**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
  
  **FORM
        10-K**
  
  **(Mark
        One)**
 **x**
              **ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
  **for
        the fiscal year ended December 31, 2006**
 **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 001-22302**
 
  **ISCO
        INTERNATIONAL, INC.**
 **(Exact
        name of registrant as specified in its charter)**
 
   **Delaware**
              
              **36-3688459****(State
                  or other jurisdiction of**
                **incorporation
                  or organization)**
              
              **(I.R.S.
                  Employer**
                **Identification
                  No.)**
  **1001
                  Cambridge Drive**
                **Elk
                  Grove Village, Illinois**
              
              **60007****(Address
                  of principal executive offices)**
              
              **(Zip
                  Code)**
   **Registrant’s
        telephone number, including area code: (847) 391-9400**
 
    **Securities
        registered pursuant to Section 12(b) of the Act:**
   **Common
                  Stock, Par Value $0.001 Per Share**
              
              **American
                  Stock Exchange****(Title
                  of each class)**
              
              **(Name
                  of each exchange on which
                  registered)**
   **Securities
        registered pursuant to Section 12(g) of the Act:**
  **None**
 **(Title
        of class)**
  **None**
 **(Title
        of class)**
  Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.    Yes  ̈ No x
  Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the
        Act.    Yes  ̈ No x
  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 if disclosure of delinquent filers pursuant to Item 405 of
        Regulation S-K is not contained herein, and will not be contained, to the
        best
        of registrant’s knowledge, in the definitive proxy or information statements
        incorporated by reference in Part III of this on Form 10-K or any amendment
        to
        this on Form 10-K.  ̈
  Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        one):
  Large
        accelerated filer  ̈ Accelerated filer  ̈ Non-accelerated
        filer x
  Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Act).    Yes  ̈ No x
  As
        of
        June 30, 2006, the aggregate market value of the registrant’s common stock
        held by non-affiliates of the registrant was approximately $32.3 million
        based
        on the last sale price of the common stock on such date as reported on the
        American Stock Exchange. This calculation excludes more than 88 million
        shares held by directors, executive officers, and two holders of more than
        10%
        of the registrant’s common stock.
  As
        of
        March 1, 2007, there were 190,388,033 shares of the registrant’s common
        stock outstanding.
  DOCUMENTS
        INCORPORATED BY REFERENCE:
  As
        stated
        in Part III of this Annual Report on Form 10-K, portions of the registrant’s
        definitive proxy statement for the registrant’s 2007 Annual Meeting of
        Stockholders to be held on June 8, 2007 are incorporated by reference in
        Part III of this Annual Report on Form 10-K.
 
  **Table
        of Contents**
  **TABLE
        OF CONTENTS**
 **PART
                    I****Forward
                  Looking Statements**Item 1.
                
                Business
                
                1Item
                    1A.
                
                Risk
                    Factors
                
                9Item
                    1B.
                
                Unresolved
                    Staff Comments
                
                17Item 2.
                
                Properties
                
                17Item 3.
                
                Legal
                    Proceedings
                
                17Item 4.
                
                Submission
                    of Matters to a Vote of Security Holders
                
                17**PART
                    II**Item 5.
                
                Market
                    for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                    Purchases of Equity Securities
                
                18Item 6.
                
                Selected
                    Financial Data
                
                18Item 7.
                
                Management’s
                    Discussion and Analysis of Financial Condition and Results Of
                    Operations
                
                20Item 7A.
                
                Quantitative
                    and Qualitative Disclosures About Market Risk
                
                28Item 8.
                
                Financial
                    Statements and Supplementary Data
                
                28Item 9.
                
                Changes
                    in and Disagreements with Accountants on Accounting and Financial
                    Disclosure
                
                50Item 9A.
                
                Controls
                    and Procedures
                
                50Item 9B.
                
                Other
                    Information
                
                50**PART
                    III**Item
                    10
                
                Directors,
                    Executive Officers and Corporate Governance
                
                51Item
                    11
                
                Executive
                    Compensation
                
                51Item
                    12
                
                Security
                    Ownership of Certain Beneficial Owners and Management and Related
                    Stockholder Matters
                
                51Item
                    13
                
                Certain
                    Relationship and Related Transactions, and Director
                    Independence
                
                51Item
                    14
                
                Principal
                    Accountant Fees and Services
                
                51**PART
                    I****V**Item 15.
                
                Exhibits
                    and Financial Statement Schedules
                
                52
  -i-
   
 **Table
        of Contents**
  **FORWARD-
        LOOKING STATEMENTS**
  Because
        we want to provide investors with more meaningful and
        useful information, this Annual Report on Form 10-K (“Form 10-K”) contains, and
        incorporates by reference, certain forward-looking statements that reflect
        our
        current expectations regarding its future results of operations, performance
        and
        achievements. We have tried, wherever possible, to identify these
        forward-looking statements by using words such as “anticipates,” “believes,”
“estimates,” “expects,” “designs,” “plans,” “intends,” “looks,” “may,” and
        similar expressions. These statements reflect our current beliefs and are
        based
        on information currently available to us. Accordingly, these statements are
        subject to certain risks, uncertainties and contingencies, including the
        factors
        set forth under Item 1A, Risk Factors, which could cause our actual
        results, performance or achievements for 2007 and beyond to differ materially
        from those expressed in, or implied by, any of these statements. You should
        not
        place undue reliance on any forward-looking statements. Except as otherwise
        required by federal securities laws, we undertake no obligation to release
        publicly the results of any revisions to any such forward-looking statements
        that may be made to reflect events or circumstances after the date of this
        Annual Report on Form 10-K or to reflect the occurrence of unanticipated
        events.
  **PART
        I**
 
 **Item 1.
        Business**
  **HISTORY**
  We
        were
        founded in 1989 by ARCH Development Corporation, an affiliate of the University
        of Chicago, to commercialize superconductor technologies initially developed
        by
        Argonne National Laboratory. We were incorporated as Illinois Superconductor
        Corporation in Illinois on October 18, 1989 and reincorporated in Delaware
        on September 24, 1993. In 2001, we shifted our focus from solely a
        superconductive filter (high-temperature superconductor product line referred
        to
        as “HTS”) provider to a customer-driven provider of more specialized Radio
        Frequency (“RF”) management solutions, with a particular focus on interference
        management, changing our name to ISCO International, Inc. We continue to
        broaden
        our solutions with an increasingly comprehensive approach toward optimization
        of
        the full radio link of a number of diverse wireless networks. Our facilities
        and
        principal executive offices are located at 1001 Cambridge Drive, Elk Grove
        Village, Illinois 60007 and our telephone number is (847) 391-9400. We
        maintain a website at *http://www.iscointl.com* .
        The
        information contained therein is not incorporated into this annual
        report.
  **BUSINESS
        STRATEGY**
  Our
        strategic goal is to become the leading supplier of RF management solutions
        to
        wireless operators. We seek to accomplish our goal by:
  •
              
              Marketing
                  our products aggressively to leading wireless
                  operators;
  •
              
              Providing
                  customers comprehensive radio link management infrastructure-based
                  solutions for wireless networks;
  •
              
              Continuing
                  to build on our strong intellectual property position selectively,
                  emphasizing speed to market; and
  •
              
              Outsourcing
                  product manufacturing and reducing product
                  cost.
  We
        focus
        on winning the support of the world’s leading wireless operators for our RF
        management solutions. We believe that our ANF and RF2 product families, as well
        as professional service support and other products, make us a preeminent
        RF
        management specialist in the market. We have taken steps to expand into a
        digital delivery platform for our ANF technologies, and expect this trend
        to
        continue. We believe that the ability to solve interference problems using
        the
        delivery size, capabilities and cost benefits of a digital platform will
        greatly
        enhance our addressable market within the field of wireless
        telecommunications.
 -1-
  **Table
        of Contents**
  We
        currently outsource production of our products. We believe that this model
        will
        allow us to maintain or achieve targeted product gross margins, minimize
        capital
        needs while reducing product costs, and maintain a very high quality level.
        We
        also believe that offering the lowest product cost will further strengthen
        our
        ability to achieve our strategic objectives.
  **RF
        MANAGEMENT ISSUES, INCLUDING INTERFERENCE, AND WIRELESS
        SYSTEMS**
  RF
        management issues are a growing problem limiting cell site coverage, capacity
        and range, as well as mobile transmit power and related battery-life issues.
        RF
        Link (or “Link”) problems cause dropped calls, poor call quality, and other
        service problems that lead to subscriber dissatisfaction and turnover (churn).
        Interference enters a carrier’s operating frequencies from such sources as: home
        electronic devices including portable phones, two-way radios used by commercial
        enterprises and governmental agencies, air-to-ground radio, police, fire
        and
        emergency services radio, military radio, wireless data networking systems,
        television and radio broadcasts, radar and other cellular networks. Interference
        is also created by electrical sources used to power cellular base station
        equipment. Interference may begin within a particular frequency or migrate
        from
        another frequency. Increased usage of co-location (multiple providers and/or
        multiple architectures from a single vendor using the same towers), increased
        sensitivity of non-voice applications, and the continued surge in wireless
        traffic result in increasing the impact of interference on wireless networks.
        With the proliferation of data applications and the limitations on tower
        availability and related budgets, wireless operators are finding that their
        own
        preferred technology combinations for their cell sites are creating interference
        with each other. Wireless operators also create self interference during
        the
        planned re-mining of existing spectrum with 3G/4G broadband technologies.
  We
        believe the proliferation of wireless devices and high data rate services
        will
        exacerbate the amount of interference bombarding carriers’ operating
        frequencies. Conventional cellular base station equipment does not effectively
        cope with interference issues. More importantly, the wireless telecommunications
        industry is undergoing significant transformation as it attempts to integrate
        existing infrastructure and technologies with newer 3G equipment. Additionally,
        the recent merger activity is forcing merged companies to integrate disparate
        technology platforms, sometimes using two and three different architectures
        in
        the same site in order to handle planned traffic. We believe this trend will
        continue. Our products are designed to address this expanding market
        need.
  In
        the
        face of expanding subscriber bases, increased minutes of cell phone use,
        demand
        for high data rate services, the ease of customer churn (changing providers)
        due
        to number portability, restricted capital budgets and intense competition,
        the
        provisioning and optimization of wireless system infrastructure is a major
        challenge for operators. As a result of these industry conditions, wireless
        equipment manufacturers, including independent wireless technology companies
        and
        large original equipment manufacturers (OEM’s) are working intensely to develop
        technologies that provide operators the tools necessary to monetize the growing
        demand for wireless services.
  Using
        our
        solutions to tightly integrate disparate technologies while simultaneously
        optimizing the radio link, including the mitigation of interference, operators
        can capture additional capacity and utilization, expand cell site range and
        coverage, reduce dropped calls, and significantly improve overall call quality.
        High speed data applications have placed a tremendous additional strain on
        wireless networks. Higher data rates require much cleaner signals than
        traditional voice-oriented networks to support the data throughput required
        for
        many of the highest average revenue per unit applications (including VoIP,
        music, television and video). As a result, we believe the value proposition
        and
        payback of our solutions are improving with increasing demand for high speed
        data, which we believe will result in increased demand for our solutions.
        Network capacity, quality and throughput are today the critical competitive
        differentiators in commercial wireless networks. All of our products improve
        one
        or more of these performance factors.
 
 We
        estimate the economic payback to operators as a result of the use of our
        solutions should typically occur in less than one year, sometimes well under
        one
        year, depending on traffic levels and overall link quality. We believe our
        solutions often present the best overall value of all alternatives available
        in
        many applications.
  -2-
  ****Table
        of Contents****
  **Target
        Market**
  We
        believe demand for our products will be primarily driven by the following
        factors:
  1.
        Existing networks are straining under heavy traffic. According to many sources,
        the annual growth rate in wireless telecommunications is roughly 15-20%.
        The
        number of handsets sold during 2006 has been reported to be more than 900
        million units worldwide.
  2.
        The
        ongoing transition from predominantly voice based networks to data based
        networks will continue to drive demand for infrastructure enhancements to
        achieve data and error rates required to support near real time data
        applications (including VoIP, music, television and video).
  3.
        Interference and coverage issues are primary causes of poor call quality,
        dropped calls and poor data throughput. We believe that as a result of
        increasing use of devices such as cellular phones, wireless data networking
        equipment, and wireless consumer appliances, wireless network operators are
        coming to view interference and coverage management technologies as necessary
        to
        protect against their customer bases “churning” to other carriers, especially
        since the full implementation of number portability (the ability to retain
        one’s
        phone number when changing wireless operators - historically a barrier to
        changing providers).
  4.
        We
        believe that newer, data-driven wireless networks and expansion into higher
        frequencies will require smaller operating cells and more base stations than
        existing cellular networks in order to cover the same geographic area. This
        is
        based, in part, on the requirement for a higher quality radio link in order
        to
        enable full 3G throughputs required by the most popular applications, as
        well as
        inherent limitation of RF transmissions in higher frequencies. High frequency
        RF
        signals require more transmission points for equivalent coverage than signals
        of
        lower frequency. Since most 3G technologies are deployed at high frequencies,
        an
        operator has to add a significant number of additional cells to match coverage
        and in-building penetration capabilities they achieved with their 2G
        deployments. To minimize the capital investment and maximize the performance
        and
        customer satisfaction of their data-driven networks, operators are compelled
        to
        look at technology options to overcome these inherent obstacles.
  5.
        The
        wireless telecommunications industry is undergoing significant transformation
        due to industry consolidation. The primary competitive driver is to reduce
        the
        cost bases, both capital and recurring costs, mostly achieved by reducing
        the
        number of cells required to support the combined customer base and to increase
        penetration such as by providing better in-building coverage. This creates
        demanding requirements to integrate disparate technologies, frequency spectrums,
        and legacy platforms while at the same time enabling the integrations of
        advanced technologies and services. Our products enable this integration
        while
        simultaneously optimizing the RF performance of the overall system.
  In
        summary, we believe we have differentiated technologies in radio link management
        and optimization and are customer-driven to closely align our solutions to
        their
        specific needs thereby maximizing our value-add to our customers. Our goal
        is to
        continue to position ourselves as a leader in this segment of the wireless
        industry.
  -3-
  ****Table
        of Contents****
  **TECHNOLOGY
        OVERVIEW**
  A
        wireless base station is roughly divided into two halves: the digital portion
        and the so-called “RF” portion.
  Our
        core
        expertise is the application of technology and experience to RF systems,
        though
        we are beginning to implement RF solutions utilizing digital technologies.
        The
        components in the receiver front-end are designed to acquire the desired
        information-bearing signal and pass it through to the digital portion of
        the
        system, where it is processed digitally and the user information is extracted.
        Typically, a portion of the signal is lost as it passes through the RF
        components. Further, undesired interference (in band and out of band) also
        leaks
        into the system due to imperfections in the characteristics of the RF
        devices.
  The
        use
        of our solutions for wireless RF systems is based on creating RF systems
        which
        block or mitigate the impact of interference, optimize signal processing
        within
        the radio path while introducing very little signal loss or
        degradation.
  Our
        two
        current primary product families are: (i) Adaptive Notch Filter (ANF TM),
        which dynamically and adaptively identifies and eliminates direct in-band
        interference in the radio link of a wide-band system such as CDMA or UMTS;
        (ii) Radio Link Radio Frequency Fidelity (RF2 TM), which includes ultra
        linear low-noise amplifier receivers, multi-couplers, filters and duplexers
        that
        enable full and integrated upgrades of legacy systems to 3G technologies
        resulting in a significant overall improvement in system performance, such
        as
        both dropped calls and increased data throughput. These products are designed
        for efficient production, emphasizing solid-state electronics over mechanical
        devices with moving parts.
  **RF2
        (Radio link Radio Frequency Fidelity)**
  We
        introduced our RF2 products in September 2003, we began to add new products to
        our RF2 family in 2004, and added a significant number of products in 2005 and
        2006. The RF2 product family is comprised of solutions that focus on optimizing
        RF handling in order to improve system performance, integrate the disparate
        technologies utilized by operators, and enable next generation 3G upgrades.
        The
        RF2 product family is designed to improve capacity and coverage in cellular base
        stations through state of the art low noise RF amplification, filtering,
        and
        combining and integration technologies.
  The
        basic
        RF2 product is a radio link solution designed and priced for network-wide
        deployment, improving system coverage integrity, in-building penetration,
        and
        voice/data capacity. This leads to improvement in wireless user perceived
        quality by reducing failed connection attempts and dropped calls, and improving
        handset battery life.
  Our
        RF2
products are easy to install, maintenance-free, and often present a performance
        benefit over alternative solutions in terms of tighter integration into/with
        existing equipment, continued ability to utilize diagnostics and monitoring
        equipment, and higher performance. Additionally, our RF2 solutions have been
        shown to deliver results generally comparable to HTS-based solutions without
        a
        cryogenic cooler or other moving parts, and with a tighter integration and
        much
        lower cost. We believe that the ease of integration and higher value compete
        strongly with other solutions.
  **RF2
        Competition**
  OEM
        competition includes solutions such as adding a carrier to the cell sites
        (to
        increase capacity), cell splitting, or even adding an entirely new base station
        so as to add capacity and coverage. After-market competition includes repeaters,
        TMA’s (tower-mounted amplifiers), GMA’s (ground-mounted amplifiers) and HTS
        receiver front ends, as well as duplexers and other non-integrated solutions.
        We
        believe these products may generally improve the coverage of the network,
        but
        lack the value of our fully integrated link management solutions.
  -4-
 ****Table
          of Contents****
  **Adaptive
        Notch Filters**
  Our
        patented ANF system identifies and suppresses in-band interference in the
        radio
        link of a wide-band system such as CDMA or UMTS. If interference is not
        eliminated, the radio link of the system may be reduced, possibly to the
        point
        of not allowing any calls on the entire channel. The ANF unit continuously
        monitors the power spectral density across the carriers in use and identifies
        narrow-band interference. The severity of multiple in-band interferers is
        prioritized, and through software control, the ANF unit dynamically inserts
        a
        highly selective filter to eliminate multiple interferers with minimal impact
        on
        the desired broadband signal. The objective of the ANF system is for operators
        to realize significant gains in performance in coverage, capacity and data
        throughput. An entire network of ANF hardware can be managed via the web-based
        management software that supports the hardware. We believe our patented ANF
        technology is the only in-band dynamically controlled interference management
        solution commercially available to the marketplace today.
  Our
        products, including projected expansions, are focused on CDMA and other
        wide-band spread spectrum systems (W-CDMA), including, for example, upgrades
        of
        GSM systems to UMTS and similar 3G technology. During 2006 we launched our
        first
        ANF solution that protects PCS (1900 MHz). We empowered this and other ANF
        platforms with a digital front end and modular design for easy adaptation
        to
        customer requirements. This new platform has significantly expanded our
        addressable market and will also serve as an enabler to a larger suite of
        dynamically adaptable RF multiplexer solutions.
  We
        have
        also developed a network-wide, web-based network management tool (web monitor),
        allowing our customers to perform management functions for all ANF units
        throughout the system. This tool with a graphical user interface allows the
        service provider to control, configure, and monitor the ANF units remotely
        from
        the network management center. This includes:
  •
              
              Remote
                  configuration of parameters within all ANF
                  units;
  •
              
              Remote
                  monitoring of alarm status for all ANF
                  units;
  •
              
              Observation
                  of interference and notch activity from all units;
                  and
  •
              
              The
                  ability to view on-line event data and reports based on measured
                  performance data.
  We
        have
        industry leading expertise in the optimization of networks. To facilitate
        rapid
        penetration of ANF, we offer professional services to the service providers’
engineering teams to identify and quantify interference, and, its effects
        on
        network performance. We have developed several custom software and hardware
        tools to perform interference analysis and interference audit. iSMART
        (Interference from System Metric Analysis Rules Tool) is a software tool
        that
        enables a service provider to identify potential ANF candidate sectors/cell
        sites by analyzing the system performance metrics data generated in their
        network. Automated Test Equipment, ANF-on-wheels and ANF Web Monitor is a
        software/hardware system that allows us to perform interference audits at
        cell
        sites of service providers regardless of the frequency band of operation.
        This
        service helps quantify interference and identify new markets (frequency bands)
        with high interference.
  We
        have
        recently added a digital front-end to our ANF products, and are working on
        a
        fully digital version that we expect to complete during 2007. We believe
        a fully
        digital ANF solution would integrate well into operator plans and provide
        the
        economics to allow far greater penetration into customer networks, as well
        as
        access to wireless applications outside of traditional cellular (e.g., WiFi
        and
        WiMax architectures), as well as mobile devices such as handsets.
  **ANF
        competition**
  We
        believe our patented ANF technology is the only in-band dynamically controlled
        interference management solution commercially available to the marketplace
        today. We hold proprietary technology on ANF. We do, however, face competition
        as described below.
 -5-
   **Table
        of Contents**
  *Direct
        Competition — After-Market Vendors*
  Fixed-frequency
        notch filters are the main form of direct competition. However, these will
        only
        work in a static interference environment, and hence do not satisfy the need
        of
        dynamic interference detection and elimination as observed in a vast majority
        of
        in-band interference scenarios. Smart antennas were also developed with the
        intent of in-band interference mitigation. However, we believe these solutions
        have limited applicability and effectiveness in eliminating in-band
        interference, particularly in a CDMA-based network, and are typically
        substantially more expensive (in addition to being less effective) than our
        ANF
        solution.
  *Direct
        Competition — OEMs*
  Digital-signal-processing
        based solutions may be under development by the various OEMs. Even if the
        manufacturers do develop such a solution for in-band interference, we believe
        that they would have limited dynamic range and hence would only be able to
        mitigate low-power interference. Most importantly they would likely not be
        available for deployment on the hundreds of thousands of legacy cell sites
        currently in service.
  *Indirect
        Competition — OEMs*
  Indirect
        competition does not directly address the problem of in-band interference,
        but
        could be viewed as a method for circumventing the problem. Examples include
        adding a carrier to a cell site (to increase capacity), cell splitting, or
        even
        adding an entirely new base station. These methods seek to overcome the effects
        of the interference by a brute force of added capacity and higher
        signal-to-noise in a problematic location. However, we believe these solutions
        to be relatively costly and do not guarantee adequate increased performance
        due
        to absolute limiting effects of in-band interference in certain
        situations.
  *Indirect
        Competition — After-Market Vendors*
  Other
        forms of indirect competition include repeaters, TMA’s, and HTS receiver front
        ends. As with the OEM-based solutions, we do not believe these directly address
        the problem of in-band interference. There are several entities attempting
        to
        develop and market digital solutions that address part of the problem that
        our
        ANF solutions address, but we believe they operate in a very different fashion
        and will not achieve the same benefits. Additionally, they are typically
        entities without significant current revenue streams or operator access.
        We have
        the benefit of a growing existing customer base and the ability to work with
        our
        customers in tightly matching next generation solutions with their
        needs.
  **Product
        Benefits**
  Our
        products are designed to address the high performance RF needs of domestic
        and
        international commercial wireless telecommunication systems by providing
        the
        following advantages:
  ***Enable
        Deployment of Data Networks.*** Beginning in 2005, our solutions have been utilized with data network
        deployments. These deployments require upgrades and changes to existing
        infrastructure. Our products have proven effective in helping customers in
        this
        area. It is generally expected that data networks will continue to be widely
        deployed, in the United States and internationally, during 2006 and
        beyond.
  ***Technology
        Integration due to Expansion or Consolidation.*** The
        wireless telecommunications industry is undergoing significant transformation
        due to industry consolidation. The primary competitive driver is to reduce
        the
        cost bases, both capital and reoccurring costs, mostly achieved by reducing
        the
        number of cells required to support the combined customer base. This creates
        demanding requirements to integrate disparate technologies, frequency spectrums,
        and legacy platforms while at the same time enabling the integrations of
        advanced technologies and services. Our products enable this integration
        while
        simultaneously optimizing the RF performance of the overall system.
  -6-
   ****Table
        of Contents****
  ***Greater
        Network Capacity and Utilization.*** Our
        solutions can increase capacity and utilization by up to 70% or more. In
        some
        cases, capacity increases because channels which were previously unusable
        due to
        interference are recovered. In other cases, system utilization increases
        because
        of lower levels of blocked or dropped calls, and increases in the ability
        of the
        system to permit weak signals to be processed with acceptable call
        quality.
  ***Improved
        Base Station Range.*** Our RF
        systems have been shown to extend the radio link range of a wireless system
        by
        up to 50%. Greater range can reduce a service operator’s capital expenditure per
        customer in lower density areas by filling in coverage gaps in existing systems
        or by reducing the number of required cell sites for new system
        deployments.
  ***Improved
        Flexibility in Locating Base Stations.*** Our RF
        products can allow wireless telecommunications service providers to co-locate
        base stations near other RF transmitters. Our products allow the cell site
        radio
        to better tolerate RF interference while reducing out-of band signals that
        could
        interfere with other nearby wireless telecommunication operators.
  ***Improved
        Call Quality - Fewer Dropped Calls and Failed Connection
        Attempts.*** Our
        products improve call quality by reducing dropped and blocked calls. During
        commercial installations, our RF products have demonstrated drastic reduction
        in
        dropped calls, by as much as 50% or more. Our products similarly reduce the
        number of ineffective connection attempts and dead zones within
        networks.
  ***Reduced
        Mobile Transmit Power.*** By
        improving the radio link, reducing the system’s noise floor and mitigating the
        destructive impact of interference, our solutions greatly reduce required
        mobile
        transmit power. This improves battery life, among other benefits.
  **COMPANY
        HIGHLIGHTS**
  **Sales
        and Marketing**
  We
        have
        historically focused our sales and marketing effort on U.S. wireless service
        providers for retrofit applications. To date, we have sold our products to
        many
        of the largest cellular operators in the United States as well as to mid-size
        and smaller U.S. wireless operators.
  We
        have
        targeted certain international customers, marketing both our existing products
        and presenting the benefits of our interference-management technology in
        the
        design and early stage deployments of new systems. Targeted regions have
        included China and other parts of the Far East as well as several countries
        within Latin America and Europe. We have engaged professional representatives
        in
        these areas to facilitate entry into the markets and follow-on services.
        Such
        representatives typically help by providing customer contacts and relationships,
        in marketing, field support, and distribution.
  Sales
        to
        three customers accounted for 98%, 97%, and 94% of our total revenues for
        2006,
        2005 and 2004, respectively. During 2006, the top three customers were Verizon
        Wireless, Alltel Corporation, and Bluegrass Cellular Corporation, respectively.
        In addition, a significant amount of our technical and managerial resources
        have
        been focused on working with these and a limited number of other operators
        and
        OEMs. Our sales, in dollars, to non-”top three” customers during 2006 was
        similar to the 2005 amount, reflecting additional penetration in our largest
        customers offsetting the continued expansion in our customer base.
  **Manufacturing**
  We
        outsource our manufacturing processes in order to provide predictable product
        yields and easy expansion to meet increased customer demand. Toward that
        end, we
        currently produce all of our products through third party manufacturers.
        We
        believe there are multiple sources available for manufacturing and foresee
        no
        problem continuing to apply our outsourcing strategy. Our internal manufacturing
        and test capability can be found in Elk Grove Village, IL.
 -7-
  **Table
        of Contents**
  **Research
        and Development**
  Our
        R&D efforts have been focused on developing and improving RF products for
        wireless telecommunications systems. As a result of such efforts, product
        performance has been improved, product size has been reduced, production
        costs
        have been lowered, product functionality has been increased, and product
        packaging has been streamlined. We are currently developing related products
        that are synergistic with our core offerings and which utilize our core
        technical competencies in the radio link management arena, allowing us to
        deliver our solutions to more customers.
  Our
        total
        R&D expenses during 2006, 2005 and 2004 were approximately $2,012,000,
        $1,767,000, and $1,119,000, respectively.
  **Intellectual
        Property and Patents**
  We
        regard
        certain elements of our product design, fabrication technology and manufacturing
        process as proprietary and protect our rights in them through a combination
        of
        patents, trade secrets and non-disclosure agreements. We also have obtained
        exclusive and non-exclusive licenses for technology developed with or by
        our
        research partners, which have included Argonne National Laboratory and
        Northwestern University. We believe that our success will depend in part
        upon
        the protection of our proprietary information, our patents and licenses of
        key
        technologies from third parties, and our ability to operate without infringing
        on the proprietary rights of others.
  **HTS
        Technology**
  We
        spent
        many years developing HTS applications, resulting in a number of products,
        processes and materials related to HTS. This experience has helped us offer
        our
        current set of state of the art solid-state solutions, such that the underlying
        technology is being utilized in the marketplace today and may be even more
        fully
        utilized in the future.
  There
        are
        two ways of designing an HTS component - “thin-film” and “thick-film”
techniques. We have technologies in both aspects that may have application
        to
        specific, but currently limited markets. We are prepared to address those
        segments should the opportunity present itself, but currently have chosen
        to
        focus on higher value-added, solid state solutions appropriate for the wireless
        telecommunications application.
  **Patents**
  We
        have
        applied for patents for inventions developed internally and acquired patents,
        through assignment of a license from the Canadian government, in connection
        with
        the purchase of the Adaptive Notch Filtering business unit of Lockheed Martin
        Canada. One of our patents is jointly owned with Lucent Technologies, Inc.
        Furthermore, we expect to pursue foreign patent rights on certain inventions
        and
        technologies critical to our products. Please refer to Note 2 of our Financial
        Statements for a discussion of patent useful lives and
        amortization.
  **Government
        Regulations**
  Although
        we believe that our wireless telecommunications products themselves are not
        licensed or governed by approval requirements of the Federal Communications
        Commission (“FCC”), the operation of base stations is subject to FCC licensing
        and the radio equipment into which our products would be incorporated is
        subject
        to FCC approval. Base stations and the equipment marketed for use therein
        must
        meet specified technical standards. Our ability to sell our RF products is
        dependent on the ability of wireless base station equipment manufacturers
        and of
        wireless base station operators to obtain and retain the necessary FCC approvals
        and licenses. In order to be acceptable to base station equipment manufacturers
        and to base station operators, the characteristics, quality, and reliability
        of
        our base station products must enable them to meet FCC technical
        standards.
 -8-
 **Table
          of Contents**
  We
        may usecertain hazardous materials in our research,
        development and any manufacturing operations. As a result, we may be subject
        to
        stringent federal, state and local regulations governing the storage, use
        and
        disposal of such materials. It is possible that current or future laws and
        regulations could require us to make substantial expenditures for preventive
        or
        remedial action, reduction of chemical exposure, or waste treatment or disposal.
        We believe we are in material compliance with all environmental regulations
        and
        to date we have not had to incur significant expenditures for preventive
        or
        remedial action with respect to the use of hazardous materials.
  **Employees**
  As
        of
        January 19, 2007, we had a total of 39 employees, 13 of whom hold advanced
        degrees. Of the employees, 5 are engaged in manufacturing and production,
        17 are
        engaged in research, development and engineering, and 11 are engaged in
        marketing and sales, and 6 are engaged in finance and administration. We
        also
        periodically employ other consultants and independent contractors on as
        as-needed basis. None of our employees are covered by a collective bargaining
        agreement. We believe that our relationship with our employees is
        good.
  **Item 1A.
        Risk Factors**
  The
        following factors, in addition to other information contained herein, should
        be
        considered carefully in evaluating us and our business.
  **RISKS
        RELATED TO THE OPERATIONS AND FINANCING OF THE COMPANY**
  **We
        have a history of losses that raises doubts about our ability to continue
        as a
        going concern**
  We
        were
        founded in October 1989 and through 1996 we were engaged principally in research
        and development, product testing, manufacturing, marketing and sales activities.
        Since 1996, we have been actively selling products to the marketplace and
        we
        continue to develop new products for sale. We have incurred net losses since
        inception. As of December 31, 2006, our accumulated deficit was
        approximately $164 million. We have only recently begun to generate revenues
        from the sale of our ANF and RF2 products, having sold more in the past two
        years than in the fourteen years of company history prior to 2005. Accordingly,
        although we showed a substantial improvement in revenues and we have indicated
        the expectation of continued improvement during 2007, it is nonetheless possible
        that we may continue to experience net losses and cannot be certain if or
        when
        we will become profitable.
  These
        conditions raise substantial doubt about our ability to continue as a going
        concern. The accompanying consolidated financial statements have been prepared
        assuming we will continue as a going concern and do not include any adjustments
        relating to the recoverability of reported assets or liabilities should we
        be
        unable to continue as a going concern.
  **If
        we fail to obtain necessary funds for our operations, we may be unable to
        maintain or improve on our technology position and unable to develop and
        commercialize our products**
  To
        date,
        we have financed our operations primarily through public and private equity
        and
        debt financings, and most recently through several financings with affiliates
        of
        our two largest shareholders. We believe that we have sufficient funds to
        operate our business until $11.3 million of our debt becomes due in August
        2007.
        That debt is held by our two largest shareholders, including affiliates.
        While
        we expect to refinance this debt no such refinancing has occurred as of the
        reporting date, therefore, the ability to refinance our debt and maintain
        adequate working capital is necessary for us to continue as a going concern.
        Additionally, we project increases in working capital requirements in order
        to
        pursue significant business opportunities during 2007 and beyond, and also
        expect to spend additional financial resources in the expansion of our business
        and product offering. As such, we may require additional capital prior to
        August
        2007. We intend to look into augmenting our existing capital position by
        continuing to evaluate potential short-term and long-term sources of capital
        whether from debt, equity, hybrid, or other methods. The primary covenant
        in our
        existing debt arrangement involves the right of the lenders to receive debt
        repayment from the proceeds of new financing activities. This covenant may
        restrict our ability to obtain new sources of financing and/or to apply the
        proceeds of a financing event toward operations until the debt is repaid
        in
        full.
 -9-
    **Table
        of Contents**
  Our
        continued existence is therefore dependent upon our continued ability to
        raise
        funds through the issuance of our equity securities or borrowings. Our plans
        in
        this regard are to obtain other debt and equity financing until such time
        as
        profitable operation and positive cash flow are achieved and maintained.
        Although we believe, based on the fact that we have raised funds through
        sales
        of common stock and from borrowings over the past several years, that we
        will be
        able to secure suitable additional financing for our operations, there can
        be no
        guarantee that such financing will continue to be available on reasonable
        terms,
        or at all. As a result, there is no assurance that we will be able to continue
        as a going concern.
  The
        actual amount of future funding requirements will depend on many factors,
        including: the amount and timing of future revenues, the level of product
        marketing and sales efforts to support our commercialization plans, the
        magnitude of research and product development programs, the ability to improve
        or maintain product margins, any merger and acquisition activity, and the
        costs
        involved in protecting patents or other intellectual property.
  **We
        have limited experience in manufacturing, sales and marketing and dependence
        on
        third party manufacturers**
  For
        us to
        be financially successful, we must either manufacture our products in
        substantial quantities, at acceptable costs and on a timely basis or enter
        into
        outsourcing arrangements with qualified manufacturers that will allow us
        the
        same result. Currently, our manufacturing requirements are met by third party
        contract manufacturers. The efficient operation of our business will depend,
        in
        part, on our ability to have these and other companies manufacture our products
        in a timely manner, cost-effectively and in sufficient volumes while maintaining
        the required quality. Any manufacturing disruption could impair our ability
        to
        fulfill orders and could cause us to lose customers.
  In
        the
        event that we are unable to maintain manufacturing arrangements on acceptable
        terms with qualified manufacturers then we would have to produce our products
        in
        commercial quantities in our own facilities. Although to date we have produced
        limited quantities of our products for commercial installations and for use
        in
        development and customer field trial programs, production of large quantities
        of
        our products at competitive costs presents a number of technological and
        engineering challenges. We may be unable to manufacture such products in
        sufficient volume. We have limited experience in manufacturing, and substantial
        costs and expenses may be incurred in connection with attempts to manufacture
        larger quantities of our products. We may be unable to make the transition
        to
        large-scale commercial production successfully.
  Our
        sales
        and marketing experience to date is very limited. We may be required to further
        develop our marketing and sales force in order to effectively demonstrate
        the
        advantages of our products over other products. We also may elect to enter
        into
        arrangements with third parties regarding the commercialization and marketing
        of
        our products. If we enter into such agreements or relationships, we would
        be
        substantially dependent upon the efforts of others in deriving commercial
        benefits from our products. We may be unable to establish adequate sales
        and
        distribution capabilities, we may be unable to enter into marketing arrangements
        or relationships with third parties on financially acceptable terms, and
        any
        such third party may not be successful in marketing our products. There is
        no
        guarantee that our sales and marketing efforts will be successful.
  **Management
        of our growth**
  Growth
        may cause a significant strain on our management, operational, financial
        and
        other resources. The ability to manage growth effectively may require us
        to
        implement and improve our operational, financial, manufacturing and management
        information systems and expand, train, manage and motivate employees. These
        demands may require the addition of new management personnel and the development
        of additional expertise by management. Any increase in resources devoted
        to
        product development and marketing and sales efforts could have an adverse
        effect
        on financial performance in future fiscal quarters. If we were to receive
        substantial orders, we may have to expand current facilities, which could
        cause
        an additional strain on our management personnel and development resources.
        The
        failure of the management team to effectively manage growth could have a
        material adverse effect on our business, operating results and financial
        condition.
 -10-
  ****Table
        of Contents****
  **RISKS
        RELATED TO OUR COMMON STOCK AND CHARTER PROVISIONS**
  **Volatility
        of common stock price**
  The
        market price of our common stock, like that of many other high-technology
        companies, has fluctuated significantly and is likely to continue to fluctuate
        in the future. Since January 1, 2005 and through December 31, 2006,
        the closing price of our common stock has ranged from a low of $0.25 per
        share
        and high of $0.46 per share. Announcements by us or others regarding the
        receipt
        of customer orders, quarterly variations in operating results, acquisitions
        or
        divestitures, additional equity or debt financings, results of customer field
        trials, scientific discoveries, technological innovations, litigation, product
        developments, patent or proprietary rights, government regulation and general
        market conditions may have a significant impact on the market price of our
        common stock. In addition, fluctuations in the price of our common stock
        could
        affect our ability to maintain the listing of our common stock on the American
        Stock Exchange.
  **Risk
        of dilution**
  As
        of
        December 31, 2006, we had outstanding options to purchase 4.9 million
        shares of common stock at a weighted average exercise price of $0.41 per
        share
        (fewer than 0.1 million of which have not yet vested) issued to employees,
        directors and consultants pursuant to the 2003 Equity Incentive Plan and
        its
        predecessor 1993 Stock Option Plan, as amended, the merger agreement with
        Spectral Solutions, and individual agreements with management and directors.
        In
        addition, on the same date we had 8.7 million unvested shares of restricted
        stock outstanding. In order to attract and retain key personnel, we may issue
        additional securities, including grants of restricted shares, in connection
        with
        or outside our company employee benefit plans, or may lower the price of
        existing stock options.
  The
        exercise of options and warrants for common stock and the issuance of additional
        shares of common stock, shares of restricted stock and/or rights to purchase
        common stock at prices below market value would be dilutive to existing
        stockholders and may have an adverse effect on the market value of our common
        stock.
  **Concentration
        of our stock ownership**
  At
        the
        time of this filing, officers, directors and principal stockholders (holding
        greater than 5% of outstanding shares) together control approximately 50%
        of the
        outstanding voting power on a fully diluted basis. The two largest stockholders,
        along with their affiliates, are also our lenders, holding all of our
        outstanding debt instruments. Consequently, these stockholders, if they act
        together, would be able to exert significant influence over all matters
        requiring stockholder approval, including the election of directors and approval
        of significant corporate transactions. In addition, this concentration of
        ownership may delay or prevent a change of control of us, even if such a
        change
        may be in the best interests of our stockholders. The interests of these
        stockholders may not always coincide with our interests or the interests
        of
        other stockholders. Accordingly, these stockholders could cause us to enter
        into
        transactions or agreements that we would not otherwise consider.
  **Certain
        provisions in our charter documents have an anti-takeover
        effect**
  There
        exist certain mechanisms that may delay, defer or prevent such a change of
        control. For instance, our Certificate of Incorporation and By-Laws provide
        that
        (i) our Board of Directors has authority to issue series of our preferred
        stock with such voting rights and other powers as the Board of Directors
        may
        determine and (ii) prior specified notice must be given by a stockholder
        making nominations to the Board of Directors or raising business matters
        at
        stockholders meetings. The effect of the anti-takeover provisions in our
        charter
        documents may be to deter business combination transactions not approved
        by our
        Board of Directors, including acquisitions that may offer a premium over
        market
        price to some or all stockholders.
  -11-
 ****Table
          of Contents****
  **Reporting
        requirements of a public company**
  As
        a
        public company, we are required to comply with various reporting obligations.
        These obligations change from time to time, and currently include full
        compliance with Section 404 of the Sarbanes-Oxley Act for our fiscal year
        ending December 31, 2007. The process of achieving full compliance might
        involve the commitment of significant resources, including substantial levels
        of
        management attention. If we fail to comply with the reporting obligations
        of the
        Exchange Act and Section 404 of the Sarbanes-Oxley Act, or if we fail to
        achieve and maintain adequate internal controls over financial reporting,
        our
        business, results of operations and financial condition, and investors’
confidence in us, could be materially adversely affected.
  As
        a
        public company, we are required to comply with the periodic reporting
        obligations of the Exchange Act, including preparing annual reports, quarterly
        reports and current reports. Our failure to prepare and disclose this
        information in a timely manner could subject us to penalties under federal
        securities laws, expose us to lawsuits and restrict our ability to access
        financing. In addition, we are required under applicable law and regulations
        to
        integrate our systems of internal controls over financial reporting. We plan
        to
        evaluate our existing internal controls with respect to the standards adopted
        by
        the Public Company Accounting Oversight Board. During the course of our
        evaluation, we may identify areas requiring improvement and may be required
        to
        design enhanced processes and controls to address issues identified through
        this
        review. This could result in significant delays and cost to us and require
        us to
        divert substantial resources, including management time, from other
        activities.
  **TECHNOLOGY
        AND MARKET RISKS**
  **We
        are dependent on wireless telecommunications**
  The
        principal target market for our products is wireless telecommunications.
        The
        devotion of substantial resources to the wireless telecommunications market
        creates vulnerability to adverse changes in this market. Adverse developments
        in
        the wireless telecommunications market, which could come from a variety of
        sources, including future competition, new technologies or regulatory decisions,
        could affect the competitive position of wireless systems. Any adverse
        developments in the wireless telecommunications market may have a material
        adverse effect on our business, operating results and financial
        condition.
  **We
        are dependent on the enhancement of existing networks and the build-out of
        next-generation networks, and the capital spending patterns of wireless network
        operators**
  Increased
        sales of products are dependent on a number of factors, one of which is the
        build-out of next generation (3G and 4G) enabled wireless communications
        networks as well as enhancements of existing infrastructure. Building wireless
        networks is capital intensive, as is the process of upgrading existing
        equipment. Further, the capital spending patterns of wireless network operators
        is beyond management’s control and depends on a variety of factors, including
        access to financing, the status of federal, local and foreign government
        regulation and deregulation, changing standards for wireless technology,
        the
        overall demand for wireless services, competitive pressures and general economic
        conditions. The build-out of next-generation networks may take years to
        complete. The magnitude and timing of capital spending by these operators
        for
        constructing, rebuilding or upgrading their systems significantly impacts
        the
        demand for our products. Any decrease or delay in capital spending patterns
        in
        the wireless communication industry, whether because of a general business
        slowdown or a reevaluation of the prospective demand for data and other
        services, would delay the build-out of these networks and may significantly
        harm
        business prospects.
  **Our
        success depends on the market’s acceptance of our products**
  Our
        RF
        products, including our ANF and RF2 products, have not been sold in very large
        quantities and a sufficient market may not develop for these products. Customers
        establish demanding specifications for performance, and although we believe
        we
        have met or exceeded these specifications to date, there is no guarantee
        that
        the wireless service providers will elect to use these solutions to solve
        their
        wireless network problems. Although we have enjoyed substantial revenue growth
        over the past two years, including the best three revenue quarters in our
        history during 2006, there is no assurance that we will continue to receive
        orders from these customers.
 -12-
   ****Table
        of Contents****
  **Rapid
        technological change and future competitive technologies could negatively
        affect
        our operations**
  The
        field
        of telecommunications is characterized by rapidly advancing technology. Our
        success will depend in large part upon our ability to keep pace with advancing
        our high performance RF technology and efficient, readily available low cost
        materials technologies. Rapid changes have occurred, and are likely to continue
        to occur, in the development of wireless telecommunications. Development
        efforts
        may be rendered obsolete by the adoption of alternative solutions to current
        wireless operator problems or by technological advances made by
        others.
  **BUSINESS
        RISKS**
  **Dependence
        on a limited number of customers**
  Sales
        to
        three customers accounted for 98%, 97%, and 94% of our total revenues for
        2006,
        2005 and 2004, respectively. During 2006, the top three customers were Verizon
        Wireless, Alltel Corporation, and Bluegrass Cellular Corporation, respectively.
        In addition, a significant amount of our technical and managerial resources
        have
        been focused on working with these and a limited number of other operators
        and
        OEMs. Our sales, in dollars, to non-”top three” customers during 2006 was
        similar to the 2005 amount, reflecting additional penetration in our largest
        customers offsetting the continued expansion in our customer base. The loss
        of
        any of these large customers might have a material adverse effect on our
        business, operating result, and financial condition.
  We
        expect
        that if our products achieve market acceptance, a limited number of wireless
        service providers and OEMs will account for a substantial portion of revenue
        during any period. Sales of many of our products depend in significant part
        upon
        the decisions of prospective and current customers to adopt and expand their
        use
        of these products. Wireless service providers, wireless equipment OEMs and
        our
        other customers are significantly larger than we are, and are able to exert
        a
        high degree of influence over us. Customers’ orders are affected by a variety of
        factors such as new product introductions, regulatory approvals, end user
        demand
        for wireless services, customer budgeting cycles, inventory levels, customer
        integration requirements, competitive conditions and general economic
        conditions. The failure to attract new customers would have a material adverse
        effect on our business, operating results and financial condition.
  **We
        have lengthy sales cycles**
  Prior
        to
        selling products to customers, we may be required to undergo lengthy approval
        and purchase processes. Technical and business evaluation by potential customers
        can take up to a year or more for products based on new technologies. The
        length
        of the approval process is affected by a number of factors, including, among
        others, the complexity of the product involved, priorities of the customers,
        budgets and regulatory issues affecting customers. We may not obtain the
        necessary approvals or ensuing sales of such products may not occur. The
        length
        of customers’ approval process or delays could make our quarterly revenues and
        earnings inconsistent and difficult to trend.
  **We
        are dependant on limited sources of supply**
  Certain
        parts and components used in our RF products are only available from a limited
        number of sources. Our reliance on these limited source suppliers exposes
        us to
        certain risks and uncertainties, including the possibility of a shortage
        or
        discontinuation of certain key components and reduced control over delivery
        schedules, manufacturing capabilities, quality and costs. Any reduced
        availability of such parts or components when required could materially impair
        the ability to manufacture and deliver products on a timely basis and result
        in
        the cancellation of orders, which could have a material adverse effect on
        our
        business, operating results and financial condition.
  -13-
   **Table
        of Contents**
  In
          addition, the purchase of certain key components involves long lead times
          and,
          in the event of unanticipated increases in demand for our products, we
          may be
          unable to manufacture products in quantities sufficient to meet customers’
demand in any particular period. We have few guaranteed supply arrangements
          with
          our limited source suppliers, do not maintain an extensive inventory of
          parts or
          components, and customarily purchase parts and components pursuant to actual
          or
          anticipated purchase orders placed from time to time in the ordinary course
          of
          business.
  Related
        to this topic, we produce substantially all of our products through third-party
        contract manufacturers. Like raw materials, the elimination of any of these
        entities or delays in the fulfillment process, for whatever reason, may impact
        our ability to fulfill customer orders on a timely basis and may have a material
        adverse effect on our business, operating results, or financial
        condition.
  To
        satisfy customer requirements, we may be required to stock certain long
        lead-time parts and/or finished product in anticipation of future orders,
        or
        otherwise commit funds toward future purchase. The failure of such orders
        to
        materialize as forecasted could limit resources available for other important
        purposes or accelerate the requirement for additional funds. In addition,
        such
        excess inventory could become obsolete, which would adversely affect financial
        performance. Business disruption, production shortfalls or financial
        difficulties of a limited source supplier could materially and adversely
        affect
        us by increasing product costs or reducing or eliminating the availability
        of
        such parts or components. In such events, the inability to develop alternative
        sources of supply quickly and on a cost-effective basis could materially
        impair
        the ability to manufacture and deliver products on a timely basis and could
        have
        a material adverse effect on our business, operating results and financial
        condition.
  **Dependence
        on key personnel**
  Our
        success will depend in large part upon our ability to attract and retain
        highly
        qualified management, engineering, manufacturing, marketing, sales and R&D
        personnel. Due to the specialized nature of our business, it may be difficult
        to
        locate and hire qualified personnel. The loss of services of one of our
        executive officers or other key personnel, or the failure to attract and
        retain
        other executive officers or key personnel, could have a material adverse
        effect
        on our business, operating results and financial condition.
  **Failure
        of products to perform properly might result in significant warranty
        expenses**
  In
        general, our products carry a warranty of one or two years, limited to
        replacement of the product or refund of the cost of the product. In addition,
        we
        offer our customers extended warranties. Repeated or widespread quality problems
        could result in significant warranty expenses and/or the loss of customer
        confidence. The occurrence of such quality problems could have a material
        adverse effect on our business, operating results and financial
        condition.
  **Intense
        competition, and continued consolidation in our industry could create stronger
        competitors and harm the business**
  The
        wireless telecommunications equipment market is very competitive. Many of
        these
        companies have substantially greater financial resources, larger research
        and
        development staffs and greater manufacturing and marketing capabilities than
        we
        do. Our products compete directly with products which embody existing and
        future
        competing commercial technologies. Other emerging wireless technologies may
        also
        provide protection from RF interference and offer enhanced range to wireless
        communication service providers, potentially at lower prices and/or superior
        performance, and may therefore compete with our products. High performance
        RF
        solutions may not become a preferred technology to address the needs of wireless
        communication service providers. Failure of our products to improve performance
        sufficiently, reliably, or at an acceptable price or to achieve commercial
        acceptance or otherwise compete with existing and new technologies, would
        have a
        material adverse effect on our business, operating results and financial
        condition.
  -14-
  ****Table
        of Contents****
  **LEGAL
        RISKS**
  **Intellectual
        Property and Patents**
  Our
        success will depend in part on our ability to obtain patent protection for
        our
        products and processes, to preserve trade secrets and to operate without
        infringing upon the patent or other proprietary rights of others and without
        breaching or otherwise losing rights in the technology licenses upon which
        any
        of our products are based. We have applied for patents for inventions developed
        internally and acquired patent rights in connection with the purchase of
        the
        Adaptive Notch Filtering business unit of Lockheed Martin Canada. One of
        the
        patents is jointly owned with Lucent Technologies, Inc. We believe there
        are a
        large number of patents and patent applications covering RF products and
        other
        products and technologies that we are pursuing. Accordingly, the patent
        positions of companies using RF technologies, including us, are uncertain
        and
        involve complex legal and factual questions. The patent applications filed
        by us
        or others may not result in issued patents or the scope and breadth of any
        claims allowed in any patents issued to us or others may not exclude competitors
        or provide competitive advantages. In addition, patents issued to us, our
        subsidiaries or others may not be held valid if subsequently challenged or
        others may claim rights in the patents and other proprietary technologies
        owned
        or licensed by us. Others may have developed or may in the future develop
        similar products or technologies without violating any of our proprietary
        rights. Furthermore, the loss of any license to technology that we might
        acquire
        in the future may have a material adverse effect on our business, operating
        results and financial condition.
  Some
        of
        the patents and patent applications owned by us are subject to non-exclusive,
        royalty-free licenses held by various U.S. governmental units. These licenses
        permit these U.S. government units to select vendors other than us to produce
        products for the U.S. Government, which would otherwise infringe our patent
        rights that are subject to the royalty-free licenses. In addition, the U.S.
        Government has the right to require us to grant licenses (including exclusive
        licenses) under such patents and patent applications or other inventions
        to
        third parties in certain instances.
  Older
        patent applications in the U.S. are currently maintained in secrecy until
        patents are issued. In foreign countries and for newer U.S. patent applications,
        this secrecy is maintained for a period of time after filing. Accordingly,
        publication of discoveries in the scientific literature or of patents themselves
        or laying open of patent applications in foreign countries or for newer U.S.
        patent applications tends to lag behind actual discoveries and filing of
        related
        patent applications. Due to this factor and the large number of patents and
        patent applications related to RF materials and technologies, and other products
        and technologies that we are pursuing, comprehensive patent searches and
        analyses associated with RF technologies and other products and technologies
        that we are pursuing are often impractical or not cost-effective. As a result,
        patent and literature searches cannot fully evaluate the patentability of
        the
        claims in our patent applications or whether materials or processes used
        by us
        for our planned products infringe or will infringe upon existing technologies
        described in U.S. patents or may infringe upon claims in patent applications
        made available in the future. Because of the volume of patents issued and
        patent
        applications filed relating to RF technologies and other products and
        technologies that we are pursuing, we believe there is a significant risk
        that
        current and potential competitors and other third-parties have filed or will
        file patent applications for, or have obtained or will obtain, patents or
        other
        proprietary rights relating to materials, products or processes used or proposed
        to be used by us. In any such case, to avoid infringement, we would have
        to
        either license such technologies or design around any such patents. We may
        be
        unable to obtain licenses to such technologies or, if obtainable, such licenses
        may not be available on terms acceptable to us or we may be unable to
        successfully design around these third-party patents.
  Our
        participation in litigation or patent office proceedings in the U.S. or other
        countries to enforce patents issued or licensed to us, to defend against
        infringement claims made by others or to determine the ownership, scope or
        validity of the proprietary rights of us and others, could result in substantial
        cost to, and diversion of effort by, us. The parties to such litigation may
        be
        larger, better capitalized than we are and better able to support the cost
        of
        litigation. An adverse outcome in any such proceedings could subject us to
        significant liabilities to third parties, require us to seek licenses from
        third
        parties and/or require us to cease using certain technologies, any of which
        could have a material adverse effect on our business, operating results and
        financial condition.
 -15-
  ****Table
        of Contents****
  **Litigation**
  We
          have
          no active lawsuits, nor any pending or threatened to the best of our knowledge.
          The act of defending against any potential claim may be costly and divert
          management attention. If we are not successful in defending against whatever
          claims and charges may be made against us in the future, there may be a
          material
          adverse effect on our business, operating results and financial
          condition.
 **Government
        Regulations**
  Although
        we believe that our wireless telecommunications products themselves are not
        subject to licensing by, or approval requirements of, the FCC, the operation
        of
        base stations is subject to FCC licensing and the radio equipment into which
        our
        products would be incorporated is subject to FCC approval. Base stations
        and the
        equipment marketed for use therein must meet specified technical standards.
        The
        ability to sell our wireless telecommunications products is dependent on
        the
        ability of wireless base station equipment manufacturers and wireless base
        station operators to obtain and retain the necessary FCC approvals and licenses.
        In order for them to be acceptable to base station equipment manufacturers
        and
        to base station operators, the characteristics, quality and reliability of
        our
        base station products must enable them to meet FCC technical standards. We
        may
        be subject to similar regulations of foreign governments. Any failure to
        meet
        such standards or delays by base station equipment manufacturers and wireless
        base station operators in obtaining the necessary approvals or licenses could
        have a material adverse effect on our business, operating results and financial
        condition. In addition, certain RF filters are on the U.S. Department of
        Commerce’s export regulation list. Therefore, exportation of such RF filters to
        certain countries may be restricted or subject to export licenses.
  We
        are
        subject to governmental labor, safety and discrimination laws and regulations
        with substantial penalties for violations. In addition, employees and others
        may
        bring suit against us for perceived violations of such laws and regulations.
        Defending against such complaints could result in significant legal costs
        for
        us. Although we endeavor to comply with all applicable laws and regulations,
        we
        may be the subject of complaints in the future, which could have a material
        adverse effect on our business, operating results and financial
        condition.
  **Environmental
        Liability**
  Certain
        hazardous materials may be used in research, development and to the extent
        of
        any manufacturing operations. As a result, we are subject to stringent federal,
        state and local regulations governing the storage, use and disposal of such
        materials. It is possible that current or future laws
  and
        regulations could require us to make substantial expenditures for preventive
        or
        remedial action, reduction of chemical exposure, or waste treatment or disposal.
        We believe we are in material compliance with all environmental regulations
        and
        to date have not had to incur significant expenditures for preventive or
        remedial action with respect to the use of hazardous materials.
  However,
        our operations, business or assets could be materially and adversely affected
        by
        the interpretation and enforcement of current or future environmental laws
        and
        regulations. In addition, although we believe that our safety procedures
        for
        handling and disposing of such materials comply with the standards prescribed
        by
        state and federal regulations, there is the risk of accidental contamination
        or
        injury from these materials. In the event of an accident, we could be held
        liable for any damages that result. Furthermore, the use and disposal of
        hazardous materials involves the risk that we could incur substantial
        expenditures for such preventive or remedial actions. The liability in the
        event
        of an accident or the costs of such actions could exceed available resources
        or
        otherwise have a material adverse effect on the business, results of operations
        and financial condition. We carry property and worker’s compensation insurances
        in full force and effect through nationally known carriers which include
        pollution cleanup or removal and medical claims for industrial
        incidents.
  -16-
  ****Table
        of Contents****
  **RISKS
        RELATED TO ACQUISITIONS AND BUSINESS EXPANSION**
  **Risks
        of future acquisitions**
  In
        the future, we may pursue acquisitions to
        obtain products, services and technologies that we believe would complement
        or
        enhance our current product or services offerings. At present, no definitive
        agreements or similar arrangements exist with respect to any such acquisition.
        An acquisition may not produce the revenue, earnings or business synergies
        as
        anticipated and may attach significant unforeseen liabilities, and an acquired
        product, service or technology might not perform as expected. If an acquisition
        is pursued, our management could spend a significant amount of time and effort
        in identifying and completing the acquisition and may be distracted from
        the
        operations of the business. In addition, management would probably have to
        devote a significant amount of resources toward integrating the acquired
        business with the existing business, and that integration may not be
        successful.
  **International
        operations**
  We
        are in
        discussions and have agreements in place with companies in non-U.S. markets
        to
        form manufacturing, product development joint ventures and other marketing,
        distribution or consulting arrangements. We also have agreements with foreign
        entities for international distribution as well as foreign sources of components
        to be used in North America. These agreements and relationships help us optimize
        our competitive position and cost structure. There are many such entities
        that
        exist, domestically and internationally, that offer similar capabilities,
        and
        thus could reduce risk exposure to the loss of such foreign
        entities.
  We
        believe that non-U.S. markets could provide a substantial source of revenue
        in
        the future. However, there are certain risks applicable to doing business
        in
        foreign markets that are not applicable to companies doing business solely
        in
        the U.S. For example, we may be subject to risks related to fluctuations
        in the
        exchange rate between the U.S. dollar and foreign currencies in countries
        in
        which we do business. In addition, we may be subject to the additional laws
        and
        regulations of these foreign jurisdictions, some of which might be substantially
        more restrictive than similar U.S. ones. Foreign jurisdictions may also provide
        less patent protection than is available in the U.S., and we may be less
        able to
        protect our intellectual property from misappropriation and infringement
        in
        these foreign markets.
  **Item 1B.
        Unresolved Staff Comments**
  Not
        applicable.
  **Item 2.
        Properties**
  We
        maintain our corporate headquarters in a 15,000 square foot building located
        in
        Elk Grove Village, Illinois under a lease which expires in October 2014.
        This
        facility houses our manufacturing, research, development, engineering,
        administration and marketing activities. We also maintain a 4,000 square
        foot
        facility located in Elk Grove Village, Illinois under a lease which expires
        in
        October 2014, which is used for R&D purposes. We believe that these
        facilities are adequate and suitable for our current needs and that additional
        space would be available on commercial terms as necessary to meet any future
        needs.
  **Item 3.
        Legal Proceedings**
  None.
        We
        were not involved in any such proceedings during 2006 nor are we aware of
        any
        pending or threatened litigation.
 
 **Item 4.
        Submission of Matters to a Vote of Security Holders**
  None.
 -17-
  
 **Table
        of Contents**
  **PART
        II**
  **Item 5.
          Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer
          Purchases of Equity Securities**
  Our
        common stock has been listed since June 2002 on the American Stock Exchange
        under the symbol “ISO.” Prior to that, and until April 1999, our stock had been
        listed on the OTC Bulletin Board under the symbol “ISCO.” From 1993 until April
        1999, our common stock was listed on the NASDAQ National Market. The following
        table shows, for the periods indicated, the reported high and low sale prices
        for the common stock. Such prices reflect prices between dealers, without
        retail
        mark up, mark down, or commissions and may or may not reflect actual
        transactions.
 
 **High**
              
              
              **Low****FISCAL
                  YEAR ENDED DECEMBER 31, 2005**First
                  Quarter
              
              $
              0.52
              
              $
              0.28Second
                  Quarter
              
              $
              0.41
              
              $
              0.22Third
                  Quarter
              
              $
              0.29
              
              $
              0.23Fourth
                  Quarter
              
              $
              0.45
              
              $
              0.25**FISCAL
                  YEAR ENDED DECEMBER 31, 2006**First
                  Quarter
              
              $
              0.43
              
              $
              0.30Second
                  Quarter
              
              $
              0.43
              
              $
              0.25Third
                  Quarter
              
              $
              0.36
              
              $
              0.27Fourth
                  Quarter
              
              $
              0.45
              
              $
              0.30
  On
        December 31, 2006, there were approximately 300 holders of record of our
        common stock. On such date the closing bid price for our common stock as
        reported on the American Stock Exchange was $0.34.
  We
        have
        never paid cash dividends on the common stock and we do not expect to pay
        any
        dividends on our common stock in the foreseeable future. In addition, borrowings
        under our line of credit are collateralized by all of our assets — we are
        prohibited from paying any dividends, other than dividends consisting solely
        of
        common stock or rights to purchase common stock, unless our lenders waive
        such
        prohibition.
  Except
        as
        reported on our Current Reports on Form 8-K filed with the Securities and
        Exchange Commission on July 26, 2006 and August 3, 2006, there were no
        recent sales of unregistered securities during 2006. Further, there were
        no
        repurchases of equity securities by us during the fourth quarter of
        2006.
  **Item 6.
        Selected Financial Data**
  The
        following table presents selected consolidated financial data with respect
        to us
        as of and for the years ended December 31, 2002, 2003, 2004, 2005, and
        2006. The selected consolidated financial data for each of the years in the
        five-year period ended December 31, 2006 have been derived from our audited
        consolidated financial statements. The information set forth below should
        be
        read in conjunction with Item 7. “Management’s Discussion and Analysis of
        Financial Condition and Results of Operations” and Item 8. “Financial
        Statements and Supplementary Data.”
  -18-
 
 **Table
        of Contents**
 **2002**
              
              **2003**
              
              **2004**
              
              **2005**
              
              **2006****CONSOLIDATED
                  STATEMENT OF****OPERATIONS
                  DATA**Net
                  sales
              $
              3,662,805
              $
              3,238,402
              $
              2,621,933
              $
              10,264,428
              $
              14,997,320Costs
                  and expenses:Cost
                  of sales
              
              3,565,140
              
              1,639,540
              
              1,527,554
              
              5,121,650
              
              9,066,929Research
                  and development
              
              2,737,084
              
              988,425
              
              1,119,406
              
              1,767,447
              
              2,011,652Selling
                  and marketing
              
              2,201,195
              
              959,798
              
              1,164,830
              
              1,861,065
              
              3,207,882General
                  and administrative
              
              7,972,948
              
              5,614,492
              
              4,757,935
              
              3,691,070
              
              4,287,080Operating
                  loss
              
              (12,813,562)
              
              (5,963,853)
              
              (5,947,792)
              
              (2,176,804)
              
              (3,576,223)Other
                  income (Expense)Interest
                  income
              
              62,954
              
              5,087
              
              8,660
              
              77,383
              
              118,590Interest
                  expense
              
              (327,224)
              
              (1,197,309)
              
              (1,028,169)
              
              (877,461)
              
              (907,351)Total
                  other expense, net
              
              (264,270)
              
              (1,192,222)
              
              (1,019,509)
              
              (800,078)
              
              (788,761)Net
                  loss
              $
              (13,077,832)
              $
              (7,156,075)
              $
              (6,967,301)
              
              (2,976,882)
              $
              (4,364,984)Basic
                  and diluted loss percommon
                  share
              $
              (0.09)
              $
              (0.05)
              $
              (0.04)
              $
              (0.02)
              $
              (0.02)Weighted
                  average number ofcommon
                  shares outstanding
              
              142,884,921
              
              148,080,749
              
              158,977,249
              
              170,786,657
              
              185,506,261**CONSOLIDATED
                  BALANCE****SHEET
                  DATA**Cash
                  and cash equivalents
              $
              216,119
              $
              346,409
              $
              402,391
              $
              3,486,430
              $
              2,886,476Working
                  capital
              
              1,333,827
              
              735,840
              
              979,413
              
              6,396,541
              
              (1,422,309)Total
                  assets
              
              19,183,000
              
              17,723,035
              
              17,133,752
              
              22,905,633
              
              26,875,195Long-term
                  debt, less current portion
              2,000,000
              
              5,000,000
              
              7,500,000
              
              10,520,369
              
              5,131,762Stockholders'
                  equity
              
              15,380,306
              
              10,943,247
              
              7,247,635
              
              10,530,716
              
              8,164,192
  We
        received $150,000 from our landlord for leasehold improvements during late
        2004
        and early 2005. Consistent with the appropriate accounting treatment of showing
        these items separately (i.e., showing the full value of the leasehold
        improvement within fixed assets and the unamortized value of the landlord
        credit
        within current liabilities) working capital and total assets were reclassified
        in the 2004 figure above to conform to the 2005 presentation of these items.
        This reclassification has no material effect on the business condition or
        results.
  -19-
 
 **Table
        of Contents**
  **Item 7.
        Management’s Discussion and Analysis of Financial Condition and Results of
        Operations**
  **A
        NOTE CONCERNING FORWARD-LOOKING STATEMENTS**
  The
        discussion below contains certain forward-looking statements that reflect
        our
        current expectations regarding the Company’s future results of operations,
        performance and achievements. Please see the discussion of such forward-looking
        statements under “Forward Looking Statements” above.
  **Overview**
  We
        have
        employed an outsourced manufacturing model wherein we supply raw materials
        to
        external parties and products are then completed. Further, this system allows
        us
        to outsource procurement in the future if we choose to do so. Manufacturing
        partners then produce to specification with Company personnel on hand to
        assist
        with quality control. Our products are designed for efficient production
        in this
        manner, emphasizing solid-state electronics over mechanical devices with
        moving
        parts. The cost benefits associated with these developments, coupled with
        enhanced product functionality, have allowed us to realize good margins and
        efficiently managed overhead costs. Extensions of developed technology, based
        on
        substantial input from customers, have allowed us to launch the RF2 product
        family and consider additional solutions while generally controlling total
        R&D cost.
  Wireless
        telecommunications has undergone significant merger activity in recent years,
        a
        trend which we believe will continue. These activities often result in operators
        with disparate technologies and spectrum assets, and the need to integrate
        those
        assets. In addition, the deployment of data applications is adding to the
        industry requirement to integrate disparate technologies into base stations
        and
        other fixed points of access, resulting in the need to manage multiple wireless
        signals and keep them from interfering with each other. We are focused on
        providing solutions that address these types of requirements. During 2006,
        we
        bid on substantially larger business opportunities than we had in recent
        years.
        These proposals often are accompanied by long approval cycles and we may
        bear
        up-front product development costs. We believe the potential benefits to
        outweigh these costs, and expect to continue to bid on these types of business
        opportunities.
  We
        announced several significant recent events during 2006 and early 2007,
        including a continuing trend of substantially increased revenue during 2006
        which saw the three best quarterly revenue figures in our history, increased
        international sales and sourcing activities, additional penetration into
        our
        largest customers, our first products based partly on digital technology,
        and $5
        million in funding intended to support new product development. Despite these
        improvements, the wireless telecommunications industry is subject to risks
        beyond our control that can negatively impact customer capital spending budgets
        (as occurred during 2003) and/or spending patterns (as occurred during 2004
        and
        to a lesser extent on a quarterly basis after 2004). In addition, a large
        portion of our debt ($11.3 million) matures in August 2007 and must be
        refinanced. For these and other reasons, our financial statements have been
        prepared assuming we will continue as a going concern.
  From
        a
        company-specific view, we have invested in measured infrastructure growth
        to
        allow for potentially substantial revenue expansion. This has caused spending
        to
        increase from 2004 levels. We believe that we now have the infrastructure
        largely in place to allow for such potential revenue expansion, and therefore
        as
        a general guideline do not expect fixed costs to rise, except for some R&D
        associated with product initiatives, during 2007.
  We
        are
        pursuing digital technologies, evidenced by the deployment of our digital
        (front
        end) ANF solution platform during 2006, subsequent extensions of that platform,
        and our expectation to complete a fully digital ANF platform during 2007.
        We
        believe that producing solutions on a digital platform will allow us to extend
        coverage in the wireless telecommunications realm, both in more aspects of
        the
        cellular market and beyond the cellular market, and thus greatly increase
        our
        available market.
  -20-
  ****Table
        of Contents****
  **Results
        of Operations**
  *Years
        Ended December 31, 2006 and 2005*
  Our
        net
        sales increased $4,733,000, or 46%, from $10,264,000 in 2005 to $14,997,000
        in
        2006. This increase was due primarily to the expansion of the RF2 product family
        and related revenues, particularly from data network deployments. An incremental
        improvement was also seen from the shipment of more ANF products during 2006
        than during prior years. We saw our first deferred software revenue during
        2006,
        carrying nearly $0.2 million in deferred software maintenance revenue into
        2007.
        We anticipate our unit volume and related revenue to increase during 2007
        as
        compared to 2006, due to existing and/or anticipated customer orders. Our
        order
        backlog as of December 31, 2006 remained minimal, which was consistent with
        the end of 2005. However, we are pursuing substantial potential revenue
        opportunities as of the beginning of 2007.
  Cost
        of
        products sold increased $3,945,000, or 77%, from $5,122,000 in 2005 to
        $9,067,000 in 2006. The increase in cost of sales was due to the increase
        in
        sales volume, as well as a less favorable product mix than was realized during
        the prior year. RF2 products have varied gross margins, but typically are below
        margins for ANF products, and the expansion of lower margin products outpaced
        that of the higher margin products. We believe that our consistent gross
        margin
        of 40% during 2006 is superior to the industry norm, but it was below our
        record
        50% achieved during 2005.
  Our
        internally funded research and development expenses increased $245,000, or
        14%,
        from $1,767,000 in 2005 to $2,012,000 during 2006. We expensed approximately
        $200,000 of capitalized patent-related charges during the second quarter
        2005,
        as we deemed such items to be unlikely to generate significant future revenues,
        so the increase in 2006 cash spend over 2005 was $200,000 more than reported
        above. We added a significant number of products to our RF2 product family
        during 2006, including a GMA (“ground mounted amplifier”), as well as the first
        digital platformed ANF products. We expect to continue to invest more in
        R&D
        during 2007 than we did during 2006 as we expand both our existing product
        families and develop two new product lines that would be applicable in wireless
        technologies beyond cellular telecommunications, particularly in the digital
        space.
  Selling
        and marketing expenses increased $1,347,000, or 72%, from $1,861,000 during
        2005
        to $3,208,000 during 2006. The increase in expense was attributable to the
        continued addition of personnel in this area as we pursue additional customers
        and larger, more diverse opportunities (these elements contributed to the
        46%
        annual revenue growth increase in 2006 over 2005; and higher if viewed on
        a
        quarterly basis during the last three quarters of 2006). We have also performed
        extensive customer development activities as we have added new customers
        and
        launched new products, including a very detailed and comprehensive interference
        study over a wide geographic range (a one-time cost of approximately $0.2
        million).
  General
        and administrative expenses increased $596,000, or 16%, from $3,691,000 in
        2005
        to $4,287,000 during 2006. This increase was largely attributable to a $0.5
        million increase in non-cash equity charges associated with stock-based
        compensation.
 
 Interest
        income increased $42,000, or 55%, from $77,000 in 2005 to $119,000 during
        2006.
        This increase was due to the timing of payments and funding from the June
        2006
        financing proceeds. Additionally, we saw improved cash flows from operations
        during the second half of 2006.
  Interest
        expense increased $30,000, or 3.4%, from $877,000 in 2005 to $907,000 during
        2006. We borrowed $5 million under a convertible debt arrangement during
        June
        2006 with our two largest shareholders, including affiliates, which also
        hold
        the remainder of our debt which matures August 2007.
  -21-
 **Table
        of Contents**
  *Years
        Ended December 31, 2005 and 2004*
  Our
        net
        sales increased $7,642,000, or 291%, from $2,622,000 in 2004 to $10,264,000
        in
        2005. This increase was due primarily to the expansion of the RF2 product family
        and related revenues, particularly from data network deployments. An incremental
        improvement was also seen from the shipment of more ANF products during 2005,
        such that we earned more revenue from ANF sales than any prior year, including
        2004.
  Cost
        of
        products sold increased $3,594,000, or 235%, from $1,528,000 in 2004 to
        $5,122,000 in 2005. The increase in cost of sales was due to the increase
        in
        sales volume offset by the more efficient allocation of fixed expenses, the
        expanded sourcing of raw materials and resulting cost decreases, and other
        efficiencies.
  Our
        internally funded research and development expenses increased $648,000, or
        58%,
        from $1,119,000 in 2004 to $1,767,000 during 2005. We expensed approximately
        $200,000 of capitalized patent-related charges during the second quarter
        2005,
        as we deemed such items to be unlikely to generate significant future revenues.
        We added a significant number of products to our RF2 product family during 2005,
        including a multicoupler solution and a PCS spectrum portfolio.
  Selling
        and marketing expenses increased $696,000, or 60%, from $1,165,000 during
        2004
        to $1,861,000 during 2005. We have continued to add personnel in this area
        as we
        pursue larger business opportunities and additional customers, and thus expect
        to continue to incur a higher level of selling and marketing expenses in
        future
        periods. It should be noted that this cost as a percentage of revenue has
        decreased from 44% during 2004 to 18% during 2005, reflecting efficiencies
        in
        higher sales volume as fixed expenses are allocated over a larger
        base.
  General
        and administrative expenses decreased $1,067,000, or 22%, from $4,758,000
        in
        2004 to $3,691,000 during 2005. This decrease was attributable to a $1 million
        decrease in legal expenses, primarily related to the concluded patent
        litigation, the reduction in facility costs by approximately $250,000 annually,
        which is offset by various increases in personnel and related costs due to
        growth in our size.
  Interest
        income increased $68,000, or 756%, from $9,000 in 2004 to $77,000 during
        2005.
        This increase was due to the timing of payments and funding from the credit
        line
        and the August 2005 financing proceeds.
  Interest
        and warrant expense decreased $151,000, or 15%, from $1,028,000 in 2004 to
        $877,000 during 2005. We borrowed $1 million under our credit line arrangement
        during 2005, but pursuant to a financing agreement with our lenders, the
        interest rate was reduced from 14% to 9% as of April 2005.
  **Liquidity
        and Capital Resources**
  The
        accompanying financial statements have been prepared assuming that we will
        continue as a going concern. As discussed in Note 3 to the financial statements,
        we incurred a net loss of $4 million during the year ended December 31,
        2006, and, as of that date, our accumulated deficit is $164 million. In
        addition, we have consistently used, rather than provided, cash in our
        operations. These factors, among others, as discussed in Note 3 to the financial
        statements, raise substantial doubt about our ability to continue as a going
        concern. We have been engaged in developing new solutions, and toward that
        end
        development spending has preceded sales revenues. Management’s plans in regard
        to these matters include the focusing of development efforts on products
        with a
        greater probability of commercial sales, increased efficiencies and reduced
        product costs within our outsourced production model, all of which are also
        described in Note 3. The financial statements do not include any adjustments,
        including any adjustments relating to the recoverability and classification
        of
        recorded asset amounts or amounts and classification of liabilities that
        might
        result from the outcome of this uncertainty. Significant uses of cash during
        2006 included the cost to produce inventory, personnel costs, facility related
        costs, increased product development (engineering) costs and sales and marketing
        efforts. Significant sources of cash during 2006 included sales and the
        resulting realization of customer receivables, the sale of $5 million in
        convertible debt in June 2006 to entities that, along with their affiliates,
        are
        our lenders and also our largest two shareholders.
 -22-
  **Table
        of Contents**
  Current
        assets including accounts receivable and inventory, and current liabilities
        including accounts payable and accrued expenses, increased from the prior
        year
        figure due to overall higher business levels. Quarterly and annual revenue
        during 2006 were the highest in our history and, on average, roughly 50%
        larger
        than that of the prior year, and thus created larger working capital balances.
        Working capital includes the classifications listed above.
  In
        view
        of the matters described in the preceding paragraph, recoverability of a
        major
        portion of the recorded asset amounts shown in the accompanying balance sheet
        is
        dependent upon continued operations, which in turn is dependent upon our
        ability
        to meet our financing requirements on a continuing basis, to maintain present
        financing, and to succeed in our future operations.
  At
        December 31, 2006, our cash and cash equivalents, excluding restricted
        certificates of deposit, were $2,886,000, a decrease of $600,000 from the
        December 31, 2005 balance of $3,486,000. This decrease was primarily
        attributable to the increase in working capital (inventories and accounts
        receivable) associated with our higher revenue levels and the timing of orders
        and related shipments.
  The
        continuing development of, and expansion in, sales of our product lines,
        any
        potential merger and acquisition activity, as well as any required defense
        of
        our intellectual property, may require a commitment of funds to undertake
        product line development and to market and sell our RF products. The actual
        amount of our future funding requirements will depend on many factors,
        including: the amount and timing of future revenues, the level of product
        marketing and sales efforts to support our commercialization plans, the
        magnitude of our research and product development programs, our ability to
        improve or maintain product margins, and the costs involved in protecting
        our
        patents or other intellectual property.
  We
        believe that we have sufficient funds to operate our business until $11.3
        million of our debt becomes due in August 2007. That debt is held by our
        two
        largest shareholders, including affiliates. While we expect to refinance
        this
        debt no such refinancing has occurred as of the reporting date, therefore,
        the
        ability to refinance our debt and maintain adequate working capital is necessary
        for us to continue as a going concern Additionally, we project increases
        in
        working capital requirements in order to pursue significant business
        opportunities during 2007 and beyond, and also expect to spend additional
        financial resources in the expansion of our business and product offerings.
        As
        such, we may require additional capital prior to August 2007. We intend to
        look
        into augmenting our existing capital position by continuing to evaluate
        potential short-term and long-term sources of capital whether from debt,
        equity,
        hybrid, or other methods. The primary covenant in our existing debt arrangement
        involves the right of the lenders to receive debt repayment from the proceeds
        of
        new financing activities. This covenant may restrict our ability to obtain
        additional financing or to apply the proceeds of a financing event toward
        operations until the debt is repaid in full.
  **Uncommitted
        Line of Credit (2002 Credit Line)**
  As
        of the
        reporting date, we have drawn $8.5 million of debt financing under a credit
        line, as described below. During October 2002, we entered into an uncommitted
        line of credit with our two largest shareholders, an affiliate of Elliott
        Associates, L.P. (Manchester Securities Corporation) and Alexander Finance,
        L.P.
        This line initially provided up to $4 million to us. This line was uncommitted,
        such that each new borrowing under the facility would be subject to the approval
        of the lenders. Borrowings on this line bore an initial interest rate of
        9.5%
        and were collateralized by all the assets of the Company. Outstanding loans
        under this agreement would be required to be repaid on a priority basis should
        we receive new funding from other sources. Additionally, the lenders were
        entitled to receive warrants to the extent funds were drawn down on the line.
        The warrants bore a strike price of $0.20 per share of common stock and were
        to
        expire on April15, 2004. The credit line was to mature and be due, including
        accrued interest thereon, on March 31, 2004. Due to a subsequent agreement
        between the parties no warrants were issued with subsequent
        borrowings.
 According
        to existing accounting pronouncements and SEC guidelines, we allocated the
        proceeds of these borrowings between their debt and equity components. As
        a
        result of these borrowings during 2002, we recorded a non-cash charge of
        $1.2
        million through the outstanding term of the warrants (April, 2004). $250,000
        and
        $862,000 of that amount were recorded during 2004 and 2003, respectively.
        These
        warrants were valued at $1.2 million of the $2 million debt instrument based
        on
        a Black-Scholes valuation that included the difference between the value
        of our
        common stock and the exercise price of the warrants on the date of each warrant
        issuance and a 30% discounted face value of the notes, leaving the remaining
        $0.8 million as the underlying value of the debt. This $1.2 million was
        amortized over the vesting period of the warrants (six quarters from the
        fourth
        quarter 2002 through the first quarter 2004).
 -23-
 **Table
            of Contents**
 During
          October 2003, we entered into an agreement with our lenders to supplement
          the
          credit line with an additional $2 million, $1 million of which was drawn
          immediately and $1 million subsequently drawn upon our request and subject
          to
          the approval of the lenders. This supplemental facility bore a 14% rate
          of
          interest and was due October 31, 2004. The term of the previous credit
          line was
          not affected by this supplement, and as such the $4 million borrowed under
          that
          line, plus accrued interest, remained due March 31, 2004.
 
  During
          February 2004, the credit line was extended to a due date of April 2005,
          with
          interest after the initial periods to be charged at 14%. No warrants or
          other
          inducements were issued with respect to this extension. Additionally, lenders
          exercised their 10 million warrants during February 2004, agreeing to let
          us use
          the funds for general purposes as opposed to repaying debt.
  During
          July 2004, we and our lenders agreed to increase the aggregate loan commitments
          under the credit line from $6,000,000 to $6,500,000. Simultaneously, we
          drew the
          remaining $1,500,000 of the financing.
  During
          November 2004, we and our lenders agreed to increase the line of credit
          to up to
          an additional $2 million to an aggregate loan commitment of $8,500,000,
          $1
          million of which was drawn immediately by us with the remaining $1 million
          drawable upon our request and subject to the approval of the lenders, which
          occurred during January 2005.
  During
          February 2005, the credit line was extended until April 2006. Interest
          during
          the extension period was to be charged at 9%. No warrants or other inducements
          were issued with respect to this extension.
  On
          August
          2, 2005, we and our lenders agreed to extend the due date from April 2006
          until
          August 2007, and the lenders also agreed to waive the Company’s obligation to
          repay its debt with proceeds from an equity financing transaction with
          its
          lenders, including affiliates, in August 2005. No warrants or other inducements
          were issued as a result of this transaction.
 **2006
        Convertible Debt**
  During
        June 2006 we entered into a Securities Purchase Agreement (the “Agreement”) and
        convertible notes (the “Notes”) with Alexander Finance, L.P., and Manchester
        Securities Corporation L.P. (together, the “Lenders”), pursuant to which the
        Lenders have agreed, to each loan us $2,500,000, or an aggregate of $5,000,000,
        in convertible debt. The Lenders, including affiliates, are our two largest
        shareholders and the lenders of the 2002 Credit Line referenced above. The
        transaction was structured as a private placement of securities pursuant
        to
        Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”)
        and Rule 506 promulgated thereunder.
  The
        Notes
        will mature on June 22, 2010 and bear an interest rate of 5% due at maturity.
        Both the principal amount and any accrued interest on the Notes are convertible
        into our common stock at a rate of $0.33 per share, subject to certain
        anti-dilution adjustments. The Lenders have the right to convert the Notes,
        both
        principal and accrued interest, into shares of common stock at the rate of
        $0.33
        per share at any time. We have the right to redeem the Notes in full in cash
        at
        any time beginning two years after the date of the Agreement. The conversion
        rate of the Notes will be subject to customary anti-dilution protections,
        provided that the number of additional shares of common stock issuable as
        a
        result of changes to the conversion rate will be capped so that the aggregate
        number of shares of common stock issuable upon conversion of the Notes will
        not
        exceed 19.99% of the aggregate number of shares of common stock presently
        issued
        and outstanding.
  The
        Notes
        are secured on a first priority basis by all of our intangible and tangible
        property and assets. Payment of the Notes is guaranteed by our two inactive
        subsidiaries, Spectral Solutions, Inc. and Illinois Superconductor Canada
        Corporation. The Agreement contains customary representations, warranties
        and
        covenants. We filed a registration statement covering the resale of the shares
        of common stock issuable upon conversion of the Notes with the Securities
        and
        Exchange Commission. Concurrently with the execution of the Agreement, the
        Lenders have waived their right under the 2002 Credit Line to receive the
        financing proceeds from the issuance of the Notes, allowing us to use the
        funds
        for product development or general working capital purposes. No fees were
        paid
        to any financial advisor, placement agent, broker or finder in connection
        with
        the transactions contemplated by the Agreement and the Notes.
 -24-
  ****Table
        of Contents****
  Assuming
        the Notes are held for the full four year term,
        18,505,719 shares of common stock would be required upon settlement, for
        both
        principal and interest. This amount is approximately 10% of the then
        approximately 186 million shares of common stock currently issued and
        outstanding. As of December 31, 2006, the Lenders, including their affiliates,
        owned approximately 43% of the Company’s outstanding shares. As a result of this
        transaction, the combined holdings of the Lenders would be approximately
        48% of
        the Company’s outstanding common stock.
  **Critical
        Accounting Policies**
  The
        discussion and analysis of our financial condition and results of operations
        are
        based upon our consolidated financial statements, which have been prepared
        in
        accordance with accounting principles generally accepted in the United States
        of
        America. The preparation of these financial statements requires us to make
        estimates and judgments that affect the reported amount of assets and
        liabilities, revenues and expenses, and related disclosure of contingent
        assets
        and liabilities at the date of our financial statements. Actual results may
        differ from these estimates under different assumptions or
        conditions.
  Critical
        accounting policies are defined as those that are reflective of significant
        judgments and uncertainties, and potentially result in materially different
        results under different assumptions and conditions. We believe that our critical
        accounting policies are limited to those described below. For a detailed
        discussion on the application of these and other accounting policies, see
        Note 2
        in the notes to the consolidated financial statements.
  **Revenue
        Recognition**
  In
        accordance with SAB No. 104, we recognize revenue when the following criteria
        are met: persuasive evidence of an arrangement exists, delivery has occurred
        or
        services have been rendered, price is fixed and determinable, and collectability
        is reasonably assured. Revenues from product sales are generally recognized
        at
        the time of shipment and are recorded net of estimated returns and allowances.
        Revenues from services are generally recognized upon substantial completion
        of
        the service and acceptance by the customer. We have under certain conditions,
        granted customers the right to return product during a specified period of
        time
        after shipment. In these situations, we establish a liability for estimated
        returns and allowances at the time of shipment and make the appropriate
        adjustment in revenue recognized for accounting purposes. During 2006, no
        revenue was recognized on products that included a right to return or otherwise
        required customer acceptance after December 31, 2006. We have established a
        program which, in certain situations, allows customers or prospective customers
        to field test our products for a specified period of time. Revenues from
        field
        test arrangements are recognized upon customer acceptance of the
        products.
  During
        2006, we began to sell the dANF product which contains software that is
        essential to the functionality of the product and as such is required to
        be
        accounted for in accordance with SOP 97-2, “Software Revenue Recognition,” as
        amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition,
        With Respect to Certain Transactions.” The revenue recognized for each separate
        element of a multiple-element software contract is based upon vendor-specific
        objective evidence of fair value, which is based upon the price the customer
        is
        required to pay when the element is sold separately. The dANF product is
        recognized as revenue upon shipment while the maintenance is deferred and
        recognized on a straight line basis during the applicable maintenance period,
        typically 1-3 years.
   -25-
  ****Table
        of Contents****
  We
          warrant our products against defects in materials and workmanship typically
          for
          a 1-2 year period from the date of shipment, though these terms may be
          negotiated on a case by case basis. A provision for estimated future costs
          related to warranty expenses is recorded when revenues are recognized.
          At both
          December 31, 2006 and 2005 we accrued $34,000 for warranty costs. This
          warranty reserve is based on the cost to replace a percentage of products
          in the
          field at a given point, adjusted by actual experience. Returns and allowances
          were not significant in any period reported, and form a data point in
          establishing the reserve. Should this warranty reserve estimate be deemed
          insufficient, by new information, experience, or otherwise, an increase
          to
          warranty expense would be required.
  **Goodwill
        and Intangible Assets**
  During
        2006, we completed our annual process of evaluating goodwill for impairment
        under SFAS No. 142 “Goodwill and Other Intangible Assets”. As the fair value of
        the enterprise, using quoted market prices for our common stock, exceeded
        the
        carrying amount, goodwill was determined to be not impaired. We assess the
        potential for impairment of goodwill annually, or more frequently if events
        or
        changes in circumstances indicate that the asset might be impaired. If we
        determine that the carrying value of goodwill is less than its fair value,
        a
        write-down may be required. In accordance with SFAS No. 144 “Accounting for the
        Impairment or Disposal of Long-Lived Assets”, we review our identifiable
        intangible assets for impairment whenever events or changes in circumstances
        indicate that the carrying amount may not be recoverable. Recoverability
        of the
        intangible assets is measured by a comparison of the carrying amount to the
        fair
        value. If intangible assets are considered to be impaired, the impairment
        to be
        recognized is measured by the amount by which the carrying amount of the
        asset
        exceeds the fair value.
  **Allowance
        for Doubtful Receivables**
  An
        allowance for doubtful receivables may be maintained for potential credit
        losses. Management specifically analyzes accounts receivable, on a client
        by
        client basis, when evaluating the adequacy of our allowance for doubtful
        receivables including customer credit worthiness and current economic trends
        and
        records any necessary bad debt expense based on the best estimate of the
        facts
        known to date. Alternatives to this approach include applying a fixed and/or
        empirical rate of bad debts to receivables. Bad debts have historically been
        very low (none in 2006 or 2005). We believe our current method to be less
        arbitrary and more reliable than the alternatives as described. Should the
        facts
        regarding the collectability of receivables change, the resulting change
        in the
        allowance would be charged or credited to income in the period such
        determination is made. Such a change could materially impact our financial
        position and results of operations.
  **Stock-Based
        Compensation**
 Effective
        January 1, 2006, we adopted the provisions of Statement of Financial Accounting
        Standards ("SFAS") No. 123R, "Share-Based Payment," ("FAS 123R") which
        establishes accounting for equity instruments exchanged for employee services.
        Under the provisions of FAS 123R, share-based compensation cost is measured
        at
        the grant date, based on the calculated fair value of the award, and is
        recognized as an expense over the employee's requisite service period (generally
        the vesting period of the equity grant). Performance-based grants (grants
        that
        vest upon a future event and not due to the passage of time) are not expensed
        until we believe it probable that vesting will occur. We elected to adopt
        the
        modified prospective transition method as provided by FAS 123R and, accordingly,
        financial statement amounts for the prior periods have not been retroactively
        adjusted to reflect the fair value method of expensing share-based compensation.
        Under the modified prospective method, share-based expense recognized after
        adoption includes: (a) share-based expense for all awards granted prior to,
        but
        not yet vested as of January 1, 2006, based on the grant date fair value
        and (b)
        share-based expense for all awards granted subsequent to January 1, 2006.
        We
        changed our equity compensation practices at the same time to emphasize grants
        of restricted stock as opposed to stock options. As most options were fully
        vested as of January 1, 2006, only a small portion of its total equity
        compensation expense came from stock options, with the vast majority coming
        from
        grants of restricted stock. Grants of restricted stock are valued at the
        market
        price on the date of grant and amortized during the service period on a
        straight-line basis or the vesting of such grant, whichever is higher.
 
 -26-
  ****Table
        of Contents****
  **Contractual
        Obligations, Commitments, and Off Balance Sheet
        Arrangements**
  No
        such
        arrangements existed as of December 31, 2006, except for leases as
        described and the minimum lease payments as detailed in this
        document.
  **Contractual
                  Obligations**
              
              **Payments
                  Due by Period****Less
                  than 1**
              
              
              
              
              
              
              
              
              **More
                  than****Year**
              
              
              **Total**
              
              
              **Year**
              
              
              **1-3
                  Years**
              
              
              **3-5
                  Years**
              
              
              **5
                  Years**Long
                  Term Debt Obligations
              
              $
              17,787,000
              
              $
              11,746,000
              
              
              -
              
              $
              6,041,000
              
              
              -Operating
                  Lease Obligations
              
              $
              1,659,000
              
              $
              201,000
              
              $
              413,000
              
              $
              427,000
              
              $
              618,000Total
              
              $
              19,446,000
              
              $
              11,947,000
              
              $
              413,000
              
              $
              6,468,000
              
              $
              618,000
 
 **Recent
        Accounting Pronouncements**
  In
        September 2006, the Financial Accounting Standards Board issued SFAS No.
        157,
        "Fair Value Measurements" ("SFAS 157"). This statement defines fair value
        as
        used in numerous accounting pronouncements, establishes a framework for
        measuring fair value in generally accepted accounting principles ("GAAP")
        and
        expands disclosure related to the use of fair value measures in financial
        statements. SFAS 157 does not expand the use of fair value measures in financial
        statements, but standardizes its definition and guidance in GAAP. SFAS 157
        is
        effective for fiscal years beginning after November 15, 2007. We plan to
        adopt
        the provisions of SFAS 157 on January 1, 2008. We are evaluating the potential
        impact of SFAS 157, but at this time do not anticipate that it will have
        an
        impact on our financial statements when adopted.
  In
        September 2006, the Securities and Exchange Commission ("SEC") released Staff
        Accounting Bulletin No. 108, "Considering the Effects of Prior Year
        Misstatements When Quantifying Misstatements in Current Year Financial
        Statements" ("SAB 108"). SAB 108 provides guidance on how the effects of
        the
        carryover or reversal of prior year financial statement misstatements should
        be
        considered in quantifying a current year misstatement. Prior practice allowed
        the evaluation of materiality on the basis of (1) the error quantified as
        the
        amount by which the current year income was misstated ("rollover method")
        or (2)
        the cumulative error quantified as the cumulative amount by which the current
        year balance sheet was misstated ("iron curtain method"). The guidance provided
        by SAB 108 requires both methods to be used in evaluating materiality.
        Immaterial prior year errors may be corrected with the first filing of prior
        year financial statements after adoption. The cumulative effect of the
        correction would be reflected in the opening balance sheet with appropriate
        disclosure of the nature and amount of each individual error corrected in
        the
        cumulative adjustment, as well as a disclosure of the cause of the error
        and
        that the error had been deemed to be immaterial in the past. We adopted SAB
        108
        for the year ended December 31, 2006, as required, and the adoption did not
        have
        a significant impact on our results of operations or financial position.
  -27-
  **Table
        of Contents**
  In
        July 2006, FASB released FASB Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes, an interpretation of FASB
        Statement
        No. 109” (FIN 48). FIN 48 clarifies the accounting and reporting for
        uncertainties in income tax positions. FIN 48 prescribes a recognition threshold
        and measurement attribute for the financial statement recognition and
        measurement of a tax position taken or expected to be taken in a tax return.
        FIN
        48 also provides guidance on derecognition, classification, interest and
        penalties, accounting in interim periods, disclosure and transition. FIN
        48 is
        effective for fiscal years ending after December 15, 2006. We will adopt
        FIN 48
        as of January 1, 2007, as required. The cumulative effects, if any, of applying
        this Interpretation will be recorded as an adjustment to retained earnings
        as of
        the beginning of the period of adoption. We do not believe the adoption of
        FIN
        48 will impact our results of operations or financial position.
  In
        May
        2005, the Financial Accounting Standards Board (FASB) issued Statement of
        Financial Accounting Standards (SFAS) No. 154, “Accounting Changes and Error
        Corrections”, a replacement of APB Opinion No. 20 and FASB Statement No. 3. This
        statement applies to all voluntary changes in accounting principle, and requires
        retrospective application to prior periods’ financial statements for changes in
        accounting principle. SFAS No. 154 was effective for us beginning on January
        1,
        2006. This statement didn't have a material impact on our financial statements.
  Effective
        January 1, 2006, we adopted SFAS No. 123(R), “Share Based Payments,” as
        described in Note 7, in the Notes to the Consolidated Financial Statements.
        For
        the year ended December 31, 2006, the effect on the results of operations
        of
        recording stock-based compensation in accordance with SFAS 123(R) was $1.6
        Million.
  **Item 7A.
        Quantitative and Qualitative Disclosures About Market Risk**
  We
        do not
        have any material market risk sensitive instruments.
  
 **Item 8.
        Financial Statements and Supplementary Data**
  -28-
  ****Table
        of Contents****
  **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
  Board
        of
        Directors
 ISCO
        International, Inc.
  We
        have
        audited the accompanying consolidated balance sheets of ISCO International,
        Inc.
        (a Delaware corporation) and subsidiaries, as of December 31, 2006 and
        2005, and the related consolidated statements of operations, stockholders’
equity, and cash flows for each of the three years ended December 31, 2006.
        These financial statements are the responsibility of the Company’s management.
        Our responsibility is to express an opinion on these financial statements
        based
        on our audits.
  We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. The Company is not required
        to
        have, nor were we engaged to perform an audit of its internal control over
        financial reporting. Our audit included consideration of internal control
        over
        financial reporting as a basis for designing audit procedures that are
        appropriate in the circumstances, but not for the purpose of expressing an
        opinion on the effectiveness of the Company’s internal control over financial
        reporting. Accordingly, we express no such opinion. An audit also includes
        examining, on a test basis, evidence supporting the amounts and disclosures
        in
        the financial statements assessing the accounting principles used and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audits provide a
        reasonable basis for our opinion.
  In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the consolidated financial position of ISCO
        International, Inc. and subsidiaries as of December 31, 2006 and 2005, and
        the consolidated results of their operations and their cash flows for each
        of
        the three years ended December 31, 2006, in conformity with accounting
        principles generally accepted in the United States of America.
  The
        accompanying financial statements have been prepared assuming that the Company
        will continue as a going concern. As discussed in Note 3, the Company incurred
        a
        net loss of $4,364,984 during the year ended December 31, 2006, and, as of
        that date, the Company’s accumulated deficit was $164,405,272. In addition, the
        Company has consistently used, rather than provided, cash in its operations.
        These factors, among others, as discussed in Note 3 to the financial statements,
        raise substantial doubt about the Company’s ability to continue as a going
        concern. Management’s plans in regard to these matters are also described in
        Note 3. The financial statements do not include any adjustments that might
        result from the outcome of this uncertainty.
  As
        discussed in Notes 2 and 7 to the consolidated financial statements, effective
        January 1, 2006, the Company adopted Statement of Financial Accounting Standard
        Number 123 (revised 2004), “Share Based Payments.”
  
  Grant
        Thornton LLP
  Chicago,
        Illinois
 March 30,
        2007
  -29-
 **Table
          of Contents**
  **ISCO
        INTERNATIONAL**
 **CONSOLIDATED
        BALANCE SHEETS**
 **December
                    31,**
                
                
                **December
                    31,****2006**
                
                
                **2005****Assets:**Current
                    Assets:Cash
                    and Cash Equivalents
                
                $
                2,886,476
                
                $
                3,486,430Inventory
                
                
                6,368,599
                
                
                2,715,170Accounts
                    Receivable, net
                
                
                2,554,716
                
                
                1,677,334Prepaid
                    Expenses and Other
                
                
                168,741
                
                
                253,167Total
                    Current Assets
                
                
                11,978,532
                
                
                8,132,101Property
                    and Equipment
                
                
                1,334,203
                
                
                1,037,432Less:
                    Accumulated Depreciation
                
                
                (811,167)
                
                
                (720,142)Net
                    Property and Equipment
                
                
                523,036
                
                
                317,290Restricted
                    Certificates of Deposit
                
                
                162,440
                
                
                242,180Goodwill
                
                
                13,370,000
                
                
                13,370,000Intangible
                    assets, net
                
                
                841,187
                
                
                844,062Total
                    Assets
                
                $
                26,875,195
                
                $
                22,905,633**Liabilities
                    and Stockholders' Equity:**Current
                    Liabilities:Accounts
                    Payable
                
                $
                1,172,844
                
                $
                416,095Inventory-related
                    material purchase accrual
                
                
                328,663
                
                
                530,134Employee-related
                    accrued liability
                
                
                284,653
                
                
                208,408Accrued
                    professional services
                
                
                93,000
                
                
                279,000Other
                    accrued liabilities and current deferred revenue
                
                
                225,724
                
                
                301,923Current
                    Portion of LT Debt, including related interest, with related
                    parties
                
                
                11,295,957
                
                
                -Total
                    Current Liabilities
                
                
                13,400,841
                
                
                1,735,560Deferred
                    facility reimbursement
                
                
                102,500
                
                
                118,988Deferred
                    revenue - non current
                
                
                75,900
                
                
                -Notes
                    and related accrued interest with related parties, net of current
                    portion
                
                
                5,131,762
                
                
                10,520,369Stockholders'
                    equity:Preferred
                    stock; 300,000 shares authorized; No shares issued and outstandingat December 31, 2006 and December 31, 2005
                
                
                -
                
                
                -Common
                    stock ($.001 par value); 250,000,000 shares authorized;
                    189,622,133and 183,252,018 shares issued and outstanding at December 31,
                    2006 andDecember 31, 2005, respectively
                
                
                189,622
                
                
                183,252Additional
                    paid-in capital
                
                
                172,379,842
                
                
                170,387,752Accumulated
                    deficit
                
                
                (164,405,272)
                
                
                (160,040,288)Total
                    Shareholders' Equity
                
                
                8,164,192
                
                
                10,530,716**Total
                    Liabilities and Shareholders' Equity**
                
                $
                26,875,195
                
                $
                22,905,633
  See
        the
        accompanying Notes which are an integral part of the financial
        statements.
 -30-
  
  **Table
        of Contents**
  **ISCO
        INTERNATIONAL**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS**
  **Year
                  Ended December 31,****2006**
              
              
              **2005**
              
              
              **2004**Net
                  sales
              
              $
              14,997,320
              
              $
              10,264,428
              
              $
              2,621,933Costs
                  and expenses:Cost
                  of sales
              
              
              9,066,929
              
              
              5,121,650
              
              
              1,527,554Research
                  and development
              
              
              2,011,652
              
              
              1,767,447
              
              
              1,119,406Selling
                  and marketing
              
              
              3,207,882
              
              
              1,861,065
              
              
              1,164,830General
                  and administrative
              
              
              4,287,080
              
              
              3,691,070
              
              
              4,757,935Total
                  costs and expenses
              
              
              18,573,543
              
              
              12,441,232
              
              
              8,569,725Operating
                  loss
              
              
              (3,576,223)
              
              
              (2,176,804)
              
              
              (5,947,792)Other
                  income (expense)Interest
                  income
              
              
              118,590
              
              
              77,383
              
              
              8,660Non-cash
                  warrant expense
              
              
              -
              
              
              -
              
              
              (250,297)Interest
                  expense
              
              
              (907,351)
              
              
              (877,461)
              
              
              (777,872)Total
                  other expense, net
              
              
              (788,761)
              
              
              (800,078)
              
              
              (1,019,509)Net
                  loss
              
              $
              (4,364,984)
              
              
              (2,976,882)
              
              $
              (6,967,301)Basic
                  and diluted loss per common share
              
              $
              (0.02)
              
              
              (0.02)
              
              $
              (0.04)Weighted
                  average number of common shares outstanding
              
              
              185,506,261
              
              
              170,786,657
              
              
              158,977,249
   See
        the
        accompanying Notes which are an integral part of the financial
        statements.
 
 -31-
  **Table
        of Contents**
  **ISCO
        INTERNATIONAL**
 **CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS’ EQUITY**
  **Years
        Ended December 31, 2004, 2005, and 2006**
 **Common**
                
                **Common**
                
                **Additional**
                
                **Accumulated****Stock**
                
                **Stock**
                
                **Paid-In**
                
                **Deficit****Shares**
                
                **Amount**
                
                **Capital**
                
                
                
                **Total****Balance
                    as of December 31, 2003**
                
                150,149,927
                $
                150,150
                $
                160,889,202
                $
                (150,096,105)
                $
                10,943,247Exercise
                    of Stock Options
                
                1,063,776
                
                1,064
                
                140,676
                
                -
                
                141,740Exercise
                    of Warrants
                
                10,000,000
                
                10,000
                
                1,990,000
                
                -
                
                2,000,000Stock-Based
                    Compensation
                
                -
                
                -
                
                879,652
                
                -
                
                879,652Non-cash
                    Warrant Expense
                
                -
                
                -
                
                250,297
                
                -
                
                250,297Net
                    Loss
                
                -
                
                -
                
                -
                
                (6,967,301)
                
                (6,967,301)**Balance
                    as of December 31, 2004**
                
                161,213,703
                $
                161,214
                $
                164,149,827
                $
                (157,063,406)
                $
                7,247,635Exercise
                    of Stock Options
                
                2,038,333
                
                2,038
                
                265,078
                
                -
                
                267,116Equity
                    Financing
                
                20,000,000
                
                20,000
                
                4,280,000
                
                -
                
                4,300,000Section
                    16b recovery
                
                -
                
                -
                
                607,223
                
                -
                
                607,223Stock-Based
                    Compensation
                
                -
                
                -
                
                1,085,624
                
                -
                
                1,085,624Net
                    Loss
                
                -
                
                -
                
                -
                
                (2,976,882)
                
                (2,976,882)**Balance
                    as of December 31, 2005**
                
                183,252,036
                $
                183,252
                $
                170,387,752
                $
                (160,040,288)
                $
                10,530,716Exercise
                    of Stock Options
                
                2,582,826
                
                2,583
                
                427,330
                
                -
                
                429,913Stock
                    Grants Vested
                
                3,787,271
                
                3,787
                
                (3,787)
                
                -Section
                    16b recovery
                
                -
                
                -
                
                3,124
                
                -
                
                3,124Stock-Based
                    Compensation
                
                -
                
                -
                
                1,565,423
                
                -
                
                1,565,423Net
                    Loss
                
                -
                
                -
                
                -
                
                (4,364,984)
                
                (4,364,984)**Balance
                    as of December 31, 2006**
                
                189,622,133
                $
                189,622
                $
                172,379,842
                $
                (164,405,272)
                $
                8,164,192
  See
        the
        accompanying Notes which are an integral part of the financial
        statements.
  -32-
 **Table
        of Contents**
  **ISCO
        INTERNATIONAL**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
  **Years
                  Ended December 31,****2006**
              
              
              **2005**
              
              
              **2004****OPERATING
                  ACTIVITIES**Net
                  loss
              
              $
              (4,364,984)
              
              $
              (2,976,882)
              
              $
              (6,967,301)Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Depreciation
              
              
              92,963
              
              
              81,174
              
              
              633,794Amortization
              
              
              54,431
              
              
              56,560
              
              
              50,325Non-cash
                  compensation charges
              
              
              1,565,423
              
              
              1,085,624
              
              
              879,651Non-cash
                  warrant issuance-related expense
              
              
              -
              
              
              -
              
              
              250,297Patent-related
                  charge
              
              
              -
              
              
              199,819
              
              
              32,564Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (877,382)
              
              
              (1,554,874)
              
              
              1,047,251Inventories
              
              
              (3,653,429)
              
              
              (1,746,122)
              
              
              (290,687)Prepaid
                  expenses and other
              
              
              84,426
              
              
              341,321
              
              
              (273,341)Accounts
                  payable
              
              
              756,749
              
              
              213,482
              
              
              (41,034)Accrued
                  liabilities and deferred revenue
              
              
              476,837
              
              
              1,290,565
              
              
              499,616Deferred
                  occupancy costs
              
              
              106,250
              
              
              -
              
              
              -Net
                  cash used in operating activities
              
              
              (5,758,716)
              
              
              (3,009,333)
              
              
              (4,178,865)**INVESTING
                  ACTIVITIES**Decrease/
                  (Increase) in restricted certificates of deposit
              
              
              79,740
              
              
              48,847
              
              
              (250,500)Payment
                  of patent costs
              
              
              (51,556)
              
              
              (49,121)
              
              
              (38,707)Acquisition
                  of property and equipment, net
              
              
              (302,458)
              
              
              (80,694)
              
              
              (117,686)Net
                  cash used in investing activities
              
              
              (274,274)
              
              
              (80,968)
              
              
              (406,893)**FINANCING
                  ACTIVITIES**Proceeds
                  from warrants
              
              
              -
              
              
              -
              
              
              2,000,000Proceeds
                  from equity issuance
              
              
              -
              
              
              4,300,000
              
              
              -Proceeds
                  from Section 16b recovery
              
              
              3,124
              
              
              607,223
              
              
              -Exercise
                  of stock options
              
              
              429,912
              
              
              267,117
              
              
              141,740Proceeds
                  from issuance of notes
              
              
              5,000,000
              
              
              1,000,000
              
              
              2,500,000Net
                  cash provided by financing activities
              
              
              5,433,036
              
              
              6,174,340
              
              
              4,641,740Increase
                  in cash and cash equivalents
              
              
              (599,954)
              
              
              3,084,039
              
              
              55,982Cash
                  and cash equivalents at beginning of period
              
              
              3,486,430
              
              
              402,391
              
              
              346,409Cash
                  and cash equivalents at end of period
              
              $
              2,886,476
              
              $
              3,486,430
              
              $
              402,391Supplemental
                  cash flow informationCash
                  paid for interest and income taxes
              
              $
              -
              
              $
              -
              
              $
              -
  See
        the
        accompanying Notes which are an integral part of the financial
        statements
 -33-
   **Table
        of Contents**
  **Notes
        to the Financial Statements**
  **1.
        Description of Business**
  ISCO
        International (including its inactive subsidiaries, Spectral Solutions, Inc.,
        and Illinois Superconductor Canada Corporation, the “Company”) addresses RF
        (Radio Frequency) and radio link optimization issues, including interference
        issues, within wireless communications. The Company uses unique products,
        including ANF, RF2, and other solutions, as well as service expertise, in
        improving the RF handling of a wireless system, particularly the radio link
        (the
        signal between the mobile device and the base station). A subset of this
        capability is mitigating the impact of interference on wireless communications
        systems. These solutions are designed to enhance the quality, capacity, coverage
        and flexibility of wireless telecommunications services. The Company has
        historically marketed its products to cellular, PCS and wireless
        telecommunications service providers and OEM’s located both in the United States
        and in international markets.
  **2.
        Summary of Significant Accounting Policies**
  **Principles
        of Consolidation**
  The
        consolidated financial statements include the accounts of the Company and
        its
        wholly owned subsidiaries. All intercompany balances and transactions have
        been
        eliminated.
  **Cash
        and Cash Equivalents**
  Cash
        and
        cash equivalents consist of demand deposits, time deposits, money market
        funds,
        and commercial paper which have original maturities of three months or less
        from
        the date of purchase. Management believes that the financial institutions
        in
        which it maintains such deposits are financially sound and, accordingly,
        minimal
        credit risk exists with respect to these deposits.
  **Accounts
        receivable**
  The
        majority of the Company’s accounts receivable is due from companies in the
        telecommunications industry. Credit is extended based on evaluation of a
        customers’ financial condition and, generally, collateral is not required.
        Accounts receivable are typically due within 30 days and are stated at amounts
        due from customers, net of an allowance for doubtful accounts. Accounts
        outstanding longer than the contractual payment terms are considered past
        due.
        The Company determines its allowance for doubtful accounts by considering
        a
        number of factors, including the length of time trade accounts receivable
        are
        past due, the Company’s previous loss history, the customer’s current ability to
        pay its obligation to the Company, and the condition of the general economy
        and
        the industry as a whole. The Company writes-off accounts receivable when
        they
        become uncollectible, and payments subsequently received on such receivables
        are
        credited to the allowance for doubtful accounts. The allowance could be
        materially different if economic conditions change or actual results deviate
        from historical trends.
  **Inventories**
  Inventories
        are stated at the lower of cost (determined on a first in, first out basis)
        or
        market.
  -34-
  **Table
          of Contents**
  **Property
          and Equipment**
  Property
          and equipment are stated at cost, less accumulated depreciation, and are
          depreciated over the estimated useful lives of the assets using both straight
          line and accelerated methods. The accelerated method used is the double
          declining balance method. Software is typically amortized over 3 years
          utilizing
          the straight-line method. Leasehold improvements are amortized using the
          straight-line method over the shorter of the useful life of the asset or
          the
          term of the lease. Amortization of leasehold improvements is included in
          depreciation expense. The useful lives assigned to property and equipment
          for
          the purpose of computing book depreciation follow:
 
 Manufacturing
                  equipment
              
              3 to 4 yearsOffice
                  equipment
              
              3
                  to 5 yearsFurniture
                  and fixtures
              
              5
                  yearsLeasehold
                  improvements
              
              Life of lease
  **Income
        Taxes**
  Deferred
        tax assets and liabilities are determined based on differences between financial
        reporting and tax bases of assets and liabilities and are measured using
        the
        enacted tax rates and laws that will be in effect when the differences are
        expected to reverse. The Company uses a valuation allowance when it determines
        the amount of deferred tax asset to include in its financial statement for
        the
        current period is not realizable. This valuation allowance is based on
        historical patterns of taxable income, recognized deferred tax liabilities,
        and
        other factors that could impact the current view of future tax asset
        utilization.
  **Revenue
        Recognition**
  Revenues
        from product sales are generally recognized at the time of shipment and are
        recorded net of estimated returns and allowances. Revenues from services
        are
        generally recognized upon substantial completion of the service and acceptance
        by the customer. We have under certain conditions, granted customers the
        right
        to return product during a specified period of time after shipment. In these
        situations, we establish a liability for estimated returns and allowances
        at the
        time of shipment and make the appropriate adjustment in revenue recognized
        for
        accounting purposes. During 2006, no revenue was recognized on products that
        included a right to return or otherwise required customer acceptance after
        December 31, 2006. We have established a program which, in certain
        situations, allows customers or prospective customers to field test our products
        for a specified period of time. Revenues from field test arrangements are
        recognized upon customer acceptance of the products.
  During
        2006, we began to sell the dANF product which contains software that is
        essential to the functionality of the product and as such is required to
        be
        accounted for in accordance with SOP 97-2, “Software Revenue Recognition,” as
        amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition,
        With Respect to Certain Transactions.” The revenue recognized for each separate
        element of a multiple-element software contract is based upon vendor-specific
        objective evidence of fair value, which is based upon the price the customer
        is
        required to pay when the element is sold separately. The dANF product is
        recognized as revenue upon shipment while the maintenance is deferred and
        recognized on a straight line basis during the applicable maintenance period,
        typically 1-3 years.
  **Product
        Warranty**
  The
        Company warrants its products against defects in materials and workmanship
        typically for a 1-2 year period from the date of shipment, though these terms
        may be negotiated on a case-by-case basis. A provision for estimated future
        costs related to warranty expenses is recorded when revenues are recognized.
        At
        both December 31, 2006 and 2005 the Company accrued $34,000 for warranty
        costs. This warranty reserve is based on the cost to replace a percentage
        of
        products in the field at a given point, adjusted by actual experience. Returns
        and allowances were not significant in any period reported, and form a data
        point in establishing the reserve. Should this warranty reserve estimate
        be
        deemed insufficient, by new information, experience, or otherwise, an increase
        to warranty expense would be required.
 -35-
  **Table
          of Contents**
  **Concentration
        of Credit Risk**
  Sales
        to
        three of the Company’s customers accounted for 98%, 97% and 94% of the Company’s
        total revenues for 2006, 2005 and 2004, respectively. The balance of Accounts
        Receivable from our top three customers was $2.5 Million and $1.7 Million
        as of
        December 31, 2006 and  2005, respectively. During 2006 the top three
        customers were Verizon Wireless, Alltel Corporation, and Bluegrass Cellular
        Corporation, respectively.
  **Advertising
        Costs**
  Advertising
        costs are charged to expense in the period incurred.
  **Research
        and Development Costs**
  Research
        and development costs related to both present and future products are charged
        to
        expense in the period incurred.
  **Net
        Loss Per Common Share**
  Basic
        and
        diluted net loss per common share are computed based upon the weighted average
        number of common shares outstanding. Approximately 5 million common shares
        issuable as of December 31, 2006 upon the exercise of options and warrants,
        and 9 million unvested shares of restricted stock, are not included in the
        per
        share calculations since the effect of their inclusion would be
        antidilutive.
  **Use
        of Estimates**
  The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires management to
        make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities at the date
        of
        the financial statements, and the reported amounts of revenues and expenses
        during the reporting period. Actual results could differ from those
        estimates.
  **Description
        of Certain Concentrations and Risks**
  The
        Company operates in a highly competitive and rapidly changing industry. Product
        revenues are currently concentrated with a limited number of customers, and
        the
        supply of certain materials is concentrated among a few providers. The
        development and commercialization of new technologies by any competitor could
        adversely affect the Company’s results of operations.
  **Goodwill
        and Intangible Assets**
  Patents
        and trademarks represent costs, primarily legal fees and expenses, incurred
        in
        order to prepare and file patent applications related to various aspects
        of the
        Company’s technology and to its current and proposed products. Patents and
        trademarks are recorded at cost and are amortized using the straight-line
        method
        over the shorter of their estimated useful lives or 17 years. The recoverability
        of the carrying values of patents and trademarks is evaluated on an ongoing
        basis by Company management. Factors involved in this evaluation include
        whether
        the item is in force, whether it has been directly threatened or challenged
        in
        litigation or administrative process, continued usefulness of the item in
        current and/or expected utilization by the Company in its solution offerings,
        perceived value of such material or invention in the marketplace, availability
        and utilization of alternative or other technologies, the perceived protective
        value of the item, and other factors.
 -36-
  **Table
        of Contents**
  During
          2006 and 2005, the Company wrote off approximately $0 and $200,000,
          respectively, in patent-related costs. Total capitalized patent and trademark
          costs were approximately $841,000 and $844,000 at December 31, 2006 and
          2005, respectively. Capitalized patent costs related to pending patents
          were
          approximately $289,000 and $266,000 at December 31, 2006 and 2005,
          respectively. Patents and trademarks were reported net of accumulated
          amortization of approximately $321,000 and $268,000 at December 31, 2006
          and 2005, respectively.
  As
        of the
        reporting date, the Company had recorded goodwill resulting from the
        acquisitions of Spectral Solutions, Inc. and the Adaptive Notch Filter division
        of Lockheed Martin Canada, Inc., both during 2000. Beginning January 1,
        2002, goodwill is no longer to be amortized but rather to be tested for
        impairment on an annual basis and between annual tests whenever there is
        an
        indication of potential impairment. Impairment losses would be recognized
        whenever the implied fair value of goodwill is determined to be less than
        its
        carrying value. SFAS 142 prescribes a two-step impairment test to determine
        whether the carrying value of the Company’s goodwill is impaired. The first step
        of the goodwill impairment test is used to identify potential impairment,
        while
        the second step measures the amount of the impairment loss. Step one to this
        test requires the comparison of the fair value of each reporting unit with
        its
        carrying amount, including goodwill. As the Company is comprised of a single
        reporting unit, the question of fair value is centered upon whether the market
        value, as measured by market capitalization, of the Company exceeds
        shareholders’ equity. The excess of the Company’s market capitalization over its
        reported shareholders’ equity indicates that the goodwill of the Company’s sole
        reporting unit was not impaired as of December 31, 2006 and
        2005.
  The
        Company’s balances of Goodwill and Intangible Assets were as
        follows:
  **Year Ended December 31,****2006**
              
              **2005****(in thousands of dollars)**Patent,
                  gross
              
              $
              1,162
              
              $
              1,112Accumulated
                  amortization
              
              
              (321)
              
              
              (268)Other
                  amortizable intangibles, net
              
              $
              841
              
              $
              844Goodwill
              
              $
              13,370
              
              $
              13,370
  The
        following table summarizes the estimated annual pretax amortization expense
        for
        the intangible assets with definitive lives:
 2007
              
              
              
              
              
              512008
              
              
              
              
              
              512009
              
              
              
              
              
              512010
              
              
              
              
              
              512011
              
              
              
              
              
              50Thereafter
              
              
              
              
              
              587Total
              
              
              
              
              $
              841
  **Fair
        Value of Financial Instruments**
  The
        carrying values of financial instruments, including accounts receivable,
        accounts payable, and long-term debt, approximates fair value.
  -37-
  ****Table
        of Contents****
  **Long
        Lived Assets**
  In
        accordance with the provisions of SFAS No. 144, “Accounting for the
        Impairment or Disposal of Long-Lived Assets,” the Company reviews long-lived
        assets, including property and equipment, for impairment whenever events
        or
        changes in business circumstances indicate the carrying amount of the assets
        may
        not be fully recoverable. Under SFAS No. 144, an impairment loss is
        recognized when estimated undiscounted future cash flows expected to result
        from
        use of the asset and its eventual disposition are less than the carrying
        amount.
        Impairment, if any, is determined using discounted cash flows. The Company
        had
        no such impairment losses in 2006 or 2005.
  **Stock-Based
        Employee Compensation**
 
 In
        December 2004, the FASB issued SFAS No.123 (revised 2004), “Share-Based Payment”
(SFAS No.123R). This statement requires that the compensation cost relating
        to
        share-based payment transactions be recognized in the financial statements.
        Compensation cost is to be measured based on the estimated fair value of
        the
        equity-based compensation awards issued as of the grant date. The related
        compensation expense will be based on the estimated number of awards expected
        to
        vest and will be recognized over the requisite service period (often the
        vesting
        period) for each grant. The statement requires the use of assumptions and
        judgments about future events and some of the inputs to the valuation models
        will require considerable judgment by management.
 
 SFAS
        No.123(R) replaces FASB Statement No.123 (SFAS No.123), “Accounting for
        Share-Based Compensation,” and supersedes APB Opinion No.25, “Accounting for
        Stock Issued to Employees.” The provisions of SFAS No.123(R) are required to be
        applied by public companies that do not file as small business issuers, as
        of
        the first interim or annual reporting period that begins after June 15, 2005,
        and all other public companies as of the first interim or annual reporting
        period that begins after December 15, 2005. On April 14, 2005, the SEC adopted
        a
        new rule amending the effective date for Statement 123(R). Based on the amended
        rule, registrants were required to implement Statement 123(R) as of the first
        annual period beginning after June 15, 2005, which was January 1, 2006 for
        us.
 
 On
        January 1, 2006, we adopted SFAS No.123(R), under the modified prospective
        application transition method without restatement of prior interim periods.
        This
        resulted in our recognizing compensation cost based on the requirements of
        SFAS
        No.123(R) for all equity-based compensation awards issued after the effective
        date of this statement. For all equity-based compensation awards that were
        unvested as of that date, compensation cost is recognized for the unamortized
        portion of compensation cost not previously included in the SFAS No.123 pro
        forma footnote disclosure. The adoption of SFAS No.123(R) had a material
        effect
        on the Company’s results of operations with respect to equity issuances during
        2006, with an equity compensation charge of $1.5 million during
        2006.
 
 The
        effects on earnings and earnings per share if the value recognition provisions
        of FAS 123(R) were applied to the twelve-month periods ended December 31,
        2005
        and 2004, respectively, is presented in the following tables:
 
 **In
                  thousands of dollars:**
              
              **Twelve
                  months ended**
                **December
                  31, 2005**
              
              **Twelve
                  months ended**
                **December
                  31, 2004**Net
                  loss, as reported
              
              $
              (2,977
              )
              $
              (6,967
              )Deduct
                  net change in stock-based employee compensation expense determined
                  under
                  fair-value-based method of all rewards, net of tax
              
              $
              (273
              )
              $
              (406
              )Pro
                  forma net loss
              
              $
              (3,250
              )
              $
              (7,373
              )Pro
                  forma net loss per share (basic)
              
              $
              (0.02
              )
              $
              (0.05
              )Pro
                  forma net loss per share (diluted)
              
              $
              (0.02
              )
              $
              (0.05
              )
 
 -38-
 **Table
        of Contents**
  The
        following table summarizes the stock option activity during the fiscal year
        ended December 31, 2006:
 
 Outstanding,
                  December 31, 2005
              
              
              8,146,000Granted
              
              
              -Forfeited
                  or canceled
              
              
              (651,000)Exercised
              
              
              (2,583,000)Outstanding,
                  December 31, 2006
              
              
              4,912,000
 
 The
        fair
        value of each option grant was estimated on the date of grant using the
        Black-Scholes option pricing model with the following weighted-average
        assumptions used for grants in 2005: no dividend yield, expected volatility
        of
        105%, risk-free interest rate of 3.8%, and an expected life of 4 years. No
        options were granted during 2006.
 
 At
        December 31, 2006, a total of 4.9 million stock options were outstanding
        under
        the Company’s equity compensation plans, all but less than 0.1 million of which
        are fully vested. Stock-based compensation expense recognized during the
        fiscal
        year ended December 31, 2006 includes compensation expense for stock options
        granted prior to this period but not yet vested, based on the grant date
        fair
        value estimated in accordance with the pro forma provisions of FAS 123. Included
        in stock-based compensation expense for the fiscal year ended December 31,
        2006
        was $0.1 million related to stock options.
 
 Restricted
        Share Rights
 
 Restricted
        share grants offer employees the opportunity to earn shares of the Company’s
        stock over time. Grants issued during 2006 generally vest over two years
        for
        employees and one year for non-employee directors. For grants during 2007
        and
        beyond, we expect that the typical vesting period for employees will be four
        years while the vesting period for non-employee directors will remain tied
        to
        the one year service period (directors are elected annually by our
        shareholders). We recognize the issuance of the shares related to these
        stock-based compensation awards and the related compensation expense on a
        straight-line basis over the vesting period, or on an accelerated basis in
        those
        cases where the actual vesting is faster than the proportional straight line
        value. Included within these grants are also performance-based shares, that
        is,
        shares that vest based on accomplishing particular objectives as opposed
        to
        vesting over time. No performance-based shares were vested during the fiscal
        year ended December 31, 2006.
 
 The
        following table summarizes the restricted stock award activity during
        2006.
 
 **Weighted****Average
                  Grant Date****Shares**
              
              
              **Fair
                  Value (per share)**Outstanding,
                  December 31, 2005
              
              
              None
              
              
              NoneGranted
              
              
              15,598,000
              
              $
              0.35Forfeited
                  or canceled
              
              
              (3,097,000)
              
              $
              0.34Vested
              
              
              (3,787,000)
              
              $
              0.35Outstanding,
                  December 31, 2006
              
              
              8,714,000
              
              $
              0.35
  The
        total
        fair value of restricted shares vested during the fiscal year ended December
        31,
        2006 was $1.3 million. Total non-cash equity compensation expense recognized
        during the fiscal year ended December 31, 2006 was $1.6 million. Non-cash
        equity
        expense for the fiscal year ended December 31, 2006 included $1.3 million
        for
        vested restricted share grants, $0.1 million for the vesting of stock options
        awarded prior to 2006, and $0.2 million for the straight-line amortization
        of
        restricted share grants that did not vest during the fiscal year ended December
        31, 2006.
 -39-
 
 **Table
        of Contents**
  **Recent
        Accounting Pronouncements**
  In
        September 2006, the Financial Accounting Standards Board issued SFAS No.
        157,
        "Fair Value Measurements" ("SFAS 157"). This statement defines fair value
        as
        used in numerous accounting pronouncements, establishes a framework for
        measuring fair value in generally accepted accounting principles ("GAAP")
        and
        expands disclosure related to the use of fair value measures in financial
        statements. SFAS 157 does not expand the use of fair value measures in financial
        statements, but standardizes its definition and guidance in GAAP. SFAS 157
        is
        effective for fiscal years beginning after November 15, 2007. We plan to
        adopt
        the provisions of SFAS 157 on January 1, 2008. We are evaluating the potential
        impact of SFAS 157, but at this time do not anticipate that it will have
        an
        impact on our financial statements when adopted.
  In
        September 2006, the Securities and Exchange Commission ("SEC") released Staff
        Accounting Bulletin No. 108, "Considering the Effects of Prior Year
        Misstatements When Quantifying Misstatements in Current Year Financial
        Statements" ("SAB 108"). SAB 108 provides guidance on how the effects of
        the
        carryover or reversal of prior year financial statement misstatements should
        be
        considered in quantifying a current year misstatement. Prior practice allowed
        the evaluation of materiality on the basis of (1) the error quantified as
        the
        amount by which the current year income was misstated ("rollover method")
        or (2)
        the cumulative error quantified as the cumulative amount by which the current
        year balance sheet was misstated ("iron curtain method"). The guidance provided
        by SAB 108 requires both methods to be used in evaluating materiality.
        Immaterial prior year errors may be corrected with the first filing of prior
        year financial statements after adoption. The cumulative effect of the
        correction would be reflected in the opening balance sheet with appropriate
        disclosure of the nature and amount of each individual error corrected in
        the
        cumulative adjustment, as well as a disclosure of the cause of the error
        and
        that the error had been deemed to be immaterial in the past. We adopted SAB
        108
        for the year ended December 31, 2006, as required, and the adoption did not
        have
        a significant impact on our financial statements.
 
 During
        July 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes,”
which will impact the recognition, measurement, and disclosure of positions
        taken for income tax purposes. The Interpretation is effective for fiscal
        years
        beginning after December 15, 2006 (January 1, 2007 for us). Because we have
        historically posted losses and have maintained a full valuation allowance
        on our
        available future income tax benefit, we do not expect this Interpretation
        to
        have a material effect on our results of operations or financial
        position.
  **Reclassifications**
  Certain
        amounts reported in prior years have been reclassified from what was previously
        reported to conform to the current year’s presentation.
  **3.
        Realization of Assets**
  The
        accompanying financial statements have been prepared in conformity with
        accounting principles generally accepted in the United States of America,
        which
        contemplate continuation of the Company as a going concern. However, the
        Company
        has sustained substantial losses from operations in recent years, and such
        losses have continued through the year ended December 31, 2006. In
        addition, the Company has used, rather than provided, cash in its operations.
        Consistent with these facts, the accompanying report from Grant Thornton,
        LLP,
        the Company’s independent registered public accounting firm, includes the
        comment that there is substantial doubt about the Company’s ability to continue
        as a going concern.
  In
        view
        of the matters described in the preceding paragraph, recoverability of a
        major
        portion of the recorded asset amounts shown in the accompanying balance sheet
        is
        dependent upon continued operations of the Company, which in turn is dependent
        upon the Company’s ability to meet its financing requirements on a continuing
        basis, to maintain present financing, and to succeed in its future operations.
        The financial statements do not include any adjustments relating to the
        recoverability and classification of recorded asset amounts or amounts and
        classification of liabilities that might be necessary should the Company
        be
        unable to continue in existence.
 -40-
  **Table
        of Contents**
  The
        Company has incurred, and continues to incur, losses from operations. For
        the
        years ended December 31, 2006, 2005, and 2004, the Company incurred net
        losses of $4.4 million, $3.0 million, and $7.0 million, respectively. During
        those years the Company implemented strategies to reduce its cash used in
        operating activities. The Company’s strategy included the consolidation of its
        manufacturing and research and development facilities and a targeted reduction
        of the employee workforce, increasing the efficiency of the Company’s processes,
        focusing development efforts on products with a greater probability of
        commercial sales, reducing professional fees and discretionary expenditures,
        and
        negotiating favorable payment arrangements with suppliers and service providers.
        More importantly, the Company configured itself along an outsourcing model,
        thus
        allowing for relatively large, efficient production without the associated
        overhead. The combination of these factors has been effective in bringing
        the
        Company closer to profitability (from a net loss as high as $28 million during
        2001) while enabling it to deliver significant quantities of solutions.
        Beginning in 2005, the Company began to invest in additional product development
        (engineering) and sales and marketing resources as it began to increase its
        volume of business. While viewed as a positive development, these expenditures
        have added to the funding requirements listed above.
  We
        believe that we have sufficient funds to operate our business until $11.3
        million of our debt becomes due in August 2007. That debt is held by our
        two
        largest shareholders, including affiliates. While we expect to refinance
        this
        debt no such refinancing has occurred as of the reporting date, therefore,
        the
        ability to refinance our debt and maintain adequate working capital is necessary
        for us to continue as a going concern Additionally, we project increases
        in
        working capital requirements in order to pursue significant business
        opportunities during 2007 and beyond, and also expect to spend additional
        financial resources in the expansion of our business and product offerings.
        As
        such, we may require additional capital prior to August 2007. We intend to
        look
        into augmenting our existing capital position by continuing to evaluate
        potential short-term and long-term sources of capital whether from debt,
        equity,
        hybrid, or other methods. The primary covenant in our existing debt arrangement
        involves the right of the lenders to receive debt repayment from the proceeds
        of
        new financing activities. This covenant may restrict our ability to obtain
        additional financing or to apply the proceeds of a financing event toward
        operations until the debt is repaid in full.
  **4.
        Inventories**
  Inventories
        consist of the following:
 **December 31,**
                
                **December 31,****2006**
                **2005**Raw
                    materials
                
                $
                2,675,000
                
                $
                1,368,000Work
                    in process
                
                
                2,332,000
                
                
                443,000Finished
                    product
                
                
                1,362,000
                
                
                904,000Total
                
                $
                6,369,000
                
                $
                2,715,000
  Cost
        of
        product sales for the years ended December 31, 2006 and 2005 includes
        approximately $165,000 and $0, respectively, of costs in excess of the net
        realizable value of inventory (including obsolete materials).
  Inventory
        balances are reported net of a reserve for obsolescence. This reserve is
        computed by taking into consideration the components of inventory, the recent
        usage of those components, and anticipated usage of those components in the
        future. At December 31, 2006 and 2005, those reserves were approximately
        $325,000 and $160,000, respectively.
   -41-
 
 **Table
        of Contents**
  **For the Years Ended December 31,****2006**
              
              **2005**
              
              **2004****(in
                  thousands of dollars)**Beginning
                  Balance
              
              $
              160
              
              $
              218
              
              $
              858Inventory
                  Obsolescence Expense
              
              
              165
              
              
              -
              
              
              57Inventory
                  Written Off
              
              
              -
              
              
              58
              
              
              697Recoveries
              
              
              -
              
              
              -
              
              
              -Ending
                  Balance
              
              $
              325
              
              $
              160
              
              $
              218
  **5.
        Allowance for Doubtful Accounts**
  **For the Years Ended December 31,****2006**
              
              **2005**
              
              **2004****(in
                  thousands of dollars)**Beginning
                  Balance
              
              $
              0
              
              $
              0
              
              $
              4Bad
                  Debt Expense
              
              
              -
              
              
              -
              
              
              -Accounts
                  Written Off
              
              
              -
              
              
              -
              
              
              -Recoveries
              
              
              0
              
              
              0
              
              
              4Ending
                  Balance
              
              $
              0
              
              $
              0
              
              $
              0
  **6.
        Capital Stock**
  The
        Company has an authorized class of undesignated preferred stock consisting
        of
        300,000 shares. Preferred stock may be issued in series from time to time
        with
        such designations, relative rights, priorities, preferences, qualifications,
        limitations and restrictions thereof, to the extent that such are not fixed
        in
        the Company’s certificate of incorporation, as the Company’s Board of Directors
        (“Board of Directors” or “Board”) determines.
  On
        February 9, 1996, the Board of Directors adopted a shareholder rights plan
        (the “Rights Plan”). In conjunction with the adoption of the Rights Plan, the
        Company created one series of preferred stock, consisting of 10,000 shares
        of
        Series A Junior Participating Preferred Stock (“Series A Preferred”). Each share
        of Series A Preferred entitled the holder to receive dividends equal to 1,000
        times the dividends per share declared with respect to the Company’s common
        stock and, in the event of liquidation, such holders would have received
        a
        preference of 1,000 times the aggregate amount to be distributed per share
        to
        the holders of the Company’s common stock. Pursuant to the Rights Plan, a Series
        A Right was associated with, and would have traded with, each share of common
        stock outstanding. This Rights Plan expired during February 2006.
  At
        December 31, 2006, authorized but unissued shares of common stock have been
        reserved for future issuance as follows:
  Options
                  outstanding (Note 7)
              
              
              4,912,000
  At
        December 31, 2006, 8.7 million shares of restricted stock had been issued
        but
        had not vested.
   -42-
 **Table
        of Contents**
  **7.
          Stock Options and Warrants**
  On
          August 19, 1993, the Board of Directors adopted the 1993 Stock Option Plan
          for employees, consultants, and directors who were not also employees of
          the
          Company (outside directors). This plan reached its ten-year expiration
          during
          2003. During the 2003 annual meeting of shareholders, the Company’s shareholders
          approved a new 2003 Equity Incentive Plan to take the place of the expiring
          1993
          plan. Unissued options from the 1993 plan were used to fund the 2003 plan.
          During the 2005 annual meeting of shareholders, the Company’s shareholders
          approved 12 million additional shares of stock to be included in the 2003
          Plan, and clarified the ability for the 2003 Plan to utilize up to
          5 million unused shares originally allocated to the 1993 Plan. The maximum
          number of shares issuable under these plans is 26,011,468. These Plans
          are
          collectively referred to as the “Plan”.
  For
        employees and consultants, the Plan provides for granting of restricted shares
        of stock, Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs).
        In the case of ISOs, the exercise price shall not be less than 100% (110%
        in
        certain cases) of the fair value of the Company’s common stock, as determined by
        the Compensation Committee or full Board as appropriate (the “Committee”), on
        the date of grant. In the case of NSOs, the exercise price shall be determined
        by the Committee, on the date of grant. The term of options granted to employees
        and consultants will be for a period not to exceed 10 years (five years in
        certain cases). Options granted under the Plan default to vest over a four-year
        period (one-fourth of options granted vest after one year from the grant
        date
        and the remaining options vest ratably each month thereafter), but the vesting
        period is determined by the Committee and may differ from the default period.
        In
        addition, the Committee may authorize option and restricted stock grants
        with
        vesting provisions that are not based solely on employees’ rendering of
        additional service to the Company.
  For
        outside directors, the Plan provides that each outside director will be
        automatically granted NSOs on the date of their initial election to the Board
        of
        Directors. On the date of the annual meeting of the stockholders of the Company,
        each outside director who is elected, reelected, or continues to serve as
        a
        director, shall be granted additional NSOs, except for those outside directors
        who are first elected to the Board of Directors at the meeting or three months
        prior. The options granted vest ratably over one or two years, based on the
        date
        of grant, and expire after ten years from the grant date. Beginning in 2006,
        the
        Compensation Committee of the Board approved grants of Restricted Stock to
        be
        used as compensation for outside directors in lieu of NSO’s.
  During
        2005, the Board elected to utilize a transition rule provided under FAS 123R,
        and accelerated the vesting to December of 2005 a total of 364,198 options
        that
        were priced above the Company’s stock price (i.e., “out of the money” options)
        and scheduled to vest after 2005. There was no compensation expense recognized
        upon the acceleration of the options in 2005. The majority of these accelerated
        options were scheduled to vest during the first quarter 2006. By employing
        this
        method, these options are excluded from the Company’s FAS 123R calculation in
        2006, but are included in the FAS 148 pro forma disclosure presented in Note
        2.
        Beginning in 2006, the Board began providing restricted stock grants in lieu
        of
        stock options within both employee and non-employee compensation programs.
        The
        impact of the new accounting standard, industry trends, and the ability to
        use
        fewer shares to achieve intended results are a few of the reasons behind
        this
        change in view. The Board has also expressed an intention to continue to
        utilize
        performance-based equity incentives for more cases of equity compensation
        than
        in years past.
  The
        fair
        value for these options was estimated at the date of grant using a Black-Scholes
        option pricing model with the following weighted-average assumptions for
        the
        years ended December 31, 2005 and 2004: risk-free interest rate of 4.1% and
        2.7%, respectively; a dividend yield of 0%; annual volatility factor of the
        expected market price of the Company’s common stock of 0.85 and 1.14,
        respectively (the daily “volatility”, which is measured as the standard
        deviation of the closing stock price for the same periods, would be 0.05
        and
        0.10); and expected life of the options of 4.0 years. **** No
        options were issued during 2006.
  The
        Black-Scholes option valuation model was developed for use in estimating
        the
        fair value of traded options which have no vesting restrictions and are fully
        transferable. In addition, option valuation models require the input of highly
        subjective assumptions, including the expected stock price volatility. Because
        the Company’s employee stock options have characteristics significantly
        different from those of traded options, and because changes in the subjective
        input assumptions can materially affect the fair value estimate, in management’s
        opinion, the existing models do not necessarily provide a reliable single
        measure of the fair value of its employee stock options.
 -43-
  **Table
        of Contents**
  The
        table
        below summarizes all option activity during the three year period ended
        December 31, 2006:
  **Options****Outstanding**
              
              
              **Exercise
                  Price Per Share****Outstanding
                  at December 31, 2003**
              
              
              6,660,000
              
              $
              0.11 —21.50Granted
              
              
              4,540,000
              
              $
              0.14
                  — 0.89Exercised
              
              
              (1,046,000)
              
              $
              0.11
                  — 0.49Forfeited
              
              
              (1,095,000)
              
              $
              0.11
                  — 21.50**Outstanding
                  at December 31, 2004**
              
              
              9,059,000
              
              $
              0.11
                  — 18.25Granted
              
              
              2,815,000
              
              $
              0.25
                  — 0.43Exercised
              
              
              (2,038,000)
              
              $
              0.11
                  — 0.14Forfeited
              
              
              (1,690,000)
              
              $
              0.11
                  — 18.25**Outstanding
                  at December 31, 2005**
              
              
              8,146,000
              
              $
              0.11
                  — 18.25Granted
              
              
              -Exercised
              
              
              (2,583,000)
              
              $
              0.11
                  - 0.39Forfeited
              
              
              (651,000)
              
              $
              0.25
                  - 18.25**Outstanding
                  at December 31, 2006**
              
              
              4,912,000
              
              $
              0.11
                  - 1.81
  The
        weighted-average exercise price of options outstanding at December 31,
        2006, 2005 and 2004, was $0.41, $0.28, and $0.40, respectively. The
        weighted-average exercise price of options granted, exercised, and forfeited
        during 2006 was N/A, $0.35 and $0.95, respectively. The weighted-average
        fair
        value of options granted during 2006, 2005 and 2004 was N/A, $0.36, and $0.18,
        respectively. No stock option grants were issued during 2006.
  Following
        is additional information with respect to options outstanding at
        December 31, 2006:
 
 **$0.11
                  to**
              
              **$0.24
                  to**
              
              **$0.45
                  to****$0.22**
              
              **$0.43**
              
              **$1.81**OUTSTANDING
                  AT DECEMBER 31, 2006Number
                  of options
              
              
              1,145,000
              
              
              2,755,000
              
              
              1,012,000Weighted-average
                  exercise price
              
              $
              0.14
              
              $
              0.35
              
              $
              0.89Weighted-average
                  remaining contractual life in years
              
              
              7
              
              
              7
              
              
              4EXERCISABLE
                  AT DECEMBER 31, 2006Number
                  of options
              
              
              1,104,000
              
              
              2,755,000
              
              
              1,012,000Weighted-average
                  exercise price
              
              $
              0.14
              
              $
              0.35
              
              $
              0.89
  The
        total
        number of unvested options outstanding at December 31, 2006 was less than
        0.1 million, which will vest based on employees’ continued service to the
        Company.
 
 -44-
  **Table
        of Contents**
  **8.
        Long-Term Debt**
  **Uncommitted
        Line of Credit (2002 Credit Line)**
  As
        of the
        reporting date, we have drawn $8.5 million of debt financing under a credit
        line, as described below. During October 2002, we entered into an uncommitted
        line of credit with our two largest shareholders, an affiliate of Elliott
        Associates, L.P. (Manchester Securities Corporation) and Alexander Finance,
        L.P.
        This line initially provided up to $4 million to us. This line was uncommitted,
        such that each new borrowing under the facility would be subject to the approval
        of the lenders. Borrowings on this line bore an initial interest rate of
        9.5%
        and were collateralized by all the assets of the Company. Outstanding loans
        under this agreement would be required to be repaid on a priority basis should
        we receive new funding from other sources. Additionally, the lenders were
        entitled to receive warrants to the extent funds were drawn down on the line.
        The warrants bore a strike price of $0.20 per share of common stock and were
        to
        expire on April15, 2004. The credit line was to mature and be due, including
        accrued interest thereon, on March 31, 2004. Due to a subsequent agreement
        between the parties no warrants were issued with subsequent
        borrowings.
  According
        to existing accounting pronouncements and SEC guidelines, we allocated the
        proceeds of these borrowings between their debt and equity components. As
        a
        result of these borrowings during 2002, we recorded a non-cash charge of
        $1.2
        million through the outstanding term of the warrants (April, 2004). $250,000
        and
        $862,000 of that amount were recorded during 2004 and 2003, respectively.
        These
        warrants were valued at $1.2 million of the $2 million debt instrument based
        on
        a Black-Scholes valuation that included the difference between the value
        of our
        common stock and the exercise price of the warrants on the date of each warrant
        issuance and a 30% discounted face value of the notes, leaving the remaining
        $0.8 million as the underlying value of the debt. This $1.2 million was
        amortized over the vesting period of the warrants (six quarters from the
        fourth
        quarter 2002 through the first quarter 2004).
  During
        October 2003, we entered into an agreement with our lenders to supplement
        the
        credit line with an additional $2 million, $1 million of which was drawn
        immediately and $1 million subsequently drawn upon our request and subject
        to
        the approval of the lenders. This supplemental facility bore a 14% rate of
        interest and was due October 31, 2004. The term of the previous credit line
        was
        not affected by this supplement, and as such the $4 million borrowed under
        that
        line, plus accrued interest, remained due March 31, 2004.
  During
        February 2004, the credit line was extended to a due date of April 2005,
        with
        interest after the initial periods to be charged at 14%. No warrants or other
        inducements were issued with respect to this extension. Additionally, lenders
        exercised their 10 million warrants during February 2004, agreeing to let
        us use
        the funds for general purposes as opposed to repaying debt.
  During
        July 2004, we and our lenders agreed to increase the aggregate loan commitments
        under the credit line from $6,000,000 to $6,500,000. Simultaneously, we drew
        the
        remaining $1,500,000 of the financing.
  During
        November 2004, we and our lenders agreed to increase the line of credit to
        up to
        an additional $2 million to an aggregate loan commitment of $8,500,000, $1
        million of which was drawn immediately by us with the remaining $1 million
        drawable upon our request and subject to the approval of the lenders, which
        occurred during January 2005.
  During
        February 2005, the credit line was extended until April 2006. Interest during
        the extension period was to be charged at 9%. No warrants or other inducements
        were issued with respect to this extension.
  On
        August
        2, 2005, we and our lenders agreed to extend the due date from April 2006
        until
        August 2007, and the lenders also agreed to waive the Company’s obligation to
        repay its debt with proceeds from an equity financing transaction with its
        lenders, including affiliates, in August 2005. No warrants or other inducements
        were issued as a result of this transaction.
 
 -45-
 
 **Table
        of Contents**
 
 **2006
        Convertible Debt**
  During
        June 2006 we entered into a Securities Purchase Agreement (the “Agreement”) and
        convertible notes (the “Notes”) with Alexander Finance, L.P., and Manchester
        Securities Corporation L.P. (together, the “Lenders”), pursuant to which the
        Lenders have agreed, to each loan us $2,500,000, or an aggregate of $5,000,000,
        in convertible debt. The Lenders, including affiliates, are our two largest
        shareholders and the lenders of the 2002 Credit Line referenced above. The
        transaction was structured as a private placement of securities pursuant
        to
        Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”)
        and Rule 506 promulgated thereunder.
  The
        Notes
        will mature on June 22, 2010 and bear an interest rate of 5% due at maturity.
        Both the principal amount and any accrued interest on the Notes are convertible
        into our common stock at a rate of $0.33 per share, subject to certain
        anti-dilution adjustments. The Lenders have the right to convert the Notes,
        both
        principal and accrued interest, into shares of common stock at the rate of
        $0.33
        per share at any time. We have the right to redeem the Notes in full in cash
        at
        any time beginning two years after the date of the Agreement. The conversion
        rate of the Notes will be subject to customary anti-dilution protections,
        provided that the number of additional shares of common stock issuable as
        a
        result of changes to the conversion rate will be capped so that the aggregate
        number of shares of common stock issuable upon conversion of the Notes will
        not
        exceed 19.99% of the aggregate number of shares of common stock presently
        issued
        and outstanding.
  The
        Notes
        are secured on a first priority basis by all of our intangible and tangible
        property and assets. Payment of the Notes is guaranteed by our two inactive
        subsidiaries, Spectral Solutions, Inc. and Illinois Superconductor Canada
        Corporation. The Agreement contains customary representations, warranties
        and
        covenants. We filed a registration statement covering the resale of the shares
        of common stock issuable upon conversion of the Notes with the Securities
        and
        Exchange Commission Concurrently with the execution of the Agreement, the
        Lenders have waived their right under the 2002 Credit Line to receive the
        financing proceeds from the issuance of the Notes, allowing us to use the
        funds
        for product development or general working capital purposes. No fees were
        paid
        to any financial advisor, placement agent, broker or finder in connection
        with
        the transactions contemplated by the Agreement and the Notes.
  Assuming
        the Notes are held for the full four year term, 18,505,719 shares of common
        stock would be required upon settlement, for both principal and interest.
        This
        amount is approximately 10% of the then approximately 186 million shares
        of
        common stock currently issued and outstanding. As of December 31, 2006, the
        Lenders, including their affiliates, owned approximately 43% of the Company’s
        outstanding shares. As a result of this transaction, the combined holdings
        of
        the Lenders would be approximately 48% of the Company’s outstanding common
        stock.
  -46-
 **Table
          of Contents**
  **9.
        Income Taxes**
  The
        Company has net operating loss carryforwards for tax purposes of approximately
        $137,002,000 at December 31, 2006. The net operating loss carryforwards
        expire in the following years:
 **Year**
              
              
              **Amount**2007
              
              
              974,0002008
              
              
              1,658,0002009
              
              
              3,973,0002010
              
              
              8,199,0002011
              
              
              11,953,0002012
              
              
              11,922,0002018
              
              
              11,146,0002019
              
              
              10,726,0002020
              
              
              15,501,0002021
              
              
              24,904,0002022
              
              
              13,982,0002023
              
              
              5,284,0002024
              
              
              9,758,0002025
              
              
              3,371,0002026
              
              
              3,651,000Total
              
              $
              137,002,000
  A
        reconciliation of income tax expense at the statutory rate to the Company’s
        actual income tax expense is shown below:
 **2006**
              
              
              **2005**
              
              
              **2004**Tax
                  benefit computed at the Federal statutory rate
              34.00%
              
              
              34.00%
              
              
              34.00%Increase
                  (decrease) in taxes due to:Change
                  in valuation allowance
              
              
              -38.80%
              
              
              -38.80%
              
              
              -38.80%State
                  taxes, net of Federal benefit
              
              
              4.80%
              
              
              4.80%
              
              
              4.80%
  Significant
        components of the Company’s deferred tax assets and liabilities are as
        follows:
 **December
                    31,**
                
                
                **December
                    31,****2006**
                
                
                **2005**Deferred
                    tax assetsNet
                    operating loss carryforward
                
                $
                52,061,000
                
                $
                50,490,000Accrued
                    liabilities
                
                
                1,223,000
                
                
                840,000Inventories
                
                
                124,000
                
                
                61,000Property
                    and Equipment
                
                
                893,000
                
                
                893,000Total
                    deferred tax assets
                
                
                54,301,000
                
                
                52,284,000Deferred
                    liabilities:Patent
                    costs
                
                
                (320,000)
                
                
                (321,000)Net
                    deferred tax assets
                
                
                53,981,000
                
                
                51,963,000Valuation
                    allowance
                
                
                (53,981,000)
                
                
                (51,963,000)Net
                    Deferred tax assets
                
                $
                —
                
                $
                —
 -47-
     **Table
        of Contents**
  The
        valuation allowance increased during 2006 and 2005 by $2,018,000 and $1,595,000,
        respectively, due primarily to the increase in the net operating loss
        carryforward. Based on the Internal Revenue Code and changes in the ownership
        of
        the Company, utilization of the net operating loss carryforwards will be
        subject
        to annual limitations.
  **10.
        Leases**
  The
        Company leases its manufacturing and office space, as well as some testing
        and
        office equipment. Under the terms of its two leases in Elk Grove Village,
        IL,
        which expire October 2014, the Company is responsible for proportionate real
        estate taxes and operating expenses.
  Future
        minimum payments under the operating leases consist of the following at
        December 31, 2006:
 
 **Year**
              
              
              **Amount**2007
              
              $
              201,0002008
              
              
              205,0002009
              
              
              208,0002010
              
              
              211,0002011
              
              
              216,000
  Rent
        expense totaled $251,000, $151,000, and $260,000 for the years ended
        December 31, 2006, 2005, and 2004, respectively.
  **11.
        401(k) Plan**
  The
        Company has a 401(k) plan covering all employees who meet prescribed service
        requirements. The plan provides for deferred salary contributions by the
        plan
        participants and a Company contribution. Through 2005, Company contributions,
        if
        any, have been at the discretion of the Board of Directors and not to exceed
        the
        amount deductible under applicable income tax laws. No Company contribution
        was
        made for the years ended December 31, 2005 and 2004. Beginning in 2006, the
        Company began providing a partial match of employee contributions, up to
        a
        maximum of 3% of employee salary.
  **12.
        Litigation**
  There
        was
        no existing, pending, or threatened litigation at the time of this
        filing.
  **13.
        Segment Reporting**
  The
        Company adopted SFAS No. 131 “Disclosures about Segments of an Enterprise
        and Related Information”. SFAS No. 131 requires a business enterprise,
        based upon a management approach, to disclose financial and descriptive
        information about its operating segments. Operating segments are components
        of
        an enterprise about which separate financial information is available and
        regularly evaluated by the chief operating decision maker(s) of an enterprise.
        Under this definition, the Company operated as a single segment for all periods
        presented.
  -48-
  ****Table
        of Contents****
  **14.
        Selected Quarterly Financial Data (Unaudited)**
  A
        summary
        of selected quarterly information for 2006 and 2005 is as follows:
 
 **2006
                  Quarter Ended****March 31**
              
              **June
                  30**
              
              
              **September
                  30**
              
              **December
                  31****(in thousands of U.S. dollars except per share amounts)**Net
                  Sales
              
              $
              1,326
              
              $
              3,446
              
              $
              6,433
              
              $
              3,792Gross
                  Profit
              
              
              495
              
              
              1,387
              
              
              2,583
              
              
              1,464Net
                  Loss
              
              
              (1,700)
              
              
              (1,231)
              
              
              (167)
              
              
              (1,267)Loss
                  per Share
              
              $
              (0.01)
              
              $
              (0.01)
              
              $
              (0.00)
              
              $
              (0.01)**2005
                  Quarter Ended****March 31**
              
              **June
                  30**
              
              
              **September
                  30**
              
              **December
                  31****(in thousands of U.S. dollars except per share amounts)**Net
                  Sales
              
              $
              3,293
              
              $
              2,484
              
              $
              2,037
              
              $
              2,450Gross
                  Profit
              
              
              1,372
              
              
              1,290
              
              
              1,265
              
              
              1,216Net
                  Loss
              
              
              (482)
              
              
              (811)
              
              
              (596)
              
              
              (1,088)Loss
                  per Share
              
              $
              0.00
              
              $
              (0.01)
              
              $
              0.00
              
              $
              (0.01)
  As
        an
        after-market vendor, the Company’s revenue has fluctuated from quarter to
        quarter, consistent with buying patterns of planning processes within wireless
        telecommunications carriers. With the advent of significant projects such
        as
        data networks, funds are often reallocated between periods and thus diminish
        the
        pool of funds available for normal activities. The Company’s objective is to be
        included in these projects, and thus realize a higher, more stable revenue
        stream.
  -49-
   **Table
        of Contents**
  **Item 9.
        Changes in and Disagreements With Accountants on Accounting and Financial
        Disclosure.**
  None.
  **Item 9A.
        Controls and Procedures**
  (a)
        An
        evaluation was performed under the supervision and with the participation
        of the
        Company’s management, including its Chief Executive Officer, or CEO, and Chief
        Financial Officer, or CFO, of the effectiveness of the Company’s disclosure
        controls and procedures, as such term is defined under Rule 13a-15(e)
        promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange
        Act”) as of December 31, 2006. Based on that evaluation, the Company’s
        management, including the CEO and CFO, concluded that the Company’s disclosure
        controls and procedures are effective to ensure that information required
        to be
        disclosed by the Company in reports that it files or submits under the Exchange
        Act, is recorded, processed, summarized and reported as specified in Securities
        and Exchange Commission rules and forms.
  (b)
        There
        were no significant changes in the Company’s internal control over financial
        reporting identified in connection with the evaluation of such controls that
        occurred during the Company’s most recent fiscal quarter that has materially
        affected, or is reasonably likely to materially affect, the Company’s internal
        control over financial reporting.
  **Item 9B.
        Other Information**
  None.
  -50-
 
 **Table
        of Contents**
  **PART
        III**
  **Item 10. Directors,
        Executive Officers, and Corporate Governance**
  The
        information required by this item is incorporated herein by reference to
        the
        similarly named sections in our definitive proxy statement for the 2007 annual
        meeting of shareholders.
  **Code
        of Conduct**
 We
        adopted aCode of Business Conduct and Ethics (“Code of
        Ethics”) applicable to our principal executive officer and principal financial
        and accounting officer and any persons performing similar functions. In
        addition, the Code of Ethics applies to our employees, officers, directors,
        agents and representatives. The Code of Ethics requires, among other things,
        that our employees avoid conflicts of interest, comply with all laws and
        other
        legal requirements, conduct business in an honest and ethical manner, and
        otherwise act with integrity and in our best interest.
 The
        Code of Ethics includes procedures for reporting violations of the Code of
        Ethics. In addition, the Sarbanes-Oxley Act of 2002 requires companies to
        have
        procedures to receive, retain and treat complaints received regarding
        accounting, internal accounting controls or auditing matters and to allow
        for
        the confidential and anonymous submission by employees of concerns regarding
        questionable accounting or auditing matters. The Code of Ethics is intended
        to
        comply with the rules of the SEC and AMEX and includes these required
        procedures. The Code of Ethics is available on our website at www.iscointl.com
        (under “Investors”). We have also filed the Code of Ethics as Exhibit 14 to this
        Annual Report on Form 10-K for the year ended December 31, 2006.
  **Item 11. Executive
        Compensation**
  The
        information required by this item is incorporated herein by reference to
        the
        similarly named sections in our definitive proxy statement for the 2007 annual
        meeting of shareholders.
  **Item 12. Security
        Ownership of Certain Beneficial Owners and Management and Related Stockholder
        Matters**
  The
        information required by this item is incorporated herein by reference to
        the
        similarly named sections in our definitive proxy statement for the 2007 annual
        meeting of shareholders.
  **Item 13. Certain
        Relationships and Related Transactions, and Director
        Independence**
  The
          information required by this item is incorporated herein by reference to
          the
          similarly named sections in our definitive proxy statement for the 2007
          annual
          meeting of shareholders.
  **Item 14. Principal
          Accountant Fees and Services**
  The
          information required by this item is incorporated herein by reference to
          the
          similarly named sections in our definitive proxy statement for the 2007
          annual
          meeting of shareholders.
 -51-
  **Table
        of Contents**
  **Item 15.
        Exhibits and Financial Statement Schedules**
  (a)
              The
                  following documents are filed as part of this Form
                  10-K:
  1.
                  The following financial statements of the Company, with the report
                  of
                  independent auditors, are filed as part of this Form 10-K:Report
                  of Independent Registered Public Accounting FirmConsolidated
                  Balance Sheets as of December 31, 2006 and 2005Consolidated
                  Statements of Operations for the Years Ended December 31, 2006,
                  2005, and
                  2004Consolidated
                  Statements of Stockholders’ Equity (Net Capital Deficiency) for the Years
                  Ended December 31, 2006, 2005 and 2004Consolidated
                  Statements of Cash Flows for the Years Ended December 31, 2006,
                  2005, and
                  2004Notes
                  to Consolidated Financial Statements2.
                  The following financial statement schedules of the Company are
                  filed as
                  part of this Form 10-K:All
                  financial schedules are omitted because such schedules are not
                  required or
                  the information required has been presented in the aforementioned
                  financial statements.3.
                  Exhibits are listed in the Exhibit Index to this Form
                  10-K.
  -52-
 **Table
        of Contents**
  **SIGNATURES**
  Pursuant
        to the requirements of Section 13 or 15(d) of the Securities Exchange Act
        of 1934, the Registrant has duly caused this Amendment to be signed on its
        behalf by the undersigned, thereunto duly authorized, on the 28th day of
        March,
        2007.
  ISCO
                  INTERNATIONALBy:
              
              /s/
                  JOHN THODEJohn
                  ThodeChief
                  Executive Officer
  Pursuant
        to the requirements of the Securities Exchange Act of 1934, this Amendment
        has
        been signed below by the following persons on behalf of the registrant and
        in
        the capacities indicated on the 28th day of March, 2007.
  **Signature**
              
              **Title**/s/
                  JOHN THODE
              
              Chief
                  Executive Officer and Director
                (Principal
                  Executive Officer and Director)John
                  Thode/s/
                  FRANK CESARIO
              
              Chief
                  Financial Officer
                (Principal
                  Financial and Accounting Officer)Frank
                  Cesario/s/
                  JAMES FUENTES
              
              Director
                  and Chairman of the BoardJames
                  Fuentes/s/
                  AMR ABDELMONEM
              
              Director
                  and Chief Technology OfficerAmr
                  Abdelmonem/s/
                  GEORGE CALHOUN
              
              DirectorGeorge
                  Calhoun/s/
                  MICHAEL FENGER
              
              DirectorMichael
                  Fenger/s/
                  RALPH PINI
              
              DirectorRalph
                  Pini/s/
                  TOM POWERS
              
              DirectorTom
                  Powers/s/
                  MARTY SINGER
              
              DirectorMarty
                  Singer
  -53-
   **Table
        of Contents**
  **ISCO
        INTERNATIONAL**
 **EXHIBIT
        INDEX**
 
 **Exhibit**
                **Number**
              
              **Description
                  of Exhibits**3.1
              
              Certificate
                  of Incorporation of the Company, incorporated by reference to Exhibit
                  3.1
                  to the Company’s Registration Statement on Form S-3/A, filed with the
                  Securities and Exchange Commission (“SEC”) on August 13, 1998,
                  Registration No. 333-56601 (the “August 1998 S-3”).3.2
              
              By-Laws
                  of the Company, incorporated by reference to Exhibit 3.2 to Amendment
                  No.
                  3 to the Company’s Registration Statement on Form S-1, filed with the SEC
                  on October 26, 1993, Registration No. 33-67756 (the “IPO Registration
                  Statement”).3.3
              
              Certificate
                  of Amendment of Certificate of Incorporation of the Company, incorporated
                  by reference to Exhibit 3.3 to the IPO Registration
                  Statement.3.4
              
              Certificate
                  of Amendment of Certificate of Incorporation of the Company, incorporated
                  by reference to Exhibit 4.3 to the Company’s Registration Statement on
                  Form S-3/A, filed with the SEC on July 1, 1999, Registration No.
                  333-77337.3.5
              
              Certificate
                  of Amendment of Certificate of Incorporation of the Company filed
                  July 18,
                  2000, incorporated by reference to the Company’s registration statement on
                  Form S-8 filed August 7, 2000 (the August 2000 S-8”).3.6
              
              Certificate
                  of Amendment to Certificate of Incorporation filed with the Secretary
                  of
                  State of the State of Delaware on June 25, 2001, incorporated by
                  reference
                  to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on June
                  27, 2001.3.7
              
              Certificate
                  of Amendment to Certificate of Incorporation filed with the Secretary
                  of
                  State of the State of Delaware on December 16, 2004, incorporated
                  by
                  reference to Exhibit 3.7 to the Company’s Annual Report on Form 10-K filed
                  on March 31, 2005 (the “2004 10-K”).4.1
              
              Specimen
                  stock certificate representing common stock, incorporated by reference
                  to
                  Exhibit 4.1 to the IPO Registration Statement.4.2
              
              Rights
                  Agreement dated as of February 9, 1996 between the Company and
                  LaSalle
                  National Trust, N.A., incorporated by reference to the Exhibit
                  to the
                  Company’s Registration Statement on Form 8-A, filed with the SEC on
                  February 12, 1996.4.3
              
              The
                  SSI Replacement Nonqualified Stock Option Plan, incorporated by
                  reference
                  to Exhibit 4.1 to the Company’s Registration Statement on Form S-8, filed
                  with the SEC on November 3, 2000, Registration No.
                  333-49268.*4.4
              
              Amendment
                  No. 1 to the Rights Agreement between ISCO International, Inc.
                  (formerly
                  Illinois Superconductor Corporation) and LaSalle National Trust
                  Association (formerly known as LaSalle National Trust Company)
                  dated as of
                  February 9, 1996, incorporated by reference to Exhibit 4.1 to the
                  Company’s Current Report on Form 8-K filed with the SEC on February 22,
                  2002.10.1 *
              
              Form
                  of Amended and Restated Director Indemnification Agreement, incorporated
                  by reference to Exhibit 10 to the Company’s Quarterly Report on Form 10-Q
                  for the quarterly period ended September 30, 1998.10.2
              
              Public
                  Law Agreement dated February 2, 1990 between Illinois Department
                  of
                  Commerce and Community Affairs and the Company, incorporated by
                  reference
                  to Exhibit 10.5 to the IPO Registration Statement.10.3
              
              Public
                  Law Agreement dated December 30, 1991 between Illinois Department
                  of
                  Commerce and Community Affairs and the Company, amended as of June
                  30,
                  1992, incorporated by reference to Exhibit 10.6 to the IPO Registration
                  Statement.10.4
              
              Subcontract
                  and Cooperative Development Agreement dated as of June 1, 1993
                  between
                  American Telephone and Telegraph Company and the Company, incorporated
                  by
                  reference to Exhibit 10.9 to the IPO Registration
                  Statement.10.5
              
              Intellectual
                  Property Agreement dated as of June 1, 1993 between American Telephone
                  and
                  Telegraph Company and the Company, incorporated by reference to
                  Exhibit
                  10.10 to the IPO Registration Statement.10.6
              
              License
                  Agreement dated January 31, 1990 between the Company and Northwestern
                  University, incorporated by reference to Exhibit 10.13 to the IPO
                  Registration Statement.10.7
              
              License
                  Agreement dated February 2, 1990 between the Company and ARCH Development
                  Corporation, incorporated by reference to Exhibit 10.14 to the
                  IPO
                  Registration Statement.10.8
              
              License
                  Agreement dated August 9, 1991 between the Company and ARCH Development
                  Corporation, incorporated by reference to Exhibit 10.15 to the
                  IPO
                  Registration Statement.10.9
              
              License
                  Agreement dated October 11, 1991 between the Company and ARCH Development
                  Corporation, incorporated by reference to Exhibit 10.16 to the
                  IPO
                  Registration Statement.10.10
              
              Public
                  Law Agreement dated August 18, 1993 between Illinois Department
                  of
                  Commerce and Community Affairs and the Company, incorporated by
                  reference
                  to Exhibit 10.17 to the IPO Registration
                  Statement.
  -54-
  **Table
        of Contents**
 
 10.11 *
              
              Form
                  of Officer Indemnification Agreement incorporated by reference
                  to Exhibit
                  10.17 to the Company’s Annual Report on Form 10-K for the year ended
                  December 31, 1998.10.12
              
              Escrow
                  Agreement dated August 8, 2000 among the Company, Russell Scott,
                  III, as
                  stockholder representative, and American National Bank and Trust
                  Company,
                  as escrow agent, incorporated by reference to Exhibit 10.25 to
                  the
                  Company’s registration statement on Form S-2 filed September 7, 2000,
                  Registration No. 333-45406 (the “September S-2”).10.13
                  *
              
              Employment
                  Agreement with Amr Abdelmonem dated January 1, 2001, incorporated
                  by
                  reference to Exhibit 10.5 to the Company’s Registration Statement on Form
                  S-3 filed on April 20, 2001.10.14
              
              ISCO
                  International, Inc. Amended and Restated 1993 Stock Option Plan,
                  incorporated by reference to Appendix C and D of the Company’s Definitive
                  Proxy materials filed on May 22, 2001.10.15
              
              Secured
                  91/2%
                  Grid Note dated October 23, 2002 between ISCO International, Inc.
                  and
                  Alexander Finance L.P. in the principal amount of $1,752,400, incorporated
                  by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K
                  filed on October 24, 2002.10.16
              
              Secured
                  91/2%
                  Grid Note dated October 23, 2002 between ISCO International, Inc.
                  and
                  Manchester Securities Corporation in the principal amount of $2,247,600,
                  incorporated by reference to Exhibit 10.4 to the Company’s Current Report
                  on Form 8-K filed on October 24, 2002.10.17
              
              Registration
                  Rights Agreement dated October 23, 2002 between ISCO International,
                  Inc.
                  Manchester Securities Corporation, and Alexander Finance L.P.,
                  incorporated by reference to Exhibit 10.7 to the Company’s Current Report
                  on Form 8-K filed on October 24, 2002.10.18
              
              ISCO
                  International, Inc. 2003 Equity Incentive Plan, incorporated by
                  reference
                  to Exhibit 99.2 to the Company’s Current Report on Form 8-K filed on June
                  20, 2006.10.19
              
              Secured
                  14% Grid Note dated October 24, 2003 between ISCO International,
                  Inc. and
                  Alexander Finance, L.P. in the principal amount of $876,200, incorporated
                  by reference to Exhibit 10.10 to the Company’s Current Report on Form 8-K
                  filed on October 27, 2003.10.20
              
              Secured
                  14% Grid Note dated October 24, 2003 between ISCO International,
                  Inc. and
                  Manchester Securities Corporation in the principal amount of $1,123,800,
                  incorporated by reference to Exhibit 10.11 to the Company’s Current Report
                  on Form 8-K filed on October 27, 2003.10.21
              
              Secured
                  14% Grid Note dated July 23, 2004 between ISCO International, Inc.
                  and
                  Alexander Finance, L.P. in the principal amount of $386,900, incorporated
                  by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K
                  filed on July 28, 2004.10.22
              
              Secured
                  14% Grid Note dated July 23, 2004 between ISCO International, Inc.
                  and
                  Manchester Securities Corporation in the principal amount of $113,100,
                  incorporated by reference to Exhibit 10.4 to the Company’s Current Report
                  on Form 8-K filed on July 28, 2004.10.23
              
              Stock
                  Purchase Agreement dated December 15, 2003 between ISCO International,
                  Inc. and Morgan & Finnegan, L.L.P., incorporated by reference to
                  Exhibit 10.1 to the Company’s Current Report of Form 8-K filed on December
                  16, 2003.10.24
              
              Office/Service
                  Center Lease Agreement dated July 20, 2004 between ISCO International,
                  Inc. and D&K Elk Grove Industrial II, LLC, incorporated by reference
                  to Exhibit 10.24 to the 2004 10-K.10.25
              
              Third
                  Amended and Restated Loan Agreement dated November 10, 2004 between
                  ISCO
                  International, Inc., Manchester Securities Corporation, and Alexander
                  Finance L.P., incorporated by reference to Exhibit 10.1 to the
                  Company’s
                  Current Report on Form 8-K filed on November 12, 2004.10.26
              
              Third
                  Amended and Restated Security Agreement dated November 10, 2004
                  between
                  ISCO International, Inc., Spectral Solutions, Inc., Illinois
                  Superconductor Canada Corporation, Manchester Securities Corporation,
                  and
                  Alexander Finance L.P., incorporated by reference to Exhibit 10.2
                  to the
                  Company’s Current Report on Form 8-K filed on November 12,
                  2004.10.27
              
              Secured
                  14% Grid Note dated November 10, 2004 between ISCO International,
                  Inc. and
                  Alexander Finance, L.P. in the principal amount of $1,100,000,
                  incorporated by reference to Exhibit 10.3 to the Company’s Current Report
                  on Form 8-K filed on November 12, 2004.10.28
              
              Secured
                  14% Grid Note dated November 10, 2004 between ISCO International,
                  Inc. and
                  Manchester Securities Corporation in the principal amount of $900,000,
                  incorporated by reference to Exhibit 10.4 to the Company’s Current Report
                  on Form 8-K filed on November 12, 2004.10.29
              
              Third
                  Amended and Restated Guaranty of Spectral Solutions, Inc. dated
                  November
                  10, 2004, incorporated by reference to Exhibit 10.5 to the Company’s
                  Current Report on Form 8-K filed on November 12, 2004.10.30
              
              Third
                  Amended and Restated Guaranty of Illinois Superconductor Canada
                  Corporation dated November 10, 2004, incorporated by reference
                  to Exhibit
                  10.6 to the Company’s Current Report on Form 8-K filed on November 12,
                  2004.10.31*
              
              Letter
                  Agreement dated January 6, 2005 between ISCO International, Inc.
                  and John
                  Thode (including Non-Qualified Stock Option Agreement) incorporated
                  by
                  reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K
                  filed on January 12, 2005.10.32
              
              Amendment
                  to Loan Documents dated February 10, 2005 between ISCO International,
                  Inc., Manchester Securities Corporation, Alexander Finance, L.P.,
                  Spectral
                  Solutions, Inc. and Illinois Superconductor Corporation, incorporated
                  by
                  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K
                  filed on February 15, 2005.
  -55-
  **Table
        of Contents**
 
 10.33
              
              Securities
                  Purchase Agreement dated July 25, 2005 by and among ISCO International,
                  Inc. Alexander Finance, L.P., Grace Brothers LTD, Elliott Associates,
                  L.P., and Elliott International, L.P., .incorporated by reference
                  to
                  Exhibit 10.1 to the Company’s Current Report of Form 8-K filed on July 26,
                  200510.34
              
              Amendment
                  to and Waiver Under Loan Documents dated July 25, 2005 by and among
                  ISCO
                  International, Inc., Manchester Securities Corporation and Alexander
                  Finance, L.P., incorporated by reference to Exhibit 10.2 to the
                  Company’s
                  Current Report of Form 8-K filed on July 26, 200510.35
              
              Letter
                  Agreement dated August 5, 2005 by and among ISCO International,
                  Inc.,
                  Elliott Associates, L.P., and Elliott International, L.P., incorporated
                  by
                  reference to Exhibit 10.1 to the Company’s Current Report of Form 8-K
                  filed on August 9, 2005.10.36*
              
              Thode
                  Employment Agreement dated January 10, 2006 between ISCO International,
                  Inc. and John S. Thode, incorporated by reference to Exhibit 10.1
                  to the
                  Company’s Current Report of Form 8-K filed on January 17,
                  2006.10.37*
              
              Abdelmonem
                  Employment Agreement dated January 12, 2006 between ISCO International,
                  Inc. and Dr. Amr Abdelmonem, incorporated by reference to Exhibit
                  10.2 to
                  the Company’s Current Report of Form 8-K filed on January 17,
                  2006.10.38*
              
              Restricted
                  Stock Agreement dated January 12, 2006 by and between ISCO International,
                  Inc. and Dr. Amr Abdelmonem, incorporated by reference to Exhibit
                  10.3 to
                  the Company’s Current Report of Form 8-K filed on January 17,
                  2006.10.39*
              
              Employment
                  Agreement dated February 6, 2006 between ISCO International, Inc.
                  and
                  Frank J. Cesario, incorporated by reference to Exhibit 10.1 to
                  the
                  Company’s Current Report of Form 8-K filed on February 9,
                  2006.10.40*
              
              Summary
                  of Non-Employee Director Compensation Policy, incorporated by reference
                  to
                  Exhibit 10.1 to the Company’s Current Report of Form 8-K filed on February
                  24, 2006.10.41
              
              Securities
                  Purchase Agreement by and among ISCO International, Inc., Manchester
                  Securities Corporation and Alexander Finance, L.P. dated June 22,
                  2006,
                  incorporated by reference to Exhibit 10.1 to the Company’s Current Report
                  on Form 8-K filed on June 28, 2006.10.42
              
              5%
                  Senior Secured Convertible Note by and between ISCO International,
                  Inc.
                  and Manchester Securities Corporation, incorporated by reference
                  to
                  Exhibit 10.2 to the Company’s Current Report on Form 8-K filed on June 28,
                  2006.10.43
              
              5%
                  Senior Secured Convertible Note by and between ISCO International,
                  Inc.
                  and Alexander Finance, L.P., incorporated by reference to Exhibit
                  10.3 to
                  the Company’s Current Report on Form 8-K filed on June 28,
                  2006.10.44
              
              Registration
                  Rights Agreement by and among ISCO International, Inc., Manchester
                  Securities Corporation and Alexander Finance, L.P. dated June 22,
                  2006,
                  incorporated by reference to Exhibit 10.4 to the Company’s Current Report
                  on Form 8-K filed on June 28, 2006.10.45
              
              Fourth
                  Amended and Restated Security Agreement by and among ISCO International,
                  Inc., Spectral Solutions, Inc., Illinois Superconductor Canada
                  Corporation, Manchester Securities Corporation and Alexander Finance,
                  L.P.
                  dated June 22, 2006, incorporated by reference to Exhibit 10.5
                  to the
                  Company’s Current Report on Form 8-K filed on June 28,
                  2006.10.46
              
              Fourth
                  Amended and Restated Guaranty of Spectral Solutions, Inc., incorporated
                  by
                  reference to Exhibit 10.6 to the Company’s Current Report on Form 8-K
                  filed on June 28, 2006.10.47
              
              Fourth
                  Amended and Restated Guaranty of Illinois Superconductor Canada
                  Corporation, incorporated by reference to Exhibit 10.7 to the Company’s
                  Current Report on Form 8-K filed on June 28, 2006.10.48
              
              Amendment
                  to and Waiver Under the Third Amended and Restated Loan Agreement
                  by and
                  among ISCO International, Inc., Spectral Solutions, Inc., Illinois
                  Superconductor Canada Corporation, Manchester Securities Corporation
                  and
                  Alexander Finance, L.P. dated June 22, 2006, incorporated by reference
                  to
                  Exhibit 10.8 to the Company’s Current Report on Form 8-K filed on June 28,
                  2006.14
              
              Code
                  of Ethics incorporated by reference to Exhibit 14 to the Company’s Annual
                  Report on Form 10-K filed on March 30, 2004.21**
              
              List
                  of subsidiaries: Spectral Solutions, Inc. and Illinois Superconductor
                  Canada Corporation23.1**
              
              Consent
                  of Grant Thornton LLP31.1**
              
              Certification
                  by Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a)
                  as
                  adopted pursuant to Section 302 of the Sarbanes Oxley Act of
                  2002.31.2**
              
              Certification
                  by Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a)
                  as
                  adopted pursuant to Section 302 of the Sarbanes Oxley Act of
                  2002.32**
              
              Certification
                  Pursuant To 18 U.S.C Section 1350, as Adopted Pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002
  *
              Management
                  contract or compensatory plan or arrangement required to be filed
                  as an
                  exhibit on this Form 10-K.**
              Filed
                  herewith.
  -56-