**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

** **

**FORM 10-QSB**

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

 

**IMPLANT SCIENCES CORPORATION**

(Exact name of registrantas 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**        |
|                                                                                 |   |                                  |
| **781-246-0700**                                                                     |
| (Issuers telephone  number)                                                          |
|                                                                                 |
| **Not Applicable**                                                                   |
| (Former name, former  address and former fiscal year, if changed since last report.) |

 

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

YES     ý                NO o

 

Indicate the number of shares outstanding of eachof the issuer’s classes of common equity, as of the latest practicable date:

 
| **Class**                      |   | **Outstanding at April 30, 2003** |
|--------------------------------|--------|-----------------------------------|
| Common  Stock, $0.10 par value |   | 6,391,556                         |

 

Transitional smallbusiness disclosure format (check one):

YES     o                NO ý

 

 

----

 

**IMPLANT SCIENCES CORPORATION**

 

**INDEX**

 
| PART I.   FINANCIAL INFORMATION |                                                 |
|--------------------------------------|------------------------------------------------------|
|                                 |                                                 |   |   |
| **Item 1.**                          | Financial Statements:                                | 3 |
|                                 |                                                 |   |   |
|                                 |                                                 | Condensed  Balance Sheets as of March 31, 2003 (unaudited) and June 30, 2002 | 3 |
|                                 |                                                 |   |   |
|                                 |                                                 | Condensed Statements  of Operations for the Three and Nine Months Ended March 31, 2003 and 2002  (unaudited) | 4 |
|                                 |                                                 |   |   |
|                                 |                                                 | Condensed Statements  of Cash Flows for the Nine Months Ended March 31, 2003 and 2002 (unaudited) | 5 |
|                                 |                                                 |   |   |
|                                 |                                                 | Notes to  Condensed Financial Statements (including data applicable to unaudited periods) | 6 |
|                                 |                                                 |   |   |
| Item  2.                             |                                                 | Management’s  Discussion and Analysis of Financial Conditionand Results of Operations | 11 |
|                                 |                                                 |   |   |
| Item 3.                              |                                                 | Controls and Procedures | 16 |
|                                 |                                                 |   |   |
| PART II.  OTHER INFORMATION     | 18                                                   |
|                                 |                                                 |   |
| Item 1.                              | Legal Proceedings                                    | 18 |
|                                 |                                                 |   |
| Item  2.                             | Changes  in Securities and Use of Proceeds           | 18 |
|                                 |                                                 |   |
| Item 3.                              | Defaults Upon  Senior Securities                     | 18 |
|                                 |                                                 |   |
| Item  4.                             | Submission  of Matters to a Vote of Security-Holders | 18 |
|                                 |                                                 |   |
| Item 5.                              | Other Information                                    | 19 |
|                                 |                                                 |   |
| Item  6.                             | List  of Exhibits and Reports on Form 8-K            | 19 |
|                                 |                                                 |   |
|                                 | Signatures                                           | 20 |
|                                 |                                                 |   |
|                                 | Certifications                                       | 21 |

 

2

----

 

Item 1. Financial Statements

 

**IMPLANT SCIENCES CORPORATION**

**CONDENSEDBALANCE SHEETS**

 
|                                                                                                                                                                                                          |   | **March 31,  2003** |      | **June 30,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|-----------|--------------------|--------|
|                                                                                                                                                                                                          |   | **(Unaudited)**     |      |               |   |
| **ASSETS**                                                                                                                                                                                                    |   |                |      |               |   |
| Current Assets:                                                                                                                                                                                               |   |                |      |               |   |
| Cash and cash equivalents                                                                                                                                                                                     |   | $                   | 1,174,000 |               | $      | 1,014,000 |   |
| Accounts receivable, net                                                                                                                                                                                      |   | 765,000             |      | 916,000            |   |
| Inventories                                                                                                                                                                                                   |   | 676,000             |      | 452,000            |   |
| Investments - available for sale securities                                                                                                                                                                   |   | 62,000              |      | 105,000            |   |
| Prepaid and other current assets                                                                                                                                                                              |   | 113,000             |      | 101,000            |   |
| Total Current Assets                                                                                                                                                                                          |   | 2,790,000           |      | 2,588,000          |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| Property and equipment, net                                                                                                                                                                                   |   | 3,406,000           |      | 3,708,000          |   |
| Other non-current assets                                                                                                                                                                                      |   | 175,000             |      | 165,000            |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| Total Assets                                                                                                                                                                                                  |   | $                   | 6,371,000 |               | $      | 6,461,000 |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                |   |                |      |               |   |
| Current Liabilities:                                                                                                                                                                                          |   |                |      |               |   |
| Accounts payable                                                                                                                                                                                              |   | $                   | 692,000   |               | $      | 573,000 |   |
| Accrued expenses                                                                                                                                                                                              |   | 578,000             |      | 778,000            |   |
| Current maturities of long-term debt                                                                                                                                                                          |   | —              |      | 176,000            |   |
| Current maturities of obligations under capital  leases                                                                                                                                                       |   | 6,000               |      | 10,000             |   |
| Total Current Liabilities                                                                                                                                                                                     |   | 1,276,000           |      | 1,537,000          |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| Long-term Liabilities:                                                                                                                                                                                        |   |                |      |               |   |
| Long-term debt, net of current maturities                                                                                                                                                                     |   | —              |      | 59,000             |   |
| Obligations under capital lease, net of current  maturities                                                                                                                                                   |   | 12,000              |      | 16,000             |   |
| Deferred income taxes                                                                                                                                                                                         |   | 29,000              |      | 29,000             |   |
| Total Long-term Liabilities                                                                                                                                                                                   |   | 41,000              |      | 104,000            |   |
| Total Liabilities                                                                                                                                                                                             |   | 1,317,000           |      | 1,641,000          |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| 7% Series A Cumulative Convertible Preferred Stock;  $10 stated value; 5,000,000 shares authorized; 189,000 shares and no shares  issued and outstanding as of March 31, 2003 and June 30, 2002, respectively |   | 1,620,000           |      | —             |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| Stockholders’ equity:                                                                                                                                                                                    |   |                |      |               |   |
| Common stock, $0.10 par value; 20,000,000 shares  authorized; 6,311,556 and 6,236,080 shares issued and outstanding as of March  31, 2003 and June 30, 2002, respectively                                     |   | 632,000             |      | 620,000            |   |
| Additional paid-in capital                                                                                                                                                                                    |   | 14,847,000          |      | 13,630,000         |   |
| Accumulated deficit                                                                                                                                                                                           |   | (11,797,000         | )         | (9,328,000         | )      |
| Deferred compensation                                                                                                                                                                                         |   | (28,000             | )         | (9,000             | )      |
| Accumulated other comprehensive income                                                                                                                                                                        |   | 2,000               |      | 45,000             |   |
| Notes receivable from employees                                                                                                                                                                               |   | (222,000            | )         | (138,000           | )      |
| Total Stockholders’ Equity                                                                                                                                                                               |   | 3,434,000           |      | 4,820,000          |   |
|                                                                                                                                                                                                          |   |                |      |               |   |
| Total Liabilities and Stockholders’ Equity                                                                                                                                                               |   | $                   | 6,371,000 |               | $      | 6,461,000 |   |

 

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

 

3

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**IMPLANT SCIENCES CORPORATION**

**CONDENSED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                                                                                                                                            |   | **Three  Months Ended  March 31,** |       | **Nine Months  Ended  March 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|------------|-----------------------------------|--------|
|                                                                                                                                                                                            |   | **2003**                           |       | **2002**                          |   | **2003** |   | **2002** |   |
| Revenues:                                                                                                                                                                                       |   |                               |       |                              |   |   |   |   |   |
| Product and contract  research:                                                                                                                                                                 |   |                               |       |                              |   |   |   |   |   |
| Medical                                                                                                                                                                                         |   | $                                  | 1,067,000  |                              | $      | 1,399,000 |   | $ | 3,399,000 |   | $ | 3,584,000 |   |
| Semiconductor                                                                                                                                                                                   |   | 234,000                            |       | 209,000                           |   | 631,000 |   | 651,000 |   |
| Government Contracts                                                                                                                                                                            |   | 392,000                            |       | 187,000                           |   | 964,000 |   | 497,000 |   |
| Total revenues                                                                                                                                                                                  |   | 1,693,000                          |       | 1,795,000                         |   | 4,994,000 |   | 4,732,000 |   |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Cost of Sales:                                                                                                                                                                                  |   |                               |       |                              |   |   |   |   |   |
| Cost of medical and  semiconductor                                                                                                                                                              |   | 999,000                            |       | 1,419,000                         |   | 2,996,000 |   | 3,114,000 |   |
| Cost of government  contracts                                                                                                                                                                   |   | 459,000                            |       | 298,000                           |   | 988,000 |   | 577,000 |   |
| Total cost of sales                                                                                                                                                                             |   | 1,458,000                          |       | 1,717,000                         |   | 3,984,000 |   | 3,691,000 |   |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Gross Margin                                                                                                                                                                                    |   | 235,000                            |       | 78,000                            |   | 1,010,000 |   | 1,041,000 |   |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Operating Expenses:                                                                                                                                                                             |   |                               |       |                              |   |   |   |   |   |
| Research and development                                                                                                                                                                        |   | 389,000                            |       | 329,000                           |   | 1,257,000 |   | 878,000 |   |
| Selling, general and  administrative (includes$98,000  and $153,000 noncash charge for stock based compensation for the three and nine month period ended March 31, 2003 and 2002,respectively) |   | 608,000                            |       | 739,000                           |   | 1,762,000 |   | 1,742,000 |   |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Total operating expenses                                                                                                                                                                        |   | 997,000                            |       | 1,068,000                         |   | 3,019,000 |   | 2,620,000 |   |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Loss from operations                                                                                                                                                                            |   | (762,000                           | )          | (990,000                          | )      | (2,009,000 | ) | (1,579,000 | ) |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Other income (expense):                                                                                                                                                                         |   |                               |       |                              |   |   |   |   |   |
| Interest income                                                                                                                                                                                 |   | 6,000                              |       | 10,000                            |   | 21,000 |   | 23,000 |   |
| Interest expense                                                                                                                                                                                |   | (267,000                           | )          | (18,000                           | )      | (479,000 | ) | (36,000 | ) |
| Other expense                                                                                                                                                                                   |   | (2,000                             | )          | (2,000                            | )      | (2,000 | ) | 3,000 |   |
|                                                                                                                                                                                            |   | (263,000                           | )          | (10,000                           | )      | (460,000 | ) | (10,000 | ) |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Loss before provision for  income taxes                                                                                                                                                         |   | (1,025,000                         | )          | (1,000,000                        | )      | (2,469,000 | ) | (1,589,000 | ) |
| Provision for income taxes                                                                                                                                                                      |   | —                             |       | —                            |   | — |   | — |   |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Net loss                                                                                                                                                                                        |   | $                                  | (1,025,000 | )                                 | $      | (1,000,000 | ) | $ | (2,469,000 | ) | $ | (1,589,000 | ) |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Preferred distribution                                                                                                                                                                          |   | —                             |       | (530,000                          | )      | — |   | (530,000 | ) |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Net loss applicable to  common shareholders                                                                                                                                                     |   | $                                  | (1,025,000 | )                                 | $      | (1,530,000 | ) | $ | (2,469,000 | ) | $ | (2,119,000 | ) |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Net loss per share:                                                                                                                                                                             |   |                               |       |                              |   |   |   |   |   |
| Per share - basic and  diluted:                                                                                                                                                                 |   |                               |       |                              |   |   |   |   |   |
| Net loss                                                                                                                                                                                        |   | $                                  | (0.16      | )                                 | $      | (0.16 | ) | $ | (0.40 | ) | $ | (0.26 | ) |
| Preferred distribution                                                                                                                                                                          |   | —                             |       | (0.09                             | )      | — |   | (0.09 | ) |
| Net loss per share  applicable to common shareholders                                                                                                                                           |   | $                                  | (0.16      | )                                 | $      | (0.25 | ) | $ | (0.40 | ) | $ | (0.35 | ) |
|                                                                                                                                                                                            |   |                               |       |                              |   |   |   |   |   |
| Weighted average common  shares outstanding used for basic and diluted earnings per share                                                                                                       |   | 6,284,556                          |       | 6,190,237                         |   | 6,243,350 |   | 6,044,711 |   |

 

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

 

4

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDSTATEMENT OF CASH FLOWS**

**(Unaudited)**

 
|                                                                         |   | **Nine  Months Ended  March 31,** |       |
|------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                         |   | **2003**                          |       | **2002** |   |
|                                                                         |   |                              |       |   |   |
| **Cash flows from operating  activities**                                    |   |                              |       |   |   |
| Net loss                                                                     |   | $                                 | (2,469,000 | ) | $ | (1,589,000 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |   |                              |       |   |   |
| Depreciation and amortization                                                |   | 598,000                           |       | 579,000 |   |
| Amortization of discount on preferred stock                                  |   | 354,000                           |       |   |   |
| Interest expense - conversion to preferred stock                             |   | 71,000                            |       |   |   |
| Stock-based compensation                                                     |   | 149,000                           |       | 196,000 |   |
| Amortization of deferred compensation                                        |   | 4,000                             |       | — |   |
| Equity in loss in Epsilon Medical                                            |   | —                            |       | 2,000 |   |
| Changes in assets and liabilities:                                           |   |                              |       |   |   |
| Accounts receivable                                                          |   | 151,000                           |       | (102,000 | ) |
| Inventories                                                                  |   | (224,000                          | )          | (185,000 | ) |
| Prepaid and other current assets                                             |   | (12,000                           | )          | (5,000 | ) |
| Accounts payable                                                             |   | 119,000                           |       | 190,000 |   |
| Accrued expenses                                                             |   | (236,000                          | )          | 10,000 |   |
|                                                                         |   |                              |       |   |   |
| Net cash used in operating activities                                        |   | (1,495,000                        | )          | (904,000 | ) |
|                                                                         |   |                              |       |   |   |
| **Cash flows from investing  activities**                                    |   |                              |       |   |   |
| Purchase of property and equipment                                           |   | (255,000                          | )          | (753,000 | ) |
| Investment - available for sale securities                                   |   | —                            |       | (60,000 | ) |
| Other non-current assets                                                     |   | (51,000                           | )          | (35,000 | ) |
|                                                                         |   |                              |       |   |   |
| Net cash used in investing activities                                        |   | (306,000                          | )          | (848,000 | ) |
|                                                                         |   |                              |       |   |   |
| **Cash flows from financing  activities**                                    |   |                              |       |   |   |
| Proceeds from issuance of common stock                                       |   | 105,000                           |       | 2,280,000 |   |
| Proceeds from issuance of convertible preferred  stock                       |   | 2,099,000                         |       | — |   |
| Repayments of long-term debt                                                 |   | (243,000                          | )          | (115,000 | ) |
|                                                                         |   |                              |       |   |   |
| Net cash provided by financing activities                                    |   | 1,961,000                         |       | 2,165,000 |   |
|                                                                         |   |                              |       |   |   |
| Net increase in cash and cash equivalents                                    |   | 160,000                           |       | 413,000 |   |
| Cash and cash equivalents, beginning                                         |   | 1,014,000                         |       | 1,065,000 |   |
| Cash and cash equivalents, ending                                            |   | $                                 | 1,174,000  |   | $ | 1,478,000 |   |
|                                                                         |   |                              |       |   |   |
| **Supplemental disclosure of cash  flow information:**                       |   |                              |       |   |   |
| Interest paid                                                                |   | $                                 | 52,000     |   | $ | 26,000 |   |
| Obligations under capital lease                                              |   | —                            |       | 35,000 |   |
|                                                                         |   |                              |       |   |   |
| **Supplemental disclosure of noncash  financing activities:**                |   |                              |       |   |   |
| Issuance of Series A warrants                                                |   | 128,000                           |       | — |   |
| Noncash beneficial conversion feature                                        |   | 537,000                           |       | — |   |
| Stock options exercised through note receivable from  shareholder            |   | 84,000                            |       | — |   |

 

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

 

5

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**IMPLANTSCIENCES CORPORATION**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

**March31, 2003**

**(Unaudited)**

 

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

 

Implant Sciences Corporation develops products for themedical device and explosives detection industry using ion implantation andthin film coatings of radioactive and non-radioactive materials. We have beenselling our I-Plantä Iodine-125radioactive seed for the treatment of prostate cancer since August 2001 througha distributor. We also have under development, interventional cardiologydevices and temporary coronary brachytherapy systems for the prevention ofrestenosis (reclosure of the artery after balloon angioplasty). In addition, weprovide services to modify the surface characteristics of orthopedic jointimplants to reduce polyethylene wear and thereby increasing the life of theimplant and provide ion implantation of electronic dopants for thesemiconductor industry. Additionally, we are developing an explosives detectiondevice to be used in the detection of trace residues of explosives.

 

**2.**              **InterimFinancial Statements**

 

The financial information for the three and ninemonths ending March 31, 2003 is unaudited but includes all adjustments(consisting only of normal recurring adjustments) which we consider necessaryfor a fair presentation of the financial position at such date and of theoperating results and cash flows for these periods. The results of operationsand cash flows for the three and nine months ended March 31, 2003 are notnecessarily indicative of results that may be expected for the entire year. Theinformation contained in this Form 10-QSB should be read in conjunction withour audited financial statements, included in our Form 10-KSB/A No. 1 as of andfor the year ending June 30, 2002 filed with the Securities and ExchangeCommission.

 

**3.**              **New Accounting Standards**

 

In November 2002, the Financial Accounting StandardsBoard (FASB) issued Interpretation (FIN) No. 45, “Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others.” Among other things, the Interpretation requiresguarantors to recognize, at fair value, their obligations to stand ready toperform under certain guarantees. FIN 45 is effective for guarantees issued ormodified on or after January 1, 2003. The provisions of FIN 45 did not have aneffect on the Company’s financial position or results of operations

 

On December 31, 2002, the FASB issued Statement ofFinancial Accounting Standards (SFAS) No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123,“Accounting for Stock-Based Compensation,” to provide alternative methods oftransition to SFAS No. 123’s fair value method of accounting for stock-basedemployee compensation in the event companies adopt SFAS No. 123 and account forstock options under the fair value method. SFAS No. 148 also amends thedisclosure provisions of SFAS 123 and Accounting Principles Board (APB) OpinionNo. 28, “Interim Financial Reporting,” to require disclosure in the summary ofsignificant accounting policies of the effects of an entity’s accounting policywith respect to stock-based employee compensation on reported net income andearnings per share in annual and interim financial statements. While theStatement does not amend SFAS No. 123 to require companies to account foremployee stock options using the fair value method, the disclosure provisionsof SFAS No. 148 are applicable to all companies with stock-based employeecompensation, regardless of whether they account for that compensation usingthe fair value method of SFAS No. 23 or the intrinsic value method of APBOpinion No. 25, “Accounting for Stock Issued to Employees.” The Company hasadopted the disclosure requirements of SFAS No. 148 during the quarter endedMarch 31, 2003. The Company will continue to use the intrinsic value method ofaccounting for stock-based employee compensation. The additional disclosuresrequired by SFAS No. 148 are as follows:

 

6

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|                                                                                                                             |   | **Three Months Ended  March 31,** |       | **Nine Months Ended  March 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|----------------------------------|--------|
|                                                                                                                             |   | **2003**                          |       | **2002**                         |   | **2003** |   | **2002** |   |
|                                                                                                                             |   |                              |       |                             |   |   |   |   |   |
| Net loss  applicable to common stock holders, as reported                                                                        |   | $                                 | (1,025,000 | )                                | $      | (1,530,000 | ) | $ | (2,469,000 | ) | $ | (2,119,000 | ) |
|                                                                                                                             |   |                              |       |                             |   |   |   |   |   |
| Add: Stock-based  employee compensation expense included in reported net loss applicable to  common stockholders, net of tax     |   | —                            |       | —                           |   | — |   | — |   |
|                                                                                                                             |   |                              |       |                             |   |   |   |   |   |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method of all awards, net of tax |   | (250,000                          | )          | (33,000                          | )      | (480,000 | ) | (105,000 | ) |
|                                                                                                                             |   |                              |       |                             |   |   |   |   |   |
| Pro forma net  loss applicable to common stockholders                                                                            |   | (1,275,000                        | )          | (1,563,000                       | )      | (2,949,000 | ) | (2,224,000 | ) |
|                                                                                                                             |   |                              |       |                             |   |   |   |   |   |
| Net loss  applicable to common stockholders per basic and dilutive shares:                                                       |   |                              |       |                             |   |   |   |   |   |
|                                                                                                                             |   |                              |       |                             |   |   |   |   |   |
| As reported                                                                                                                      |   | (0.16                             | )          | (0.25                            | )      | (0.40 | ) | (0.35 | ) |
| Pro forma                                                                                                                        |   | (0.20                             | )          | (0.25                            | )      | (0.47 | ) | (0.37 | ) |
|                                                                                                                                  |        |                                   |            |                                  |        |  |  |  |  |  |  |  |  |

 

In January 2003, the FASB issued FIN No. 46, “Consolidation of VariableInterest Entities.” FIN 46’s consolidation criteria are based on analysis ofrisks and rewards, not control, and represent a significant and complexmodification of previous accounting principles. FIN 46 represents an accountingchange, not a change in the underlying economics of asset sales. FIN 46 iseffective for consolidated financial statements issued after June 30, 2003. TheCompany believes the adoption of FIN 46 will not have an effect on itsfinancial position or future results of operations.

 

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

 

Basic earnings per share are computed based only onthe weighted average number of common shares outstanding during the period.Diluted earnings per share is computed by using the weighted average number ofcommon shares outstanding during the period, plus the dilutive effects ofshares issuable through the exercise of stock options (common stockequivalents) unless their inclusion would be antidilutive.

 

**5.**              **Comprehensive Income (Loss)**

 

We have accumulated other comprehensive income (loss)resulting from the unrealized gain (loss) on an investment in marketable equitysecurities of CardioTech International, Inc. which is recorded in thestockholders’ equity section of the balance sheet (Note 9). Comprehensiveincome (loss) is summarized below:

 

|                              |   | **Three  Months Ended  March 31,** |       | **Nine  Months Ended  March 31,** |   |
|-----------------------------------|--------|------------------------------------|------------|-----------------------------------|--------|
|                              |   | **2003**                           |       | **2002**                          |   | **2003** |   | **2002** |   |
|                              |   |                               |       |                              |   |   |   |   |   |
| Net loss                          |   | $                                  | (1,025,000 | )                                 | $      | (1,000,000 | ) | $ | (2,464,000 | ) | $ | (1,589,000 | ) |
| Other comprehensive (loss) income |   | (19,000                            | )          | 17,000                            |   | (43,000 | ) | 17,000 |   |
|                              |   |                               |       |                              |   |   |   |   |   |
| Comprehensive loss                |   | $                                  | (1,044,000 | )                                 | $      | (983,000 | ) | $ | (2,512,000 | ) | $ | (1,572,000 | ) |

 

7

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

 

Contract revenue under cost sharing research anddevelopment agreements is recognized as eligible expenses are incurred. Invoicingof research and development contracts occurs in accordance with the terms ofthe contract. Revenue recognized but unbilled is recorded as unbilled accountsreceivable. At March 31, 2003, unbilled accounts receivable representedapproximately 6% of total accounts receivable. Generally, there are noprerequisites necessary to bill.

 

**7.**              **Credit Arrangement**

 

We had a term loan facility of $1,500,000, of which$750,000 was utilized at September 30, 2002. On October 7, 2002, we paid theremaining balance of principal and interest of approximately $192,000 inconnection with the Series A 7% Cumulative Convertible Preferred Stockfinancing and terminated the Term Loan (Note 8). The company currently does notmaintain a credit facility.

 

**8.**              **Equity Transactions**

 

On October 7, 2002, we issued 250,000 shares of SeriesA 7% Cumulative Convertible Preferred Stock (“Convertible Preferred Stock”)having a stated value of $10 per share, pursuant to a Securities PurchaseAgreement executed on October 7, 2002 with the Laurus Master Fund, Ltd. Wereceived $2,500,000 in gross proceeds, less a management and placement agentfee of approximately $300,000, and related transaction costs of approximately$101,000. The terms of the Convertible Preferred Stock provide for repayment ofoutstanding principal and accrued interest in either cash or with shares of ourcommon stock, at our option over a 14 month period beginning February 1, 2003.If we elect to convert into shares of our common stock, the common stock willbe valued at $5.19 per share. However, if the closing price of our common stockfor any of the 11 trading days prior to a repayment date is less than $5.70,the common stock will be valued at the greater of 83% of the average of thethree lowest closing prices during the 30 trading days immediately precedingthe repayment date or $2.02 and Laurus Master Fund Ltd. will be permitted toconvert such part of the monthly payment, up to the amount we elected to repayin shares of common stock. Any part of the monthly amount not converted intocommon stock shall be paid in cash on the following monthly repayment date. TheSecurities Purchase Agreement contains default covenants, including certainfinancial covenants. At March 31, 2003, we were not in compliance with the cashburn covenant, however, the agreement allows us to be out of compliance withthis financial covenant three times. We also granted the investor a securityinterest in substantially all of our assets. During the third quarter of 2003,we converted $168,113 of outstanding principal and $20,200 of accrued interestinto 71,000 shares of common stock in accordance with the terms of theagreement.  The conversion of interestinto common stock resulted in additional interest expense of $14,000 during thequarter, in excess of the 7% stated interest rate.

 

In connection with the issuance of the ConvertiblePreferred Stock, the investor received a warrant to purchase 55,000 shares ofour common stock. The common stock purchase warrant may be exercised at anytime and is valid for five years from the date of issuance at an exercise priceof $6.23 per share. The warrant was recorded as a discount from the preferredstock at its estimated fair value of $128,000.

 

In accordance with the provisions of Emerging IssuesTask Force (EITF) Issue No. 00-27, “Application of EITF Issue No. 98-5‘Accounting for Convertible Securities with Beneficial Conversion Features ofContingently Adjustable Conversion Ratios’, to Certain Convertible Securities”,which became effective in November 2000, the allocated value of the ConvertiblePreferred Stock contained a beneficial conversion feature calculated based onthe difference between the effective conversion price of the proceeds allocatedto the Convertible Preferred Stock and the fair market value of the commonstock at the date of issuance. The discount arising from the beneficial conversion feature aggregated$537,000. The discount is being charged to interest expense during the periodfrom the issuance of the Convertible Preferred Stock to the mandatoryredemption date of April 7, 2004. We recognized $42,000 and $83,000 ofdividends as interest expense for the three and nine months ended March 31,2003, respectively.

 

We valued the Convertible Preferred Stock at issuanceto be $1,434,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe discount on the beneficial conversion. The amounts recorded in theaccompanying condensed financial statements at March 31, 2003, represent theamounts attributed to the sale of the Convertible Preferred Stock, net cashproceeds of $2,099,000 ($401,000 of issuance costs incurred), amount allocatedto warrants of $128,000, and the amount of the discount related to the value ofbeneficial conversion feature of $537,000. We are accreting these discounts onthe carrying value of the preferred stock to its redemption value of $2,500,000at April 7, 2004.

 

Additionally, we were required to make payments eitherin cash or stock, on a monthly basis. We did not make the monthly cash payments.  However, on May 19, 2003, we received a waiver for defaultamounts totaling $189,000 at March 31, 2003. During the three months ended March 31, 2003, Laurus redeemedapproximately 17,000 shares of Convertible Preferred Stock into 61,000 of theCompany’s stock at conversion prices ranging from $2.02 to $3.30 pershare..  As of March 31, 2003, theprincipal balance outstanding of the Convertible Preferred Stock isapproximately $2,300,000.

 

8

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We utilized approximately $192,000 of the proceeds torepay the outstanding Term Loan to Citizens Bank on October 7, 2002 and we willutilize the remaining proceeds to commercialize our explosives detectionsystem, purchase certain equipment to expand our semiconductor business, andfor general working capital purposes.

 

During the three and nine months ended March 31, 2003,the Company granted 4,300 and 54,300 nonqualified stock options, respectively,to purchase common stock to a consultant in exchange for services. The Companyaccounts for stock-based compensation issued to non-employees in accordancewith the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”and EITF No. 96-18, “Accounting for Equity Instruments That Are Issued to OtherThan Employees for Acquiring, or in Conjunction with Selling, Goods orServices.” The Company recorded approximately $8,100 and $66,300 in expensesassociated with the issuance of options to consultants for the three and ninemonths ended March 31, 2003. The Company estimated the fair value of thenonqualified stock options using the Black-Scholes option-pricing model. TheCompany estimated the fair value of the nonqualified stock options granted tonon-employees, during the three and nine month period ended March 31, 2003,using the following input assumptions:

 

| Volatility               |   | 57.5% - 63.6% |   |
|--------------------------|--------|---------------|--------|
| Dividend yield           |   | 0%            |   |
| Risk-free  interest rate |   | 3.65% - 4.05% |   |
| Expected lives           |   | 10 years      |   |

 

In addition, the Company granted 100,000 warrants topurchase common stock to other consultants in exchange for services, during thethree and nine months ended March 31, 2003. The Company recorded approximately$90,000 in expense associated with the issuance of options to consultants forthe three and nine months ended March 31, 2003. The Company estimated the fairvalue of the common stock warrants using the Black-Scholes option-pricingmodel. The Company estimated the fair value of the warrants using the followinginput assumptions:

 

| Volatility              |   | 63.6%   |   |
|-------------------------|--------|---------|--------|
| Dividend yield          |   | 0%      |   |
| Risk-free interest rate |   | 3.60%   |   |
| Expected lives          |   | 5 years |   |

 

On April 15, 2003, the Company extended the expiration date of certainwarrants to purchase 1,279,100 shares of common stock issued in connection withthe Company's IPO (IPO Warrants). The expiration date was extended from June30, 2003 to June 30, 2005. The Company did not receive any consideration fromthe holders of the warrants, and will recognize this transaction as a preferreddistribution during the forth quarter ending June 30, 2003, based upon theestimated fair value of the extension of approximately $269,000.

 

**9.**              **Related Party Transactions**

 

SFAS No. 57, “Related Party Disclosures,” specifiesthe nature of information that should be disclosed in financial statementsregarding related party transactions. CardioTech International, Inc.(CardioTech) a public company, is a related party with us by virtue of itssignificant business relationships. CardioTech is a publicly traded companywhose common stock trades under the symbol CTE on the American Stock Exchange.

 

Certain of our directors hold positions as directorsof CardioTech. Our Chief Executive Officer (CEO) and Chairman of the Board ofDirectors is also a director of CardioTech. The CEO and Chairman of the Boardof Directors of CardioTech is also a director in our company and chairman ofthe Audit Committee.

 

In March 2000, we entered into a joint researchagreement with CardioTech to develop a proprietary porous polymer biocompatiblecoating technology as a platform for our proprietary radioactive brachytherapytechnology. Through March 31, 2003 we paid CardioTech $115,000 pursuant to theaforementioned agreement. Additionally, we acquired 60,000 shares of the commonstock of CardioTech at a price of $1.00 per share. We

 

9

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have also accrued $35,000 as of March 31, 2003 for the final paymentdue in connection with this agreement and we are currently obligated topurchase an additional 40,000 shares of CardioTech’s common stock at $1.00 pershare. As of March 31, 2003, the fair market value of the CardioTech sharesheld as investment in available for sale securities is approximately $62,000.

 

Accountsreceivable from related parties as of March 31, 2003 consisted of a loan of$138,000 to our CEO and a loan of $84,000 to an employee. The loan to our CEOwas used to exercise options for 50,000 shares of our common stock on December9, 1997. The loan is due and payable upon the earlier of the disposal of the50,000 shares or December 9, 2003 at an interest rate of 6% per annum. The loanto an employee was used to exercise options for 20,000 shares of our commonstock on November 15, 2002. The loan is due and payable on November 15, 2005and bears interest at the rate of 3% per annum. These transactions werereported as a reduction of stockholders’ equity.

 

10

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**Item 2.****           Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

The following management discussion and analysisshould be read in conjunction with the financial statements and notes theretoas filed in the Company’s Form 10-KSB/A No. 1 for the year ended June 30, 2002.In addition to historical information, this Form 10-QSB containsforward-looking statements. The forward-looking statements are subject tocertain risks and uncertainties that could cause actual results to differmaterially from those reflected in such forward-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. The Companyundertakes no obligation to revise or publicly release the results of anyrevision to these forward-looking statements. Readers should carefully reviewdocuments that the Company files from time to time with the Securities andExchange Commission, including the Company’s Quarterly Reports and AnnualReports filed by the Company in fiscal 2002 and 2003.

** **

**Resultsof Operations**

* *

*Comparison for the three monthsended March 31 2003 and 2002*

* *

*Revenues.*Total revenues for the three months ended March 31, 2003 were$1,693,000 as compared to $1,795,000 for the comparable prior year period, adecrease of $102,000 or 6%. The decrease is primarily attributable to decreasesin revenues from prostate seed sales and medical and industrial coatings sales.This decrease is offset in part by the revenue recognized from new governmentcontracts to develop new applications and products using our Laser Ion MobilitySpectrometry (“IMS”) technology. Our Laser IMS technology is the platformtechnology used in our explosives detection devices. Government contractsrevenues increased by $205,000 or 110% for the quarter ended March 31, 2003 ascompared with the same period last year. I-Plant prostate seed sales for thethree months ended March 31, 2003 were approximately $623,000 as compared to$833,000 for the comparable prior year period, a decrease of $210,000 or 25%.The decrease in prostate seed revenues was due to expected downward pricingpressure, which has been experienced throughout the industry, leading to areduction in our price per seed. Management believes this trend of downwardpricing pressures may continue. We also experienced a 12% decrease in thevolume of seeds sold as a result of competitive market forces, price wars,ongoing consolidation and changes in seed reimbursement by insurance companies.In the fourth quarter of fiscal 2003, management hired a new director ofnational sales in order to open new channels of distribution for sales of ourprostate seeds and to assist our current distributors in growing the volume ofseeds sold. Revenues from medical and industrial coatings for the three monthsended March 31, 2003 were $438,000 as compared to $567,000 for the comparableprior year period, a decrease of $129,000 or 23%. The decrease in revenues frommedical coatings is due primarily to an $86,000 decrease in industrial coatingsales resulting from certain customers pursuing different product processes notrequiring radiopacity and the completion of a sizeable development program fora customer. In addition, we experienced a 10% decrease in sales to our majormedical coating customer as a result of the relocation of the same customer’smanufacturing division, which was completed by the end of March 2003. Revenuesfrom semiconductors for the three months ended March 31, 2003 were $234,000 ascompared to $209,000 for the comparable prior year period, an increase of$25,000 or 12%. The increase was primarily attributable to an increase insemiconductor production jobs and the addition of new customers who requireoutsourced ion implantation services for research and development activities.We believe that fluctuations in sales in our semiconductor business fromquarter-to-quarter are normal occurrences, however we do believe that moderategrowth will continue to be achieved. Less than 5% of all revenues were derivedfrom foreign sources.

 

Combined sales to our two major customers, the Howmedica/OsteonicsDivision of Stryker Corporation and MED-TEC Iowa, our distributor of prostateseeds, accounted for 61% and 71% of revenue for the three months ended March31, 2003 and 2002, respectively. Our government contract and grant revenue accountedfor 23% and 10% of revenue for the three months ended March 31, 2003 and 2002,respectively. Government contract and grant revenue as a percentage of totalrevenues increased as a result of our receiving several new grants andcontracts, primarily related to our Laser IMS technology. Grant revenues,principally Small Business Innovative Research (SBIR) programs, fluctuate dueto: (a) our desire to obtain external funding for its research and developmentefforts; (b) the availability of government funding; and (c) the time requiredto obtain approval of a grant application. We have been successful in obtainingSBIR grants in fiscal 2003 and 2002 and expect to continue to seek continuationor replacement of our existing SBIR grants during the remainder of fiscal 2003and beyond.

* *

*Costof Sales*. Cost of sales for the three months ended March 31,2003 were $1,458,000 as compared to $1,717,000 for the comparable prior yearperiod resulting in a decrease of $259,000 or 15%. This decrease is, ingeneral, attributable to decreased labor and benefit expenses resulting from areduction of the workforce and

 

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reduction of costs relating to prostate seed manufacturing. As apercentage of revenues, the cost of medical and semiconductor revenuesdecreased to 77% for the three months ended March 31, 2003 as compared to 88%for the comparable prior year period. The decrease in costs in medical andsemiconductor revenues as a percentage of revenues is attributable to (a) highersales volume in the semiconductor business, which has a high fixed cost for theion implantation process, and (b) a reduction of labor in the manufacturingarea. Management is evaluating and implementing strategies to improve the costof materials to produce prostate seeds, developing new products related to thedelivery of seeds in prostate procedures, and assessing additional channels ofdistribution that could increase seed sales volume. During fiscal 2003 and2002, we utilized SBIR grants as a significant source of funding for ourresearch and development efforts. We will continue to use SBIR grants as asource of funding for our research and development efforts in fiscal 2003. Ourobligation with respect to these grants is to perform the research on abest-efforts basis. Periodically, we may continue our research and developmentefforts related to these projects at our own expense. This cost is consideredcompany-funded research and development.

* *

*Researchand Development*. Research and development expense for thethree months ended March 31, 2003 was $389,000 as compared to $329,000 for thecomparable prior year period, resulting in an increase of $60,000 or 18%. Thisincrease is a result of continued development work in the areas of explosivesand toxic substance detection, temporary brachytherapy and radioactive prostateseed product compliments. Costs incurred in connection with our explosives andtoxic substance detection device was approximately $72,000 for the three monthsended March 31, 2003 as compared to $21,000 for the comparable prior yearperiod. We anticipate increases in future expenditures resulting from these andnew product development plans.

* *

*Selling,General and Administrative*. Selling, general andadministrative expenses for the three months ended March 31, 2003 were $608,000as compared to $739,000 for the comparable prior year period, resulting in adecrease of $131,000 or 18%. Selling, general and administrative expensesincluded $98,000 and $196,000 of noncash stock based compensation recorded inconnection with the issuance of stock options to a consultant and warrants tooutside agents in the three months ended March 31, 2003 and 2002, respectively.Net of the noncash stock based compensation, selling, general and administrativeexpenses decreased by $34,000 or 7%. This decrease reflects management’scontinued exercise of strict cost containment measures to ensure control overour administrative spending.

* *

*OtherExpense, Net.* For the three month period ended March 31,2003, we recorded other expense, net, of $263,000 as compared to other expense,net, of $10,000 for the comparable prior year period, an increase of $253,000.The increase in other expense, net, is primarily attributable to the accretionof discounts being charged to interest expense on the preferred stock financing(See Note 8 to the condensed financial statements) in the amount of $256,000.

* *

*NetLoss.* Net loss for the three month period ended March 31,2003 was $1,025,000 as compared to $1,000,000 for the comparable prior yearperiod, an increase in net loss of $25,000. This increase in net loss isprimarily a result of the accretion of discounts being charged to interestexpense on the preferred stock financing, combined with our continued researchin connection with our efforts to commercialize our new explosives detectiondevice and develop new applications using our Laser IMS technology.

 

The Company’s earnings before interest, taxes,depreciation, amortization and stock based compensation (“Adjusted EBITDA”) forthe three months ended March 31, 2003 were a negative Adjusted EBITDA of$476,000 as compared to a negative Adjusted EBITDA of $597,000 for thecomparable prior year period, an improvement in Adjusted EBITDA of $121,000 or20%. The Company calculated Adjusted EBITDA by adding depreciation,amortization and stock based compensation of $286,000 and $393,000 to the lossfrom operations of $762,000 and $990,000 for the three month period ended March31, 2003 and 2002, respectively. Adjusted EBITDA is not comparable to earningsdetermined in accordance with accounting principals generally accepted in theUnited States of America. Accordingly, Adjusted EBITDA as determined by theCompany may not be comparable to similarly titled measures reported by othercompanies. We believe that this computation is useful in analyzing operatingperformance, but should be used only in conjunction with results reported inaccordance with generally accepted accounting principles. This improvement inAdjusted EBITDA primarily reflects cost containment measures implemented by theCompany.

 

The basic and diluted net loss per share for the threemonths ended March 31, 2003 was $0.16 per share and equal to that of thecomparable prior year period.

 

12

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*Comparison for the nine months endedMarch 3, 2003 and 2002*

* *

*Revenues.*Total revenues for the nine months ended March 31, 2003 were$4,994,000 as compared to $4,732,000 for the comparable prior year period, anincrease of $262,000 or 6%. The increase is primarily attributable to revenuerecognized from new government contracts to develop new applications andproducts using our Laser IMS technology. Our Laser IMS technology is theplatform technology used in our explosives detection devices. Governmentcontracts revenues increased by $467,000 or 94% as compared with the sameperiod last year. Sales of the I-PlantTM prostate seed decreased by$38,000 or 2% as compared with the comparable prior year period. While thevolume of seeds sold increased by 11%, the revenue per seed declined as aresult of the industry-wide competitive downward pricing pressures. Managementbelieves the volume of prostate seed sales will maintain a trend of stronggrowth, but the severe pricing pressure throughout the industry may have anegative effect on seed revenue. Revenues from medical and industrial coatingsfor the nine months ended March 31, 2003 were $1,406,000 as compared to$1,553,000 for the comparable prior year period, a decrease of $147,000 or 10%.The decrease in revenues from coatings is due to a $160,000 decrease inindustrial coating sales resulting from certain customers pursuing differentproduct processes not requiring radiopacity. This decrease was offset by a$12,000, or 1%, increase in sales to our major medical coating customer.Revenues from semiconductors for the nine months ended March 31, 2003 were$631,000 as compared to $647,000 for the comparable prior year period, adecrease of $15,000 or 2%. The decrease was attributable to a reduction insales for one customer. This decrease in semiconductor sales was offset by a$100,000 increase in new semiconductor production jobs and the addition of newcustomers who require outsourced ion implantation services for research anddevelopment activities. We believe that fluctuations in sales in oursemiconductor business from quarter-to-quarter are normal occurrences, however,we do believe that moderate growth will continue to be achieved. Less than 5%of all revenues were derived from foreign sources.

 

Combined sales to our two major customers, theHowmedica/Osteonics Division of Stryker Corporation and MED-TEC Iowa, ourdistributor of prostate seeds, accounted for 64% and 68% of revenue for thenine months ended March 31, 2003 and 2002. Our government contract and grantrevenue accounted for 19% and 10% of revenue for the nine months ended March31, 2003 and 2002, respectively. Government contract and grant revenue as apercentage of total revenues increased as a result of our receiving several newgrants and contracts, primarily related to our Laser IMS technology. Grantrevenues, principally Small Business Innovative Research (SBIR) programs,fluctuate due to: (a) our desire to obtain external funding for its researchand development efforts; (b) the availability of government funding; and (c)the time required to obtain approval of a grant application. We have beensuccessful in obtaining SBIR grants in fiscal 2003 and 2002 and expect tocontinue to seek continuation or replacement of its existing SBIR grants duringthe remainder of fiscal 2003 and beyond.

* *

*Costof Sales*. Cost of sales for the nine months ended March 31,2003 were $3,984,000 as compared to $3,691,000 for the comparable prior yearperiod, an increase of $293,000 or 11%. The increase in cost of sales isattributable to the increased expenses related to the performance of governmentcontracts. As a percentage of revenues, the cost of medical and semiconductorrevenue remained at 74% for the nine months ended March 31, 2003 and thecomparable prior year period. Management continues to evaluate and implementstrategies to improve the cost of materials to produce prostate seeds, developnew products related to the delivery of seeds in prostate procedures, andassess additional channels of distribution that could increase seed salesvolume. During fiscal 2003 and 2002, we utilized SBIR grants as a significantsource of funding for our research and development efforts. We will continue touse SBIR grants as a source of funding for our research and development effortsin fiscal 2003. Our obligation with respect to these grants is to perform theresearch on a best-efforts basis. Periodically, we may continue our researchand development efforts related to these projects at its own expense. This costis considered company-funded research and development.

* *

*Researchand Development*. Research and development expense for thenine months ended March 31, 2003 was $1,257,000 as compared to $878,000 for thecomparable prior year period, an increase of $379,000 or 43%. This increase isa result of continued development work in the areas of explosives and toxicsubstance detection, temporary brachytherapy and radioactive prostate seedproduct compliments. Costs incurred in connection with our explosives and toxicsubstance detection device was approximately $328,000 for the nine months endedMarch 31, 2003 as compared to $46,000 for the comparable prior year period. Weanticipate increases in future expenditures resulting from these and newproduct development plans.

 

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*Selling**, Generaland Administrative*. Selling, general and administrative expenses forthe nine months ended March 31, 2003 were $1,762,000 as compared to $1,742,000for the comparable prior year period, an increase of $20,000 or 1%. Selling,general and administrative expenses included $149,000 and $196,000 of noncashstock based compensation recorded in connection with the issuance of stockoptions to a consultant and warrants to outside agents, in the nine monthsended March 31, 2003 and 2002 respectively. Net of the noncash stock basedcompensation, selling, general and administrative expenses increased by $63,000or 4%. This increase reflects our addition of certain administrative personnelnecessary to support our continued growth and investor relations costs.However, management continues to exercise strict cost containment measures toensure control over our administrative spending.

* *

*OtherExpense, Net.* For the nine month period ended March 31, 2003,we recorded other expense, net, of $460,000, as compared to other expense, netof $10,000 for the comparable prior year period, an increase of $450,000. Theincrease in other expense, net, is attributable to the accretion of discountsbeing charged to interest expense on the preferred stock financing (See Note 8to condensed financial statements), in the amount of $457,000.

* *

*NetLoss.* Net loss for the nine month period ended March 31, 2003was $2,469,000 as compared to $1,589,000 for the comparable prior year period,an increase in net loss of $880,000 or 55%.

 

The Company’s earnings before interest, taxes,depreciation, amortization and stock based compensation (“Adjusted EBITDA”) forthe nine months ended March 31, 2003 were a negative Adjusted EBITDA of$1,259,000 as compared to a negative Adjusted EBITDA of $804,000 for thecomparable prior year period, an increase in negative Adjusted EBITDA of$455,000 or 57%. The Company calculated Adjusted EBITDA by adding depreciation,amortization and stock based compensation of $750,000 and $775,000 to the lossfrom operations of $2,009,000 and $1,579,000 for the nine month period endedMarch 31, 2003 and 2002, respectively. Adjusted EBITDA is not comparable toearnings determined in accordance with generally accepted accountingprinciples. Accordingly, Adjusted EBITDA as determined by the Company may notbe comparable to similarly titled measures reported by other companies. Webelieve that this computation is useful in analyzing operating performance, butshould be used only in conjunction with results reported in accordance withgenerally accepted accounting principles.

 

The basic and diluted net loss per share for the ninemonths ended March 31, 2003 was $0.40 per share as compared to $0.26 per sharefor the comparable prior year period, a decrease in net loss of $0.14 or 54%.

 

**Liquidity and Capital Resources**

 

As of March 31,2003, we had approximately $1,174,000 in cash in the form of cash andshort-term investments. During the nine months ended March 31, 2003, operatingactivities used cash of approximately $1,495,000. Net cash used by operatingactivities primarily reflects the $2,469,000 net loss, a $224,000 increase ininventory, and a $200,000 increase in accrued expenses; offset by a $151,000decrease in accounts receivable, a $119,000 increase in accounts payable,$149,000 fair value of stock-based compensation, $338,000 of amortization ofdiscount on preferred stock and $598,000 of depreciation and amortization.During the nine months ended March 31, 2003, investing activities used cash ofapproximately $306,000, which was primarily attributable to $255,000 used inthe purchase of property and equipment. During the nine months ended March 31,2003, financing activities provided approximately $1,961,000 in cash. Net cashprovided by financing activities is primarily attributable to the privateplacement of the Series A 7% Cumulative Convertible Preferred Stock, whichprovided $2,099,000, net of management and transaction fees of $401,000; andthe exercise of $105,000 of common stock options. This was offset by therepayment of $243,000 in long-term debt and capital lease obligations.

 

On October 7, 2002, we issued 250,000 shares of SeriesA 7% Cumulative Convertible Preferred Stock having a stated value of $10 pershare, pursuant to a Securities Purchase Agreement executed on October 7, 2002with the Laurus Master Fund, Ltd. We received $2,500,000 in gross proceeds,less a management and placement agent fee of approximately $300,000, andrelated transaction costs of approximately $101,000. The terms of the Series A7% Cumulative Convertible Preferred Stock provide for repayment in cash or withshares of our common stock beginning February 1, 2003. If we elect to convertinto shares of our common stock, the common stock will be valued at $5.19 pershare. However, if the closing price of our common stock for any of the 11trading days prior to a monthly repayment date is less than $5.70, the commonstock will be valued at the greater of 83% of the average of the three lowestclosing prices during the 30 trading days immediately preceding the repaymentdate or $2.02 and Laurus Master Fund, Ltd. will be permitted to convert suchpart of the monthly payment, up to the amount we elected to repay in shares ofcommon stock.  Any part of the monthlyamount not converted into common stock shall be paid in cash on the followingmonthly repayment date. The Securities Purchase Agreement contains defaultcovenants, including certain financial covenants. At March 31,2003 we were notin compliance with the cash burn covenant, however, the agreement allows us tobe out of compliance with this financial covenant three times. We also issuedto Laurus Master Fund, Ltd. a common stock purchase warrant to purchase 55,000shares of our common stock 

 

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at $6.23 per share and granted them a security interest insubstantially all of our assets. During the third quarter of 2003, we converted$168,113 of outstanding principal and $20,200 of accrued interest into 71,000shares of common stock in accordance with the terms of the agreement.  The conversion of interest into common stockresulted in additional interest expense of $14,000 during the quarter, inexcess of the 7% stated interest rate. We utilized approximately $192,000 ofthe proceeds to repay the outstanding Term Loan to Citizens Bank on October 7,2002 and we will utilize the remaining proceeds to commercialize our explosivesdetection system, purchase certain equipment to expand our semiconductorbusiness, and for general working capital purposes.

 

In connection with the issuance of the Series Aconvertible preferred stock, the investor received a warrant to purchase 55,000shares of our common stock. The common stock purchase warrant may be exercisedat any time and is valid for five years from the date of issuance at anexercise price of $6.23 per share. In connection with the above, we granted theinvestor a security interest in substantially all of our assets. The warrantwas recorded as a discount from the preferred stock at its estimated fair valueof $128,000.

 

In accordance with the provisions of Emerging IssuesTask Force (EITF) Issue 00-27, “Application of EITF Issue No. 98-5 ‘Accountingfor Convertible Securities with Beneficial Conversion Features of ContingentlyAdjustable Conversion Ratios’, to Certain Convertible Securities”, which becameeffective in November 2000, the allocated value of the Series A convertiblepreferred stock contained a beneficial conversion feature calculated based onthe difference between the effective conversion price of the proceeds allocatedto the Series A convertible preferred stock and the fair market value of thecommon stock at the date of issuance. The discount arising from the beneficial conversion feature aggregated$537,000. The discount is being charged to interest expense during the periodfrom the issuance of the preferred stock to the mandatory redemption date ofApril 7, 2004.

 

We valued the Series A Preferred Stock at issuance tobe $1,434,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature. The amounts recorded in our financialstatements represents the amounts attributed to the sale of the preferredstock, net cash proceeds of $2,099,000 ($401,000 of issuance costs incurred),amount allocated to warrants of $25,000, and the amount of the discount relatedto the value of beneficial conversion feature of $537,000. We are accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,500,000 at April 7, 2004.

 

Additionally, we were required to make payments eitherin cash or stock, on a monthly basis. We did not make the monthly cash payments.  However, on May 19, 2003, we received a waiver for defaultamounts totaling $189,000 at March 31, 2003. During the three months ended March 31, 2003, Laurus redeemedapproximately 17,000 shares of Convertible Preferred Stock into 61,000 of theCompany’s stock at conversion prices ranging from $2.02 to $3.30 pershare.  As of March 31, 2003, theprincipal balance outstanding of the Convertible Preferred Stock isapproximately $2,300,000.

 

We had a term loan facility of $1,500,000 of which$750,000 was utilized at September 30, 2002. On October 7, 2002, we paid theremaining balance of principal and interest of approximately $192,000 inconnection with the Series A 7% Cumulative convertible Preferred Stockfinancing and terminated the Term Loan. The term loan facility is no longeravailable.

 

We are developing several explosive detection systemsthat could be used in airports, public and government buildings, and sportingevent facilities. The systems use our proprietary Laser IMS technology, whichincludes the use of laser beams in combination with ion mobility spectrometry,to electronically detect minute quantities of explosive vapor molecules in theair. This project has been ongoing since approximately May 1999. In November2001, we developed a portable prototype and in December 2001 we demonstrated itto an independent third party. Following this demonstration, we decided topursue the technology. At present, we are developing both portable andbench-top systems for use in airports and Department of Defense facilities.Prototype units have been transported to the Department of Defense andDepartment of Transportation facilities for demonstration and evaluation.

 

This project is currently being undertaken by both ourinternal scientists and certain outside contractors. The development of newapplications is typically funded through government grants or internal funding.Originally, we funded a research and development program for the electronicdetection system to produce enough data to write grant proposals for theDepartment of Defense to detect unexploded bombs and mines. Since March 2000,we have received six contracts totaling $1,538,000 for detection of toxicchemicals or explosives from agencies such as the Departments of the Army, AirForce and Navy; as well as the National Institute of Health. On August 12,2002, we signed a Cooperative Research and Development Agreement with an agencyof the Department of Transportation which will permit us and the government toexchange critical test data and for us to deliver a certain number of units tothe Department of Transportation for independent evaluation and field testing.

 

In June 2000, we developed our first generationdevice, which demonstrated sensitivity to the explosive TNT. In June 2001, wedeveloped a second generation prototype with increased sensitivity andselectivity. This device can detect and specify an increasing number ofcompounds within various explosive materials. The explosives that have beentested to date are TNT, RDX, PETN, EGDN, and DNT. RDX is the primary componentof C3 and C4 explosives, such as Datasheet and Semtex, as well as certain typesof black powder explosives. We

 

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believe these explosives represent the majority of the explosivespresently used in terrorist activities. After the attack on the World TradeCenter occurred on September 11, 2001, management made the decision to continuethe internal funding of the project rather than await funding through governmentgrants. In December 2001, we successfully demonstrated our working prototype ofthe electronic detection system to several third parties. Our electronicdetection system has been subjected to controlled testing by third parties andsuccessfully detected C4. As a result of the successful demonstration, webelieved it was appropriate to further pursue the commercial development of ourelectronic detection system device.

 

Consistent with our policy to protect our proprietarytechnologies, we have submitted seven patent applications to the United StatesPatent and Trademark Office. These patent applications will cover specificdesign configurations that are responsible for our improved vapor detectionsensitivity.

 

We are developing several versions of our explosivesdetection systems, including: i) a table-top unit, which can be used to screenpassengers and carry-on baggage in airports; and ii) a portable system, whichcan be used to replace bomb-sniffing dogs to clear buildings, aircrafts, orships where hidden bombs are believed to exist. We plan to first market thesesystems to U.S. government agencies for use in airports, government buildingsand facilities.

 

Although our operations and spending continue to focuson the sales of our semiconductor, medical coatings and prostate seed products,we are currently expending significant resources in the development of ourexplosives detection devices. We continue to fund as much research anddevelopment as possible through government grants in accordance with theprovisions of the respective grant awards. We will require additional fundingin order to advance the commercial development of the explosives detectionsystem. We will attempt to obtain such financing by: (i) government grants,(ii) the exercise of the redeemable common stock purchase warrants, (iii)private financing, or (iv) strategic partnerships. However, there can be noassurance that we will be successful in our attempts to raise such additionalfinancing.

 

We will require substantial funds for further researchand development, future pre-clinical and clinical trials, regulatory approvals,continued expansion of commercial-scale manufacturing capabilities, and themarketing of our products. Our capital requirements depend on numerous factors,including but not limited to, the progress of our research and developmentprograms; the progress of pre-clinical and clinical testing; the time and costsinvolved in obtaining regulatory approvals; the cost of filing, prosecuting,defending and enforcing any intellectual property rights; competingtechnological and market developments; changes in our development ofcommercialization activities and arrangements; and the purchase of additionalfacilities and capital equipment.

 

As of March 31, 2003 we were conducting our operationswith approximately $1,174,000 in cash. We estimate such amounts combined withour cash flow from operations will be sufficient to fund our working capital inthe next twelve months. Future expenditures for research and product development,especially relating to outside testing and clinical trials, are discretionaryand, accordingly, can be adjusted, as can certain selling, general andadministrative expenses, based on the availability of cash.

* *

*Critical Accounting Policies*

 

Our significant accounting policies are described inNote 1 to the financial statements included in Item 7 of our Form 10-KSB/A No.1 as of June 30, 2002. Our discussion and analysis of our financial conditionand results of operations are based upon the financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of assets, liabilities,revenues and expenses, and related disclosure of contingent assets andliabilities. On an on-going basis, we evaluate our estimates, including thoserelated to bad debts, product returns, inventories, investments, intangibleassets and warranty obligations. We base our estimates on historical experienceand on various other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. In the past, actual results have not been materiallydifferent from our estimates. However, results may differ from these estimatesunder different assumptions or conditions. There has been no change to ourcritical accounting policies through the quarter ending March 31, 2003.

** **

**Item 3.    Controlsand Procedures**

 

“Disclosure controls andprocedures” are controls and other procedures designed to ensure that we timelyrecord, process, summarize and report the information that we are required todisclose in the reports that we file or submit with the SEC. These includecontrols and procedures designed to ensure that such information is

 

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accumulated and communicated to our management, including our Presidentand Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure.

 

As required under theSarbanes-Oxley Act of 2002, our President and Chief Financial Officer conducteda review of our disclosure controls and procedures as of a date within 90 daysof the date of this report. They concluded, as of the evaluation date, that ourdisclosure controls and procedures are effective. We have made no significantchanges since the evaluation date to our internal controls relating toaccounting and financial reporting.

 

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PART II: OTHERINFORMATION

 

Item 1. LegalProceedings

 

Not Applicable

 

Item 2. Changes in Securities and Use of Proceeds

 

On October 7, 2002, weissued 250,000 shares of Series A 7% Cumulative Convertible Preferred Stock(“Convertible Preferred Stock”) having a stated value of $10 per share,pursuant to a Securities Purchase Agreement executed on October 7, 2002 withthe Laurus Master Fund, Ltd. We received $2,500,000 in gross proceeds, less amanagement and placement agent fee of approximately $300,000, and relatedtransaction costs of approximately $101,000. The terms of the Series A 7%Cumulative Convertible Preferred Stock provide for repayment in cash or withshares of our common stock beginning February 1, 2003. If we elect to convertinto shares of our common stock, the common stock will be valued at $5.19 pershare. However, if the closing price of our common stock for any of the 11trading days prior to a repayment date is less than $5.70, the common stockwill be valued at the greater of 83% of the average of the three lowest closingprices during the 30 trading days immediately preceding the repayment date or$2.02. The Securities Purchase Agreement contains default covenants, includingcertain financial covenants. We also issued to Laurus Master Fund, Ltd. a fiveyear common stock purchase warrant to purchase 55,000 shares of our commonstock at $6.23 per share and granted them a security interest in substantiallyall of our assets. We utilized approximately $192,000 of the proceeds to repaythe outstanding Term Loan to Citizens Bank on October 7, 2002 and we willutilize the remaining proceeds to commercialize our explosives detectionsystem, purchase certain equipment to expand our semiconductor business, andfor general working capital purposes.

 

This private placementwas exempt from registration pursuant to Section 4(2) of the Securities Act of1933, as amended.

 

During the three monthsended March 31, 2003, Laurus redeemed approximately 17,000 shares ofConvertible Preferred Stock into 61,000 of the Company’s stock at conversionprices ranging from $2.02 to $3.30 per share. As of March 31, 2003, the principalbalance outstanding of the Convertible Preferred Stock is approximately$2,300,000.

 

Item 3. Defaults Upon Senior Securities

 

Not Applicable

 

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

 

We held our annualshareholders meeting on January 7, 2003. Anthony Armini, Stephen Bunker, ShaunCave, David Eisenhaure and Michael Szycher were elected as directors of theCompany to hold office until the 2003 annual meeting of the shareholders. Theresults for this proposal were as follows:

 
| **NAME**         |   | **FOR**   |   | **WITHHELD** |
|------------------|--------|-----------|--------|--------------|
| Anthony Armini   |   | 5,099,152 |   | 117,500      |
| Stephen Bunker   |   | 5,188,952 |   | 27,700       |
| Shaun Cave       |   | 5,188,952 |   | 27,700       |
| David Eisenhaure |   | 5,188,952 |   | 27,700       |
| Michael Szycher  |   | 5,188,952 |   | 27,700       |

 

Proposal No. 2 wasan amendment to the Company’s 2002 Incentive and Nonqualified Stock OptionPlan. The results for this proposal were as follows:

 
| **FOR**   |   | **AGAINST** |   | **ABSTAIN** |
|-----------|--------|-------------|--------|-------------|
| 4,952,735 |   | 253,917     |   | 10,000      |

 

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Item 5. OtherInformation

 

**CertificationsUnder Sarbanes-Oxley Act**

Our chief executive officer and chief financialofficer have furnished to the SEC the certification with respect to this Reportthat is required by Section 906 of the Sarbanes-Oxley Act of 2002.

 

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

 

(a)                                  Exhibits

99.1 CertificationPursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of theSarbanes-Oxley Actof 2002.

 

(b)                                                         CurrentReport on Form 8K Dated April 24, 2003 regarding the Change of Auditorsdismissing  Ernst & Young LLP andappointing BDO Seidman, LLP

 

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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: May 20, 2003 | /s/ Anthony J. Armini        |   |
|               | Anthony J. Armini            |
|               | President and CEO            |
|               |                         |
| Date: May 20, 2003 | /s/ Diane J. Ryan            |   |
|               | Diane J. Ryan                |
|               | Chief Financial Officer      |
|                    |                              |  |  |

 

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**CERTIFICATIONS**

 

I, AnthonyJ. Armini, President and Chief Executive Officer of Implant SciencesCorporation, certify that:

 

1.     I have reviewedthis quarterly report on Form 10-QSB of Implant Sciences Corporation;

 

2.              Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make the statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.              Based on my knowledge, thefinancial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.              The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a.               designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b.              evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c.               presented in this quarterlyreport our conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

 

5.              The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a.               all significant deficienciesin the design or operation of internal controls which could adversely affectthe registrant’s ability to record, process, summarize and report financialdata and have identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b.              any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls.

 

6.              The registrant’s othercertifying officers and I have indicated in this quarterly report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
|   | Date: May  20, 2003                    |
|--------|----------------------------------------|
|   |                                   |
|   | /s/  Anthony J. Armini                 |   |
|   |                                   |
|   | Anthony  J. Armini                     |
|   | President  and Chief Executive Officer |

 

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I, Diane J.Ryan, Chief Financial Officer of Implant Sciences Corporation, certify that:

 

1.               I have reviewed thisquarterly report on Form 10-QSB of Implant Sciences Corporation;

 

2.               Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make the statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.               Based on my knowledge, thefinancial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a.               designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b.              evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c.               presented in this quarterlyreport our conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

 

5.            The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a.               all significant deficienciesin the design or operation of internal controls which could adversely affectthe registrant’s ability to record, process, summarize and report financialdata and have identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b.              any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls.

 

6.            The registrant’s othercertifying officers and I have indicated in this quarterly report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
|   | Date: May  20, 2003      |
|--------|--------------------------|
|   |                     |
|   | /s/ Diane  J. Ryan       |   |
|   |                     |
|   | Diane J.  Ryan           |
|   | Chief  Financial Officer |

 

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