## **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

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

 

**FORM 10-QSB**

 

| **ý**                                 |   | **Quarterly  report pursuant to section 13 or 15(d) of the Securities Exchange Act of  1934.**                                                                                                                                                                                                                                |
|--------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                       |   |                                                                                                                                                                                                                                                                                                                          |
|                                       |   | **For the quarterly period ending September  30, 2003**                                                                                                                                                                                                                                                                       |
|                                       |   |                                                                                                                                                                                                                                                                                                                          |
|                                       |   | **or**                                                                                                                                                                                                                                                                                                                        |
|                                       |   |                                                                                                                                                                                                                                                                                                                          |
| **o**                                      |   | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934.**                                                                                                                                                                                                                               |
|                                       |   |                                                                                                                                                                                                                                                                                                                          |
|                                       |   | **For the transition period from                         to                         .** |
|                                       |   |                                                                                                                                                                                                                                                                                                                          |
| **Commission file number  000-25839** |

 

**IMPLANTSCIENCES CORPORATION**

(Exact name of registrant as specified in itscharter)

 

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

 

**781-246-0700**

(Issuers telephone number)

 

**NotApplicable**

(Former name, former address and formerfiscal 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 Act of1934 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 October 31, 2003** |
|------------------------------|--------|-------------------------------------|
| Common Stock, $.10 par value |   | 6,948,746                           |

 

Transitional small business disclosure format(check one):

YES   o    NO   ý

 

This document consists of 22 pages.

 

 

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**IMPLANTSCIENCES CORPORATION**

 

**INDEX**

 
| PART I.   FINANCIAL INFORMATION |                                                 |
|--------------------------------------|------------------------------------------------------|
|                                 |                                                 |
| Item 1.                              | Financial Statements:                                |   |
|                                 |                                                 |   |   |
|                                 |                                                 | Condensed Balance Sheets as of September 30, 2003 and June 30, 2003  (unaudited) |   |
|                                 |                                                 |   |   |
|                                 |                                                 | Condensed Statements of Operations for the Three Months Ended  September 30, 2003 and 2002 (unaudited) |   |
|                                 |                                                 |   |   |
|                                 |                                                 | Condensed Statements of Cash Flows for the Three Months Ended  September 30, 2003 and 2002 (unaudited) |   |
|                                 |                                                 |   |   |
|                                 |                                                 | Notes to Condensed Financial Statements (including data applicable to  unaudited periods) |   |
|                                 |                                                 |   |   |
| 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                                           |   |

 

2

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**IMPLANT SCIENCES CORPORATION**

**CONDENSED BALANCE SHEETS**

**(Unaudited)**

 
|                                                                                                                                                                                                                |   | **September 30,  2003** |      | **June 30,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|-----------|--------------------|--------|
|                                                                                                                                                                                                                |   |                    |      |               |   |
| **ASSETS**                                                                                                                                                                                                          |   |                    |      |               |   |
| Current assets:                                                                                                                                                                                                     |   |                    |      |               |   |
| Cash and cash equivalents                                                                                                                                                                                           |   | $                       | 1,604,000 |               | $      | 959,000 |   |
| Accounts receivable, net                                                                                                                                                                                            |   | 974,000                 |      | 778,000            |   |
| Inventories                                                                                                                                                                                                         |   | 518,000                 |      | 473,000            |   |
| Investments - available for sale securities                                                                                                                                                                         |   | 204,000                 |      | 177,000            |   |
| Prepaid and other current assets                                                                                                                                                                                    |   | 40,000                  |      | 33,000             |   |
| Total current assets                                                                                                                                                                                                |   | 3,340,000               |      | 2,420,000          |   |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| Property and equipment, net                                                                                                                                                                                         |   | 4,721,000               |      | 4,741,000          |   |
| Amoritzable intangible assets, net (Note 10)                                                                                                                                                                        |   | 937,000                 |      | —             |   |
| Other non-current assets, net                                                                                                                                                                                       |   | 132,000                 |      | 136,000            |   |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| Total assets                                                                                                                                                                                                        |   | $                       | 9,130,000 |               | $      | 7,297,000 |   |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| **LIABILITIES AND STOCKHOLDERS'  EQUITY**                                                                                                                                                                           |   |                    |      |               |   |
| Current liabilities:                                                                                                                                                                                                |   |                    |      |               |   |
| Accounts payable                                                                                                                                                                                                    |   | $                       | 634,000   |               | $      | 749,000 |   |
| Accrued expenses                                                                                                                                                                                                    |   | 524,000                 |      | 669,000            |   |
| Current portion of long-term debt                                                                                                                                                                                   |   | 1,614,000               |      | 1,269,000          |   |
| Obligations under capital leases                                                                                                                                                                                    |   | 5,000                   |      | 5,000              |   |
| Total current liabilities                                                                                                                                                                                           |   | 2,777,000               |      | 2,692,000          |   |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| Long-term liabilities:                                                                                                                                                                                              |   |                    |      |               |   |
| Noncurrent obligations under capital lease                                                                                                                                                                          |   | 9,000                   |      | 11,000             |   |
| Long-term debt                                                                                                                                                                                                      |   | 513,000                 |      | —             |   |
| Total liabilities                                                                                                                                                                                                   |   | 3,299,000               |      | 2,703,000          |   |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| Convertible preferred stock:  5,000,000 shares authorized                                                                                                                                                      |   |                    |      |               |   |
| 7% Series A Cumulative Convertible Preferred  Stock, $10 stated value;  250,000 shares designated; 45,125 and 150,000 Series A shares issued and  outstanding at September 30, 2003 and June 30, 3003, respectively |   | 258,000                 |      | 966,000            |   |
| 5% Series B Cumulative Convertible Preferred  Stock, $10 stated value;  200,000 shares designated; 200,000 and 0 Series B shares issued and  outstanding at September 30, 2003 and June 30, 3003, respectively      |   | 1,001,000               |      | —             |   |
| Stockholders' equity:                                                                                                                                                                                               |   |                    |      |               |   |
| Common stock, $.10 par value; 20,000,000 shares  authorized; 6,918,246 and 6,650,156 issued and outstanding as of September  30, 2003 and June 30, 2003, respectively                                               |   | 692,000                 |      | 665,000            |   |
| Additional paid-in capital                                                                                                                                                                                          |   | 18,283,000              |      | 16,064,000         |   |
| Accumulated deficit                                                                                                                                                                                                 |   | (14,186,000             | )         | (12,988,000        | )      |
| Deferred compensation                                                                                                                                                                                               |   | (139,000                | )         | (7,000             | )      |
| Accumulated other comprehensive income                                                                                                                                                                              |   | 144,000                 |      | 117,000            |   |
| Notes receivable from employees                                                                                                                                                                                     |   | (222,000                | )         | (223,000           | )      |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| Total stockholders' equity                                                                                                                                                                                          |   | 4,572,000               |      | 3,628,000          |   |
|                                                                                                                                                                                                                |   |                    |      |               |   |
| Total liabilities and stockholders' equity                                                                                                                                                                          |   | $                       | 9,130,000 |               | $      | 7,297,000 |   |

 

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

 

3

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                                               |   | **Three Months Ended  September 30,** |       |
|----------------------------------------------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                                                               |   | **2003**                              |       | **2002** |   |
| Revenues:                                                                                          |   |                                  |       |   |   |
| Product revenues:                                                                                  |   |                                  |       |   |   |
| Medical                                                                                            |   | $                                     | 1,014,000  |   | $ | 1,194,000 |   |
| Semiconductor                                                                                      |   | 259,000                               |       | 209,000 |   |
| Government contracts                                                                               |   | 363,000                               |       | 172,000 |   |
| Total revenues                                                                                     |   | 1,636,000                             |       | 1,575,000 |   |
|                                                                                               |   |                                  |       |   |   |
| Costs and expenses:                                                                                |   |                                  |       |   |   |
| Cost of product revenues                                                                           |   | 970,000                               |       | 1,055,000 |   |
| Cost of government contracts                                                                       |   | 190,000                               |       | 172,000 |   |
| Total costs and expenses                                                                           |   | 1,160,000                             |       | 1,227,000 |   |
|                                                                                               |   |                                  |       |   |   |
| Gross margin                                                                                       |   | 476,000                               |       | 348,000 |   |
|                                                                                               |   |                                  |       |   |   |
| Operating expenses:                                                                                |   |                                  |       |   |   |
| Research and development                                                                           |   | 482,000                               |       | 416,000 |   |
| Selling, general and administrative                                                                |   | 706,000                               |       | 522,000 |   |
| Total operating expenses                                                                           |   | 1,188,000                             |       | 938,000 |   |
|                                                                                               |   |                                  |       |   |   |
| Loss from operations                                                                               |   | (712,000                              | )          | (590,000 | ) |
|                                                                                               |   |                                  |       |   |   |
| Other income (expense):                                                                            |   |                                  |       |   |   |
| Interest income                                                                                    |   | 5,000                                 |       | 4,000 |   |
| Interest expense                                                                                   |   | (43,000                               | )          | (5,000 | ) |
| Equity loss in Epsilon Medical                                                                     |   | (4,000                                | )          | — |   |
| Total other income (expense)                                                                       |   | (42,000                               | )          | (1,000 | ) |
|                                                                                               |   |                                  |       |   |   |
| Net loss                                                                                           |   | (754,000                              | )          | (591,000 | ) |
|                                                                                               |   |                                  |       |   |   |
| Preferred distribution, dividends and accretion  (Note 8)                                          |   | (444,000                              | )          | — |   |
|                                                                                               |   |                                  |       |   |   |
| Net loss applicable to common shareholders                                                         |   | $                                     | (1,198,000 | ) | $ | (591,000 | ) |
|                                                                                               |   |                                  |       |   |   |
| Net loss per share                                                                                 |   |                                  |       |   |   |
| Per share - basic and diluted                                                                      |   |                                  |       |   |   |
| Net loss                                                                                           |   | (0.11                                 | )          | (0.10 | ) |
| Preferred distribution                                                                             |   | (0.07                                 | )          | — |   |
| Net loss per share applicable to common  shareholders                                              |   | $                                     | (0.18      | ) | $ | (0.10 | ) |
|                                                                                               |   |                                  |       |   |   |
| Weighted average common shares outstanding used in  computing basic and diluted earnings per share |   | 6,794,229                             |       | 6,216,080 |   |

 

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

 

4

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                                                          |   | **Three Months Ended  September 30,** |      |
|-------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|-----------|
|                                                                                                                          |   | **2003**                              |      | **2002** |   |
|                                                                                                                          |   |                                  |      |   |   |
| **Cash flows from operating  activities**                                                                                     |   |                                  |      |   |   |
| Net loss                                                                                                                      |   | $                                     | (754,000  | ) | $ | (591,000 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities:                                                  |   |                                  |      |   |   |
| Depreciation and amortization                                                                                                 |   | 255,000                               |      | 211,000 |   |
| Stock-based compensation expense                                                                                              |   | 138,000                               |      | — |   |
| Equity in loss in Epsilon Medical                                                                                             |   | 4,000                                 |      | — |   |
| Changes in assets and liabilities:                                                                                            |   |                                  |      |   |   |
| Accounts receivable                                                                                                           |   | (196,000                              | )         | 87,000 |   |
| Inventories                                                                                                                   |   | (45,000                               | )         | (125,000 | ) |
| Prepaid and other current assets                                                                                              |   | (7,000                                | )         | (33,000 | ) |
| Accounts payable                                                                                                              |   | (115,000                              | )         | 267,000 |   |
| Accrued expenses                                                                                                              |   | (164,000                              | )         | (71,000 | ) |
|                                                                                                                          |   |                                  |      |   |   |
| Net cash used in operating activities                                                                                         |   | (884,000                              | )         | (255,000 | ) |
|                                                                                                                          |   |                                  |      |   |   |
| **Cash flows from investing  activities**                                                                                     |   |                                  |      |   |   |
| Purchase of property and equipment                                                                                            |   | (166,000                              | )         | (157,000 | ) |
| Other non-current assets                                                                                                      |   | —                                |      | (17,000 | ) |
|                                                                                                                          |   |                                  |      |   |   |
| Net cash used in investing activities                                                                                         |   | (166,000                              | )         | (174,000 | ) |
|                                                                                                                          |   |                                  |      |   |   |
| **Cash flows from financing  activities**                                                                                     |   |                                  |      |   |   |
| Proceeds from common stock                                                                                                    |   | 25,000                                |      | 50,000 |   |
| Proceeds from issuance of Series B preferred  stock, net of issuance costs                                                    |   | 1,822,000                             |      | — |   |
| Repayments of long-term debt                                                                                                  |   | (54,000                               | )         | (44,000 | ) |
| Repayments of capital lease obligations                                                                                       |   | (2,000                                | )         | (3,000 | ) |
| Repayments of equipment financing                                                                                             |   | (96,000                               | )         | — |   |
|                                                                                                                          |   |                                  |      |   |   |
| Net cash provided by financing activities                                                                                     |   | 1,695,000                             |      | 3,000 |   |
|                                                                                                                          |   |                                  |      |   |   |
| Net increase (decrease) in cash and cash  equivalents                                                                         |   | 645,000                               |      | (426,000 | ) |
| Cash and cash equivalents, beginning                                                                                          |   | 959,000                               |      | 979,000 |   |
| Cash and cash equivalents, ending                                                                                             |   | $                                     | 1,604,000 |   | $ | 553,000 |   |
|                                                                                                                          |   |                                  |      |   |   |
| **Noncash Investing and Financing  Activity:**                                                                                |   |                                  |      |   |   |
| Issuance of Series B warrants                                                                                                 |   | $                                     | 125,000   |   | $ | — |   |
| Noncash beneficial conversion feature - Series B                                                                              |   | $                                     | 768,000   |   | $ | — |   |
| Conversion of Series A Cumulative Convertible  Preferred stock and accrued dividends into common stock                        |   | $                                     | 1,049,000 |   | $ | — |   |
| 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       |   | $                                     | 363,000   |   | $ | — |   |
| Accretion of 5% Series B Cumulative Convertible  Preferred Stock dividends,  beneficial  conversion feature and warrants |   | $                                     | 72,000    |   | $ | — |   |

 

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

 

5

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**IMPLANT SCIENCES CORPORATION**

**NOTES****TO CONDENSEDFINANCIAL STATEMENTS**

**September 30, 2003**

**(Unaudited)**

 

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

 

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

 

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

 

The financial information for the threemonths ended September 30, 2003 is unaudited but includes all adjustments(consisting only of normal recurring adjustments) which we consider necessaryfor a fair presentation of the financial position at such date and of theoperating results and cash flows for this period.  The results of operations and cash flows for the three monthsended September 30, 2003 are not necessarily indicative of results that may beexpected for the entire year.  Theinformation contained in this Form 10-QSB should be read in conjunction withour audited financial statements, included in our Form 10-KSB/A as of and forthe year ended June 30, 2003 filed with the Securities and Exchange Commissionon October 1, 2003.

 

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

 

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

 

The Company haselected to use the disclosure-only provisions of SFAS No. 123 and SFAS No. 148,“Accounting for Stock-Based Compensation-Transition and Disclosure.”  Had compensation expense for stock optiongrants to employees been determined based on the fair value method at the grantdates for awards under the stock option plans consistent with the methodprescribed by SFAS No. 123, the Company’s net loss would have increased to thepro forma amounts indicated as follows:

 

6

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|                                                                                                                                   |   | **Three Months Ended  September 30,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                                                                                                   |   | **2003**                              |       | **2002** |   |
|                                                                                                                                   |   |                                  |       |   |   |
| Net  loss applicable to common shareholders, as reported                                                                               |   | $                                     | (1,198,000 | ) | $ | (591,000 | ) |
|                                                                                                                                   |   |                                  |       |   |   |   |   |
| Add:  Stock-based employee compensation expense  included in reported net loss applicable to common shareholders, net of tax      |   | 133,000                               |       | — |   |
|                                                                                                                                   |   |                                  |       |   |   |
| Deduct:  Total stock-based employee compensation  expense determined under the fair value based method of all awards, net of  tax |   | (82,000                               | )          | (35,000 | ) |
|                                                                                                                                   |   |                                  |       |   |   |
| Pro  forma net loss applicable to common shareholders                                                                                  |   | $                                     | (1,147,000 | ) | $ | (626,000 | ) |
|                                                                                                                                   |   |                                  |       |   |   |
| Net  loss applicable to common shareholders per basic and dilutive shares:                                                             |   |                                  |       |   |   |
| As  reported                                                                                                                           |   | $                                     | (0.18      | ) | $ | (0.10 | ) |
| Pro  forma                                                                                                                             |   | $                                     | (0.17      | ) | $ | (0.10 | ) |

 

In August 2003, the Company issued 45,550shares of restricted common stock to employees in lieu of raises.  These shares of restricted stock wereunregistered and subject to forfeiture if the employee’s employment with theCompany ceased prior to January 2, 2004. Additionally the shares may not be sold, transferred or assigned untilAugust 2004.  The Company recordeddeferred compensation of $265,000 related to this transaction.  This amount is being amortized over the fourmonth vesting period.  During thequarter ended September 30, 2003, the Company recorded $133,000 in compensationexpense.

 

The Companygranted 2,000 warrants to purchase common stock to a consultant in exchange forservices, during the three months ended September 30, 2003.  The Company recorded approximately $5,000 inexpense associated with this issuance for the three months ended September 30,2003.  The Company estimated the fairvalue of the common stock warrants using the Black-Scholes option-pricingmodel.  The Company estimated the fairvalue of the warrants using the following input assumptions:

 

| Volatility              |   | 67.5    | %      |
|-------------------------|--------|---------|--------|
| Dividend yield          |   | 0       | %      |
| Risk-free interest rate |   | 2.87    | %      |
| Expected lives          |   | 5 years |   |

 

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

 

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

 

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

 

The Company has accumulated othercomprehensive income resulting from the unrealized gain on an investment inmarketable equity securities of CardioTech International Inc. (Note 9) which isrecorded in the stockholders’ equity section of the balance sheet.  Comprehensive income is summarized below:

 

7

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|                        |   | **Three  Months Ended  September 30,** |     |
|-----------------------------|--------|----------------------------------------|----------|
|                        |   | **2003**                               |     | **2002** |   |
|                        |   |                                   |     |   |   |
| Net  loss                   |   | $                                      | (754,000 | ) | $ | (591,000 | ) |
| Other  comprehensive income |   | 27,000                                 |     | 24,000 |   |
|                        |   |                                   |     |   |   |
| Comprehensive  loss         |   | $                                      | (727,000 | ) | $ | (567,000 | ) |

 

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

 

Contract revenue under cost sharing researchand development agreements is recognized as eligible expenses areincurred.  Invoicing of research anddevelopment contracts occurs in accordance with the terms of the contract.  Revenue recognized but unbilled is recordedas unbilled accounts receivable.  AtSeptember 30, 2003 and June 30, 2003, unbilled accounts receivable representedapproximately 22% and 10% of total accounts receivable, respectively.  Generally, there are no prerequisitesnecessary to bill.

 

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

 

In June, 2003, the Company purchased a MC3,mass-analyzed ion implanter and wafer handling end-station (the “System”) fromAxcelis Technologies, Inc. (“Axcelis”) for a price of $1,300,000.  The Company has financed the System withAxcelis via monthly installments of approximately $43,000 beginning July 2003and continuing through December 31, 2003. Interest is being calculated at prime plus 6.25%.  The Company must make a lump sum payment forthe unpaid balance of the purchase price of approximately $1,109,000 not laterthan December 31, 2003.  Title for theequipment shall remain with Axcelis until the system is paid in full.  Should the Company fail to pay the balancein full, Axcelis has the right to recover the system from the Company.  The value of the equipment is included inproperty and equipment.  The Company isattempting to refinance this note payable prior to December 31, 2003.  In the event that the Company is unable torefinance the equipment, it will be returned to Axcelis.  As of September 30, 2003, the unpaid balanceon this equipment is approximately $1,174,000, all of which is classified ascurrent.

 

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

 

On October 7, 2002, the Company issued250,000 shares of Series A 7% Cumulative Convertible Preferred Stock (“SeriesA”) having a stated value of $10 per share, pursuant to a Securities PurchaseAgreement executed on October 7, 2002 with the Laurus Master Fund, Ltd.  The Company received $2,500,000 in grossproceeds, less a management and placement agent fee of approximately $300,000,and related transaction costs of approximately $101,000.  The terms of the Series A provide forrepayment of outstanding principal and accrued dividends in either cash or withshares of the Company’s common stock, at the Company’s option, over a 14 monthperiod beginning February 1, 2003.  Ifthe Company elects to convert into shares of the Company’s common stock, thecommon stock will be valued at $5.19 per share.  However, if the closing price of the Company’s common stock forany of the 11 trading days prior to a monthly repayment date is less than$5.70, the common stock will be valued at the greater of 83% of the average ofthe three lowest closing prices during the 30 trading days immediatelypreceding the repayment date or $2.02 and Laurus Master Fund, Ltd. will bepermitted to convert such part of the monthly payment, up to the amount theCompany elected to repay, into shares of common stock.  Any part of the monthly amount not convertedinto common stock shall be paid in cash on the following monthly repaymentdate.  The Company also granted theinvestor a security interest in substantially all of the Company’s assets.  In connection with the issuance of theSeries A, the investor received a warrant to purchase 55,000 shares of theCompany’s common stock.  The commonstock purchase warrant may be exercised at any time and is valid for five yearsfrom the date of issuance at an exercise price of $6.23 per share.

 

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

 

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based on the difference between the effective conversion price of theproceeds allocated to the Series A and the fair market value of the commonstock at the date of issuance.  Thediscount arising from the beneficial conversion feature aggregated $537,000.  The discount is being amortized and recordedas a preferred dividend during the period from the issuance of the preferredstock to the mandatory redemption date of April 7, 2004.

 

The Company valued the Series A at issuanceat $1,434,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $2,099,000 ($401,000of issuance costs incurred), amount allocated to warrants of $128,000, and theamount of the discount related to the value of beneficial conversion feature of$537,000.  The Company is accretingthese discounts on the carrying value of the preferred stock to its redemptionvalue of $2,500,000 at April 7, 2004. The accretion of these amounts is being recorded as a preferred dividendin the period of accretion.  During thethree month period ended September 30, 2003, approximately $362,000 wasamortized.

 

During the three months ended September 30,2003, Laurus redeemed 104,875 shares of Series A into 211,500 shares of theCompany’s common stock, at conversion prices ranging from $4.21 to $5.19 pershare, into $1,049,000 of outstanding principal and approximately $8,000 ofaccrued interest.  As of September 30,2003, the principal balance outstanding of the Series A was approximately$451,000.  The conversion of accruedinterest into common stock resulted in additional dividend expense of $4,000during the quarter, in excess of 7% stated interest rate.

 

On August28, 2003, the Company issued 200,000 shares of Series B 5%Cumulative Convertible Preferred Stock (“Series B”) having a stated value of$10 per share, pursuant to a Securities Purchase Agreement executed on August28, 2003 with the Laurus Master Fund, Ltd. The Company received $2,000,000 in gross proceeds, less a management andplacement agent fee of approximately $108,000, and related transaction costs ofapproximately $70,000.  The terms of theSeries B provide for repayment with shares of the Company’s common stock or incash, pursuant to an amortization schedule. Repayment of the Series B commences on December 1, 2003.  The Company has the sole option to determinewhether to satisfy payment of the monthly amount in full on each repayment dateeither in cash or in shares of common stock, or a combination of both.  However, if the closing price for any of the11 trading days preceding a repayment date is less than $6.00, the Companywould be required to pay such monthly amount in cash at 105% of the monthlyobligation.  If the payment of themonthly amount is made in common stock, the fixed conversion price is$5.50.  The Company also issued toLaurus a warrant to purchase 25,000 shares of common stock at $6.88 per shareand 45,000 shares of common stock at $8.25 per share.  The Securities Purchase Agreement also provides for a securityinterest in substantially all of the Company’s assets and provides Laurus aright of first refusal on future financing arrangements during the Term of theagreement.  In the event Laurus declinesto exercise its right of first refusal, it hereby agrees to enter into suchdocumentation as shall be reasonable requested by the Company in order tosubordinate its rights under the Series B to the subsequent financier.  The Company will utilize the proceeds ofthis financing to commercialize its explosives detection system and for generalworking capital purposes.

 

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

 

The Company valued the Series B at issuanceto be $929,000 based on the relative fair market values of the financialinstruments issued in connection with this placement, net of offering costs andthe beneficial conversion feature.  Theamounts recorded in the financial statements represent the amounts attributedto the sale of the preferred stock, net cash proceeds of $1,822,000 ($178,000of issuance costs incurred), amount allocated to warrants of $125,000, and theamount of the discount related to the value of beneficial

 

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conversion feature of $768,000. The Company is accreting these discounts on the carrying value of thepreferred stock to its redemption value of $2,000,000 at March 1, 2005.  The accretion of these amounts is beingrecorded as a preferred dividend in the period of accretion.  During the period ended September 30, 2003,approximately $72,000 was amortized.  Asof September 30, 2003, the outstanding principal of the Series B was$2,000,000.  For the three months endedSeptember 30, 2003, the Company accrued approximately $9,000 of dividends.

 

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

 

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

 

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

 

Accounts receivable from related parties asof September 30, 2003 consisted of a loan of $138,000 to the Company’s chiefexecutive officer, which was used to exercise options for 50,000 shares of theCompany’s common stock on December 9, 1997. The loan is due and payable December 9, 2003.  This transaction is reported as a reduction of stockholders’equity.

 

In March 2000, the Company entered into ajoint research agreement with CardioTech to develop a proprietary porouspolymer biocompatible coating technology as a platform for the Company’sproprietary radioactive brachytherapy technology.  In consideration for this agreement, the Company agreed to pay$150,000 in cash and purchase 100,000 shares of CardioTech stock at a price of$1.00 per share.  The final cash paymentof $35,000 has been accrued at September 30, 2003.  Through September 30, 2003, the Company acquired 60,000 shares ofcommon stock of CardioTech at a price of $1.00 per share.  As of September 30, 2003, the fair marketvalue of the CardioTech shares held as investment is $204,000.  At September 30, 2003, the Company isobligated to purchase 40,000 shares of common stock at $1.00 per share.  CardioTech is a publicly traded company whosecommon stock trades under the symbol CTE on the American Stock Exchange.  To date, the Company has not purchased theseshares.

 

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

 

On July 31, 2003, the Company entered into anagreement with its former exclusive distributor of prostate seeds, to releaseeach other from further obligations under the 2000 Agreement.  The new agreement conveys to the Companydirect marketing and sales capabilities to sell its I-Plant Seed brachytherapyseeds for use in the treatment of prostate cancer.  In connection with this, the Company’s former exclusivedistributor will work cooperatively to transition customers and marketingmaterials directly to the Company.  Thedistributor also agreed not to compete with the Company for a period of threeyears.  The Company will pay thedistributor an average of approximately $39,000 per month over the 28 months,beginning September 1, 2003.  As ofSeptember 30, 2003, the outstanding principal balance is approximately$953,000.  For the three months endedSeptember, 20, 2003, the Company recorded approximately $9,000 of interestexpense relating to this transaction.

 

The present value of this asset was recordedas approximately $1,007,000, using a rate of 10.24%, and will be amortizedevenly over its estimated useful life of 29 months.  As of September 30, 2003, approximately $70,000 of amortizationexpense was recognized.

 

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

 

The following management discussion and analysis should be read inconjunction with the financial statements and notes thereto as filed in ourForm 10-KSB/A for the year ended June 30, 2003.  In addition to historical information, this Form 10-QSB containsforward-looking statements.  Theforward-looking statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from those reflected in suchforward-looking statements.  Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s opinions only as of the date hereof.  We undertake no obligation to revise orpublicly release the results of any revision to these forward-lookingstatements.  Readers should carefullyreview documents that we file from time to time with the Securities and ExchangeCommission, including our Quarterly Reports and Annual Reports filed by theCompany in fiscal 2003 and 2004.

 

**Results of Operations**

 

*Comparison for the three months endedSeptember 30, 2003 and 2002*

 

*Revenues. *Total revenues for the three months endedSeptember 30, 2003 were $1,636,000 as compared to $1,575,000 for the comparableprior year period, an increase of $61,000 or 4%.  The increase is attributable primarily to the revenue recognizedfrom new government contracts to develop new applications and products usingour Laser Ion Mobility Spectrometry (“IMS”) technology.  Our Laser IMS technology is the platformtechnology used in our explosives detection devices.  Government contracts revenues increased by $191,000 or 111% forthe quarter ended September 30, 2003 as compared with the same period lastyear.  Our grant revenues, principallySmall Business Innovative Research (SBIR) programs, fluctuate due to: (a) ourdesire to obtain external funding for its research and development efforts; (b)the availability of government funding; and (c) the time required to obtainapproval of a grant application.  Wehave been successful in obtaining SBIR grants in fiscal 2003 and 2002.  We expect to continue to seek continuationor replacement of our existing SBIR grants during fiscal 2004 and beyond

 

Revenues from semiconductors for the three months ended September 30,2003 were $259,000 as compared to $209,000 for the comparable prior yearperiod, an increase of $50,000 or 24%. The increase was primarily attributable to an increase in semiconductorproduction jobs and the addition of new customers who require outsourced ionimplantation services for research and development activities.  We believe that fluctuations in sales in oursemiconductor business from quarter-to-quarter are normal occurrences, howeverwe do believe that moderate growth will continue to be achieved.

 

These increases in revenue were offset by reduced revenues of theI-PlantTM prostate seed. Sales for the three months ended September 30, 2003 were approximately$631,000 as compared to $698,000 for the comparable prior year period, adecrease of $67,000 or 10%.  Thedecrease in prostate seed revenues was due to continued downward pricingpressure, which has been experienced throughout the industry, leading to areduction in our price per seed.  Wealso experienced a 13% decrease in the volume of seeds sold as a result ofcompetitive market forces, price wars, ongoing consolidation, and changes inseed reimbursement by insurance companies. Management believes this trend of downward pricing pressures maycontinue.

 

In the fourth quarter of fiscal 2003, management hired a new directorof national sales in order to open new channels of distribution for sales ofour prostate seeds and to assist our current distributors in growing the volumeof seeds sold.  In the first quarter offiscal 2004, the Company entered into a new agreement with MED-TEC, our formerexclusive distributor of I-Plant prostate seeds to replace the originalDistributor Agreement, which had expired. This new agreement outlines an orderly transition of the direct salesresponsibilities for the I-Plant prostate seed to the Company.  Management believes this direct marketingand sales program will put the sales process in the complete control of theCompany, result in an immediate increase in gross margin per brachytherapyseed, and expand the Company’s distribution channel targeting the radiationoncology market.  As a result, MED-TECwill work cooperatively with the Company to transition its customers andmarketing materials directly to Implant Sciences and MED-TEC also agreed not tocompete with the Company for a period of three years.  Implant Sciences is paying MED-TEC an average of approximately$39,000 per month over a period of 28 months, beginning September 1, 2003.  As of September 30, 2003, the outstandingprincipal balance is approximately $953,000.

 

Revenues from medical and industrial coatings for the three monthsended September 30, 2003 were $383,000 as compared to $496,000 for thecomparable prior year period, a decrease of $113,000 or 23%.  The

 

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decrease in revenues from medical and industrial coatings is dueprimarily to a $73,000 decrease in industrial coating sales resulting fromcertain customers pursuing different product processes not requiringradiopacity and the completion of a sizeable development program for a customerin fiscal 2002.  Medical coatingsrevenues for the three months ended September 30, 2003 decreased by $39,000 or9% as compared with the comparable prior year period.  This decrease is due to the disruption related to relocation ofour customer’s production facility to a new location.  Less than 5% of all revenues were derived from foreign sources.

 

Combined sales to our two major customers, the Howmedica/OsteonicsDivision of Stryker Corporation and MED-TEC Iowa, our former exclusivedistributor of prostate seeds, accounted for 61% and 70% of revenue for thethree months ended September 30, 2003 and 2002, respectively.  As a result of the non-compete agreementwith MED-TEC, sales to this customer will end in October 2003, as we begin todirectly bill our prostate seed customers. Our government contract and grant revenue accounted for 22% and 11% ofrevenue for the three months ended September 30, 2003 and 2002,respectively.  Government contract andgrant revenue as a percentage of total revenues increased as a result of ourreceiving several new grants and contracts, primarily related to our Laser IMStechnology

 

*Cost of Sales*.  Cost of sales for the three months ended September 30, 2003 was$1,160,000 as compared to $1,227,000 for the comparable prior year period, adecrease of $67,000 or 5%.  Included inthese costs is approximately $46,000 of non-cash stock-based compensation.  This decrease in cost is primarilyattributable to a decrease in labor and benefit expenses resulting from areduction of the workforce and reduction of costs relating to prostate seedmanufacturing.  As a percentage ofproduct revenues, the cost of medical and semiconductor product revenuesincreased slightly to 76% for the three months ended September 30, 2003 ascompared to 75% for the comparable prior year period.  Cost of government contracts for the three month period endedSeptember 30, 2003 was $190,000 as compared to $172,000 for the comparableprior year period, an increase of $18,000 or 10%.  This increase is a result of the increased expenses related tothe award of new contracts in the first quarter of fiscal 2004.  During the fiscal quarters ended September30, 2003 and 2002, we utilized Small Business Innovative Research grants as asource of funding for our research and development efforts.  Our obligation with respect to these grantsis to perform the research on a best-efforts basis.

 

*Research and Development*.  Research and development expense for thethree months ended September 30, 2003 was $482,000 as compared to $416,000 forthe comparable prior year period, an increase of $66,000 or 16%.  This increase is primarily the result ofcontinued development work in the areas of explosives and toxic substancedetection, temporary brachytherapy and radioactive prostate seed productcompliments and $39,000 of non-cash stock-based compensation.

 

*Selling, General and Administrative*.  Selling, general and administrative expensesfor the three months ended September 30, 2003 were $706,000 as compared to$522,000 for the comparable prior year period, an increase of $184,000 or 35%.  Selling, general and administrative expensesincluded $48,000 and $0 of noncash stock-based compensation recorded inconnection with the issuance of stock to employees and warrants to an outsideagent, and depreciation and amortization expenses of $100,000 and $19,000, inthe three months ended September 30, 2003 and 2002, respectively.  This increase in amortization expense is aresult of the amortization of the MED-TEC non-compete agreement , which isbeing amortized over a 29 month period beginning July 31, 2003.  Net of the noncash stock-based compensation,and depreciation and amortization, general and administrative expensesincreased by $55,000 or 11%.  Thisincrease reflects our addition of certain administrative personnel needed tosupport our continued growth and increased travel and trade show costs relatingto the marketing our products.  However,management continues to exercise strict cost containment measures to ensurecontrol over our administrative spending.

 

*Other Income and Expenses, Net.*  For the three month period ended September30, 2003, we recorded other expense, net of $42,000 as compared to otherexpense, net of $1,000 in the comparable prior year period.  The increase is primarily a result of theinterest payments relating to the equipment financing with Axcelis Technologiesand the MED-TEC agreement.

 

*NetLoss.*  Net loss forthe three months ended September 30, 2003 was $754,000 as compared to $591,000for the comparable prior year period, an increase of $163,000 or 28%.  Net loss for September 30, 2003 includes anapproximate charge of $138,000 related to stock based compensation as comparedto $0 in the comparable prior year period. Accordingly, the net loss for the period ended September 30, 2003,before giving effect to the charge for stock-based compensation is $616,000 ascompared to $591,000 for the comparable prior year period.  This increase in net loss is attributable,in part, to the marked increase in research and development

 

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expenses relating to thecontinued development work in the areas of explosives and toxic substancedetection, temporary brachytherapy and radioactive prostate seed productcompliments.

 

Additionally, during the period ended September 30, 2003, accretion ofdividends, the beneficial conversion feature and amortization of warrantsrelating to the Series A in the amount of $363,000, and $81,000 relating to theSeries B, was recognized as a preferred distribution.  The effect of these transactions had no overall effect onstockholders’ equity or cash, but increased net loss per share applicable tocommon shareholders by $0.07 per share. The basic and diluted net loss per share applicable to common shares forthe period ended September 30, 2003 was ($0.18) per share as compared to($0.10) per share for the comparable prior year period, an increase in net lossapplicable to common shares per share of $0.08 or 80%.

 

**Liquidity and Capital Resources**

 

As of September 30, 2003 we had approximately $1,604,000 in cash in theform of cash and cash equivalents. During the three months ended September 30, 2003, operating activitiesused cash of approximately $884,000. Net cash used by operating activities primarily reflects the net loss of$754,000, a $45,000 increase in inventory, a $7,000 increase in prepaid andother current assets, a $115,000 decrease in accounts payable, a $164,000decrease in accrued expenses and a $196,000 increase in accounts receivable;offset by depreciation and amortization of $255,000 and stock-basedcompensation expense of $138,000. During the three months ended September 30,****2003, investing activitiesused cash of approximately $166,000, primarily attributable to the purchase ofproperty and equipment.  During thethree months ended September 30, 2003, financing activities providedapproximately $1,695,000 in cash.  Netcash provided by financing activities primarily includes net proceeds from theSeries B preferred stock and the exercise of stock options offset by paymentson our capital lease, non-compete agreement and equipment financing.

 

On October 7,2002, the Company issued 250,000 shares of Series A 7% Cumulative ConvertiblePreferred Stock (“Series A”) having a stated value of $10 per share, pursuantto a Securities Purchase Agreement executed on October 7, 2002 with the LaurusMaster Fund, Ltd.  The Company received$2,500,000 in gross proceeds, less a management and placement agent fee ofapproximately $300,000, and related transaction costs of approximately$101,000.  The terms of the Series Aprovide for repayment of outstanding principal and accrued dividends in eithercash or with shares of the Company’s common stock, at the Company’s option,over a 14 month period beginning February 1, 2003.  If the Company elects to convert into shares of the Company’scommon stock, the common stock will be valued at $5.19 per share.  However, if the closing price of theCompany’s common stock for any of the 11 trading days prior to a monthlyrepayment date is less than $5.70, the common stock will be valued at thegreater of 83% of the average of the three lowest closing prices during the 30trading days immediately preceding the repayment date or $2.02 and LaurusMaster Fund, Ltd. will be permitted to convert such part of the monthlypayment, up to the amount the Company elected to repay, into shares of commonstock.  Any part of the monthly amountnot converted into common stock shall be paid in cash on the following monthlyrepayment date.  The Company alsogranted the investor a security interest in substantially all of the Company’sassets.  In connection with the issuanceof the Series A, the investor received a warrant to purchase 55,000 shares ofthe Company’s common stock.  The commonstock purchase warrant may be exercised at any time and is valid for five yearsfrom the date of issuance at an exercise price of $6.23 per share.

 

In accordancewith the provisions of Emerging Issues Task Force (EITF) Issue 00-27,“Application of EITF Issue No. 98-5 ‘Accounting for Convertible Securities withBeneficial Conversion Features of Contingently Adjustable Conversion Ratios’,to Certain Convertible Securities”, which became effective in November 2000,the allocated value of the Series A contained a beneficial conversion featurecalculated based on the difference between the effective conversion price ofthe proceeds allocated to the Series A and the fair market value of the commonstock at the date of issuance.  Thediscount arising from the beneficial conversion feature aggregated $537,000.  The discount is being amortized and recordedas a preferred dividend during the period from the issuance of the preferredstock to the mandatory redemption date of April 7, 2004.

 

The Companyvalued the Series A at issuance at $1,434,000 based on the relative fair marketvalues of the financial instruments issued in connection with this placement,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 $2,099,000 ($401,000 of issuance costs incurred), amountallocated

 

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to warrants of $128,000, andthe amount of the discount related to the value of beneficial conversionfeature of $537,000.  The Company isaccreting these discounts on the carrying value of the preferred stock to itsredemption value of $2,500,000 at April 7, 2004.  The accretion of these amounts is being recorded as a preferreddividend in the period of accretion. During the three month period ended September 30, 2003, approximately$362,000 was amortized.

 

During thethree months ended September 30, 2003, Laurus redeemed 104,875 shares of SeriesA into 211,500 shares of the Company’s common stock, at conversion pricesranging from $4.21 to $5.19 per share, into $1,049,000 of outstanding principaland approximately $8,000 of accrued interest. As of September 30, 2003, the principal balance outstanding of theSeries A was approximately $451,000. The conversion of accrued interest into common stock resulted inadditional dividend expense of $4,000 during the quarter, in excess of 7%stated interest rate.

 

On August 28, 2003, the Company issued 200,000 shares ofSeries B 5% Cumulative Convertible Preferred Stock (“Series B”) having a statedvalue of $10 per share, pursuant to a Securities Purchase Agreement executed onAugust 28, 2003 with the Laurus Master Fund, Ltd.  The Company received $2,000,000 in gross proceeds, less amanagement and placement agent fee of approximately $108,000, and relatedtransaction costs of approximately $70,000. The terms of the Series B provide for repayment with shares of theCompany’s common stock or in cash, pursuant to an amortization schedule.  Repayment of the Series B commences onDecember 1, 2003.  The Company has thesole option to determine whether to satisfy payment of the monthly amount infull on each repayment date either in cash or in shares of common stock, or acombination of both.  However, if theclosing price for any of the 11 trading days preceding a repayment date is lessthan $6.00, the Company would be required to pay such monthly amount in cash at105% of the monthly obligation.  If thepayment of the monthly amount is made in common stock, the fixed conversionprice is $5.50.  The Company also issuedto Laurus a warrant to purchase 25,000 shares of common stock at $6.88 pershare and 45,000 shares of common stock at $8.25 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.  In the event Laurusdeclines to exercise its right of first refusal, it hereby agrees to enter intosuch documentation as shall be reasonable requested by the Company in order tosubordinate its rights under the Series B to the subsequent financier.  The Company will utilize the proceeds ofthis financing to commercialize its explosives detection system and for generalworking capital purposes.

 

In accordancewith the provisions of Emerging Issues Task Force (EITF) Issue 00-27,“Application of EITF Issue No. 98-5 ‘Accounting for Convertible Securities withBeneficial Conversion Features of Contingently Adjustable Conversion Ratios’,to Certain Convertible Securities”, which became effective in November 2000,the allocated value of the Series B contained a beneficial conversion featurecalculated based on the difference between the effective conversion price ofthe proceeds allocated to the Series B and the fair market value of the commonstock at the date of issuance.  Thediscount arising from the beneficial conversion feature aggregated$768,000.  The discount is being amortizedand recorded as a preferred dividend during the period from the issuance of thepreferred stock to the mandatory redemption date of March 1, 2005.

 

The Companyvalued the Series B at issuance at $929,000 based on the relative fair marketvalues of the financial instruments issued in connection with this placement,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 $1,822,000 ($178,000 of issuance costs incurred), amountallocated to warrants of $125,000, and the amount of the discount related tothe value of beneficial conversion feature of $768,000.  The Company is accreting these discounts onthe carrying value of the preferred stock to its redemption value of $2,000,000at March 1, 2005.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.  During the period endedSeptember 30, 2003, approximately $72,000 was amortized.  As of September 30, 2003, the outstandingprincipal of the Series B was $2,000,000. For the three months ended September 30, 2003, the Company accruedapproximately $9,000 of dividends.

 

We are developing several explosive detection systems that could beused in airports, public and government buildings, and sporting eventfacilities.  The systems use ourproprietary Laser IMS technology, which includes the use of laser beams incombination with ion mobility spectrometry, to electronically detect minutequantities of explosive vapor molecules in the air.  This project has been ongoing since approximately May 1999.  In November 2001, we developed a portableprototype and in December 2001 we demonstrated it to the U.S. Department ofTransportation.  Following thisdemonstration, we decided to pursue the technology.  At

 

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present, we are developing both portable and bench-top systems for usein airports and Department of Defense facilities.  Prototype units have been transported to the Department ofDefense and Department of Homeland Security (DHS) for demonstration andevaluation.

 

The U.S. Navy tested the unit in simulated outdoor conditions and theirengineers were satisfied with the results of the tests.  The Transportation Security Administrationof the DHS also tested the breadboard system at their technical center inAtlantic City and as a result of these tests, awarded the Company an initialgrant of $600,000 to continue development of a pre-prototype to be used at thecarry-on checkpoints at U.S, airports. There can be no guarantee however, that the final production model willpass the government tests or that the government will purchase any equipmentfrom the Company.

 

This project is currently being undertaken by both our internalscientists and certain outside contractors. The development of new applications is typically funded throughgovernment grants or internal funding. Originally, we funded a research and development program for theelectronic detection system to produce enough data to write grant proposals forthe Department of Defense to detect unexploded bombs and mines.  Since March 2000, we have received sevencontracts totaling approximately $2,400,000 for detection of toxic chemicals orexplosives from agencies such as the Departments of the Army, Air Force, MarineCorps and Navy; as well as the National Institutes of Health.  On August 12, 2002, we signed a CooperativeResearch and Development Agreement with an agency of the Department ofTransportation which will permit us and the government to exchange criticaltest data and for us to deliver a certain number of units to the Department ofTransportation for independent evaluation and field testing.

 

In June 2000, we developed our first generation device, whichdemonstrated sensitivity to the explosive TNT. In June 2001, we developed a second generation prototype with increasedsensitivity and selectivity.  Thisdevice can detect and specify an increasing number of compounds within variousexplosive materials.  The explosivesthat have been tested to date are TNT, RDX, PETN, EGDN, and DNT.  RDX is the primary component of C3 and C4explosives, such as Datasheet and Semtex, as well as certain types of blackpowder explosives.  We believe theseexplosives represent the majority of the explosives presently used in terroristactivities.  After the attack on theWorld Trade Center occurred on September 11, 2001, management made the decisionto continue the internal funding of the project rather than await funding throughgovernment grants.  Our electronic detectionsystem has been subjected to controlled testing by third parties andsuccessfully detected C4.  As a resultof the successful demonstration, we believed it was appropriate to furtherpursue the commercial development of our electronic detection system device.

 

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

 

We are developing several versions of our explosives detection systems,including: (i) a table-top unit, which can be used to screen passengers andcarry-on baggage in airports; and (ii) a portable system, which can be used toreplace bomb-sniffing dogs to clear buildings, aircrafts, or ships where hiddenbombs are believed to exist.  Wereceived $600,000 from the U.S. Navy in November 2002 for further developmentof the portable device.  This device wasdelivered to the U.S. Navy for testing in May 2003.  Tests were successfully completed and the U. S. Navy is nowrequesting funds for further development of this equipment.  We plan to first market these systems toU.S. government agencies for use in airports, government buildings andfacilities.

 

Although our operations and spending continue to focus on the sales ofour semiconductor, medical coatings and prostate seed products, we arecurrently expending significant resources in the development of our explosivesdetection devices.  We continue to fundas much research and development as possible through government grants inaccordance with the provisions of the respective grant awards.  We will require additional funding in orderto advance the commercial development of the explosives detection system.  We will attempt to obtain such financing by:(i) government grants, (ii) the exercise of the redeemable common stockpurchase warrants, (iii) private financing, or (iv) strategicpartnerships.  However, there can be noassurance that we will be successful in our attempts to raise such additionalfinancing.

 

We will require substantial funds for further research and development,future pre-clinical and clinical trials, regulatory approvals, continued expansionof commercial-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 progress of pre-clinical and clinicaltesting; the time and costs involved in obtaining regulatory approvals; thecost of filing, prosecuting, defending and enforcing any

 

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

 

As of September 30, 2003, we were conducting our operations withapproximately $1,604,000 in cash and cash equivalents.  We estimate such amounts combined with ourcash flow from operations will be sufficient to fund our working capital in thenext twelve months.  This does notinclude the obligation to Axcelis Technologies of approximately $1,174,000.  The Company is working on obtainingfinancing for this obligation.  Futureexpenditures for research and product development, especially relating tooutside testing and clinical trials, are discretionary and, accordingly, can beadjusted, as can certain selling, general and administrative expenses, based onthe availability of cash.

 

The Company’s future minimum payments under contractual obligationsrelated to capital leases, operating leases and term notes as of September 30,2003, are as follows:

 
|                  |   | **Capital  Lease** |   | **Operating  Leases** |   | **Axcelis  Technologies,  Inc.  (1)** |   | **MED-TEC** |      | **Total** |   |
|-----------------------|--------|--------------------|--------|-----------------------|--------|--------------------------------------------|--------|-------------|-----------|-----------|--------|
| Year  ending June 30: |   |               |   |                  |   |                                       |   |        |      |      |   |
| 2004                  |   | $                  | 5,000  |                  | $      | 331,500                                    |   | $           | 1,174,000 |      | $      | 347,000 |   | $ | 1,857,500 |   |
| 2005                  |   | 5,000              |   | 531,000               |   |                                       |   | 394,000     |      | 930,000   |   |
| 2006                  |   | 4,000              |   | 568,000               |   |                                       |   | 212,000     |      | 784,000   |   |
| 2007                  |   | —             |   | 569,000               |   |                                       |   |        |      | 569,000   |   |
| 2008                  |   | —             |   | 570,000               |   |                                       |   |        |      | 570,000   |   |
| Thereafter            |   | —             |   | 285,000               |   |                                       |   |        |      | 285,000   |   |
| Total                 |   | $                  | 14,000 |                  | $      | 2,854,500                                  |   | $           | 1,174,000 |      | $      | 953,000 |   | $ | 4,995,500 |   |

 

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(1) Future obligations may increase or decrease depending on the Company’sability to refinance this obligation.  Title for the equipment shall remain with Axcelis until thesystem is paid in full.  Should theCompany fail to pay the balance in full, Axcelis has the right to recover thesystem from the Company

 

The Company is also obligated to purchase40,000 shares of common stock of CardioTech at $1.00 per share pursuant to aresearch and development agreement (Note 9).

 

*Critical Accounting Policies*

 

Our significant accounting policies are described in Note 1 to thefinancial statements included in Item 7 of our Form 10-KSB/A No. 1 as of June30, 2003.  Our discussion and analysisof our financial condition and results of operations are based upon thefinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities.  On an on-going basis,we evaluate our estimates, including those related to bad debts, productreturns, 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.  There has been no change to our critical accountingpolicies during the quarter ending September 30, 2003.

 

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

 

Based on an evaluation of our disclosure controls and procedures (asdefined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of1934), the chief executive officer and chief financial officer have concludedthat our disclosure controls and procedures as of the end of the three monthsended September 30, 2003, are designed to ensure that information required tobe disclosed by us in the reports that we file or submit

 

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under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and areoperating in an effective manner.

 

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

 

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PART II:  OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Not Applicable

 

Item 2. Changes in Securities and Use of Proceeds

 

On October 7, 2002, the Company issued250,000 shares of Series A 7% Cumulative Convertible Preferred Stock (“SeriesA”) having a stated value of $10 per share, pursuant to a Securities PurchaseAgreement executed on October 7, 2002 with the Laurus Master Fund, Ltd.  The Company received $2,500,000 in grossproceeds, less a management and placement agent fee of approximately $300,000,and related transaction costs of approximately $101,000.  The terms of the Series A provide forrepayment of outstanding principal and accrued dividends in either cash or withshares of the Company’s common stock, at the Company’s option, over a 14 monthperiod beginning February 1, 2003.  Ifthe Company elects to convert into shares of the Company’s common stock, thecommon stock will be valued at $5.19 per share.  However, if the closing price of the Company’s common stock forany of the 11 trading days prior to a monthly repayment date is less than$5.70, the common stock will be valued at the greater of 83% of the average ofthe three lowest closing prices during the 30 trading days immediatelypreceding the repayment date or $2.02 and Laurus Master Fund, Ltd. will bepermitted to convert such part of the monthly payment, up to the amount theCompany elected to repay, into shares of common stock.  Any part of the monthly amount not convertedinto common stock shall be paid in cash on the following monthly repayment date.  The Company also granted the investor asecurity interest in substantially all of the Company’s assets.  In connection with the issuance of theSeries A, the investor received a warrant to purchase 55,000 shares of theCompany’s common stock.  The commonstock purchase warrant may be exercised at any time and is valid for five yearsfrom the date of issuance at an exercise price of $6.23 per share.

 

During the three months ended September 30,2003, Laurus redeemed approximately 105,000 shares of Convertible PreferredStock into 210,000 of the Company’s common stock at conversion prices rangingfrom $4.21 to $5.19 per share.  As ofSeptember 30, 2003, the principal balance outstanding of the ConvertiblePreferred Stock is approximately $451,000.

 

On August28, 2003, the Company issued 200,000 shares of Series B 5%Cumulative Convertible Preferred Stock (“Series B”) having a stated value of$10 per share, pursuant to a Securities Purchase Agreement executed on August28, 2003 with the Laurus Master Fund, Ltd. The Company received $2,000,000 in gross proceeds, less a management andplacement agent fee of approximately $108,000, and related transaction costs ofapproximately $70,000.  The terms of theSeries B provide for repayment with shares of the Company’s common stock or incash, pursuant to an amortization schedule. Repayment of the Series B commences on December 1, 2003.  The Company has the sole option to determinewhether to satisfy payment of the monthly amount in full on each repayment dateeither in cash or in shares of common stock, or a combination of both.  However, if the closing price for any of the11 trading days preceding a repayment date is less than $6.00, the Companywould be required to pay such monthly amount in cash at 105% of the monthlyobligation.  If the payment of themonthly amount is made in common stock, the fixed conversion price is$5.50.  The Company also issued toLaurus a warrant to purchase 25,000 shares of common stock at $6.88 per shareand 45,000 shares of common stock at $8.25 per share.  The Securities Purchase Agreement also provides for a securityinterest in substantially all of the Company’s assets and provides Laurus aright of first refusal on future financing arrangements during the Term.  In the event Laurus declines to exercise itsright of first refusal, it hereby agrees to enter into such documentation asshall be reasonable requested by the Company in order to subordinate its rightsunder the Series B to the subsequent financier.  The Company will utilize the proceeds of this financing tocommercialize its explosives detection system and for general working capitalpurposes.

 

As of September 30, 2003, the outstandingprincipal of the Series B was $2,000,000.

 

Item 3. Defaults Upon Senior Securities

 

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Not Applicable

 

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

 

Not Applicable

 

Item 5. Other Information

 

**Certifications Under Sarbanes-Oxley Act**

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

 

Item 6.  List of Exhibits andReports on Form 8-K

 

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

 

None.

 

(b)           The registrant has filed no reports on Form 8-K duringthe quarter ended September 30, 2003.

 

None.

 

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SIGNATURES

 

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

 
|                    |   | Implant Sciences Corporation |
|-------------------------|--------|------------------------------|
|                    |   |                         |
| Date: November 13, 2003 |   | /s/ Anthony J. Armini        |   |
|                    |   | Anthony J. Armini            |
|                    |   | President and CEO            |
|                    |   |                         |
| Date: November 13, 2003 |   | /s/ Diane J. Ryan            |   |
|                    |   | Diane J. Ryan                |
|                    |   | Chief Financial Officer      |
|                         |        |                              |  |  |

 

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