## **UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 
| **ý** | ** ** | **Quarterly  report pursuant to section 13 or 15(d) of the Securities Exchange Act of  1934.**                         |
|------------|------------|------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                             |
| ** ** | ** ** | **For  the quarterly period ending March 31, 2006.**                                                                   |
|       |       |                                                                                                                   |
| **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 its charter)

 

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

 

**781-246-0700**

(Registrant’s Telephone Number, Including Area Code)

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

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

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.

YES  ý    NO  o

 

Indicateby checkmark whether the Registrant is an accelerated filer (as defined in Rule12B-2 of the Exchange Act)

YES  o    NO  ý

 

Indicateby checkmark whether the Registrant is a shell company (as defined in Rule12B-2 of the Exchange Act)

YES  o    NO  ý

 

Stateissuer’s revenues for its most recent fiscal year: $12,286,000

 

The aggregate market valueof the voting stock held by non-affiliates of the registrant was approximately$40,186,000 as of January 31, 2006 (based on the closing price for such stockas of January 31, 2006).

 

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

 

| **Class**                    | ** ** | **Outstanding at April 30, 2006** |
|------------------------------|------------|-------------------------------------------------------|
| Common Stock, $.10 par value |       | 11,458,326                                            |

 

 

----

 

**IMPLANT SCIENCES CORPORATION**

 

**INDEX**

 
| ** **                    | **Page No.**                                                                                                 |
|-------------------------------|--------------------------------------------------------------------------------------------------------------|
| PART I. FINANCIAL INFORMATION |                                                                                                         |
|                          |                                                                                                         |
| Item  1.                      | Financial  Statements (unaudited):                                                                           |   |
|                          |                                                                                                         |   |
|                          | Condensed Consolidated Balance Sheets as of  March 31, 2006 and June 30, 2005                                | 3 |
|                          |                                                                                                         |   |
|                          | Condensed Consolidated Statements of  Operations for the Three and Nine Months Ended March 31, 2006 and 2005 | 4 |
|                          |                                                                                                         |   |
|                          | Condensed Consolidated Statements of  Cash Flows for the Nine Months Ended March 31, 2006 and 2005           | 5 |
|                          |                                                                                                         |   |
|                          | Notes to Condensed  Consolidated Financial Statements                                                        | 7 |
|                          |                                                                                                         |   |
| Item 2.                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                  | 19 |
|                          |                                                                                                         |   |
| Item 3.                       | Quantitative and Qualitative Disclosure  About Market Risk                                                   | 29 |
|                          |                                                                                                         |   |
| Item 4.                       | Controls and Procedures                                                                                      | 29 |
|                          |                                                                                                         |   |
| PART II. OTHER  INFORMATION   |                                                                                                         |
|                          |                                                                                                         |
| Item 1.                       | Legal Proceedings                                                                                            | 31 |
|                          |                                                                                                         |   |
| Item 1A.                      | Risk Factors                                                                                                 | 31 |
|                          |                                                                                                         |   |
| Item 2.                       | Unregistered  Sales of Equity Securities                                                                     | 31 |
|                          |                                                                                                         |   |
| Item 3.                       | Defaults  Upon Senior Securities                                                                             | 31 |
|                          |                                                                                                         |   |
| Item 4.                       | Submission  of Matters to a Vote of Security-Holders                                                         | 31 |
|                          |                                                                                                         |   |
| Item 5.                       | Other Information                                                                                            | 32 |
|                          |                                                                                                         |   |
| Item 6.                       | Exhibits and  Reports on Form 8-K                                                                            | 32 |
|                          |                                                                                                         |   |
|                          | Signatures                                                                                                   |   |
|                               |                                                                                                              |  |  |

 

2

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**IMPLANTSCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                                                                                                                                              | ** ** | **March 31**    | ** ** | **June 30,**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|---------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                              | ** ** | **2006**        | ** ** | **2005**      | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                                              | ** ** | **(unaudited)** | ** ** | **(audited)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                              |       |            |       |          |       |
| Current  assets:                                                                                                                                                                                                                                                                                                                                                        |       |            |       |          |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                               |       | $               | 2,006,000  |          | $          | 1,549,000 |   |
| Accounts receivable, less allowance of  $145,000 and $147,000, respectively                                                                                                                                                                                                                                                                                             |       | 3,211,000       |       | 3,003,000     |       |
| Accounts receivable, unbilled                                                                                                                                                                                                                                                                                                                                           |       | 469,000         |       | 298,000       |       |
| Inventories (Note 3)                                                                                                                                                                                                                                                                                                                                                    |       | 2,194,000       |       | 1,204,000     |       |
| Investments - available for sale securities                                                                                                                                                                                                                                                                                                                             |       | 304,000         |       | 204,000       |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                                                                               |       | 221,000         |       | 224,000       |       |
| Total current assets                                                                                                                                                                                                                                                                                                                                                    |       | 8,405,000       |       | 6,482,000     |       |
|                                                                                                                                                                                                                                                                                                                                                                    |       |            |       |          |       |
| Property and  equipment, net (Note 4)                                                                                                                                                                                                                                                                                                                                   |       | 9,346,000       |       | 10,434,000    |       |
| Amortizable  intangible assets, net (Note 11)                                                                                                                                                                                                                                                                                                                           |       | 1,540,000       |       | 2,057,000     |       |
| Investment  in unconsolidated subsidiary (Note 5)                                                                                                                                                                                                                                                                                                                       |       | 344,000         |       | 531,000       |       |
| Other  non-current assets                                                                                                                                                                                                                                                                                                                                               |       | 479,000         |       | 511,000       |       |
| Goodwill  (Note 11)                                                                                                                                                                                                                                                                                                                                                     |       | 12,123,000      |       | 12,213,000    |       |
| Total assets                                                                                                                                                                                                                                                                                                                                                            |       | $               | 32,237,000 |          | $          | 32,228,000 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                          |       |            |       |          |       |
| Current  liabilities:                                                                                                                                                                                                                                                                                                                                                   |       |            |       |          |       |
| Current maturities of long-term debt and  obligations under capital lease                                                                                                                                                                                                                                                                                               |       | $               | 391,000    |          | $          | 2,052,000 |   |
| Line of credit                                                                                                                                                                                                                                                                                                                                                          |       | 500,000         |       | —        |       |
| Payable to Med-Tec                                                                                                                                                                                                                                                                                                                                                      |       | 248,000         |       | 348,000       |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                        |       | 2,106,000       |       | 2,445,000     |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                        |       | 2,013,000       |       | 1,526,000     |       |
| Current portion of long term lease  liability                                                                                                                                                                                                                                                                                                                           |       | 102,000         |       | 102,000       |       |
| Current portion of Series D redemption                                                                                                                                                                                                                                                                                                                                  |       | 304,000         |       | —        |       |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                                        |       | 840,000         |       | 773,000       |       |
| Total current liabilities                                                                                                                                                                                                                                                                                                                                               |       | 6,504,000       |       | 7,246,000     |       |
| Long-term  liabilities:                                                                                                                                                                                                                                                                                                                                                 |       |            |       |          |       |
| Long-term debt and obligations under  capital lease, net of current maturities                                                                                                                                                                                                                                                                                          |       | 642,000         |       | 897,000       |       |
| Long-term lease liability                                                                                                                                                                                                                                                                                                                                               |       | 625,000         |       | 701,000       |       |
| Derivative value of preferred stock  conversion                                                                                                                                                                                                                                                                                                                         |       | 486,000         |       | —        |       |
| Total liabilities                                                                                                                                                                                                                                                                                                                                                       |       | 8,257,000       |       | 8,844,000     |       |
|                                                                                                                                                                                                                                                                                                                                                                    |       |            |       |          |       |
| Series D Convertible Redeemable Preferred  Stock; $10 stated value; 5,000,000 shares authorized; 500,000 and 0 shares  issued and outstanding, at March 31, 2006 and June 30, 2005, respectively,  net of $2,029,000 attributible to warrants and conversion feature (Note 8)  and currently redeemable portion. (liquidation preference of $5,000,000 plus  dividends) |       | 2,965,000       |       | —        |       |
|                                                                                                                                                                                                                                                                                                                                                                    |       |            |       |          |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                                                                             |       |            |       |          |       |
| Common stock, $0.10 par value; 50,000,000  shares authorized; 11,457,126 and 10,734,393 shares issued and outstanding,  respectively                                                                                                                                                                                                                                    |       | 1,146,000       |       | 1,075,000     |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                                              |       | 53,440,000      |       | 50,995,000    |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                                     |       | (33,459,000     | )          | (28,115,000   | )          |
| Deferred compensation                                                                                                                                                                                                                                                                                                                                                   |       | (24,000         | )          | (349,000      | )          |
| Accumulated other comprehensive income  (loss)                                                                                                                                                                                                                                                                                                                          |       | 148,000         |       | (5,000        | )          |
| Treasury stock, 22,449 common shares, at  cost                                                                                                                                                                                                                                                                                                                          |       | (236,000        | )          | (217,000      | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                                                                         |       | 21,015,000      |       | 23,384,000    |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                                                                                                         |       | $               | 32,237,000 |          | $          | 32,228,000 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements

 

3

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**IMPLANTSCIENCES CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(unaudited)**

 
| ** **                                                                                     | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                          | ** ** | **2005**                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                                                      |       |                              |       |                             |       |   |   |   |   |
| Medical                                                                                        |       | $                                 | 1,173,000  |                             | $          | 1,083,000 |   | $ | 3,313,000 |   | $ | 2,976,000 |   |
| Semiconductor                                                                                  |       | 3,906,000                         |       | 1,604,000                        |       | 10,363,000 |   | 3,226,000 |   |
| Explosives detection                                                                           |       | 1,469,000                         |       | 175,000                          |       | 5,084,000 |   | 1,475,000 |   |
| Total revenues                                                                                 |       | 6,548,000                         |       | 2,862,000                        |       | 18,760,000 |   | 7,677,000 |   |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Cost of  revenues:                                                                             |       |                              |       |                             |       |   |   |   |   |
| Cost of medical revenues                                                                       |       | 901,000                           |       | 787,000                          |       | 2,690,000 |   | 2,586,000 |   |
| Cost of semiconductor revenues                                                                 |       | 3,071,000                         |       | 1,613,000                        |       | 8,707,000 |   | 3,526,000 |   |
| Cost of explosives detection revenues                                                          |       | 1,570,000                         |       | 481,000                          |       | 4,889,000 |   | 1,561,000 |   |
| Total cost of revenues                                                                         |       | 5,542,000                         |       | 2,881,000                        |       | 16,286,000 |   | 7,673,000 |   |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Gross margin                                                                                   |       | 1,006,000                         |       | (19,000                          | )          | 2,474,000 |   | 4,000 |   |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Operating  expenses:                                                                           |       |                              |       |                             |       |   |   |   |   |
| Research and development                                                                       |       | 86,000                            |       | 715,000                          |       | 894,000 |   | 1,566,000 |   |
| Selling, general and administrative                                                            |       | 2,063,000                         |       | 1,464,000                        |       | 6,653,000 |   | 3,811,000 |   |
| Total operating expenses                                                                       |       | 2,149,000                         |       | 2,179,000                        |       | 7,547,000 |   | 5,377,000 |   |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Loss from  operations                                                                          |       | (1,143,000                        | )          | (2,198,000                       | )          | (5,073,000 | ) | (5,373,000 | ) |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Other income  (expenses):                                                                      |       |                              |       |                             |       |   |   |   |   |
| Interest income                                                                                |       | 17,000                            |       | 6,000                            |       | 35,000 |   | 37,000 |   |
| Interest expense                                                                               |       | (42,000                           | )          | (35,000                          | )          | (198,000 | ) | (82,000 | ) |
| Equity losses in unconsolidated  subsidiaries                                                  |       | (116,000                          | )          | (40,000                          | )          | (240,000 | ) | (68,000 | ) |
| Mark to market of derivative value of  preferred stock conversion                              |       | 20,000                            |       | —                           |       | 911,000 |   | — |   |
| Total other income (expense), net                                                              |       | (121,000                          | )          | (69,000                          | )          | 508,000 |   | (113,000 | ) |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Net loss                                                                                       |       | (1,264,000                        | )          | (2,267,000                       | )          | (4,565,000 | ) | (5,486,000 | ) |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Preferred  distribution, dividends and accretion                                               |       | (391,000                          | )          | (615,000                         | )          | (778,000 | ) | (1,182,000 | ) |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Net loss  applicable to common shareholders                                                    |       | $                                 | (1,655,000 | )                                | $          | (2,882,000 | ) | $ | (5,343,000 | ) | $ | (6,668,000 | ) |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Net loss per share applicable to common  shareholders, basic and diluted                       |       | $                                 | (0.15      | )                                | $          | (0.30 | ) | $ | (0.48 | ) | $ | (0.74 | ) |
|                                                                                           |       |                              |       |                             |       |   |   |   |   |
| Weighted average common shares outstanding  used in computing basic and diluted loss per share |       | 11,379,275                        |       | 9,618,367                        |       | 11,170,989 |   | 8,989,237 |   |

 

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

 

4

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**IMPLANT SCIENCES CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

** **
| ** **                                                                                                                               | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                               | ** ** | **March 31,**         | ** ** |
| ** **                                                                                                                               | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Cash  flows from operating activities:**                                                                                               |       |                  |       |   |   |
| Net loss                                                                                                                                 |       | $                     | (4,565,000 | ) | $ | (5,486,000 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                                             |       |                  |       |   |   |
| Depreciation and amortization                                                                                                            |       | 1,769,000             |       | 1,289,000 |   |
| Amortization of intangible assets                                                                                                        |       | 526,000               |       | — |   |
| Stock-based compensation expense                                                                                                         |       | 1,972,000             |       | 318,000 |   |
| Equity loss in unconsolidated subsidiaries                                                                                               |       | 240,000               |       | 68,000 |   |
| Loss on equipment sale or write down                                                                                                     |       | 43,000                |       | 6,000 |   |
| Gain on mark to market of derivative value  of preferred stock conversion                                                                |       | (911,000              | )          | — |   |
| Changes in operating assets and  liabilities:                                                                                            |       |                  |       |   |   |
| Accounts receivable                                                                                                                      |       | (380,000              | )          | 537,000 |   |
| Inventories                                                                                                                              |       | (990,000              | )          | (265,000 | ) |
| Prepaid expenses and other current assets                                                                                                |       | 2,000                 |       | (22,000 | ) |
| Deferred revenue                                                                                                                         |       | 67,000                |       | — |   |
| Accounts payable                                                                                                                         |       | 494,000               |       | (268,000 | ) |
| Accrued expenses                                                                                                                         |       | (401,000              | )          | 1,176,000 |   |
| Net cash used in operating activities                                                                                                    |       | (2,134,000            | )          | (2,647,000 | ) |
|                                                                                                                                     |       |                  |       |   |   |
| **Cash  flows from investing activities:**                                                                                               |       |                  |       |   |   |
| Purchase of property and equipment                                                                                                       |       | (605,000              | )          | (635,000 | ) |
| Proceeds from sale of equipment                                                                                                          |       | —                |       | 1,400,000 |   |
| Investment in - available for sale  securities                                                                                           |       | —                |       | (25,000 | ) |
| Investment in Core Systems                                                                                                               |       | —                |       | (2,603,000 | ) |
| Investment in Accurel Systems International                                                                                              |       | —                |       | (6,978,000 | ) |
| (Increase) decrease in other non-current  assets                                                                                         |       | (75,000               | )          | 23,000 |   |
| Net cash used in investing activities                                                                                                    |       | (680,000              | )          | (8,818,000 | ) |
|                                                                                                                                     |       |                  |       |   |   |
| **Cash  flows from financing activities:**                                                                                               |       |                  |       |   |   |
| Proceeds from issuance of common stock                                                                                                   |       | —                |       | 7,408,000 |   |
| Proceeds from exercise of employee options  and stock purchase plan                                                                      |       | 171,000               |       | 867,000 |   |
| Proceeds from exercise of warrants and  non-employee options                                                                             |       | 69,000                |       | 141,000 |   |
| Payments of additional issuance costs  related to private placement of common stock                                                      |       | (31,000               | )          | — |   |
| Proceeds from secured term note, net of  fees and transaction costs                                                                      |       | 2,833,000             |       | — |   |
| Proceeds from issuance of Series D  Convertible Redeemable Preferred Stock, net of issuance costs and repayment  of of secured term note |       | 1,894,000             |       | — |   |
| Dividends on Series D Convertible  Redeemable Preferred Stock                                                                            |       | (207,000              | )          | — |   |
| Repayments of long-term debt and capital  lease obligations                                                                              |       | (1,958,000            | )          | (1,756,000 | ) |
| Proceeds from bank line of credit                                                                                                        |       | 500,000               |       |   |   |
| Acqusition of treasury shares                                                                                                            |       | —                |       | (54,000 | ) |
| Net cash provided by financing activities                                                                                                |       | 3,271,000             |       | 6,606,000 |   |
|                                                                                                                                     |       |                  |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                                                                    |       | 457,000               |       | (4,859,000 | ) |
| Cash and cash equivalents, beginning                                                                                                     |       | 1,549,000             |       | 6,906,000 |   |
| Cash and cash equivalents, ending                                                                                                        |       | $                     | 2,006,000  |   | $ | 2,047,000 |   |

 

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

 

5

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| ** **                                                                                                                  | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                  | ** ** | **March 31,**         | ** ** |
| ** **                                                                                                                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                                                                  | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Supplemental  Disclosure of Cash Flow Information:**                                                                      |       |                  |       |   |   |
| Interest  paid in cash                                                                                                      |       | $                     | 136,000    |   | $ | 46,000 |   |
|                                                                                                                        |       |                  |       |   |   |
| **Noncash  Investing and Financing Activity:**                                                                              | ** ** | ** **            | ** ** | ** ** | ** ** |
| Conversion of 5% Series C Cumulative  Convertible Preferred Stock and accrued dividends into common stock                   |       | $                     | —     |   | $ | 1,406,000 |   |
| Accretion of 5% Series C Cumulative  Convertible Preferred Stock dividends, beneficial conversion feature and  warrants     |       | $                     | —     |   | $ | 704,000 |   |
|                                                                                                                        |       |                  |       |   |   |
| Value of IPO  warrant extension                                                                                             |       | $                     | —     |   | $ | 479,000 |   |
|                                                                                                                        |       |                  |       |   |   |
| Accretion of Series D Convertible  Redeemable Preferred Stock, derivative value of preferred stock conversion  and warrants |       | $                     | 572,000    |   | $ | — |   |
|                                                                                                                        |       |                  |       |   |   |
| Capital  equipment acquired under capital lease                                                                             |       | $                     | 42,000     |   | $ | — |   |

 

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

 

6

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**IMPLANTSCIENCES CORPORATION**

**NOTES TO CONDENSED FINANCIAL STATEMENTS**

**March 31,2006**

**(Unaudited)**

 

**1.****                                     ****Description of Business andBasis of Presentation**

 

ImplantSciences Corporation (the “Company”) develops products for the medical deviceand explosives detection industry and provides services to the semiconductorindustry.  Its core technology involvesion implantation and thin film coatings of radioactive and non-radioactivematerials.  The Company has received Foodand Drug Administration 510(k) clearance to market radioactive seeds for thetreatment of prostate cancer and breast cancer. The Company also modifies the surface characteristics of orthopedicjoint implants to reduce polyethylene wear, thereby increasing the life of theimplant.  The Company also provides ionimplantation, analytical services and equipment to the semiconductor industry.  The Company manufactures trace explosivesdetection equipment while continuing to make significant investments indeveloping new applications of its explosives detection technologies.

 

Thesecondensed consolidated financial statements have been prepared on a goingconcern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business.  For the three and nine month periods endedMarch 31, 2006 the Company had net losses of $1,264,000 and $4,565,000respectively.  The Company also had cashand cash equivalents of $2,006,000 and net working capital of $1,901,000 onMarch 31, 2006.  The Company continuallyreviews its operating plans to determine if it has adequate cash flows to fundits operations and achieve its operating plans. Although the Company believes it can achieve these plans there can be noassurances that it will.  If the Companyfails to achieve its revenue and gross margin goals, it would have to undertakeadditional steps to fund operations. These steps may include: obtaining additional financing, entering intostrategic agreements to fund the development of our products, selling certainassets, and/or cutting costs and expenses.

 

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

 

Theaccompanying condensed consolidated financial statements of the Company havebeen prepared in accordance with the accounting principles generally acceptedin the United States of America. In the opinion of management, the accompanyingcondensed consolidated financials statements include all adjustments(consisting only of normal recurring adjustments), which the Company considersnecessary for a fair presentation of the financial position at such date and ofthe operating results and cash flows for these periods.  The results of operations and cash flows forthe three and nine month periods ended March 31, 2006, may not necessarily beindicative of results that may be expected for any succeeding quarter or forthe entire fiscal year.  The informationcontained in this Form 10-Q should be read in conjunction with the Company’saudited financial statements, included in our Form 10-KSB as of and for theyear ended June 30, 2005 filed with the Securities and Exchange Commission onOctober 13, 2005.

 

Theaccompanying consolidated financial statements include the accounts of theCompany and its wholly owned subsidiaries Accurel Systems International(“Accurel”) and Core Systems Incorporated (“Core”) (the “Subsidiaries”).  All intercompany balances have beeneliminated in consolidation.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America (“U.S. GAAP”) requiresmanagement to make estimates and judgments, which are evaluated on an on-goingbasis, that affect the amounts reported in the Company’s condensed consolidatedfinancial statements and accompanying notes. Management bases its estimates on historical experience and on variousother assumptions that it believes are reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities and the amounts of revenues and expenses that are notreadily apparent from other sources. Actual results could differ from those estimates and judgments, Inparticular, significant estimates and judgments include those related torevenue recognition, allowance for doubtful accounts, useful lives of propertyand equipment, inventory reserves, business combinations, valuation of goodwilland acquired intangible assets, instruments which contain features of bothequity and debt instruments, derivatives, share-based compensation, incometaxes and warranty reserves.

 

7

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**3.****                                     ****Inventories**

 

Inventoriesconsist of the following:

 
| ** **       | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|------------------|------------|---------------|------------|--------------|------------|
| ** **       | ** ** | **2006**      | ** ** | **2005**     | ** ** |
| Raw  materials   |       | $             | 1,417,000  |         | $          | 548,000 |   |
| Work-in-progress |       | 440,000       |       | 416,000      |       |
| Finished  goods  |       | 337,000       |       | 240,000      |       |
|             |       | $             | 2,194,000  |         | $          | 1,204,000 |   |

 

**4.****                                     ****Property and Equipment**

 

Propertyand equipment consists of the following**:**

 
| ** **                                       | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|--------------------------------------------------|------------|---------------|------------|--------------|------------|
| ** **                                       | ** ** | **2006**      | ** ** | **2005**     | ** ** |
| Total property  and equipment                    |       | 16,220,000    |       | 15,624,000   |       |
| Less:  accumulated depreciation and amortization |       | (6,874,000    | )          | (5,190,000   | )          |
|                                             |       |          |       |         |       |
| Property and  equipment, net                     |       | $             | 9,346,000  |         | $          | 10,434,000 |   |
|                                                  |            |               |            |              |            |  |  |

 

**5.****                                     ****Related Party Transactions**

 

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

 

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

 

InMarch 2000, the Company entered into a joint research agreement with CardioTechto develop a proprietary porous polymer biocompatible coating technology as aplatform for the Company’s proprietary radioactive brachytherapytechnology.  In consideration for thisagreement, the Company agreed to pay $150,000 in cash and purchase 100,000shares of CardioTech stock at a price of $1.00 per share.  The Company has purchased these shares, andas of March 31, 2006, the fair market value is $278,000 and is recorded asinvestments in available for sale securities in the accompanying consolidatedbalance sheet.  The unrealized holdinggains and losses are recorded as accumulated other comprehensive income (loss)within stockholders’ equity.

 

InMarch 2004 the Company entered into an Exchange & Venture Agreement withCardioTech and CorNova.  The Company’sCEO and the Company’s Chairman of the Nominating Committee are also on theBoard of Directors of CorNova.

 

**6.****                                     ****Employee Stock-BasedCompensation**

 

OnDecember 16, 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123 (Revised 2004) “Share-Based Payments,” (“SFAS 123R”), which is arevision of SFAS No. 123, “Accounting for Stock-Based Compensation.”  SFAS 123R supersedes Accounting PrincipalBoard 

 

8

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(“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No.95, “Statement of Cash Flows.” Generally, the approach in SFAS 123R is similar to the approachdescribed in SFAS 123,however, SFAS 123R requires all share-based payments toemployees, including grants of employee stock options and stock issued fromcertain employee stock purchase plans, to be recognized in earnings based ontheir modified-grant date fair values. Pro forma disclosure is no longer an alternative.

 

Priorto July 1, 2005, as was permitted under SFAS No. 123, the Company accounted forstock-based awards using the intrinsic value method under APB No. 25.  In general, pursuant to APB No. 25, when theexercise price of options granted to employees and non-employee directors underthese plans equals the market price of the underlying stock on the date of thegrant, no compensation expense was recorded.

 

EffectiveJuly 1, 2005, the Company adopted SFAS 123R. The Company selected the modified prospective method of adoption inwhich compensation cost is recognized beginning with the effective date for allshare-based payments to employees after June 30, 2005 and any unvestedshare-based payments to employees as of the effective date.  In accordance with the modified prospectivemethod of adoption, the Company’s results of operations for prior periods havenot been restated.

 

TheCompany has refined certain estimates used previously based upon the guidanceprovided under SFAS 123R, specifically the expected life of the option andestimated forfeitures.   The calculationof the fair value of the awards for quarters ended September 30, 2005 andthereafter has been adjusted to reflect these refined assumptions.

 

Thefollowing table illustrates the effect on net loss applicable to commonshareholders and net loss per share applicable to common shareholders as if thefair value method had been applied to all outstanding and unvested awards inthe prior period:

 
| ** **                                                                                                                                         | ** ** | **Three Months Ended   March 31,** | ** ** | **Nine Months Ended   March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **2005**                           | ** ** | **2005**                          | ** ** |
| Net loss  applicable to common shareholders as reported.                                                                                           |       | $                                  | (2,882,000 | )                                 | $          | (6,668,000 | ) |
|                                                                                                                                               |       |                               |       |                              |       |
| Add: share-based employee compensation  expense included in proforma net loss and reported net loss applicable to  common shareholders, net of tax |       | 71,000                             |       | 208,000                           |       |
|                                                                                                                                               |       |                               |       |                              |       |
| Deduct: total share-based employee  compensation expense determined under the fair value based method of all  awards, net of tax                   |       | (466,000                           | )          | (1,482,000                        | )          |
|                                                                                                                                               |       |                               |       |                              |       |
| Proforma net loss, for the periods  applicable to common shareholders after adopting SFAS 123R                                                     |       | $                                  | (3,277,000 | )                                 | $          | (7,942,000 | ) |
|                                                                                                                                               |       |                               |       |                              |       |
| Net loss per share applicable to common  shareholders, basic and diluted:                                                                          |       |                               |       |                              |       |
| As reported                                                                                                                                        |       | $                                  | (0.30      | )                                 | $          | (0.74 | ) |
| Pro forma                                                                                                                                          |       | $                                  | (0.34      | )                                 | $          | (0.88 | ) |

 

Under the provisions of SFAS 123R the Company recorded $503,000 and$1,917,000 of stock based compensation in its condensed consolidated statementof operations for the three and nine month periods ended March 31, 2006,respectively, which includes $16,000 and $45,000 of compensation expenseattributable to its Employee Stock Purchase Plan for the same three and ninemonth periods, respectively.  The stockbased compensation is included in the following expense categories:

 

9

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| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **March 31, 2006**     | ** ** | **March 31, 2006**    | ** ** |
|                                 |       |                   |       |                  |       |
| Cost of  revenues                    |       | $                      | 340,000    |                  | $          | 512,000 |   |
| Research and  development            |       | (172,000               | )          | 104,000               |       |
| Selling,  general and administrative |       | 335,000                |       | 1,301,000             |       |
| ** **                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| Total  FAS123R compensation expense  |       | $                      | 503,000    |                  | $          | 1,917,000 |   |

 

In the period ended March 31, 2006, the Company reclassed $280,000 ofstock-based compensation from research and development to cost of revenues.This adjustment was made due to the high percentage of time certain researchand development department employees are working on government contracts.

 

The Company also had $11,000 and $56,000 of compensation expenseattributable to non-employee options and warrants, for the three month and ninemonth periods, respectively.

 

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

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

 

----

(1)          The estimate of an option’s expected life has been updated and revisedfor all grants outstanding prior to adoption based upon guidance provided underSFAS 123R and the Securities and Exchange Commission’s Staff AccountingBulletin (“SAB”) Topic 107. The estimate of expected life was revised to usethe “simplified method” to determine the expected life of an option versus thecontractual life as previously used.

 

**7.****                         ****Share-based CompensationPlans**

 

TheCompany has two types of shared based compensation plans, a Stock Option Planand an Employee Stock Purchase Plan.  TheStock Option Plan is administered by a committee (“the Committee”) of at leasttwo outside Directors.

 

*Stock Option Plans*

 

InSeptember 1998, the Company adopted the 1998 Stock Option Plan (the “1998Plan”).  The 1998 Plan provides for thegrant of incentive stock options and nonqualified stock options to employeesand affiliates.  The exercise price ofthe options equal 100% of the fair market value on the date of the grant or110% of the fair market value for greater than 10% beneficial owners of theCompany stock.  Options expire between fiveand ten years from the date of the option grant and have various vestingperiods.  Options may be exercised by theHolder delivering to the Company cash in an amount equal to such aggregateexercise price, or with the consent of the Committee, shares of Company CommonStock having a fair market value equal to such aggregate exercise price, apersonal recourse note issued to the Company in a principal amount equal tosuch aggregate exercise price or other acceptable consideration including acashless exercise/resale procedure or any combination of the foregoing.  The Committee may in its

 

10

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discretionprovide upon the grant of any option that the Company shall have an option torepurchase, upon terms and conditions determined by the Committee, all or anynumber of shares purchased upon exercise of such option.

 

In December 2000, the Company adopted the 2000 Incentive and NonQualified Stock Option Plan (the “2000 Plan”). The 2000 Plan provides for the grant of incentive stock options andnonqualified stock options to employees and affiliates.  The exercise price of the options equal 100%of the fair market value on the date of the grant or 110% of the fair marketvalue for greater than 10% beneficial owners of the Company stock.  Options expire between five and ten yearsfrom the date of the option grant and have various vesting periods. Options maybe exercised by the Holder delivering to the Company cash in an amount equal tosuch aggregate exercise price, or with the consent of the Committee, shares ofCompany Common Stock having a fair market value equal to such aggregateexercise price, a personal recourse note issued to the Company in a principalamount equal to such aggregate exercise price or other acceptable considerationincluding a cashless exercise/resale procedure or any combination of theforegoing.  The Committee may in itsdiscretion provide upon the grant of any option that the Company shall have anoption to repurchase, upon terms and conditions determined by the Committee,all or any number of shares purchased upon exercise of such option.

 

In December 2004, the Company adopted the 2004 Stock Option Plan (the“2004 Plan”).  The 2004 Plan provides forthe grant of incentive stock options and nonqualified stock options toemployees and affiliates.  The exerciseprice of the options equal 100% of the fair market value on the date of thegrant or 110% of the fair market value for greater than 10% beneficial ownersof the Company stock.  Options expirebetween five and ten years from the date of the option grant and have variousvesting periods.  At the December 2005annual meeting the shareholders voted to increase the shares available forissuance under the 2004 Plan by 500,000 to 1,000,000 shares. Options may beexercised by the Holder delivering to the Company cash in an amount equal tosuch aggregate exercise price, or with the consent of the Committee, shares ofCompany Common Stock having a fair market value equal to such aggregateexercise price, a personal recourse note issued to the Company in a principalamount equal to such aggregate exercise price or other acceptable considerationincluding a cashless exercise/resale procedure or any combination of theforegoing.

 

A summary of option activity under the plans as of and for the periodMarch 31, 2006 are as follows:

 
| ** **                         | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding  at June 30, 2005      |       | 1,908,331  |       | $                                      | 5.66       |   |
|                               |       |       |       |                                   |       |
| Granted                            |       | 88,000     |       | 6.72                                   |       |
| Exercised                          |       | (2,500     | )          | 2.10                                   |       |
| Canceled                           |       | (189,440   | )          | 6.27                                   |       |
|                               |       |       |       |                                   |       |
| Outstanding  at September 30, 2005 |       | 1,804,391  |       | $                                      | 5.64       |   |
|                               |       |       |       |                                   |       |
| Granted                            |       | 335,250    |       | 4.09                                   |       |
| Exercised                          |       | —     |       | —                                 |       |
| Canceled                           |       | (82,754    | )          | 0.42                                   |       |
|                               |       |       |       |                                   |       |
| Outstanding  at December 31, 2005  |       | 2,056,887  |       | $                                      | 5.60       |   |
|                               |       |       |       |                                   |       |
| Granted                            |       | 37,500     |       | 4.19                                   |       |
| Exercised                          |       | (23,755    | )          | 1.50                                   |       |
| Canceled                           |       | (176,181   | )          | 8.63                                   |       |
|                               |       |       |       |                                   |       |
| Outstanding  at March 31, 2006     |       | 1,894,451  |       | $                                      | 5.61       |   |

 

11

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Asummary of the unvested option activity under the plans as of and during thenine month period ended March 31, 2006 is as follows:

 
| **Unvested Options**            | ** ** | **Shares** | ** ** | **Weighted-  Average   Exercise Price** | ** ** |
|---------------------------------|------------|------------|------------|-----------------------------------------|------------|
| Unvested at  at June 30, 2005   |       | 891,969    |       | $                                       | 6.98       |   |
|                            |       |       |       |                                    |       |
| Granted                         |       | 88,000     |       | 4.79                                    |       |
| Vested                          |       | (138,450   | )          | 5.47                                    |       |
| Forfeited                       |       | (62,216    | )          | 5.71                                    |       |
|                            |       |       |       |                                    |       |
| Unvested at  September 30, 2005 |       | 779,303    |       | $                                       | 6.88       |   |
|                            |       |       |       |                                    |       |
| Granted                         |       | 94,000     |       | 3.83                                    |       |
| Vested                          |       | (67,234    | )          | 7.16                                    |       |
| Forfeited                       |       | (3,000     | )          | 6.17                                    |       |
|                            |       |       |       |                                    |       |
| Unvested at  December 31, 2005  |       | 803,069    |       | $                                       | 6.48       |   |
|                            |       |       |       |                                    |       |
| Granted                         |       | 37,500     |       | 4.19                                    |       |
| Vested                          |       | (69,946    | )          | 7.11                                    |       |
| Forfeited                       |       | (28,300    | )          | 9.30                                    |       |
|                            |       |       |       |                                    |       |
| Unvested at  March 31, 2006     |       | 742,323    |       | $                                       | 6.21       |   |

 

Asof March 31, 2006 there was $2,165,000 of total unrecognized compensationexpense related to unvested share based compensation arrangements under thevarious share-based compensation plans. This expense is expected to be recognized as follows:

 
| **Year ending June 30:** | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|
| Q4 2006                  |       | $          | 450,000    |   |
| 2007                     |       | 1,162,000  |       |
| 2008                     |       | 512,000    |       |
| 2009                     |       | 41,000     |       |
|                     |       |       |       |
| Total                    |       | $          | 2,165,000  |   |

 

*Employee Stock Purchase Plan*

 

InSeptember 1998, the Company adopted the 1998 Employee Stock Purchase Plan (the“ESPP”).  The ESPP provides a methodwhereby employees of the Company will have an opportunity to acquire anownership interest in the Company through the purchase of shares of commonstock of the Company through payroll deductions.  After 12 months of employment, an employee iseligible to participate and can defer up to 10% of their wages into this ESPP,with a maximum of $25,000 in any calendar year. The purchase price of the common stock is calculated at the lower of 85%of the closing price of the stock on the first day of the plan period or thelast day of the ESPP plan period.  Theperiods are January 1 to June 30 and July 1 to December 31.  Fractional shares are not issued.  Participants may withdraw at any time bygiving written notice to the Company and will be credited the amounts ofdeferrals in their account.  The maximumnumber of shares eligible to be issued under the ESPP is 141,000.  As of March 31, 2006, a total of 78,163shares are available for issuance under the ESPP.   Compensation expense under the ESPP for theperiod ended March 31, 2006 is $16,000.

 

12

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

 

OnJuly 6, 2005, the Company executed a $3.0 million secured term note payable toLaurus Master Fund, Ltd. (“Laurus”).  The Company received $3,000,000 in gross proceeds, less a management feeof $135,000 and related transaction costs of approximately $32,000.  The term note was collateralized bysubstantially all of the Company’s assets, had a 4-month term and bore interestat a rate equal to the prime rate plus once percent (1%).  In connection with the financing, on September30, 2005, the Company issued Laurus a warrant to purchase up to 250,000 sharesof the Company’s common stock at a price equal to $3.75 per share.  Net proceeds from the financing were used forincreasing the capacity of the Quantum SnifferTM production line, increasingunit inventories and the repayment of certain indebtedness due and owed by theCompany to the former shareholders of Accurel in connection with theacquisition of this wholly-owned subsidiary.

 

On September 30, 2005, the Company issued 500,000 shares of Series DConvertible Redeemable Preferred Stock (“Series D”) having a stated value of$10 per share, pursuant to a Securities Purchase Agreement with Laurus (the“Agreement”). The Series D has a dividend equal to the prime rate plus onepercent (8.75% as of March 31, 2006) and provides for redemption over athirty-six month period pursuant to an amortization schedule. The Companyreceived $5,000,000 in gross proceeds, less a management and placement agentfee of approximately $90,000, related transaction and issuance costs of approximately$144,000, and the repayment of $3,032,000 of principal and interest related tothe July 6, 2005 term note.

 

Thefollowing table reflects the required redemption of the Series D before theeffect of the accrued dividends:

 
| Monthly  redemption      | ** ** |
|--------------------------|------------|
| ** **               | ** ** | **Preferred Stock   Redemption** | ** ** |
| **Year ending June 30:** | ** ** | **Schedule** | ** ** |
| Q4 2006                  |       | $456,000 |   |
| 2007                     |       | 1,824,000 |   |
| 2008                     |       | 1,824,000 |   |
| 2009                     |       | 896,000 |   |
| Total                    |       | $5,000,000 |   |

 

Themonthly redemption of approximately $152,000 plus accrued dividends commenceson January 1, 2006.  Subject to certainconditions, it is at the Company’s option to pay this amount in cash or incommon stock at a fixed conversion price of $6.80 per common share.  The following conditions must be met in orderto facilitate payment in common stock: (1) the shares must be issued pursuant to an effective registrationstatement, (2) the average closing market price of the common stock for thefive trading days immediately preceding a payment date must exceed the fixedconversion price by 110% and no one day’s closing price may be less than thefixed conversion price, and (3) the conversion dollar value may not exceed theaggregate of the prior 22 trading days’ dollar volume.  The dividend rate is subject to a 2% decreasefor every 25% the average trading price for the five trading days prior to arepayment date exceeds the fixed conversion price, to a minimum of 0%.  In addition, upon notifying the holder, theCompany has the option of redeeming any outstanding shares of Series D withcash by paying 130% of the stated value plus accrued interest.

 

Asa condition of closing, the Company and each of its Subsidiaries granted asecurity interest in their respective assets as well as providing 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 agreed to enter into suchdocumentation as shall be reasonably requested by the Company in order tosubordinate its rights under the Series D to the subsequent financier.   The registration rights associated with theAgreement state that the Company will use its best efforts to have theregistration statement effective within 120 days from closing.  In addition, the Company is required tomaintain an effective registration statement, 

 

13

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andensure that shares are not suspended from trading.  Upon notice from Laurus, should the Companybe declared in default of these items and have not cured the default within theprescribed period, the Company may be assessed liquidated damages equal to 1/30thof 0.1% of the outstanding preferred balance, payable in cash, for each day theevent has occurred and remains outstanding. However, pursuant to the Agreement “liquidated damages do not applyshould the Securities and Exchange Commission (“SEC”) have an issue withrespect to the Holder or with respect to the structure of the transaction.”

 

Inconjunction with the Series D, the Company also issued to Laurus a warrant topurchase up to 50,000 shares of the Company’s common stock at a price equal to$10.20 per share.  The Company utilizedthe proceeds of the Series D to repay the $3 million term note with Laurusdated July 6, 2005, plus accrued interest, and for working capital.

 

Inaccordance with the provisions of Emerging Issues Task Force (“EITF”) Issue00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, the Company concluded that theSeries D contained a conversion feature which should be valued at fair valueand be recorded as a liability on the balance sheet.  This conversion feature is not considered tobe a “conventional preferred” instrument because the Agreement includes certainconditions under which the conversion price may be reset.  This condition would suggest that the numberof shares to be issued upon conversion is not fixed, a requirement of aconventional preferred .instrument.. This conversion feature was determined to be a liability since it may berequired to be repaid in cash, cannot be paid in unregistered shares and hascertain penalties.  These conditionsdefine the conversion feature as an embedded derivative which must be separatedfrom the host and reported at fair value pursuant to SFAS No. 133 “Accountingfor Derivative Instruments and Hedging Activities” (SFAS No. 133).

 

TheSeries D also contains certain features affecting the dividend rate.  In the first feature, the dividend rate issubject to adjustment based on the market price of the Company’s commonstock.  The Company has evaluated thisitem to consider whether it would be considered an embedded derivative asdefined in SFAS No. 133.  While having adividend rate that can fluctuate with the stock price is a feature that hascharacteristics of an embedded derivative, this feature would be classified asa derivative asset.  An independentappraiser was hired to value this asset derivative and the value was determinedto be immaterial.  The second feature,related to potential default provisions, could potentially increase thedividend and redemption price, similar to a default or penalty clause in adebt-like instrument. In evaluating whether this penalty feature would beconsidered an embedded derivative, the Company considered the provisions ofSFAS No. 133 paragraph 12 and 13, and determined that this feature would not beconsidered a derivative as it does not have a “net settlement” provision.

 

Theconversion feature aggregated to $1,397,000 on September 30, 2005 based on theBlack Scholes valuation model and the following assumptions:  volatility 80%, expected life 1.5 years, anda risk free interest rate of 3.96%.  Theconversion feature is marked to market at each reporting period with changes inits fair value flowing through the statement of operations.  As of March 31, 2006, the fair value of thisconversion feature approximated $486,000.

 

The Company valued the Series D at issuance at its residual value of$2,700,000 based on the fair values of the financial instruments issued inconnection with this preferred stock financing, including the warrants, theconversion feature and offering costs. The amounts recorded in the financial statements represent the amountsattributed to the sale of the preferred stock, the amount allocated to warrantsof $632,000, the value attributed to conversion feature of $1,397,000 and$271,000 of issuance costs (including $154,000 of unamortized costs of the July6, 2005 term note).  The Company isaccreting these discounts on the carrying value of the Series D to itsredemption value of $5,000,000 at September 1, 2008, or the actual conversiondate, whichever is earlier.  Theaccretion of these amounts is being recorded as a preferred dividend in theperiod of accretion.  During the threemonth period ended March 31, 2006, approximately $571,000 was amortized.  As of March 31, 2006, Laurus waived theCompany’s obligation to pay the monthly amortization payments for the periodJanuary 2006 through March 2006 until September 30, 2009.  The Company is currently working with Laurusto identify alternatives to cash payments to satisfy future redemptions shouldthe restrictions identified in the Series D prohibit conversion of the Series Dinto common stock.  The outstandingprincipal of the Series D was $5,000,000 at March 31, 2006.

 

14

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The accounting for the Series D financing and related instruments iscurrently under review by the SEC and is subject to change based on the SEC’sfinal interpretation and review of the Company’s accounting.

 

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

 

Basicloss per share is computed based only on the weighted average number of commonshares outstanding during the period. Diluted earnings per share is computed by using the weighted averagenumber of common shares outstanding during the period, plus the dilutiveeffects of shares issuable through the exercise of stock options and warrants(common stock equivalents) unless their inclusion would be antidilutive.  The shares underlying the Series D have notbeen included in the earnings per share calculation.

 

**10.****                              ****Financial Information bySegment**

 

UnderSFAS No. 131, “Disclosures about Segments of an Enterprise and RelatedInformation,” operating segments are defined as components of an enterpriseabout which separate financial information is available that is evaluatedregularly by the chief operating decision maker, or decision making group, indeciding how to allocate resources and in assessing performance.  The Company’s chief operating decision makinggroup is composed of the chief executive officer and members of seniormanagement. The Company’s reportable segments are:  Medical, Semiconductor and Explosives.

 

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

 

Therevenues and expenses related to these segments for the three and nine monthsended March 31, 2006 and 2005, respectively are as follows:  

 
| ** **    | ** ** | **Three Months Ended** | ** **      |
|---------------|------------|------------------------|-----------------|
| ** **    | ** ** | **March 31,**          | ** **      |
| ** **    | ** ** | **2006**               | ** **      | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **    | ** ** | **Revenues**           | ** **      | **COGS** | ** ** | **Gross Margin** | ** ** |
| Medical       |       | $                      |  1,173,000 |   | $ |  1,083,000 |   | $ |  901,000 |   | $ |  787,000 |   | $ |  272,000 |   | $ |  296,000 |   |
| Semiconductor |       | 3,906,000              |            | 1,604,000 |   | 3,071,000 |   | 1,613,000 |   | 835,000 |   | (9,000 | ) |
| Explosives    |       | 1,469,000              |            | 175,000 |   | 1,570,000 |   | 481,000 |   | (101,000 | ) | (306,000 | ) |
| Total         |       | $                      |  6,548,000 |   | $ |  2,862,000 |   | $ | 5,542,000 |   | $ |  2,881,000 |   | $ | 1,006,000 |   | $ |  (19,000 | ) |
|               |            |                        |                 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **    | ** ** | **Nine Months Ended** | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **March 31,**         | ** ** |
| ** **    | ** ** | **2006**              | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **    | ** ** | **Revenues**          | ** ** | **COGS** | ** ** | **Gross Margin** | ** ** |
| Medical       |       | $                     | 3,313,000  |   | $ | 2,976,000 |   | $ | 2,690,000 |   | $ | 2,586,000 |   | $ | 623,000 |   | $ | 390,000 |   |
| Semiconductor |       | 10,363,000            |       | 3,226,000 |   | 8,707,000 |   | 3,526,000 |   | 1,656,000 |   | (300,000 | ) |
| Explosives    |       | 5,084,000             |       | 1,475,000 |   | 4,889,000 |   | 1,561,000 |   | 195,000 |   | (86,000 | ) |
| Total         |       | $                     | 18,760,000 |   | $ | 7,677,000 |   | $ | 16,286,000 |   | $ | 7,673,000 |   | $ | 2,474,000 |   | $ | 4,000 |   |
|               |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

15

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**11.****                              ****Goodwill and OtherIntangible Assets:**

 

AtMarch 31, 2006, the Company had goodwill and intangible assets of$13,663,000.  SFAS No. 142, “Goodwill andOther Intangible Assets”, requires that goodwill and intangible assets withindefinite lives no longer be amortized but instead be measured for impairmentat least annually or whenever events indicate that there may be animpairment.  The Company has fourreporting units, medical, explosives detection, semiconductor wafer processingand semiconductor analytical services. All of the Company’s goodwill isallocated to the semiconductor wafer processing and the semiconductoranalytical services reporting units. Determining the reporting unit’s fair value requires management to makeestimates based on market conditions and operational performance. Absent anevent that indicates a specific impairment may exist, management has selectedAugust 31 as the date of performing the annual goodwill impairment test.  In order to determine if impairment exists,management continually estimates the reporting unit’s fair value based onmarket conditions and operational performance. The Company may employ the work of independent appraisers in making itsdetermination.  As of August 31, 2005,goodwill existed in two of our reporting units, our semiconductor waferprocessing and semiconductor analytical services units. The Company, inconjunction with a report from an independent appraiser made its annualassessment of goodwill attributable to its semiconductor wafer processingreporting unit on August 31, 2005 and determined that the reporting unit’s goodwillwas not impaired.  In addition,management conducted an internal assessment of the semiconductor analyticalservices reporting unit’s goodwill and concluded that these assets were notimpaired as well.

 

Thefollowing table summarizes the Company’s goodwill assets as of March 31, 2006and June 30, 2005:

 
| **Reporting Unit**                 | ** ** | **March 31, 2006** | ** ** | **June 30, 2005** | ** ** |
|------------------------------------|------------|--------------------|------------|-------------------|------------|
|                               |       |               |       |              |       |
| Semiconductor  Wafer Processing    |       | $                  | 4,548,000  |              | $          | 4,647,000 |   |
|                               |       |               |       |              |       |
| Semiconductor  Analytical Services |       | 7,575,000          |       | 7,566,000         |       |
|                               |       |               |       |              |       |
| Total Goodwill                     |       | $                  | 12,123,000 |              | $          | 12,213,000 |   |

 

Thechange in the value of the goodwill assets since June 30, 2005 primarilyreflect the satisfaction of a $112,000 liability in the semiconductor waferprocessing segment offset by additional acquisition related expenses.

 

Intangibleassets with finite lives are valued, at their acquisition, according to thefuture cash flows they are estimated to produce.  These assigned values are amortized over theperiod of time those cash flows are estimated to be produced.  Management continually evaluates whetherevents or circumstances have occurred that indicate that the estimatedremaining useful life or the carrying value of these assets has been impaired.As of March 31, 2006 management believes no impairment exists.

 

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

 

Thefollowing table summarizes the Company’s intangible assets as of March 31, 2006and June 30, 2005:

 

16

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| ** **       | ** ** | ** **      | ** ** | **March 31, 2006**          | ** ** | **June 30, 2005**              | ** ** |
|------------------|------------|-----------------|------------|-----------------------------|------------|--------------------------------|------------|
| ** **       | ** ** | **Useful Life** | ** ** | **Gross Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Amount** | ** ** | **Gross Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying   Amount** | ** ** |
|             |       |            |       |                        |       |                           |       |   |   |   |   |   |   |   |   |
| Non-Compete      |       | 18-36 mo.       |       | $                           | 1,057,000  |                           | $          | 1,043,000 |   | $ | 14,000 |   | $ | 1,057,000 |   | $ | 809,000 |   | $ | 248,000 |   |
|             |       |            |       |                        |       |                           |       |   |   |   |   |   |   |   |   |
| Name Recognition |       | 60-84 mo.       |       | 200,000                     |       | 30,000                         |       | 170,000 |   | 200,000 |   | 9,000 |   | 191,000 |   |
|             |       |            |       |                        |       |                           |       |   |   |   |   |   |   |   |   |
| Customer  Base   |       | 60 mo.          |       | 1,630,000                   |       | 363,000                        |       | 1,267,000 |   | 1,630,000 |   | 119,000 |   | 1,511,000 |   |
|             |       |            |       |                        |       |                           |       |   |   |   |   |   |   |   |   |
| Technology       |       | 60 mo.          |       | 125,000                     |       | 36,000                         |       | 89,000 |   | 125,000 |   | 18,000 |   | 107,000 |   |
|             |       |            |       |                        |       |                           |       |   |   |   |   |   |   |   |   |
| Total            |       |            |       | $                           | 3,012,000  |                           | $          | 1,472,000 |   | $ | 1,540,000 |   | $ | 3,012,000 |   | $ | 955,000 |   | $ | 2,057,000 |   |

 

Estimatedfuture amortization expense for intangible assets with finite lives as of March31, 2006 is as follows:

 
| Remainder of fiscal year |   | 2006       |   | $       | 104,000   |   |
|--------------------------|--------|------------|--------|---------|-----------|--------|
|                     |   | 2007       |   | 387,000 |      |
|                     |   | 2008       |   | 380,000 |      |
|                     |   | 2009       |   | 380,000 |      |
|                     |   | 2010       |   | 244,000 |      |
|                     |   | thereafter |   | 45,000  |      |
|                     |   |       |   | $       | 1,540,000 |   |

 

**12.****         ****Credit Arrangements**

 

Atthe time of its acquisition, Accurel had a $1,400,000 fixed rate installmentnote with a bank with terms providing for monthly payments of $29,000 plusinterest at a rate of 6.84%, through September 1, 2008, (“the Accurelnote”).  The bank has consented tocontinue the Accurel note under the same terms after the acquisition. As ofMarch 31, 2006, the Accurel note balance is $904,000.  The Accurel note is collateralized bysubstantially all assets of Accurel.

 

TheAccurel note requires Accurel to report monthly financial results to the bankand for Accurel to comply with certain financial covenants including cash flowand tangible net worth ratios and net income. As of March 31, 2006, Accurel wasin compliance with the covenants.

 

On June 8, 2005, the Company executed a revolving credit facility for$1,500,000 with Silicon Valley based Bridge Bank, N.A.  The revolving credit facility expires onDecember 31, 2006, provides for advances of up to eighty percent (80%) of theCompany’s eligible accounts receivable, bears interest at the prime rate plusone-half percent (1/2%) (8.25% as of March 31, 2006), is collateralized bycertain assets of the Company and is subject to certain covenants, including anadjusted quick ratio and tangible net worth. As of March 31, 2006, the Company had drawn $500,000 on the creditfacility.  As of March 31, 2006 theCompany was in compliance with the covenants.

 

**13.****         ****Proforma Financial Information**

 

Thefollowing table presents selected unaudited financial information of theCompany including Core and Accurel as if their respective acquisitions hadoccurred on July 1, 2004.  The unauditedproforma

 

17

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resultsare not necessarily indicative of the results that would have occurred had theacquisitions of Core  and Accurel beenconsummated on July 1, 2004, or of future results.

 

IMPLANT SCIENCES CORPORATION

PROFORMA CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **March 31,**          | ** ** | **March 31,**         | ** ** |
| ** **                                                     | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                                                        |       | $                      | 6,548,000  |                  | $          | 4,440,000 |   | $ | 18,760,000 |   | $ | 14,526,000 |   |
|                                                           |       |                   |       |                  |       |   |   |   |   |
| Net Loss  Before Taxes                                         |       | (1,264,000             | )          | (2,259,000            | )          | (4,565,000 | ) | (5,958,000 | ) |
|                                                           |       |                   |       |                  |       |   |   |   |   |
| Preferred  distribution, dividends                             |       | (391,000               | )          | (615,000              | )          | (778,000 | ) | (1,182,000 | ) |
|                                                           |       |                   |       |                  |       |   |   |   |   |
| Net Loss                                                       |       | $                      | (1,655,000 | )                     | $          | (2,874,000 | ) | $ | (5,343,000 | ) | $ | (7,140,000 | ) |
|                                                           |       |                   |       |                  |       |   |   |   |   |
| Net loss per share applicable to common  shareholders          |       | $                      | (0.15      | )                     | $          | (0.28 | ) | $ | (0.48 | ) | $ | (0.70 | ) |
|                                                           |       |                   |       |                  |       |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted |       | 11,379,000             |       | 10,374,000            |       | 11,171,000 |   | 11,166,000 |   |
|                                                                |            |                        |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 

**14.****         ****Commitments and Contingencies**

 

OnMarch 24, 2006, the Company brought suit in the United States District Court inthe District of Massachusetts against Rapiscan Systems, Inc. (“Rapiscan”) andits parent, OSI Systems, Inc. (“OSI”). The Company is requesting rescission of an agreement between the Companyand Rapiscan, entered into on March 23, 2005 (the “Agreement”), for lack ofperformance and other grounds.  In thealternative, the Company is seeking termination of the Agreement due tomaterial breaches of contract and implied covenant of good faith and fair dealingand for damages due to Rapiscan’s breach of contract and the implied covenantof good faith and fair dealing.

 

OnMarch 27, 2006, the Company received notice that Rapiscan filed a complaintagainst the Company and its contract manufacturer, Columbia Tech, in the UnitedStates District Court for the Central District of California, regarding theAgreement.  Rapiscan’s complaint againstthe Company is based upon claims of breach of contract and  breach of warranty and is requesting a decreefor specific performance, declaratory relief and injunctive relief.  Rapiscan’s complaint against Columbia Tech isbased upon injunctive relief, declaratory relief and tortuous interference withcontractual relations.  On April 12, 2006,Rapiscan dismissed all claims against Columbia Tech.

 

**15.****         ****Subsequent Events**

 

OnMay 10, 2006 Laurus Master Fund, LLP waived the monthly redemptions for theperiod January 1, 2006 through March 31, 2006 to September 30, 2009 and waivedthe redemptions for the period April 1, 2006 through May 1, 2006 to May 16,2006.

 

18

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| **ITEM 2.** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND  RESULTS OF OPERATIONS** |
|-------------|-------------------------------------------------------------------------------------------------------|

 

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

 

ImplantSciences Corporation (“Implant” or the “Company”), incorporated in 1984, hasthree locations.  It operates out of a51,000 square foot leased facility in Wakefield, Massachusetts.  Since October 15, 2004, Implant also operatesout of a 35,000 square foot leased facility in Sunnyvale, California and sinceMarch 9, 2005, out of a 20,000 square foot leased facility also in Sunnyvale,California.  The Company hasapproximately 155 employees and runs three shifts in Wakefield and two shiftsin Sunnyvale.  The Company generatesrevenues from the sale of ion implantation and analytical services for thesemiconductor industry, radioactive prostate seeds and medical coatings,explosives trace detection equipment and government research and developmentcontracts for both medical products and explosives detection segments.Semiconductor products and services are conducted in both the Wakefield andSunnyvale facilities.  Medical andindustrial coatings, radioactive prostate seed manufacturing, explosivesdetection equipment manufacturing and research and development programs areconducted in Wakefield.

 

Thethree months and nine months ended March 31, 2006 includes revenues from CoreSystems Incorporated (“Core”) which was acquired by the Company on October 15,2004, and Accurel Systems International (“Accurel”) which was acquired on March9, 2005.  These acquisitions contributedrevenues of $3.4 million in the quarter compared to total revenues of $6.5million and $9.5 million for the nine months compared to total revenues of$18.8 million. Core and Accurel are included in the semiconductor segment.  Revenues from our explosives detectionsegment, during the three months and nine months ended March 31, 2006, were$1.5 million and $5.1 million, respectively. These revenues reflect the first significant shipments of our explosivesdetection product during the nine month period ended March 31, 2006, includinga previously announced order from China.

 

Asa result of the acquisition of Core and Accurel on October 15, 2004 and March9, 2005, respectively, and the Company’s presentation of consolidated financialstatements, it should be noted that the fiscal 2006 and fiscal 2005 financialstatements are not comparative and therefore may not be meaningful information.

 

OnJuly 1, 2005, the Company adopted SFAS No. 123R, “Share-Based Payments,” (“SFASNo. 123R”) which is a revision of SFAS No. 123, “Accounting for Stock-BasedCompensation,” (“SFAS No. 123”) using the modified prospective method.  Prior to this, the Company had elected to usethe disclosure-only provisions of SFAS No. 123. The Company was required toadopt SFAS No. 123R on July 1, 2005 because it no longer qualifies as a “smallbusiness” filer for SEC reporting purposes as of that date. Under SFAS 123R,the Company is required to account for all options granted to employees on orafter July 1, 2005 and any unvested portion of options outstanding as of July1, 2005 (the “effective date”), using the fair value method. The Companypreviously accounted for its employee stock-based compensation arrangementsunder the provisions of Accounting Principal Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees,” (“APB 25”) rather than thealternative fair value accounting method provided for under SFAS No. 123.Previously under APB 25, when the exercise price of options granted toemployees and non-employee directors under these plans equals the market priceof the underlying stock on the date of the grant, generally, no compensationexpense is recorded.  Because of theadoption of SFAS No. 123R comparisons with previous periods may not bemeaningful.

 

**RESULTS OFOPERATIONS**

 

The following is adiscussion and analysis of the financial condition and results of operation ofthe Company for the three and nine month period ended March 31, 2006 and March31, 2005.  It should be read inconjunction with the condensed consolidated financial statements and notesthereto appearing elsewhere herein.

 

19

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*ThreeMonth Period Ended March 31, 2006 vs. March 31, 2005*

 

*Revenues.* Total revenues for the three month period ended March 31, 2006 were$6,548,000 as compared to $2,862,000 for the comparable prior year period, anincrease of $3,686,000 or 129%.   Ourrevenues by business segment are as follows:

 
| ** **      | ** ** | **Revenues**                           | ** ** |
|-----------------|------------|----------------------------------------|------------|
| ** **      | ** ** | **Three Month Period Ended March 31,** | ** ** |
| ** **      | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Medical         |       | $                                      | 1,173,000  |   | $ | 1,083,000 |   |
| Semiconductor   |       | 3,906,000                              |       | 1,604,000 |   |
| Explosives      |       | 1,469,000                              |       | 175,000 |   |
| Total  Revenues |       | $                                      | 6,548,000  |   | $ | 2,862,000 |   |

 

Theoverall increase in revenues is attributable to revenues from explosivesdetection products, Core and Accurel. Explosives detection included shipmentsof the Company’s explosives detection equipment. and revenues from itspreviously announced development contract with the Transportation SecurityAdministration (“TSA”). The TSA contract is expected to be completed bySeptember 2006. Revenues from contracts exceeded product revenues during thequarter ended March 31, 2006.

 

Corewas acquired on October 15, 2004 and Accurel was acquired on March 9, 2005 andtheir results are included in the previous year period since those respectivedates.   Revenues from Core and Accurelaggregated approximately $3,448,000 and are included in our semiconductorsegment.  Semiconductor revenues were$3,906,000 as compared to $1,604,000 in the comparable prior year period, anincrease of $2,302,000 or 144%.  Sincethe acquisition of Core, the Company has transitioned some semiconductor workfrom Wakefield to Sunnyvale to take advantage of operating efficiencies.

 

Medicalrevenues were $1,173,000 as compared to $1,083,000 for the comparable prioryear period, an increase of $90,000 or 8%. The increase in medical revenues was due primarily to an increasedvolume of radioactive prostate seed sales combined with sales from ourtreatment planning software product. After a lengthy period of decline,management believes seed volumes have now stabilized, and has taken steps toachieve increasing seed volumes in the coming year, including the benefits ofselling our treatment planning software to our customers. The treatmentplanning software is a proprietary treatment planning technology marketed as“I-PlantTPS”TM. In its latest version, a new module aidsthe physician in making two and three dimensional maps of stage, grade andlocation of cancer within the prostate gland. This “Pathology Mapping Module”TMis in addition to the standard treatment planning function used for prostatebrachytherapy and will provide for image guided, focal treatment of thedisease.

 

Revenues from the Company’sexplosives detection business increased to $1,469,000 as compared to $175,000for the comparable prior year period, an increase of $1,294,000 or 739%.  This increase is attributable to the shipmentof explosives detection equipment during the quarter in addition to revenuesfrom a TSA contract.  In the previousyear most of the Company’s government contracts were completed and significantshipments of its explosives detection product had not started. The Company hasbeen transitioning the explosives business from primarily acontracts/development business to a product sales business.  To that extent, we have established strategicsales and distribution relationships both domestically and internationally.

 

*Cost of Revenues*.  Costof revenues for the three months ended March 31, 2006 was $5,542,000 ascompared to $2,881,000 for the comparable prior year period, an increase of $2,661,000or 92%.  The cost of revenues by businesssegment is as follows:

 

20

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| ** **             | ** ** | **Cost of Revenue**                    | ** ** |
|------------------------|------------|----------------------------------------|------------|
| ** **             | ** ** | **Three Month Period Ended March 31,** | ** ** |
| ** **             | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Medical                |       | $                                      | 901,000    |   | $ | 787,000 |   |
| Semiconductor          |       | 3,071,000                              |       | 1,613,000 |   |
| Explosives             |       | 1,570,000                              |       | 481,000 |   |
| Total Cost  of Revenue |       | $                                      | 5,542,000  |   | $ | 2,881,000 |   |

 

Theoverall increase in cost of revenues is primarily a result of costsattributable to product costs of explosives detection equipment, and costsassociated with the operations of Core and Accurel.  The cost of our explosives detection revenueswas $1,570,000 compared to $481,000 in the comparable prior year period, anincrease of $1,089,000 or 226%. This increase is directly attributable to thecost of product shipped during the period. The Company has made a significantinvestment in the development and manufacturability of its explosives detectionproducts.  During the quarter, most ofthe manufacturing of its explosives detection products was transitioned to a contractmanufacturer.  The transition to contractmanufacturing gives the Company more flexibility to handle changes in volumesand is expected to provide operating efficiencies resulting in overall lowercosts for its product.

 

Accurelwas acquired on March 9, 2005 and its results were not included in the entirecomparable prior year period.  Cost ofrevenues at Accurel totaled $1,485,000 for the period and are included in oursemiconductor segment. Medical products costs were $901,000 as compared to $787,000in the comparable prior year period, an increase of $114,000 or 14%.  This increase is primarily due to increasedseed sales volumes.   Included in cost ofsales for the period ended March 31, 2006, is $340,000 of share-basedcompensation as required by SFAS No. 123R.

 

*Gross Margins*.  Overall gross margins were 15%of revenues in the three month period ended March 31, 2006 as compared to aloss on the gross margin of 1% of revenues in the comparable prior yearperiod.  The increase in the gross marginpercentage is attributable to the volume of explosives detection equipmentbuilt and shipped during the period. The result of this transition was a decreasein gross margin loss of $101,000 or 7% of sales for the explosives detectionsegment for the three months ended March 31, 2006, as compared to gross marginlosses of $306,000 or 175% in the comparable prior year period. Alsocontributing were margins on explosives development contracts.. Semiconductormargins were 21% of revenues as compared to a gross margin loss of 1% in thecomparable prior year period. This turnaround is attributable to Accurel.  Accurel was acquired on March 9, 2005 and itsresults are not included in the comparable prior year period.  Medical margins declined to 23% of revenuesfrom 27% in the prior year period.  Thisdecline is attributable to higher volumes of lower margin seed sales ascompared to the comparable period in the previous year.  Gross margins by business segment are asfollows:

 
| ** **           | ** ** | **Gross Margin**                       | ** ** |
|----------------------|------------|----------------------------------------|------------|
| ** **           | ** ** | **Three Month Period Ended March 31,** | ** ** |
| ** **           | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Medical              |       | 23                                     | %          | 27 | % |
| Semiconductor        |       | 21                                     | %          | -1 | % |
| Explosives           |       | -7                                     | %          | -175 | % |
| Total gross  margin% |       | 15                                     | %          | -1 | % |

 

*Research and Development*. Research and development expense for the three month period ended March31, 2006 was $86,000 as compared to $715,000 for the comparable prior yearperiod, a decrease of $629,000 or 88%. During the three months ended March 31,2006 the Company was able to use research personnel on its government contractwork and the expenses were charged to cost of sales. The Company continues toexpend funds to further the development of new products in the areas ofexplosives and toxic substance detection and temporary brachytherapy areas.

 

21

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*Selling, General and Administrative*. Selling, general and administrative expenses for the three month periodended March 31, 2006 were $2,063,000 as compared to $1,464,000 for thecomparable prior year period, an increase of $599,000 or 41%.  Included in selling, general andadministrative costs for the period ended March 31, 2006, is $335,000 ofshare-based compensation as required by SFAS No. 123R.  Other factors contributing to the increaseare $414,000 of additional selling, general and administrative expensesincurred due to the acquisition of Accurel, which were not in the previousyear’s numbers.  Accurel was acquired onMarch 9, 2005 and its results were not included in the comparable prior yearperiod prior to that date.  Sellingexpenses associated with our treatment planning software line was $97,000 inthe three month period ended March 31, 2006 as compared to $0 for thecomparable prior year period.

 

*Other Income and Expenses, Net*.  Forthe three months ended March 31, 2006, the Company recorded other expense net, of$121,000 as compared to other expense, net, of $69,000, in the comparable prioryear period. Other income includes $20,000 of income attributable to marking tomarket the derivative value of the preferred stock conversion associated withthe Series D preferred stock.  Equitylosses in unconsolidated subsidiaries increased by $76,000 in the currentfiscal year period due to the Company’s share of losses at CorNova.

 

*Net Loss.*  Net loss for the three monthperiod ended March 31, 2006 was $1,264,000 as compared with $2,267,000 for thecomparable prior year period, a decrease in net loss of $1,103,000 or 44%.  The decrease in net loss is primarily due toan increased margin contribution from our explosives detection segment of $205,000and a $826,000 improvement in gross margin from our semiconductor segment.  The fiscal 2006 results include $503,000 ofnon-cash compensation due to FAS No.123R.  The acquisition of Core on October 15, 2004 was expected to have apositive impact on earnings from expected operating efficiencies and increasedrevenues when combined with the Company’s existing semiconductoroperations.  Management continues tofocus on opportunities for Core that could have significant profit potential.The Company continually reviews its goodwill assets for potentialimpairment.  The Company has fourreporting units for measuring goodwill and intangible assets, medical,explosives detection, semiconductor wafer processing and semiconductoranalytical services. All of the Company’s goodwill is allocated to thesemiconductor wafer processing and the semiconductor analytical servicesreporting units.  Determining thereporting unit’s fair value requires management to make estimates based onmarket conditions and operational performance. Absent an event that indicates aspecific impairment may exist, management has selected August 31 as the date ofperforming the annual goodwill impairment test. The results of this assessment,based on management forecasts, conclude that the goodwill is not impaired.  However, if events should occur and animpairment charge is warranted it could have a significant impact on theCompany’s financial results for the period then reported.

 

Preferreddistribution, dividends and accretion were $391,000 in the three month periodended March 31, 2006 as compared to $615,000 in the period ended March 31,2005.  The dividend on the Series DRedeemable Convertible Preferred Stock (the “Series D”) is at the prime rate ofinterest plus 1% (8.75%) of the outstanding balance.  The value ascribed to warrants issued withthe Series D, and the beneficial conversion feature, are accreted over the 36month term of the Series D.

 

*Nine MonthPeriod Ended March 31, 2006 vs. March 31, 2005*

 

*Revenues.* Total revenues for the nine month period ended March 31, 2006 were$18,760,000 as compared to $7,677,000 for the comparable prior year period, anincrease of $11,083,000 or 144%.   Ourrevenues by business segment are as follows:

 
| ** **      | ** ** | **Revenues**                          | ** ** |
|-----------------|------------|---------------------------------------|------------|
| ** **      | ** ** | **Nine Month Period Ended March 31,** | ** ** |
| ** **      | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Medical         |       | $                                     | 3,313,000  |   | $ | 2,976,000 |   |
| Semiconductor   |       | 10,363,000                            |       | 3,226,000 |   |
| Explosives      |       | 5,084,000                             |       | 1,475,000 |   |
| Total  Revenues |       | $                                     | 18,760,000 |   | $ | 7,677,000 |   |

 

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Theoverall increase in revenues is attributable primarily to revenues from Coreand Accurel. Core was acquired on October 15, 2004 and its results are includedin the previous year period from that day. Accurel was acquired on March 9, 2005 and its results were included inthe previous year period from the day of acquisition.   Revenues from Core and Accurel aggregatedapproximately $9,482,000 and are included in our semiconductor segment.  Semiconductor revenues were $10,363,000 ascompared to $3,266,000 in the comparable prior year period, an increase of$7,097,000 or 217%.  Since theacquisition of Core on October 15, 2004 the Company has transitioned somesemiconductor work and equipment from Wakefield to Sunnyvale, to take advantageof operating efficiencies.

 

Medicalrevenues were $3,313,000 as compared to $2,976,000 for the comparable prioryear period, an increase of $337,000 or 11%. The increase in medical revenues was due primarily to an increasedvolume of radioactive prostate seed sales combined with sales from ourtreatment planning software product. After a lengthy period of decline, management believes seed volumes havenow stabilized, and has taken steps to achieve increasing seed volumes in thecoming year, including the benefits of selling our treatment planning softwareto our customers. The treatment planning software is a proprietary treatmentplanning technology marketed as “I-PlantTPS”TM. In itslatest version, a new module aids the physician in making two and threedimensional maps of stage, grade and location of cancer within the prostategland. This “Pathology Mapping Module”TM is in addition to thestandard treatment planning function used for prostate brachytherapy and willprovide for image guided, focal treatment of the disease.

 

Revenues from the Company’sexplosives detection business increased to $5,084,000 as compared to $1,475,000for the comparable prior year period, an increase of $3,609,000 or 245%.  This increase is attributable to shipments ofthe Company’s explosives detection equipment. The Company has been transitioningthe explosives business from primarily a contracts/development business to aproduct sales business.  To that extent,we have established strategic sales and distribution relationships bothdomestically and internationally.  TheCompany had previously announced a major order for its explosives detectionproduct from its distributor in China and shipped the majority of that orderduring the second quarter of fiscal 2006.

 

*Cost of Revenues*.  Costof revenues for the nine months ended March 31, 2006 was $16,286,000 ascompared to $7,673,000 for the comparable prior year period, an increase of $8,613,000or 112%.  The cost of revenues bybusiness segment is as follows:

 
| ** **              | ** ** | **Cost of Revenues**                  | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **Nine Month Period Ended March 31,** | ** ** |
| ** **              | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Medical                 |       | $                                     | 2,690,000  |   | $ | 2,586,000 |   |
| Semiconductor           |       | 8,707,000                             |       | 3,526,000 |   |
| Explosives              |       | 4,889,000                             |       | 1,561,000 |   |
| Total Cost  of Revenues |       | $                                     | 16,286,000 |   | $ | 7,673,000 |   |

 

Theoverall increase in cost of revenues is primarily a result of costsattributable to Core and Accurel.  Corewas acquired on October 15, 2004 and its results are included from thatday.  Accurel was acquired on March 9,2005, and its results were included in the comparable prior year period as ofthat date.  Cost of revenues at Core andAccurel totaled $7,396,000 and are included in our semiconductor segment.  In addition, our cost of revenues alsoincreased due to higher volumes of product sales related to the explosivesdetection equipment.  The cost of ourexplosives detection revenues were $4,889,000 compared to $1,561,000 in thecomparable prior year period, an increase of $3,328,000 or 213%. Medicalproducts costs increased to $2,690,000 as compared to $2,586,000 in thecomparable prior year period, an increase of $104,000 or 4%.  Included in cost of sales for the nine monthperiod ended March 31, 2006, is $512,000 of share-based compensation asrequired by SFAS No. 123R.

 

*Gross Margins*.  Overall gross margins were 13%of revenues in the nine month period ended March 31, 2006 as compared to 0% ofrevenues in the comparable prior year period.   Semiconductor margins were 16% of revenues as compared to a loss ongross margin of 9% in the comparable prior year period. This turnaround isattributable to Accurel.  Accurel wasacquired on March 9, 2005 and its results are not included in the comparable

 

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prior year period.  Management expects continued semiconductorgross margin improvements as volumes continue to increase and operatingefficiencies at Core are realized. Medical margins reflect an increase in ourcoatings business.  Explosives detectiongross margins are 4% of revenues as compared to loss of 6% in the comparableprior year period.  Gross margins bybusiness segment are as follows:

 
| ** **           | ** ** | **Gross Margin**                      | ** ** |
|----------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **Nine Month Period Ended March 31,** | ** ** |
| ** **           | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Medical              |       | 19                                    | %          | 13 | % |
| Semiconductor        |       | 16                                    | %          | -9 | % |
| Explosives           |       | 4                                     | %          | -6 | % |
| Total gross  margin% |       | 13                                    | %          | 0 | % |

 

*Research and Development*. Research and development expense for the nine month period ended March31, 2006 was $894,000 as compared to $1,566,000 for the comparable prior yearperiod, a decrease of $672,000 or 43%. In the nine month period ended March 31, 2006, certain of the Company’sR&D resources were temporarily transferred to explosives detection productmanufacturing team to assist with order fulfillment of our handheld explosivesdetectors and to work on the TSA contract. As such, the expensesassociated  with these resources wereincluded in our cost of sales.  However,the Company continues to expend funds to further the development of newproducts in the areas of explosives and toxic substance detection and inapplications for temporary brachytherapy.

 

*Selling, General and Administrative*. Selling, general and administrative expenses for the nine month periodended March 31, 2006 were $6,653,000 as compared to $3,811,000 for thecomparable prior year period, an increase of $2,842,000 or 75%.   This increase is primarily related to$1,201,000 of additional selling, general and administrative expenses incurreddue to the acquisition of Accurel. Accurel was acquired March 9, 2005, and Core was acquired on October 15,2004, their results were not included in the entire comparable prior yearperiod.  Included in selling, general andadministrative costs for the period ended March 31, 2006 is $1,301,000 ofshare-based compensation as required by SFAS No. 123R.

 

*Other Income and Expenses, Net*.  Forthe nine months ended March 31, 2006, we recorded other income, net, of$508,000 as compared to other expense, net, of $113,000, in the comparableprior year period.  This change includesinterest expense of $198,000, primarily due to the Laurus financing in July of2005 and debt held by Accurel as compared to interest expense of $82,000 in thecomparable prior year period.    Inaddition, equity losses in unconsolidated subsidiaries increased by $172,000 inthe current fiscal year period. Other income also includes $911,000 of incomeattributable to marking to market the derivative value of the preferred stockconversion.

 

*Net Loss.*  Net loss for the nine monthperiod ended March 31, 2006 was $4,565,000 as compared with $5,486,000 for thecomparable prior year period, a decrease in net loss of $921,000 or 17%.  The decrease in net loss is primarily due toimproved operating results due to the acquisition of Accurel and improvedresults form the explosives detection equipment, $911,000 of other net incomedue to the marking to market of the conversion feature of the Series Dpreferred stock off set by $1,917,000 of non-cash compensation expense asrequired by FAS123R.  Previous yearresults do not included FAS No.123R compensation expense.  The acquisition of Core Systems on October15, 2004 was expected to have a positive impact on earnings because of expectedoperating efficiencies and increased revenues when combined with the Company’sexisting semiconductor operations.  Thesebenefits have been slow to develop and Core has not made a significantcontribution to earnings since it was acquired. Management continues to focus on opportunities for Core that could havesignificant profit potential. The Company continually reviews its goodwillassets for potential impairment.  TheCompany has four reporting units, medical, explosives detection, semiconductorwafer processing and semiconductor analytical services. All of the Company’sgoodwill is allocated to the semiconductor wafer processing and thesemiconductor analytical services reporting units.  Determining the reporting unit’s fair valuerequires management to make estimates based on market conditions andoperational performance. Absent an event that indicates a specific impairmentmay exist, management has selected August 31 as the date of performing theannual goodwill impairment test. The results of this assessment, based onmanagement forecasts, conclude that the goodwill is not impaired.  However, if events should occur and an

 

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impairment charge is warrantedit could have a significant impact on the Company’s financial results for theperiod then reported.

 

Preferred distribution,dividends and accretion were $778,000 in the nine month period ended March 31,2006 as compared to $1,182,000 in the period ended March 31, 2005.  In addition, the Company recorded a $911,000gain due to marking to market the derivative value of the preferred stockconversion.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

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

 

Asof March 31, 2006, the Company had approximately $2,006,000 in the form of cashand cash equivalents and net working capital of $1,901,000.  During the nine month period ended March 31,2006, operating activities used cash of approximately $2,134,000.  Net cash used by operating activitiesprimarily reflects a net loss of $4,565,000 offset by $4,550,000 indepreciation, amortization and other non-cash expenses and $911,000 of incomeattributable to the gain on the derivative value of the preferred stockconversion associated with the Series D preferred stock.

 

In addition the Companyinvested $990,000 in inventory as it continues its production of its explosivesdetection products.  The Company’saccounts receivables increased $380,000 due to shipments of its explosives detectionproduct late in the quarter, and unbilled government contracts.  It is expected that these receivables will becollected in the Company’s fourth quarter. During the nine months ended March 31, 2006, investing activities usedcash of approximately $680,000 which was primarily attributable to $605,000used for additions to property and equipment. The additions were primarily used to increase production capacity atCore and for explosives detection products manufacturing in Wakefield.  During the nine month period ended March 31,2006, financing activities provided approximately $3,271,000 in cash.

 

OnJuly 6, 2005, the Company executed a $3.0 million secured term note payable toLaurus Master Fund, Ltd. (“Laurus”).  The Company received $3,000,000 in gross proceeds, less a management feeof $135,000 and related transaction costs of approximately $32,000.  The term note was collateralized bysubstantially all of the Company’s assets, had a 4-month term and bore interestat a rate equal to the prime rate plus once percent (1%).  In connection with the financing, onSeptember 30, 2005, the Company issued Laurus a warrant to purchase up to250,000 shares of the Company’s common stock at a price equal to $3.75 pershare.  Net proceeds from the financingwere used for increasing the capacity of the Quantum SnifferTM production line,increasing unit inventories and the repayment of certain indebtedness due andowed by the Company to the former shareholders of Accurel in connection withthe acquisition of this wholly-owned subsidiary.

 

OnSeptember 30, 2005, the Company issued 500,000 shares of the Series D having astated value of $10 per share, pursuant to a Securities Purchase Agreement withLaurus Master Fund, Ltd. (the “Agreement”). The Series D has a dividend equalto the prime rate plus one percent (1%) (8.75% as of March 31, 2006) and provides for redemption over athirty-six month period pursuant to an amortization schedule. The Companyreceived $5,000,000 in gross proceeds, less a management and placement agentfee of approximately $90,000, related transaction and issuance costs ofapproximately $144,000, and the repayment of $3,032,000 of principal andinterest related to the July 6, 2005 term note.

 

25

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Thefollowing table reflects the required redemption of the Series D before theeffect of the accrued dividends:

 
| Monthly  redemption      |       |
|--------------------------|------------|
| **Year ending June 30:** | ** ** | **Preferred Stock   Redemption   Schedule** | ** ** |
| Q4 2006                  |       | $ | 456,000 |   |
| 2007                     |       | 1,824,000 |   |
| 2008                     |       | 1,824,000 |   |
| 2009                     |       | 896,000 |   |
| Total                    |       | $ | 5,000,000 |   |

 

TheAgreement requires monthly redemption of approximately $152,000 plus accrueddividends commenced on January 1, 2006. Subject to certain conditions, it is at the Company’s option to pay thisamount in cash or in common stock at a fixed conversion price of $6.80 percommon share.  The following conditionsmust be met in order to pay in common stock: (1) the shares must be issued pursuant to an effective registration statement,(2) the average closing market price of the common stock for the five tradingdays immediately preceding a payment date must exceed the fixed conversionprice by 110% and no one day’s closing price may be less than the fixedconversion price, and (3) the conversion dollar value may not exceed theaggregate of the prior 22 trading days’ dollar volume.  The dividend rate is subject to a 2% decreasefor every 25% the average trading price for the five trading days prior to aredemption date exceeds the fixed conversion price, to a minimum of 0%.  In addition, upon notifying the holder, theCompany has the option of redeeming any outstanding shares of Series D withcash by paying 130% of the stated value plus accrued interest.

 

Asa condition of closing, the Company and each of its Subsidiaries granted asecurity interest in their respective assets as well as providing 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 agreed to enter into suchdocumentation as shall be reasonably requested by the Company in order tosubordinate its rights under the Series D to the subsequent financier.   The registration rights associated with thisagreement state that the Company will use its best efforts to have theregistration statement effective within 120 days from closing.  In addition, the Company is required tomaintain an effective registration statement, and ensure that shares are notsuspended from trading.  Upon notice fromLaurus, should the Company be declared in default of these items and have notcured the default within the prescribed period, the Company may be accessedliquidated damages equal to 1/30th of 0.1% of the outstandingpreferred balance, payable in cash, for each day the event has occurred andremains outstanding.  However, liquidateddamages do not apply should the Securities and Exchange Commission (“SEC”) havean issue with respect to the Holder or with respect to the structure of thetransaction.

 

Inconjunction with the Series D, the Company also issued to Laurus a warrant topurchase up to 50,000 shares of the Company’s common stock at a price equal to$10.20 per share.  The Company utilizedthe proceeds of the Series D to repay the $3 million term note with Laurusdated July 6, 2005, plus accrued interest, and for working capital.

 

Inaccordance with the provisions of Emerging Issues Task Force (“EITF”) Issue00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, the Company concluded that theSeries D contained a conversion feature which should be valued at fair valueand be recorded as a liability on the balance sheet.  This conversion feature is not a“conventional preferred” because the agreement includes certain conditionsunder which the conversion price may be reset. This condition would suggest that the number of shares to be issued uponconversion is not fixed, a requirement of a conventional preferredclassification.  This conversion featurewas also concluded to be a liability as it may be required to be repaid incash, cannot be paid in unregistered shares and has certain penalties.  These conditions define the conversionfeature as an embedded derivative which must be separated from the host andreported at fair value pursuant to SFAS 133.

 

TheSeries D also contains certain features affecting the dividend rate.  In the first feature, the dividend rate issubject to adjustment based on the market price of the Company’s common stock.  The Company has evaluated

 

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this item to consider whetherit would be considered an embedded derivative as defined in SFAS No. 133.  While having a dividend rate that canfluctuate with the stock price is a feature that has characteristics of anembedded derivative, this feature would be classified as a derivativeasset.  An independent appraiser washired to value this asset derivative and the value was determined to beimmaterial.  The second feature, relatedto potential default provisions, could potentially increase the dividend andredemption price, similar to a default or penalty clause in a debt-likeinstrument. In evaluating whether this penalty feature would be considered anembedded derivative, the Company considered the provisions of SFAS No. 133paragraph 12 and 13, and determined that this feature would not be considered aderivative as it does not have a “net settlement” provision.

 

Theconversion feature aggregated to $1,397,000 on September 30, 2005 based on theBlack Scholes pricing model and the following assumptions:  volatility 80%, expected life 1.5 years, anda risk free interest rate of 3.96%.  Theconversion feature will be marked to market at each reporting period withchanges flowing through the statement of operations.  As of March 31, 2006, the value of thisconversion feature aggregated to $486,000.

 

TheCompany valued the Series D at issuance at its residual value of $2,700,000based on the fair values of the financial instruments issued in connection withthis preferred stock financing, including the warrants, the conversion featureand offering costs.  The amounts recordedin the financial statements represent the amounts attributed to the sale of thepreferred stock, the amount allocated to warrants of $632,000, the valueattributed to conversion feature of $1,397,000 and $271,000 of issuance costs(including $154,000 of unamortized costs of the July 6, 2005 term note).  The Company is accreting these discounts onthe carrying value of the preferred stock to its redemption value of $5,000,000at September 1, 2008, or the actual conversion date, whichever is earlier.  The accretion of these amounts is beingrecorded as a preferred dividend in the period of accretion.  During the three month period ended March 31,2006, approximately $571,000 was amortized. As of March 31, 2006, Laurus waived the Company’s obligation to pay themonthly redemptions for the period January 2006 through March 2006 untilSeptember 30, 2009.  The Company iscurrently working with Laurus to identify alternatives to cash payments tosatisfy future redemptions should the restrictions identified in the Series Dprohibit conversion of preferred stock into common stock.  The outstanding principal of the Series D was$5,000,000 at March 31, 2006.

 

Theaccounting for the Series D financing is currently under review by the SEC andis subject to change based on the SEC’s final interpretation and review of theCompany’s accounting.

 

Althoughwe continue to fund as much research and development as possible throughgovernment grants and contracts in accordance with the provisions of therespective grant awards, we will require additional funding in order tocontinue the advancement of the commercial development and manufacturing of ourexplosives detection systems.  We willattempt to obtain such financing by: (i) government grants, (ii) the exerciseof the redeemable common stock purchase warrants, (iii) private financing, or(i) strategic partnerships.  However,there can be no assurance that we will be successful in our attempts to raisesuch additional financing.   Shouldfunding not be available, we may be forced to sell certain company assets inorder to fund the continued research and development of our explosives detectionproduct and/or curtail the amount of resources dedicated to it.

 

Wewill require substantial funds for further research and development, regulatoryapprovals and continued expansion of commercial-scale manufacturingcapabilities, and the marketing of our products.  Our capital requirements depend on numerousfactors, including but not limited to, the progress of our research anddevelopment programs; the cost of filing, prosecuting, defending and enforcingany intellectual property rights; competing technological and marketdevelopments; changes in our development of commercialization activities andarrangements; and the purchase of additional facilities and capital equipment.

 

TheCompany’s future minimum payments under contractual obligations related tocapital leases, operating leases and term notes as of March 31, 2006 are asfollows:

 

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| ** **            | ** ** | **Debt and   Capital   Leases** | ** ** | **Operating   Lease** | ** ** | **MED-TEC** | ** ** | **Total** | ** ** |
|-----------------------|------------|---------------------------------|------------|-----------------------|------------|-------------|------------|-----------|------------|
| Year ending  June 30: |       |                            |       |                  |       |        |       |      |       |
| 2006                  |       | $                               | 100,000    |                  | $          | 414,000     |       | $         | 110,000    |   | $ | 624,000 |   |
| 2007                  |       | 393,000                         |       | 1,681,000             |       | 138,000     |       | 2,212,000 |       |
| 2008                  |       | 386,000                         |       | 1,713,000             |       | —      |       | 2,099,000 |       |
| 2009                  |       | 140,000                         |       | 1,454,000             |       | —      |       | 1,594,000 |       |
| 2010                  |       | 14,000                          |       | 838,000               |       | —      |       | 852,000   |       |
|                  |       |                            |       |                  |       |        |       |      |       |
| Total                 |       | $                               | 1,033,000  |                  | $          | 6,100,000   |       | $         | 248,000    |   | $ | 7,381,000 |   |
|                       |            |                                 |            |                       |            |             |            |           |            |  |  |  |  |  |

 

*Critical Accounting Policies*

 

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

 

*Share-Based Payment.*****  InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment,” which is a revision of Statement No. 123 as amended byNo. 148, “Accounting for Stock-Based Compensation”. SFAS 123Rsupercedes APB Opinion No. 25. Generally, the approach in SFAS123R issimilar to the approach described in SFAS Statement No. 123. However, SFAS123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the income statement based on their fairvalues at the date of grant. Pro forma disclosure is no longer an alternative.This Statement was effective for the Company beginning with the first quarterof fiscal 2006.

 

SFAS123R permits public companies to adopt its requirements using one of twomethods. The “modified prospective” method requires compensation cost to berecognized beginning with the Statement’s effective date (a) based on therequirements of SFAS 123R for all share-based payments granted after theeffective date and (b) based on the requirements of Statement 123 for allawards granted to employees prior to the effective date of SFAS 123R thatremain unvested on the effective date. The “modified retrospective” methodincludes the requirements of the modified prospective method described above,but also permits entities to restate based on the amounts previously recognizedunder Statement 123 for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year ofadoption. The Company has not adopted the “modified retrospective” method andprevious amounts have not been restated (Note 6).

 

InApril 2005, the U.S. Securities and Exchange Commission issued StaffAccounting Bulletin No. 107. The Bulletin confirms the latitude in SFAS123R’s provisions on selecting models for valuing share options and clarifiesother positions on accounting and disclosure for share-based-paymentarrangements. In addition, the Bulletin permits registrants to choose fromdifferent models to estimate the fair value of share options, provides guidanceon developing assumptions used in the models, and addresses the interactionbetween SFAS 123R and other SEC literature.

 

28

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

 

**Item3.   Quantitative and QualitativeDisclosures About Market Risk**

 

InterestRate Risk

 

The Company’s financialinstruments include cash and cash equivalents. Cash and cash equivalents include cash on hand, demand deposits andshort-term investments with maturities of three months or less whenacquired.  Cash equivalents represent adeposit in a money market account and a certificate of deposit.  The Company does not utilize derivativefinancial instruments, derivative commodity instruments or other market risksensitive instruments, positions or transactions in any material fashion.  The principal objective of the Company’sasset management activities is to maximize net investment income, whilemaintaining acceptable levels of interest rate risk and facilitating itsfunding needs.  At March 31, 2006, thecarrying values of the Company’s financial instruments approximated fair valuesbased upon current market prices and rates.

 

**Item 4.****   ****Controls and Procedures**

 

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

 

As we disclosed in our 10-KSB, our independent registered publicaccounting firm reported to our Audit Committee certain conditions involvinginternal controls which they believed represent material weaknesses in ourinternal control environment. These matters relate to our ability to accountfor the acquisitions or, more specifically, post acquisition adjustments andthe correct interpretation of related accounting literature. These matters canbe related to our ability to interpret the accounting literature correctly forunusual events.  A material weakness is asignificant deficiency, or combination of significant deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected.

 

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

 

The internal control structure deficiency identified by our independentregistered public accounting firm was that our internal control structure didnot include a formalized process for reviewing documented evidence of certainunusual one-time transactions with and the analysis of the appropriateauthoritative accounting guidance with outside advisors to ensure theinterpretation was correct.

 

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

 

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

 

•   For material transactions that are unique or outside our coreoperations, we will continue to document our process for accounting for suchtransactions and we will improve our process for researching the applicableaccounting literature and documenting our conclusions, by consulting withoutside experts to ensure our interpretations are correct.

 

•   We will prepare a standardized memorandum for each transaction that isunique or outside our normal core operations that is material to our financialstatements. This memo will be reviewed and approved by the Vice President ofFinance and the Chief Financial Officer.

 

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We will enhance formal communication with, and approval by, our ChiefFinancial Officer and Audit Committee of our application of GAAP and accountingpolicy decisions for transactions that are outside our core operations and theadvice received from outside experts. In addition, we have hired a senior staffaccountant to assist with the financial close process.

 

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**PARTII:  OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

On March 24, 2006, the Company brought suit in theUnited States District Court in the District of Massachusetts against RapiscanSystems, Inc. (“Rapiscan”) and its parent, OSI Systems, Inc. (“OSI”).  The Company is requesting rescission of anagreement between the Company and Rapiscan, entered into on March 23, 2005 (the“Agreement”), for lack of performance and other grounds.  In the alternative, the Company is seekingtermination of the Agreement due to material breaches of contract and impliedcovenant of good faith and fair dealing and for damages due to Rapiscan’sbreach of contract and the implied covenant of good faith and fair dealing.

 

On March 27, 2006, the Company received notice thatRapiscan filed a complaint against the Company and its contract manufacturer,Columbia Tech, in the United States District Court for the Central District ofCalifornia, regarding the Agreement. Rapiscan’s complaint against the Company is based upon claims of breachof contract and  breach of warranty andis requesting a decree for specific performance, declaratory relief andinjunctive relief.  Rapiscan’s complaintagainst Columbia Tech is based upon injunctive relief, declaratory relief andtortuous interference with contractual relations.  On April 12, 2006, Rapiscan dismissed allclaims against Columbia Tech.

 

A copy of the Agreement is included as Exhibit 10.1to the Form 8-K/A filed by the Company with the Securities and ExchangeCommission on April 7, 2005.

 

**Item 1 ARisk Factors**

 

Thefollowing factors should be considered carefully in evaluating the Company andits business:

 

This Report on Form 10-QSB contains certainforward-looking statements that are based on current expectations.  In light of the important factors that canmaterially affect results, including those set forth in this paragraph andbelow, the inclusion of forward-looking information herein should not beregarded as a representation by the Company or any other person that theobjectives or plans of the Company will be achieved.  The Company may encounter competitive,technological, financial and business challenges making it more difficult thanexpected to continue to develop and market its products; the market may notaccept the Company’s existing and future products; the Company may be unable toretain existing key management personnel; the Company has pending litigation;the Company has net losses; the Company may not be able to raise additionalcapital; and there may be other material adverse changes in the Company’soperations or business. Assumptions relating to budgeting, marketing, and othermanagement decisions are subjective in many respects and thus susceptible tointerpretations and periodic revisions based on actual experience and businessdevelopments, the impact of which may cause the Company to alter its marketing,or other budgets, which may in turn affect the Company’s financial position andresults of operations.  The reader istherefore cautioned not to place undue reliance on forward-looking statementscontained herein, which speak solely as of the date of this Form 10-Q.  The Company assumes no responsibility toupdate any forward-looking statements as a result of new information, futureevents, or otherwise.

 

**Item 2.  UnregisteredSales of Equity**

 

NotApplicable

 

**Item 3.  Defaults UponSenior Securities**

 

NotApplicable

 

**Item 4.  Submission ofMatters to a Vote of Security-Holders**

 

None

 

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**Item 5.  OtherInformation**

 

None

 

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

 

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

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

 

(b)    Reports on Form 8-K

 

Current Report on Form 8-K dated January 9, 2006, regarding theappointment of Brown & Brown LLP as the Company’s independent registeredaccounting firm.

 

Current Report on Form 8-K dated January 11, 2006, regarding theappointment of the Company’s audit committee chair.

 

Current Report of Form 8-K dated March 30, 2006, regarding terminationof a material definitive agreement.

 

32

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