UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549









FORM
10-Q







(Mark
One)


x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the quarterly period ended September 30, 2009




OR




 ̈
            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: 000-27372









StockerYale,
Inc.


(Exact
name of registrant as specified in its charter)







Massachusetts
            04-2114473(State
      or other jurisdiction of
              incorporation
      or organization)
            (I.R.S.
      Employer
              Identification
      No.)




32
      Hampshire Road
              Salem,
      New Hampshire
            03079(Address
      of principal executive offices)
            (Zip
      Code)




Registrant’s
telephone number, including area code: (603) 893-8778







Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x    No   ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes o   Noo




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.




Large accelerated filer   ̈
            Accelerated filer   ̈
            Non-accelerated filer   ̈
            Smaller reporting company  x(Do not
      check if a smaller
              reporting
      company)




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).    Yes   ̈    No  x




As of
October 26, 2009, there were 44,868,432 shares of the registrant’s common stock
issued and outstanding.










STOCKERYALE,
INC.




INDEX
TO FORM 10-Q




PagePART
      I - FINANCIAL INFORMATIONItem 1
                        Financial
      Statements
                        
                        3Item 2
                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        
                        20Item 3
                        Quantitative
      and Qualitative Disclosures About Market Risk
                        
                        23Item 4T
                        Controls
      and Procedures
                        
                        23PART
      II - OTHER INFORMATIONItem 1
                        Legal
      Proceedings
                        
                        24Item 1A
                        Risk
      Factors
                        
                        24Item 5
                        Other
      Information
                        
                        24Item 6
                        Exhibits
                        
                        24




2


Item 1.
            Financial
      Statements.




STOCKERYALE,
INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS


In
thousands except share and per share data


Unaudited




September
      30,
                                          2009
                                        
                                        
                                        December 31,
                                          2008AssetsCurrent
      assets:Cash
      and cash equivalents
                                        
                                        $
                                        1,223
                                        
                                        
                                        $
                                        1,635Restricted
      cash
                                        
                                        
                                        8
                                        
                                        
                                        
                                        7Accounts
      receivable less allowances of $14 at September 30, 2009 and $39 at
      December 31, 2008
                                        
                                        
                                        1,169
                                        
                                        
                                        
                                        1,673Inventories
                                        
                                        
                                        1,415
                                        
                                        
                                        
                                        1,418Prepaid
      expenses and other current assets
                                        
                                        
                                        422
                                        
                                        
                                        
                                        114Current
      assets-discontinued operations
                                        
                                        
                                        4,696
                                        
                                        
                                        
                                        4,900Total
      current assets
                                        
                                        
                                        8,933
                                        
                                        
                                        
                                        9,747Net
      property, plant and equipment
                                        
                                        
                                        3,929
                                        
                                        
                                        
                                        4,241Goodwill
                                        
                                        
                                        4,799
                                        
                                        
                                        
                                        4,410Acquired
      intangible assets, net
                                        
                                        
                                        1,391
                                        
                                        
                                        
                                        1,795Other
      long-term assets
                                        
                                        
                                        2
                                        
                                        
                                        
                                        436Long-term
      assets-discontinued operations
                                        
                                        
                                        6,432
                                        
                                        
                                        
                                        6,813Total
      assets
                                        
                                        $
                                        25,486
                                        
                                        
                                        $
                                        27,442Liabilities
      and Stockholders’ EquityCurrent
      liabilities:Revolving
      lines of credit
                                        
                                        $
                                        4,018
                                        
                                        
                                        $
                                        3,869Current
      portion of long-term debt, net of unamortized discount of $604 at
      September 30, 2009 and $856 at December 31, 2008
                                        
                                        
                                        6,934
                                        
                                        
                                        
                                        4,118Current
      portion of capital and financing lease obligations
                                        
                                        
                                        530
                                        
                                        
                                        
                                        563Accounts
      payable
                                        
                                        
                                        2,235
                                        
                                        
                                        
                                        2,829Accrued
      expenses
                                        
                                        
                                        1,715
                                        
                                        
                                        
                                        916Current
      liabilities-discontinued operations
                                        
                                        
                                        3,379
                                        
                                        
                                        
                                        2,638Total
      current liabilities
                                        
                                        
                                        18,811
                                        
                                        
                                        
                                        14,933Long-term
      debt, net of unamortized discount of $268 at September 30, 2009 and $658
      at December 31, 2008
                                        
                                        
                                        3,789
                                        
                                        
                                        
                                        6,372Capital
      and financing lease obligations, net of current portion
                                        
                                        
                                        3,224
                                        
                                        
                                        
                                        3,320Warrant
      liability
                                        
                                        
                                        199
                                        
                                        
                                        
                                        —Deferred
      income taxes, net
                                        
                                        
                                        151
                                        
                                        
                                        
                                        486Long-term
      liabilities-discontinued operations
                                        
                                        
                                        43
                                        
                                        
                                        
                                        52Total
      liabilities
                                        
                                        
                                        26,217
                                        
                                        
                                        
                                        25,163Stockholders’
      equity (deficit):Common
      stock, par value $0.001; 100,000,000 shares authorized; 44,868,432 shares
      issued and outstanding at September 30, 2009 and 43,464,413 shares issued
      and outstanding at December 31, 2008
                                        
                                        
                                        45
                                        
                                        
                                        
                                        43Paid-in
      capital
                                        
                                        
                                        102,720
                                        
                                        
                                        
                                        103,270Accumulated
      other comprehensive income
                                        
                                        
                                        2,628
                                        
                                        
                                        
                                        2,518Accumulated
      deficit
                                        
                                        
                                        (106,124
                                        )
                                        
                                        
                                        (103,552
                                        )Total
      stockholders’ equity (deficit)
                                        
                                        
                                        (731
                                        )
                                        
                                        
                                        2,279Total
      liabilities and stockholders’ equity (deficit)
                                        
                                        $
                                        25,486
                                        
                                        
                                        $
                                        27,442




See
notes to unaudited condensed consolidated financial statements.


3




STOCKERYALE,
INC.


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


Unaudited




Three
      Months Ended
                                            September
      30,
                                          
                                          
                                          Nine
      months Ended
                                            September
      30,2009
                                          
                                          
                                          2008
                                          
                                          
                                          2009
                                          
                                          
                                          2008In
      thousands except per share dataRevenue
                                          
                                          $
                                          2,347
                                          
                                          
                                          $
                                          3,723
                                          
                                          
                                          $
                                          7,801
                                          
                                          
                                          $
                                          11,493Cost
      of sales
                                          
                                          
                                          1,628
                                          
                                          
                                          
                                          2,378
                                          
                                          
                                          
                                          5,588
                                          
                                          
                                          
                                          7,882Gross
      profit
                                          
                                          
                                          719
                                          
                                          
                                          
                                          1,345
                                          
                                          
                                          
                                          2,213
                                          
                                          
                                          
                                          3,611Operating
      expenses:Selling
      expenses
                                          
                                          
                                          386
                                          
                                          
                                          
                                          436
                                          
                                          
                                          
                                          1,199
                                          
                                          
                                          
                                          1,498General
      and administrative
                                          
                                          
                                          943
                                          
                                          
                                          
                                          1,953
                                          
                                          
                                          
                                          3,233
                                          
                                          
                                          
                                          5,062Research
      and development
                                          
                                          
                                          155
                                          
                                          
                                          
                                          136
                                          
                                          
                                          
                                          424
                                          
                                          
                                          
                                          388Amortization
      of intangibles
                                          
                                          
                                          198
                                          
                                          
                                          
                                          228
                                          
                                          
                                          
                                          559
                                          
                                          
                                          
                                          809Loss
      from operations
                                          
                                          
                                          (963
                                          )
                                          
                                          
                                          (1,408
                                          )
                                          
                                          
                                          (3,202
                                          )
                                          
                                          
                                          (4,146
                                          )Other
      (income) and expense, net
                                          
                                          
                                          412
                                          
                                          
                                          
                                          688
                                          
                                          
                                          
                                          (930
                                          )
                                          
                                          
                                          953Amortization
      of debt discount and financing costs
                                          
                                          
                                          207
                                          
                                          
                                          
                                          1,377
                                          
                                          
                                          
                                          1,382
                                          
                                          
                                          
                                          2,024Interest
      expense
                                          
                                          
                                          47
                                          
                                          
                                          
                                          42
                                          
                                          
                                          
                                          121
                                          
                                          
                                          
                                          115Loss
      from continuing operations before income tax benefit
                                          
                                          
                                          (1,629
                                          )
                                          
                                          
                                          (3,515
                                          )
                                          
                                          
                                          (3,775
                                          )
                                          
                                          
                                          (7,238
                                          )Income
      tax benefit
                                          
                                          
                                          (205
                                          )
                                          
                                          
                                          (80
                                          )
                                          
                                          
                                          (214
                                          )
                                          
                                          
                                          (203
                                          )Loss
      from continuing operations
                                          
                                          
                                          (1,424
                                          )
                                          
                                          
                                          (3,435
                                          )
                                          
                                          
                                          (3,561
                                          )
                                          
                                          
                                          (7,035
                                          )Income
      / (loss) from discontinued operations, net of tax
                                          
                                          
                                          (26
                                          )
                                          
                                          
                                          336
                                          
                                          
                                          
                                          (214
                                          )
                                          
                                          
                                          (514
                                          )Net
      loss
                                          
                                          $
                                          (1,450
                                          )
                                          
                                          $
                                          (3,099
                                          )
                                          
                                          $
                                          (3,775
                                          )
                                          
                                          $
                                          (7,549
                                          )Basic
      and diluted net loss per share from continuing operations
                                          
                                          $
                                          (0.03
                                          )
                                          
                                          $
                                          (0.09
                                          )
                                          
                                          $
                                          (0.08
                                          )
                                          
                                          $
                                          (0.19
                                          )Basic
      and diluted net income (loss) per share from discontinued
      operations
                                          
                                          $
                                          0.00
                                          
                                          
                                          $
                                          0.01
                                          
                                          
                                          $
                                          (0.01
                                          )
                                          
                                          $
                                          (0.01
                                          )Basic
      and diluted net loss per share
                                          
                                          $
                                          (0.03
                                          )
                                          
                                          $
                                          (0.08
                                          )
                                          
                                          $
                                          (0.09
                                          )
                                          
                                          $
                                          (0.20
                                          )Basic
      and diluted weighted average shares outstanding:
                                          
                                          
                                          44,109
                                          
                                          
                                          
                                          39,189
                                          
                                          
                                          
                                          43,480
                                          
                                          
                                          
                                          37,834




See
notes to unaudited condensed consolidated financial statements.




4


STOCKERYALE,
INC.


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


Unaudited


Nine
      months EndedSeptember
      302009
                                                
                                                
                                                2008In
      thousandsOperationsNet
      loss
                                                
                                                $
                                                (3,775
                                                )
                                                
                                                $
                                                (7,549
                                                )Loss
      from discontinued operations, net of tax
                                                
                                                
                                                214
                                                
                                                
                                                
                                                514Loss
      from continuing operations
                                                
                                                
                                                (3,561
                                                )
                                                
                                                
                                                (7,035
                                                )Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Stock
      based compensation
                                                
                                                
                                                427
                                                
                                                
                                                
                                                732Depreciation
      and amortization
                                                
                                                
                                                970
                                                
                                                
                                                
                                                1,291Amortization
      of debt discount and financing costs
                                                
                                                
                                                1,382
                                                
                                                
                                                
                                                2,024Non
      cash interest expense
                                                
                                                
                                                201
                                                
                                                
                                                
                                                214Change
      in fair value of warrants
                                                
                                                
                                                (92
                                                )
                                                
                                                
                                                —Provision
      for inventories
                                                
                                                
                                                39
                                                
                                                
                                                
                                                28(Gain)
      loss on disposal of assets
                                                
                                                
                                                (32
                                                )
                                                
                                                
                                                103Provision
      for bad debts
                                                
                                                
                                                15
                                                
                                                
                                                
                                                24Deferred
      income taxes
                                                
                                                
                                                (214
                                                )
                                                
                                                
                                                (190
                                                )Other
      change in assets and liabilities:Accounts
      receivable
                                                
                                                
                                                609
                                                
                                                
                                                
                                                (454
                                                )Inventories
                                                
                                                
                                                81
                                                
                                                
                                                
                                                147Prepaid
      expenses and other current assets
                                                
                                                
                                                (306
                                                )
                                                
                                                
                                                (115
                                                )Accounts
      payable
                                                
                                                
                                                (706
                                                )
                                                
                                                
                                                1,392Accrued
      expenses
                                                
                                                
                                                356
                                                
                                                
                                                
                                                38Other
      assets and liabilities
                                                
                                                
                                                12
                                                
                                                
                                                
                                                13Net
      cash used in continuing operations
                                                
                                                
                                                (819
                                                )
                                                
                                                
                                                (1,788
                                                )Net
      cash provided by (used in) discontinued operations
                                                
                                                
                                                1,508
                                                
                                                
                                                
                                                (1,092
                                                )Net
      cash provided by (used in) operating activities
                                                
                                                
                                                689
                                                
                                                
                                                
                                                (2,880
                                                )InvestingProceeds
      from sale of assets
                                                
                                                
                                                —
                                                
                                                
                                                
                                                38Payments
      of financing obligation
                                                
                                                
                                                (246
                                                )
                                                
                                                
                                                (191
                                                )Purchases
      of property, plant and equipment
                                                
                                                
                                                (36
                                                )
                                                
                                                
                                                (55
                                                )Net
      cash used in continuing investing activities
                                                
                                                
                                                (282
                                                )
                                                
                                                
                                                (208
                                                )Net
      cash used in discontinued operations
                                                
                                                
                                                (157
                                                )
                                                
                                                
                                                (94
                                                )Net
      cash used in investing activities
                                                
                                                
                                                (439
                                                )
                                                
                                                
                                                (302
                                                )FinancingNet
      proceeds from sale of common stock
                                                
                                                
                                                12
                                                
                                                
                                                
                                                —Proceeds
      from issuance of notes payable
                                                
                                                
                                                500
                                                
                                                
                                                
                                                1,959Borrowings
      of revolving credit facilities, net
                                                
                                                
                                                78
                                                
                                                
                                                
                                                1,881Principal
      repayment of long-term debt
                                                
                                                
                                                (686
                                                )
                                                
                                                
                                                (1,411
                                                )Debt
      issuance costs
                                                
                                                
                                                —
                                                
                                                
                                                
                                                (21
                                                )Restricted
      cash related to credit facilities
                                                
                                                
                                                (1
                                                )
                                                
                                                
                                                1Net
      cash provided by (used in) continuing financing
    activities...
                                                
                                                
                                                (97
                                                )
                                                
                                                
                                                2,409Net
      cash used in discontinued operations
                                                
                                                
                                                (8
                                                )
                                                
                                                
                                                (6
                                                )Net
      cash provided by (used in) financing activities...
                                                
                                                
                                                (105
                                                )
                                                
                                                
                                                2,403Effect
      of exchange rate on cash
                                                
                                                
                                                (557
                                                )
                                                
                                                
                                                725Net
      change in cash and equivalents
                                                
                                                
                                                (412
                                                )
                                                
                                                
                                                (54
                                                )Cash
      and equivalents, beginning of period
                                                
                                                
                                                1,635
                                                
                                                
                                                
                                                1,577Cash
      and equivalents, end of period
                                                
                                                $
                                                1,223
                                                
                                                
                                                $
                                                1,523Supplemental
      disclosure of cash flow informationCash
      paid for interest
                                                
                                                $
                                                137
                                                
                                                
                                                $
                                                123Assets
      acquired under lease arrangements
                                                
                                                $
                                                371
                                                
                                                
                                                $
                                                —Issuance
      of restricted stock
                                                
                                                $
                                                —
                                                
                                                
                                                $
                                                114Issuance
      of common stock to settle liabilities
                                                
                                                $
                                                370
                                                
                                                
                                                $
                                                214Common
      stock issued with financing
                                                
                                                $
                                                —
                                                
                                                
                                                $
                                                1,013Fair
      value of warrant modifications and issuances (in connection with
      financing)
                                                
                                                $
                                                38
                                                
                                                
                                                $
                                                816




See
notes to unaudited condensed consolidated financial statements.




5


STOCKERYALE,
INC.




NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




(1)
ORGANIZATION AND BASIS OF PRESENTATION




The
accompanying unaudited condensed consolidated financial statements have been
prepared by StockerYale, Inc. (the “Company”) and, in the opinion of management,
reflect all adjustments of a normal recurring nature necessary for a fair
statement of the results of operations for the three and nine month periods
ended September 30, 2009 and 2008; the financial position at September 30,
2009 and December 31, 2008, and the cash flows for the nine month
periods ended September 30, 2009 and 2008. These interim results are not
necessarily indicative of results for a full year or any other interim
period.




The
accompanying consolidated financial statements and notes are condensed as
permitted by Form 10-Q and do not contain certain information included in the
annual financial statements and notes of the Company. These statements are
prepared on a going concern basis, which contemplates the realization of assets
and satisfaction of liabilities in the normal course of business. The Company’s
continuation as a going concern is dependent on its ability to generate
sufficient cash flow to meet its obligations on a timely basis through improved
operations and/or additional financing. These unaudited condensed consolidated
financial statements and notes should be read in conjunction with the
consolidated financial statements and notes included in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2008.




The
Company took a number of actions during 2008 and the first nine months of 2009
to restructure its debt, improve its operational efficiency and its overall
financial performance.




On
October 13, 2009, the Company and its wholly owned subsidiary, StockerYale
Canada, Inc. (“SYC”), sold substantially all North American assets and rights of
SYC and the Company's specialty optical fiber product line to Coherent Inc. The
sale price consisted of a cash payment of $15,000,000 and the assumption of
certain liabilities, including approximately $3,400,000 of accounts payable,
accrued expenses and other obligations associated with the sold
assets.  Proceeds from the transaction were used to pay off in full
all obligations owed to Laurus Master Fund, Ltd. and its related entities
(approximately $7,900,000 including fees), fees related to the transaction of
approximately $850,000, the settlement of various obligations of approximately
$950,000, and for working capital and general corporate purposes for the
Company's ongoing and future operations.  The Company expects to
record a gain in the fourth quarter relating to the consummated
transaction.  In addition, the current and previous financial
statements have been restated to present the entities sold as discontinued
operations (see Note 15).




The
Company will continue to operate its LED systems and Photonic Products
businesses, which are based in Ireland and the United Kingdom. In the past, the
Company reported three segments: lasers, Photonic Products, and optical
components. All of the optical component segment and a portion of the laser
segment were sold.




As a
result of the Company's reduced debt levels and its focus on two core business
segments, management believes that it has adequate capital to sustain current
operations.




On
October 7, 2009, the Company and its wholly owned subsidiary, StockerYale UK
Limited, amended the bonds held by the former shareholders of Photonic Products
Ltd. which were originally scheduled to mature on October 31,
2009.  The amendment deferred principal amounts originally due October
31, 2009 to a monthly payment schedule over the period from November 1, 2009
through October 31, 2010 and increased the interest rate.  See
footnote (14).




The
Company’s common stock trades on the OTC Bulletin Board under the ticker symbol
“STKR.OB.”




(2) USE
OF ESTIMATES




The
preparation of financial statements in conformity with generally accepted
accounting principles (GAAP) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of income and expenses during the reporting
periods. Actual results in the future could vary from the amounts derived from
management’s estimates and assumptions.


6




(3)
RECENT ACCOUNTING PRONOUNCEMENTS





Revenue Recognition.  In
October 2009, the Financial Accounting Standards Board (FASB) issued
amended revenue recognition guidance for arrangements with multiple
deliverables. The new guidance eliminates the residual method of revenue
recognition and allows the use of management’s best estimate of selling price
for individual elements of an arrangement when vendor specific objective
evidence (VSOE), vendor objective evidence (VOE) or third-party evidence (TPE)
is unavailable. For the company, this guidance is effective for all new or
materially modified arrangements entered into on or after January 1, 2011
with earlier application permitted as of the beginning of a fiscal year. Full
retrospective application of the new guidance is optional. The company is
currently assessing its implementation of this new guidance, but does not expect
a material impact on the Consolidated Financial Statements.





Business
Combinations.  In December 2007, the Financial Accounting Standards
Board (“FASB”) issued new guidance on business combinations.  This guidance
establishes principles and requirements for how the Company: 
(1) recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree; (2) recognizes and measures the goodwill acquired in the business
combination or a gain from a bargain purchase; and (3) determines what
information to disclose to enable users of the financial statements to evaluate
the nature and financial effects of the business combination.  The business
combinations guidance also requires acquisition-related transaction and
restructuring costs to be expensed rather than treated as part of the cost of
the acquisition.  This guidance applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15,
2008.  The Company adopted the business combination guidance on
January 1, 2009 and will only impact the Company if any acquisitions
are completed subsequently.




In April
2009, the FASB issued guidance relating to accounting for assets acquired and
liabilities assumed in a business combination that arise from
contingencies.  This pronouncement amends the guidance on business
combinations to clarify the initial and subsequent recognition, subsequent
accounting, and disclosure of assets and liabilities arising from contingencies
in a business combination.  This pronouncement requires that assets
acquired and liabilities assumed in a business combination that arise from
contingencies be recognized at fair value, as determined in accordance with the
fair value measurements guidance, if the acquisition-date fair value can be
reasonably estimated.  If the acquisition-date fair value of an asset or
liability cannot be reasonably estimated, the asset or liability would be
measured at the amount that would be recognized in accordance with the
accounting guidance for contingencies.  This pronouncement became effective
for the Company as of January 1, 2009, and the provisions of the
pronouncement are applied prospectively to business combinations with an
acquisition date on or after the date the guidance became effective.  The
adoption of this pronouncement did not have a material impact on the Company’s
financial position or results of operations.




Fair Value Measurements and
Disclosures.  In April 2009, the FASB issued additional guidance on
fair value measurements and disclosures.  Fair value is defined as the
price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants under current market
conditions.  The new guidance requires an evaluation of whether there has
been a significant decrease in the volume and level of activity for the asset or
liability in relation to normal market activity for the asset or
liability.  If there has been a significant decrease in activity,
transactions or quoted prices may not be indicative of fair value and a
significant adjustment may need to be made to those prices to estimate fair
value.  Additionally, an entity must consider whether the observed
transaction was orderly (that is, not distressed or forced).  If the
transaction was orderly, the obtained price can be considered a relevant,
observable input for determining fair value.  If the transaction is not
orderly, other valuation techniques must be used when estimating fair
value.  This guidance, which was applied by the Company prospectively as of
June 30, 2009, did not impact the Company’s results of operations, cash
flows or financial position.




In August
2009, the FASB issued additional guidance on the fair value measurement of
liabilities.  The new guidance provides clarification on the measurement
and reporting of a liability in circumstances in which a quoted price in an
active market for the identical liability is not available.  This guidance
is effective for the reporting period beginning October 1,
2009.




Derivatives and
Hedging.  In March 2008, the FASB issued new disclosure requirements
for derivativeinstruments and hedging
activities.  The new disclosure requirements will provide users of
financial statements with an enhanced understanding of:  (1) how and
why an entity uses derivative instruments; (2) how derivative instruments
and related hedged items are accounted for; and (3) how derivative
instruments and related hedged items affect an entity’s financial position,
financial performance and cash flows.  This guidance requires qualitative
disclosures about objectives and strategies for using derivatives, quantitative
disclosures about fair value amounts of and gains and losses on derivative
instruments and disclosures about credit-risk-related contingent features in
derivative instruments.  This statement applies to all entities and all
derivative instruments.  This guidance is effective for financial
statements issued for fiscal years and interim periods beginning after
November 15, 2008.  The Company adopted this guidance on
January 1, 2009 and it did not impact the Company’s results of operations,
cash flows or financial position.


7





In
June 2008, the FASB ratified the consensus reached by the Emerging Issues Task
Force (EITF) which clarifies the determination of whether an instrument (or an
embedded feature) is indexed to an entity’s own stock, which would qualify as a
scope exception to derivative accounting. The Company adopted this guidance as
of January 1, 2009 and it did not have a material impact on the Company’s
consolidated financial statements.





Financial
Instruments. In April 2009, the FASB
issued guidance to require disclosures about fair value of financial instruments
in interim financial statements, in addition to the annual financial statements
as already required.  This guidance, which was applied by the Company
prospectively as of June 30, 2009, did not have a material impact on the
Company’s results of operations, cash flows or financial position.





Subsequent
Events.  In May 2009, the FASB issued guidance on subsequent events
which establishes general standards of accounting for and disclosure of events
that occur after the balance sheet date but before financial statements are
issued or are available to be issued.  This guidance is based on the same
principles as currently exist in auditing standards and was issued by the FASB
to include accounting guidance that originated as auditing standards into the
body of authoritative literature issued by the FASB.  The standard
addresses the period after the balance sheet date during which management of a
reporting entity should evaluate events or transactions that may occur for
potential recognition or disclosure in the financial statements, the
circumstances under which an entity should recognize events or transactions
occurring after the balance sheet date in its financial statements and the
disclosures that an entity should make about events or transactions that
occurred after the balance sheet date.  The Company adopted this guidance
during the quarterly period ended June 30, 2009.  For the quarter
ended September 30, 2009, the Company evaluated subsequent events through
November 19, 2009, which wasthe date the
accompanying financial statements were available to be
issued.




(4) LOSS
PER SHARE




The
Company calculates basic and diluted net loss per common share by dividing the
net loss applicable to common stockholders by the weighted average number of
shares of common stock outstanding. Common stock equivalents that were
outstanding as of September 30, 2009 and 2008, but were considered anti-dilutive
securities and excluded from the diluted net income per share calculations, were
as presented below:




September
      30,2009
                              
                              
                              2008Options
      outstanding
                              
                              
                              5,203,159
                              
                              
                              
                              4,167,189Warrants
      outstanding
                              
                              
                              8,522,850
                              
                              
                              
                              7,349,383Unvested
      restricted stock grants
                              
                              
                              760,221
                              
                              
                              
                              1,457,978Total
      potentially dilutive common stock equivalents
                              
                              
                              14,486,230
                              
                              
                              
                              12,974,550




(5)
REVENUE RECOGNITION




The
Company recognizes revenue from sales of products and funded research and
development and product development for commercial companies and government
agencies. The Company recognizes revenue from product sales at the time of
shipment and when persuasive evidence of an arrangement exists, performance of
the Company’s obligation is complete, the price to the buyer is fixed or
determinable, and collectability is reasonably assured. The Company’s custom
products are supplied to original equipment manufacturers and produced in
accordance with a customer-approved design. Custom product revenue is recognized
when the criteria for acceptance has been met. Title to the product
generally passes upon shipment, as products are generally shipped FOB shipping
point. In certain limited situations, distributors have the right to return
products. Such rights of return have not precluded revenue recognition because
the Company has a long history with such returns and accordingly is able to
estimate a reserve for their cost.





Revenues
from funded research and development and product development is recognized based
on contractual arrangements, which may be based on cost reimbursement or fixed
fee-for-service models. Revenue from reimbursement contracts is recognized as
services are performed and collectability is reasonably assured. On fixed-price
contracts, revenue is generally recognized on a percentage-of completion basis
based on proportion of costs incurred to the total estimated costs of the
contract or under the proportional method. Over the course of a fixed-price
contract, the Company routinely evaluates whether revenue and profitability
should be recognized in the current period. The Company estimates the
proportional performance on their fixed-price contracts on a monthly basis
utilizing hours incurred to date as a percentage of total estimated hours to
complete the project. If the Company does not have a sufficient basis to measure
progress toward completion, revenue is recognized upon completion of
performance. This method is used because reasonably dependable estimates of
costs and revenue earned can be made, based on historical experience and
milestones identified in any particular contract. When the current estimates of
total contract revenue and contract costs indicate a loss, a provision for the
entire loss on the contract is recorded.


8




If a
contract involves the provision of multiple elements and the elements qualify
for separation, total estimated contract revenue is allocated to each element
based on the relative fair value of each element provided. The amount of revenue
allocated to each element is limited to the amount that is not contingent upon
the delivery of another element in the future. Revenue is then recognized for
each element as described above.




(6)
WARRANTY




The
Company provides warranties on most of its products for periods of between one
to two years. The warranty is limited to the cost of the product and the Company
will repair or replace the product as required. The Company monitors the actual
warranty repair costs and trends versus the reserve as a percent of sales. The
Company periodically adjusts the warranty provision based on the actual
experience and for any particular known instances.




Warranty
Reserves:





Nine
      months Ended September 302009
                              
                              
                              2008In thousandsBalance
      at December 31
                              
                              $
                              116
                              
                              
                              $
                              98Charges
      to costs and expenses
                              
                              
                              25
                              
                              
                              
                              41Account
      write-offs and other deductions
                              
                              
                              (37
                              )
                              
                              
                              (12
                              )Balance
      at September 30
                              
                              $
                              104
                              
                              
                              $
                              127





(7)
FINANCIAL INSTRUMENTS





The
Company’s financial instruments consist mainly of cash and cash equivalents,
accounts receivable, short-term debt, accounts payable and long-term debt. The
estimated fair value of these financial instruments approximates their carrying
value due to the short-term maturity of certain instruments and the variable
interest rates associated with certain instruments, which have the effect of
re-pricing such instruments regularly. As of September 30, 2009, the Company
estimated the fair value of long term fixed rate debt to be approximately
$12,033,000 compared to its carrying value of $11,272,000.





(8) FAIR
VALUE OF WARRANT LIABILITIES





On
October 26, 2006, the Company issued warrants for the purchase of 2,375,000
shares of the Company’s common stock, which have exercise price reset features.
These warrants have an exercise price of $1.15 and expire in October 2016.
The Company adopted FASB guidance on January 1, 2009 under which certain
warrants that were previously treated as stockholders’ equity under the
derivative treatment exemption were no longer eligible for equity
treatment.  Effective January 1, 2009, the fair value of these common
stock purchase warrants was reclassified from equity to liability status as if
these warrants were treated as a derivative liability since their date of issue
in October 2006. On January 1, 2009, the Company reclassified from
additional paid-in capital, as a cumulative effect adjustment, $1.2 million
to beginning retained earnings and $0.3 million to a long-term warrant
liability.  The Company recognized a gain of approximately $92,000
from the change in fair value of these warrants for the nine months ended
September 30, 2009.





The
common stock purchase warrants were not issued with the intent of effectively
hedging any future cash flow, fair value of any asset, liability or any net
investment in a foreign operation. The warrants do not qualify for hedge
accounting, and all future changes in the fair value of these warrants will be
recognized currently in earnings until the warrants are exercised or
expire.





These
common stock purchase warrants do not trade in an active securities market, and
the Company estimated the fair value of these warrants using the Black-Scholes
option pricing model using the following assumptions:


9





September
      30,
                        2009
                      
                      
                      January
      1,
                        2009Volatility
                      
                      
                      106.7
                      %
                      
                      
                      101.4
                      %Expected
      option life
                      
                      7.1
      years
                      
                      
                      7.8
      yearsInterest
      rate (risk free)
                      
                      
                      3.22
                      %
                      
                      
                      2.46
                      %Dividends
                      
                      $
                      0.0
                      
                      
                      $
                      0.0





The
Company uses a three-tier fair value hierarchy to classify and disclose all
assets and liabilities measured at fair value on a recurring basis, as well as
assets and liabilities measured at fair value on a non-recurring basis, in
periods subsequent to their initial measurement.  These tiers
include:  Level 1, defined as quoted market prices in active markets
for identical assets or liabilities; Level 2, defined as inputs other than
Level 1 that are observable, either directly or indirectly, such as quoted
prices for similar assets or liabilities, quoted prices in markets that are not
active, model-based valuation techniques for which all significant assumptions
are observable in the market, or other inputs that are observable or can be
corroborated by observable market data for substantially the full term of the
assets or liabilities; and Level 3, defined as unobservable inputs that are
not corroborated by market data.





The
warrant liabilities are the Company’s only liabilities measured at fair value on
a recurring basis and are summarized as follows (unaudited):


In
Thousands


September
      30,Level
      1
                          
                          
                          Level
      2
                          
                          
                          Level
      3
                          
                          
                          2009Fair
      value of warrants
                          
                          $
                          -
                          
                          
                          $
                          199
                          
                          
                          $
                          -
                          
                          
                          $
                          199Total
                          
                          $
                          -
                          
                          
                          $
                          199
                          
                          
                          $
                          -
                          
                          
                          $
                          199




Determining
which category an asset or liability falls within the hierarchy requires
significant judgment. The Company evaluates its hierarchy disclosures each
quarter.




(9)
INVENTORIES




Inventories
are stated at the lower of cost (first-in, first-out basis) or market and
include materials, labor and overhead. Inventories are as follows:




September
      30,
                                              2009
                                            
                                            
                                            December 31,
                                              2008In
      thousandsFinished
      goods
                                            
                                            $
                                            220
                                            
                                            
                                            $
                                            198Work-in-process
                                            
                                            
                                            44
                                            
                                            
                                            
                                            130Raw
      materials
                                            
                                            
                                            1,151
                                            
                                            
                                            
                                            1,090Net
      inventories
                                            
                                            $
                                            1,415
                                            
                                            
                                            $
                                            1,418




(10)
STOCK BASED COMPENSATION PLANS AND STOCK-BASED COMPENSATION EXPENSE




The
Company has stock-based compensation plans for its employees, officers, and
directors. The plans permit the grant of a variety of awards with various terms
and prices as determined by the Governance, Nominating and Compensation
Committee (“GNCC”) of the Company’s Board of Directors.  The grants
vest over terms of two to four years and are priced at fair market value or in
certain circumstances 110% of the fair market value, of the common stock on the
date of the grant. The options are generally exercisable after the period
specified in the option agreement, but no option may be exercised after 10 years
from the date of grant.




Additionally,
in the case of incentive stock options, the exercise price may not be less than
100% of the fair market value of the Company’s common stock on the date of
grant. However, there is an exception in the case of a grant to an employee who
owns or controls more than 10% of the combined voting power of all classes of
the Company’s stock or the stock of any parent or subsidiary. In that case, the
exercise price shall not be less than 110% of the fair market value on the date
of grant. In the case of non-qualified stock options, the exercise price shall
not be less than the fair market value of the Company’s common stock on the date
of grant, except in the case of a grant to an independent director, in which
case the exercise price shall be equal to fair market value determined by
reference to market quotations on the date of grant.


10




The
Company estimates the fair value of stock options using the Black-Scholes option
pricing model.




Stock
Option Awards




The fair
value of each option grant is estimated using the Black-Scholes option pricing
model at the date of the grant. The fair value is then amortized on a
straight-line basis over the requisite service periods of the awards, which is
generally the vesting period. Use of a valuation model requires management to
make certain assumptions with respect to selected model inputs. Expected
volatility was calculated based on the historical volatility of the Company’s
stock, at the time of the award. The average expected option term was estimated
using the simplified method for estimating purposes. The risk-free interest rate
is based on U.S. Treasury zero-coupon issues assumed at the date of grant and no
dividends were assumed in the calculation. The compensation expense recognized
for all equity-based awards is net of estimated forfeitures for the nine months
ending September 30, 2009 and 2008. Forfeitures are estimated based on the
historical trends. There were 2,906,996 options granted during the nine months
ended September 30, 2009. There were 2,046,572 options granted in the nine
months ended September 30, 2008.




On
January 16, 2009, the GNCC adopted a stock option incentive program for 2009.
The GNCC adopted a policy of granting performance-based options to purchase
shares of the Company’s common stock to various executive officers and key
employees. All options shall vest and become exercisable on the date the Company
publicizes its earnings press release regarding fiscal 2009 results, if the
stated performance goal is met. The Company records the related expense, if any,
over the requisite service period, and assesses the probability of attaining the
performance goals at each reporting date.  If the performance goals
are not met, the options will terminate. Options for a total of 1,865,000 shares
of common stock were granted under this performance-based program on
January 16, 2009.  Management has assessed the likelihood of
meeting the performance target, and in its opinion it is unlikely that they will
do so.  The Company did not incur any stock compensation expense
related to this plan in the three or nine month periods ended September 30,
2009.




On
March 17, 2008, the GNCC adopted a stock option incentive program for
2008.  Options to purchase a total of 1,522,300 shares of common stock
were granted under this performance-based program on March 17, 2008, all of
which were forfeited when the performance goals were not met. As the performance
goals were not met, the options immediately terminated and the previously
accrued compensation cost of approximately $490,000 was reversed in the fourth
quarter of 2008, resulting in no net compensation recorded in 2008 related to
the program.




The fair
value of options at the date of grant was estimated using the Black-Scholes
option pricing model. The assumptions for grants during the nine months ended
September 30, 2009 and 2008 were as follows:





Nine
      months Ended
                    September
      30,
                    2009
                
                
                Nine
      months Ended
                    September
      30,
                    2008Volatility
                
                
                101.4%-104.8
                %
                
                
                98.88
                %Expected
      option life
                
                6.08
      years
                
                
                5.65
      yearsInterest
      rate (risk free)
                
                
                1.54%-2.86
                %
                
                
                2.54
                %Dividends
                
                
                N/A
                
                
                
                N/AWeighted
      average grant date fair value
                
                $
                0.12
                
                
                $
                0.41




A summary
of option activity as of September 30, 2009 and changes during the first nine
months of 2009 is presented below:




Options
                        Outstanding
                      
                      
                      Weighted
                        Average
                        Exercise Price
                        per
      Share
                      
                      
                      Weighted
                        Average
                        Remaining
                        Contractual Term
                        (in
      Years)
                      
                      
                      Aggregate Intrinsic
                        Value
                        (in thousands)Balance
      at December 31, 2008
                      
                      
                      2,987,889
                      
                      
                      $
                      3.45
                      
                      
                      
                      4.58
                      
                      
                      $
                      —Granted
                      
                      
                      2,906,996
                      
                      
                      
                      0.15
                      
                      
                      
                      —
                      
                      
                      
                      —Exercised
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Cancelled
                      
                      
                      (691,726
                      )
                      
                      
                      1.73
                      
                      
                      
                      —
                      
                      
                      
                      —Balance
      at September 30, 2009
                      
                      
                      5,203,159
                      
                      
                      $
                      1.88
                      
                      
                      
                      7.28
                      
                      
                      $
                      16Vested
      and Exercisable at September 30, 2009
                      
                      
                      1,743,651
                      
                      
                      $
                      4.77
                      
                      
                      
                      3.33
                      
                      
                      $
                      —


11




As of
September 30, 2009, there was a total unrecognized compensation cost related to
continuing operations of approximately $141,000 related to non-vested stock
options outstanding, excluding performance options. The cost is expected to be
recognized over the next 1.48 years. There were no options exercised in the nine
months ended September 30, 2009 and September 30, 2008.




Restricted
Share Awards (“RSAs”)




The
Company has awarded to a number of employees restricted shares of the Company’s
common stock. The RSAs vest in equal annual installments over a period of four
years. The fair market value of the RSAs is based on the fair market value per
share of the Company’s common stock on the date of grant and is expensed over
the vesting period. During the quarter ended September 30, 2009, no shares of
restricted stock were issued and 522,834 shares of previously issued restricted
stock vested. During the nine months ended September 30, 2008, no shares of
restricted stock were issued and 600,020 shares of previously issued restricted
stock vested.




A summary
of the status of the Company’s RSAs as of September 30, 2009 and changes during
the first nine months is presented below:




Shares
                          
                          
                          Weighted
                            Average
                            Grant-Date Fair ValueNon-vested
      at December 31, 2008
                          
                          
                          1,368,394
                          
                          
                          $
                          1.17Granted
                          
                          
                          -
                          
                          
                          
                          -Vested
                          
                          
                          (522,834
                          )
                          
                          
                          1.13Cancelled
                          
                          
                          (85,339
                          )
                          
                          
                          1.35Non-vested
      at September 30, 2009
                          
                          
                          760,221
                          
                          
                          $
                          1.19




As of
September 30, 2009, there was a total unrecognized compensation cost related to
continuing operations of approximately $541,000 related to non-vested RSAs. The
Company expects to recognize the costs over the next 1.53 years.




(11)
COMPREHENSIVE LOSS




Comprehensive
income (loss) is defined as the change in equity of a business enterprise during
a period from transactions and other events and circumstances from non-owner
sources.  The following table summarizes all components of the
Company’s comprehensive income (loss).




Three
      Months Ended
                            September
      30,
                          
                          
                          Nine
      months Ended
                            September
      30,2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008In
      thousandsNet
      loss
                          
                          $
                          (1,450
                          )
                          
                          $
                          (3,099
                          )
                          
                          $
                          (3,775
                          )
                          
                          $
                          (7,549
                          )Other
      comprehensive income (loss):Cumulative
      translation adjustment
                          
                          
                          261
                          
                          
                          
                          (186
                          )
                          
                          
                          110
                          
                          
                          
                          (242
                          )Comprehensive
      loss
                          
                          $
                          (1,189
                          )
                          
                          $
                          (3,285
                          )
                          
                          $
                          (3,665
                          )
                          
                          $
                          (7,791
                          )




12




(12)
GOODWILL





The
changes in the carrying amount of goodwill for the nine months ended September
30, 2009 are as follows:




September
      30, 2009In
      thousandsBalance
      at January 1, 2009
                              
                              $
                              4,410Effect
      of exchange rate
                              
                              
                              389Balance
      at September 30, 2009
                              
                              $
                              4,799





There
were no goodwill impairment losses recorded during the three months or nine
months ended September 30, 2009.





(13)
INTANGIBLE ASSETS




Intangible
assets consist of trademarks, acquired patents and patented technologies,
distributor and customer relationships and related contracts, trade and brand
names and associated logos, technology design and programs, non-compete
agreements and other intangible assets. There are no intangible assets with
indefinite lives. Acquired patented technologies and trademarks are amortized
over their estimated useful lives of between 3 - 16 years.




Gross
carrying amounts and accumulated amortization of intangible assets were as
follows as of September 30, 2009 for each intangible asset class.




Gross Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Carrying Value(in thousands)Acquired
      patents, patented technology and purchased technology
                    
                    $
                    3,034
                    
                    
                    $
                    (2,994
                    )
                    
                    $
                    40Trademarks
                    
                    
                    471
                    
                    
                    
                    (471
                    )
                    
                    
                    —Acquired
      trade name
                    
                    
                    500
                    
                    
                    
                    (166
                    )
                    
                    
                    334Acquired
      customer contracts and relationships
                    
                    
                    2,030
                    
                    
                    
                    (1,117
                    )
                    
                    
                    913Acquired
      non-compete agreement
                    
                    
                    657
                    
                    
                    
                    (584
                    )
                    
                    
                    73Acquired
      technology design and programs
                    
                    
                    343
                    
                    
                    
                    (114
                    )
                    
                    
                    229Other
                    
                    
                    118
                    
                    
                    
                    (73
                    )
                    
                    
                    45Total
                    
                    $
                    7,021
                    
                    
                    $
                    (5,630
                    )
                    
                    $
                    1,391




Gross
carrying amounts and accumulated amortization of intangible assets were as
follows as of December 31, 2008 for each intangible asset
class.




Gross Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Carrying Value(in thousands)Acquired
      patents, patented technology and purchased technology
                    
                    $
                    3,039
                    
                    
                    $
                    (2,977
                    )
                    
                    $
                    62Trademarks
                    
                    
                    471
                    
                    
                    
                    (471
                    )
                    
                    
                    -Acquired
      trade name
                    
                    
                    438
                    
                    
                    
                    (118
                    )
                    
                    
                    320Acquired
      customer contracts and relationships
                    
                    
                    1,779
                    
                    
                    
                    (796
                    )
                    
                    
                    983Acquired
      non-compete agreement
                    
                    
                    576
                    
                    
                    
                    (416
                    )
                    
                    
                    160Acquired
      technology design and programs
                    
                    
                    301
                    
                    
                    
                    (82
                    )
                    
                    
                    219Other
                    
                    
                    104
                    
                    
                    
                    (53
                    )
                    
                    
                    51Total
                    
                    $
                    6,708
                    
                    
                    $
                    (4,913
                    )
                    
                    $
                    1,795




Amortization
expense from continuing operations of intangible assets was approximately
$198,000 and $228,000 for the three months ended September 30, 2009 and 2008,
and approximately $559,000 and $809,000 for the nine months ended September 30,
2009 and 2008.




As of
September 30, 2009, the estimated future amortization expense of intangible
assets, in thousands, is as follows:




2009
                    
                    
                    2010
                    
                    
                    2011
                    
                    
                    2012
                    
                    
                    2013
                    
                    
                    2014
      &
                      thereafterAmortization
      expense of intangible assets
                    
                    $
                    132
                    
                    
                    $
                    400
                    
                    
                    $
                    334
                    
                    
                    $
                    186
                    
                    
                    $
                    186
                    
                    
                    $
                    153




13




(14)
DEBT




A summary
of the Debt Obligations of the Company is as follows:


September
      30,
                                
                                
                                December
      31,2009
                                
                                
                                2008In
      thousandsAcquired
      note payable to Barclay’s Bank, maturing on November 16, 2009 and
      having an interest rate of 2.5% above Barclay’s base rate (3.0% at
      September 30, 2009).
                                
                                $
                                2
                                
                                
                                $
                                22Borrowings
      under Revolving Credit facility with Barclay’s Bank Sales Financing, due
      on demand, with an interest rate of 2.65% above Barclay’s base rate (3.15%
      as of September 30, 2009).
                                
                                
                                550
                                
                                
                                
                                710Borrowings
      under line of credit with Laurus Master Fund, Ltd., due on demand, with an
      interest rate of 10% at September 30, 2009.
                                
                                
                                3,468
                                
                                
                                
                                3,159Notes
      Payable to Laurus Master Fund, Ltd. and affiliates maturing
on
                                  June
      30, 2010, with an interest rate 12% at September 30, 2009, net of
      unamortized discount of $190 at September 30, 2009 and $460 at December
      31, 2008.
                                
                                
                                2,735
                                
                                
                                
                                2,690Note
      Payable to an affiliate of Laurus Master Fund, Ltd. maturing
      on
                                  June
      30, 2010, with an interest rate of 12%, net of unamortized discount of $27
      at September 30, 2009 and $90 at December 31, 2008.
                                
                                
                                640
                                
                                
                                
                                676Senior
      Fixed Rate Secured Bond to a private investor with an interest rate
      of  12%, maturing on July 30, 2011 net of unamortized
      discount of $117 at September 30, 2009 and $166 at December 31,
      2008
                                
                                
                                2,383
                                
                                
                                
                                1,028Senior
      Fixed Rate Secured Bond payable to a private investor, maturing on
      October 31, 2011 with an interest rate of 10%, net of unamortized
      discount of $539 at September 30, 2009 and $798 at December 31,
      2008.
                                
                                
                                2,563
                                
                                
                                
                                3,674Bonds
      payable to the former stockholders of Photonic Products Ltd. maturing on
      October 31, 2009, with an interest rate of LIBOR plus 1%, (1.29% at
      September 30, 2009).
                                
                                
                                2,400
                                
                                
                                
                                2,400Sub-total
      debt
                                
                                
                                14,741
                                
                                
                                
                                14,359Less
      – lines of credit / revolver
                                
                                
                                (4,018
                                )
                                
                                
                                (3,869
                                )Less—Current
      portion of long-term debt, net of discount
                                
                                
                                (6,934
                                )
                                
                                
                                (4,118
                                )Total
      long-term debt
                                
                                $
                                3,789
                                
                                
                                $
                                6,372




Laurus
Master Fund




On
October 14, 2009, the Company paid in full its obligations to Laurus Master
Fund, Ltd. and its affiliates described below. As discussed in Note 1,
approximately $7,900,000 of the proceeds from the October 13, 2009 sale were
used to repay approximately $7,060,000 ($6,843,000 outstanding as of September
30, 2009) of borrowings under the line of credit and notes payable with Laurus
along with $645,000 of related deferred fees and $143,000 of accrued interest on
October 14, 2009.




Line of Credit
Agreement:




On
June 28, 2006, the Company entered into a Security and Purchase Agreement,
as amended at various times through October 13, 2009, with Laurus Master Fund,
Ltd (“Laurus”), establishing a  three-year revolving line of credit of
up to $4 million limited to qualifying receivables and inventories as defined in
the agreement. The Security and Purchase Agreement granted a security interest
in and lien upon all of the Company’s assets in favor of Laurus. The note could
be prepaid at any time without penalty or premium.




On July
28, 2009, the Company entered into a Waiver and Amendment with Laurus and its
affiliates, dated as of July 16, 2009, to amend the line of credit under the
Security and Purchase agreement and the Term Note Payable.  The Waiver
and Amendment extended the due date of the line of credit from June 28, 2009 to
October 15, 2009 and revised the interest rate on the outstanding balance to 10%
per annum. As discussed above, this obligation was included in the
$7,060,000 of borrowings repaid on October 14,2009 from the proceeds of the
October 13, 2009 sale.




14




On April
16, 2009, the Company and Laurus entered into an agreement, effective March 31,
2009, to extend the overadvance by amending the note.  The amendment
grants a fee, payable in cash, to Laurus of $400,000 on June 30,
2010.    This $400,000 has been expensed over the three
month period of the extension.





At
September 30, 2009, $3,468,007 was outstanding under the line of credit, which
included a $500,000 overadvance, and was classified as lines of
credit/revolver.  The credit line was overdrawn at September 30, 2009
by approximately $382,000, which was due and payable.





At
December 31, 2008, $3,159,324 was outstanding under the line of credit,
which included a $500,000 overadvance, and was classified as lines of
credit/revolver. The credit line availability at December 31, 2008 was
approximately $235,000.





Term Note
Payable:




On
December 30, 2005, under the terms of a Securities Purchase Agreement, as
amended at various times through October 13, 2009, the Company issued a secured
term note in the aggregate principal amount of $4 million to Laurus. The note
was collateralized by certain assets of the Company.


On July
28, 2009, the Company entered into a Waiver and Amendment with Laurus and its
affiliates, dated as of July 16, 2009, to amend the line of credit under the
Security and Purchase agreement and the Term Note Payable.  The Waiver
and Amendment allowed the Company to defer principal payments between June 1,
2009 through October 1, 2009 which was due and payable on October 15, 2009 and
revised the interest rate on the outstanding balances to 12% per annum. As
discussed above, this obligation was included in the $7,060,000 of
borrowings repaid on October 14,2009 from the proceeds of the October 13,
2009 sale.




At
September 30, 2009, $3,591,673 was outstanding under the combined notes, all of
which has been classified as short-term debt and reported net of $216,102 of
unamortized debt discount.





At December 31, 2008, $3,916,671
was outstanding under the combined notes, which was classified as $1,408,326
short-term debt and $2,508,345 long-term debt and reported net of $550,794 of
unamortized debt discount, which was classified as $418,176 short-term and
$132,618 long-term.




Private
Investor Notes and Bonds




Photonic
Products Ltd. Financing




On
October 31, 2006, StockerYale (UK) Ltd. issued a 10% Senior Fixed Rate
Secured Bond, as amended at various times, in the original principal amount of
$4,750,000 to Eureka Interactive Fund Limited. The bond is due on
October 31, 2011. StockerYale (UK) Ltd. agreed to make payments of
principal and interest over the term; however, an amount equal to 50% of the
original principal sum of $4,750,000 will be paid on October 31, 2011. The
outstanding principal on the bond accrues interest at an annual rate of 10%.
StockerYale (UK) Ltd. may prepay the bond at any time, in whole or in part,
without penalty or premium. The bond is secured by all of the equity interests
of Photonic Products Ltd. owned by StockerYale (UK) Ltd. The Company used the
net proceeds to make the cash payment for the acquisition of Photonic Products
Ltd. The remaining proceeds were used for transaction fees and working
capital.  On August 16, 2007, the Eureka Interactive Fund Limited
transferred this bond to a private investor.




At
September 30, 2009, $3,101,881 remained outstanding under the combined note
which has been classified as $740,091 short-term debt and $2,361,790 long- term
debt and reported net of $539,173 of unamortized debt discount, which has been
reported as $300,758 as short-term and $238,415 as long-term.  On
September 30, 2009, the Company was $158,000 (principal and interest) in
arrears.




At
December 31, 2008, $4,471,926 remained outstanding under the combined note
which was classified as $740,091 short-term debt and $3,731,835 long- term debt
and reported net of $798,251 of unamortized debt discount, which was reported as
$300,758 as short-term and $238,415 as long-term.


15




StockerYale
Ireland Senior Fixed Rate Secured Bond




On
July 24, 2008, StockerYale (IRL) Ltd. issued a three-year 12% Senior Fixed
Rate Secured Bond, as amended at various times, to a private investor in the
original principal amount of €935,000 ($1,472,905 at July 24, 2008) secured by
all of the assets of StockerYale (IRL) Ltd. The bond matures on July 30,
2011. StockerYale (IRL) Ltd. agreed to make payments of principal and interest
of approximately €31,000 over the term beginning August 30, 2008. The
outstanding principal on the bond accrues interest at an annual rate of 12%.
StockerYale (IRL) Ltd. may prepay the bond at any time, in whole or in part,
without penalty or premium. The Company used the net proceeds for working
capital.




At
September 30, 2009, $2,499,840 remained outstanding under the bond, which has
been classified as $804,222 short-term debt and $1,695,618 long-term debt and
reported, net of $117,104 of unamortized debt discount, which has been reported
as $86,846 short-term and $30,258 long-term. On September 30, 2009, the Company
was $235,000 (principal and interest) in arrears.




At
December 31, 2008, $1,193,829 remained outstanding under the bond, which
was classified as $403,817 short-term debt and $790,012 long-term debt and
reported, net of $165,810 of unamortized debt discount, which was reported as
$100,050 short-term and $65,760 long-term.




Barclay’s
Bank, PLC




On
February 6, 2008, the Company’s Photonic Products subsidiary entered into a
Confidential Invoice Discounting Agreement with Barclay’s Bank Sales Financing
(“Barclay’s”). Under the Discounting Agreement, a three-year revolving line of
credit was established. The Discounting Agreement provides for a revolving line
of credit and grants a security interest in and lien upon all of Photonic
Products’ trade receivables in favor of Barclay’s.




The
facility requires the maintenance of certain covenants. The Company may elect to
prepay amounts due under the facility at any time, in whole or in part, upon 3
months notice. If the prepayment amount comes before the end of the “Minimum
Period of the Agreement”, Barclay’s reserves the right to charge fees in
accordance with the terms and conditions of the agreement.  On June
26, 2009, Photonic Products agreed to amend the terms of the Agreement with
Barclay’s. Under the amended terms, the maximum amount allowed outstanding under
the line of credit is £650,000 ($1,070,000 USD).  The outstanding
principal under the note accrues interest at an annual rate of 2.65% above
Barclay’s base rate. The interest rate was 3.15% as of September 30,
2009.




The
amount outstanding under the facility was approximately $550,000 as of September
30, 2009 and $710,000 as of December 31, 2008, all of which was classified as
short-term debt under revolving lines of credit.




Photonic
Products Ltd.




StockerYale
(UK) Ltd., a wholly owned subsidiary of the Company, issued bonds to each of the
former stockholders of Photonic Products Ltd. with an aggregate initial
principal amount equal to $2,400,000. Under the terms of issuance, the
outstanding principal accrued interest at an annual rate of 1% above the LIBOR
rate as determined on the first business day of each month. All unpaid principal
plus accrued but unpaid interest under the bonds was originally due and payable
on October 31, 2009.




On
October 7, 2009, the Company and StockerYale (UK) Ltd. entered into a Deed of
Variation with the bondholders in which the Company and StockerYale (UK) Ltd.
agreed: a) to make principal payments to one of the bondholders  of
$120,000 on October 31, 2009 and $120,000 on January 8, 2010 plus monthly
payments of simple interest at an annual rate of 7% on the outstanding amounts
until paid ; and (b) to make monthly payments to each of the other two
bondholders in the aggregate amount of  $47,000 on the last day of
each calendar month, beginning on November 30, 2009 and to continue until and
including October 31, 2010 plus monthly payments of simple interest at an annual
rate of 7% to be made on the last day of each month beginning on November 30,
2009 through November 30, 2010 when a balloon payment of $1,596,000 will be
due.




StockerYale
(UK) Ltd. may elect to prepay the bonds at any time, in whole or in part,
without penalty or premium. If the former stockholders of Photonic Products Ltd.
breach any representation, warranty, covenant or agreement made in the
acquisition agreement, StockerYale (UK) Ltd. or the Company may make a claim and
the amounts outstanding under the bonds will be reduced by an amount equal to
any damages, claims, demands, losses, expenses, costs, obligations and
liabilities reasonably and foreseeably arising to the Company and/or StockerYale
(UK) Ltd. If StockerYale (UK) Ltd. fails to make any payments under the bonds,
the former stockholders of Photonic Products Ltd. will then have the right to
require payment from the Company in the form of newly issued shares of the
Company’s common stock.




As of
September 30 2009, and December 31, 2008, $2,400,000 was outstanding under the
bonds issued to the former stockholders of Photonic Products Ltd., all of which
was classified as current portion of long-term debt.


16


(15)
DISCONTINUED OPERATIONS





Subsequent
to the quarter ended September 30, 2009, on October 13, 2009, the Company and
SYC, entered into an agreement and sold substantially all North American assets
and rights of SYC and the Company's specialty optical fiber product line to
Coherent Inc. The purchase price consisted of a cash payment of $15,000,000 and
the assumption of certain liabilities, including approximately $3,400,000 of
accounts payable and other obligations associated with the sold assets.  A
portion of the cash payment, $750,000, was placed in escrow for a one year
period. The assets to be sold or disposed of and liabilities to be transferred
and the results of those operations are classified and included in discontinued
operations for all periods presented.  Proceeds from the transaction
will be used to pay the Laurus debt in the amount of $7,900,000 (including
fees), expenses associated with the transaction and settlement of various
obligations of $1,800,000.





Revenues
from the discontinued operations for the three months ended September 30, 2009
and 2008 were $3.9 million and $4.8 million. The pre-tax loss from discontinued
operations for the three months ended September 30, 2009, was approximately
$(26,000) and the pre-tax gain for the three months ended September 30, 2008,
was approximately $313,000.  All amounts have been reported as net
income (loss) from discontinued operations.





Revenues
from the discontinued operations for the nine months ended September 30, 2009
and 2008 were $10.8 million and $13.6 million. The pre-tax losses from
discontinued operations for the nine months ended September 30, 2009 and 2008
were approximately $214,000 and $515,000.  All amounts have been
reported as net loss from discontinued operations.  Interest expense
was also allocated to discontinued operations.





The
Company allocated interest expense to the discontinued
operations.  The Company expects to record a gain on the sale of
discontinued operations in the fourth quarter of 2009.




(16)
COMMITMENTS AND CONTINGENCIES




Lease
obligation treated as financing




On
December 30, 2005, the Company closed a sale-leaseback transaction on the
Company’s Salem, New Hampshire headquarters with 55 Heritage LLC. The lease
agreement grants the Company the option to extend the initial term for a period
of five years. Because the transaction did not qualify as a sale for reporting
purposes, the net proceeds were classified as a financing lease obligation. This
was primarily due to the terms of the lease agreement. Accordingly, the Company
continues to carry the value of the building on its balance sheet and record
depreciation expense until the criteria to record a sale are met.




During
the quarter ended September 30, 2009, the Company recorded $66,000 as non-cash
interest expense and $16,000 as a decrease of the lease obligation due to a
reduction in the deposit amount left with the landlord of $29,000 during the
third quarter of 2009. During the quarter ended September 30, 2008, the
Company recorded $70,000 as non-cash interest expense and $7,000 as an increase
of the lease obligation due to a reduction in the deposit amount left with the
landlord of $47,500 during the third quarter of 2008.  For the nine
months ended September 30, 2009, the Company recorded $202,000 as non-cash
interest expense and $44,000 as an increase of the lease obligation. For the
nine months ended September 30, 2008, the Company recorded $214,000 as
non-cash interest expense and $23,000 as an increase of the lease
obligation.  At September 30, 2009, $3,625,000 was recorded on the
balance sheet as a financing lease obligation, which was classified as $420,375
short-term obligation and $3,204,565 long-term obligation, and has been reported
net of a $71,000 deposit. The net book value of the building at September 30,
2009, was approximately $3,183,000.




At
December 31, 2008, $3,669,000 was recorded on the balance sheet as a
financing lease obligation, which has been classified as $444,000 short-term
obligation and $3,225,000 long-term obligation, and has been reported net of a
$157,500 deposit. The net book value of the building at December 31, 2008, was
approximately $3,410,000.




Simultaneously
with the closing of the sale of its North American businesses to Coherent Inc.
and subsequent to the quarter end, the Company entered into a lease amendment
with respect to the Company's corporate headquarters in Salem, New Hampshire.
The amendment provides for the reduction of the square footage leased by the
Company, to allow for a direct lease between the landlord and Coherent, and
revised rent payments by the Company of $16,949 per month for the remainder of
2009 and $12,712 per month for 2010, with such lease expiring no later than
December 31, 2010, subject to the landlord's right to recapture such leased
space earlier.




17


Other
obligations





SYC
conducted research and development, manufacturing, sales and administration from
a property located at 275 Kesmark Street, Montreal, Quebec, Canada. SYC
sub-leases portions of the facility to PyroPhotonics Lasers, Inc.




Simultaneously
with the closing of the sale of its North American businesses to Coherent and
subsequent to quarter end, SYC executed a lease amendment with the
landlord.  The Montreal lease amendment shortens the term of the
Montreal Lease from having an expiration date of November 31, 2015 to: (a) with
respect to space subleased by Coherent from SYC, the date one year from Closing
plus the option by Coherent to extend for up to three additional months; and (b)
with respect to space being subleased by an existing subtenant of SYC, the date
of termination of such sublease. In connection with such amendment, SYC agreed
to pay the landlord Cdn $550,000, plus applicable taxes, which includes cash and
the forfeiture by SYC of prepaid rent of Cdn $260,000. SYC retains the ultimate
obligations under the lease.  In addition, certain restoration costs,
if any, are the obligation of SYC.




On June
12, 2008, StockerYale (IRL) Ltd. entered into a lease commitment for its
operations in Cork, Ireland.  The lease term began on August 22, 2008,
for an initial term of five years with rent and service charges of approximately
€102,000 per year.




Photonics
Products Ltd. leases approximately 13,000 square feet of space in Hatfield Broad
Oak, Hertfordshire, UK. The lease runs for a term of nine years ending September
29, 2013. It also leases approximately 4,000 square feet in Bishops
Stortford, UK, through September 2011.   Photonic Products Ltd.
also leases sales offices in Grobenzell, Germany and Huntington Beach,
California.




(17)
SEGMENT INFORMATION




Operating
segments are identified as components of an enterprise about which separate
discrete financial information is available for evaluation by the chief
decision-making group, in making decisions how to allocate resources and assess
performance. The Company’s chief decision-maker is the Chief Executive Officer.
The Company’s accounting policies and method of presentation for segments is
consistent with that used throughout the consolidated financial
statements.




Following
the sale to Coherent, the Company operates in two segments: LED’s (light
emitting diode systems) and Photonic Products.  In the LED segment,
the Company designs and manufactures LED systems for the inspection, machine
vision, medical and military markets. The Photonic Products segment distributes
laser diodes and designs and manufactures custom laser diodes modules for
industrial, commercial and medical applications. The policies relating to
segments are the same as the Company’s corporate policies.




The
Company evaluates performance and allocates resources based on revenues and
operating income (loss). The operating loss for each segment includes selling,
research and development and expenses directly attributable to the segment. In
addition, the operating loss includes amortization of acquired intangible
assets, including any impairment of these assets and of goodwill. Certain of the
Company’s indirect overhead costs, which include corporate general and
administrative expenses, are allocated between the segments based upon an
estimate of costs associated with each segment. Segment assets include accounts
receivable, inventory, machinery and equipment, goodwill and intangible assets
directly associated with the product line segment.




All
revenues and costs associated with our discontinued businesses have been
eliminated from segment reporting, so that the net effect is to report from
continuing operations only.




Three Months Ended September 30,
      2009
                
                
                Three Months Ended September 30,
      2008In thousands
                
                
                In thousandsLED
                
                
                Photonic
                  Products
                
                
                Total
                
                
                LED
                
                
                Photonic Products
                
                
                TotalNet
      Sales
                
                $
                795
                
                
                $
                1,552
                
                
                $
                2,347
                
                
                $
                1,390
                
                
                $
                2,333
                
                
                $
                3,723Gross
      Profit
                
                
                210
                
                
                
                509
                
                
                
                719
                
                
                
                664
                
                
                
                681
                
                
                
                1,345Operating
      Loss
                
                
                (294
                )
                
                
                (670
                )
                
                
                (963
                )
                
                
                (214
                )
                
                
                (1,194
                )
                
                
                (1,408
                )




18





Nine months Ended September 30,
      2009
                
                
                Nine months Ended September 30,
      2008In thousands
                
                
                In thousandsLED
                
                
                Photonic
                  Products
                
                
                Total
                
                
                LED
                
                
                Photonic Products
                
                
                TotalNet
      sales
                
                $
                2,589
                
                
                $
                5,212
                
                
                $
                7,801
                
                
                $
                3,487
                
                
                $
                8,006
                
                
                $
                11,493Gross
      Profit
                
                
                831
                
                
                
                1,382
                
                
                
                2,213
                
                
                
                1,375
                
                
                
                2,236
                
                
                
                3,611Operating
      loss
                
                
                (964
                )
                
                
                (2,238
                )
                
                
                (3,202
                )
                
                
                (1,103
                )
                
                
                (3,043
                )
                
                
                (4,146
                )




September 30,2009
                    
                    
                    December 31, 2008In thousands
                    
                    
                    In thousandsLED
                    
                    
                    Photonic
                      Products
                    
                    
                    Corporate
                    
                    
                    Total
                    
                    
                    LED
                    
                    
                    PhotonicProducts
                    
                    
                    Corporate
                    
                    
                    TotalTotal
      current assets
                    
                    $
                    1,152
                    
                    
                    $
                    1,854
                    
                    
                    $
                    1,231
                    
                    
                    $
                    4,237
                    
                    
                    $
                    1,156
                    
                    
                    $
                    2,049
                    
                    
                    $
                    1,642
                    
                    
                    $
                    4,847Property,
      plant & equipment, net
                    
                    $
                    183
                    
                    
                    $
                    440
                    
                    
                    $
                    3,306
                    
                    
                    $
                    3,929
                    
                    
                    $
                    189
                    
                    
                    $
                    480
                    
                    
                    $
                    3,572
                    
                    
                    $
                    4,241Acquired
      intangible assets, net
                    
                    $
                    40
                    
                    
                    $
                    1,351
                    
                    
                    
                    —
                    
                    
                    $
                    1,391
                    
                    
                    $
                    60
                    
                    
                    $
                    1,735
                    
                    
                    
                    —
                    
                    
                    $
                    1,795Goodwill
                    
                    $
                    507
                    
                    
                    $
                    4,292
                    
                    
                    
                    —
                    
                    
                    $
                    4,799
                    
                    
                    $
                    507
                    
                    
                    $
                    3,903
                    
                    
                    
                    —
                    
                    
                    $
                    4,410Other
      long-term assets
                    
                    $
                    —
                    
                    
                    $
                    —
                    
                    
                    $
                    2
                    
                    
                    $
                    222
                    
                    
                    $
                    —
                    
                    
                    $
                    133
                    
                    
                    $
                    303
                    
                    
                    $
                    436Total
                    
                    $
                    1,882
                    
                    
                    $
                    7,937
                    
                    
                    $
                    4,539
                    
                    
                    $
                    14,358
                    
                    
                    $
                    1,912
                    
                    
                    $
                    8,300
                    
                    
                    $
                    5,517
                    
                    
                    $
                    15,729




The
Company’s sales by geographic region are denominated in U.S. dollars. These
sales are as follows:




In
      ThousandsThree Months Ended
                                              September
      30,
                                          
                                          
                                          Nine months Ended
                                              September 30,Sales
      by region
                                          
                                          2009
                                          
                                          
                                          2008
                                          
                                          
                                          2009
                                          
                                          
                                          2008Domestic
      – United States
                                          
                                          $
                                          838
                                          
                                          
                                          $
                                          1,264
                                          
                                          
                                          $
                                          3,300
                                          
                                          
                                          $
                                          4,281Canada
                                          
                                          
                                          -
                                          
                                          
                                          
                                          50
                                          
                                          
                                          
                                          44
                                          
                                          
                                          
                                          201Europe
                                          
                                          
                                          1,285
                                          
                                          
                                          
                                          2,070
                                          
                                          
                                          
                                          3,851
                                          
                                          
                                          
                                          5,595Asia
                                          
                                          
                                          164
                                          
                                          
                                          
                                          137
                                          
                                          
                                          
                                          393
                                          
                                          
                                          
                                          1,099Other
                                          
                                          
                                          60
                                          
                                          
                                          
                                          202
                                          
                                          
                                          
                                          213
                                          
                                          
                                          
                                          317Total
                                          
                                          $
                                          2,347
                                          
                                          
                                          $
                                          3,723
                                          
                                          
                                          $
                                          7,801
                                          
                                          
                                          $
                                          11,493




19


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




The
following discussion of the consolidated financial condition and results of
operations of the Company should be read in conjunction with the unaudited
condensed consolidated financial statements and the related notes thereto
included elsewhere in this Form 10-Q. Except for the historical information
contained herein, the following discussion, as well as other information in this
report, contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E
of the Securities Exchange Act of 1934, as amended, and is subject to the “safe
harbor” created by those sections. Some of the forward-looking statements can be
identified by the use of forward-looking terms such as “believes,” “expects,”
“may,” “will,” “should,” “could,” “seek,” “intends,” “plans,” “estimates,”
“anticipates” or other comparable terms. Forward-looking statements involve
inherent risks and uncertainties. A number of important factors could cause
actual results to differ materially from those in the forward-looking
statements. We urge you to consider the risks and uncertainties described in
“Risk Factors” in this report and in our annual report on Form 10-K for the year
ended December 31, 2008. We undertake no obligation to update our
forward-looking statements to reflect events or circumstances after the date of
this report. We caution readers not to place undue reliance upon any such
forward-looking statements, which speak only as of the date made.




Overview




The
Company is an independent designer and manufacturer of laser diode modules and
LED systems for industry-leading original equipment manufacturers (OEMs), as
well as a distributor of visible, infrared and blue violet laser diodes. Our
products include the Photonic Products brand of laser diode modules, diodes, and
StockerYale LED systems for the machine vision, industrial inspection, defense
and security, biomedical and medical markets. Our products are sold to over 800
customers, primarily in North America, Europe and the Pacific Rim. We sell
directly to, and work with, a group of distributors and machine vision
integrators to sell their specialized illumination products.




RESULTS
OF OPERATIONS




The
following discussion should be read in conjunction with the attached unaudited
condensed consolidated financial statements and notes thereto and with our
audited financial statements and notes thereto included in the Company’s annual
report on Form 10-K for the year ended December 31, 2008.




We are a
leader in the design, development and manufacturing of low power laser
modules.  In addition, we distribute laser diodes for leading diode
manufacturers, and develop and manufacture LED systems. Our products serve a
wide range of applications and industries including machine vision and
industrial inspection, biomedical and medical, defense and security, and other
commercial applications. Our advanced technologies are driven by a deep
understanding of the needs of our customers and the industries in which they
work.




The
Company took a number of actions during 2008 and the first nine months of 2009
to restructure its debt, improve its operational efficiency and its overall
financial performance.  The Company engaged Needham & Company, LLC
to assist it in reviewing and evaluating financial and strategic alternatives,
and subsequent to the quarter ended September 30, 2009, we reached an agreement
with Coherent to sell substantially all of the North American assets of the
Company. The sale
price consisted of a cash payment of $15,000,000 and the assumption of certain
liabilities, including approximately $3,400,000 of accounts payable and other
obligations.  Proceeds from the transaction were used to pay off in
full all obligations owed to Laurus and its related entities (approximately
$7,900,000 including fees) and for working capital and general corporate
purposes for the Company's ongoing and future operations.  The Company
expects to record a net gain related to the transaction in the fourth quarter of
2009.




On
October 7, 2009, the Company and its wholly owned subsidiary, StockerYale (UK)
Limited, amended the bonds held by the former shareholders of Photonic Products
Ltd. to amortize and begin principal payments on the bonds that were due and
payable October 31, 2009.


20


The
Company will continue to operate its LED systems and Photonic Products
businesses, which are based in Ireland and the United Kingdom. In the past, the
company reported three segments: lasers, Photonic Products, and optical
components.  The optical component segment was sold in its
entirety.




The
Company’s common stock trades on the OTC Bulletin Board under the ticker symbol
“STKR.OB.”




OPERATING
RESULTS OF CALENDAR QUARTERS ENDED SEPTEMBER 30, 2009 AND 2008




Net Sales
(from continuing operations)




Net sales
were $2.3 million for the three months ended September 30, 2009, a 37% decrease
from $3.7 million for the third quarter of 2008.  Adjusted for the
impact of foreign currency translation, the decrease in sales was
30%.  The decrease in sales was due to decreased demand from the LED
segment (46%) and Photonic Products segment (31%).  The decrease also
includes the negative impact of foreign currency translation of approximately
$252,000 of which $174,000 is related to the decline in the British Pound
(“GBP”) from the prior year.




Gross
Profit (from continuing operations)




Gross
profit was $0.7 million for the three months ended September 30, 2009, compared
to $1.3 million for the third quarter of 2008. During the three months ended
September 30, 2009, gross margin was 30.6% compared with 36.1% in the third
quarter of 2008, principally due to the decrease in sales in our LED segment of
approximately 46% and the resulting impact on gross margin in that
segment.




Operating
Expenses (from continuing operations)




Operating
expenses totaled $1.5 million for the third quarter of 2009, decreasing 41% from
$2.5 million for the third quarter of 2008. The decrease in expenses from the
prior year result from lower costs in 2009 due to cost reduction initiatives of
approximately $426,000, one-time expense of acquisition costs of $452,000 in
2008 relating to an acquisition transaction that did not close and a favorable
foreign currency impact in 2009 of approximately $122,000.




Operating
loss was $1.0 million compared with an operating loss of $1.4 million for the
third quarter of 2008. Operating losses decreased primarily due to the
$452,000 of expenses relating to an acquisition transaction that did not close
in 2008.




Non-Operating
Expenses (from continuing operations)




Other
expenses, which are comprised primarily of non-cash debt discount and financing
costs, resulted in expense of $666,000 for the three months ended September 30,
2009, versus expenses of $2,107,000 in the three months ended September 30,
2008. The decline arose mainly from one-time expenses in 2008 relating to an
acquisition transaction that did not close of approximately $961,000, and from
translation adjustments due to the weakening of the US dollar against the GBP,
and the Euro of approximately $0.6 million.




Discontinued
Operations




The net
loss from discontinued operations for the three months ended September 30, 2009,
was approximately $(26,000) and the net gain for the three months ended
September 30, 2008, was approximately $313,000. All amounts have been reported
as net gain (loss) from discontinued operations. Interest expense was also
allocated to discontinued operations.




Net
Loss




Net loss
including discontinued operations was $1.5 million or $0.03 per share. This
compares to net loss of $3.1 million or $0.08 per share for the third quarter of
2008




Benefit
for Income Taxes (from continuing operations)




Our
historical operating losses raise doubt about our ability to realize the
benefits of our deferred tax assets. As a result, we provide a valuation
allowance for the net deferred tax assets that may not be realized. We recorded
a deferred tax benefit of approximately $205,000 in the three months ended
September 30, 2009, related to one of our non-U.S. based subsidiaries. We
recorded a deferred tax benefit of approximately $80,000 in the three months
ended September 30, 2008, related to the same non-U.S. based subsidiary, which
are considered realizable in that tax jurisdiction.


21




NINE
MONTHS ENDED SEPTEMBER 30, 2009 AND 2008




Net Sales
(from continuing operations)




Net sales
were $7.8 million for the nine months ended September 30, 2009, a 32% decrease
from $11.5 million for the nine months ended September 30, 2008. Adjusted for
the impact of foreign currency translation, the decrease in sales was
20%.  The decrease in sales was due to decreased demand from the LED
segment (26%) and the Photonic Products segment (35%).  The decrease
also includes the negative impact of foreign currency translation of
approximately $1.4 million of which $1.0 million is related to the decline in
GBP from the prior year.




Gross
Profit (from continuing operations)




Gross
profit was $2.2 million for the nine months ended September 30, 2009. This
represents a 39% decrease from $3.6 million for the first nine months of 2008.
During the nine months ended September 30, 2009, gross margin was 38.4% compared
with 31.4% in the comparable period of 2008, principally due to the decrease in
sales in our Photonic Products segment of approximately 35% and the resulting
impact on gross margin in that segment.   Gross profit was
favorably impacted from foreign currency exchange of approximately
$89,000.




Operating
Expenses (from continuing operations)




Operating
expenses totaled $4.9 million for the nine months ended September 30, 2009,
versus $6.9 million in the same period of 2008.   The decrease in
operating expense was mainly due to actions taken to decrease the Company’s cost
structure in 2009, one-time expenses of $784,000 relating to an acquisition
transaction that did not close in 2008, and the favorable impact from foreign
currency exchange in 2009 of approximately $674,000.




Operating
loss was $3.2 million compared with operating losses of $4.1 million for the
same period of 2008.




Non-Operating
Expenses (from continuing operations)




Other
expenses, which are comprised primarily of non-cash debt discount and financing
costs, showed an expense of $0.5 million for the nine months ended September 30,
2009, versus an expense of $3.1 million during the nine months ended September
30, 2008.  The change in expense was mainly from one-time expenses in 2008
of approximately $961,000 relating to a acquisition transaction that did not
close, a gain due to the weakening of the U.S. dollar against the British Pound
(GBP), and the Euro of approximately $2.0 million, a gain on the valuation of
the warrant liability of approximately $92,000, offset by an decrease in cost of
financing expenses of approximately $642,000.




Discontinued
Operations




The net
losses from discontinued operations for the nine months ended September 30, 2009
and 2008 were approximately $214,000 and $515,000.  All amounts have
been reported as net loss from discontinued operations.  Interest
expense was also allocated to discontinued operations.




Net
Loss




Net loss
including discontinued operations was $3.8 million or $0.09 per share. This
compares to net loss of $7.5 million or $0.20 per share for the first nine
months of 2008.




Provision
Benefit for Income Taxes (from continuing operations)




Our
historical operating losses raise doubt about our ability to realize the
benefits of our deferred tax assets. As a result, we provide a valuation
allowance for the net deferred tax assets that may not be realized. We recorded
a deferred tax benefit of approximately $214,000 for the nine months ended
September 30, 2009, related to the same non-U.S. based subsidiary compared to
$203,000 for the nine months ended September 30, 2008, which are considered
realizable in that tax jurisdiction.


22




LIQUIDITY
AND CAPITAL RESOURCES




Our cash
balance was $1.2 million at September 30, 2009 versus $1.6 million at
December 31, 2008.  The reduction was primarily a result of the
principal and interest payments and payments against revolving lines of credit,
which were partially offset by a new loan in the amount of $0.5 million from a
private investor.




As of
September 30, 2009, our net accounts receivable balance was $1.2 million
compared to $1.7 million at year end. Our days sales outstanding decreased from
47 days at December 31, 2008 to 45 days at September 30, 2009.




Inventories
at September 30, 2009 were flat to the $1.4 million at December 31,
2008.




Capital
spending for the nine months ending September 30, 2009 was $36,000. The Company
has no material contingent capital expenditure commitments as of September 30,
2009 and has no plans to purchase additional capital items between
October 1, 2009 and December 31, 2009.




As a
result of the sale of substantially all North American assets of the Company on
October 13, 2009, the Company’s management believes it has adequate funds to
sustain current operations.  Proceeds from the sale amounted to
$15,000,000 from which approximately $9,700,000 was used to repay loans, pay
expenses associated with the sale, and other settlements and
obligations.  In addition, $750,000 of the proceeds is held in escrow
for a period of one year from the date of sale. The cash balance was $6.3
million, including $750,000 held in escrow, on October 31, 2009, after the
payment of loans, transaction expenses and other obligations.




As
previously disclosed, on March 27, 2009, the Company entered into the First
Amendment to Stock and Warrant Purchase Agreement, dated as of March 23, 2009
(the “Amendment”), with Lewis Opportunity Fund LP (“Lewis”) which extended the
closing date of that certain Stock and Warrant Purchase Agreement (the “Purchase
Agreement”) to June 30, 2009.  Under the Purchase Agreement, Lewis
agreed to purchase from the Company, and the Company agreed to sell to Lewis,
2,000,000 shares of the Company’s common stock at a per share purchase of $0.25,
for an aggregate purchase price of $500,000.




The
Company did not receive the funds by September 30, 2009, and is evaluating the
options for closing the Purchase Agreement.




OFF-BALANCE
SHEET ARRANGEMENTS




We have
no significant off-balance sheet arrangements, including derivative instruments
that have or are reasonably likely to have a current or future material effect
on our financial condition, changes in financial condition, revenues or
expenses, results of operations, liquidity, capital expenditures or capital
resources.




Item 3.
            Quantitative
      and Qualitative Disclosures About Market
Risk.




Not
required.




Item 4T.
            Controls
      and Procedures.




Evaluation
of disclosure controls and procedures.




Our Chief
Executive Officer and Chief Financial Officer have evaluated the effectiveness
of our disclosure controls and procedures as of September 30, 2009. Based on
that evaluation, our Chief Executive Officer and Chief Financial Officer have
concluded that, as of September 30, 2009, our disclosure controls and procedures
were effective in ensuring that the information we are required to disclose in
the reports we file or submit under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported on a timely basis, and that this
information is accumulated and communicated to management as appropriate to
allow timely decisions regarding required disclosures.


23




Changes
in Internal Control Over Financial Reporting




There was no change in our internal
control over financial reporting during the quarter ended September 30, 2009,
that materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.




PART
II: OTHER INFORMATION




Item 1.
            Legal
      Proceedings.




From time
to time, we may become involved in litigation relating to claims arising out of
operations in the normal course of business, which we consider routine and
incidental to our business. We currently are not a party to any legal
proceedings, the adverse outcome of which, in management’s opinion, would have a
material adverse effect on our business, results of operation or financial
condition.




Item 1A.
            Risk
      Factors.




Other
than with respect to the risk factor below, there have been no material changes
to the risk factors disclosed in Part I, “Item 1A. Risk Factors” in our annual
report on Form 10-K for the fiscal year ended December 31, 2008.  The
risks described below, and in our annual report on Form 10-K, are not the only
risks facing the Company. Additional risks and uncertainties not currently known
to us or that we currently deem to be immaterial also may materially adversely
affect our business, financial condition and/or operating results.




Our purchase and sale agreement with
the buyer of our North American assets includes indemnification obligations
which may negatively affect our liquidity.  On October 13,
2009, we sold substantially all North American assets of SYC and our specialty
optical fiber product line to Coherent Inc.  Pursuant to the purchase
and sale agreement, we agreed to indemnify Coherent Inc. for any losses
sustained, for any breach of or inaccuracy in any of the representations or
warranties we made to Coherent Inc. in the purchase and sale agreement, provided
that we are not obligated to indemnify Coherent Inc. for any amount in excess of
$15,000,000.  Should any of our representations or warranties prove to
be inaccurate, we could be obligated to pay Coherent Inc. up to $15,000,000,
which would negatively affect our liquidity and our ability to continue
operations.




Item 5.
            Other
      Information.





During
the quarter ended September 30, 2009, we made no material changes to the
procedures by which stockholders may recommend nominees to our Board of
Directors, as described in our most recent proxy statement.




Item 6.
            Exhibits.




The
Exhibits listed in the Exhibit Index immediately preceding such Exhibits are
filed with, or incorporated by reference in, this report.


24


SIGNATURES




In
accordance with the requirements of the Securities Exchange Act of 1934, the
Registrant caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.




STOCKERYALE, INC.Date:
      November 20, 2009
              By:
              /s/
      MARK W. BLODGETTMark
      W. BlodgettPresident,
      Chief Executive Officer and Chairman of the BoardDate:
      November 20, 2009
              By:
              /s/
      TIMOTHY P. LOSIKTimothy
      P. LosikChief
      Operating Officer and Chief Financial
Officer
  25
  EXHIBIT
INDEX




Exhibit
                        Number
                      
                      Description10.1
                      
                      Deed
      of Variation, dated October 7, 2009, by and among StockerYale, Inc.,
      StockerYale (UK) Limited, Antony Brian Pope, Johanna Pope and Damon
      Cookman is incorporated herein by reference to Exhibit 10.1 to the
      Registrant’s Current Report on Form 8-K dated October 7, 2009 (File No.
      000-27372).10.2
                      
                      Purchase
      and Sale Agreement, dated as of October 13, 2009, by and among
      StockerYale, Inc., Coherent Inc., and StockerYale Canada, Inc. is
      incorporated herein by reference to Exhibit 10.1 to the Registrant’s
      Current Report on Form 8-K dated October 13, 2009 (File No.
      000-27372).10.3
                      
                      Lease
      Amending Agreement, dated as of October 13, 2009, between StockerYale
      Canada, Inc. and the Standard Life Assurance Company of Canada is
      incorporated herein by reference to Exhibit 10.2 to the Registrant’s
      Current Report on Form 8-K dated October 13, 2009 (File No.
      000-27372).10.4
                      
                      First
      Amendment to Lease, dated as of October 13, 2009, between StockerYale,
      Inc. and 55 Heritage (Salem) LLC is incorporated herein by reference to
      Exhibit 10.3 to the Registrant’s Current Report on Form 8-K dated October
      13, 2009 (File No. 000-27372).31.1
                      
                      Certification
      of Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2
                      
                      Certification
      of 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. Section 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. Section 1350, as
      Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.
  26