## **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

| **ý** | **Quarterly  report pursuant to section 13 or 15(d) of the Securities Exchange  Act of 1934. For the quarterly period ending September 30, 2005.**                                                                                                     |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                                                                                  |
| **o**      | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934. For the transition period from            to          .** |

 

**Commission file number  000-25839**

 

**IMPLANT SCIENCES CORPORATION**

(Exact name ofregistrant as specified in its charter)

 
| **Massachusetts**                         | ** ** | **04-2837126**          |
|-------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction             |       | (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)

 

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

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

 

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

YES   ý         NO   o

 

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

YES   o         NO   ý

 

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

 

The aggregate marketvalue of the voting stock held by non-affiliates of the registrant wasapproximately $35,990,000 as of October 31, 2005 (based on the closingprice for such stock as of October 31, 2005).

 

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

 
| Class                         |   | Outstanding at October 31,  2005 |
|-------------------------------|--------|---------------------------------------|
| Common Stock,  $.10 par value |   | 11,401,724                            |

 

 

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**IMPLANTSCIENCES CORPORATION**

 

**INDEX**

 
| ** **                          | ** **                                                                                                                | **Page No.** |
|-------------------------------------|---------------------------------------------------------------------------------------------------------------------------|-------------------|
| PART I.  FINANCIAL INFORMATION |                                                                                                                      |              |
|                                |                                                                                                                      |              |
| Item 1.                             | Financial Statements:                                                                                                     |              |   |
|                                |                                                                                                                      |              |   |
|                                | Condensed Consolidated  Balance Sheets as of September 30, 2005 (unaudited) and June 30,  2005 (audited)        |              | 3 |
|                                |                                                                                                                      |              |   |
|                                | Condensed Consolidated  Statements of Operations for the Three Months Ended September 30, 2005  and 2004 (unaudited) |              | 4 |
|                                |                                                                                                                      |              |   |
|                                | Condensed Consolidated  Statements of Cash Flows for the Three Months Ended September 30, 2005  and 2004 (unaudited) |              | 5 |
|                                |                                                                                                                      |              |   |
|                                | Notes to Condensed  Consolidated Financial Statements (unaudited)                                                         |              | 6 |
|                                |                                                                                                                      |              |   |
| Item  2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               |              | 14 |
|                                |                                                                                                                      |              |   |
| Item 3.                             | Quantitative and Qualitative  Disclosure About Market Risk                                                                |              | 22 |
|                                |                                                                                                                      |              |   |
| Item 4.                             | Controls and Procedures                                                                                                   |              | 22 |
|                                |                                                                                                                      |              |   |
| PART II. OTHER INFORMATION     |                                                                                                                      |              |
|                                |                                                                                                                      |              |   |
| Item 1.                             | Legal Proceedings                                                                                                         |              | 24 |
|                                |                                                                                                                      |              |   |
| Item 2.                             | Unregistered Sales of Equity  Securities                                                                                  |              | 24 |
|                                |                                                                                                                      |              |   |
| Item 3.                             | Defaults Upon Senior  Securities                                                                                          |              | 24 |
|                                |                                                                                                                      |              |   |
| Item 4.                             | Submission of Matters to a  Vote of Security-Holders                                                                      |              | 2 |
|                                |                                                                                                                      |              |   |
| Item 5.                             | Other Information                                                                                                         |              | 24 |
|                                |                                                                                                                      |              |   |
| Item 6.                             | Exhibits and Reports on Form 8-K                                                                                     |              | 24 |
|                                |                                                                                                                      |              |   |
|                                | Signatures                                                                                                                |              | 26 |

 

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                  | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **(unaudited)**              | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                  |       |                         |       |                    |       |
| Current  assets:                                                                                                                                                            |       |                         |       |                    |       |
| Cash  and cash equivalents                                                                                                                                                  |       | $                            | 3,432,000  |                    | $          | 1,549,000 |   |
| Accounts  receivable, less allowance of $147,000 and $147,000, respectively                                                                                                 |       | 2,462,000                    |       | 3,003,000               |       |
| Accounts  receivable, unbilled                                                                                                                                              |       | 542,000                      |       | 298,000                 |       |
| Inventories  (Note 3)                                                                                                                                                       |       | 1,768,000                    |       | 1,204,000               |       |
| Investments  - available for sale securities (Note 5)                                                                                                                       |       | 257,000                      |       | 204,000                 |       |
| Prepaid  expenses and other current assets                                                                                                                                  |       | 304,000                      |       | 224,000                 |       |
| Total  current assets                                                                                                                                                       |       | 8,765,000                    |       | 6,482,000               |       |
|                                                                                                                                                                        |       |                         |       |                    |       |
| Property  and equipment, net (Note 4)                                                                                                                                       |       | 10,093,000                   |       | 10,434,000              |       |
| Amortizable  intangible assets, net (Note 11)                                                                                                                               |       | 1,850,000                    |       | 2,057,000               |       |
| Investment  in unconsolidated subsidiary (Notes)                                                                                                                            |       | 449,000                      |       | 531,000                 |       |
| Other  non-current assets                                                                                                                                                   |       | 505,000                      |       | 511,000                 |       |
| Goodwill  (Note 11)                                                                                                                                                         |       | 12,235,000                   |       | 12,213,000              |       |
| Total  assets                                                                                                                                                               |       | $                            | 33,897,000 |                    | $          | 32,228,000 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                               |       |                         |       |                    |       |
| Current  liabilities:                                                                                                                                                       |       |                         |       |                    |       |
| Current  maturities of long-term debt and obligations under capital lease                                                                                                   |       | $                            | 403,000    |                    | $          | 2,052,000 |   |
| Payable  to Med-Tec                                                                                                                                                         |       | 318,000                      |       | 348,000                 |       |
| Accrued  expenses                                                                                                                                                           |       | 2,242,000                    |       | 2,445,000               |       |
| Accounts  payable                                                                                                                                                           |       | 1,690,000                    |       | 1,526,000               |       |
| Current  portion of long term lease liability                                                                                                                               |       | 102,000                      |       | 102,000                 |       |
| Deferred  revenue                                                                                                                                                           |       | 1,379,000                    |       | 773,000                 |       |
| Total  current liabilities                                                                                                                                                  |       | 6,134,000                    |       | 7,246,000               |       |
|                                                                                                                                                                        |       |                         |       |                    |       |
| Long-term  liabilities:                                                                                                                                                     |       |                         |       |                    |       |
| Long-term  debt and obligations under capital lease, net of current maturities                                                                                              |       | 835,000                      |       | 897,000                 |       |
| Long-term  lease liability                                                                                                                                                  |       | 680,000                      |       | 701,000                 |       |
| Total  liabilities                                                                                                                                                          |       | 7,649,000                    |       | 8,844,000               |       |
|                                                                                                                                                                        |       |                         |       |                    |       |
| Convertible  preferred stock:                                                                                                                                               |       |                         |       |                    |       |
|                                                                                                                                                                        |       |                         |       |                    |       |
| Series D  Cumulative Convertible Preferred Stock; $10 stated value; 500,000 shares  designated; 500,000 shares 0 shares issued and outstanding, respectively  (Note 8) |       | 3,207,000                    |       | —                  |       |
|                                                                                                                                                                        |       |                         |       |                    |       |
| Stockholders’  equity:                                                                                                                                                 |       |                         |       |                    |       |
| Common  stock, $0.10 par value; 20,000,000 shares authorized;  11,379,275 and 10,734,393 shares issued and outstanding, respectively                                        |       | 1,140,000                    |       | 1,075,000               |       |
| Additional  paid-in capital                                                                                                                                                 |       | 52,657,000                   |       | 50,995,000              |       |
| Accumulated  deficit                                                                                                                                                        |       | (30,482,000                  | )          | (28,115,000             | )          |
| Deferred  compensation                                                                                                                                                      |       | (63,000                      | )          | (349,000                | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                              |       | 6,000                        |       | (5,000                  | )          |
| Treasury  stock, 22,449 and 22,449 common shares, respectively, at cost                                                                                                     |       | (217,000                     | )          | (217,000                | )          |
| Total  stockholders’ equity                                                                                                                                            |       | 23,041,000                   |       | 23,384,000              |       |
|                                                                                                                                                                        |       |                         |       |                    |       |
| Total  liabilities and stockholders’ equity                                                                                                                            |       | $                            | 33,897,000 |                    | $          | 32,228,000 |   |

 

The accompnayingnotes are an integral part of these condensed consolidated financial statements

 

3

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                                      | ** ** | **Three Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Revenues:                                                                                       |       |                                       |       |   |   |
| Medical                                                                                         |       | $                                          | 1,149,000  |   | $ | 960,000 |   |
| Semiconductor                                                                                   |       | 3,122,000                                  |       | 334,000 |   |
| Explosives  detection                                                                           |       | 401,000                                    |       | 980,000 |   |
| Total  revenues                                                                                 |       | 4,672,000                                  |       | 2,274,000 |   |
|                                                                                            |       |                                       |       |   |   |
| Cost  of revenues:                                                                              |       |                                       |       |   |   |
| Cost  of medical revenues                                                                       |       | 959,000                                    |       | 797,000 |   |
| Cost  of semiconductor revenues                                                                 |       | 2,697,000                                  |       | 371,000 |   |
| Cost  of explosives detection revenues                                                          |       | 1,022,000                                  |       | 638,000 |   |
| Total  cost of revenues                                                                         |       | 4,678,000                                  |       | 1,806,000 |   |
|                                                                                            |       |                                       |       |   |   |
| Gross  margin                                                                                   |       | (6,000                                     | )          | 468,000 |   |
|                                                                                            |       |                                       |       |   |   |
| Operating  expenses:                                                                            |       |                                       |       |   |   |
| Research  and development                                                                       |       | 316,000                                    |       | 586,000 |   |
| Selling,  general and administrative                                                            |       | 1,923,000                                  |       | 1,060,000 |   |
| Total  operating expenses                                                                       |       | 2,239,000                                  |       | 1,646,000 |   |
|                                                                                            |       |                                       |       |   |   |
| Loss  from operations                                                                           |       | (2,245,000                                 | )          | (1,178,000 | ) |
|                                                                                            |       |                                       |       |   |   |
| Other  income (expenses):                                                                       |       |                                       |       |   |   |
| Interest  income                                                                                |       | 11,000                                     |       | 16,000 |   |
| Interest  expense                                                                               |       | (92,000                                    | )          | (18,000 | ) |
| Equity  losses in unconsolidated subsidiaries                                                   |       | (41,000                                    | )          | (11,000 | ) |
| Total  other expense, net                                                                       |       | (122,000                                   | )          | (13,000 | ) |
|                                                                                            |       |                                       |       |   |   |
| Net  loss                                                                                       |       | (2,367,000                                 | )          | (1,191,000 | ) |
|                                                                                            |       |                                       |       |   |   |
| Preferred  distribution, dividends and accretion                                                |       | —                                     |       | (284,000 | ) |
|                                                                                            |       |                                       |       |   |   |
| Net  loss applicable to common shareholders                                                     |       | $                                          | (2,367,000 | ) | $ | (1,475,000 | ) |
|                                                                                            |       |                                       |       |   |   |
| Net  per share applicable to common shareholders, basic and diluted                             |       | $                                          | (0.22      | ) | $ | (0.17 | ) |
|                                                                                            |       |                                       |       |   |   |
| Weighted  average common shares outstanding used in computing basic and diluted loss  per share |       | 10,962,703                                 |       | 8,466,559 |   |

 

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

 

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**IMPLANT SCIENCES CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| **Cash flows from operating activities:**                                                                                    |       |                                       |       |   |   |
| Net  loss                                                                                                                    |       | $                                          | (2,367,000 | ) | $ | (1,191,000 | ) |
|                                                                                                                         |       |                                       |       |   |   |
| Adjustments  to reconcile net loss to net cash used in operating activities:                                                 |       |                                       |       |   |   |
| Depreciation  and amortization                                                                                               |       | 579,000                                    |       | 334,000 |   |
| Amortization  of intangible assets                                                                                           |       | 207,000                                    |       | — |   |
| Stock-based  compensation expense                                                                                            |       | 411,000                                    |       | 63,000 |   |
| Equity  loss in unconsolidated subsidiaries                                                                                  |       | 41,000                                     |       | 11,000 |   |
| Loss  on equipment write down                                                                                                |       | —                                     |       | 6,000 |   |
| Changes  in operating assets and liabilities:                                                                                |       |                                       |       |   |   |
| Accounts  receivable                                                                                                         |       | 296,000                                    |       | (889,000 | ) |
| Inventories                                                                                                                  |       | (564,000                                   | )          | (8,000 | ) |
| Prepaid  expenses and other current assets                                                                                   |       | (80,000                                    | )          | 30,000 |   |
| Deferred  revenue                                                                                                            |       | 606,000                                    |       | — |   |
| Accounts  payable                                                                                                            |       | 136,000                                    |       | 378,000 |   |
| Accrued  expenses                                                                                                            |       | (224,000                                   | )          | 18,000 |   |
| Net  cash used in operating activities                                                                                       |       | (959,000                                   | )          | (1,248,000 | ) |
|                                                                                                                         |       |                                       |       |   |   |
| **Cash flows from (for) investing activities:**                                                                              |       |                                       |       |   |   |
| Purchase  of property and equipment                                                                                          |       | (170,000                                   | )          | (142,000 | ) |
| Investment  in Core Systems                                                                                                  |       | (9,000                                     | )          | — |   |
| Investment  in Accurel Systems International                                                                                 |       | (2,000                                     | )          | — |   |
| Increase  in other non-current assets                                                                                        |       | (19,000                                    | )          | (83,000 | ) |
| Net  cash used in investing activities                                                                                       |       | (200,000                                   | )          | (225,000 | ) |
|                                                                                                                         |       |                                       |       |   |   |
| **Cash flows from financing activities:**                                                                                    |       |                                       |       |   |   |
| Proceeds  from issuance of common stock in connection with the exercise of options and  the Employee Stock Purchase Plan     |       | 29,000                                     |       | 774,000 |   |
| Proceeds  from exercise of warrants and non-employee options                                                                 |       | 69,000                                     |       | 10,000 |   |
| Proceeds  from issuance of 5% Series D Cumulative Convertible Preferred Stock, net  of issuance costs                   |       | 4,729,000                                  |       | — |   |
| Repayments  of long-term debt and capital lease obligations                                                                  |       | (1,760,000                                 | )          | (194,000 | ) |
| Acqusition  of treasury shares                                                                                               |       | —                                     |       | (54,000 | ) |
| Proceeds  from issuance of common stock in connection with private placement, net of  issuance costs                         |       | (25,000                                    | )          | (25,000 | ) |
| Net  cash provided by financing activities                                                                                   |       | 3,042,000                                  |       | 511,000 |   |
|                                                                                                                         |       |                                       |       |   |   |
| Net  (decrease) increase in cash and cash equivalents                                                                        |       | 1,883,000                                  |       | (962,000 | ) |
| Cash  and cash equivalents, beginning                                                                                        |       | 1,549,000                                  |       | 6,906,000 |   |
| Cash  and cash equivalents, ending                                                                                           |       | $                                          | 3,432,000  |   | $ | 5,944,000 |   |
|                                                                                                                         |       |                                       |       |   |   |
| **Supplemental Disclosure of Cash Flow  Information:**                                                                       |       |                                       |       |   |   |
| Interest  paid in cash                                                                                                       |       | $                                          | 109,000    |   | $ | 18,000 |   |
|                                                                                                                         |       |                                       |       |   |   |
| **Noncash Investing and Financing Activity:**                                                                                |       |                                       |       |   |   |
| Conversion  of Series C Cumulative Convertible Preferred Stock and accrued dividends  into common stock                 |       | $                                          | —     |   | $ | 577,000 |   |
| Accretion  of 5% Series C Cumulative Convertible Preferred Stock dividends,  beneficial conversion feature and warrants |       | $                                          | —     |   | $ | 284,000 |   |
| Capital  equipment acquired under capital lease                                                                              |       | $                                          | 42,000     |   | $ | — |   |

 

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

 

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**IMPLANTSCIENCES CORPORATION**

**NOTESTO CONDENSED FINANCIAL STATEMENTS**

**September 30,2005**

**(Unaudited)**

 

**1.****             Descriptionof Business**

 

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 therapy.  The Company also modifies the surfacecharacteristics of orthopedic joint implants to reduce polyethylene wear andthereby increasing the life of the implant. The Company also provides ion implantation, analytical services andequipment to the semiconductor industry. The Company continues to make significant investments in developing newapplications of its explosives detection systems while ramping up itsmanufacturing capabilities in anticipation of order fulfillment.

 

Thesecondensed consolidated financial statements have been prepared on a going concernbasis, which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. For the three months ended September 30, 2005 the Company had a netloss from continuing operations of $2,367,000. The Company also had cash and cash equivalents of $3,432,000 and networking capital of $2,631,000.  TheCompany continually reviews its operating plans to determine if it has adequatecash flows to fund its operations and achieve its operating plans.  Although the Company believes it can achievethese plans there can be no assurances that it will.  If the Company fails to achieve its revenue andgross margin goals, it would have to undertake additional steps to fundoperations.  These steps may include: obtainingadditional financing, entering into strategic agreements to fund thedevelopment of our products 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 includes 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 result of operations and cash flows forthe three months ended September 30, 2005 may not necessarily be indicativeof results that may be expected for any succeeding quarter or for the entire fiscalyear.  The information contained in this Form 10-Qshould be read in conjunction with the Company’s audited financial statements,included in our Form 10-KSB as of and for the year ending June 30,2005 filed with the Securities and Exchange Commission on October 13,2005.

 

Theaccompanying consolidated financial statements include the accounts of theCompany and its wholly owned subsidiaries. All intercompany balances have been eliminated in consolidation.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States (“U.S. GAAP”) requires management tomake estimates and judgments, which are evaluated on an on-going basis, thataffect the amounts reported in the Company’s condensed consolidated financialstatements and accompanying notes. Management bases its estimates on historical experience and on variousother assumptions that it believes are reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities and the amounts of revenues and expenses that are notreadily apparent from other sources. Actual results could differ from those estimates and judgments, Inparticular, significant estimates and judgments include those related torevenue recognition, allowance for doubtful accounts, useful lives of propertyand equipment, inventory reserves, business combinations, valuation forgoodwill and acquired intangible assets, and warranty reserves.

 

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**3.****             Inventories**

 

Inventories consist ofthe following:

 
| ** **       | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** |
|------------------|------------|------------------------------|------------|-------------------------|------------|
| Raw materials    |       | $                            | 837,000    |                    | $          | 548,000 |   |
| Work-in-progress |       | 536,000                      |       | 416,000                 |       |
| Finished goods   |       | 395,000                      |       | 240,000                 |       |
|             |       | $                            | 1,768,000  |                    | $          | 1,204,000 |   |

 

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

 

Property and equipmentconsists of the following**:**

 
| ** **                                       | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| Total property and  equipment                    |       | 15,837,000                   |       | 15,624,000              |       |
| Less: Accumulated  depreciation and amortization |       | (5,744,000                   | )          | (5,190,000              | )          |
|                                             |       |                         |       |                    |       |
| Property, plant and  equipment, net              |       | $                            | 10,093,000 |                    | $          | 10,434,000 |   |
|                                                  |            |                              |            |                         |            |  |  |

 

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

 

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

 

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

 

In March 2000,the Company entered into a joint research agreement with CardioTech to develop aproprietary porous polymer biocompatible coating technology as a platform forthe Company’s proprietary radioactive brachytherapy technology.  In consideration for this agreement, theCompany agreed to pay $150,000 in cash and purchase 100,000 shares of CardioTechstock at a price of $1.00 per share.  Asof September 30, 2005, the Company has purchased these shares, the fairmarket value of which is $257,000 and is recorded as investments in availablefor sale securities in the accompanying consolidated balance sheet.  The unrealized holding gains and losses arerecorded as accumulated other comprehensive income (loss) within stockholders’equity.

 

In March 2004the 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.****             EmployeeStock-Based Compensation**

 

On December 16,2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(Revised 2004) (“SFAS 123R”), “Share-Based Payments,” which is a revision ofSFAS No. 123, “Accounting for Stock-Based Compensation.”  SFAS 123R supersedes Accounting PrincipalBoard (“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 issimilar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees,including grants of

 

7

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employee stock optionsand stock issued from certain employee stock purchase plans, to be recognizedin the income statement based on their fair values.  Pro forma disclosure is no longer analternative.

 

Prior to thequarter ending September 30, 2005, as was permitted under SFAS No. 123,the Company accounted for stock-based awards using the intrinsic value methodunder APB No. 25.  Under APB No. 25,when the exercise price of options granted to employees and non-employeedirectors under these plans equals the market price of the underlying stock onthe date of the grant, no compensation expense was recorded.

 

Effective July 1,2005, the Company adopted SFAS 123R.  TheCompany selected the modified prospective method of adoption in whichcompensation cost is recognized beginning with the effective date for allshare-based payments to employees after July 1, 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.

 

The Company hasrefined certain estimates used previously based upon the guidance providedunder SFAS 123R, specifically the expected life of the option.  The calculation of the fair value of theawards for the quarter ended September 30, 2005 has been adjusted toreflect these refined assumptions..

 

The followingtable illustrates the effect on net loss applicable to common shareholders andnet loss per share applicable to common shareholders as if the fair valuemethod had been applied to all outstanding and unvested awards in the priorperiod:

 
| ** **                                                                                                                                         | ** ** | **Three Months Ended  September 30,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
|                                                                                                                                               |       |                                             |       |
| Net  loss applicable to common shareholders as reported for the three month period  ended September 30, 2004.                                 |       | $                                                | (1,475,000 | ) |
|                                                                                                                                               |       |                                             |       |   |
| Add:  Stock-based employee compensation expense included in proforma net loss and  reported net loss applicable to common shareholders, net of tax |       | 59,000                                           |       |
| Deduct:  Total stock-based employee compensation expense determined under the fair  value based method of all awards, net of tax                   |       | (213,000                                         | )          |
|                                                                                                                                               |       |                                             |       |
| Proforma  net loss, for the three month periods ended September 30, 2004  applicable to common shareholders after adopting SFAS 123R          |       | $                                                | (1,629,000 | ) |
|                                                                                                                                               |       |                                             |       |
| Net  loss per share applicable to common shareholders, basic and diluted:                                                                          |       |                                             |       |
| As  reported                                                                                                                                       |       | $                                                | (0.17      | ) |
| Pro  forma, three months ended September 30, 2004                                                                                             |       | $                                                | (0.19      | ) |
|                                                                                                                                               |       |                                             |       |
| Weighted  average common shares outstanding, basic and diluted                                                                                     |       | 7,317,677                                        |       |

 

8

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Under the provisions of SFAS 123R the Company recorded $385,000 ofstock based compensation on its condensed consolidated statement of operationsfor the three month period ended September 30, 2005, included in thefollowing expense categories:

 

| Cost  of revenues                     |   | $      | 82,000  |   |
|---------------------------------------|--------|--------|---------|--------|
| Research and  development             |   | $      | 68,000  |   |
| Selling, general and  administrative  |   | $      | 235,000 |   |
|                                  |   |   |    |
| Total SFAS 123R  compensation expense |   | $      | 385,000 |   |

 

Expense related to shares to be purchased in the Employee StockPurchase Plan were not material. The Company also had $26,000 of compensationexpense attributable to non-employee options and warrants.

 

The fair value ofeach option award is estimated on the date of grant using the Black-Scholesoption pricing model using the assumptions noted in the following table.  Expected volatilities are based on historicalvolatility of the Company’s stock options. The Company uses historical data to estimate option forfeitures withinthe valuation model. The expected term of options granted is calculated usingthe “Simplified Method” as outlined SFAS 123R and reflects the period of timethat options granted are expected to be outstanding.  The risk-free rate for periods within thecontractual life of the option is based on the U.S Treasury yield curve ineffect at the time of grant.

 
| ** **              | ** ** | **Stock Options  Plans** | ** ** | **Stock Purchase  Plan** | ** ** |
|-------------------------|------------|--------------------------|------------|--------------------------|------------|
| Risk free interest rate |       | 3.34%-4.35%              |       | 3.22                     |       |
| Expected dividend yield |       | 0%                       |       | 0%                       |       |
| Expected lives (years)  |       | 3.5 - 6 years(1)         |       | 6 months                 |       |
| Expected volatility     |       | 57% - 80%                |       | 81%                      |       |

 

----

(1)   Theestimate of an options expected life has been updated and revised for allgrants outstanding prior to adoption based upon guidance provided under SFAS 123Rand SAB Topic 14. The estimate of expected life was revised to use the “simplifiedmethod” to determine the expected life of an option versus the contractual lifeas previously used.

 

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

 

The Company hastwo types of shared based compensation plans, a Stock Option Plan and anEmployee Stock Purchase Plan.

 

*StockOption Plans*

 

In September 1998,the Company adopted the 1998 Stock Option Plan (the “1998 Plan”).  The 1998 Plan provides for the grant ofincentive stock options and nonqualified stock options to employees andaffiliates.  The exercise price of theoptions equals 100% of the fair market value on the date of the grant.  Options expire ten years from the date of theoption grant and vest ratably over a three-year period commencing with thesecond year.

 

In December 2000,the Company adopted the 2000 Incentive and Non Qualified Stock Option Plan (the“2000 Plan”).  The 2000 Plan provides forthe grant of incentive stock options and nonqualified stock options toemployees and affiliates.  The exerciseprice of the options equal 100% of the fair market value

 

9

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on the date of the grantor 110% of the fair market value for greater than 5% beneficial owners of theCompany stock.  Options expire betweenfive and ten years from the date of the option grant and have variable vestingperiods.

 

In December 2004,the Company adopted the 2004 Stock Option Plan. The 2004 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 variable vesting periods

 

A summary ofoption activity under the plans as of and for the period September 30,2005 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                                |       | (184,440   | )          | 6.30                                    |       |
|                                    |       |       |       |                                    |       |
| Outstanding at September 30,  2005 |       | 1,809,391  |       | $                                       | 6.30       |   |

 

A summary of theunvested option activity under the plans as of and during the three monthperiod ended September 30, 2005 is as follows:

 
| **Unvested  Options**                | ** ** | **Shares** | ** ** | **Weighted-  Average  Fair Value** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------------------|------------|
| Unvested at at June 30,  2005   |       | 891,969    |       | $                                  | 4.79       |   |
|                                 |       |       |       |                               |       |
| Granted                              |       | 88,000     |       | 4.79                               |       |
| Vested                               |       | (141,503   | )          | 5.47                               |       |
| Forfeited                            |       | (64,099    | )          | 5.71                               |       |
|                                 |       |       |       |                               |       |
| Unvested at September 30,  2005 |       | 774,367    |       | $                                  | 4.59       |   |

 

As of September 30,2005 there was $2,917,000 of total unrecognized compensation expense related tounvested share based compensation arrangements under the plan.  This expense is expected to be recognized asfollows:

 
| **Year  ending June 30:** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| 2006                           |       | $          | 1,235,000  |   |
| 2007                           |       | 1,151,000  |       |
| 2008                           |       | 502,000    |       |
| 2009                           |       | 29,000     |       |
|                           |       |       |       |
| Total                          |       | $          | 2,917,000  |   |

 

10

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*EmployeeStock Purchase Plan*

 

In September 1998,the Company adopted the 1998 Employee Stock Purchase Plan (the “Plan”).  The Plan provides a method whereby employeesof the Company will have an opportunity to acquire an ownership interest in theCompany through the purchase of shares of common stock of the Company throughpayroll deductions.  After 12 months ofemployment, an employee is eligible to participate and can defer up to 10% oftheir wages into this Plan, with a maximum of $25,000 in any calendaryear.  The purchase price of the commonstock is calculated at the lower of 85% of the closing price of the stock onthe first day of the plan period or the last day of the plan period.  The periods are January 1 to June 30and July 1 to December 31. Fractional shares are not issued. Participants may withdraw at any time by giving written notice to theCompany and will be credited the amounts of deferrals in their account.  The maximum number of shares eligible to beissued under the Plan is 141,000.  As of June 30,2005, a total of 119,681 shares are available for issuance under the Plan.  Estimated compensation expense under the planfor the period ended September 30, 2005 is $17,000.

 

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

 

On July 6,2005, the Company executed a $3.0 million secured term note payable to LaurusMaster Fund, Ltd. (“Laurus”).  TheCompany received $3,000,000 in gross proceeds, less a management fee of$135,000 and related transaction costs of approximately $32,000.  The term note was secured by substantiallyall of the Company’s assets, had a 4-month term and bore interest at a rateequal to prime plus 1% per annum.  Inconnection with the financing, on September 30, 2005, the Company issuedLaurus a warrant to purchase up to 250,000 shares of the Company’s common stockat a price equal to $3.75 per share.  Netproceeds from the financing were used for increasing the capacity of the QuantumSnifferTM production line, increasing unit inventories and the repayment ofcertain indebtedness due and owing by the Company to the former shareholders ofAccurel Systems International in connection with the acquisition of thiswholly-owned subsidiary.

 

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

 

The Company alsoissued to Laurus a warrant to purchase 50,000 shares of common stock at $10.20per share.  The Securities PurchaseAgreement provides for a security interest in substantially all of the Company’sassets and provides Laurus a right of first refusal on future financingarrangements during the term of the agreement. In the event Laurus declines to exercise its right of first refusal, itagreed to enter into such documentation as shall be reasonable requested by theCompany in order to subordinate its rights under the Series D to thesubsequent financier.  The Companyutilized the proceeds to repay the $3 million term note Laurus signed on July 7,2005, plus accrued interest, and for working capital.

 

In accordance withthe provisions of Emerging Issues Task Force (“EITF”) Issue 00-27, “Applicationof EITF Issue No. 98-5 ‘Accounting for Convertible Securities withBeneficial Conversion Features of Contingently Adjustable Conversion Ratios’,to Certain Convertible Securities,” which became effective in November 2000,the allocated value of the Series D contained a beneficial conversionfeature calculated based on the difference between the effective conversionprice of the proceeds allocated to the Series D and the fair market valueof the common stock at the date of issuance. The discount arising from the beneficial conversion feature aggregated$460,000.  The discount is being amortizedand recorded as a preferred dividend during the period from the issuance of thepreferred stock to the mandatory redemption date of September 1, 2008, orthe actual conversion date, whichever is earlier using the effective interest

 

11

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method.

 

The Company valuedthe Series D at issuance to be $3,207,000 based on the relative fairmarket values of the financial instruments issued in connection with this preferredstock financing, net of offering costs and the beneficial conversionfeature.  The amounts recorded in thefinancial statements represent the amounts attributed to the sale of thepreferred stock, the amount allocated to warrants of $1,062,000, (whichincludes the value of the warrants issued in connection with the term note aswell as those issued with the preferred stock), the amount of the discountrelated to the value of beneficial conversion feature of $460,000 and $271,000of issuance costs (including $154,000 of unamortized costs of the July 6,2005 term note).  The Company isaccreting these discounts on the carrying value of the preferred stock to itsredemption value of $5,000,000 at September 1, 2008, or the actualconversion date, whichever is earlier. The accretion of these amounts is being recorded as a preferred dividendin the period of accretion.  As of September 30,2005, no amounts have been accreted and no preferred shares have beenconverted. Net cash proceeds were $1,851,000 (which included repayments of$3,032,000 of principal and interest related to the July 6, 2005 term noteand $117,000 of issuance costs).

 

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

 

Basic loss pershare is computed based only on the weighted average number of common sharesoutstanding during the period.  Dilutedearnings per share is computed by using the weighted average number of commonshares outstanding during the period, plus the dilutive effects of sharesissuable through the exercise of stock options and warrants (common stockequivalents) unless their inclusion would be antidilutive.

 

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

 

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

 

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

 

The revenues andexpenses related to these segments for the three months ended September 30,2005 and 2004 are:

 
| ** **   | ** ** | **Three Months Ended September 30, 2005** | ** ** |
|--------------|------------|------------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                    | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                              | 1,149,000  |   | $ | 3,122,000 |   | $ | 401,000 |   | $ | 4,672,000 |   |
| COGS         |       | (959,000                                       | )          | (2,697,000 | ) | (1,022,000 | ) | (4,678,000 | ) |
| Gross Margin |       | $                                              | 190,000    |   | $ | 425,000 |   | $ | (621,000 | ) | $ | (6,000 | ) |

 
| ** **   | ** ** | **Three Months Ended September 30, 2004** | ** ** |
|--------------|------------|------------------------------------------------|------------|
| ** **   | ** ** | **Medical**                                    | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total** | ** ** |
| ** **   | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue      |       | $                                              | 960,000    |   | $ | 334,000 |   | $ | 980,000 |   | $ | 2,274,000 |   |
| COGS         |       | (797,000                                       | )          | (371,000 | ) | (638,000 | ) | (1,806,000 | ) |
| Gross Margin |       | $                                              | 163,000    |   | $ | (37,000 | ) | $ | 342,000 |   | $ | 468,000 |   |

 

12

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

 

At September 30,2005, the Company had goodwill and intangible assets of $14,085,000.  SFAS No. 142, Goodwill and OtherIntangible Assets, requires that goodwill and intangible assets with indefinitelives no longer be amortized but instead be measured for impairment at leastannually or whenever events indicate that there may be an 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 31as the date of performing theannual goodwill impairment test.  In order to determine ifimpairment exists, management continually estimates the reporting unit’s fairvalue based on market conditions and operational performance.  The Company may employ the work ofindependent appraisers in making its determination.  As of August 31, 2005, goodwill existedin two of our reporting units, our semiconductor wafer processing andsemiconductor analytical services units. The Company, in conjunction with a report from and independent appraisermade its annual assessment of goodwill attributable to its semiconductor waferprocessing reporting unit on August 31, 2005 and determined that thereporting unit’s goodwill is not impaired. In addition, management conducted an internal assessment of thesemiconductor analytical services reporting unit’s goodwill and concluded thatthese assets were not impaired as well.

 

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

 
| **Reporting  Unit**                | ** ** | **September 30, 2005** | ** ** | **June 30, 2005** | ** ** |
|------------------------------------|------------|-----------------------------|------------|------------------------|------------|
|                               |       |                        |       |                   |       |
| Semiconductor Wafer  Processing    |       | $                           | 4,660,000  |                   | $          | 4,647,000 |   |
|                               |       |                        |       |                   |       |
| Semiconductor  Analytical Services |       | 7,574,000                   |       | 7,566,000              |       |
|                               |       |                        |       |                   |       |
| Total  Goodwill                    |       | $                           | 12,234,000 |                   | $          | 12,213,000 |   |

 

Intangibleassets with finite lives are valued according to the future cash flows they areestimated to produce.  These assignedvalues are amortized over the period of time those cash flows are estimated tobe produced.  Management continuallyevaluates whether events or circumstances have occurred that indicate that theestimated remaining useful life or the carrying value of these assets has beenimpaired. As of September 30, 2005 management believes no impairmentexists.

 

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

 

13

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The followingtable summarizes the Company’s intangible assets as of September 30, 2005and June 30, 2005:

 
| ** **        | ** ** | ** **      | ** ** | **September 30, 2005** | ** ** | **June 30, 2005**        | ** ** |
|-------------------|------------|-----------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **        | ** ** | **Useful Life** | ** ** | **Gross Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|              |       |            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Non-Compete       |       | 18-36 mo.       |       | $                           | 1,057,000  |                          | $          | 922,000 |   | $ | 135,000 |   | $ | 1,057,000 |   | $ | 809,000 |   | $ | 248,000 |   |
|              |       |            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Name  Recognition |       | 60-84 mo.       |       | 200,000                     |       | 16,000                        |       | 184,000 |   | 200,000 |   | 9,000 |   | 191,000 |   |
|              |       |            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Customer  Base    |       | 60 mo.          |       | 1,630,000                   |       | 200,000                       |       | 1,430,000 |   | 1,630,000 |   | 119,000 |   | 1,511,000 |   |
|              |       |            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Technology        |       | 60 mo.          |       | 125,000                     |       | 24,000                        |       | 101,000 |   | 125,000 |   | 18,000 |   | 107,000 |   |
|              |       |            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Total             |       |            |       | $                           | 3,012,000  |                          | $          | 1,162,000 |   | $ | 1,850,000 |   | $ | 3,012,000 |   | $ | 955,000 |   | $ | 2,057,000 |   |

 

Estimated future amortization expense for intangible assets with finitelives as of September 30, 2005 is as follows:

 
| Remainder  of fiscal year |   | 2006       |   | $       | 414,000   |   |
|---------------------------|--------|------------|--------|---------|-----------|--------|
|                      |   | 2007       |   | 387,000 |      |
|                      |   | 2008       |   | 380,000 |      |
|                      |   | 2009       |   | 380,000 |      |
|                      |   | 2010       |   | 244,000 |      |
|                      |   | thereafter |   | 45,000  |      |
|                      |   |       |   | $       | 1,850,000 |   |

 

**12.****          CreditArrangements**

 

At the time of itsacquisition, Accurel Systems had a $1,400,000 fixed rate installment note witha bank. The note calls for monthly payments of $29,000 plus interest at a rateof 6.84%, through September 1, 2008. The bank has consented to continue the note under the same terms afterthe acquisition. As of September 30, 2005, the note balance is $1,079,000.  The note is secured by substantially allassets of Accurel.

 

The Loan Agreementrequires Accurel to report monthly financial results to the bank and forAccurel to comply with certain financial covenants.  As of September 30, 2005, Accurel was incompliance with the covenants.

 

On June 8, 2005, the Company executeda revolving credit facility for $1,500,000 with Silicon Valley based BridgeBank, N.A.  The revolving credit facilityhas a one year term, provides for advances of up to eighty percent (80%) of theCompany’s eligible accounts receivable, bears interest at the prime rate plusone-half percent (1/2%), and is secured by certain assets of the Company and issubject to certain covenants.  As of September 30,2005, the company has not drawn down any funds on the credit facility.

 

**13.****          SubsequentEvents**

 

On October 12,2005, the Company executed a modification to its revolving credit facility for$1,500,000 with Bridge Bank, N.A. extending the expiration date to December 31,2006 and modifying certain compliance covenants.  All other terms remain unchanged.

 

14

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

 

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

 

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

 

The quarter ended September 30,2005 includes revenues from Core Systems which was acquired by the Company on October 15,2004, and Accurel Systems which was acquired on March 9, 2005.  These acquisitions contributed revenues of$3.0 million in the quarter out of total revenues of $4.7 million. Core andAccurel are included in the semiconductor segment.  Revenues from our explosives detectionsegment, during the quarter ended September 30, 2005, are down $600,000 fromthe prior year quarter.  This decline isattributable to government contracts in the previous year quarter which werecompleted by December 31, 2004.  Wehave recently announced the signing of a development agreement with theTransportation Security Administration (“TSA”) for our explosives detectionproducts and are scheduled to ship explosives detection equipment against apreviously announced order from China in the coming months.

 

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

 

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

 

**RESULTSOF OPERATIONS**

 

The following is adiscussion and analysis of the financial condition and results of operation ofthe Company for the three month period ended September 30, 2005 and2004.  It should be read in conjunctionwith the condensed consolidated financial statements and notes theretoappearing elsewhere herein.

 

15

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*ThreeMonth Period Ended September 30, 2005 vs. September 30, 2004*

 

*Revenues.* Total revenues for the period ended September 30, 2005were $4,672,000 as compared to $2,274,000 for the comparable prior year period,an increase of $2,398,000 or 105%.  Ourrevenues by business segment are as follows:

 
| **Three  Months Ended September 30, 2005** |
|-------------------------------------------------|
| **Medical**                                     | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Revenues** | ** ** |
|                                            |   |   |   |   |   |   |   |
| $                                               | 1,149,000 |   | $ | 3,122,000 |   | $ | 401,000 |   | $ | 4,672,000 |   |
|                                                 |  |  |  |  |  |  |  |  |  |  |  |

 
| **Three  Months Ended September 30, 2004** |
|-------------------------------------------------|
| **Medical**                                     | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Revenues** | ** ** |
|                                            |   |   |   |   |   |   |   |
| $                                               | 960,000 |   | $ | 334,000 |   | $ | 980,000 |   | $ | 2,274,000 |   |
|                                                 |  |  |  |  |  |  |  |  |  |  |  |

 

The overall increase in revenues isattributable primarily to revenues from Core Systems and Accurel Systems. Coreand Accurel were acquired on October 15, 2004 and March 9, 2005 respectively,and their results were not included in the previous year period.  Revenues from Core and Accurel totaledapproximately $2,952,000 and are included in our semiconductor segment.  Semiconductor revenues were $3,122,000 ascompared to $334,000 in the comparable prior year period, an increase of $2,788,000or 835%.  Since the acquisition of Coreon October 15, 2004 the Company has transitioned some semiconductor workfrom Wakefield to Sunnyvale to take advantage of operating efficiencies.

 

Medical revenues were $1,149,000 as comparedto $960,000 for the comparable prior year period, an increase of $189,000 or 20%.  The increase in medical revenues was dueprimarily from a turn around in the radioactive seeds volumes, providing$93,000 of the increase, and revenues from a new non-orthopedic relatedcoatings customer.  After a lengthyperiod of decline, management believes seed volumes have now stabilized, andhas taken steps to achieve increasing seed volumes in the coming year,including the benefits of selling our recently acquired treatment planningsoftware to our customers. The treatmentplanning software is a proprietary treatment planning technology marketed as “I-PlantTPS”TM. In its latest version, a new module aids the physicianin making 2 and 3 dimensional maps of stage, grade and location of cancerwithin the prostate gland. This “Pathology Mapping Module”TM is inaddition to the standard treatment planning function used for prostateBrachytherapy and will provide for image guided, focal treatment of thedisease.

 

Revenues from the Company’s explosivesdetection business declined to $401,000 as compared to $980,000 for the comparableprior year period, a decrease of $579,000 or 59%.  This decrease is attributable to certaingovernment contracts which were in place in the prior year period that had beencompleted prior to the current fiscal year.  Explosives detection contract revenues were$288,000 and $935,000 for the three months ended September 30, 2005 and2004, respectively. The Company is transitioning the explosives business fromprimarily a contracts/development business to a product sales business.  To that extent, we have established strategicsales and distribution relationships both domestically and internationally.  The Company recently announced a major orderfor its explosives detection product from its distributor in China that isexpected to begin shipping during the second quarter of fiscal 2006.  Explosives detection product revenues were$113,000 and $45,000 for the three months ended September 30, 2005 and2004, respectively.

 

*Cost ofRevenues*.  Cost ofrevenues for the three months ended September 30, 2005 was $4,678,000 ascompared to $1,806,000 for the comparable prior year period, an increase of $2,872,000or 159%.  The cost of revenues bybusiness segment is as follows:

 

16

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| **Three  Months Ended September 30, 2005** |
|-------------------------------------------------|
| **Medical**                                     | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Cost of  Revenues** | ** ** |
|                                            |   |   |   |   |   |   |   |
| $                                               | 959,000 |   | $ | 2,697,000 |   | $ | 1,022,000 |   | $ | 4,678,000 |   |
|                                                 |  |  |  |  |  |  |  |  |  |  |  |

 
| **Three  Months Ended September 30, 2004** |
|-------------------------------------------------|
| **Medical**                                     | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Cost of  Revenues** | ** ** |
|                                            |   |   |   |   |   |   |   |
| $                                               | 797,000 |   | $ | 371,000 |   | $ | 638,000 |   | $ | 1,806,000 |   |
|                                                 |  |  |  |  |  |  |  |  |  |  |  |

 

The overall increase incost of revenues is primarily a result of costs attributable to Core andAccurel.  Core and Accurel were acquired onOctober 15, 2004 and March 9, 2005, respectively, and their resultswere not included in the comparable prior year period.  Cost of revenues at Core and Accurel totaled$2,335,000 and are included in our semiconductor segment.  In addition, our cost of revenues alsoincreased due to our efforts to ramp up our explosives detection manufacturingcapability as we transition from primarily contract/development revenues tohigher volumes of product sales related to the explosives detection equipment.  The cost of our explosives detection revenueswere $1,022,000 compared to $638,000 in the comparable prior year period, anincrease of $384,000 or 60%. Medical products costs increased to $959,000 ascompared to $797,000 in the comparable prior year period, an increase of$162,000 or 20%.  This increase isprimarily due to materials required to provide increased volumes of radioactiveseeds. Included in cost of sales for the period ended September 30, 2005, is$82,000 of share-based compensation as required by SFAS 123R.

 

*GrossMargins*.  Overall grossmargins were 0% of revenues in the three month period ended September 30,2005 as compared to 21% of revenues in the comparable prior year period.  The decrease in the gross margin percentageis attributable to the transition from contract/development work in theexplosives detection segment, to product manufacturing.  This transition has created a situation inwhich the Company had declining revenues, due to completion of major contracts inthe prior fiscal year, at the same time it is expanding its productmanufacturing capability and building limited saleable product which resultedin certain fixed manufacturing costs being incurred and expensed.  The result of this transition was a grossmargin loss $621,000 or 155% of sales for the explosives detection segment forthe three months ended September 30, 2005, as compared to gross margins of$342,000 or 35% in the comparable prior year period.  Semiconductor margins were 14% of revenues ascompared to a gross margin loss of 11% in the comparable prior year period.This turnaround is attributable to Accurel. Accurel was acquired on March 9, 2005 and its results are notincluded in the comparable prior year period.  Management expects continued semiconductorgross margin improvements as volumes continue to increase and operatingefficiencies at Core are realized.  Grossmargins by business segment are as follows:

 
| **Three  Months Ended September 30, 2005** |
|-------------------------------------------------|
| **Medical**                                     | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Gross  Margin** | ** ** |
| 16                                              | % | 14 | % | -155 | % | 0 | % |

 
| **Three  Months Ended September 30, 2004** |
|-------------------------------------------------|
| **Medical**                                     | ** ** | **Semiconductor** | ** ** | **Explosives** | ** ** | **Total Gross  Margin** | ** ** |
| 17                                              | % | -11 | % | 35 | % | 21 | % |

 

17

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*Researchand Development*. Research and development expense for the three month period ended September 30,2005 was $316,000 as compared to $586,000 for the comparable prior year period,a decrease of $270,000 or 46%.  In thethree month period ended September 30, 2005, certain of the Company’s R&Dresources were temporarily transferred to explosives detection productmanufacturing team to assist with order fulfillment of our handheld explosivesdetectors.  However, the Companycontinues to expend funds to further the development of new products in theareas of explosives and toxic substance detection and temporary brachytherapyareas.  Included in research and developmentcosts for the period ended September 30, 2005, is $68,000 of share-basedcompensation as required by SFAS 123R.

 

*Selling,General and Administrative*. Selling, general and administrative expenses for the three month periodended September 30, 2005 were $1,923,000 as compared to $1,060,000 for thecomparable prior year period, an increase of $865,000 or 82%.  This increase is primarily related to $624,000of additional selling, general and administrative expenses incurred due to theacquisition of Core and Accurel.  Coreand Accurel were acquired on October 15, 2004 and March 9, 2005,respectively and their results were not included in the comparable prior yearperiod.  Selling expense associated withour treatment planning software line were $92,000 in the three month periodended September 30, 2005 as compared to $0 for the same period in 2004. Includedin selling, general and administrative costs for the period ended September 30,2005, is $235,000 of share-based compensation as required by SFAS 123R.

 

*OtherIncome and Expenses, Net*. For the year ended September 30, 2005, we recorded other expense,net, of $122,000 as compared to $13,000, in the comparable prior year period.  This increase includes interest expense of$92,000, primarily due to the Laurus financing in July of 2005 and debtheld by Accurel as compared to interest expense of $18,000 in the comparable prioryear period.  In addition, equity lossesin unconsolidated subsidiaries increased by $30,000 in the current fiscal yearperiod.

 

*Net Loss.*  Net loss for the three month period ended September 30,2005 was $2,367,000 as compared with $1,191,000 for the comparable prior yearperiod, an increase in net loss of $1,176,000 or 99%.  The increase in net loss is primarily due tolosses in the explosives detection business due to the completion of certaingovernment contracts during the prior fiscal year and costs related toincreasing our manufacturing capability ahead of expected product orders. Theincrease in net loss due to our explosives detection business is approximately$963,000. This is offset somewhat by our transfer of R&D expenses to costof sales resulting in lower R&D costs for the period.  The acquisition of Core Systems on October 15,2004 was expected to have a positive impact on earnings because of expectedoperating efficiencies and increased revenues when combined with the Company’sexisting semiconductor operations.  Thesebenefits have been slow to develop and Core has experienced losses since it wasacquired.  Management continues to focuson opportunities for Core that could have significant profit potential. TheCompany continually reviews its goodwill assets for potential impairment.  The Company has four reporting units,medical, explosives detection, semiconductor wafer processing and semiconductoranalytical services. All of the Company’s goodwill is allocated to thesemiconductor wafer processing and the semiconductor analytical servicesreporting units.  Determining thereporting unit’s fair value requires management to make estimates based onmarket conditions and operational performance. Absent an event that indicates aspecific impairment may exist, management has selected August 31 as thedate of performing the annual goodwill impairment test. The results of 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.

 

  Preferred distribution, dividends andaccretion were $0 in the three month period ended September 30, 2005 ascompared to $284,000 in the period ended September 30, 2004.  This decrease is attributable to theconversion of preferred stock to common stock prior to the three month periodending September 30, 2005.  Includedin net loss for the period ended September 30, 2005, is $385,000 of share-basedcompensation as required by SFAS 123R. The Company also had $26,000 of non-SFAS 123R compensation.

 

18

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**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 and/or cutting costsand expenses.

 

As of September 30,2005, the Company had approximately $3,432,000 in the form of cash and cashequivalents and net working capital of $2,631,000.  During the three month period ended September 30,2005, operating activities used cash of approximately $959,000.  Net cash used by operating activitiesprimarily reflects the $2,367,000 net loss offset by $1,217,000 in depreciation,amortization and other non-cash expenses. In addition the Company invested $564,000 in inventory as it continuesits production of the explosives detection product, which is expected to shipin the Company’s second quarter.  The Companyrealized cash of $296,000 from its accounts receivables due to timely paymentsfrom revenues booked at the end of the fiscal 2005 fourth quarter. Accountspayables and accruals were paid down by $88,000. Deferred revenues increased$606,000, primarily from cash deposits received by the Company for products scheduledto ship in the Company’s second quarter.  During the three months ended September 30,****2005, investing activities used cash of approximately $200,000,which was primarily attributable to $170,000 used for additions to plant andequipment.  The additions were primarilyused to increase production capacity at Core and for explosives detectionproducts production in Wakefield.  Duringthe three month period ended September 30, 2005, financing activitiesprovided approximately $3,042,000 in cash.

 

On July 6, 2005, the Company executed a $3.0 millionsecured term note from Laurus Master Fund, Ltd. The Company received $3,000,000 in gross proceeds, less a management feeof $135,000 and related transaction costs of approximately $32,000.  The term note was secured by substantiallyall of the Company’s assets, had a 4-month term and bore interest at a rateequal to prime plus 1% per annum.  Inconnection with the financing, on September 30, 2005, the Company issuedLaurus a warrant to purchase up to 250,000 shares of the Company’s common stockat a price equal to $3.75 per share.  Netproceeds from the financing were used for increasing the capacity of theQuantum SnifferTM production line, increasing unit inventories and the repaymentof certain indebtedness due and owing by the Company to the former shareholdersof Accurel Systems International.

 

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

 

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

 

The Company also issuedto Laurus a warrant to purchase 50,000 shares of common stock at $10.20 pershare.  The Securities Purchase Agreementprovides for a security interest in substantially all of the Company’s assetsand provides Laurus a right of first refusal on future financing arrangementsduring the term of the agreement.  In theevent Laurus declines to exercise its right of first refusal, it agreed toenter into such documentation as shall be reasonable requested by the Companyin order to subordinate its rights under the Series D to the subsequentfinancier.  The Company utilized theproceeds to repay the $3 million term note to Laurus signed on July 7,2005 plus accrued interest, and for working capital.

 

In accordance with theprovisions of Emerging Issues Task Force (EITF) Issue 00-27, “Application ofEITF Issue No. 98-5 ‘Accounting for Convertible Securities with BeneficialConversion Features of Contingently Adjustable Conversion Ratios’, to CertainConvertible Securities,” which became effective in November 2000, theallocated value of the Series D contained a beneficial conversion featurecalculated based on the difference between

 

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the effective conversionprice of the proceeds allocated to the Series D and the fair market valueof the common stock at the date of issuance. The discount arising from the beneficial conversion feature aggregated$460,000.  The discount is being amortizedand recorded as a preferred dividend during the period from the issuance of thepreferred stock to the mandatory redemption date of September 1, 2008, orthe actual conversion date, whichever is earlier using the effective interestmethod.

 

The Company valued the Series Dat issuance to be $3,207,000 based on the relative fair market values of thefinancial instruments issued in connection with this preferred stock financing,net of offering costs and the beneficial conversion feature.  The amounts recorded in the financialstatements represent the amounts attributed to the sale of the preferred stock,the amount allocated to warrants of $1,062,000, (which includes the value ofthe warrants issued in connection with the term note as well as those issuedwith the preferred stock), the amount of the discount related to the value ofbeneficial conversion feature of $460,000 and $271,000 of issuance costs(including $154,000 of unamortized costs of the July 6, 2005 termnote).  The Company is accreting thesediscounts on the carrying value of the preferred stock to its redemption valueof $5,000,000 at September 1, 2008, or the actual conversion date,whichever is earlier.  The accretion ofthese amounts is being recorded as a preferred dividend in the period ofaccretion.  As of September 30,2005, no amounts have been accreted and no preferred shares have beenconverted. Net cash proceeds were $1,851,000 (which included repayments of$3,032,000 of principal and interest related to the July 6, 2005 term noteand $117,000 of issuance costs).

 

We are currentlyexpending significant resources to set up our explosives detection manufacturingfacility in anticipation of our explosives detection equipment orders.  Although we continue to fund as much researchand development as possible through government grants and contracts inaccordance with the provisions of the respective grant awards, we will requireadditional funding in order to continue the advancement of the commercialdevelopment and manufacturing of the explosives detection system.  We will attempt to obtain such financing by: (i) governmentgrants, (ii) the exercise of the redeemable common stock purchasewarrants, (iii) private financing, or (iv) strategicpartnerships.  However, there can be noassurance that we will be successful in our attempts to raise such additionalfinancing.  Should funding not beavailable, we may be forced to sell certain company assets in order to fund thecontinued research and development of our explosives detection product and/orcurtail the amount of resources dedicated to it.

 

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

 

The Company’s futureminimum payments under contractual obligations related to capital leases,operating leases and term notes as of September 30, 2005 are as follows:

 
| ** **                | ** ** | **Debt and  Capital Leases** | ** ** | **Operating  Lease** | ** ** | **MED-TEC** | ** ** | **Total** | ** ** |
|---------------------------|------------|------------------------------|------------|----------------------|------------|-------------|------------|-----------|------------|
| Year ending June 30: |       |                         |       |                 |       |        |       |      |       |
| 2006                      |       | $                            | 305,000    |                 | $          | 1,224,000   |       | $         | 318,000    |   | $ | 1,847,000 |   |
| 2007                      |       | 393,000                      |       | 1,673,000            |       |        |       | 2,066,000 |       |
| 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                     |       | $                            | 1,238,000  |                 | $          | 6,902,000   |       | $         | 318,000    |   | $ | 8,458,000 |   |

 

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*CriticalAccounting Policies*

 

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

 

 *Share-Based Payment.***** In December 2004, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment,”which is a revision of Statement No. 123 as amended by No. 148, “Accounting for Stock-Based Compensation”.SFAS 123R supercedes APB Opinion No. 25. Generally, the approach in SFAS123Ris similar 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 is effective for the Company beginning with the first quarter offiscal 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 and previousamounts have not been restated (Note 6).

 

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

 

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

 

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**Item 3.   Quantitative and Qualitative Disclosure sAbout Market Risk**

 

Interest Rate Risk

 

The Company’s financialinstruments include cash and cash equivalents. Cash and cash equivalents include cash on hand, demand deposits andshort-term investments with maturities of three months or less whenacquired.  Cash equivalents represent adeposit in a money market account and a certificate of deposit.  The Company does not utilize derivativefinancial instruments, derivative commodity instruments or other market risksensitive instruments, positions or transactions in any material fashion.  The principal objective of the Company’sasset management activities is to maximize net investment income, whilemaintaining acceptable levels of interest rate risk and facilitating its fundingneeds.  At September 30, 2005, 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 concluded that, as of the end of the period covered by this Quarterly Report, our Disclosure Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

In addition, we have begun the process to identify and hire additional personnel to assist with the financial close process.  We have hired an outside consultant to identify and screen potential candidates for this position and have begun the interview process.

 

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PART II: OTHER INFORMATION

 

Item 1.  LegalProceedings

 

None

 

Item 2.  Unregistered Sales of Equity

 

On September 30, 2005, the Companyissued 500,000 shares of Series D Convertible Preferred Stock (“Series D”)in a private placement pursuant to Section 4(2) of the Securities Act of 1933,as amended, having a stated value of $10 per share, pursuant to a SecuritiesPurchase Agreement executed on September 30, 2005, with the Laurus MasterFund, Ltd.  The Company received$5,000,000 in gross proceeds, less a management and placement agent fee ofapproximately $90,000, and related transaction costs of approximately $27,000.  The Series D has a dividend equal to theprime rate plus one percent (1%) and provides for repayment over a thirty-sixmonth period pursuant to an amortization schedule.  The monthly redemption amount ofapproximately $152,000 may be paid in cash or common shares at the option ofthe Company, subject to certain restrictions, commencing on January 1,2006.  If the payment of the monthlyamount is made in common stock, the fixed conversion price is $6.80 per commonshare.

 

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

 

As of September 30,2005, the outstanding principal balance of the Series D was $5,000,000.

 

Item 3.  Defaults Upon Senior Securities

 

Not Applicable

 

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

 

Not Applicable

 

Item 5.  OtherInformation

 

On October 27,2005, Implant Sciences Corporation (the “Company”) received notification fromits independent registered public accounting firm, BDO Seidman, LLP (“BDO”),advising the Company that it was resigning as the Company’s independentregistered public accounting firm.  Thisresignation will become effective upon completion of BDO’s review of theCompany’s quarterly results for the first fiscal quarter and three months endedSeptember 30, 2005.

 

On November 2,2005, the Audit Committee of the Company’s Board of Directors engaged the firmof Brown & Brown, LLP (“Brown”) to complete the review of the Company’ssubsequent quarterly results and until such time that the Company officiallyappoints Brown & Brown as its independent registered public accountingfirm. This appointment is pending the completion of Brown & Brown’sformal client acceptance process.

 

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

 

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

 

24

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

 

(b)    Reportson Form 8-K

 

Current Report on Form 8-Kdated July 14, 2005, regarding a short term note with Laurus Master Fund.

 

Current Report on Form 8-Kdated October 5, 2005, regarding the preferred stock financing with LaurusMaster Fund.

 

Current Report on Form 8-Kdated November 2, 2005, regarding the resignation of the Company’sindependent registered accounting firm.

 

 

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SIGNATURES

 

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

 
|                    | Implant Sciences Corporation |   |
|-------------------------|------------------------------|--------|
|                    |                         |   |
| Date: November 21, 2005 | /s/ Anthony J. Armini        |   |
|                    | Anthony J. Armini            |   |
|                    | President and CEO            |   |
|                    |                         |   |
| Date: November 21, 2005 | /s/ Diane J. Ryan            |   |
|                    | Diane J. Ryan                |   |
|                    | Chief Financial Officer      |   |

 

 

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