**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-Q**

(**Mark One)**
| **x**                                             | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------|-----------------------------------------------------------------------------------------------|
| ** **                                        | ** **                                                                                    |
| **For the  quarterly period ended July 31, 2007** |
| ** **                                        | ** **                                                                                    |
| **or**                                            |
| ** **                                        | ** **                                                                                    |
| **o**                                             | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(D) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from              to               **

**Commission file number:  001-12531**

**ISONICS CORPORATION**

(Exact name ofregistrant as specified in its charter)

 

| **California**                   | ** ** | **77-0338561**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (IRS Employer        |
| incorporation or  organization)  |       | Identification  No.) |

 

**5906 McIntyre StreetGolden, Colorado 80403**(Address of principal executive offices with zip code)

**(303) 279-7900**(Registrant’s telephone number, including area code)

**N/A**(Former name, former address and formerfiscal year, if changed since last report)

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

Indicate bycheck mark whether the Registrant is a large accelerated filer, an acceleratedfiler or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|--------------------------------|--------------------------|------------------------------|

 

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

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.
| Class                             | ** ** | **Outstanding at September 12, 2007** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------------|------------|
| Common Stock –  no par value |       | 12,658,150  shares                                        |       |

 

 

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**Isonics Corporation and Subsidiaries**

**TABLE OF CONTENTS**
| Part I:    | Financial  Information |                                                                                               |
|------------|------------------------|----------------------------------------------------------------------------------------------------|
|       |                   |                                                                                               |
|       | Item 1:                | Financial  Statements                                                                              |   |
|       |                   |                                                                                               |   |
|       |                   | Condensed Consolidated  Balance Sheets as of July 31, 2007 and April 30, 2007                      |   |
|       |                   |                                                                                               |   |
|       |                   | Condensed Consolidated  Statements of Operations for the Three Months Ended July 31, 2007 and 2006 |   |
|       |                   |                                                                                               |   |
|       |                   | Condensed Consolidated  Statements of Cash Flows for the Three Months Ended July 31, 2007 and 2006 |   |
|       |                   |                                                                                               |   |
|       |                   | Notes to  Condensed Consolidated Financial Statements                                              |   |
|       |                   |                                                                                               |   |
|       | Item 2:                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations        |   |
|       |                   |                                                                                               |   |
|       | Item 3:                | Quantitative  and Qualitative Disclosures About Market Risk                                        |   |
|       |                   |                                                                                               |   |
|       | Item 4:                | Controls and  Procedures                                                                           |   |
|       |                   |                                                                                               |   |
| Part II:   | Other Information      |                                                                                               |
|       |                   |                                                                                               |
|       | Item 1:                | Legal Proceedings                                                                                  |   |
|       |                   |                                                                                               |   |
|       | Item  1A:              | Risk Factors                                                                                       |   |
|       |                   |                                                                                               |   |
|       | Item 2:                | Unregistered  Sales of Equity Securities and Use of Proceeds                                       |   |
|       |                   |                                                                                               |   |
|       | Item 4:                | Submission  of Matters to a Vote of Security Holders                                               |   |
|       |                   |                                                                                               |   |
|       | Item 5:                | Other Information                                                                                  |   |
|       |                   |                                                                                               |   |
|       | Item  6:               | Exhibits                                                                                           |   |
|       |                   |                                                                                               |   |
| Signatures |                   |

 

2

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**Part I:  Financial Information**

**Item 1: Financial Statements**

**Isonics Corporation and Subsidiaries**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share amounts)**

**ASSETS**

 
| ** **                                                             | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **July 31, 2007** | ** ** | **April 30, 2007** | ** ** |
| CURRENT ASSETS:                                                        |       |                        |       |                         |       |
| Cash and cash  equivalents                                             |       | $                           | 1,482      |                         | $          | 1,556 |   |
| Accounts  receivable (net of allowances of $148 and $146,respectively) |       | 3,416                       |       | 3,678                        |       |
| Inventories                                                            |       | 1,363                       |       | 1,259                        |       |
| Prepaid expenses  and other current assets                             |       | 1,216                       |       | 1,388                        |       |
| Assets of  discontinued operations                                     |       | —                      |       | 491                          |       |
| Total current  assets                                                  |       | 7,477                       |       | 8,372                        |       |
|                                                                   |       |                        |       |                         |       |
| LONG-TERM ASSETS:                                                      |       |                        |       |                         |       |
| Property and  equipment, net                                           |       | 5,966                       |       | 5,666                        |       |
| Goodwill                                                               |       | 3,631                       |       | 3,631                        |       |
| Intangible  assets, net                                                |       | 259                         |       | 303                          |       |
| Equity in net  assets of investee                                      |       | 340                         |       | 382                          |       |
| Other assets                                                           |       | 565                         |       | 606                          |       |
| Total long-term  assets                                                |       | 10,761                      |       | 10,588                       |       |
|                                                                   |       |                        |       |                         |       |
| TOTAL ASSETS                                                           |       | $                           | 18,238     |                         | $          | 18,960 |   |

 

**LIABILITIESAND STOCKHOLDERS’ EQUITY**

 
| ** **                                                                                                                                                     | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                     | ** ** | **July 31, 2007** | ** ** | **April 30, 2007** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                           |       |                        |       |                         |       |
| Accounts payable                                                                                                                                               |       | $                           | 976        |                         | $          | 973 |   |
| Accrued  liabilities                                                                                                                                           |       | 2,608                       |       | 2,522                        |       |
| Derivative  liabilities                                                                                                                                        |       | 1,008                       |       | 1,021                        |       |
| Current portion  of obligations under capital lease                                                                                                            |       | 487                         |       | 340                          |       |
| Current portion  of notes payable                                                                                                                              |       | 445                         |       | 134                          |       |
| Current portion  of convertible debentures, net of discount                                                                                                    |       | —                      |       | —                       |       |
| Liabilities of  discontinued operations                                                                                                                        |       | —                      |       | 72                           |       |
| Total current  liabilities                                                                                                                                     |       | 5,524                       |       | 5,062                        |       |
|                                                                                                                                                           |       |                        |       |                         |       |
| Obligations under  capital lease, net of current portion                                                                                                       |       | 1,085                       |       | 710                          |       |
| Notes payable, net of  current portion                                                                                                                         |       | —                      |       | —                       |       |
| Other long-term  liabilities                                                                                                                                   |       | 1,478                       |       | 888                          |       |
| Convertible debentures,  net of discount and current portion                                                                                                   |       | 9,374                       |       | 8,634                        |       |
|                                                                                                                                                           |       |                        |       |                         |       |
| TOTAL LIABILITIES                                                                                                                                              |       | 17,461                      |       | 15,294                       |       |
|                                                                                                                                                           |       |                        |       |                         |       |
| Minority interest in  consolidated subsidiary                                                                                                                  |       | 11                          |       | 111                          |       |
|                                                                                                                                                           |       |                        |       |                         |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                     |       |                        |       |                         |       |
| Common stock -  no par value; 175,000,000 shares authorized; shares issued and outstanding:  July 31, 2007 – 12,658,150; April 30, 2007 – 12,639,400 |       | 64,348                      |       | 64,319                       |       |
| Additional paid  in capital                                                                                                                                    |       | 20,872                      |       | 20,705                       |       |
| Accumulated  deficit                                                                                                                                           |       | (84,454                     | )          | (81,469                      | )          |
| Total  stockholders’ equity                                                                                                                               |       | 766                         |       | 3,555                        |       |
|                                                                                                                                                           |       |                        |       |                         |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                |       | $                           | 18,238     |                         | $          | 18,960 |   |

 

See notes to condensedconsolidated financial statements.

3

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**Isonics Corporation and Subsidiaries**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(inthousands, except per share data)**

**(Unaudited)**
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                 | ** ** | **July 31,**                | ** ** |
| ** **                                                                 | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Revenues:                                                                  |       | $                                |       |   | $ |   |   |
| Products                                                                   |       | 871                              |       | 1,598 |   |
| Services                                                                   |       | 4,998                            |       | 5,188 |   |
| Total revenues                                                             |       | 5,869                            |       | 6,786 |   |
|                                                                       |       |                             |       |   |   |
| Cost of revenues:                                                          |       |                             |       |   |   |
| Products                                                                   |       | 875                              |       | 1,430 |   |
| Services                                                                   |       | 4,123                            |       | 4,137 |   |
| Total cost of  revenues                                                    |       | 4,998                            |       | 5,567 |   |
|                                                                       |       |                             |       |   |   |
| Gross margin                                                               |       | 871                              |       | 1,219 |   |
|                                                                       |       |                             |       |   |   |
| Operating expenses:                                                        |       |                             |       |   |   |
| Selling, general  and administrative                                       |       | 2,090                            |       | 3,768 |   |
| Research and  development                                                  |       | 1,017                            |       | 1,404 |   |
| Total operating  expenses                                                  |       | 3,107                            |       | 5,172 |   |
|                                                                       |       |                             |       |   |   |
| Operating loss                                                             |       | (2,236                           | )          | (3,953 | ) |
|                                                                       |       |                             |       |   |   |
| Other income (expense):                                                    |       |                             |       |   |   |
| Amortization of  debt issuance costs                                       |       | (41                              | )          | (115 | ) |
| Interest and  other income                                                 |       | 97                               |       | 40 |   |
| Interest expense                                                           |       | (1,429                           | )          | (650 | ) |
| Foreign exchange                                                           |       | —                           |       | — |   |
| Gain on  extinguishment of debt                                            |       | —                           |       | 227 |   |
| Gain on  derivative instruments                                            |       | 13                               |       | 2,131 |   |
| Equity in net  loss of investee                                            |       | (42                              | )          | (88 | ) |
| Total other  income (expense), net                                         |       | (1,402                           | )          | 1,545 |   |
| Loss from continuing  operations before income taxes and minority interest |       | (3,638                           | )          | (2,408 | ) |
| Income tax expense                                                         |       | —                           |       | — |   |
| Minority interest in  operations of consolidated subsidiary                |       | 100                              |       | — |   |
| Loss from continuing  operations                                           |       | (3,538                           | )          | (2,408 | ) |
| Discontinued  operations:                                                  |       |                             |       |   |   |
| Gain on  operations of discontinued operations, net of income taxes        |       | 37                               |       | 36 |   |
| Gain on disposal  of discontinued operations, net of income taxes          |       | 516                              |       | — |   |
| Gain on  discontinued operations, net of income taxes                      |       | 553                              |       | 36 |   |
| NET LOSS                                                                   |       | $                                | (2,985     | ) | $ | (2,372 | ) |
|                                                                       |       |                             |       |   |   |
| **Net income (loss) per share –  basic and diluted:**                 |       |                             |       |   |   |
| Continuing operations                                                      |       | $                                | (0.28      | ) | $ | (0.21 | ) |
| Discontinued  operations                                                   |       | $                                | 0.04       |   | $ | 0.00 |   |
| Attributable to  common stockholders                                       |       | $                                | (0.24      | ) | $ | (0.21 | ) |
| Weighted average common shares used in computing per share  information    |       | 12,654                           |       | 11,367 |   |

 

See notes to condensedconsolidated financial statements.

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**Isonics Corporation and Subsidiaries**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands, except share amounts)**

**(Unaudited)**
| ** **                                                                                            | ** ** | **Three Months Ended July 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
|                                                                                                  |       |                                                |       |   |   |
| Net cash used in  operating activities                                                                |       | $                                                   | (453       | ) | $ | (3,442 | ) |
|                                                                                                  |       |                                                |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                |       |                                                |       |   |   |
| Purchases of  property and equipment                                                                  |       | (96                                                 | )          | (360 | ) |
| Equity  investment in a business                                                                      |       | —                                              |       | (100 | ) |
| Proceeds from  sale of discontinued operations, net of selling costs                                  |       | 805                                                 |       | — |   |
| Cash provided by  (used in) investing activities                                                      |       | 709                                                 |       | (460 | ) |
|                                                                                                  |       |                                                |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                |       |                                                |       |   |   |
| Principal payments  under capital lease obligations                                                   |       | (106                                                | )          | (3 | ) |
| Principal  payments on borrowings                                                                     |       | (224                                                | )          | (4,549 | ) |
| Proceeds from  issuance of common stock                                                               |       | —                                              |       | 15 |   |
| Proceeds from  the issuance of convertible debentures and related warrants, net of offering  costs    |       | —                                              |       | 12,270 |   |
| Cash (used in)  provided by financing activities                                                      |       | (330                                                | )          | 7,733 |   |
|                                                                                                  |       |                                                |       |   |   |
| NET (DECREASE) INCREASE  IN CASH AND CASH EQUIVALENTS                                                 |       | (74                                                 | )          | 3,831 |   |
| Cash and cash  equivalents at beginning of period                                                     |       | 1,556                                               |       | 1,586 |   |
| Cash and cash  equivalents at end of period                                                           |       | $                                                   | 1,482      |   | $ | 5,417 |   |
|                                                                                                  |       |                                                |       |   |   |
| Supplemental disclosure  of cash flow information:                                                    |       |                                                |       |   |   |
| Cash paid during  the period for:                                                                     |       |                                                |       |   |   |
| Interest                                                                                              |       | $                                                   | 71         |   | $ | 70 |   |
| Income taxes                                                                                          |       | $                                                   | —     |   | $ | — |   |
|                                                                                                  |       |                                                |       |   |   |
| Supplemental disclosure  of noncash investing and financingactivities:                                |       |                                                |       |   |   |
| Capital lease  obligation for property and equipment                                                  |       | $                                                   | 628        |   | $ | — |   |
| Accruals for  property and equipment                                                                  |       | $                                                   | —     |   | $ | 245 |   |
| Capitalized debt  issuance costs associated with issuance of common stock in a financing  transaction |       | $                                                   | —     |   | $ | 601 |   |
| Payment in common stock  of principal due on convertible debentures                                   |       | $                                                   | —     |   | $ | 3,943 |   |

 

See notes to condensed consolidated financialstatements.

5

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**Isonics Corporation and Subsidiaries**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 - BASIS OF PRESENTATION**

Theaccompanying condensed consolidated balance sheet as of April 30, 2007, hasbeen derived from audited financial statements. The accompanying unaudited interim condensed consolidated financialstatements of Isonics Corporation and Subsidiaries have been prepared on thesame basis as the annual audited financial statements and in accordance withaccounting principles generally accepted in the United States (“US GAAP”) forinterim financial information and the rules and regulations of the Securitiesand Exchange Commission (“SEC”) for interim financial statements.  In the opinion of management, such unauditedinformation includes all adjustments (consisting only of normal recurringaccruals) necessary for a fair presentation of this interim information.  Operating results and cash flows for interimperiods are not necessarily indicative of results that can be expected for theentire year.  The information included inthis report should be read in conjunction with our audited consolidatedfinancial statements and notes thereto included in our Annual Report on Form10-K for the year ended April 30, 2007.

Duringthe three months ended January 31, 2007, we reclassified the operations of ourlife sciences business as discontinued operations in accordance with SFAS No.144, *Accounting for the impairment orDisposal of Long-Lived Assets* (“SFAS 144”).  Prior year condensed consolidated financialstatements have been restated to present the operations of the life sciencesbusiness as discontinued operations.  SeeNote 5 for additional information.

OnFebruary 13, 2007, we effected a one-for-four reverse stock split of our commonshares upon the filing of a Certificate of Amendment to our Articles ofIncorporation with the California Secretary of State.  All impactedamounts included in the consolidated financial statements and notes theretohave been restated for the stock split.

***Going Concern***

Whileas of July 31, 2007, we have working capital of $1,953,000 and stockholders’equity of  $766,000, we incurredsignificant losses from operations and used significant cash flow to fundoperations during the most recent several fiscal years and through July 31,2007.  Historically, we have relied uponoutside investor funds to maintain our operations and develop our business. Weanticipate we will continue to require funding from investors for workingcapital as well as business expansion during this fiscal year and we canprovide no assurance that additional investor funds will be available on termsacceptable to us.  In addition, we haveconvertible debentures outstanding in the cumulative amount of $19,445,000(which represents the face amount of the debentures and related accruedinterest) as of July 31, 2007, which is due in May 2009 unless an Event ofDefault was to occur and the holder then declared an Event of Default.  See Note 8 for discussion of a potential waiverthat may be required to remedy a potential Event of Default.  These conditions raise substantial doubtabout our ability to continue operations as a going concern.

During the year ended April 30, 2007, and subsequently, we restructuredour management team with the goal of refocusing our product lines, seekingjoint venture partners and improving operating performance at the businesssegments through a focus on strategic products, increased efficiencies inbusiness processes and improvements to the cost structure of each segment.  Despite these changes, our ability tocontinue as a going concern is dependent upon raising capital through debt orequity financing and ultimately by increasing revenue and achieving profitableoperations. We can offer no assurance that we will be successful in our effortsto raise additional proceeds or achieve profitable operations.  The accompanying condensed consolidatedfinancial statements have been prepared on a going concern basis, whichcontemplates the realization of assets and the settlement of liabilities in thenormal course of business.

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**NOTE 2 -SIGNIFICANT ACCOUNTING POLICIES**

***NetIncome (Loss) Per Share***

Basic net income (loss) pershare is computed using the weighted average number of common sharesoutstanding during the period. Contingently issuable shares are included in the computation of basicnet income (loss) per share when the related conditions are satisfied.  Diluted net income (loss) per share iscomputed using the weighted average number of common shares and potentiallydilutive securities outstanding during the period.  Potentially dilutive securities consist ofcontingently issuable shares, the incremental common shares issuable uponconversion of convertible debt (using the “if converted” method) and sharesissuable upon the exercise of stock options and warrants (using the “treasurystock” method).  Potentially dilutivesecurities are excluded from the computation if their effect is anti-dilutive.

As of July 31, 2007, (a) a total of5,119,000 outstanding stock options (excluding 3,550,000 stock options notdeemed granted under US GAAP because the underlying plan or increase to theunderlying plan has not been approved by our shareholders) and common stockwarrants and (b) the unissued shares underlying our outstanding convertibledebentures (with a cumulative outstanding face amount of $18,000,000 at July31, 2007) were excluded from the diluted net loss per share calculation, astheir inclusion would be anti-dilutive. As of July 31, 2006, (a) a total of 5,790,261 outstanding stock optionsand common stock warrants and (b) the unissued shares underlying ouroutstanding convertible debentures (with a cumulative outstanding face amountof $18,062,500 at July 31, 2006) were excluded from the diluted net loss pershare calculation, as their inclusion would be anti-dilutive.

During the three months ended July31, 2007, we issued the following shares of common stock:
| Description                  | ** ** | **Number of Common Stock Shares** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|
| Balance as of April 30, 2007 |       | 12,639,400                                            |       |
| Shares issued for services   |       | 18,750                                                |       |
| Balance as of July 31, 2007  |       | 12,658,150                                            |       |

 

The aforementioned equitytransactions increased common stock in the accompanying condensed consolidatedbalance sheets by $29,000 for the three months ended July 31, 2007.

***RecentlyIssued Accounting Standards***

In July 2006, the FinancialAccounting Standards Board (“FASB”) issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109*(“FIN 48”).  This interpretation clarifies the applicationof SFAS 109 by defining a criterion that an individual tax position must meetfor any part of the benefit of that position to be recognized in an enterprise’sfinancial statements and also provides guidance on measurement, derecognition,classification, interest and penalties, accounting in interim periods anddisclosure.  FIN 48 requires therecognition of penalties and interest on any unrecognized tax benefits. Ourpolicy is to reflect penalties and interest as part of income tax expense asthey become applicable.  We adopted FIN48 effective May 1, 2007.  Nounrecognized tax benefits were recorded as of the date of adoption.  Due to certain “change in ownership”rules (as defined by the IRS), utilization of our federal net operatinglosses may be subject to certain annual limitations.  We have not completed a formal assessment asto the extent of such potential limitations. We file income tax returns in theU.S. federal and various state jurisdictions. We are no longer subject to U.S.federal and state and local 

7

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examinations by taxauthorities for fiscal years prior to 2004.

In September 2006, theFASB issued SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”). SFAS 157 defines fair value,establishes a framework and gives guidance regarding the methods used formeasuring fair value, and expands disclosures about fair value measurements.SFAS 157 is effective for our fiscal year commencing May 1, 2008,including interim periods within that fiscal year.  We are currently evaluating the impact ofadopting SFAS 157 on our results of operations and financial condition.

In February 2007, the FASBissued SFAS No. 159, *The Fair Value Optionfor Financial Assets and Financial Liabilities* (“SFAS 159”).  SFAS 159 provides the option to reportcertain financial assets and liabilities at fair value, with the intent tomitigate volatility in financial reporting that can occur when related assetsand liabilities are recorded on different bases.   SFAS 159 alsoamends SFAS No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*, by providing the optionto record unrealized gains and losses on held-for-sale and held-to-maturitysecurities currently.  SFAS 159 is effective for our fiscal yearcommencing May 1, 2008, including interim periods within that fiscal year.  The implementation of FAS 159 is not expectedto have a material impact on our results of operations or financial position.

**NOTE 3 –FINANCIAL STATEMENT COMPONENTS**

***Inventories***

Inventoriesconsist of the following (in thousands):
|                        | ** ** | **July 31, 2007** | ** ** | **April 30, 2007** | ** ** |
|------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Finished goods         |       | $                           | 647        |                         | $          | 497 |   |
| Work in process        |       | 37                          |       | 47                           |       |
| Materials and supplies |       | 679                         |       | 715                          |       |
| Total inventories      |       | $                           | 1,363      |                         | $          | 1,259 |   |

 

***Property and equipment***

Property and equipmentconsist of the following (in thousands):
| ** **                                | ** ** | **July 31, 2007** | ** ** | **April 30, 2007** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Office furniture and equipment            |       | $                           | 361        |                         | $          | 331 |   |
| Production equipment                      |       | 8,373                       |       | 7,613                        |       |
| Vehicles                                  |       | 191                         |       | 191                          |       |
| Construction in process                   |       | 779                         |       | 854                          |       |
| Leasehold improvements                    |       | 1,215                       |       | 1,215                        |       |
|                                      |       |                        |       |                         |       |
| Accumulated depreciation and amortization |       | (4,953                      | )          | (4,538                       | )          |
| Total property and equipment, net         |       | $                           | 5,966      |                         | $          | 5,666 |   |

 

**NOTE 4 –SEGMENTINFORMATION**

We currently have threereportable segments: homeland security products, security services andsemiconductor products and services.  Ourhomeland security products segment includes both operations regarding our IonMobility Spectroscopy (“IMS”) technology (see Note 11) and, through our90%-owned subsidiary (SenseIt Corp, see Note 6), the

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development ofnext-generation infrared imaging and night vision technology through ourDevelopment & Licensing Agreement with Lucent Technologies, Inc.  Our security services segment providessecurity and investigative services and is substantially comprised of theoperations of Protection Plus Security Corporation (“PPSC”), which was acquiredin May 2005.  Our semiconductor productsand services segment provides 300-millimeter(and smaller diameter) silicon wafer reclaim and test products, wafer thinningand custom wafer products for the semiconductor industry.  Our segments are strategic business units,each of which consists of similar products or services.  They are managed separately because eachsegment requires different technology and marketing strategy and because eachsegment sells to different customers. Reconciling items consist primarily of corporate assets or expenses thathave not been allocated to a specific reportable segment and the assets of ourformer life sciences business which were categorized as discontinued operationsprior to their sale in June 2007.  Priorperiod amounts have been reclassified to conform to current periodpresentation.

Information by segment isset forth below (in thousands):
|                                      | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **July 31,**                | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Segment revenues:                    |       |                             |       |   |   |
| Homeland  security products          |       | $                                | —     |   | $ | — |   |
| Security  services                   |       | 3,756                            |       | 3,877 |   |
| Semiconductor  products and services |       | 2,113                            |       | 2,909 |   |
| Total                                |       | $                                | 5,869      |   | $ | 6,786 |   |

 
|                                      | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **July 31,**                | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Segment operating (loss) income:     |       |                             |       |   |   |
| Homeland  security products          |       | $                                | (1,321     | ) | $ | (1,114 | ) |
| Security  services                   |       | 70                               |       | (274 | ) |
| Semiconductor  products and services |       | (361                             | )          | (199 | ) |
| Reconciling  amounts (1)             |       | (624                             | )          | (2,366 | ) |
| Total                                |       | $                                | (2,236     | ) | $ | (3,953 | ) |

** **
|                                      | ** ** | **July 31,** | ** ** | **April 30,** | ** ** |
|--------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                           | ** ** | **2007**          | ** ** | **2007**           | ** ** |
| Total assets:                        |       |              |       |               |       |
| Homeland  security products          |       | $                 | 1,210      |               | $          | 1,943 |   |
| Security  services                   |       | 6,689             |       | 6,127              |       |
| Semiconductor  products and services |       | 8,612             |       | 9,068              |       |
| Reconciling  amounts (2)             |       | 1,747             |       | 1,822              |       |
| Total                                |       | $                 | 18,238     |               | $          | 18,960 |   |

 

(1)   Reconciling amounts for the operating (loss)income information includes corporate expenses consisting primarily ofcorporate salaries and benefits, professional and consulting fees, investorrelations costs, insurance and directors’ compensation.

(2)   Reconciling amountsfor the total asset information includes corporate assets consisting primarilyof cash and cash equivalents invested centrally, unamortized debt issuancecosts and miscellaneous prepaid items as well as, for April 30, 2007, theassets of our 

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former life sciences business which were categorized asdiscontinued operations prior to their sale in June 2007.

**NOTE 5 –DISCONTINUEDOPERATIONS**

During the three months endedJanuary 31, 2007, we elected to discontinue the operation of our life sciencesbusiness and to put the assets and business up for sale.  We decided to sell this business as it nolonger fit our long-term strategy and because of deteriorating businessconditions in the historical, revenue producing products in the segment.  Accounting rules required us to treat theoperations of the life sciences business as discontinued operations whereby thenet financial impact of the operations of the business (including revenue) iscombined into a single line item and prior periods are reclassified for thispresentation. On June 19, 2007, we completed the sale of this business fortotal cash proceeds of $850,000, out of which we paid a selling fee of $45,000and repaid a loan underlying production equipment in the amount of $40,000.

The business’ revenue, which isreported as discontinued operations in the accompanying condensed consolidatedstatements of operations, for the three months ended July 31, 2007 and 2006,was $101,000 and $616,000, respectively. The business’ gain on operations of discontinued operations, net ofincome taxes, for the three months ended July 31, 2007 and 2006, was $37,000and $36,000, respectively.

Following is a summary of the netassets sold on the closing date of June 19, 2007, and included in the condensedconsolidated balance sheet as discontinued operations on April 30, 2007 (inthousands):
|                             | ** ** | **June 19,** | ** ** | **April 30,** | ** ** |
|-----------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                  | ** ** | **2007**          | ** ** | **2007**           | ** ** |
| Cash                        |       | $                 | —     |               | $          | 110 |   |
| Accounts receivable         |       | —            |       | 25                 |       |
| Inventory                   |       | 8                 |       | 66                 |       |
| Property and equipment, net |       | 223               |       | 228                |       |
| Other assets                |       | 56                |       | 62                 |       |
| Total assets                |       | $                 | 287        |               | $          | 491 |   |

 
|                                          | ** ** | **June 19,** | ** ** | **April 30,** | ** ** |
|------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                               | ** ** | **2007**          | ** ** | **2007**           | ** ** |
| Accounts payable and accrued liabilities |       | $                 | —     |               | $          | 33 |   |
| Note payable                             |       | —            |       | 39                 |       |
| Total liabilities                        |       | $                 | —     |               | $          | 72 |   |

 

**NOTE 6 –INVESTMENT IN SENSEIT CORP**

On October 26, 2006, we enteredinto a Class A Common Stock Purchase Agreement (the “Purchase Agreement”) withSenseIt Corp, a Delaware corporation (“SenseIt”), with the intent ofaccelerating next generation infrared imaging and night vision surveillancetechnology development and driving related commercialization activities inconnection with our Development & Licensing Agreement with LucentTechnologies Inc. (currently known as Alcatel-Lucent), (the “Lucent Agreement”and “Lucent,” respectively).  The jointventure was established through our acquisition of an initial 90% ownershipinterest in SenseIt in exchange for assigning to SenseIt all of our interestunder the Lucent Agreement, although we will continue to be jointly andseverally liable with SenseIt to Lucent for amounts due to 

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Lucent under the assigned LucentAgreement.  The assignment was approved by Lucent.

Pursuant to the PurchaseAgreement, on October 27, 2006, we purchased shares of the Class A common stockof SenseIt in exchange for cash and other consideration, including, but notlimited to, an assignment of all of our rights, title and interest in theLucent Agreement.  As described above, we now have a 90% ownershipinterest in SenseIt.  Our ownership interest will be adjusted if SenseItreceives additional financing from third parties, and upon the occurrence of aThreshold Event.  The term “Threshold Event” is described in SenseIt’sCertificate of Incorporation, as amended, as the receipt by SenseIt ofcumulative $20 million in certain equity financing.  At that time, theClass A common stock and Class B common stock will be converted into commonstock, and the holder of the Class B common stock (held by the ChristopherToffales, chief executive officer of SenseIt and Chairman of the Board of IsonicsCorporation) will be entitled to a 10% ownership interest.  The remaining90% of the common stock outstanding will be allocated among the prior holdersof common stock and Class A common stock.

In August 2007, we acquired anadditional 10,000 shares of Class A common stock of SenseIt for considerationof $100,000.  Subsequent to this sharepurchase, we own 674,650 shares of Class A common stock of SenseIt.

We did not make the $1,000,000payment that was due to Lucent on or before July 16, 2007.  As a result of not making this payment,Lucent may, after certain steps of notification and periods to cure have beenexhausted, cancel the Lucent Agreement and all licenses granted to usthereunder or cease working on the project and then assess us a “start-up” feeif funding was to resume.  Effective July26, 2007, we received official notification from Lucent that we failed to makethe $1,000,000 payment to Lucent by July 16, 2007, and that in the event suchnon-payment continues for more than ten days, Lucent may at is discretion,suspend work on the development project. On September 7, 2007, we received official notification from Lucent thatthey intend to suspend work on the development project if receipt of the $1,000,000payment is not received by September 16, 2007, although Lucent also has theright to terminate the agreement.  Wewill not be able to make such payment by September 16, 2007, due to a lack ofworking capital. We can offer no assurance that if Lucent suspends the projectthat they will choose to restart the project even if we were to successfullyraise the funds necessary to make the delinquent payment along with anystart-up fee which may be required.  Wealso cannot offer any assurance that we will be able to raise the fundsnecessary to make all of the required payments to Lucent, or that thetechnology will be developed to a point where we want to continue to make suchpayments when due.  Additionally andsubject to the aforementioned project risks and contingencies, SenseIt may needto seek outside financing to make payments to Lucent and, if so elected andsubject to availability of financing, such outside financing would dilute ourownership interest in SenseIt.

**NOTE 7 – EQUITY**

###### ***2005 StockOption Plan***

In May2007, our Board of Directors approved a resolution increasing the sharesavailable for issuance to 2,875,000, an increase of 2,000,000 shares.  Any options granted from this increasedallotment will not be exercisable until approved by our shareholders and weexpect to include the proposal to approve this plan as an item to be consideredat our next annual meeting of shareholders. Due to a lack of working capital, we have decided to postpone our annualshareholder meeting of shareholders from our earlier contemplated timing ofNovember 2007 to a later period.

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***Equity Instruments Issued for Services***

In May2007, we entered into a consulting agreement with CEOcast, Inc. to provideinvestor relations services.  Thecompensation terms of the agreement included the issuance of 18,750 shares ofour common stock, which was valued at $29,000. The common stock was recorded as prepaid consulting expense and will beamortized ratably over the service period of six months.  For the three months ended July 31, 2007, werecognized $5,000 of selling, general and administrative expense related to theshares of common stock issued under the agreement.

InJune 2007, we granted options to purchase 200,000 shares of our common stock toSound Business Solutions, Inc., an entity whose principal has been providingmanagement services in our semiconductor products and services segment.  This option was granted pursuant to our 2005Stock Option Plan.  The stock optionsgranted to Sound Business Solutions Inc. are subject to the following vestingschedule: 66,667 shares vested immediately upon grant; 66,667 shares vested onSeptember 7, 2007; and 66,666 shares vest on January 31, 2008.  The stock options granted to Sound BusinessSolutions Inc. are exercisable through June 18, 2011, at $1.45 per share.  Options to purchase 50,000 shares (valued at$53,000 using the Black-Scholes pricing model) are currently exercisable whileoptions to purchase 150,000 shares are subject to our shareholders approvingthe aforementioned increase to the cumulative shares issuable under the 2005Stock Option Plan.  A charge in theamount of $28,000 was recognized as a selling, general and administrativeexpense for the three months ended July 31, 2007.  This charge related to the portion of thefair value of the currently exercisable option to purchase 50,000 shares thatis associated with work performed in the reporting period.  Under SFAS 123(R), a stock option is notconsidered granted for accounting purposes until stockholder approval is obtained(unless such approval is deemed a formality, which is not the case for theproposed increase to the 2005 Stock Option Plan).  As such, no expense has been recognized inthe condensed consolidated financial statements related to the option topurchase 150,000 shares of common stock. When and if the increase to the 2005 Stock Option Plan is approved bythe shareholders, we expect a stock-based compensation charge to be incurredbased on the fair value of the stock options on the date of shareholderapproval.

**NOTE 8 – BORROWINGS**

***Capital Lease***

In May2007, we entered into a capital lease to finance equipment to be used inproduction by our semiconductor products and services segment.  The lease is in the principal amount of$628,000, bears a nominal interest rate of 16%, has a term of 36 months andincludes a bargain purchase option whereby we have the right subsequent to theexpiration of the lease term to purchase the asset under lease for no more than5% of the original equipment cost. Additionally, we issued the lessor a common stock warrant (valued at$39,000 using the Black-Scholes pricing model) to purchase 40,000 shares ofcommon stock at $1.50 per share.  Thecommon stock warrant vested immediately, expires on May 28, 2010, and is beingamortized to interest expense over the term of the lease.

***April 2007 Debenture***

InApril 2007, we issued to YA Global Investments, L.P. (“YA Global”), formerlyknown as Cornell Capital Partners, LP, a convertible debenture with a faceamount of $2,000,000 (the “April 2007 Debenture”) along with detachable commonstock warrants.  For the three monthsended July 31, 2007, using the effective interest method we amortized $37,000of the discount on the April 2007 Debenture to interest expense.  As of July 31, 2007, the April 2007 Debenturehas an outstanding face amount of $2,000,000 and is recorded in our condensedconsolidated balance sheets at a carrying amount (net of discount) of$1,701,000.  We also recorded accruedinterest on the April 2007 Debenture in the amount of $66,000 for the threemonths ended July 31, 2007.  As of July31, 2007, cumulative 

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accruedinterest is $80,000; such accrued interest is included in other long-termliabilities in the condensed consolidated balance sheets and is due uponmaturity of the April 2007 Debenture in May 2009.

We arecontractually required to obtain shareholder approval of this transaction by nolater than November 30, 2007, including the ability to issue a maximum of 10million shares upon conversion of the April 2007 Debenture and 250,000 sharesfor issuance upon exercise of the April 2007 Debenture Warrant.  Due to a lack of working capital, we havedecided to postpone our annual meeting of shareholders to a time subsequent toNovember 30, 2007.  If, as expected, wedo not obtain shareholder approval of the April 2007 Debenture by November 30,2007, and do not receive a waiver from the holder of the April 2007 Debenture,the holder of that debenture may declare an Event of Default.  Remedies for an Event of Default include the optionto accelerate payment of the full principal amount of the April 2007 Debenture,together with interest and other amounts due (a cumulative amount of $2,080,000at July 31, 2007), to the date of acceleration and the holder will have theright to request such payment in cash or in shares of our common stock.  If the holder of the April 2007 Debenturedeclares an Event of Default, it is unlikely that we will be able to cure thedefault or contest any efforts that the holder may take to foreclose againstits security interest in substantially all of our assets.

***2006 Convertible Debentures***

InMay, June and November 2006, we issued to YA Global convertible debentures witha cumulative face amount of $16,000,000 (the “2006 Debentures”) along withdetachable common stock warrants.  Forthe three months ended July 31, 2007, using the effective interest method weamortized $708,000 of the discount on the 2006 Debentures to interestexpense.  As of July 31, 2007, the 2006Debentures have a cumulative outstanding face amount of $16,000,000 and arerecorded in our condensed consolidated balance sheets at a carrying amount (netof discount) of $7,673,000.  We alsorecorded accrued interest on the 2006 Debentures in the amount of $524,000 forthe three months ended July 31, 2007.  Asof July 31, 2007, cumulative accrued interest is $1,375,000; such accruedinterest is included in other long-term liabilities in the condensedconsolidated balance sheets and is due upon maturity of the 2006 Debentures inMay 2009.

Certainevents, as defined in the 2006 Debenture agreements, may allow the 2006Debentures holder to declare an Event of Default.  One default provision included in the 2006Debenture agreements provides that the holder of the 2006 Debentures candeclare an Event of Default under the 2006 Debentures if we are declared indefault under any other debenture or other financial liability instrument inexcess of $500,000.  If the holder of theApril 2007 Debenture were to declare an Event of Default under that debenture(as discussed previously within this footnote), the holder of the 2006Debentures could declare an Event of Default under the 2006 Debentures.  Remedies for an Event of Default, include theoption to accelerate payment of the full principal amount of the Debentures,together with interest and other amounts due (a cumulative amount of$17,375,000), to the date of acceleration and the holder will have the right torequest such payment in cash or in shares of our common stock.  If the holder of the 2006 Debentures declaresan Event of Default, it is unlikely that we will be able to cure the default orcontest any efforts that the holder may take to foreclose against its securityinterest in substantially all of our assets.

**NOTE 9 – COMMITMENTS AND CONTINGENCIES**

As ofJuly 31, 2007, we had commitments outstanding for capital expenditures ofapproximately $100,000.

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**NOTE 10 - RELATEDPARTY TRANSACTIONS**

We have a research anddevelopment agreement with Institut fur Umwelttechnologien GmbH (“IUT”), anequity method investee of which we own 30%. We funded $78,000 and $460,000 under this agreement for the three monthsended July 31, 2007 and 2006, respectively (and a total of $2,986,000 sinceentering into our first research and development agreement in June 2004).  All funded payments have been included asresearch and development in the accompanying condensed consolidated statementsof operations.

**NOTE  11 – SUBSEQUENTEVENTS**

Certain events occurringsubsequent to July 31, 2007, are discussed within other notes to the condensedconsolidated financial statements.

In August 2007, we electedto suspend the development, manufacture and sale of our IMS-basedproducts.  The suspension was dueprimarily to a lack of working capital but we have also had difficultycompeting in the market space.  We willcontinue to seek alternatives towards finding a means of monetizing ourIMS-based investment, including the development of a strategic partnership oran outright sale of the technology.  Itis unclear as to when (if at all) we will resume activity on our IMS-based productsand we can offer no assurance that we will be able to monetize any portion ofour IMS-based investment.  We arecurrently evaluating the impact of this decision on the carrying value ofcertain assets recorded in our condensed consolidated balance sheets.

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**Item2:  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

*Certainstatements in this report, other than purely historical information, includingestimates, projections, statements relating to our business plans, objectivesand expected operating results, and the assumptions upon which those statementsare based, are “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements generallyare identified by the words “believe,” “expect,” “intend,” “estimate,” “anticipate,”“project,” “will,” “plan,” “will continue,” “will likely result” and similarexpressions.  Forward-looking statementsare based on current expectations and assumptions that are subject to risks anduncertainties which may cause actual results to differ materially from theforward-looking statements.  A detaileddiscussion of these and other risks and uncertainties that could cause actualresults and events to differ materially from such forward-looking statements isincluded in the section entitled “Risk Factors” (refer to Item 1A of PartII).  We undertake no obligation to updateor revise publicly any forward-looking statements, whether as a result of newinformation, future events or otherwise.*

***GeneralDiscussion***

We are focused on the developmentand provision of homeland security products and services and the manufacture of300-millimeter (and smaller diameter) silicon wafer reclaim and test products,wafer thinning and custom wafer products for the semiconductor industry.  During the past several years, our operationshave been characterized by working capital and cash flow shortfalls, and theneed for a significant amount of third party investment to enable us to meetour financial obligations.  Although wehave met our obligations to date (except for the $1,000,000 payment that was dueto Lucent on July 16, 2007), we have frequently been required to allocate ouravailable cash among various obligations. During the three months ended July 31, 2007 and subsequently, we havealso refocused our operations and have attempted to reduce significantly ourexpenses, including the cash flow necessary to pay our corporate and divisionaloverhead.

In June 2007 we sold our lifesciences business (which supplied isotopes for life sciences and health-careapplications) as it no longer fit our long-term strategy for building asustainable and profitable homeland security and semiconductor company andbecause of deteriorating business conditions in the historical, revenueproducing products in this business.

In August 2007, we elected tosuspend the development, manufacture and sale of our IMS-based products.  The suspension was due primarily to a lack ofworking capital but we have also had difficulty competing in the marketspace.  We will continue to seek alternativestowards finding a means of monetizing our IMS-based investment, including thedevelopment of a strategic partnership or an outright sale of thetechnology.  It is unclear as to when (ifat all) we will resume activity on our IMS-based products and we can offer noassurance that we will be able to monetize any portion of our IMS-basedinvestment.

We continue to work towardsdeveloping a next-generation infrared imaging and night vision surveillancetechnology with our partner Lucent but as discussed further below, we have notbeen able to make our required development payments to Lucent.  As a result of not making our requireddevelopment payments on a timely basis, Lucent has the right (until we make theoutstanding payment) to suspend or terminate the project without recourse tous.  We were recently notified by Lucentthat if we did not make the outstanding $1,000,000 payment by September 16,2007, Lucent intends to suspend work on the development project, althoughLucent also has the right to terminate the agreement.  We will not be able to make such payment bySeptember 16, 2007, due to a lack of working capital.  We continue to seek financing in order toresume the project but we can offer no assurance that we will be successful or,if successful, Lucent will chose to restart the project.  If Lucent were to terminate the project wewill likely lose our entire investment in SenseIt as it will become valueless.

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Although ourcommon stock is quoted on the Nasdaq Capital Market, as of July 31, 2007, ourstockholders’ equity was $766,000 and thus we have failed to meet the listing requirementof either stockholders’ equity of at least $2,500,000 or market value of listedsecurities of at least $35,000,000.  As aresult, upon filing this Form 10-Q we expect to receive a notice from Nasdaqfor failure to comply with this requirement. In addition, our per-share bid price is (and has been for some time)below the required $1.00 minimum requirement and as a result we expect toreceive a notice from Nasdaq for failure to comply with this requirement aswell.  Given our current lack of workingcapital, ongoing operating losses and difficulty in obtaining additionalfinancing it is likely that we will not be able to cure thesedeficiencies.  If we are not able to curesuch deficiencies, it most likely will result in our delisting from the NasdaqCapital Market.

Liquidity and Capital Resources

We have had working capitalshortages in the past and, although we raised capital totaling more than$45,800,000 (net of expenses and $4,100,000 of payments related to our 8%Debentures) since May 1, 2004, we have generated significant losses, which haveimpacted working capital.  As of July 31,2007, our condensed consolidated balance sheet reflects working capital of$1,953,000.  In addition, as a result ofour continued operating losses and projected declining working capital balancesduring the year ending April 30, 2008, the auditors report included with ourfinancial statements for the year ended April 30, 2007, included an explanatoryparagraph indicating substantial doubt about our ability to continue as a goingconcern.

Based on the amount of capital wehave remaining and our expected negative cash flow from operations andinvesting activities, we anticipate that we will not be able to positivelyimpact our working capital unless we are able to substantially increase ourrevenues or reduce our expenses thereby generating positive cash flow fromoperations and (ultimately) operating income. We believe we have sufficient working capital to finance our anticipatedoperations and projected negative cash flow only into our quarter endingJanuary 31, 2008, unless we are able to achieve significant additionalfinancing.  Because of the potentialdilution associated with the outstanding debentures and the holder’s securityinterest in substantially all of our assets, we believe that it is unlikelythat we will be able to obtain additional financing unless we are able to reachan accommodation with our existing debenture holder.

We are contractually required toobtain shareholder approval of the April 2007 Debenture (held by YA Global) byno later than November 30, 2007.  Due toa lack of working capital, we have decided to postpone our annual meeting ofshareholders to a time subsequent to November 30, 2007.  If, as expected, we do not obtain shareholder approval of the April 2007Debenture by November 30, 2007, and do not receive a waiver from theholder of the April 2007 Debenture, theholder of that debenture may declare an Event of Default.  Further, a default provision in the 2006Debentures (also held by YA Global) would allow the holder to also declare anEvent of Default of that debenture agreement if we were declared in default ofthe April 2007 Debenture.  Remedies foran Event of Default under all convertible debenture agreements include theoption to accelerate payment of the full principal amount of the respectivedebenture, together with interest and other amounts due (a cumulative$19,455,000 as of July 31, 2007), to the date of acceleration and the holderwill have the right to request such payment in cash or in shares of our commonstock.  If the holder declares default,it is unlikely that we will be able to cure the default or contest any effortsthat the holder may take to foreclose against its security interest insubstantially all of our assets.

Seeadditional discussion of liquidity and capital resources inthe Liquidity and Capital Resources section included further below in this Item2: Management’s Discussion and Analysis of Financial Condition and Results ofOperations.

Overview

During theyear ended April 30, 2007, and the three months ended July 31, 2007, wegenerated sales from stable and radioactive isotopes, silicon wafer reclaim 

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and testproducts, wafer thinning and custom wafer products for the semiconductorindustry, although sales from stable and radioactive isotopes were reported asdiscontinued operations in the accompanying condensed consolidated statementsof operations as described below. Additionally, as a result of the acquisitionof PPSC in May 2005, we also generated revenues from providing securityservices for leading businesses and institutions in healthcare, education,retail, manufacturing, banking and the art world.  For information about segment revenue, referto Note 4 (Segment Information) to the condensed consolidated financialstatements located in Item 1: Financial Statements.

In June 2007 we sold our lifesciences business (which supplied isotopes for life sciences and health-careapplications) as it no longer fit our long-term strategy for building asustainable and profitable homeland security and semiconductor company andbecause of deteriorating business conditions in the historical, revenueproducing products in this business. Accounting rules required us to treat the operations of the lifesciences business as discontinued operations whereby the net financial impactof the operations of the business (including revenue) is combined into a singleline item and prior periods are reclassified for this presentation.  Revenue for the life sciences business, reportedin the single line item of gain on operations of discontinued operations, netof income taxes, was $101,000 and $616,000 for the three months ended July 31,2007 and 2006, respectively.

The followingis a more specific discussion of our current operations.

Homeland Security

Isonics Homeland Security andDefense Corporation (“HSDC”) focuses the majority of our efforts in thehomeland security sector.  These effortsincluded entry into the security services market through our acquisition ofPPSC in May 2005, acquisition and (prior to August 2007) development of our IMSdetection technology and our entry into an agreement (currently in default)with Lucent and a 90% owned joint venture named SenseIt Corp to developinnovative infrared imaging and night vision surveillance technology.   HSDC’s ownership also includes our 30%minority interest in IUT.  The followingis a detail of each of our product lines within our homeland securityoperations:

**SecurityServices** - In May 2005, we acquired PPSC, a provider of securityservices located in New York, New York. Since the effective date of the acquisition, PPSC has deliveredsignificant revenue to our condensed consolidated financial statements and hasprovided gross margin of approximately 22% of revenues for the three monthsended July 31, 2007.

During the fourth quarter of theyear ended April 30, 2007, and the three months ended July 31, 2007, weimplemented cost cutting initiatives that were expected to positively impactthe results of PPSC’s operations.  Additionallywe initiated plans to improve operating margins at PPSC by focusing oncustomers that are willing to pay for premium security services, a market inwhich we believe that PPSC is able to differentiate itself from its peers.  As a result, we have and will exitlower-margin business areas for premium accounts that prefer higher quality ofservice.  As a result of the impact ofcertain of these cost cutting initiatives, the segment generated operatingincome of $70,000 for the three months ended July 31, 2007, as compared to anoperating loss of $(274,000) for the three months ended July, 2006.  For the three months ended July 31, 2007 and2006, the operating loss includes non-cash amortization of acquisition-relatedcustomer intangibles and stock-based compensation expense in the amount of$45,000 and $90,000, respectively.

While we believe that these costcutting initiatives and refocused sales and marketing efforts will enable PPSCto report positive operating income for the year ending April 30, 2008, we canoffer no assurance that this will actually occur.

PPSC has successfully obtained itsfederal Government Contract Schedule (“GSA Schedule”) for securityservices.  Although we have selectively 

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pursued and continue to pursuegovernment contracts in addition to commercial contracts, we have not acquiredany federal government security contracts to date and we can offer no assurancethat we will be able to do so.

**DetectionTechnology –**During our year ended April 30,2007 and through July 31, 2007, we offered our existing IMS-based products (thepanel-mounted IMS and EnviroSecure), although we have not engaged in anysignificant marketing efforts for these products since late in calendar year2006.  Although we continued to offerEnviroSecureTM, a system that can monitor and identify chemical weapons andtoxic substances in the air in a variety of venues including airports, masstransit facilities, sports venues and public and private sector officebuildings, we did not make any sales of this product or engage in anysignificant marketing activities.  Oursales of the panel-mounted IMS product have been extremely limited and haveresulted in deferred revenue that we have not yet substantially recognized. Wehave not recently engaged in any marketing efforts for that product, and we donot intend to recommence any marketing efforts until (if ever) we areadequately capitalized, have a commercial product and have identified a market.

During the latter half of the yearended April 30, 2007, we redefined and refocused the operations of HSDC tofocus on the development of partnerships with leading prime contractors in thesecurity and defense, industrial and transportation markets, although we havenot yet developed any such partnerships. By working with these types of partners, we believed that we would beable to more effectively and efficiently complete the development of ourIMS-based products with the goal of incorporating them into the products andsystems of our partners.  If we weresuccessful in developing these types of strategic partnerships, we believedthat we would be in a better position to compete with the current industryleaders through leveraging the marketing arms and customer bases of thesepartners.  This change in strategicdirection delayed the time frame for significant product sales but we werehopeful that it would allow for a significant reduction in development costsand a greater penetration of the market in the future.

In August 2007, we elected tosuspend the development, manufacture and sale of our IMS-based products.  The suspension was due primarily to a lack ofworking capital but we have also had difficulty competing in the marketspace.  We will continue to seekalternatives towards finding a means of monetizing our IMS-based investment,including the development of a strategic partnership or an outright sale of thetechnology.  It is unclear as to when (ifat all) we will resume activity on our IMS-based products and we can offer noassurance that we will be able to monetize any portion of our IMS-based investment.

In November 2005, we signed adevelopment agreement with DualDraw LLC (“Dual Draw”), a manufacturer of airquality equipment.  Under this agreement,we worked to incorporate our panel-mounted IMS-based system into the DualDrawmailroom inspection workstation, a downdraft workstation that keeps toxicsubstances away from the breathing zone of mailroom workers who are sorting oropening mail and captures such substances with a HEPA (high efficiencyparticulate air) filtration system.  Theincorporation of our IMS capability provides an alarm if certain toxic orexplosive substances are detected.  Wecompleted seven commercial installations of our panel-mounted IMS-based productin the AirChx system manufactured by Dual Draw during the year ended April 30,2007, as well as an additional eight units during the three months ended July31, 2007.  We have not received paymentfrom DualDraw for the latter eight units, and our anticipated revenue for allunits are primarily being classified as deferred revenue pending completion ofcertain tasks. We do not expect to receive any more purchase orders fromDualDraw for our panel-mounted IMS-based product.

**Infrared ImagingTechnology –**In December, 2005, we approved adevelopment plan that resulted in us becoming obligated under the LucentAgreement we entered into with Lucent in September 2005 which, in October 2006,we assigned to our 90% owned subsidiary, SenseIt, which is described in moredetail below.  Under the LucentAgreement, we are attempting to develop a next-generation infrared imaging andnight vision surveillance technology based on Lucent’s micro electro-mechanicalsystems (“MEMS”) technology under development at its nanotechnology fabricationfacility.  Infrared technology, whichconverts infrared radiation in the non-visible spectrum, such as body 

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heat, into a visible image, iscommonly found in both commercial and military/homeland security applicationsincluding night vision goggles and cameras, rifle scopes and threat detectiondevices used to identify concealed weapons or explosives.  The MEMS approach to infrared imaging, ifsuccessful, may lead to products which we believe will at least equal theperformance of, with a lower power consumption and price than, productscurrently available in the marketplace today. Additionally, a MEMS-based product may also provide for costefficiencies in the manufacturing process. The development plan contemplates a proof-of-concept during calendaryear 2007, followed by steps towards commercialization, though we can provideno assurance that a commercially attractive product will ultimately beavailable.

In October 2006, we acquired a 90%interest in SenseIt in exchange for assigning to SenseIt all of our interestunder the Lucent Agreement, although we will continue to be jointly andseverally liable with SenseIt to Lucent for amounts due to Lucent under theassigned Lucent agreement. The remaining 10% of SenseIt is owned by ChristopherToffales (our Chairman of the Board), who also serves as President and ChiefExecutive Officer of SenseIt.

We have paid Lucent $6,000,000 ofthe $12,000,000 due, and we have paid an additional $750,000 to SenseIt for itsworking capital purposes or on behalf of SenseIt during initial incorporation.

We are currently seeking additionalfinancing to allow us to fund SenseIt so that SenseIt can make its delinquentand future contractual development payments to Lucent.  Because SenseIt has failed to make amandatory $1,000,000 payment to Lucent (which payment was due July 16, 2007),Lucent has advised us that it intends to suspend work on the project, althoughLucent may also terminate the agreement. There can be no assurance that once suspended, Lucent will ever agree torecommence work on the project.  If weare unable to arrive at an agreement with Lucent to recommence work on theproject and raise sufficient funds to enable us to cure our delinquency withLucent, we will likely lose our entire investment in SenseIt as it will becomevalueless.

We cannot offer any assurance thatwe will be able to raise the funds necessary to make all of the requiredpayments to Lucent, or that the technology will be developed to a point wherewe want to continue to make such payments when due.  Additionally and subject to theaforementioned project risks and contingencies, SenseIt may need to seekoutside financing to make payments to Lucent and, if so elected, such outsidefinancing would dilute our ownership interest in SenseIt.  Lastly, although we are hopeful of a positiveoutcome, we can offer no assurance that the development activity underway withLucent and SenseIt will yield technologically relevant and commercially viableproducts.

In addition to Lucent’s right toterminate the project because of SenseIt’s non-payment, SenseIt has the rightto terminate the development project for any reason (including if thedevelopment work is not proceeding up to our expectations) from time-to-time,so long as termination is prior to the first commercial sale of a licensedproduct.  Additionally, upon thecommencement of commercial sales, if ever, we would be obligated to payroyalties based on revenue, potentially a sales referral fee based on revenueand also an annual exclusivity payment (to Lucent) to maintain our exclusiverights to the developed technology.

Semiconductor Products and Services

Our semiconductor operations, basedin Vancouver, Washington, showed continued operational and financialimprovement during the years ended April 30, 2007 and 2006, although we haveexperienced a softening of demand for our products and services during thethree months ended July 31, 2007 and subsequently (as discussed furtherbelow).  The segment generated operatingincome for the year ended April 30, 2007, in the amount of $326,000 (whichincludes a non-cash charge of $122,000 for stock-based compensation expense) ascompared to an operating loss for the year ended April 30, 2006, in the amountof $(5,151,000).  The positive operatingincome results primarily from our ongoing effort to reduce our reliance on lowmargin small diameter products and diversify into higher margin 300-millimeterproducts and services, wafer thinning and custom wafer products.

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The large-diameter wafer segmenthas become one of the fastest growing segments of the silicon wafer market andthe revenues and gross margins associated with the services are greater thanthose associated with the small diameter market.   As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 46% of segmentrevenue for the three months ended July 31, 2007 ($970,000 of revenue) and 54%of segment revenue for the year ended April 30, 2007 ($7,049,000 of revenue),as compared to approximately 36% of segment revenue for the year ended April30, 2006 ($2,053,000 of revenue).  At thesame time, there has also been a focus on operational efficiency andeffectiveness, which has resulted in increased productivity and processingyields.  Further, we continue to gain newcustomers and are also in the process of attempting to qualify our product atothers.

While we reportedsignificant revenue and operating income growth in our semiconductor operationsfor the year ended April 30, 2007, many of our top semiconductor customersexperienced weakened business results in recent quarters.  In addition, some customers have reportedinventory buildup in reclaim and/or test products.  As a result of these two factors, we haverecently seen a slowdown in orders of reclaim and test materials, which has hada negative impact on our operations.

The slowdownsignificantly impacted our revenues, results of operations and cash flows forthe three months ended July 31, 2007, in which we generated an operating lossof $(361,000) as compared to $(199,000) for the three months ended July 31,2006.  The impact of the slowdown inorders on our business is magnified when the results are compared to the threemonths ended April 30, 2007, whereby we generated operating income of $286,000.

In order tominimize the effect of the slowdown, we have implemented many cost cuttingmeasures and will continue to do so.  Itis unclear as to when our customers’ demand will rebound but we believe thatthis is a relatively short-term condition and are hopeful that we will begin tosee a recovery during the next six months. While we continue to aggressively pursue and add new customers tomitigate the underlying uncertainties with our existing customer base, weexpect to reflect a significant reduction in revenue for the three months endedOctober 31, 2007 (as compared to the three months ended October 31, 2006) andthe reporting of an operating loss for the segment.  We continue to monitor thesituation closely and while we believe that we will see improving financialresults in this operating segment (over the long-term), we cannot offer anyassurance that we will be able to regain or sustain operating profitability infuture periods.

General

Our consolidated revenues in thefuture will depend primarily on our success in developing and selling productsin the homeland security and continued performance in the semiconductormarkets.  Our profitability will bedependent upon our ability to manage our costs and to increase our revenues inall of our business segments.  However,we can offer no assurance that we will be able to increase our revenues or ourprofitability.

***Resultsof Operations***

The following table sets forth, forthe periods indicated, condensed consolidated statements of operations dataexpressed as a percentage of revenues. The table and the discussion below should be read in conjunction withthe condensed consolidated financial statements and the notes thereto appearingelsewhere in this report.  In January2007, we elected to discontinue the operation of our life sciences business andto put the assets and business up for sale (which was sold in June 2007).  As a result, we reclassified the operationsof our life sciences business as discontinued operations.  Prior year information has been reclassifiedto conform with the current year presentation.

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|                                                                                           | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                | ** ** | **July 31,**                | ** ** |
| ** **                                                                                | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                                                                      |       |                             |       |   |   |
| Revenues                                                                                  |       | 100.0                            | %          | 100.0 | % |
| Cost of revenues                                                                          |       | 85.2                             |       | 82.0 |   |
| Gross  margin                                                                             |       | 14.8                             |       | 18.0 |   |
|                                                                                      |       |                             |       |   |   |
| Operating expenses:                                                                       |       |                             |       |   |   |
| Selling,  general and administrative                                                      |       | 35.6                             |       | 55.5 |   |
| Research  and development                                                                 |       | 17.3                             |       | 20.7 |   |
| Total  operating expenses                                                                 |       | 52.9                             |       | 76.2 |   |
| Operating loss                                                                            |       | (38.1                            | )          | (58.2 | ) |
|                                                                                      |       |                             |       |   |   |
| Other income (expense), net                                                               |       | (23.9                            | )          | 22.7 |   |
| Loss from continuing operations before income taxes and  elimination of minority interest |       | (62.0                            | )          | (35.5 | ) |
| Income tax expense                                                                        |       | —                           |       | — |   |
| Minority interest in operations of consolidated  subsidiary                               |       | 1.7                              |       | — |   |
| Loss from continuing operations                                                           |       | (60.3                            | )          | (35.5 | ) |
| Gain on discontinued operations, net of income taxes                                      |       | 9.4                              |       | 0.5 |   |
| NET LOSS                                                                                  |       | (50.9                            | )%         | (35.0 | )% |

 

***Revenues***

Revenues from our security servicesand semiconductor products and services segments decreased for the three monthsended July 31, 2007, as compared to the same period of our prior fiscal year,as described in the following table:
|                                    | ** ** | **Three Months Ended** | ** ** |
|------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **July 31,**                | ** ** |
| ** **                         | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Homeland security products         |       | $                                | —     |   | $ | — |   |
| Security services                  |       | 3,756,000                        |       | 3,877,000 |   |
| Semiconductor products andservices |       | 2,113,000                        |       | 2,909,000 |   |
| Total                              |       | $                                | 5,869,000  |   | $ | 6,786,000 |   |

 

The decrease in revenue from thesecurity services segment for the three months ended July 31, 2007, is due tothe net loss of several mainly lower margin security services contracts duringthe current period.  We continue tomarket our services aggressively by seeking premium accounts that prefer higherquality of service.  While we anticipatethat we will be able to grow revenue in this segment by securing additional newsecurity contracts in our PPSC subsidiary and retaining existing customersunder contract currently with PPSC, we cannot provide any assurance that wewill be able to do so.

While wereported significant revenue and operating income growth in our semiconductoroperations for the year ended April 30, 2007, many of our top semiconductorcustomers experienced weakened business results in recent quarters.  In addition, some customers have reportedinventory buildup in reclaim and/or test products.  As a result of these two factors, we haverecently seen a slowdown in orders of reclaim and test materials, which has hada negative impact on our operations.

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Theslowdown significantly impacted our revenues, which decreased by approximately27% to $2,113,000 for the three months ended July 31, 2007, as compared to$2,909,000 for the three months ended July 31, 2006.  The impact of the slowdown in orders on our businessis magnified when the results are compared to the three months ended April 30,2007, whereby we recorded revenues of $3,686,000.

Inorder to minimize the effect of the slowdown, we have implemented many costcutting measures and will continue to do so. It is unclear as to when our customers’ demand will rebound but webelieve that this is a relatively short-term condition and are hopeful that wewill begin to see a recovery during the next six months.  While we continue to aggressively pursue and addnew customers to mitigate the underlying uncertainties with our existingcustomer base, we expect to reflect a significant reduction in revenue for thethree months ended October 31, 2007 (as compared to the three months endedOctober 31, 2006) and the reporting of an operating loss for that segment.  We continue to monitor the situation closely and while we believe thatwe will see improving financial results in this operating segment (over thelong-term), we cannot offer any assurance that we will be able to regain orsustain operating profitability in future periods.

Our homeland securityproducts segment recorded no revenue for the three months ended July 31, 2007and 2006.  The proceeds related to theinstallation of eight commercial units of our panel-mounted IMS-based productin the AirChx system manufactured by Dual Draw during the three months endedJuly 31, 2007 have been classified as deferred revenue pending completion ofcertain tasks.

In August 2007, we electedto suspend the development, manufacture and sale of our IMS-basedproducts.  The suspension was dueprimarily to a lack of working capital but we have also had difficultycompeting in the market space.  We willcontinue to seek alternatives towards finding a means of monetizing our IMS-basedinvestment, including the development of a strategic partnership or an outrightsale of the technology.  It is unclear asto when (if at all) we will resume activity on our IMS-based products and as aresult, we don’t anticipate any sales of our IMS-based products during thethree months ended October 31, 2007.

Although we have diversifiedour sources of revenue, we continue to have concentrations of revenue withcertain customers.  For the three monthsended July 31, 2007, two security services customers accounted for 18% and 13%of revenues, respectively, and one semiconductor products and services customeraccounted for 11% of revenues as compared to the three months ended July 31,2006, in which two security services customers accounted for 15% and 10% ofrevenues, respectively, and one semiconductor products and services customeraccounted for 23% of revenues. Significant reductions in sales to any of these large customers havehad, and may in the future have, an adverse effect by reducing our revenues andour gross margins.  Present or futurecustomers could terminate their purchasing patterns with us or significantlychange, reduce or delay the amount of products or services ordered from us.

***Gross Margin***

Our gross margin decreasedfor the three months ended July 31, 2007, as compared to the same period of ourprior fiscal year, both on a dollar amount and on a percentage of revenues, asreflected in the following table:
|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | 871,000    |   | $ | 1,219,000 |   |
| Percent of revenues |       | 14.8                                                | %          | 18.0 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The decrease in gross marginon a percentage basis is due primarily to the downturn in our semiconductorproducts whereby the downturn has lead to a significant decrease in revenuewhich has forced us to allocate our fixed facility costs over a lower base,correspondingly decreasing gross margins on a percentage basis.  To a lesser extent, the decrease on apercentage basis is also due to the provision of lower prices in order to 

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obtain new or keep existingbusiness.

The decrease in gross marginon a dollar basis is due mainly to the decrease in revenue for oursemiconductor products and services segment along with the net loss of severalmainly lower margin security services contracts during the current period.  As a result of the slowdown in orders ofreclaim and/or test wafers during the three months ended July 31, 2007, andinto the three months ending October 31, 2007 (as discussed above) it iscurrently unclear if we will be successful in maintaining or increasingquarterly gross margins (on a dollar basis) in our semiconductor products andservices segment for the year ending April 30, 2008.

On a dollar basis, grossmargin is expected to increase correspondingly with increases in revenue, ifany, with dependencies on customer and supplier pricing.  Our ability to positively impact consolidatedgross margin will in a large part be dependent upon our ability to grow salesin our security service segment through increased sales of security servicesand in our semiconductor products and services segment through increased salesof 300-millimeter products and services and wafer thinning services.

On a percentage of revenuebasis, in general we anticipate that the gross margin percentage in oursecurity services segment (within 1-2 percentage points) will remain relativelystable.  As a result of the currentdownturn which has and may lead to more increased competition and lower prices,our semiconductor products and services segment will most likely experience adecrease in gross margins as a percentage of revenues during the year endingApril 30, 2008, as compared to the year ended April 30, 2007.  Due to fixed facility costs included in costof revenues in the semiconductor products and services segment, the grossmargin percentage is particularly sensitive to volume and revenue changes.

***Selling, General and Administrative Expenses***

Our selling, general andadministrative expenses decreased both as a dollar amount and as a percentageof revenue for the three months ended July 31, 2007, as compared to the samerespective period of our prior fiscal year, as reflected in the followingtable:
|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | 2,090,000  |   | $ | 3,768,000 |   |
| Percent of revenues |       | 35.6                                                | %          | 55.5 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The $1,678,000 decrease inselling, general and administrative expenses for the three months ended July31, 2007, compared to the same period in the prior year is attributable to acombination of factors, including:

·                  approximately $425,000 due to a decrease instaffing and expenditures at the corporate office;

·                  approximately $320,000 due to a decrease instaffing and expenditures in the security services segment;

·                  approximately $300,000 due to a decrease instaffing and operations in the homeland security products segment;

·                  inclusion in the three months ended July 31,2006, of a noncash charge in the amount of $357,000 related to the amendment tothe number of shares issuable and exercise price of certain warrants withratchet provisions;

·                  an approximate $280,000 decrease in noncashstock-based compensation expense.

Although we are activelyfocused on reducing selling, general and administrative expenditures, weanticipate that our reported selling, general and administrative expenses willincrease during fiscal year 2008 due primarily to stock-based incentivecompensation issued as part of a series of management changes made in February2007.  No expense has been 

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recognized to date relatedto the option grants made in February 2007 because the new underlying stockoption plan or the proposed increase to an existing underlying stock optionplan have not been approved by shareholders. There can be no assurance that anticipated selling, general andadministrative expenses will result in increased revenues from product sales.

***Research and Development Expenses***

Our research and developmentexpenses decreased on both a dollar and a percentage of revenues basis for thethree months ended July 31, 2007, as compared to the same period of our priorfiscal year, as reflected in the following table:
|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | 1,017,000  |   | $ | 1,404,000 |   |
| Percent of revenues |       | 17.3                                                | %          | 20.7 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The majority of research anddevelopment expenses for the three months ended July 31, 2007 and 2006 relateprimarily to the development of next-generation infrared imaging and nightvision surveillance technology through our Lucent relationship and our IMStechnology.

Historically a significantamount of the research and development on the IMS technology was performed byIUT.  This amount however was reducedsignificantly for the three months ended July 31, 2007, as we had changed ourfocus to a strategic, customer-based focus instead of a product orientation. Wefunded $78,000 and $460,000 under our agreement with IUT for the three monthsended July 31, 2007 and 2006, respectively. As a result of the suspension of the development, manufacture and saleof our IMS-based products as described above, we expect that future researchand development expense with IUT to be minimal.

In December 2005, weapproved a development plan with Lucent that obligated us under the LucentAgreement.  Under the Lucent Agreement,we are attempting to develop a next-generation infrared imaging and nightvision surveillance technology.  InOctober 2006, we acquired a 90% interest in SenseIt in exchange for assigningto SenseIt all of our interest under the Lucent Agreement (such assignment wasapproved by Lucent) and we also entered into a new statement of work withLucent (which was also transferred to SenseIt). Inasmuch as SenseIt has failed to meet its payment obligations under theagreement with Lucent, SenseIt may lose its rights under that agreement.  Even if SenseIt (with funding from Isonics orother sources) is able to resume operations under the Lucent agreement, we canprovide no assurance that a commercially attractive product will ultimately beavailable.

For the three months endedJuly 31, 2007 and 2006, we recognized research and development expense relatedto the Lucent Agreement of $833,333. Under the Lucent agreement, SenseIt must provide funding of $1,000,000per quarter in development funding for the next five quarters (in addition tofunding the payment not made that was due on or before July 16, 2007) or risklosing its rights under the Lucent Agreement. Although the funding is an obligation of SenseIt, we have a right offirst refusal to provide SenseIt the necessary funding by purchasing additionalshares of SenseIt Series A Common Stock at $10 per share.  We believe that our interest in SenseIt couldbe significantly diluted were SenseIt to seek funding from third parties atthis stage.  Also under the LucentAgreement, SenseIt has the right to terminate the development project for anyreason from time-to-time, so long as termination is prior to the firstcommercial sale of a licensed product. As such, assuming (without assurance) SenseIt continues with thedevelopment program, we expect our quarterly research and development expensefor this purpose to remain elevated.  Ifwe are unable to provide SenseIt with the funds necessary to make the quarterlyLucent payments due to Lucent, SenseIt will be required to seek funding fromoutside sources.

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We believe that thedevelopment and introduction of new product applications is critical to ourfuture success, but we are unable to continue any significant research anddevelopment efforts given our current working capital shortages.  If we expend any funds for research anddevelopment, we are unlikely to expend those funds on our IMS-basedproducts.  However (assuming we are ableto raise sufficient funds and Lucent chooses to restart the project (which cannotbe assured), we expect that research and development expenses would increase atSenseIt.  It is likely that research anddevelopment expenditures will continue to vary as a percentage of revenuesbecause of the timing and amount of future revenues and the timing of andavailability of working capital for research and development expenses. Exceptfor work being performed on our semiconductor products at our facilities inVancouver, Washington, we operate no other facilities of our own for researchand development.  Significantly all otherresearch and development work is performed by outside entities, none of whichwe control.  Although we expendsignificant resources on research and development, we cannot offer anyassurance that our current or future lines of business or products resulting fromour research and development efforts will be profitable or generate significantrevenues.

***Operating (Loss) Income***

For the three months endedJuly 31, 2007 and 2006, our operating segments incurred operating (loss) incomeas follows:
|                                      | ** ** | **Three months ended July 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Homeland  security products          |       | $                                                   | (1,321,000 | ) | $ | (1,114,000 | ) |
| Security  services                   |       | 70,000                                              |       | (274,000 | ) |
| Semiconductor  products and services |       | (361,000                                            | )          | (199,000 | ) |
| Reconciling  amounts (1)             |       | (624,000                                            | )          | (2,366,000 | ) |
| Total                                |       | $                                                   | (2,236,000 | ) | $ | (3,953,000 | ) |

 

----

(1) Reconciling amounts forthe operating loss information includes corporate expenses consisting primarilyof corporate salaries and benefits, professional and consulting fees, investorrelations costs, insurance and directors’ compensation. In January 2007, weelected to discontinue the operation of our life sciences business and put theassets and business up for sale (which was sold in June 2007).  As a result, we reclassified the operationsof our life sciences business as discontinued operations.  Prior year information has been reclassifiedto conform with the current year presentation.

Our homeland securityproducts segment has generated significant operating losses as our effort todevelop and commercialize our IMS technology has not been successful.  As a result of the suspension of thedevelopment, manufacture and sale of our IMS-based products as described above,we expect that future operating losses will decrease as we seek alternativestowards finding a means of monetizing our IMS-based investment, including thedevelopment of a strategic partnership or an outright sale of thetechnology.  It is unclear as to when (ifat all) we will resume activity on our IMS-based products and we can offer noassurance that we will be able to monetize any portion of our IMS-basedinvestment.

For the three months endedJuly 31, 2007 and 2006, our security services segment delivered revenue of$3,756,000 and $3,877,000, respectively. The operating income for the three months ended July 31, 2007, is dueprimarily to the benefits received from the cost cutting initiatives weimplemented at PPSC during the six months ended July 31, 2007 (see below foradditional discussion).  The operatingloss for the three months ended July 31, 2006 is inclusive of a write-off of asingle customer’s accounts receivable balance in the amount of $114,000.  Although we continue to pursue selecteddomestic government contracts, we have taken steps to reduce our spending onsales and marketing in this area.

During the six months endedJuly 31, 2007, we implemented significant cost cutting initiatives that areexpected to positively impact the results of PPSC’s operations.  Additionally we initiated plans to improveoperating margins at PPSC by focusing on customers that are willing to pay forpremium security services, where PPSC is able to differentiate itself from its 

25

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peers.  As a result, we have and will continue toexit lower-margin business areas in lieu of premium accounts that prefer higherquality of service.  While we believethat these cost cutting initiatives and refocused sales and marketing effortswill enable PPSC to report positive operating income for the year ending April30, 2008, we can offer no assurance that this will actually occur.

Our semiconductoroperations, based in Vancouver, Washington, showed continued operational andfinancial improvement during the years ended April 30, 2007 and 2006, althoughwe have experienced a softening of demand for our products and services duringthe three months ended July 31, 2007 and subsequently (as discussed furtherbelow).  The segment generated operatingincome for the year ended April 30, 2007, in the amount of $326,000 (whichincludes a non-cash charge of $122,000 for stock-based compensation expense) ascompared to an operating loss for the year ended April 30, 2006, in the amountof $(5,151,000).  The positive operatingincome results primarily from our ongoing effort to reduce our reliance on lowmargin small diameter products and diversify into higher margin 300-millimeterproducts and services, wafer thinning and custom wafer products.

The large-diameter wafersegment has become one of the fastest growing segments of the silicon wafermarket and the revenues and gross margins associated with the services aregreater than those associated with the small diameter market.   As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 46% of segment revenuefor the three months ended July 31, 2007 ($970,000 of revenue) and 54% ofsegment revenue for the year ended April 30, 2007 ($7,049,000 of revenue), ascompared to approximately 36% of segment revenue for the year ended April 30,2006 ($2,053,000 of revenue).  At thesame time, there has also been a focus on operational efficiency andeffectiveness, which has resulted in increased productivity and processingyields.  Further, we continue to gain newcustomers and are also in the process of attempting to qualify our product atothers.

Whilewe reported significant revenue and operating income growth in oursemiconductor operations for the year ended April 30, 2007, many of our topsemiconductor customers experienced weakened business results in recentquarters.  In addition, some customers havereported inventory buildup in reclaim and/or test products.  As a result of these two factors, we haverecently seen a slowdown in orders of reclaim and test materials, which has hada negative impact on our operations.

Theslowdown significantly impacted our results of operations and cash flows forthe three months ended July 31, 2007 in which we generated an operating loss of$(361,000) as compared to $(199,000) for the three months ended July 31,2006.  The impact of the slowdown inorders on our business is magnified when the results are compared to the threemonths ended April 30, 2007 whereby we generated operating income of $286,000.

Inorder to minimize the effect of the slowdown, we have implemented many costcutting measures and will continue to do so. It is unclear as to when our customers’ demand will rebound but webelieve that this is a relatively short-term condition and are hopeful that wewill begin to see a recovery during the next six months.  While we continue to aggressively pursue andadd new customers to mitigate the underlying uncertainties with our existingcustomer base, we expect to reflect a significant reduction in revenue for thethree months ended October 31, 2007 (as compared to the three months endedOctober 31, 2006) and the reporting of an operating loss for that segment.  We continue to monitor the situation closely and while we believe thatwe will see improving financial results in this operating segment (over thelong-term), we cannot offer any assurance that we will be able to regain orsustain operating profitability in future periods.

***Other Income (Expense), net***

Other income (expense), netdecreased for the three months ended July 31, 2007 and 2006 as both a dollaramount and as a percentage of revenues, as reflected in the following table:

26

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|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | (1,402,000 | ) | $ | 1,545,000 |   |
| Percent of revenues |       | (23.9                                               | )%         | 22.7 | % |
|                     |            |                                                     |            |  |  |  |  |

 

For the three months endedJuly 31, 2007, other income (expense), net consists of interest expense of$(1,429,000), the amortization of debt issuance costs of $(41,000) and equityin the net loss of an investee of $(42,000) partially offset by interest andother income of $97,000 and a gain on derivative instruments of $13,000.  Included in interest expense for the threemonths ended July 31, 2007 are non-cash charges of $1,335,000 related primarilyto the amortization of the discount and the accrual of interest on ouroutstanding convertible debentures.

For the three months endedJuly 31, 2006, other income (expense), net consists of the recording of a gainon derivative instruments in the amount of $2,131,000 related to the change infair value of the two derivative liabilities which we recorded in our condensedconsolidated balance sheets and the recording of a gain on extinguishment ofdebt in the amount of $227,000, which resulted from the retirement of$3,880,000 in principal amount of 8% Debentures partially offset by $(650,000)of interest expense, $(115,000) of amortization of debt issuance costs andequity in the net loss of an investee of $(88,000).

We expect that our otherexpenses will be volatile based on the future timing of repayment , if ever, ofthe remaining convertible debentures (see the Liquidity and Capital Resourcesdiscussion below) and the fluctuations in fair value of and classification ofthe instruments underlying our derivative liabilities.

***Income Taxes***

We currently operate at aloss and expect to operate at a loss until (if ever) our operations begin togenerate sufficient revenue. The losses incurred in the current year are notexpected to generate an income tax benefit because of the uncertainty of therealization of the deferred tax asset. As a result, we have provided avaluation allowance against our net deferred tax asset because, based onavailable evidence including our continued operating losses, it is more likelythan not that all of the deferred tax assets will not be realized.Additionally, due to certain “change in ownership” rules (as defined bythe IRS), utilization of our federal net operating losses may be subject tocertain annual limitations.

***Minority Interest in Operations of Consolidated Subsidiary***

Minority interest inoperations of consolidated subsidiary for the three months ended July 31, 2007and 2006 is reflected in the following table:
|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | 100,000    |   | — |   |
| Percent of revenues |       | 1.7                                                 | %          | — |   |
|                     |            |                                                     |            |  |  |  |

 

The amount of minorityinterest in operations of consolidated subsidiary recorded for the three monthsended July 31, 2007, relates to our purchase of a 90% interest in SenseIt inOctober 2006 and the subsequent operation of the business.  The amount is expected to fluctuate in futureperiods dependent upon the development and, potentially, financing activitiesof SenseIt in future reporting periods. As indicated above, we do not have the capital necessary to make furtherinvestments in SenseIt and, as a result, SenseIt may lose its only businessopportunity – participation in the Lucent Agreement.

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***Gain on Discontinued Operations, net of Income Taxes***

Gain on discontinuedoperations, net of income taxes increased on both a dollar and a percentage ofrevenues basis for the three months ended July 31, 2007, as compared to thesame period of our prior fiscal year as reflected in the following table:
|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | 553,000    |   | $ | 36,000 |   |
| Percent of revenues |       | 9.4                                                 | %          | 0.5 | % |
|                     |            |                                                     |            |  |  |  |  |

 

In January 2007, we decidedto discontinue the operation of our life sciences business and to put theassets and business up for sale (which was sold in June 2007).  We decided to sell this business as it nolonger fit our long-term strategy and because of deteriorating businessconditions in the historical, revenue producing products in the segment.  Accounting rules required us to treat theoperations of the life sciences business as discontinued operations whereby thenet financial impact of the operations of the business is combined into asingle line item and prior periods are reclassified for this presentation.  The gain, net of income taxes, resulting fromoperations of the life sciences business was $37,000 and $36,000 for the threemonths ended July 31, 2007 and 2006, respectively.  The gain on sale of the life sciencesbusiness was recorded in the three months ended July 31, 2007, in the amount of$516,000.  Revenue for the life sciencesbusiness, reported in the single line item of gain on operations ofdiscontinued operations, net of income taxes, was $101,000 and $616,000 for thethree months ended July 31, 2007 and 2006, respectively.

***Net Loss***

Net loss for the threemonths ended July 31, 2007 and 2006 is reflected in the following table:
|                     | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                   | (2,985,000 | ) | $ | (2,372,000 | ) |
| Percent of revenues |       | (50.9                                               | )%         | (35.0 | )% |
|                     |            |                                                     |            |  |  |  |  |

 

We anticipate thatconsolidated losses will continue until (if ever): (i) revenues from ourcurrent operations substantially increase or (ii) we generate substantialrevenues from products introduced as a result of our research and developmentprojects.  Further, the revenue increasesmust increase faster than any increases in operating and research and developmentexpenses.  Additionally, we expect thatour consolidated net loss will continue as we continue to work through thedownturn in the semiconductor market.  Asnoted above, we have suspended development and marketing of our IMS-basedproducts and Lucent has advised us that it intends to suspend operation underits agreement with SenseIt.  Therefore,we can offer no assurance that we will be able to proceed with either of theseprojects or that the development and commercialization of these technologieswill ever occur.

We anticipate that ouroperations during the remainder of fiscal year 2008 will result in a loss sincewe are not likely to increase our revenues from our existing products orgenerate additional sales from the new products we may develop in a sufficientamount (if at all) to offset our operating and research and developmentexpenses.

**Liquidityand Capital Resources**

Included in the followingtable are condensed consolidated balance sheet items as of July 31, 2007 andApril 30, 2007 and condensed consolidated cash flow items for the three monthsended July 31, 2007 and 2006:

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|                                                              | ** ** | **As of**        | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|
| **(in thousands)**                                      | ** ** | **July 31,**2007 | ** ** | **Change** | ** ** | **April 30,**2007 | ** ** |
| Cash and cash  equivalents                                   |       | $                     | 1,482      |   | $ | (74 | ) | $ | 1,556 |   |
|                                                         |       |                  |       |   |   |   |   |
| Working capital                                              |       | $                     | 1,953      |   | (1,357 | ) | 3,310 |   |
|                                                         |       |                  |       |   |   |   |   |
| Current  convertible debentures, net of discount             |       | $                     | —     |   | — |   | — |   |
| Convertible  debentures, net of discount and current portion |       | 9,374                 |       | 740 |   | 8,634 |   |
| Total convertible debentures, net of discount                |       | $                     | 9,374      |   | $ | 740 |   | $ | 8,634 |   |
|                                                         |       |                  |       |   |   |   |   |
| Total  convertible debentures, face value outstanding        |       | $                     | 18,000     |   | $ | — |   | $ | 18,000 |   |

 
|                                                       | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **July 31,**2007            | ** ** | **Change** | ** ** | **July 31,**2006 | ** ** |
|                                                  |       |                             |       |   |   |   |   |
| Net cash used in  operating activities                |       | $                                | (453       | ) | $ | 2,989 |   | $ | (3,442 | ) |
| Net cash  provided by (used in) investing activities  |       | 709                              |       | 1,169 |   | (460 | ) |
| Net cash (used  in) provided by financing activities  |       | (330                             | )          | (8,063 | ) | 7,733 |   |
| Net (decrease) increase  in cash and cash equivalents |       | $                                | (74        | ) | $ | (3,905 | ) | $ | 3,831 |   |

 

Working Capital

Our working capital was$1,953,000 as of July 31, 2007, as compared to working capital of $3,310,000 asof April 30, 2007. This $1,357,000 decrease in working capital for thethree months ended July 31, 2007, is due to a combination of factors, of whichthe significant factors are set out below:

Factors which increased working capital

·                  net cash of $805,000 received from the saleof our life sciences business in June 2007.

Factors which decreased working capital

·                  $1,433,000 of cash consumed directly inoperating activities (calculated as $453,000 of cash used in operatingactivities, increased by $980,000 of the cash impact of net changes in othercurrent assets or liabilities included therein);

·                  $96,000 related to purchases of fixed assets;

·                  $172,000 representing the current portion ofcapital lease entered into during the three months ended July 31, 2007;

·                  $90,000 in reclassification of capital leasesfrom long-term to current;

·                  $344,000 of notes payable entered into duringthe three months ended July 31, 2007, in the normal course of business.

Based on the amount ofcapital we have remaining and our expected negative cash flow from operationsand investing activities, we anticipate that we will not be able to positivelyimpact our working capital unless we are able to substantially increase our revenuesor 

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reduce our expenses therebygenerating positive cash flow from operations and (ultimately) operatingincome.   We believe we have sufficientworking capital to finance our anticipated operations and projected negativecash flow only into our quarter ending January 31, 2008, unless we are able toachieve significant additional financing. Because of the potential dilution associated with the outstandingdebentures and the holder’s security interest in substantially all of ourassets, we believe that it is unlikely that we will be able to obtainadditional financing unless we are able to reach an accommodation with ourexisting debenture holder.

Convertible Debentures

We currently have two seriesof convertible debentures outstanding, the 2006 Debentures and the April 2007Debenture (together referred to as the “13% Debentures”).  Selected information regarding the 13%Debentures follows (dollars in thousands):
| ** **                                 | ** ** | **2006  Debentures**             | ** ** | **April 2007  Debenture** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|-----------|------------|
| Debenture  agreement date(s)               |       | May,  June and   November   2006 |       | April  2007                    |       | —    |       |
|                                       |       |                             |       |                           |       |      |       |
| Due date -  principal and interest         |       | May  2009                        |       | May  2009                      |       | —    |       |
|                                       |       |                             |       |                           |       |      |       |
| Interest rate                              |       | 13                               | %          | 13                             | %          | —    |       |
|                                       |       |                             |       |                           |       |      |       |
| Outstanding  balances as of July 31, 2007: |       |                             |       |                           |       |      |       |
| Face value                                 |       | $                                | 16,000     |                           | $          | 2,000     |       | $ | 18,000 |   |
| Accrued interest                           |       | 1,375                            |       | 80                             |       | 1,455     |       |
| Total liability                            |       | $                                | 17,375     |                           | $          | 2,080     |       | $ | 19,455 |   |

 

We are contractuallyrequired to obtain shareholder approval of the April 2007 Debenture (held by YAGlobal) by no later than November 30, 2007. Due to a lack of working capital, we have decided to postpone our annualmeeting of shareholders to a time subsequent to November 30, 2007.  If, as expected, we do not obtain shareholder approval of the April 2007Debenture by November 30, 2007, and do not receive a waiver from theholder of the April 2007 Debenture, theholder of that debenture may declare an Event of Default.  Further, a default provision in the 2006Debentures (also held by YA Global) would allow the holder to also declare anEvent of Default of that debenture agreement if we were declared in default ofthe April 2007 Debenture.  Remedies foran Event of Default under all convertible debenture agreements include theoption to accelerate payment of the full principal amount of the respectivedebenture, together with interest and other amounts due (a cumulative$19,455,000 as of July 31, 2007), to the date of acceleration and the holderwill have the right to request such payment in cash or in shares of our commonstock.  If the holder declares default,it is unlikely that we will be able to cure the default or contest any effortsthat the holder may take to foreclose against its security interest insubstantially all of our assets.

Cash Flows

As of July 31, 2007, we had$1,482,000 of cash and cash equivalents, a decrease of $74,000 as compared to$1,556,000 at April 30, 2007. Our principal source of funding for thethree months ended July 31, 2007 was from the existing working capital as ofApril 30, 2007, along with the $805,000 (net of selling costs of $45,000)received for the sale of our life sciences business in June 2007.   Our principal source of funding for thethree months ended July 31, 2006 was from the issuance of the 2006Debentures (with a face amount of $13,000,000) for which we received netproceeds of $12,270,000.

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Cash used in operatingactivities of $(453,000) and $(3,442,000) for the three months ended July 31,2007 and 2006, respectively, was primarily the result of a net loss of$(2,985,000) (which included noncash expenses and gains in the net amount of a$(935,000) expense) and of $(2,372,000) (which included noncash expenses andgains in the net amount of a $725,000 gain), respectively.

Investing activitiesprovided cash of $709,000 and used cash of $(460,000) for the three monthsended July 31, 2007 and 2006, respectively. Cash provided by investingactivities for the three months ended July 31, 2007, consisted of $805,000 (netof selling costs of $45,000) received for the sale of our life sciencesbusiness in June 2007 offset by $96,000 expended on additions of property andequipment.  Cash used in investingactivities for the three months ended July 31, 2006, consisted of $360,000expended on additions of property and equipment and $100,000 expended on a 9%equity investment in a business.

Financing activities usedcash of $(330,000) and provided cash of $7,733,000 for the three months endedJuly 31, 2007 and 2006, respectively. Cash used in financing activities for thethree months ended July 31, 2007, consisted of payments of principal on capitalleases and notes payable in the amounts of $106,000 and $224,000,respectively.  Cash provided by financingactivities for the three months ended July 31, 2006, resulted primarily fromthe issuance of the 6% Debentures, which yielded net proceeds of $12,270,000offset primarily by principal payments on borrowings of $4,549,000.

Additional LiquidityConsiderations

As of July 31, 2007, we have1,992,377 common stock warrants exercisable at $5.00 related to the 8%Debenture transaction.  In May 2006,1,139,250 of these common stock warrants were modified to reduce theiranti-dilution provisions to a price-protection provision only. If we were toenter into a financing agreement in the future with an effective price lessthen $5.00 (or of the holder of our 13% Debentures was to convert a portion ofany outstanding debenture at a conversion rate less than $5.00), the remaining853,125 common stock warrants that have a full anti-dilution provision, wouldratchet into a greater number of common stock warrants at a lower exerciseprice.

As of July 31, 2007, we hadcommitments outstanding for capital expenditures of approximately$100,000.  Although our commitment tocontinue to fund the development operations under the agreement between SenseItand Lucent is not an obligation, it is our desire to continue to do so.  However, we do not currently have the capitalto permit us to meet that commitment and, if Lucent terminates the developmentprogram, we will most likely lose our entire investment in SenseIt as it willbecome valueless.

We have satisfied ourworking capital requirements primarily through financing activities in thepast, including the issuance of the 8% Debentures in February 2005 and the13% Debentures in May, June and November 2006 and April 2007. During ouryear ended April 30, 2007, we cured several listing deficiencies withNasdaq.   We expect to receive additionaldeficiency notifications in the near future, which, if not cured timely, willmost likely result in our delisting from the Nasdaq Capital Market. Any suchdelisting, if it should occur, will make future financing activitiessignificantly more difficult.

The assumptions underlyingthe above statements include, among other things, that there will be nomaterial adverse developments in the business or market in general. There canbe no assurances however that those assumed events will occur. If our plans arenot achieved, there may be further negative effects on the results ofoperations and cash flows, which could have a material adverse effect on our financialposition.

***Off-Balance Sheet Arrangements***

We have no material changesto the disclosure on this matter made in our Annual Report on Form 10-K for theyear ended April 30, 2007.

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***Critical Accounting Estimates***

We consider an accountingestimate to be critical if 1) the accounting estimate requires us to makeassumptions about matters that were highly uncertain at the time the accountingestimate was made, and 2) changes in the estimate that are reasonably likely tooccur from period to period, or use of different estimates that we reasonablycould have used in the current period, would have a material impact on ourfinancial condition or results of operations.

Management has discussed thedevelopment and selection of these critical accounting estimates with the AuditCommittee of our Board of Directors and the Audit Committee has reviewed theforegoing disclosure.  In addition, thereare other items within our financial statements that require estimation, butare not deemed critical as defined above. Changes in estimates used in these and other items could have a materialimpact on our financial statements.

*Goodwilland Intangible Assets*

Goodwillis recorded on our books for acquisitions where the purchase price is in excessof the cumulative fair values of the identified tangible and intangibleassets.  The assignment of fair value tothe identified tangible and intangible assets requires significant judgment andmay require independent valuations of certain identified assets.  Once goodwill and other intangible assets areestablished on our balance sheet, we evaluate the assets for impairment asdescribed in the following paragraphs.

Inaccordance with SFAS No. 142 *Goodwilland Other Intangible Assets*, goodwill is not amortized, but insteadis tested for impairment on an annual basis or more frequently if the presenceof certain circumstances indicates that impairment may have occurred.  The impairment review process, which issubjective and requires significant judgment at many points during theanalysis, compares the fair value of the reporting unit in which goodwillresides to its carrying value.  If thecarrying value of a reporting unit exceeds its fair value, then the amount ofthe impairment loss must be measured. The impairment loss is calculated bycomparing the implied fair value of reporting unit goodwill to its carryingamount. In calculating the implied fair value of reporting unit goodwill, thefair value of the reporting unit is allocated to all of the other assets andliabilities of that unit based on their fair values. The excess of the fairvalue of a reporting unit over the amount assigned to its other assets andliabilities is the implied fair value of goodwill. An impairment loss would berecognized when the carrying amount of goodwill exceeds its implied fair value.We have goodwill in the amount of $3,631,000 on our condensed consolidatedbalance sheet as of July 31, 2007, related to the acquisition of PPSC in May2005.  During the three months endedJanuary 31, 2007, we performed our annual impairment review on theaforementioned goodwill and concluded that the goodwill is not impaired.

For intangible assets otherthan goodwill, SFAS No. 144 *Accounting forthe Impairment or Disposal of Long-Lived Assets* (“SFAS 144”) is theauthoritative standard on the accounting for the impairment of such intangibleassets.  As required, we perform testsfor impairment of intangible assets other than goodwill whenever events orcircumstances suggest that such assets may be impaired.  To evaluate potential impairment, SFAS No.144 requires us to assess whether the future cash flows related to these assetswill be greater than their carrying value at the time of the test. Accordingly,while our cash flow assumptions are consistent with the plans and estimates weare using to manage the underlying businesses, there is significant judgment indetermining the cash flows attributable to our other intangible assets overtheir respective estimated useful lives. We have remaining other net intangible assets in the amount of $259,000on our condensed consolidated balance sheet as of July 31, 2007, comprised ofour IMS detection technology acquired in December 2002 and the customer baseacquired in our acquisition of PPSC in May 2005.  We are required to periodically evaluate ourother intangible assets balances for impairments. If we were to incuradditional impairments to our other intangible assets, it could have an adverseimpact on our future earnings, if any.

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*Valuation of Equity Transactions*

Wevalue transactions associated with common or preferred stock that isconvertible into common stock based on the market value of the underlyingcommon stock on the date of the signing of the agreement (or, sometimes, at thedate of conversion). We value transactions associated with common stockwarrants at the appropriate measurement date utilizing at a minimum, theBlack-Scholes pricing model, with assumptions as to volatility, risk-freeinterest rate and estimated life of the warrants based on historicalinformation related to the life of the underlying warrant. If the assumptionsused, as they relate to volatility, risk-free interest rate and estimated lifeof the warrants, were materially different, the overall valuation of thesetransactions could change significantly.

*Valuation of Convertible Debenture Transactions*

Weenter into transactions that include debentures that are convertible intocommon stock at rates that may be fixed or variable and also include detachablecommon stock warrants.  We allocate theproceeds from the debenture transactions based on the estimated fair values ofthe debentures and the warrants.  If theassumptions used, as they relate to volatility, risk-free interest rate andestimated life of the warrants (including any anti-dilution adjustment provisions)and the fair value of the debentures (included the specific conversionfeatures) were materially different, the overall allocation of proceeds forthese transactions could change significantly. Further, at times we have classified certain embedded conversionfeatures or warrants issued in convertible debenture transactions as derivativeliabilities in accordance with US GAAP. The estimates of fair value of these derivative liabilities involvecomplex assumptions in the initial recording of the liabilities and in themark-to-market required for each reporting period.  If the assumptions used to determine the fairvalue of these liabilities were materially different, the valuation of theliabilities could change significantly.

*Stock-Based Compensation Expense*

Weaccount for stock-based compensation in accordance with SFAS 123(R).  Under the fair value recognition provisionsof SFAS 123(R), stock-based compensation cost is estimated at the grant datebased on the fair value of the award and is recognized as expense ratably overthe requisite service period of the award. Determining the appropriate fair value model and calculating the fairvalue of stock-based awards, which includes estimates of stock price volatility,forfeiture rates and expected lives, requires judgment that could materiallyimpact our operating results.

**Item 3:Quantitative and Qualitative Disclosures About Market Risk**

We are exposed to marketrisk related to changes in interest rates, equity security market values,foreign currency rates and the market price of our common stock.

Interest Rates

Our investment portfolioconsists of cash and cash equivalents (in the amount of $1,482,000 as of July31, 2007), all of which is exposed to interest rate fluctuations.  The primary objective of our investments isto earn a market rate of return while preserving principal and maximizingliquidity.  The interest earned on theseinvestments (with a blended yield of 0.5% at July 31, 2007) may vary based onfluctuations in the prevailing interest rate.

Equity Securities

We do not hold anyinvestments in marketable equity securities. However, we hold interests in various wholly- and partially-ownedsubsidiaries.  These securities arenon-marketable.  Our investment in thesesubsidiaries may be impacted by the underlying economic conditions of theentity, including the ability to raise additional capital and the likelihood ofour being able to realize our investments through liquidity events such asinitial public offerings, mergers or 

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private sales.  These investments involve a great deal ofmarket risk, and there can be no assurance that a specific company will grow orbecome successful.  Consequently, wecould lose all or part of our investment. Additionally, because IUT is located in Germany, our investment in theentity (and our share of their earnings or losses) may be impacted by changesin foreign currency rates.  The carryingamount of this investment is $340,000 as of July 31, 2007.

Derivative Instruments

We do not purchasederivative instruments on the open market. However, in accordance with current US GAAP, we have classified certainwarrants as derivative instruments (a $1,008,000 current liability at July 31,2007).  Classification as derivativeliabilities was required because there is a possibility that the instrumentscould be required to be settled on a net cash basis.  We are required to mark these instruments tomarket as of the end of each reporting period and to recognize the change in fairvalue in our condensed consolidated statements of operations.  Our stock price has been historicallyvolatile and the fair values of these instruments are sensitive to changes inour underlying stock price.  As such, thecarrying amount of these instruments may be volatile from period to period.  For the three months ended July 31, 2007, werecorded a gain on derivative instruments in the aggregate amount of $13,000such amount representing the change in fair value between April 30, 2007, andJuly 31, 2007.  See Note 9 to theconsolidated financial statements located in Item 8. “Financial Statements andSupplementary Data” of our Form 10-K for the year ended April 30, 2007, for amore detailed discussion of the derivative instruments.

**Item 4:Controls and Procedures**

Our management, with the participationof our principal executive officer and our principal financial officer haveevaluated the effectiveness of our disclosure controls and procedures asrequired by Exchange Act Rule 13a-15(b) as of July 31, 2007 (the end of theperiod covered by this report). Based on that evaluation, our principalexecutive officer and our principal financial officer have concluded that thesedisclosure controls and procedures are effective as of such date.

Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatinformation required to be disclosed in our reports filed or submitted underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’srules and forms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in our reports filed under theExchange Act is accumulated and communicated to our management, including ourprincipal executive officer and our principal financial officer, asappropriate, to allow timely decisions regarding required disclosure.

Therewere no changes in our internal control over financial reporting during thethree months ended July 31, 2007, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.****

**Part II: Other Information**

**Item1:  Legal Proceedings**

None.

**Item 1A:Risk Factors**

*In additionto the other information set forth in this report, you should carefullyconsider the following factors, which could materially affect our business,financial condition or future results. The risks described below are not the only risks we face. *

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*Additionalrisks and uncertainties not currently known to us or that we currently deem tobe immaterial also may materially adversely affect our business, financialcondition or results of operations.*

**We havehistorically had working capital shortages, even following significantfinancing transactions and we received an opinion from our auditors indicatinga substantial doubt regarding our ability to continue as a going concern.**

We have had working capitalshortages in the past and, although we raised capital totaling more than$45,800,000 (net of expenses and $4,100,000 of payments related to our 8%Debentures) since May 1, 2004, we have generated significant losses, which haveimpacted working capital.  As of July 31,2007, our condensed consolidated balance sheet reflects working capital of$1,953,000.  In addition, as a result ofour continued operating losses and projected declining working capital balancesduring the year ending April 30, 2008, the auditors report included with ourfinancial statements for the year ended April 30, 2007 included an explanatoryparagraph indicating substantial doubt about our ability to continue as a goingconcern.

Based on the amount ofcapital we have remaining and our expected negative cash flow from operationsand investing activities, we anticipate that we will not be able to positivelyimpact our working capital unless we are able to substantially increase ourrevenues or reduce our expenses thereby generating positive cash flow fromoperations and (ultimately) operating income. We believe we have sufficient working capital to finance our anticipatedoperations and projected negative cash flow only into our quarter endingJanuary 31, 2008, unless we are able to achieve significant additionalfinancing.  Because of the potentialdilution associated with the outstanding debentures and the holder’s securityinterest in substantially all of our assets, we believe that it is unlikelythat we will be able to obtain additional financing unless we are able to reachan accommodation with our existing debenture holder.

We are contractuallyrequired to obtain shareholder approval of the April 2007 Debenture (held by YAGlobal) by no later than November 30, 2007. Due to a lack of working capital, we have decided to postpone our annualmeeting of shareholders to a time subsequent to November 30, 2007.  If, as expected, we do not obtain shareholder approval of the April 2007Debenture by November 30, 2007, and do not receive a waiver from theholder of the April 2007 Debenture, theholder of that debenture may declare an Event of Default.  Further, a default provision in the 2006Debentures (also held by YA Global) would allow the holder to also declare anEvent of Default of that debenture agreement if we were declared in default ofthe April 2007 Debenture.  Remedies foran Event of Default under all convertible debenture agreements include theoption to accelerate payment of the full principal amount of the respectivedebenture, together with interest and other amounts due (a cumulative$19,455,000 as of July 31, 2007), to the date of acceleration and the holderwill have the right to request such payment in cash or in shares of our commonstock.  If the holder declares default,it is unlikely that we will be able to cure the default or contest any effortsthat the holder may take to foreclose against its security interest insubstantially all of our assets.

**Our ability to obtain further necessary financing is limited.**

We have historicallyfinanced our operating losses and cash flow deficits through private placementsof our equity and debt securities.  Ouroutstanding 13% Debentures contain significant restrictions on our ability toraise any additional capital for so long as the convertible debentures areoutstanding.  While ultimately ourability to finance our operations will depend on our ability to generaterevenues that exceed our expenses, we have short-term needs for significantadditional financing which may not be available because of the outstandingdebentures, as well as the significant number of outstanding options andwarrants which contain adjustment provisions should we issue shares of ourcommon stock at prices below the current exercise prices.  We do not believe that we will be able toobtain additional financing without the cooperation of our principal debentureholder.  Although we have had numerousdiscussions with our principal debenture holder, we cannot offer any assurancethat it will take the steps necessary for us to obtain the financing we need tocontinue our business operations through the 

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current fiscal year.  Ultimately our only source of additionalcapital may be the holder of our outstanding debentures, and if that holderdeclines (for any reason) to invest additional amounts into Isonics, we may notbe able to continue as a going concern.

**We may be delisted from the Nasdaq Capital Market anddelisting may adversely impact our ability to raise capital.**

Althoughour common stock is quoted on the Nasdaq Capital Market, at July 31, 2007 ourstockholders’ equity was $766,000 and thus we have failed to meet the listingrequirement of either stockholders’ equity of at least $2,500,000 or marketvalue of listed securities of at least $35,000,000.  As a result, upon filing this Form 10-Q weexpect to receive a notice from Nasdaq for failure to comply with thisrequirement.  In addition, our per-sharebid price is (and has been for some time) below the required $1.00 minimumrequirement and as a result we expect to receive a notice from Nasdaq forfailure to comply with this requirement as well.  Given our current lack of working capital,ongoing operating losses and difficulty in obtaining additional financing it islikely that we will not be able to cure these deficiencies.  If we are not able to cure such deficiencies,it most likely will result in our delisting from the Nasdaq Capital Market.

Because our financingactivities are dependent to a large extent on eventual liquidity for theinvestors, any such delisting, if it should occur, will make future financingactivities significantly more difficult, may raise liquidity issues for currentinvestors and may place some of our existing obligations into default.

**We havethree business segments and, for the three months ended July 31, 2007, two ofour three segments operated at a loss.**

For the three months endedJuly 31, 2007 and 2006, our operating segments incurred operating (loss) incomeas follows:
|                                      | ** ** | **For the three months ended July 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                                              | ** ** | **2006** | ** ** |
| Homeland  security products          |       | $                                                                     | (1,321,000 | ) | $ | (1,114,000 | ) |
| Security  services                   |       | 70,000                                                                |       | (274,000 | ) |
| Semiconductor  products and services |       | (361,000                                                              | )          | (199,000 | ) |
| Reconciling  amounts (1)             |       | (624,000                                                              | )          | (2,366,000 | ) |
| Total                                |       | $                                                                     | (2,236,000 | ) | $ | (3,953,000 | ) |

 

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(1) Reconciling amounts forthe operating loss information includes corporate expenses consisting primarilyof corporate salaries and benefits, professional and consulting fees, investorrelations costs, insurance and directors’ compensation. In January 2007, weelected to discontinue the operation of our life sciences business and put theassets and business up for sale (which was sold in June 2007).  As a result, we reclassified the operationsof our life sciences business as discontinued operations.  Prior year information has been reclassifiedto conform with the current year presentation.

We expect that these losses(on a consolidated basis) will continue for the foreseeable future.  As described in the next risk factor, unlesswe are able to develop and sell new products profitably, we may be unable toremain competitive and it is likely that our losses and negative cash flow willcontinue.

**Unless weare able to develop and sell our products profitably, we may be unable toremain competitive, furthering the likelihood that our losses and negative cashflow will continue.**

Our ability to generatepositive cash flow, additional revenues, and ultimately net income, isdependent upon the success of our homeland security products, security servicesand semiconductor operations.  We have discontinueddevelopment of our IMS-based products.

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Whilewe reported significant revenue and operating income growth in oursemiconductor operations for the year ended April 30, 2007, many of our topsemiconductor customers experienced weakened business results in recentquarters.  In addition, some customershave reported inventory buildup in reclaim and/or test products.  As a result of these two factors, we haverecently seen a slowdown in orders of reclaim and test materials, which has hada negative impact on our operations.

Theslowdown significantly impacted our results of operations and cash flows forthe three months ended July 31, 2007, in which we generated an operating lossof $(361,000) as compared to $(199,000) for the three months ended July 31,2006.  The impact of the slowdown inorders on our business is magnified when the results are compared to the threemonths ended April 30, 2007, whereby we generated operating income of $286,000.

Inorder to minimize the effect of the slowdown, we have implemented many costcutting measures and will continue to do so. It is unclear as to when our customers’ demand will rebound but webelieve that this is a relatively short-term condition and are hopeful that wewill begin to see a recovery during the next six months.  While we continue to aggressively pursue andadd new customers to mitigate the underlying uncertainties with our existingcustomer base, we expect to reflect a significant reduction in revenue for thethree months ended October 31, 2007 (as compared to the three months endedOctober 31, 2006) and the reporting of an operating loss for that segment.  We continue to monitor the situation closely and while we believe thatwe will see improving financial results in this operating segment (over thelong-term), we cannot offer any assurance that we will be able to regain orsustain operating profitability in future periods.

We have had limited successin marketing our homeland security products, having sold to date only fifteenunits of our panel-mounted IMS-based product. In August 2007, we elected to suspend the development, manufacture andsale of our IMS-based products.  Thesuspension was due primarily to a lack of working capital but we have also haddifficulty competing in the market space. We will continue to seek alternatives towards finding a means ofmonetizing our IMS-based investment, including the development of a strategicpartnership or an outright sale of the technology.  It is unclear as to when (if at all) we willresume activity on our IMS-based products and we can offer no assurance that wewill be able to monetize any portion of our IMS-based investment.

**We haveissued securities during the years ended April 30, 2007, 2006 and 2005, andsubsequently which has resulted (and will in the future when warrant exercisesor conversions occur) in dilution to our existing shareholders.  This was accomplished to provide necessaryworking capital or obtain assets and services. We will likely issue more securities to raise additional capital or toobtain other services or assets, any of which may result in substantialadditional dilution.**

During the course of thelast three fiscal years, we have raised in excess of $45,800,000 (net ofexpenses and $4,100,000 of payments related to our 8% Debentures) to financeour business operations and acquisitions. During that period and subsequently,we have also issued a number of shares, options, and warrants, to acquireservices and assets from third parties and pursuant to our stock optionplans.  If possible under terms that webelieve to be appropriate given our financial condition and other circumstances(including our existing capital structure), we intend to raise additionalfinancing during our year ending April 30, 2008.  We also expect to issue additional shares,options, and warrants where we can to obtain necessary services.  Some of the issuances we have made in thepast and are likely to make in the future have been issued at prices belowmarket and (as is frequently the case with declining market prices) at pricesbelow our historical market prices. Consequently, our shareholders have suffered dilution in the value oftheir shares and can expect that we will be issuing additional securities onsimilar terms.  Further dilution can beexpected to occur when our outstanding options and warrants are exercised ordebentures are converted at prices below the market.

**Two formerholders of a portion of the then outstanding 8% Debentures have asserted that adefault existed.**

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Two entities who held 8%Debentures (which were paid in full as of February 1, 2007) have previouslyasserted that the issuance of the 13% Debentures constituted a default (due toa potential variable conversion provision contained within the 13% Debentureswhich gives the 13% Debenture holder the right to convert the 13% Debenturesinto common stock at the lower of $5.00 or at a discount to market, subject tocertain limitations and as defined) under the 8% Debentures.  We have contested that allegation (based onsuch clause not surviving the final agreement and a defense of *in pari delicto*), and will defend it incourt if necessary.  Although we have nothad any further communication from the former holders regarding this issueother than the allegation of default, any litigation would be time consumingand expensive and, although we believe that we have significant grounds tocontest the existence of any default, we cannot be assured of success.  If they were to prove a default, we could beliable for 130% of the principal amount of their 8% Debentures on the closingdate of the 13% Debenture transaction (an amount of approximately $1,200,000,including accrued interest).

**Accountingcharges resulting from our issuance of the 13% Debentures may lead tosignificant non-cash charges which would adversely impact future interest expense,net income and earnings per share and may also lead to future volatility in ourfinancial statement components.**

As a result of the issuanceof the 13% Debentures, we will be required to record significant non-cashinterest charges over the life of the 13% Debentures (in addition to interestexpense relating to the 13% interest rate borne by the 13% Debentures whichwill be paid in cash or shares of our common stock, at our option).  Thiswill likely result in a significant adverse impact to future net income andearnings per share and will likely introduce additional volatility to ourfuture operating results.

**Historically we depended upon few customers for a significantportion of our revenues and our business could have been materially andadversely affected if we lost any one of those customers.**

Wehave been dependent on a few significant customers who have purchased ourproducts or services in amounts greater than 10% of our consolidatedrevenues.  A decision by any significantcustomer to substantially decrease or delay purchases from us or an inabilityto collect significant amounts owed to us could have a material adverse effecton our consolidated financial condition and results of operations.

**We realized increased expenses, reducedrevenues and longer than anticipated delays in integrating past businessacquisitions into our operations, and we may face similar difficulties withfuture acquisitions as well.**

Weexperienced increased costs and delays in integrating the operations of thebusiness and assets we acquired from EnCompass Materials Group, Ltd. (“EMG”) inJune 2004, and we also realized revenues that were significantly reduced fromthat which we had anticipated which adversely affected the operations of oursemiconductor division.  Regardless ofthe extent of our planning, we may recognize increased costs and delays, andreduced revenues, when integrating future business acquisitions into ourbusiness operations and strategy.  Whilewe believe that we have and will continue to plan for integration of acquiredbusiness operations to the best of our ability, we cannot offer any assurancethat any or all such efforts will proceed as anticipated.

**If demand for any of our products grows suddenly, we may lackthe resources to meet demand or we may be required to increase our capitalspending significantly.**

If weare able to develop and market our products successfully, we may experienceperiods of rapid growth that place a significant strain on our financial andmanagerial resources.  Through our researchand development efforts we are also attempting to develop additional productsand lines of business.  Our ability tomanage growth effectively, particularly given our increasing scope ofoperations, will require us to continue to implement and improve our 

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management,operational and financial information systems, and will require us to developthe management skills of our personnel and to train, motivate and manage ouremployees.  Our failure to effectivelymanage growth could increase our costs of operations and reduce our margins andliquidity, which could have a material adverse effect on our business,financial condition and results of operations.

**Because we are dependent upon our keypersonnel for our future success, if we fail to retain or attract keypersonnel, our business will be adversely affected.**

Our future success willdepend in significant part upon the continued service of our key technical,sales and senior management personnel and consultants, including ChristopherToffales, our Chairman of the Board. Currently Mr. Toffales is covered by atwo-year employment agreement that is renewable on an annual basis.  We believethat our future success will also depend upon our ability to attract and retainother qualified personnel for our operations. The failure to attract or retain such persons could materially adverselyaffect our business, financial condition and results of operations.

**We may not be able to protect our intellectual property,which would reduce our competitive advantage.**

We relyprimarily on a combination of patents and patent applications, trade secrets,confidentiality procedures, and contractual provisions to protect ourtechnology.  Despite our efforts toprotect our technology, unauthorized parties may attempt to copy aspects of ourproducts or to obtain and use information that we regard as proprietary.  Policing unauthorized use of our technologyand products is difficult.  In addition,the laws of many countries do not protect our rights to information, materialsand intellectual property that we regard as proprietary and that are protectedunder the laws of the United States.  Wemay not be able to protect our proprietary interests, or our competitors mayindependently develop similar technology or intellectual property.  If either one of these situations occurs, wemay lose existing customers and our business may suffer.

The validity of any of thepatents licensed to us, or that may in the future be owned by us, may not beupheld if challenged by others in litigation. Further, our products or technologies, even if covered by our patents,may infringe upon patents owned by others. We could incur substantial costs in defending suits brought against us,or any of our licensors, for infringement, in suits by us against others forinfringement, or in suits contesting the validity of a patent.  Any such proceeding may be protracted.  In any suit contesting the validity of apatent, the patent being contested would be entitled to a presumption ofvalidity and the contesting party would be required to demonstrate invalidityof such patent by clear and convincing evidence.  If the outcome of any such litigation wereadverse to our interests, our liquidity and business operations would be materiallyand adversely affected.

**We face technologicalchange and intense competition both domestically and internationally which mayadversely affect our ability to sell our products profitably.**

The markets for our homelandsecurity and semiconductor products and services are characterized by rapidlyevolving technology and a continuing process of development. Our future successwill depend upon our ability to develop and market products that meet changingcustomer and technological needs on a cost effective and timely basis.  If we fail to remain competitive byanticipating the needs of our customers and our customers contract with othersuppliers, our revenues and resulting cash flow could be materially andadversely affected.

**Oursemiconductor products and services segment is dependent on the performance ofseveral key pieces of equipment.  If anyof these items were not to perform to their ability or were taken out ofservice for any significant amount of time, our ability to produce productwould be severely compromised.**

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The performance of oursemiconductor products and services segment is directly tied to the performanceof several key pieces of equipment, which are typically intricate andexpensive.  The average time betweenfailures is typically long and the corresponding time for repair is typicallyshort; as a result, most of the time the issues are routine and are quicklyrepaired. However, this is not always the case and there have been times in thepast when critical tools have been out of service for a period of time, whichhad a negative impact on revenues in the short term.  Further, due to our historical workingcapital shortages and the significant historical net losses, we are unable topurchase the necessary equipment redundancy. Any future equipment issues could have a significant impact on ourability to produce and ship the products to our customers, thereby potentiallyimpacting both our revenues and related cash flows.

**We could be subject to environmental regulation by federal,state and local agencies, including laws that impose liability without fault,which could produce working capital shortages and lessen stockholders’ equity.**

OurIMS-based products use radioactive sources. As a result, we are subject to a variety of federal, state, and localenvironmental regulations relating to the use, storage, discharge and disposalof hazardous chemicals used during manufacturing processes.  Regulations that become applicable to ouroperations in the future could restrict our ability to expand our facilities orcould require us to acquire costly equipment or to incur other significantexpenses to comply with governmental regulations.  Historically, our costs of compliance withenvironmental regulations have not been significant because we use licensedmanufacturers in connection with the manufacture of these products.

**We are controlled by our Board of Directors; individualpurchasers of our shares will have little ability to elect directors or controlour management.**

Our shares are widely-held,and our management beneficially owns our securities in an amount less than 10%of the outstanding votes at any shareholders’ meeting.  Nevertheless, it is likely that the Board ofDirectors will be able to influence all matters submitted to stockholders forapproval, including the election and removal of directors and any merger,consolidation or sale of substantially all of our assets, and to control ourmanagement and affairs.  Such control mayhave the effect of delaying, deferring or preventing a change in control,impeding a merger, consolidation or takeover or other business combinationinvolving us or discouraging a potential acquirer from making a tender offer orotherwise attempting to obtain control of our business, even if such atransaction would be beneficial to other stockholders.

**We risk exposing ourselves to an above-policy limit productliability claim, which could adversely affect our working capital, shareholders’equity and profitability.**

The sale and use of explosive and chemical detectionproducts may expose us to potential liability risks that are inherent with theoperation of these types of products (including, but not limited to faileddetection).  We currently have productliability insurance; however, there is a risk that our insurance would notcover completely or would fail to cover a claim, in which case we may not havethe financial resources to satisfy such claims, and the payment of claims wouldrequire us to use funds that are otherwise needed to conduct our business andmake our products.

**Our common stock is vulnerable to pricing andpurchasing actions that are beyond our control and, therefore, personsacquiring or holding our shares or warrants may be unable to resell theirshares at a profit as a result of this volatility.**

Thetrading price of our securities has been subject to wide fluctuations inresponse to quarter-to-quarter variations in our operating results, ourannouncements of technological innovations or new products by us or ourcompetitors, delays in our product development and marketing, and other eventsand factors over which we have no influence or control. The securities marketsthemselves have experienced significant price and volume fluctuations that maybe unrelated 

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to the operating performanceof particular companies. Regulatory developments in the United States andforeign countries, public concern as to the safety of products containingradioactive compounds, economic and other external factors, all affect themarket price of our securities. *In addition,the realization of any of the risks described in these “Risk Factors” couldhave a significant and adverse impact on such market prices*.

**SEC penny stock regulations may limitthe ability to trade our securities.**

Althoughour common stock is currently quoted on the Nasdaq Capital Market, our commonstock has in the past been (and may, if delisted by Nasdaq again be) subject toadditional disclosure requirements for penny stocks mandated by the SecuritiesEnforcement Remedies and Penny Stock Reform Act of 1990.  The SEC Regulations generally define a pennystock to be an equity security that is not traded on the Nasdaq Stock Marketand has a market price of less than $5.00 per share. We have, at times in thepast, been included within the SEC Rule 3a-51 definition of a penny stock. Whenour common stock is considered to be a “penny stock,” trading is covered byRule 15g-9 promulgated under the Securities Exchange Act of 1934, fornon-Nasdaq and non-national securities exchange listed securities, adding asignificant amount of broker-dealer compliance to transactions in pennystocks.  Many brokers are unwilling toengage in transactions in penny stocks and, therefore, if we lose our listingon the Nasdaq Capital Market, the marketability of our securities may weakensignificantly.

Wecannot give any assurance that we will be able to meet the Nasdaq requirementsto maintain our Capital Market listing, or that if we do, a stable tradingmarket will develop for our stock or our warrants. See “We may be delisted fromthe Nasdaq Capital Market and delisting may adversely impact our ability toraise capital” for additional risk factors associated with potential Nasdaqlisting deficiencies.

**Future sales of our common stock maycause our stock price to decline.**

Our stock price has declinedfrom a price of approximately $24.00 (adjusted for the reverse split) per shareat the beginning of 2005 to prices of less than $0.55 (adjusted for the reversesplit) at various times since May 2006. Our stock price may decline further asa result of future sales of our shares, the perception that such sales mayoccur, our financial or operational performance, or other reasons.  As of September 12, 2007, approximately900,000 shares of common stock held by existing stockholders constitute “restrictedshares” as defined in Rule 144 under the Securities Act.  The restricted shares may only be sold ifthey are registered under the Securities Act, or sold under Rule 144, oranother exemption from registration under the Securities Act.

Approximately 90% of therestricted shares of our common stock are either eligible for sale pursuant toRule 144 or have been registered under the Securities Act for resale by theholders.  We are unable to estimate theamount, timing, or nature of future sales of outstanding common stock.  Sales of substantial amounts of our commonstock in the public market may cause the stock’s market price to decline.

**We havenever paid any cash dividends on our common stock and we do not anticipatepaying cash dividends on our common stock in the foreseeable future.**

We have never declared orpaid a cash dividend on our common stock. We presently intend to retain our earnings, if any, to fund developmentand growth of our business and, therefore, we do not anticipate paying cashdividends in the foreseeable future.  Additionally,the terms of the 13% Debentures contain restrictions on our ability to paydividends to holders of our common stock.

**If we failto effect and maintain registration of the common stock issued or issuablepursuant to conversion of our convertible debentures, or certain of ouroutstanding common stock warrants, we**

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**may beobligated to pay the investors of those securities liquidated damages.**

We have various obligationsto file and obtain the effectiveness of certain registration statements whichinclude certain outstanding common stock and common stock underlyingoutstanding convertible debentures and common stock warrants.  Once effective, the prospectus containedwithin a registration statement can only be used for a period of time asspecified by statute without there being a post-effective amendment filed thathas become effective under the Securities Act of 1933.  If we are unable to meet these obligations,we may be obligated to pay liquidated damages of 1% of the principal amount ofthe 13% Debentures outstanding per month (up to $180,000 per month).  We cannot offer any assurance that we will beable to maintain the currency of the information contained in a prospectus orto obtain the effectiveness of any registration statement or post-effectiveamendments that we may file.

**As a publiccompany, we are subject to a significant amount of regulation.  In the past we have received requests forinformation from the Securities and Exchange Commission and from Nasdaq.  Any such inquiry or investigation that mayresult may adversely affect the market for our stock or our Company.**

Regulators of publiccompanies such as Isonics have the authority to commence inquiries andinvestigations where the regulators have concerns.  The investigations, while involving thecompany, may not have anything to do with actions taken by the company or ourfailure to act.  Furthermore, theregulators may not inform us when the issues they were addressing are resolved.  From October 2004 through February 2005, bothNasdaq and the SEC requested documents from us with respect to inquiries theywere undertaking (related primarily to questions regarding our press releases,public relations advisors, certain other disclosures that were made publiclyand the termination of Grant Thornton LLP as our independent auditor).   We also met with representatives of Nasdaqto discuss issues related to market activity, press announcements, SEC filings,status of our business and other issues.  We provided information, which we believe to be responsive to all of thequestions posed in the Nasdaq inquiry and to the SEC.  We have not received any requests foradditional information from either the SEC or Nasdaq relating to those earlierinquiries since February 2005 and while we believe these issues are behind us,if any action resulted from these inquiries in the future, it may adverselyimpact us, and our ability to carry on our business.

**We failedto provide necessary funding to SenseIt to make the most recent developmentpayment to Lucent and, as a result, Lucent could terminate the agreement andour investment in SenseIt would be impaired. Even if we are able to make the development payment we have missed orfuture development payments when due, there is no guarantee that thedevelopment activity will yield technologically relevant and commerciallyviable products.**

SenseIt failed to make thedevelopment payment due to Lucent on July 16, 2007.  SenseIt was unable to make this paymentbecause we were unable to provide adequate funding to SenseIt.  Consequently, Lucent may in its discretiontake steps to terminate the agreement and all licenses granted to us thereunderor cease working on the project and then assess SenseIt a “start-up” fee iffunding was to resume.  On July 26, 2007,we received official notification from Lucent that we failed to make the$1,000,000 payment to Lucent by July 16, 2007, and that in the event suchnon-payment continues for more than ten days, Lucent may at is discretion,suspend work on or terminate the development project.  On September 7, 2007, we were notified byLucent that if we fail to make the payment by September 16, 2007, Lucentintends to suspend work on the development project, although Lucent also has aright to terminate the agreement.  Wewill not be able to make such payment by September 16, 2007, due toinsufficient working capital.  If Lucentwere to terminate the project we will most likely lose our entire investment inSenseIt as it will become valueless.

Because of our continuingworking capital shortages, we may not be able to provide SenseIt funding forcurrent or future development payments to Lucent, and SenseIt may not be ableto find third-party investors to provide it the necessary capital.  If the Lucent agreement were to be canceled,our investment in SenseIt would be impaired. Lastly, although we are hopeful 

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of a positive outcome, wecan offer no assurance that the development activity underway with Lucent andSenseIt will yield technologically relevant and commercially viable products.

**Provisions****in our charter documentscould prevent or delay a change in control, which could delay or prevent atakeover.**

Our Articles ofIncorporation authorize the issuance of “blank check” preferred stock with suchdesignations, rights, and preferences, as may be determined by our Board ofDirectors.  Accordingly, the Board ofDirectors may, without shareholder approval, issue shares of preferred stockwith dividend, liquidation, conversion, voting, or other rights that couldadversely affect the voting power or other rights of the holders of our commonstock.  Preferred stock could also beissued to discourage, delay, or prevent a change in our control, although we donot currently intend to issue any additional series of our preferred stock.

**Provisionsin our bylaws provide for indemnification of officers and directors to the fullextent permitted by California law, which could require us to direct funds awayfrom our business and products.**

Our Bylaws provide forindemnification of officers and directors to the full extent permitted byCalifornia law, our state of incorporation. We may be required to pay judgments, fines, and expenses incurred by anofficer or director, including reasonable attorneys’ fees, as a result ofactions or proceedings in which such officers and directors are involved byreason of being or having been an officer or director. Funds paid insatisfaction of judgments, fines and expenses may be funds we need for theoperation of our business and the development of our products, therebyaffecting our ability to attain profitability. This could cause our stock price to drop.

**We willneed to make substantial financial and man-power investments in order to assessour internal controls over financial reporting and our internal controls overfinancial reporting may be found to be deficient.**

Section 404 of theSarbanes-Oxley Act of 2002 requires management to assess our internal controlsover financial reporting and requires auditors to attest to that assessment.Current regulations of the Securities and Exchange Commission, or SEC, requireus to include this assessment and attestation in our Annual Report on Form 10-Kcommencing with the annual report for our fiscal year ending April 30,2008.   We have incurred and, to theextent our working capital allows, will continue to incur significant increasedcosts in implementing and responding to these requirements. In particular, therules governing the standards that must be met for management to assess itsinternal controls over financial reporting under Section 404 are complex,and require significant documentation, testing and possible remediation. Ourprocess of reviewing, documenting and testing our internal controls overfinancial reporting may cause a significant strain on our management,information systems and other financial and human resources. We may have toinvest in additional accounting and software systems. We may be required tohire additional personnel and to use outside legal, accounting and advisoryservices. In addition, we will incur additional fees from our auditors as theyperform the additional services necessary for them to provide theirattestation. If (because of a lack of financial resources or other reasons) weare unable to complete the work necessary to comply with the section 404requirements, or we are unable to favorably assess the effectiveness of ourinternal control over financial reporting when we are required to, or if ourindependent auditors are unable to provide an unqualified attestation report onsuch assessment (if applicable for the fiscal year ending April 30, 2008), wemay be required to change our internal control over financial reporting toremediate deficiencies. In addition, investors may lose confidence in thereliability of our financial statements causing our stock price to decline.

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**Item 2:Unregistered Sales of Equity Securities and Use of Proceeds**

**Clayton Dunning Capital Partners, Inc.**

Asconsideration for entering into a financial advisory agreement on March 4, 2007we granted Clayton Dunning Capital Partners, Inc. (“Clayton Dunning”) a warrantto purchase 100,000 shares of our common stock.   The following is the information required byItem 701 of Regulation S-K.

(a)                                  On March 5, 2007 we granted Clayton Dunning awarrant (which was simultaneously transferred to Roadrunner Capital Group) topurchase 100,000 shares of our common stock at $1.65 per share exercisable fortwo years.

(b)                                 There was no placement agent or underwriterfor the transaction.

(c)                                  The warrant was issued in consideration forClayton Dunning entering into a financial consulting agreement with us.

(d)                                 We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 andRegulation D for the issuance of the common stock.   We did not engage in any public advertisingor general solicitation in connection with this transaction.  The investorrepresented to us that it was an accredited investor and had access to all ofour reports filed with the Securities and Exchange Commission, our pressreleases and other financial, business and corporate information.  Basedon our investigation, we believe that the investor obtained all informationregarding Isonics it requested, received answers to all questions it posed, andotherwise understood the risks of accepting our securities for investmentpurposes.

(e)                                  The warrant is exercisable or exchangeableinto shares of common stock.

(f)                                    No cash proceeds were received.

**CEOcast Inc**.

On May 22, 2007 we entered into a consultingagreement with CEOcast Inc. (“CEOcast”), and as partial consideration for theinvestor relation services CEOcast will provide to us, we issued CEOcast 18,750shares of our restricted common stock.  The following is the information required by Item 701 of Regulation S-K.

(a)                                  On May 22, 2007 we issued CEOcast 18,750shares of our restricted common stock.

(b)                                 There was no placement agent or underwriterfor the transaction.

(c)                                  The shares were issued in consideration forCEOcast entering into an agreement with us, and we received no cash therefore.

(d)                                 We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 andRegulation D for the issuance of the common stock.   We did not engage in any public advertisingor general solicitation in connection with this transaction.  The investorrepresented to us that it was an accredited investor had access to all of ourreports filed with the Securities and Exchange Commission, our press releasesand other financial, business and corporate information.  Based on ourinvestigation, we believe that the investor obtained all information regardingIsonics it requested, received answers to all questions it posed, and otherwiseunderstood the risks of accepting our securities for investment purposes.

(e)                                  The shares were common stock and, therefore,are not exercisable or exchangeable into shares of common stock.

(f)                                    No cash proceeds were received.

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**SoundBusiness Solutions, Inc.**

OnJune 19, 2007, we entered into a consulting agreement with Sound BusinessSolutions, Inc, a corporation controlled by Joanna Lohkamp.  Ms. Lohkamp served as the Chief OperatingOfficer of our wholly owned subsidiary IVI through September 7, 2007, and continues to be involved in the businessin other capacities.   Pursuant to thatagreement we granted Sound Business Solutions, Inc. options to purchase 200,000shares of our common stock. The following is the information required by Item701 of Regulation S-K.

(a)                                  On June 19, 2007, we granted Sound BusinessSolutions Inc. options to purchase 200,000 shares of our common stock pursuantto our 2005 Equity Plan (a portion not yet subject to a registrationstatement).  The options are exercisableat $1.45 and expire on June 18, 2011. Options to acquire 66,667 shares vested immediately, options to acquire66,667 shares vest on September 7, 2007, and 66,666 of the options vest onJanuary 31, 2008.

(b)                                 There was no placement agent or underwriterfor the transaction.

(c)                                  The options were granted in consideration forSound Business Solutions Inc. entering into the consulting agreement by whichit agreed to provide services to Isonics. We received no cash for the issuanceof the options.

(d)                                 We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for theissuance of the stock options.   We didnot engage in any public advertising or general solicitation in connection withthis transaction, and we provided the investor with disclosure of all aspectsof our business, including providing the investor with our reports filed withthe Securities and Exchange Commission, our press releases, access to ourauditors, and other financial, business, and corporate information. We believethat Ms. Lohkamp, the sole owner of Sound Business Solutions, is an accreditedinvestor.  We believe that the investorobtained all information regarding Isonics it requested, received answers toall questions it (and its advisors) posed, and otherwise understood the risks ofaccepting our securities for investment purposes.

(e)                                  The stock options are exercisable to purchaseshares of common stock as described above.

(f)                                    No proceeds were received.

**MichaelCaridi**

OnJune 22, 2007, our wholly owned subsidiary PPSC entered into an employmentagreement (the “Employment Agreement”) with Michael Caridi to serve as PPSC’sSenior Vice President.  Pursuant to theEmployment Agreement, we granted Mr. Caridi options to purchase 150,000 sharesof our common stock pursuant to our 2007 Restructuring Equity Plan, which planis subject to shareholder approval.  Thefollowing is the information required by Item 701 of Regulation S-K.

(a)                                  On June 22, 2007, we granted Michael Caridioptions to purchase 150,000 shares of our common stock.  The options are exercisable at $1.50 andexpire on June 21, 2012.  The options aresubject to the following vesting schedule: (i) 50,000 options vested immediately; (ii) 25,000 shares vest sixmonths from the date of the Employment Agreement;  (iii) 25,000 options vest nine months fromthe date of the Employment; and (iv) 50,000 shares vest upon achieving certain operating income levels forthe fiscal year ending April 30, 2008. Options shall only vest if Mr. Caridi is an employee of PPSC on eachvesting date.

(b)                                 There was no placement agent or underwriterfor the transaction.

(c)                                  The stock options were granted inconsideration for Mr. Caridi entering into the employment agreement with ourwholly-owned subsidiary, 

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PPSC.  We received no cash for the issuance of theoptions.

(d)                                 We relied on the exemption from registrationprovided by Section 4(2) under the Securities Act of 1933 for the issuance ofthe stock options.   We did not engage inany public advertising or general solicitation in connection with this transaction,and we provided the investor with disclosure of all aspects of our business,including providing the investor with our reports filed with the Securities andExchange Commission, our press releases, access to our auditors, and otherfinancial, business, and corporate information. We believe that the investorobtained all information regarding Isonics it requested, received answers toall questions he (and its advisors) posed, and otherwise understood the risksof accepting our securities for investment purposes.

(e)                                  The stock options are exercisable to purchaseshares of common stock as described above.

(f)                                  No proceeds were received.

**Item4:  Submission of Matters to a Vote ofSecurity Holders**

None

**Item 5:Other Information**

We held our last annualmeeting of shareholders on October 30, 2006, and a special meeting of ourshareholders on January 2, 2007.  In thedefinitive proxy statement for our January 2, 2007 special meeting, we advisedour shareholders that we expected to hold our next annual meeting ofshareholders in October 2007, and that proposals from shareholders must bereceived by May 1, 2007 for consideration for inclusion in the proxy.  Due to a lack of working capital, we havedecided to postpone our annual meeting of shareholders, but have not yetdetermined when we will hold the meeting or whether we will hold any meeting inour current fiscal year.  We have givenconsideration to holding the meeting in February 2008 or thereafter.  The Nasdaq Marketplace Rules require that ourannual meeting of shareholders be held on or before the end of our currentfiscal year (April 30, 2008).  Asdescribed above, it is likely that we will be delisted from Nasdaq before theend of our current fiscal year.  Althoughwe do not yet know whether or when we will be holding our next shareholders’meeting, we are requiring that proposals from our shareholders forconsideration at the next meeting must be presented to us not later thanOctober 1, 2007, and should be addressed to Corporate Secretary, IsonicsCorporation, 5906 McIntyre Street, Golden, Co 80403.  After October 1, 2007, any shareholderproposal will be considered untimely.  Ifwe extend the date of our shareholders’ meeting further, we will provide a newdate for receipt of proposals.

**Item 6:Exhibits**

Exhibits.
| 3.1  |   | Restated  articles of incorporation (incorporated by reference from our Current Report  on Form 8-K (File No. 001-12531), dated June 13, 2007 and filed on June  25, 2007, and incorporated herein by reference. |
|------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  |   | Restated bylaws  (incorporated by reference from our Current Report on Form 8-K (File No.  001-12531), dated March 27, 2006, and filed on March 31, 2006, and  incorporated herein by reference.                      |
| 31.1 |   | Certification of  Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act                                                                                                                              |
| 31.2 |   | Certification of  Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act                                                                                                                              |
| 32.1 |   | Certification of  Chief Executive Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                          |
| 32.2 |   | Certification of  Chief Financial Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                          |

 

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**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized, in the City of Golden, County of Jefferson, State of Colorado, onthe 14th day of September 2007.
|        | Isonics Corporation |                                                 |
|--------|---------------------|------------------------------------------------------|
|   | (Registrant)        |                                                 |
|   |                |                                                 |   |
|   |                |                                                 |   |
|   | By                  | /s/ John Sakys                                       |   |
|   |                | John Sakys                                           |   |
|   |                | President, interim Chief Executive Officer           |   |
|   |                |                                                 |   |
|   |                |                                                 |   |
|   | By                  | /s/ Kenneth J. Deane                                 |   |
|   |                | Kenneth J. Deane                                     |   |
|   |                | Chief Accounting Officer and Chief Financial Officer |

 

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