## ** **

## **UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

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

## ** **

**FORM 10-QSB**

 
| **ý** | ** ** | **Quarterly  report pursuant to section 13 or 15(d) of the Securities Exchange Act of  1934.**                                                                                    |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                   |
|       |       | **For the quarterly period ending December 31,  2004.**                                                                                                                           |
|       |       | ** **                                                                                                                                                                             |
|       |       | **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 registrant asspecified 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)

 

**NotApplicable**

(Former name, former addressand former fiscal year, if changed since last report.)

 

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

 

YES  ý       NO  o

 

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

 
| **Class**                     |   | **Outstanding at January 31, 2005** |
|-------------------------------|--------|------------------------------------------|
| Common  Stock, $.10 par value |   | 9,053,645                                |

 

Transitional small businessdisclosure format (check one):

 

YES  o       NO  ý

 

----

 

**IMPLANTSCIENCES CORPORATION**

 

**INDEX**

 
| PART I.  FINANCIAL INFORMATION |
|--------------------------------|
|                           |   |   |
| Item 1.                        | Financial Statements: |   |
|                           |   |   |
|                           |   | Condensed Consolidated Balance Sheets as of  December 31, 2004 (unaudited) and June 30, 2004 |   |
|                           |   |   |   |
|                           |   | Condensed Consolidated Statements of  Operations for the Three and Six Months Ended December 31, 2004 and 2003  (unaudited) |   |
|                           |   |   |   |
|                           |   | Condensed Consolidated Statements of Cash  Flows for the Six Months Ended December 31, 2004 and 2003 (unaudited) |   |
|                           |   |   |   |
|                           |   | Notes to Condensed Consolidated Financial  Statements (unaudited) |   |
|                           |   |   |   |
| Item 2.                        |   | Management’s Discussion and Analysis of Financial Condition and  Results of Operations |   |
|                           |   |   |   |
| Item 3.                        |   | Controls and Procedures |   |
|                           |   |   |
| PART II. OTHER INFORMATION     |
|                           |   |   |
| Item 1.                        | Legal Proceedings |   |
|                           |   |   |
| Item 2.                        | Changes in Securities and Use of Proceeds |   |
|                           |   |   |
| Item 3.                        | Defaults Upon Senior Securities |   |
|                           |   |   |
| Item 4.                        | Submission of Matters to a Vote of  Security-Holders |   |
|                           |   |   |
| Item 5.                        | Other Information |   |
|                           |   |   |
| Item 6.                        | Exhibits and Reports on Form 8-K |   |
|                           |   |   |
|                           | Signatures |   |

 

1

----

 

**IMPLANTSCIENCES CORPORATION**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                       | ** ** | **December 31,  2004** | ** ** | **June 30,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **(Unaudited)**             | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                                                                       |       |                        |       |                    |       |
|                                                                                                                                                                                                                             |       |                        |       |                    |       |
| Current  assets:                                                                                                                                                                                                                 |       |                        |       |                    |       |
| Cash and  cash equivalents                                                                                                                                                                                                       |       | $                           | 2,180,000  |                    | $          | 6,906,000 |   |
| Accounts  receivable, less allowance of $246,000 and $89,000 respectively                                                                                                                                                        |       | 1,545,000                   |       | 709,000                 |       |
| Accounts  receivable, unbilled                                                                                                                                                                                                   |       | 1,100,000                   |       | 1,434,000               |       |
| Inventories                                                                                                                                                                                                                      |       | 686,000                     |       | 481,000                 |       |
| Investments  - available for sale securities                                                                                                                                                                                     |       | 295,000                     |       | 419,000                 |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                       |       | 146,000                     |       | 140,000                 |       |
| Total  current assets                                                                                                                                                                                                            |       | 5,952,000                   |       | 10,089,000              |       |
| Property and  equipment, net                                                                                                                                                                                                     |       | 7,525,000                   |       | 4,308,000               |       |
| Goodwill                                                                                                                                                                                                                         |       | 4,762,000                   |       | —                  |       |
| Amortizable  intangible assets, net                                                                                                                                                                                              |       | 490,000                     |       | 625,000                 |       |
| Deferred tax  asset                                                                                                                                                                                                              |       | 869,000                     |       | —                  |       |
| Investment  in unconsolidated subsidiary                                                                                                                                                                                         |       | 28,000                      |       | 63,000                  |       |
| Other  non-current assets                                                                                                                                                                                                        |       | 161,000                     |       | 139,000                 |       |
| Total assets                                                                                                                                                                                                                     |       | $                           | 19,787,000 |                    | $          | 15,224,000 |   |
|                                                                                                                                                                                                                             |       |                        |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                   |       |                        |       |                    |       |
|                                                                                                                                                                                                                             |       |                        |       |                    |       |
| Current  liabilities:                                                                                                                                                                                                            |       |                        |       |                    |       |
| Accounts  payable                                                                                                                                                                                                                |       | $                           | 1,475,000  |                    | $          | 578,000 |   |
| Accrued  expenses                                                                                                                                                                                                                |       | 1,082,000                   |       | 740,000                 |       |
| Payable to  Med-Tec                                                                                                                                                                                                              |       | 414,000                     |       | 394,000                 |       |
| Line of  credit                                                                                                                                                                                                                  |       | 16,000                      |       | —                  |       |
| Current  maturities of long-term debt and obligations under capital lease                                                                                                                                                        |       | 54,000                      |       | 101,000                 |       |
| Deferred  revenue                                                                                                                                                                                                                |       | 121,000                     |       | 23,000                  |       |
| Total  current liabilities                                                                                                                                                                                                       |       | 3,162,000                   |       | 1,836,000               |       |
| Long-term  liabilities:                                                                                                                                                                                                          |       |                        |       |                    |       |
| Deferred tax  liability                                                                                                                                                                                                          |       | 869,000                     |       | —                  |       |
| Payable to  Med-Tec, net of current maturities                                                                                                                                                                                   |       | —                      |       | 212,000                 |       |
| Long-term  debt and obligations under capital lease, net of current maturities                                                                                                                                                   |       | 49,000                      |       | 6,000                   |       |
| Total  liabilities                                                                                                                                                                                                               |       | 4,080,000                   |       | 2,054,000               |       |
| Convertible  preferred stock: 5,000,000 shares authorized  5% Series C Cumulative Redeemable Convertible Preferred Stock; $10 stated  value; 250,000 shares designated; 25,762 and 131,875 issued and outstanding,  respectively |       | 124,000                     |       | 670,000                 |       |
| Stockholders’  equity:                                                                                                                                                                                                      |       |                        |       |                    |       |
| Common  stock, $0.10 par value; 20,000,000 shares authorized;  9,053,645 and 8,370,338 shares issued and outstanding, respectively                                                                                               |       | 905,000                     |       | 837,000                 |       |
| Treasury  Stock, 9,103 and 3,103 common shares, repectively, at cost                                                                                                                                                             |       | (88,000                     | )          | (34,000                 | )          |
| Additional  paid-in capital                                                                                                                                                                                                      |       | 38,486,000                  |       | 31,360,000              |       |
| Accumulated  deficit                                                                                                                                                                                                             |       | (23,315,000                 | )          | (19,527,000             | )          |
| Deferred  compensation                                                                                                                                                                                                           |       | (586,000                    | )          | (449,000                | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                          |       | 181,000                     |       | 313,000                 |       |
| Total  stockholders’ equity                                                                                                                                                                                                 |       | 15,583,000                  |       | 12,500,000              |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                 |       | $                           | 19,787,000 |                    | $          | 15,224,000 |   |

 

The accompanying notes arean integral part of these condensed consolidated financial statements.

 

2

----

 

**IMPLANTSCIENCES CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                                                                                                                                     | ** ** | **2004**                                  | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                                                                                                                                                                                      |       |                                      |       |                                    |       |   |   |   |   |
| Medical                                                                                                                                                                                                                        |       | $                                         | 933,000    |                                    | $          | 1,208,000 |   | $ | 1,893,000 |   | $ | 2,366,000 |   |
| Semiconductor                                                                                                                                                                                                                  |       | 1,288,000                                 |       | 234,000                                 |       | 1,622,000 |   | 529,000 |   |
| Explosives  detection                                                                                                                                                                                                          |       | 320,000                                   |       | 447,000                                 |       | 1,300,000 |   | 631,000 |   |
| Total  revenues                                                                                                                                                                                                                |       | 2,541,000                                 |       | 1,889,000                               |       | 4,815,000 |   | 3,526,000 |   |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Costs and  expenses:                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Cost of  medical revenue                                                                                                                                                                                                       |       | 1,002,000                                 |       | 975,000                                 |       | 1,799,000 |   | 1,800,000 |   |
| Cost of  semiconductor revenue                                                                                                                                                                                                 |       | 1,536,000                                 |       | 291,000                                 |       | 1,907,000 |   | 548,000 |   |
| Cost of  explosives detection revenue                                                                                                                                                                                          |       | 442,000                                   |       | 240,000                                 |       | 1,080,000 |   | 318,000 |   |
| Total costs  and expenses                                                                                                                                                                                                      |       | 2,980,000                                 |       | 1,506,000                               |       | 4,786,000 |   | 2,666,000 |   |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Gross margin                                                                                                                                                                                                                   |       | (439,000                                  | )          | 383,000                                 |       | 29,000 |   | 860,000 |   |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Operating  expenses:                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Research and  development, (includes $51,000 and $132,000 and $89,000 and $172,000 non-cash  charge for stock-based compensation for the three and six months ended December 31,  2004 and 2003, respectively)            |       | 282,000                                   |       | 464,000                                 |       | 868,000 |   | 893,000 |   |
| Selling,  general and administrative, (includes $38,000 and $195,000 and $63,000 and  $259,000 non-cash charge for stock-based compensation for the three and six  months ended December 31, 2004 and 2003, respectively) |       | 1,276,000                                 |       | 990,000                                 |       | 2,330,000 |   | 1,750,000 |   |
| Total  operating expenses                                                                                                                                                                                                      |       | 1,558,000                                 |       | 1,454,000                               |       | 3,198,000 |   | 2,643,000 |   |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Loss from  operations                                                                                                                                                                                                          |       | (1,997,000                                | )          | (1,071,000                              | )          | (3,169,000 | ) | (1,783,000 | ) |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Other income  (expense):                                                                                                                                                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| Interest  income                                                                                                                                                                                                               |       | 15,000                                    |       | 3,000                                   |       | 31,000 |   | 7,000 |   |
| Interest  expense                                                                                                                                                                                                              |       | (29,000                                   | )          | (36,000                                 | )          | (47,000 | ) | (78,000 | ) |
| Loss on sale  of capital asset                                                                                                                                                                                                 |       | —                                    |       | —                                  |       | (6,000 | ) | — |   |
| Equity  losses in unconsolidated subsidiaries                                                                                                                                                                                  |       | (17,000                                   | )          | (3,000                                  | )          | (28,000 | ) | (7,000 | ) |
| Total other  expense, net                                                                                                                                                                                                      |       | (31,000                                   | )          | (36,000                                 | )          | (50,000 | ) | (78,000 | ) |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Net loss                                                                                                                                                                                                                       |       | (2,028,000                                | )          | (1,107,000                              | )          | (3,219,000 | ) | (1,861,000 | ) |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Preferred  distribution, dividends and accretion                                                                                                                                                                               |       | (283,000                                  | )          | (530,000                                | )          | (567,000 | ) | (973,000 | ) |
| Net loss  applicable to common shareholders                                                                                                                                                                                    |       | $                                         | (2,311,000 | )                                       | $          | (1,637,000 | ) | $ | (3,786,000 | ) | $ | (2,834,000 | ) |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Net loss per  share applicable to common shareholders, basic and diluted                                                                                                                                                       |       | $                                         | (0.26      | )                                       | $          | (0.23 | ) | $ | (0.44 | ) | $ | (0.41 | ) |
|                                                                                                                                                                                                                           |       |                                      |       |                                    |       |   |   |   |   |
| Weighted average  common shares outstanding, basic and diluted                                                                                                                                                                 |       | 8,882,786                                 |       | 7,029,911                               |       | 8,674,673 |   | 6,912,070 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

3

----

 

**IMPLANT SCIENCES CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                        | ** ** | **Six Months Ended**  | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                        | ** ** | **December 31,** | ** ** |
| ** **                                                                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Cash flows from operating  activities**                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Net loss                                                                          |       | $                     | (3,219,000 | ) | $ | (1,861,000 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:      |       |                  |       |   |   |
| Depreciation  and amortization                                                    |       | 783,000               |       | 564,000 |   |
| Stock-based  compensation expense                                                 |       | 153,000               |       | 520,000 |   |
| Equity in  loss in unconsolidated subsidiary                                      |       | 28,000                |       | 7,000 |   |
| Loss on sale  of equipment                                                        |       | 6,000                 |       | — |   |
| Changes in  operating assets and liabilities, exclusive of acquisition:           |       |                  |       |   |   |
| Accounts  receivable                                                              |       | (52,000               | )          | (129,000 | ) |
| Inventories                                                                       |       | (31,000               | )          | (54,000 | ) |
| Prepaid and  other current assets                                                 |       | 68,000                |       | (17,000 | ) |
| Accounts  payable                                                                 |       | 237,000               |       | (170,000 | ) |
| Accrued  expenses                                                                 |       | 282,000               |       | (52,000 | ) |
| Net cash  used in operating activities                                            |       | (1,745,000            | )          | (1,192,000 | ) |
|                                                                              |       |                  |       |   |   |
| **Cash  flows from investing activities**                                         |       |                  |       |   |   |
| Purchase of  property and equipment                                               |       | (359,000              | )          | (155,000 | ) |
| Investment  in for sale securities                                                |       | —                |       | (40,000 | ) |
| Investment  in unconsolidated subsidiary                                          |       | 60,000                |       | — |   |
| Cash used  for the acquisition of Core Systems Incorporated, net of cash received |       | (2,597,000            | )          | — |   |
| Other  non-current assets                                                         |       | (103,000              | )          | (52,000 | ) |
| Net cash  used in investing activities                                            |       | (2,999,000            | )          | (247,000 | ) |
|                                                                              |       |                  |       |   |   |
| **Cash  flows from financing activities**                                         |       |                  |       |   |   |
| Proceeds  from issuance of common stock                                           |       | 831,000               |       | 172,000 |   |
| Proceeds  from issuance of Series B preferred stock, net of issuance costs        |       | —                |       | 1,818,000 |   |
| Proceeds  from issuance of Series C preferred stock, net of issuance costs        |       | —                |       | 2,289,000 |   |
| Proceeds  from warrant exercises                                                  |       | 66,000                |       | — |   |
| Payments of  additional issuance costs relating to private placement              |       | (25,000               | )          | — |   |
| Acquisition  of treasury stock                                                    |       | (54,000               | )          | — |   |
| Proceeds from  capital lease obligations                                          |       | 61,000                |       | — |   |
| Repayment of  debt acquired from Core Systems                                     |       | (562,000              | )          | — |   |
| Repayments  of long-term debt and capital lease obligations                       |       | (299,000              | )          | (221,000 | ) |
| Repayments  of equipment financing                                                |       | —                |       | (699,000 | ) |
| Net cash  provided by financing activities                                        |       | 18,000                |       | 3,359,000 |   |
|                                                                              |       |                  |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                             |       | (4,726,000            | )          | 1,920,000 |   |
| Cash and  cash equivalents, beginning                                             |       | 6,906,000             |       | 959,000 |   |
| Cash and  cash equivalents, ending                                                |       | $                     | 2,180,000  |   | $ | 2,879,000 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

4

----

 
| ** **                                                                                                               | ** ** | **Six Months Ended**  | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                               | ** ** | **December 31,** | ** ** |
| ** **                                                                                                               | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Supplemental  Disclosure of Cash Flow Information:**                                                                   |       |                  |       |   |   |
| Interest  paid in cash                                                                                                   |       | $                     | 47,000     |   | $ | — |   |
|                                                                                                                     |       |                  |       |   |   |
| **Noncash  Investing and Financing Activity:**                                                                           |       |                  |       |   |   |
| Issuance of  Series B warrants                                                                                           |       | $                     | —     |   | $ | 125,000 |   |
| Noncash  beneficial conversion feature - Series B                                                                        |       | $                     | —     |   | $ | 767,000 |   |
| Issuance of  Series C warrants                                                                                           |       | $                     | —     |   | $ | 210,000 |   |
| Noncash  beneficial conversion feature - Series C                                                                        |       | $                     | —     |   | $ | 605,000 |   |
| Conversion  of Series A Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |       | $                     | —     |   | $ | 1,500,000 |   |
| Conversion  of Series B Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |       | $                     | —     |   | $ | 550,000 |   |
| Conversion  of Series C Cumulative Convertible Preferred stock and accrued dividends into  common stock                  |       | $                     | 1,141,000  |   | $ | — |   |
| Value of  amortizable intangible asset acquired in exchange for long term note payable                                   |       | $                     | —     |   | $ | 1,007,000 |   |
| Accretion of  7% Series A Cumulative Convertible Preferresd Stock dividends, beneficial  conversion feature and warrants |       | $                     | —     |   | $ | 556,000 |   |
| Accretion of  5% Series B Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants  |       | $                     | —     |   | $ | 294,000 |   |
| Accretion of  5% Series C Cumulative Convertible Preferred Stock dividends, beneficial  conversion feature and warrants  |       | $                     | 567,000    |   | $ | 69,000 |   |
|                                                                                                                     |       |                  |       |   |   |
| **On October 15,  2004, the Company acquired Core Systems Incorporated as follows:**                                |       |                  |       |   |   |
| **Fair  value of assets:**                                                                                               |       |                  |       |   |   |
| Accounts  receivable                                                                                                     |       | $                     | 450,000    |   |   |   |
| Inventory                                                                                                                |       | 174,000               |       |   |   |
| Property,  plant and equipment                                                                                           |       | 3,422,000             |       |   |   |
| Other  intangible assets                                                                                                 |       | 75,000                |       |   |   |
| Goodwill                                                                                                                 |       | 4,762,000             |       |   |   |
| Other assets                                                                                                             |       | 74,000                |       |   |   |
| **Liabilities  assumed:**                                                                                                |       |                  |       |   |   |
| Accounts  payable and accrued expenses                                                                                   |       | (877,000              | )          |   |   |
| Debt and  capital leases                                                                                                 |       | (621,000              | )          |   |   |
| **Purchase  price:**                                                                                                     |       |                  |       |   |   |
| Cash paid  for purchase of Core Systems, net of cash acquired                                                            |       | (2,597,000            | )          |   |   |
|                                                                                                                     |       |                  |       |   |   |
| Fair value  of warrants issued                                                                                           |       | (1,102,000            | )          |   |   |
| Fair value  of common stock issued                                                                                       |       | $                     | 3,760,000  |   |   |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

5

----

 

**IMPLANTSCIENCES CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**December 31,2004**

**(Unaudited)**

 

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

 

ImplantSciences Corporation (the “Company”) develops products for the medical deviceand explosives detection industry using ion implantation and thin film coatingsof radioactive and non-radioactive materials. The Company has received Food and Drug Administration 510(k) clearanceto market its I-PlantäIodine-125 radioactive seed for the treatment of prostate cancer.  The Company also has under developmentbrachytherapy systems for the treatment of breast cancer. The Company alsomodifies the surface characteristics of orthopedic joint implants to reducepolyethylene wear and thereby increasing the life of the implant and provideswafer processing services and equipment for the semiconductor industry.  Additionally, the Company continues todevelop explosives detection systems to be used in the detection of trace residuesof explosives.

 

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

 

The financialinformation for the three and six months ended December 31, 2004 and 2003is unaudited but includes all adjustments (consisting only of normal recurringadjustments), which we consider necessary for a fair presentation of thefinancial position at such date and of the operating results and cash flows forthese periods.  The result of operationsand cash flows for the three and six months ended December 31, 2004 arenot necessarily indicative of results that may be expected for the entireyear.  The information contained in thisForm 10-QSB should be read in conjunction with our audited financialstatements, included in our Form 10-KSB/A No. 1 as of and for the year ending June 30,2004 filed with the Securities and Exchange Commission on November 9,2004.  Certain amounts in the priorperiod financial statements have been reclassified to conform to the currentperiod’s presentation.

 

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

 

The Companyaccounts for its employee stock based compensation arrangements under theprovisions of Accounting Principal Board (APB) Opinion No. 25, “Accounting forStock Issued to Employees,” rather than the alternative fair value accountingmethod provided for under Statement of Financial Accounting Standards (SFAS) No.123, “Accounting for Stock-Based Compensation.” Under APB 25, when the exercise price of options granted to employeesand non-employee directors under these plans equals the market price of theunderlying stock on the date of the grant, no compensation expense is recorded.

 

The Company has elected to use the disclosure-only provisions of SFASNo. 123 and SFAS No. 148, “Accounting for Stock-Based Compensation-Transitionand Disclosure.”  Had compensationexpense for stock option grants to employees been determined based on the fairvalue method at the grant dates for awards under the stock option plansconsistent with the method prescribed by SFAS No. 123, the Company’s net losswould have increased to the pro forma amounts indicated as follows:

 

6

----

 
| ** **                                                                                                                       | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                                       | ** ** | **2004**                                  | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                             |       |                                      |       |                                    |       |   |   |   |   |
| Net loss  applicable to common shareholders, as reported                                                                         |       | $                                         | (2,311,000 | )                                       | $          | (1,637,000 | ) | $ | (3,786,000 | ) | $ | (2,834,000 | ) |
| Add:  Stock-based employee compensation expense included in reported net loss  applicable to common shareholders, net of tax     |       | 77,000                                    |       | 371,000                                 |       | 136,000 |   | 504,000 |   |
| Deduct:  Total stock-based employee compensation expense determined under the fair  value based method of all awards, net of tax |       | (651,000                                  | )          | (302,000                                | )          | (864,000 | ) | (384,000 | ) |
|                                                                                                                             |       |                                      |       |                                    |       |   |   |   |   |
| Pro forma  net loss applicable to common shareholders                                                                            |       | $                                         | (2,885,000 | )                                       | $          | (1,568,000 | ) | $ | (4,514,000 | ) | $ | (2,714,000 | ) |
|                                                                                                                             |       |                                      |       |                                    |       |   |   |   |   |
| Net loss per  share applicable to common shareholders, basic and diluted:                                                        |       |                                      |       |                                    |       |   |   |   |   |
| As reported                                                                                                                      |       | $                                         | (0.26      | )                                       | $          | (0.23 | ) | $ | (0.44 | ) | $ | (0.41 | ) |
| Pro forma                                                                                                                        |       | $                                         | (0.32      | )                                       | $          | (0.22 | ) | $ | (0.52 | ) | $ | (0.39 | ) |

 

In December 2003,the Company issued stock options below fair market value.  This amount is being amortized over thevesting period of the options which averages 3 years.  During the quarter ended December 31,2004, the Company recorded $59,000 in compensation expense related to thistransaction.

 

In December 2004,the Company recorded deferred compensation of $144,000 relating to stockoptions issued at prices below fair market value.  This amount is being amortized over thevesting period of the options which averages 3 years.  During the quarter ended December 31,2004, the Company recorded compensation expense of $18,000 related to thistransaction.

 

In September 2004,the Company issued warrants to consultants in exchange for services.  This amount is being amortized over thevesting period of the warrants which averages 3 years.  During the quarter ended December 31,2004, the Company recorded approximately $13,000 in expense associated withthese transactions.  The Companyestimated the fair value of the common stock warrants using the Black-Scholesoption-pricing model.

 

In October 2004,the Company issued 200,000 common stock warrants to a consultant in connectionwith the Core acquisition.    The Companyestimated the fair value of the warrants, using the Black Scholesoption-pricing model, to be approximately $1,102,000 and recorded this asadditional purchase price during the three months ended December 31, 2004.

 

The Companyestimated the fair value of the warrants using the following input assumptions:

 

| Volatility               |   | 65 –  68%    |   |
|--------------------------|--------|-------------------|--------|
| Dividend  yield          |   | 0%                |   |
| Risk-free  interest rate |   | 4.1 - 4.3%        |   |
| Expected  lives          |   | 5 – 10 years |   |

 

7

----

 

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

 

Basic earningsper share is computed based only on the weighted average number of commonshares outstanding during the period. Diluted earnings per share is computed by using the weighted averagenumber of common shares outstanding during the period, plus the dilutiveeffects of shares issuable through the exercise of stock options (common stockequivalents) unless their inclusion would be antidilutive.

 

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

 

The Company has accumulated other comprehensive income (loss) resultingfrom the unrealized gain/loss on an investment in marketable equity securitiesof CardioTech International Inc. (Note 8) and the recognition of the unrealizedgain/loss of the Company’s share of CardioTech and Implant Sciences stock ownedby CorNova (Note 10) which is recorded in the stockholders’ equity section ofthe balance sheet.  Comprehensive income(loss) is summarized below:

 
| ** **                         | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                         | ** ** | **2004**                                  | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|                               |       |                                      |       |                                    |       |   |   |   |   |
| Net Loss                           |       | $                                         | (2,028,000 | )                                       | $          | (1,107,000 | ) | $ | (3,219,000 | ) | $ | (1,861,000 | ) |
| Other  Comprehensive Income (Loss) |       | (2,000                                    | )          | 80,000                                  |       | (132,000 | ) | 107,000 |   |
|                               |       |                                      |       |                                    |       |   |   |   |   |
| Comprehensive  Loss                |       | $                                         | (2,030,000 | )                                       | $          | (1,027,000 | ) | $ | (3,351,000 | ) | $ | (1,754,000 | ) |
|                                    |            |                                           |            |                                         |            |  |  |  |  |  |  |  |  |  |

 

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

 

Contractrevenue under cost sharing research and development agreements is recognized aseligible expenses are incurred. Invoicing of research and development contracts occurs in accordancewith the terms of the contract.  Revenuerecognized but unbilled is recorded as unbilled accounts receivable.  At December 31, 2004, unbilled accountsreceivable represented approximately 38% of total accounts receivable.   Generally, there are no prerequisitesnecessary to bill.

 

**7.****              Private Placement**

 

On November 25, 2003, the Company issued 250,000shares of Series C 5% Cumulative Convertible Preferred Stock (“Series C”)having a stated value of $10 per share, pursuant to a Securities PurchaseAgreement executed on November 25, 2003 with the Laurus Master Fund, Ltd.(Laurus). The Company received $2,500,000 in gross proceeds, less a managementand placement agent fee of approximately $125,000, and related transactioncosts of approximately $86,000.  Theterms of the Series C provide for repayment with shares of the Company’s commonstock or in cash, pursuant to an amortization schedule.  Repayment of the Series C commenced on March 31,2004.  The Company has the sole option todetermine whether to satisfy payment of the monthly amount in full on eachrepayment date either in cash or in shares of common stock, or a combination ofboth, unless the closing price of the Company’s common stock for any of theeleven trading days preceding a repayment date was less than $7.35, wherein theCompany will be required to pay such monthly amount in cash.  If the payment of the monthly amount is madein common stock, the fixed conversion price is $6.75.  The Company also issued to Laurus a warrantto purchase 50,000 shares of common stock at $8.44 per share and 50,000 sharesof common stock at

 

8

----

 

$10.13 per share.  The Securities Purchase Agreement alsoprovides for a security interest in substantially all of the Company’s assetsand provides Laurus a right of first refusal on future financing arrangementsduring the Term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it agreed toenter into such documentation as shall be reasonable requested by the Companyin order to subordinate its rights under the Series C to the subsequentfinancier.  The Company  utilized the proceeds of this financing topurchase an ion implanter and for general working capital purposes.

 

In accordancewith the provisions of Emerging Issues Task Force (EITF) Issue 00-27, “Applicationof EITF Issue No. 98-5 ‘Accounting for Convertible Securities with BeneficialConversion Features of Contingently Adjustable Conversion Ratios’, to CertainConvertible Securities”, which became effective in November 2000, theallocated value of the Series C contained a beneficial conversion featurecalculated based on the difference between the effective conversion price ofthe proceeds allocated to the Series C and the fair market value of the commonstock at the date of issuance.   The discount arising from the beneficial conversionfeature aggregated $700,000.  Thediscount is being amortized and recorded as a preferred dividend during theperiod from the issuance of the preferred stock to the mandatory redemptiondate of June 1, 2005, or the actual conversion date, whichever is earlierusing the effective interest method.

 

The Companyvalued the Series C at issuance to be $1,284,000 based on the relative fairmarket values of the financial instruments issued in connection with thisplacement, net of offering costs and the beneficial conversion feature.  The amounts recorded in the financialstatements represent the amounts attributed to the sale of the preferred stock,net cash proceeds of $2,289,000 ($211,000 of issuance costs incurred), theamount allocated to warrants of $305,000, and the amount of the discountrelated to the value of beneficial conversion feature of $700,000.  The Company is accreting these discounts onthe carrying value of the preferred stock to its redemption value of $2,500,000at June 1, 2005, or the actual conversion date, whichever is earlier.  The accretion of these amounts is beingrecorded as a preferred dividend in the period of accretion.  During the period ended December 31,2004, approximately $274,000 was amortized. As of December 31, 2004, the outstanding principal of the Series Cwas approximately $258,000.

 

During thethree months ended December 31, 2004, Laurus redeemed 56,353 shares ofSeries C into 83,486 shares of the Company’s common stock at conversion priceof $6.75 per share and redeemed approximately $6,000 of accrued dividends into896 shares of the Company’s common stock. During the three months ended December 31, 2004, the Companyaccrued approximately $6,000 of dividends. The conversion of accrued dividends into common stock resulted inadditional dividends of approximately $3,000 during the three months ended December 31,2004, in excess of 5% stated value.

 

**8.****              Related PartyTransactions**

 

SFAS No. 57, “RelatedParty Disclosures,” specifies the nature of information that should bedisclosed in financial statements regarding related party transactions.  CardioTech International, Inc. (“CardioTech”)a public company, whose common stock trades under the symbol CTE on theAmerican Stock Exchange, is a related party with the Company by virtue of itssignificant business relationships.

 

Certaindirectors of the Company hold positions as directors of CardioTech.  The CEO and Chairman of the Board ofDirectors of the Company is also a director of CardioTech.  The CEO and Chairman of the Board ofDirectors of CardioTech is also a director of the Company.

 

In March 2000,the Company entered into a joint research agreement with CardioTech to developa proprietary porous polymer biocompatible coating technology as a platform forthe Company’s proprietary radioactive brachytherapy technology.  In consideration for this agreement, theCompany agreed to pay $150,000 in cash and purchase 100,000 shares ofCardioTech stock at a price of $1.00 per share. As of December 31, 2004, the fair market value of the 100,000shares of CardioTech stock is $295,000, which is recorded as investment inavailable for sale securities in the accompanying balance sheet.

 

In March 2004the Company entered into an Exchange & Venture Agreement with CardioTechand CorNova, Inc. (Note 10).  The Company’sCEO and a director are also on the Board of Directors of CorNova.

 

9

----

 

**9.****              MED-TEC**

 

On July 31,2003, the Company entered into an agreement with its former exclusivedistributor of prostate seeds, to release each other from further obligationsunder the 2000 Agreement.  The newagreement conveys to the Company direct marketing and sales capabilities tosell its I-Plant Seed brachytherapy seeds for use in the treatment of prostatecancer.  In connection with this, theCompany’s former exclusive distributor transitioned customers and marketing materials directly to theCompany.  The distributor also agreed notto compete with the Company for a period of three years.  The Company will pay the distributor anaverage of approximately $39,000 per month over the 28 months, beginning September 1,2003.  As of December 31, 2004 , theoutstanding principal balance is approximately $414,000.  For the three months ended December 31,2004, the Company recorded approximately $12,000 of interest expense relatingto this transaction.

 

The presentvalue of this asset was recorded as approximately $1,007,000, using a rate of10.24%, and is being amortized over its estimated useful life of 29months.  During the three months ended December 31,2004, approximately $208,000 of accumulated amortization expense was recognized.

 

**10.****       Investment inUnconsolidated Subsidiaries**

 

In March 2004,the Company entered into an Exchange & Venture Agreement with CardioTechInternational and CorNova.  CorNova is astart-up company focused on the development and marketing of innovativeinterventional cardiology products.  TheCompany issued 10,344 shares of common stock bearing an aggregate fair marketvalue of $113,000 as of the date of issuance. In exchange, the Company received 1,500,000 shares of the CorNova’scommon stock, which represents a 30% ownership position, and a position on theBoard of Directors.

 

Upon CorNovasecuring additional financing, in the minimum amount of $1,000,000 and up to amaximum amount of $3,000,000 (the “Series A Financing”), CardioTech and theCompany will each issue additional shares of their common stock (the “InvestmentShares”), where the number of Investment Shares to be issued will be equal totwenty-five percent (25%) of the gross proceeds of the Series A Financing.  As of December 31, 2004, 10,344 shareshave been issued, 3,103 of which have been categorized as treasury stock.  During the three months ended December 31,2004, the Company recognized approximately $17,000 of other expenserepresenting the Company’s portion of CorNova’s net loss.  The Company also recorded approximately$2,000 as unrealized loss, which is accumulated other comprehensive income forthe three months ended December 31, 2004. This unrealized loss relates to the Company’s portion of the decline invalue of the Investment Shares issued to CorNova.  The Company is accounting for this investmentunder the equity method under APB Opinion No. 18, “The Equity Method ofAccounting for Investments in Common Stock.”

 

Subsequent to December 31,2004, CorNova obtained the Series A financing, in the amount of $3,000,000, andthe Company will be issuing 76,687 shares of common stock to CorNova accordingto  the terms of the agreement.

 

**11.****       Bay Area MRI**

 

In March 2004, the Company entered into aconsulting agreement with Christopher Lang and Bay Area MRI to assist theCompany in the sale of radioactive prostate seeds.  As compensation for consulting services, theCompany may be required to pay commissions of up to $600,000 ($300,000 in cashand $300,000 in shares of common stock.). During the period , the Company issued 3,205 shares of restricted commonstock, bearing an aggregate fair market value of approximately $37,500 andadvanced $50,000 of cash commissions. In the period ended September 31,2004 the Company had determined that this asset was impaired and has recorded areserve against the prepaid commission of approximately $81,000 or 100% of

 

10

----

 

the recorded prepaid commission.

 

**12.****       Treasury Stock**

 

In June 2004,the Board authorized the Company to repurchase of up to 300,000 shares of theCompany’s common stock, from time to time in the open market, privatelynegotiated transactions, block transactions or at time and prices deemedappropriate by management.  As of December 31,2004, the Company had repurchased a total of 6,000 shares of common stock atprices ranging from $8.91 to $9.02 per share at a total cost of approximately$54,000, which is recorded as treasury stock in the accompanying balance sheet.

 

**13.****       Financial Information bySegment**

 

Under SFAS No.131, “Disclosures about Segments of anEnterprise and Related Information,” operating segments are defined ascomponents of an enterprise about which separate financial information isavailable that is evaluated regularly by the chief operating decision maker, ordecision making group, in deciding how to allocate resources and in assessingperformance.  The Company’s chiefoperating decision making group is composed of the chief executive officer andmembers of senior management. The Company’s reportable segments are:  Medical, Semiconductor and Explosives.

 

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

 

The revenues and expenses relatedto these segments for the three and six months ended December 31, 2004 and2003, respectively, are:

 

11

----

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

 
| ** **   | ** ** | **Three Months Ended December 31,  2003** | ** ** |
|--------------|------------|------------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                    | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| Revenue      |       | $                                              | 1,208,000  |   | $ | 234,000 |   | $ | 447,000 |   | $ | 1,889,000 |   |
| COGS         |       | (975,000                                       | )          | (291,000 | ) | (240,000 | ) | (1,506,000 | ) |
| Gross Margin |       | $                                              | 233,000    |   | $ | (57,000 | ) | $ | 207,000 |   | $ | 383,000 |   |

 
| ** **   | ** ** | **Six Months Ended December 31,  2004** | ** ** |
|--------------|------------|----------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                  | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| Revenue      | ** ** | $                                            | 1,893,000  | ** ** | $ | 1,622,000 | ** ** | $ | 1,300,000 |   | $ | 4,815,000 |   |
| COGS         | ** ** | (1,799,000                                   | )          | (1,907,000 | ) | (1,080,000 | ) | (4,786,000 | ) |
| Gross Margin | ** ** | $                                            | 94,000     | ** ** | $ | (285,000 | ) | $ | 220,000 | ** ** | $ | 29,000 | ** ** |

 
| ** **   | ** ** | **Six Months Ended December 31,  2003** | ** ** |
|--------------|------------|----------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                  | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| Revenue      | ** ** | $                                            | 2,366,000  |   | $ | 529,000 |   | $ | 631,000 |   | $ | 3,526,000 |   |
| COGS         | ** ** | (1,800,000                                   | )          | (548,000 | ) | (318,000 | ) | (2,666,000 | ) |
| Gross Margin | ** ** | $                                            | 566,000    |   | $ | (19,000 | ) | $ | 313,000 |   | $ | 860,000 |   |

 

**14.****       Acquisition of Core Systems Incorporated**

 

On October 15,2004, the Company completed the acquisition of Core Systems Incorporated, aprivately held semiconductor wafer processing company.  The transaction was structured as areorganization of Core with and into a newly formed, wholly-owned subsidiary ofthe Company.  The operating results ofCore Systems have been included in the Company’s statement of operationsbeginning October 15, 2004.

 

The aggregate purchase price ofCore was $7,459,000, which consisted of $2,000,000 in cash; 311,437 shares ofthe Company’s common stock with an aggregate fair value of $3,250,000; directacquisition costs of approximately $1,588,000, which includes a warrant with afair value of $1,102,000, and the payment of approximately $621,000 of debt andother obligations coincident with the closing. The fair value of the Company’scommon stock was determined based on the average market price of the Company’scommon stock over the twenty day period prior to the date of the definitive agreement, pursuant to EmergingIssues Task Force (“EITF”) Issue No. 99-12, “Determination of theMeasurement Date for the Market Price of Acquirer Securities Issued in aPurchase Business Combination.” The initial shares are subject to adjustment ifthe average closing price of Company stock, for a twenty day period prior tothe end of a six month Lock-up, is higher or lower by more than 25% from theinitial Closing Price.  In addition thepurchase is subject to an earn out which will be accounted for as additionalpurchase price when and if earned.

 

12

----

 

Total Purchase Price

 

| Cash                        |   | $         | 2,000,000 |   |
|-----------------------------|--------|-----------|-----------|--------|
| Equity                      |   | 3,250,000 |      |
| Equity used  to retire debt |   | 510,000   |      |
| Warrant                     |   | 1,102,000 |      |
| Direct Costs                |   | 597,000   |      |
|                        |   | $         | 7,459,000 |   |

 

The following table summarizes thepreliminary allocation of the purchase price to the fair value of the assetsacquired and liabilities assumed at the date of acquisition:

 
| ** **                             | ** ** | **October 15, 2004** | ** ** |
|----------------------------------------|------------|---------------------------|------------|
| Accounts  receivable                   |       | $                         | 450,000    |   |
| Inventory                              |       | 174,000                   |       |
| Property,  plant and equipment         |       | 3,422,000                 |       |
| Other  intangible assets               |       | 75,000                    |       |
| Goodwill                               |       | 4,762,000                 |       |
| Other assets                           |       | 74,000                    |       |
| Accounts  payable and accrued expenses |       | (877,000                  | )          |
| Debt and  capital leases               |       | (621,000                  | )          |
|                                   |       |                      |       |
|                                   |       | $                         | 7,459,000  |   |

 

The above allocation of the preliminarypurchase price, including the value of the intangible assets, is subject tochange.  The Company believes that in thefinal valuation of acquired assets, values could be assigned to technologyrelated intangible assets and customer related intangible assets.  The final allocation of the aggregatepurchase price is expected to be completed during the three months ended March 31,2005, at which time the Company will make retroactive adjustments, if needed,to its results of operations for the three and six months ended December 31,2004.

 

The acquisition of Core isaccounted for as a purchase under SFAS No. 141, “Business Combinations.”Accordingly, the operating results of Core are included in the accompanyingcondensed consolidated financial statements since the acquisition date as partof the Company’s semiconductor reporting segment.

 

The following table presentsselected unaudited financial information of the Company including Core SystemsIncorporated as if the acquisition had occurred on July 1, 2003.  The unaudited pro forma results are notnecessarily indicative of the results that would have occurred had theacquisition of Core Systems been consummated on July 1, 2003, or of futureresults.

 

13

----

 

 
| **IMPANT SCIENCES CORPORATION**                    |
|----------------------------------------------------|
| **PROFORMA CONSOLIDATED STATEMENT OF  OPERATIONS** |
| **(Unaudited)**                                    |

 
| ** **                                                         | ** ** | **Three Months Ended**

**December 31,** | ** ** | **Six Months Ended**

**December 31,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                         | ** ** | ** **                               | ** ** |
| ** **                                                         | ** ** | **2004**                                 | ** ** | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                               |       |                                     |       |                                   |       |   |   |   |   |
| **Revenue**                                                        |       | $                                        | 2,767,000  |                                   | $          | 2,689,000 |   | $ | 6,214,000 |   | $ | 5,476,000 |   |
|                                                               |       |                                     |       |                                   |       |   |   |   |   |
| **Net Income (Loss) Before Taxes**                                 |       | (2,068,000                               | )          | (1,330,000                             | )          | (3,517,000 | ) | (2,254,000 | ) |
|                                                               |       |                                     |       |                                   |       |   |   |   |   |
| **Preferred distribution, dividends**                              |       | (284,000                                 | )          | (530,000                               | )          | (568,000 | ) | (973,000 | ) |
| **Income Tax Expense**                                             |       |                                     |       |                                   |       |   |   |   |   |
|                                                               |       |                                     |       |                                   |       |   |   |   |   |
| **Net Income (Loss)**                                              |       | $                                        | (2,352,000 | )                                      | $          | (1,860,000 | ) | $ | (4,085,000 | ) | $ | (3,227,000 | ) |
|                                                               |       |                                     |       |                                   |       |   |   |   |   |
| **Net loss per share applicable to common  shareholders**          |       | $                                        | (0.26      | )                                      | $          | (0.25 | ) | $ | (0.46 | ) | $ | (0.44 | ) |
|                                                               |       |                                     |       |                                   |       |   |   |   |   |
| **Weighted average common shares outstanding,  basic and diluted** |       | 8,882,786                                |       | 7,399,227                              |       | 8,882,786 |   | 7,272,386 |   |
|                                                                    |            |                                          |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**15.****       Bank line of credit**

 

In connectionwith its acquisition of Core Systems, the Company assumed a $1,000,000Factoring line of credit with a bank. The Factoring agreement calls for the bank to advance 80% of qualifiedsales invoices to the Company in exchange for a fee of 1% of each invoiceadvanced and interest of prime plus 2.5% of the outstanding balance (7.75% at December 31,2004).  The agreement contains certainfinancial covenants which must be reported monthly to the bank.  As of December 31, 2004 the Company wasin violation of the net operating profit covenant; however, in a letter dated December 29,2004 the bank issued a waiver of this default. The amount of the advances outstanding under this line of credit wasapproximately $16,000 as of December 31, 2004.  For the three months ended December 31,2004, the Company recognized approximately $13,000 in interest expense relatingto this line of credit.

 

**16.****       Recent Account Pronouncements**

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting forStock-Based

 

14

----

 

Compensation.  SFAS No. 123 (R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123 (R) is similar to the approach described in SFAS No. 123.  However, SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values.  Pro-forma disclosure is no longer an alternative.  The Company expects to adopt SFAS No. 123 (R) on July 1, 2005.

 

15

----

 

**Item 2****.****                                  ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

The following management discussion andanalysis should be read in conjunction with the financial statements and notesthereto as filed in our Form 10-KSB/A No. 1 for the year ended June 30,2004.  In addition to historicalinformation, this Form 10-QSB contains forward-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 are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sopinions only as of the date hereof.  Weundertake no obligation to revise or publicly release the results of anyrevision to these forward-looking statements. Readers should carefully review documents that we file from time to timewith the Securities and Exchange Commission, including our Quarterly Reportsand Annual Reports filed by us in fiscal 2003 and 2004.

 

Implant Sciences Corporation, incorporated in1984, has two locations.  It operates outof a 51,000 square foot leased facility in Wakefield, Massachusetts and since October 15,2004, when it acquired Core Systems, Inc, also out of a 35,000 square foot leased facility in Sunnyvale,California.  The Company hasapproximately 125 employees and runs three shifts in Wakefield and two shiftsin Sunnyvale.  The Company generatesrevenues from the sale of ion implantation services, radioactive prostate seedsand explosives trace detection equipment, as well as government research anddevelopment contracts.  Ion implantationservices include semiconductor wafer processing and medical and industrialcoatings.  Semiconductor products andservices are conducted in both the Wakefield and Sunnyvale facilities.  Medical and industrial coatings, radioactiveprostate seed manufacturing, explosives detection equipment manufacturing andresearch and development programs are conducted in Wakefield.

 

The Company has made and continues to make asignificant financial commitment to the development of its trace explosivesdetection products.  However, in order tocontinue explosives trace detection research and development, additionalsources of funding will need to be identified to help support this businesssegment.

 

As a result of the acquisition of CoreSystems on October 15, 2004, and the Company’s presentation ofconsolidated financial statements, it should be noted that comparativeinformation may not be meaningful.

 

**Resultsof Operations**

 

*Comparison for the three months ended December 31,2004  and 2003*

 

*Revenues. *Total revenues for the three months ended December 31,2004 were $2,541,000 as compared to $1,889,000 for the comparable prior yearperiod, an increase of $652,000 or 35%. The increase is primarily attributable to $1,128,000 of revenues fromCore Systems since it was acquired on October 15, 2004.  The Core Systems revenues are included in oursemiconductor business segment.   Thisincrease was offset by a $275,000 or 23% decrease in medical product sales,primarily a reduction in prostate seeds of $201,000 or 58% combined with a$73,000 or 44% decrease in medical sales relating to the completion of certaingovernment grants.  In addition,explosive detection sales decreased $127,000 or 28% as compared with thecomparable prior year period, due to the completion of several governmentcontracts, as compared with the comparable prior year period.

 

It should be noted that our revenuesrecognized from Small Business Innovative Research (SBIR) programs, fluctuatedue to: (a) our desire to obtain external funding for our research anddevelopment efforts; (b) the availability of government funding; and (c) thetime required to obtain approval of a grant application.  We have been successful in obtaining SBIRgrants in fiscal 2004 and 2003 and we expect to continue to seek continuationor replacement of our existing SBIR grants during fiscal 2005 and beyond.

 

In the first quarter of fiscal 2004, weentered into a new agreement with MED-TEC, our former exclusive distributor ofI-Plant prostate seeds to replace the original Distributor Agreement, which hadexpired.  Management believes this directmarketing and sales program will enable the Company to expand distributionchannels targeting the radiation oncology market.  MED-TEC agreed to work cooperatively with theCompany to transition its customers and marketing materials directly to ImplantSciences and MED-TEC also agreed not to compete with the Company for a periodof three years.  Implant Sciences ispaying MED-TEC an average of approximately $39,000 per month over a period of29 months, beginning September 1, 2003. As of December 31, 2004, the outstanding principal balance isapproximately $414,000.

 

16

----

 

*Cost of Sales. *Cost of sales for the three months ended December 31,2004 was $2,980,000 as compared to $1,506,000 for the comparable prior yearperiod, an increase of $1,474,000 or 98%. This increase is primarily a result of the acquisition of Core Systemsand an additional $1,089,000 in associated expenses incurred by Core in thethree month period ended December 31, 2004.  Also, the Company recognized an additional$34,000 of depreciation expense as well as a $32,000 for warranty expensesrelating to the manufacturing of our explosives detector devices.  In addition, direct labor costs increased $100,000as we continue to build our manufacturing work force in anticipation of neworders for our explosives trace detectors.

 

*Research andDevelopment*  Research and Development expenses for thethree months ended December 31, 2004 was $282,000 compared to $464,000 forthe comparable prior year period, a decrease of $182,000 or 39%** Included in these expenses are $51,000 and$132,000 of non-cash stock-based compensation for the period ended December 31,2004 and 2003 respectively. Additionally, in the quarter ended December 31, 2004, $250,000 ofpreviously expensed research and development material costs were transferred toinventory to be used in manufacturing. After adjusting for the non-cash stock-based compensation and theadjustment for research and development materials transferred to the stockroom,research and development expenses for the three months ended December 31,2004increased by $149,000 or 45% over the comparable prior year period.  This increase is a result of increasedpersonnel costs and temporary help combined with additional rent expenses dueto a physical expansion of the department.

 

*Selling General andAdministrative * Selling, general and administrative expensefor the three month period ended December 31, 2004 was $1,276,000 comparedto $990,000 for the comparable prior year period, an increase of $286,000 or29%.  Selling, general andadministrative expenses included $38,000 and $195,000 of noncash stock-basedcompensation recorded in connection with the issuance of stock to employees andwarrants to an outside agents, and depreciation and amortization expenses of$128,000 and $126,000, in the three months ended December 31, 2004 and2003, respectively.  Net of the noncashstock-based compensation, and depreciation and amortization, general andadministrative expenses increased by $441,000 or 66%. This increase is partly attributable $229,000 and $0 of additionalexpenses relating to the Core acquisition, during the three month period ended December 31,2004 and 2003, respectively.  Inaddition, salaries increased due the hiring of additional staff in the financedepartment as well as increased travel and trade show expenses.

 

*Other expense,Net  *For the three month period ended December 31,2004 the company recorded other expense, net of $31,000 as compared to otherexpense, net of $36,000 for the comparable prior year period.  The decrease in other expenses, net is due toincreased interest income and a reduction in interest expense.

 

*Net Loss *Net loss for the three month period ended December 31,2004 was $2,028,000 as compared to a loss of $1,107,00 for the comparable prioryear period, an increase of $921,000 or 83%.

 

Additionally,during the period ended December 31, 2004, accretion of dividends, thebeneficial conversion feature and amortization of warrants in the amount of$283,000 relating to the Series C, was recognized as a preferred distributionas compared with $530,000 for the Series A and B for the prior yearperiod.  These transactions have nooverall effect on stockholders’ equity or cash, but increased net loss pershare applicable to common shareholders by $0.03 and $0.08 per sharerespectively.  The basic and diluted netloss per share applicable to common shares for the period ended December 31,2004 was $0.26 per share as compared to $0.23 per share for the comparableprior year period, a increase in net loss applicable to common shares of $0.03or 13%.

 

*Comparison for the six months ended December 31,2004 and 2003*

 

*Revenues. *Total revenues for the six months ended December 31,2004 were $4,815,000 as compared to $3,526,000 for the comparable prior yearperiod, an increase of $1,289,000 or 37%. The increase is primarily attributable to $1,128,000 of revenues fromCore Systems since it was acquired on October 15, 2004 and an increase of$669,000 or 106% from our explosives detection segment.  The Core Systems revenues are included in oursemiconductor business segment.  Government contract revenues increased by $520,000 and medical andindustrial coating sales increased by $134,000, as compared with thecorresponding prior year period.  Theseincreases were offset by a $473,000 or 20% decrease in medical product sales ascompared with the corresponding prior year period.

 

17

----

 

*Cost of Sales *Cost of sales for the six months ended December 31,2004 was $4,786,000 as compared to $2,666,000 for the comparable prior yearperiod, an increase of $2,120,000 or 80%. Included in the cost of sales for the period ended December 31,2004 are $1,089,000 of costs from Core Systems incurred since it’s acquisitionon October 15, 2004.  Explosivesdetection expenses increased by $762,000 or 240% as compared with thecomparable prior year period as we completed certain government contracts.  Additionally, we continue to invest in ourexplosive detection manufacturing department in anticipation of new orders forour explosives trace detectors.

 

*Research andDevelopment*  Research and Development expenses for the sixmonths ended December 31, 2004 were $868,000 compared to $893,000 for thecomparable prior year period, a decrease of $25,000 or 3%.  Inlcuded in these expenses are $89,000 and$172,000 of non-cash stock-based compensation expense for the six month periodsended December 31, 2004 and 2003, respectively.  Additionally, in the quarter ended December 31,2004, $250,000 of previously expensed research and development material costswere transferred to inventory to be used in manufacturing.  After adjusting for the non-cash stock-basedcompensation and the research and development materials transferred toinventory, research and development expenses for the six months ended December 31,2004 increased by $308,000 or 43% over the comparable prior year period.  This increase is a result of increasedpersonnel and temporary help combined with additional rent expenses due to aphysical expansion of the department.

 

*Selling, General andAdministrative.*  Selling, general and administrative expensesfor the six month period ending December 31, 2004 were $2,330,000 ascompared to $1,750,000 for the comparable prior year period, an increase of$580,000 or 33%. Selling, general and administrative expenses included$63,000 and $259,000 of noncash stock-based compensation recorded in connectionwith the issuance of stock to employees and warrants to outside agents in thesix months ended December 31, 2004 and 2003, respectively.  Net of the noncash stock-based compensation,general and administrative expenses increased by $776,000 or 52%.  Included in selling, general andadministrative expenses for the six month period ended December 31, 2004and 2003 are $229,000 and $0 respectively relating  to Core Systems incurred since itsacquisition on October 15, 2004. Salaries increased due to the hiring of additionalstaff in the finance department combined with increased rent anddepreciation.  Travel and marketingexpenses increased as we continue to promote our trace detection technology.

 

*Other Expense,Net  *For the six month period ended December 31,2004 the company recorded other expense, net of $50,000 as compared to otherexpense, net of $78,000 for the comparable prior year period, a decrease of$28,000 or 36%.  The decrease in otherexpenses, net is due to increased interest income and a reduction in interestexpense.

 

*Net Loss *Net loss for the six month period ended December 31,2004 was $3,219,000 as compared to a loss of $1,861,000 for the comparableprior year period, an increase of $1,358,000 or 73%.  Contributing to these losses are reduced grossmargins in the medical products segment of $472,000 do to lower manufacturinglevels and yield losses.  Semiconductormargins decreased $266,000 primarily due to increased costs attributable tobringing on additional wafer processing capabilities.  Also contributing to the loss were anadditional costs attributable to the ramp up of the Company’s explosivesdetection business.

 

Additionally,during the period ended December 31, 2004, accretion of dividends, thebeneficial conversion feature and amortization of warrants in the amount of$567,000 relating to the Series C, was recognized as a preferred distributionas compared with $973,000 for the Series A and B for the prior yearperiod.  The effect of these transactionshas no overall effect on stockholders’ equity or cash, but increased net lossper share applicable to common shareholders by $0.07 and $0.14 per sharerespectively.  The basic and diluted netloss per share applicable to common shares for the period ended December 31,2004 was $0.44 per share as compared to $0.41 per share for the comparableprior year period, a increase in net loss applicable to common shares of $0.03or 7%.

 

**Liquidity and Capital Resources**

 

As of December 31, 2004, we hadapproximately $2,180,000 in cash and cash equivalents.  During the six months ended December 31,2004, operating activities used cash of approximately $1,745,000.  Net cash used by operating activitiesprimarily reflects the net loss of $3,219,000, offset by depreciation andamortization of $783,000, stock-based compensation expense of $153,000 and anincrease in accounts payable and other accrued liabilities of $519,000.  During the six months ended December 31,2004, investing activities used cash of approximately $2,999,000, $2,597,000 ofwhich was used in the acquisition of Core Systems.  During the six months

 

18

----

 

ended December 31, 2004, financing activities providedapproximately $18,000 in cash.  Net cashprovided by financing activities primarily includes $831,000 of net proceedsfrom the exercise of employee stock options and issuance of warrants. offset bypayments on the factoring line of credit, repayment of debt, and theacquisition of treasury stock.

 

On November 25,2003, the Company issued 250,000 shares of Series C 5% CumulativeConvertible Preferred Stock (“Series C”) having a stated value of $10 pershare, pursuant to a Securities Purchase Agreement executed on November 25,2003 with the Laurus Master Fund, Ltd. (Laurus).  The Company received $2,500,000 in grossproceeds, less a management and placement agent fee of approximately $125,000,and related transaction costs of approximately $86,000.  The terms of the Series C provide forrepayment with shares of the Company’s common stock or in cash, pursuant to anamortization schedule.  Repayment of theSeries C commenced on March 31, 2004. The Company has the sole option to determine whether to satisfy paymentof the monthly amount in full on each repayment date either in cash or inshares of common stock, or a combination of both, unless the closing price ofthe Company’s common stock for any of the eleven trading days preceding arepayment date was less than $7.35, wherein the Company will be required to paysuch monthly amount in cash.  If thepayment of the monthly amount is made in common stock, the fixed conversionprice is $6.75.  The Company also issuedto Laurus a warrant to purchase 50,000 shares of common stock at $8.44 pershare and 50,000 shares of common stock at $10.13 per share.  The Securities Purchase Agreement alsoprovides for a security interest in substantially all of the Company’s assetsand provides Laurus a right of first refusal on future financing arrangementsduring the Term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it hereby agreesto enter into such documentation as shall be reasonable requested by theCompany in order to subordinate its rights under the Series C to the subsequentfinancier.  The Company will utilize the proceedsof this financing to purchase an ion implanter and for general working capitalpurposes.

 

In accordance with the provisions of EmergingIssues Task Force (EITF) Issue 00-27, “Application of EITF Issue No. 98-5 ‘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 C containeda beneficial conversion feature calculated based on the difference between theeffective conversion price of the proceeds allocated to the Series C and thefair market value of the common stock at the date of issuance.  The discount arising from the beneficial conversionfeature aggregated $700,000.  Thediscount is being amortized and recorded as a preferred dividend during theperiod from the issuance of the preferred stock to the mandatory redemptiondate of June 1, 2005, or the actual conversion date, whichever is earlierusing the effective interest method.

 

The Company valued the Series C at issuanceto be $1,284,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $2,289,000 ($211,000of issuance costs incurred), the amount allocated to warrants of $305,000, andthe amount of the discount related to the value of beneficial conversionfeature of $700,000.  The Company isaccreting these discounts on the carrying value of the preferred stock to itsredemption value of $2,500,000 at June 1, 2005, or the actual conversiondate, whichever is earlier.  Theaccretion of these amounts is being recorded as a preferred dividend in theperiod of accretion.  During the periodended December 31, 2004, approximately $274,000 was amortized.  As of December 31, 2004, the outstandingprincipal of the Series C was approximately $258,000.

 

During the three months ended December 31,2004, Laurus redeemed 56,353 shares of Series C into 83,486 shares of theCompany’s common stock at conversion price of $6.75 per share and redeemedapproximately $6,000 of accrued dividends into 896 shares of the Company’scommon stock.  During the three monthsended December 31, 2004, the Company accrued approximately $6,000 ofdividends.  The conversion of accrueddividends into common stock resulted in additional dividends of approximately$3,000 during the three months ended December 31, 2004, in excess of 5%stated value.

 

We are developing several explosive detectionsystems that could be used in airports, public and government buildings, andsporting event facilities.  The systemsuse our proprietary Laser IMS technology, which includes the use of laser beamsin combination with ion mobility spectrometry, to electronically detect minutequantities of explosive vapor molecules in the air.  This project has been ongoing since approximatelyMay 1999.  In November 2001, wedeveloped a portable prototype and in December 2001 we demonstrated it tothe U.S.

 

19

----

 

Department of Transportation. Following this demonstration, we decided to pursue the technology.  At present, we are developing both portableand bench-top systems for use in airports and Department of Defensefacilities.  Prototype units have beentransported to the Department of Defense and Department of Transportationfacilities for demonstration and evaluation.

 

This project is currently being undertaken byboth our internal scientists and outside contractors.  The development of new applications istypically funded through government grants or internal funding.  Originally, we funded a research anddevelopment program for the explosives detection system to produce enough datato write grant proposals for the Department of Defense to detect unexplodedbombs and mines.  Since March 2000,we have received seven contracts totaling $1,789,000 for detection of toxicchemicals or explosives from agencies such as the Departments of the Army, AirForce, Marine Corps and Navy; as well as the National Institutes of Health andthe Department of Homeland Security.  Inaddition, on August 12, 2002, we signed a Cooperative Research andDevelopment Agreement with an agency of the Department of Homeland Securitywhich will permit us and the government to exchange critical test data and forus to deliver a certain number of units to the Department of Homeland Securityfor independent evaluation and field testing.

 

In June 2000, we developed our firstgeneration device, which demonstrated sensitivity to the explosive TNT.  In June 2001, we developed a secondgeneration prototype with increased sensitivity and selectivity.  This device can detect and specify anincreasing number of compounds within various explosive materials.  The explosives that have been tested to dateare TNT, RDX, PETN, EGDN, and DNT.  RDXis the primary component of C3 and C4 explosives, such as Datasheet and Semtex,as well as certain types of black powder explosives.  We believe these explosives represent themajority of the explosives presently used in terrorist activities.  After the attack on the World Trade Centeroccurred on September 11, 2001, management made the decision to continuethe internal funding of the project rather than await funding throughgovernment grants.  Our electronicdetection system has been subjected to controlled testing by third parties andsuccessfully detected C4.  As a result ofthe successful demonstration, we believed it was appropriate to further pursuethe commercial development of our electronic detection system device.

 

Consistent with our policy to protect ourproprietary technologies, we have been awarded one patent and submitted seven(7) patent applications to the United States Patent and Trademark Office.  These patent applications will cover specificdesign configurations that are responsible for our improved vapor detectionsensitivity.

 

We are developing several versions of ourexplosives detection systems, including: (i) a table-top unit, which can beused to screen passengers and carry-on baggage in airports; and (ii) a portablesystem, which can be used to replace bomb-sniffing dogs to clear buildings,aircrafts, or ships where hidden bombs are believed to exist.  We received $600,000 from the U.S. Navy in November 2002for further development of the portable device. This device was delivered to the U.S. Navy for testing in May 2003.  Tests were successfully completed and in December 2003,the U. S. Navy awarded the Company an additional $1,300,000 to turn thisprototype into a manufacturable unit and deliver three units for testing.   We plan to first market these systems toU.S. government agencies for use in airports, government buildings andfacilities.

 

Although our operations and spending continueto focus on the sales of our semiconductor, contract manufacturing, medicalcoatings and prostate seed products, we are currently expending significantresources in the development of our explosives 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 funding in order to advance the commercialdevelopment of the explosives detection system. 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 no assurance that we will be successful in our attempts to raisesuch additional financing.

 

We will require substantial funds for furtherresearch and development, regulatory approvals and continued expansion ofcommercial-scale manufacturing capabilities, and the marketing of ourproducts.  Our capital requirementsdepend on numerous factors, including but not limited to, the progress of ourresearch and development programs; the cost of filing, prosecuting, defendingand enforcing any intellectual property rights; competing technological andmarket developments; changes in our development of commercialization activitiesand arrangements; and the purchase of additional facilities and capital equipment.

 

20

----

 

As of December 31, 2004, we wereconducting our operations with approximately $2,180,000 in cash and cashequivalents. Our current balance of cash and cash equivalents may not beadequate to fund operations and our current level of spending on research andproduct development.  Future expendituresfor research and product development will require additional sources of fundingand the Company is currently exploring its options.  Certain selling, general and administrativeexpenses can be adjusted, based on the availability of cash

 

The Company’s future minimum payments undercontractual obligations related to capital leases, operating leases and termnotes as of December 31, 2004, are as follows:

 
| ** **                | ** ** | **Capital  Leases and Long Term Debt** | ** ** | **Operating  Lease** | ** ** | **MED-TEC  (1)** | ** ** | **Total** | ** ** |
|---------------------------|------------|----------------------------------------|------------|----------------------|------------|------------------|------------|-----------|------------|
| Year ending June 30: |       |                                   |       |                 |       |             |       |      |       |
| 2005                      |       | $                                      | 30,000     |                 | $          | 532,000          |       | $         | 234,000    |   | $ | 796,000 |   |
| 2006                      |       | 32,000                                 |       | 1,105,000            |       | 180,000          |       | 1,317,000 |       |
| 2007                      |       | 14,000                                 |       | 1,133,000            |       |             |       | 1,147,000 |       |
| 2008                      |       | 14,000                                 |       | 1,162,000            |       |             |       | 1,176,000 |       |
| 2009                      |       | 13,000                                 |       | 884,000              |       |             |       | 897,000   |       |
|                      |       |                                   |       |                 |       |             |       |      |       |
| Total                     |       | $                                      | 103,000    |                 | $          | 4,816,000        |       | $         | 414,000    |   | $ | 5,333,000 |   |

 

----

(1) Relates to MED-TEC payment obligation(See Note 9 of financial statements).

 

On June 30, 2004, we entered into an employment agreement with Dr.Anthony J. Armini, the Company’s President and CEO, with an initial term ofthree years and an automatic renewal for a successive period of three years,unless we or Dr. Armini give the other party not less than three months writtennotice of non-renewal.  Under thisemployment agreement, Dr. Armini serves as our president and chief executiveofficer at a base salary of up to $210,000. In addition, Dr. Armini may participate in our employee fringe benefitplans or programs generally available to employees of comparable status andposition.  We are entitled to terminatehis employment for any material breach of his employment agreement at any timeupon at least 30 days written notice.  Inthe event we terminate Dr. Armini’s employment without cause, we will pay him12 months salary.  Under his employmentagreement, he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Armini is subject to a non-competition provision.

 

On June 30, 2004, we entered into anemployment agreement Dr. Stephen Bunker, the Company’s Vice President and ChiefScientist, with an initial term of three years and an automatic renewal for asuccessive period of three years, unless we or Dr. Bunker give the other partynot less than three months written notice of non-renewal.  Under this employment agreement, Dr. Bunker servesas our vice president and chief executive scientist at a base salary of up to$150,000.  In addition, Dr. Bunker mayparticipate in our employee fringe benefit plans or programs generallyavailable to employees of comparable status and position.  We are entitled to terminate his employmentfor any material breach of his employment agreement at any time upon at least30 days’ written notice.  In the event weterminate Dr. Bunker’s employment without cause, we will pay him 12 monthssalary.  Under his employment agreement,he is subject to restrictive covenants, including confidentialityprovisions.  Also, during his employmentand for a period of two years after the term of the employment agreement, Dr.Bunker is subject to a non-competition provision.

 

On October 15, 2004 (“Closing Date”), theCompany completed the acquisition of Core. In connection with the Transaction, the Company issued 311,437 shares ofits common stock as the Stock Consideration and $2,000,000 in cash, to theformer Core stockholders.

 

The holders of the shares of common stockcomprising the Stock Consideration have agreed not to sell any of their sharesof common stock for a period of six (6) months from the Closing Date.  Pursuant to the terms of the

 

21

----

 

merger agreement, the shares of common stock comprising the StockConsideration will be adjusted in the event the Company’s stock price at theend of the lock-up period is either greater than twenty-five percent (25%)higher or lower than $10.4355 per share. In addition, the merger agreement includes an earnout provision equal toCore’s earnings before taxes, depreciation and amortization for the twelve (12)month period beginning on October 13, 2004, the execution date of themerger agreement, and ending on October 12, 2005, which will be paid inthe form of additional shares of the Company’s common stock. The number ofshares to be issued in connection with the earnout, if any, will be calculatedby dividing the dollar amount of the earnout by the twenty (20) day averageclosing price of the Company’s common stock prior to the end of the earnoutPeriod.  The earnout shares will also besubject to a six (6) month lock-up, beginning on October 13, 2005, andwill be adjusted in the event the Company’s stock price is either greater thantwenty-five percent (25%) higher or lower than the earnout share price at theend of the earnout lock-up period.  TheCompany has agreed to use its “best-efforts” to file a registration statementwith the Securities and Exchange Commission, registering the resale of all ofthe shares of common stock included in the Stock Consideration within six (6)months from the Closing Date.

 

Additionally, pursuant to the terms of themerger agreement, ten percent (10%) of each of the Stock Consideration and theCash Consideration has been heldback by the Company, pursuant to a holdbackagreement, for a period of twelve (12) months from the Closing Date for thepurpose of settling any undisclosed liabilities that may be discovered by theCompany during the Holdback Period, for indemnification of any breach of therepresentations and warranties made by Core and its primary stockholder, andfor other potential expenses related to the transaction.

 

In June 2004, the Board authorized theCompany to repurchase of up to 300,000 shares of the Company’s common stock,from time to time in the open market, privately negotiated transactions, blocktransactions or at time and prices deemed appropriate by management.  As of December 31, 2004, the Companyrepurchased 6,000 shares of common stock at prices ranging from $8.91 to $9.02per share at a total cost of approximately $54,000, which is recorded astreasury stock in the accompanying balance sheet.

 

*Critical Accounting Policies*

 

Our significant accounting policies are describedin Note 2 to the financial statements included in Item 7 of our Form 10-KSB/ANo. 1 as of June 30, 2004.  Ourdiscussion and analysis of our financial condition and results of operationsare based upon the financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States.  The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities.  On anon-going basis, we evaluate our estimates, including those related to baddebts, product returns, inventories, investments, intangible assets and warrantyobligations.  We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. In the past, actual results have not been materially different from ourestimates.  However, results may differfrom these estimates under different assumptions or conditions. During thequarter ended December 31, 2004, we adopted SFAS 142 “Goodwill and OtherIntangible Assets,” and accordingly, goodwill and other intangible assets withindefinite lives are not being amortized, but rather such assets are subject toannual impairment reviews or more frequently, if events or circumstancesindicate that they may be impaired.

 

22

----

 

**Item 3.****         Controlsand Procedures**

 

Based on an evaluation of our disclosurecontrols and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under theSecurities Exchange Act of 1934), the chief executive officer and chieffinancial officer have concluded that our disclosure controls and procedures asof the end of the three month period ended December 31, 2004, are designedto ensure that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms and areoperating in an effective manner.

 

Based upon the Controls Evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this quarterly report, except as described in the following paragraphs, our Disclosure Controls are effective to ensure that material information relating to our company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our Internal Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles.

 

During our June 30, 2004 audit, our independent auditors reported to our Audit Committee certain matters involving internal controls that our independent auditors considered to be a reportable condition, but not a material weakness, under standards established by the American Institute of Certified Public Accountants. The reportable condition relates to the June 30, 2004 financial close process, including financial statement account analysis.  This reportable condition resulted from inadequate staffing and supervision over the review and financial statement close function. The reportable condition lead, in the audit process, to the identification and resolution of accounting matters and substantiation and evaluation of certain account balances and financial information.

 

The reportable condition had been discussedin detail among management, our Audit Committee and our independent auditors,and we are committed to addressing and resolving these matters fully andpromptly, by putting in place the personnel, processes, technology and otherresources appropriate to support our financial close processes. As part of thiscommitment, we have hired an experienced full time controller to coordinate andreview the financial statement close procedure.

 

23

----

 

PART II:  OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

Not Applicable

 

Item 2.  Changes in Securitiesand Use of Proceeds

 

During thethree months ended December 31, 2004, Laurus redeemed 56,353 shares ofSeries C into 83,486 shares of the Company’s common stock at conversion priceof $6.75 per share and redeemed approximately $6,000 of accrued dividends into896 shares of the Company’s common stock. During the three months ended December 31, 2004, the Companyaccrued approximately $6,000 of dividends. The conversion of accrued dividends into common stock resulted inadditional dividends of approximately $3,000 during the three months ended December 31,2004, in excess of 5% stated value.

 

Item 3.  Defaults Upon SeniorSecurities

 

Not Applicable

 

Item 4.  Submission of Matters ofa Vote to Security-Holders

 

Weheld our annual shareholders meeting on December 14, 2004.  Anthony Armini, Stephen Bunker, DavidEisenhaure, Gerald Entine and Michael Szycher were elected as directors of theCompany to hold office until the 2005 annual meeting of the shareholders.  The results for this proposal were asfollows:

 
| **NAME**          | ** ** | **FOR**   | ** ** | **WITHHELD** | ** ** |
|-------------------|------------|-----------|------------|--------------|------------|
| Anthony  Armini   |       | 8,459,466 |       | 136,201      |       |
| Stephen  Bunker   |       | 8,460,691 |       | 134,976      |       |
| David  Eisenhaure |       | 8,449,966 |       | 145,701      |       |
| Gerald  Entine    |       | 8,447,733 |       | 147,934      |       |
| Michael  Szycher  |       | 8,456,666 |       | 139,001      |       |

 

ProposalNo. 2 was an amendment to the Company’s 2000 Incentive and Nonqualified StockOption Plan.  The results for thisproposal were as follows:

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **WITHHELD** | ** ** |
|-----------|------------|-------------|------------|--------------|------------|
| 4,305,161 |       | 474,923     |       | 2,931        |       |

 

ProposalNo. 3 was to approve the Company’s 2004 Incentive and Nonqualified Stock OptionPlan.  The results for this proposal wereas follows:

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **WITHHELD** | ** ** |
|-----------|------------|-------------|------------|--------------|------------|
| 4,483,086 |       | 285,698     |       | 14,231       |       |

 

Item 5.  Other Information

 

**Certifications UnderSarbanes-Oxley Act**

Our chief executive officer and chieffinancial officer have furnished to the SEC the certification with respect tothis Report that is required by Section 906 of the Sarbanes-Oxley Act of2002.

 

24

----

 

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

 

(a)          The following exhibits,required by Item 601 of Regulation S-B, are filed as part of this QuarterlyReport on Form 10-QSB.  Exhibit numbers,where applicable, in the left hand column correspond to those of Item 601 ofRegulation S-B.

 
| **Exhibit No.** |   | **Description**                                                                                                                                       |
|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1            |   | Certification of Chief Executive Officer  pursuant to Section 302 Sarbanes-Oxley Act of 2002                                                     |
|            |   |                                                                                                                                                  |
| 31.2            |   | Certification of Chief Financial Officer  pursuant to Section 302 Sarbanes-Oxley Act of 2002                                                     |
|            |   |                                                                                                                                                  |
| 32.1            |   | Certification of the Chief Executive  Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |
|            |   |                                                                                                                                                  |
| 32.2            |   | Certification of the Chief Financial  Officer Pursuant to 18 U.S.C. 1350, as adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |

 

(b)                                 CurrentReport on Form 8-K dated December 29, 2004, regarding the acquisition ofCore Systems.

 

25

----

 

SIGNATURES

 

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

 
|                         |   | Implant Sciences Corporation |
|------------------------------|--------|------------------------------|
|                         |   |                         |
| Date: February 22, 2005 |   | /s/ Anthony J. Armini        |   |
|                         |   | Anthony J. Armini            |
|                         |   | President and CEO            |
|                         |   |                         |
|                         |   |                         |
| Date: February 22, 2005 |   | /s/ Diane J. Ryan            |   |
|                         |   | Diane J. Ryan                |
|                         |   | Chief Financial Officer      |
|                              |        |                              |  |  |

 

26

----