfinancing by: (i) government grants, (ii) the exercise of theredeemable common stock purchase warrants, (iii) private financing, or (i) strategicpartnerships.  However, there can be noassurance that we will be successful in our attempts to raise such additionalfinancing.   Should funding not beavailable, we may be forced to sell certain company assets in order to fund thecontinued research and development of our explosives detection product and/orcurtail the amount of resources dedicated to it.

 

We will requiresubstantial funds for further research and development, regulatory approvalsand continued expansion of commercial-scale manufacturing capabilities, and themarketing of our products.  Our capitalrequirements depend on numerous factors, including but not limited to, theprogress of our research and development programs; the cost of filing,prosecuting, defending and enforcing any intellectual property rights;competing

 

26

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technological and marketdevelopments; changes in our development of commercialization activities andarrangements; and the purchase of additional facilities and capital equipment.

 

The Company’s futureminimum payments under contractual obligations related to capital leases,operating leases and term notes as of December 31, 2005 are as follows:

 
| ** **                | ** ** | **Debt and  Capital Leases** | ** ** | **Operating  Lease** | ** ** | **MED-TEC** | ** ** | **Total** | ** ** |
|---------------------------|------------|------------------------------|------------|----------------------|------------|-------------|------------|-----------|------------|
| Year ending June 30: |       |                         |       |                 |       |        |       |      |       |
| 2006                      |       | $                            | 200,000    |                 | $          | 827,000     |       | $         | 130,000    |   | $ | 1,157,000 |   |
| 2007                      |       | 393,000                      |       | 1,681,000            |       | 138,000     |       | 2,212,000 |       |
| 2008                      |       | 386,000                      |       | 1,713,000            |       | —      |       | 2,099,000 |       |
| 2009                      |       | 140,000                      |       | 1,454,000            |       | —      |       | 1,594,000 |       |
| 2010                      |       | 14,000                       |       | 838,000              |       | —      |       | 852,000   |       |
|                      |       |                         |       |                 |       |        |       |      |       |
| Total                     |       | $                            | 1,133,000  |                 | $          | 6,513,000   |       | $         | 268,000    |   | $ | 7,914,000 |   |

 

*CriticalAccounting Policies*

 

Our significantaccounting policies are described in Note 2 to the financial statementsincluded in Item 7 of our Form 10-KSB as of June 30, 2005.  Our discussion and analysis of our financialcondition and results of operations are based upon the financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States.  Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses, and related disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to bad debts, product returns, inventories,investments, intangible assets and warranty obligations.  We base our estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources.  Inthe past, actual results have not been materially different from ourestimates.  However, results may differfrom these estimates under different assumptions or conditions.  We adopted SFAS No. 142 and,accordingly, goodwill and other intangible assets with indefinite lives are nolonger amortized, but rather such assets are subject to annual impairmentreviews or more frequently, if events or circumstances indicate that they maybe impaired.

 

*Share-Based Payment.*****  In December 2004,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 123 (revised 2004), “Share-Based Payment,” which is a revision of Statement No. 123as amended by No. 148, “Accountingfor Stock-Based Compensation”. SFAS 123R supercedes APB Opinion No. 25.Generally, the approach in SFAS123R is similar to the approach described in SFASStatement No. 123. However, SFAS123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values at the date of grant. Pro formadisclosure is no longer an alternative. This Statement was effective for theCompany beginning with the first quarter of fiscal 2006.

 

SFAS123R permits public companies to adopt its requirements using one of twomethods. The “modified prospective” method requires compensation cost to berecognized beginning with the Statement’s effective date (a) based on therequirements of SFAS 123R for all share-based payments granted after theeffective date and (b) based on the requirements of Statement 123 for allawards granted to employees prior to the effective date of SFAS 123R thatremain unvested on the effective date. The “modified retrospective” methodincludes the requirements of the modified prospective method described above,but also permits entities to restate based on the

 

27

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amounts previouslyrecognized under Statement 123 for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year ofadoption. The Company has not adopted the “modified retrospective” method and previousamounts have not been restated (Note 6).

 

In April 2005,the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 107.The Bulletin confirms the latitude in SFAS 123R’s provisions on selectingmodels for valuing share options and clarifies other positions on accountingand disclosure for share-based-payment arrangements. In addition, the Bulletinpermits registrants to choose from different models to estimate the fair valueof share options, provides guidance on developing assumptions used in themodels, and addresses the interaction between SFAS 123R and other SECliterature.

 

TheCompany applies the requirements of SFAS 123R using the Black-Scholes optionpricing model to value its share options, and the “modified prospective” methodupon adoption of SFAS 123R.

 

**Item 3.   Quantitative and Qualitative DisclosuresAbout Market Risk**

 

Interest Rate Risk

 

The Company’s financialinstruments include cash and cash equivalents. Cash and cash equivalents include cash on hand, demand deposits andshort-term investments with maturities of three months or less whenacquired.  Cash equivalents represent adeposit in a money market account and a certificate of deposit.  The Company does not utilize derivativefinancial instruments, derivative commodity instruments or other market risksensitive instruments, positions or transactions in any material fashion.  The principal objective of the Company’sasset management activities is to maximize net investment income, whilemaintaining acceptable levels of interest rate risk and facilitating itsfunding needs.  At December 31,2005, the carrying values of the Company’s financial instruments approximatedfair values based upon current market prices and rates.

 

**Item 4.   Controlsand Procedures**

 

Based upon the Controls Evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this Quarterly Report, our Disclosure Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with accounting principles generally accepted in the United States of America.

 

As we disclosed in our 10-KSB, our independent registered public accounting firm reported to our Audit Committee certain conditions involving internal controls which they believed represent material weaknesses in our internal control environment. These matters relate to our ability to account for the acquisitions or, more specifically, post acquisition adjustments and the correct interpretation of related accounting literature. These matters can be related to our ability to interpret the accounting literature correctly for unusual events.  A material  weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

 

Our management and the Audit Committee agreed with our independent registered public accounting firm on the matter raised in their report and agreed to address the deficiency. We intend to perform the following related to these deficiencies:

 

The internal control structure deficiency identified by our independent registered public accounting firm was that our internal control structure did not include a formalized process for reviewing documented evidence of certain unusual one-time transactions with and the analysis of the appropriate authoritative accounting guidance with outside advisors to ensure the interpretation was correct.

 

To remediate this internal control deficiency, management has commenced implementation of the following measures:

 

28

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•          The Company has hired an experienced financial consultant to assist with the interpretation of accounting guidance as needed.

 

•          For material transactions that are unique or outside our core operations, we will continue to document our process for accounting for such transactions and we will improve our process for researching the applicable accounting literature and documenting our conclusions, by consulting with outside experts to ensure our interpretations are correct.

 

•          We will prepare a standardized memorandum that is required to be completed for each transaction that is unique or outside our normal core operations that is material to our financial statements. This memo will be reviewed and approved by the Vice President of Finance and the Chief Financial Officer.

 

•          We will enhance formal communication with, and approval by, our Chief Financial Officer and Audit Committee of our application of GAAP and accounting policy decisions for transactions that are outside our core operations and the advice received from outside experts.

 

In addition, we have hired a senior staff accountant to assist with the financial close process.

 

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**PART II: OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

None

 

**Item 1 A Risk Factors**

 

Interest Rate Risk

 

TheCompany’s financial instruments include cash and cash equivalents.  Cash and cash equivalents include cash onhand, demand deposits and short-term investments with maturities of threemonths or less when acquired.  Cashequivalents represent a deposit in a money market account and a certificate ofdeposit.  The Company does not utilizederivative financial instruments, derivative commodity instruments or othermarket risk sensitive instruments, positions or transactions in any materialfashion.  The principal objective of theCompany’s asset management activities is to maximize net investment income,while maintaining acceptable levels of interest rate risk and facilitating itsfunding needs.  At December 31,2005, the carrying values of the Company’s financial instruments approximatedfair values based upon current market prices and rates.

 

**Item 2.  Unregistered Sales of Equity**

 

On September 30, 2005, the Companyissued 500,000 shares of Series D Convertible Preferred Stock (“Series D”)in a private placement pursuant to Section 4(2) of the Securities Actof 1933, as amended, having a stated value of $10 per share, pursuant to aSecurities Purchase Agreement executed on September 30, 2005, with theLaurus Master Fund, Ltd.  The Companyreceived $5,000,000 in gross proceeds, less a management and placement agentfee of approximately $90,000, and related transaction costs of approximately$27,000.  The Series D has adividend equal to the prime rate plus one percent (1%) and provides forrepayment over a thirty-six month period pursuant to an amortizationschedule.  The monthly redemption amountof approximately $152,000 may be paid in cash or common shares at the option ofthe Company, subject to certain restrictions, commencing on January 1,2006.  If the payment of the monthlyamount is made in common stock, the fixed conversion price is $6.80 per commonshare.

 

TheCompany also issued to Laurus Master Fund, Ltd. a warrant to purchase 250,000shares of common stock at an exercise price of $3.75 per share and a warrant topurchase 50,000 shares of common stock at $10.20 per share.  The Securities Purchase Agreement alsoprovides for a security interest in substantially all of the Company’s assetsand provides Laurus a right of first refusal on future financing arrangementsduring the term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it agreed toenter into such documentation as shall be reasonably requested by the Companyin order to subordinate its rights under the Series D to the subsequentfinancier.  The Company utilized theproceeds to repay the $3 million term note signed on July 7, 2005 plusaccrued interest, and for working capital.

 

As of December 31,2005, the outstanding principal balance of the Series D was $5,000,000.

 

**Item 3.  Defaults Upon Senior Securities**

 

Not Applicable

 

**Item 4.  Submission of Matters to a Vote ofSecurity-Holders**

 

Weheld our annual shareholder’s meeting on December 13, 2004.  Anthony Armini, Stephen Bunker, DavidEisenhaure, Michael Szycher and Michael Turmelle were elected as directors ofthe Company to hold office until the 2006 annual meeting of shareholders.  The results for this vote were as follows:

 

30

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| **Name**         | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|------------------|------------|------------|------------|--------------|------------|
|             |       |       |       |         |       |
| Anthony Armini   |       | 10,297,787 |       | 275,413      |       |
|             |       |       |       |         |       |
| Stephen Bunker   |       | 10,362,396 |       | 210,804      |       |
|             |       |       |       |         |       |
| Michael Szycher  |       | 10,352,421 |       | 220,779      |       |
|             |       |       |       |         |       |
| David Eisenhaure |       | 10,385,687 |       | 187,513      |       |
|             |       |       |       |         |       |
| Michael Turmelle |       | 10,385,812 |       | 187,388      |       |

 

ProposalNo. 2 was an amendment to the Company’s 2004 Incentive and NonqualifiedStock Option Plan raising the number of shares that may be issued under theplan from 500,000 to 1,000,000.  Theresults for this proposal were as follows:

 

| **For**   | ** ** | **Against** | ** ** | **Withheld** | ** ** | **Abstain** | ** ** |
|-----------|------------|-------------|------------|--------------|------------|-------------|------------|
| 3,602,281 |       | 525,838     |       | 19,361       |       | 19,361      |       |

 

Proposal No. 3 was to approve an increase to the number of authorizedshares of capital stock raising the number of shares from 20,000,000 to 50,000,000.  The results for this proposal were asfollows:

 

| **For**   | ** ** | **Against** | ** ** | **Withheld** | ** ** | **Abstain** | ** ** |
|-----------|------------|-------------|------------|--------------|------------|-------------|------------|
| 9,947,001 |       | 615,109     |       | 11,090       |       | 11,090      |       |

 

**Item5.  Other Information**

 

None

 

**Item 6.  List of Exhibits and Reports on Form 8-K**

 

(a)            Thefollowing exhibits, required by Item 601 of Regulation S-B, are filed as partof this Quarterly Report on Form 10-QS. Exhibit numbers, where applicable, in the left hand columncorrespond to those of Item 601 of Regulation S-B.

 

31

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| **Exhibit No.** | ** ** | **Description**                                                                                                                                             | ** ** |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                 |       |                                                                                                                                                        |       |
| 31.1                 |       | Certification of Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                   |       |
|                 |       |                                                                                                                                                        |       |
| 31.2                 |       | Certification of the Chief Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                               |       |
|                 |       |                                                                                                                                                        |       |
| 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. |       |

 

(b)           Reports on Form 8-K

 

Current Report on Form 8-K/ A dated November 30, 2005, regarding the resignation of  the Company’s independent registeredaccounting firm.

 

Current Report on Form 8-Kdated January 9, 2006, regarding the appointment of Brown & BrownLLP as the Company’s independent registered accounting firm.

 

Current Report on Form 8-Kdated January 11, 2006, regarding the appointment of the Company’s auditcommittee chair.

 

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SIGNATURES

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                    | Implant Sciences  Corporation |
|-------------------------|-------------------------------|
|                    |                          |
| Date: February 21, 2006 | /s/ Anthony J. Armini         |   |
|                    | Anthony J. Armini             |
|                    | President and CEO             |
|                    |                          |
| Date: February 21, 2006 | /s/ Diane J. Ryan             |   |
|                    | Diane J. Ryan                 |
|                    | Chief Financial Officer       |
|                         |                               |  |  |

 

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