**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

(**Mark One)**

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

 

**For thetransition period from              to             **

 

**Commissionfile number:  001-12531**

 

**ISONICS CORPORATION**

(Exact name ofregistrant as specified in its charter)

** **

| **California**                                                    | ** ** | **77-0338561**                      |
|-------------------------------------------------------------------|------------|-------------------------------------|
| (State or other  jurisdiction of

incorporation or  organization) |       | (IRS Employer

Identification  No.) |

 

**5906McIntyre Street**

**Golden,Colorado 80403**

(Address ofprincipal executive offices with zip code)

 

**(303)279-7900**

(Registrant’stelephone number, including area code)

 

**N/A**

(Former name,former address and former fiscal year, if changed since last report)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes x     No o

 

Indicate by check mark whether theRegistrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer x |
|--------------------------------|--------|---------------------|--------|------------------------------|

 

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

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.

 

| **Class**                         | ** ** | **Outstanding at December 12, 2007** |
|-----------------------------------|------------|-------------------------------------------|
| Common Stock — no par  value |       | 12,658,150 shares                         |

 

 

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**IsonicsCorporation and Subsidiaries**

** **

**TABLE OFCONTENTS**

 
| Part I:  | Financial  Information |
|---------------|------------------------|
|          |                   |   |
|          | Item 1:                | Financial  Statements |
|          |                   |   |
|          |                   | Condensed  Consolidated Balance Sheets as of October 31, 2007 and April 30,  2007 |
|          |                   |   |
|          |                   | Condensed Consolidated  Statements of Operations for the Three and Six Months Ended October 31,  2007 and 2006 |
|          |                   |   |
|          |                   | Condensed  Consolidated Statements of Cash Flows for the Six Months Ended  October 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:  FinancialInformation**

** **

**Item 1: Financial Statements**

 

**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except shareamounts)**

 

**ASSETS**
| ** **                                                             | ** ** | **(Unaudited)**           | ** ** | ** **              | ** ** |
|------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                             | ** ** | **October 31, 2007** | ** ** | **April 30, 2007** | ** ** |
| CURRENT ASSETS:                                                        |       |                      |       |                    |       |
| Cash and cash  equivalents                                             |       | $                         | 753        |                    | $          | 1,556 |   |
| Accounts  receivable (net of allowances of $122 and $146,respectively) |       | 3,357                     |       | 3,678                   |       |
| Inventories                                                            |       | 793                       |       | 1,259                   |       |
| Prepaid expenses  and other current assets                             |       | 506                       |       | 1,388                   |       |
| Assets of  discontinued operations                                     |       | —                    |       | 491                     |       |
| Total current  assets                                                  |       | 5,409                     |       | 8,372                   |       |
|                                                                   |       |                      |       |                    |       |
| LONG-TERM ASSETS:                                                      |       |                      |       |                    |       |
| Property and  equipment, net                                           |       | 5,560                     |       | 5,666                   |       |
| Goodwill                                                               |       | 3,631                     |       | 3,631                   |       |
| Intangible  assets, net                                                |       | 78                        |       | 303                     |       |
| Equity in net  assets of investee                                      |       | 303                       |       | 382                     |       |
| Other assets                                                           |       | 520                       |       | 606                     |       |
| Total long-term  assets                                                |       | 10,092                    |       | 10,588                  |       |
|                                                                   |       |                      |       |                    |       |
| TOTAL ASSETS                                                           |       | $                         | 15,501     |                    | $          | 18,960 |   |

 

**LIABILITIESAND STOCKHOLDERS’ EQUITY (DEFICIT)**
| ** **                                                                                                                                                                  | ** ** | **(Unaudited)**           | ** ** | ** **              | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **October 31, 2007** | ** ** | **April 30, 2007** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                        |       |                      |       |                    |       |
| Accounts payable                                                                                                                                                            |       | $                         | 966        |                    | $          | 973 |   |
| Accrued  liabilities                                                                                                                                                        |       | 2,083                     |       | 2,522                   |       |
| Derivative  liabilities                                                                                                                                                     |       | 517                       |       | 1,021                   |       |
| Current portion  of obligations under capital lease                                                                                                                         |       | 548                       |       | 340                     |       |
| Current portion  of notes payable                                                                                                                                           |       | 129                       |       | 134                     |       |
| Current portion  of convertible debentures, net of discount                                                                                                                 |       | —                    |       | —                  |       |
| Liabilities of  discontinued operations                                                                                                                                     |       | —                    |       | 72                      |       |
| Total current  liabilities                                                                                                                                                  |       | 4,243                     |       | 5,062                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| Obligations under capital lease, net of current  portion                                                                                                                    |       | 900                       |       | 710                     |       |
| Other long-term liabilities                                                                                                                                                 |       | 2,085                     |       | 888                     |       |
| Convertible debentures, net of discount and current  portion                                                                                                                |       | 10,206                    |       | 8,634                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| TOTAL LIABILITIES                                                                                                                                                           |       | 17,434                    |       | 15,294                  |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| Minority interest in consolidated subsidiary                                                                                                                                |       | —                    |       | 111                     |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| STOCKHOLDERS’ EQUITY (DEFICIT):                                                                                                                                        |       |                      |       |                    |       |
| Common stock -  no par value; 175,000,000 shares authorized; shares issued and outstanding:  October 31, 2007 — 12,658,150; April 30, 2007 — 12,639,400 |       | 64,348                    |       | 64,319                  |       |
| Additional paid  in capital                                                                                                                                                 |       | 20,934                    |       | 20,705                  |       |
| Accumulated  deficit                                                                                                                                                        |       | (87,215                   | )          | (81,469                 | )          |
| Total  stockholders’ equity (deficit)                                                                                                                                  |       | (1,933                    | )          | 3,555                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                   |       | $                         | 15,501     |                    | $          | 18,960 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per sharedata)**

**(Unaudited)**

** **
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                 | ** ** | **October 31,**   | ** ** | **October 31,** | ** ** |
| ** **                                                                 | ** ** | **2007**               | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues:                                                                  |       | $                      |       |                 | $          |   |   | $ |   |   | $ |   |   |
| Products                                                                   |       | 1,145                  |       | 1,723                |       | 2,016 |   | 3,321 |   |
| Services                                                                   |       | 4,910                  |       | 5,532                |       | 9,908 |   | 10,720 |   |
| Total revenues                                                             |       | 6,055                  |       | 7,255                |       | 11,924 |   | 14,041 |   |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Cost of revenues:                                                          |       |                   |       |                 |       |   |   |   |   |
| Products                                                                   |       | 1,476                  |       | 1,398                |       | 2,351 |   | 2,828 |   |
| Services                                                                   |       | 4,096                  |       | 4,060                |       | 8,219 |   | 8,197 |   |
| Total cost of  revenues                                                    |       | 5,572                  |       | 5,458                |       | 10,570 |   | 11,025 |   |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Gross margin                                                               |       | 483                    |       | 1,797                |       | 1,354 |   | 3,016 |   |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                                        |       |                   |       |                 |       |   |   |   |   |
| Selling, general  and administrative                                       |       | 1,864                  |       | 4,097                |       | 3,954 |   | 7,865 |   |
| Impairment loss  on intangible assets                                      |       | 145                    |       | —               |       | 145 |   | — |   |
| Research and  development                                                  |       | 165                    |       | 784                  |       | 1,182 |   | 2,188 |   |
| Total operating  expenses                                                  |       | 2,174                  |       | 4,881                |       | 5,281 |   | 10,053 |   |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Operating loss                                                             |       | (1,691                 | )          | (3,084               | )          | (3,927 | ) | (7,037 | ) |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Other income (expense):                                                    |       |                   |       |                 |       |   |   |   |   |
| Amortization of  debt issuance costs                                       |       | (46                    | )          | (44                  | )          | (87 | ) | (159 | ) |
| Interest and  other income                                                 |       | 2                      |       | 14                   |       | 99 |   | 54 |   |
| Interest expense                                                           |       | (1,497                 | )          | (769                 | )          | (2,926 | ) | (1,419 | ) |
| Foreign exchange                                                           |       | 7                      |       | 1                    |       | 7 |   | 1 |   |
| Gain on  extinguishment of debt                                            |       | —                 |       | —               |       | — |   | 227 |   |
| Gain on  derivative instruments                                            |       | 491                    |       | 189                  |       | 504 |   | 2,320 |   |
| Equity in net  income (loss) of investee                                   |       | (38                    | )          | 98                   |       | (80 | ) | 10 |   |
| Total other  income (expense), net                                         |       | (1,081                 | )          | (511                 | )          | (2,483 | ) | 1,034 |   |
| Loss from continuing operations before income taxes  and minority interest |       | (2,772                 | )          | (3,595               | )          | (6,410 | ) | (6,003 | ) |
| Income tax expense                                                         |       | —                 |       | —               |       | — |   | — |   |
| Minority interest in operations of consolidated  subsidiary                |       | 11                     |       | 42                   |       | 111 |   | 42 |   |
| Loss from continuing operations                                            |       | (2,761                 | )          | (3,553               | )          | (6,299 | ) | (5,961 | ) |
| Discontinued operations:                                                   |       |                   |       |                 |       |   |   |   |   |
| Gain (loss) on  operations of discontinued operations, net of income taxes |       | —                 |       | (48                  | )          | 37 |   | (12 | ) |
| Gain on disposal  of discontinued operations, net of income taxes          |       | —                 |       | —               |       | 516 |   | — |   |
| Gain (loss) on  discontinued operations, net of income taxes               |       | —                 |       | (48                  | )          | 553 |   | (12 | ) |
| NET LOSS                                                                   |       | $                      | (2,761     | )                    | $          | (3,601 | ) | $ | (5,746 | ) | $ | (5,973 | ) |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| **Net loss per share — basic and diluted**                            |       |                   |       |                 |       |   |   |   |   |
| Continuing  operations                                                     |       | $                      | (0.22      | )                    | $          | (0.31 | ) | $ | (0.50 | ) | $ | (0.52 | ) |
| Discontinued  operations                                                   |       | $                      | (0.00      | )                    | $          | (0.00 | ) | $ | 0.04 |   | $ | (0.00 | ) |
| Net loss                                                                   |       | $                      | (0.22      | )                    | $          | (0.31 | ) | $ | (0.46 | ) | $ | (0.52 | ) |
| Weighted average common shares used in computing per  share information    |       | 12,658                 |       | 11,669               |       | 12,656 |   | 11,518 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands, except shareamounts)**

**(Unaudited)**

** **
| ** **                                                                                            | ** ** | **Six Months Ended October 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                            | ** ** | **2007**                              | ** ** | **2006** | ** ** |
| Net cash used in operating activities                                                                 |       | $                                     | (815       | ) | $ | (5,757 | ) |
|                                                                                                  |       |                                  |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                 |       |                                  |       |   |   |
| Purchases of  property and equipment                                                                  |       | (79                                   | )          | (1,166 | ) |
| Equity  investment in a business                                                                      |       | —                                |       | (100 | ) |
| Proceeds from  assets held for sale                                                                   |       | 60                                    |       | — |   |
| Proceeds from  sale of discontinued operations, net of selling costs                                  |       | 805                                   |       | — |   |
| Cash provided by  (used in) investing activities                                                      |       | 786                                   |       | (1,266 | ) |
|                                                                                                  |       |                                  |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                 |       |                                  |       |   |   |
| Principal  payments under capital lease obligations                                                   |       | (230                                  | )          | (7 | ) |
| Principal  payments on borrowings                                                                     |       | (544                                  | )          | (5,388 | ) |
| 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                                                      |       | (774                                  | )          | 6,890 |   |
|                                                                                                  |       |                                  |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                             |       | (803                                  | )          | (133 | ) |
| Cash and cash  equivalents at beginning of period                                                     |       | 1,556                                 |       | 1,586 |   |
| Cash and cash  equivalents at end of period                                                           |       | $                                     | 753        |   | $ | 1,453 |   |
|                                                                                                  |       |                                  |       |   |   |
| Supplemental disclosure of cash flow information:                                                     |       |                                  |       |   |   |
| Cash paid during  the period for:                                                                     |       |                                  |       |   |   |
| Interest                                                                                              |       | $                                     | 139        |   | $ | 99 |   |
| Income taxes                                                                                          |       | $                                     | —     |   | $ | — |   |
|                                                                                                  |       |                                  |       |   |   |
| Supplemental disclosure of noncash investing and  financingactivities:                                |       |                                  |       |   |   |
| Capital lease  obligation for property and equipment                                                  |       | $                                     | 628        |   | $ | — |   |
| Accruals for  property and equipment                                                                  |       | $                                     | —     |   | $ | 1,385 |   |
| 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                                   |       | $                                     | —     |   | $ | 4,511 |   |

 

See notes to condensed consolidated financial statements.

 

5

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**Isonics Corporation andSubsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**NOTE 1 — BASIS OFPRESENTATION**

 

The accompanying condensed consolidated balance sheet as of April 30,2007, has been derived from audited financial statements.  The accompanying unaudited interim condensedconsolidated financial statements of Isonics Corporation and Subsidiaries havebeen prepared on the same basis as the annual audited financial statements andin accordance with accounting principles generally accepted in the UnitedStates (“US GAAP”) for interim financial information and the rules andregulations of the Securities and Exchange Commission (“SEC”) for interimfinancial statements.  In the opinion ofmanagement, such unaudited information includes all adjustments (consistingonly of normal recurring accruals) necessary for a fair presentation of thisinterim information.  Operating resultsand cash flows for interim periods are not necessarily indicative of resultsthat can be expected for the entire year. The information included in this report should be read in conjunctionwith our audited consolidated financial statements and notes thereto includedin our Annual Report on Form 10-K for the year ended April 30, 2007.

 

During the three months ended January 31, 2007, we reclassifiedthe operations of our life sciences business as discontinued operations inaccordance with SFAS No. 144, *Accountingfor the impairment or Disposal 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.

 

On February 13, 2007, we effected a one-for-four reverse stocksplit of our common shares upon the filing of a Certificate of Amendment to ourArticles of Incorporation with the California Secretary of State.  Allimpacted amounts included in the consolidated financial statements and notesthereto have been restated for the stock split.

 

***Going Concern***

 

While as of October 31, 2007, we have working capital of$1,166,000, we have a stockholders’ deficit of ($1,933,000) and have incurred significant losses from operations andused significant cash flow to fund operations during the most recent severalfiscal years and through October 31, 2007. Historically, we have relied upon outside investor funds to maintain ouroperations and develop our business. We anticipate we will continue to requirefunding from investors for working capital as well as business expansion duringthis fiscal year and we can provide no assurance that additional investor fundswill be available on terms acceptable to us. In addition, we have convertible debentures outstanding in thecumulative amount of $20,044,000 (which is comprised of the $18,000,000 faceamount of the debentures plus related accrued interest) as of October 31,2007, which are due in May 2009 unless an Event of Default was to occurand the holder then declared an Event of Default.  Subsequent to October 31, 2007, wepotentially became non-compliant with certain non-financial covenants of theconvertible debentures as more fully discussed in Note 8.  We are in discussions with the holder of theconvertible debentures concerning waivers and potential corrective actionsrelated to the covenants in question. The convertible debentures and related accrued interest are classifiedas long-term liabilities as of October 31, 2007, based on our belief thatwe will be able to satisfactorily resolve these matters with the holders of theconvertible debentures.  However, as of December 17,2007, no waivers have been obtained and management cannot provide assurancethat the holder of the convertible debentures will not declare an Event ofDefault.  These conditions raise substantialdoubt about our ability to continue operations as a going concern.

 

During the yearended April 30, 2007, and subsequently, we restructured our managementteam with the goal of refocusing our product lines, seeking joint venturepartners and improving operating performance at the business segments through afocus on strategic products, increased efficiencies in business processes 

 

6

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and improvementsto the cost structure of each segment. Despite these changes, our ability to continue as a going concern isdependent upon raising capital through debt or equity financing, obtainingappropriate waivers from the holders of our convertible debentures and/orsatisfactorily curing any non-compliance provisions of the debenture agreementsand ultimately by increasing revenue and achieving profitable operations. Wecan offer no assurance that we will be successful in our efforts to raiseadditional 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.

 

**NOTE 2 — SIGNIFICANT ACCOUNTING POLICIES**

** **

***Net Income (Loss) Per Share***

 

Basic net income (loss)per share 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 October 31, 2007, (a) a total of 5,112,125 outstandingstock options (excluding 3,550,000 stock options not deemed granted under USGAAP because the underlying plan or increase to the underlying plan has notbeen approved by our shareholders) and common stock warrants and (b) theunissued shares underlying our outstanding convertible debentures (with acumulative outstanding face amount of $18,000,000 at October 31, 2007)were excluded from the diluted net loss per share calculation, as theirinclusion would be anti-dilutive.  As of October 31, 2006, (a) atotal of 5,797,010 outstanding stock options and common stock warrants and (b) theunissued shares underlying our outstanding convertible debentures (with acumulative outstanding face amount of $13,000,000 at October 31, 2006)were excluded from the diluted net loss per share calculation, as theirinclusion would be anti-dilutive.

 

During the six months ended October 31, 2007, we issued thefollowing 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 October 31, 2007 |       | 12,658,150                        |       |

 

The aforementioned equity transactions increased common stock in theaccompanying condensed consolidated balance sheets by $29,000 for the sixmonths ended October 31, 2007.

 

***Recently Issued Accounting Standards***

 

In July 2006, the Financial AccountingStandards Board (“FASB”) issued Interpretation No. 48, *Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109*(“FIN 48”). This interpretation clarifies the application of SFAS 109 by defining acriterion that an individual tax position must meet for any part of the benefitof that position to be recognized in an enterprise’s financial statements andalso provides guidance on measurement, derecognition, classification, interestand penalties, accounting 

 

7

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ininterim periods and disclosure.  FIN 48requires the recognition of penalties and interest on any unrecognized taxbenefits. Our policy is to reflect penalties and interest as part of income taxexpense as they become applicable.  Weadopted FIN 48 effective May 1, 2007. No unrecognized tax benefits were recorded as of the date ofadoption.  Due to certain “change inownership” rules (as defined by the IRS), utilization of our federal netoperating losses 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 examinations by tax authorities for fiscal yearsprior to 2004.

 

In September 2006,the FASB issued SFAS No. 157, *FairValue Measurements* (“SFAS 157”). SFAS 157 defines fairvalue, establishes a framework and gives guidance regarding the methods usedfor measuring fair value, and expands disclosures about fair valuemeasurements. SFAS 157 is effective for our fiscal year commencing May 1,2008 for those items that are recognized or disclosed at fair value in thefinancial statements on a recurring basis (at least annually), includinginterim periods within that fiscal year. The effective date of SFAS 157 for items not included in theaforementioned category has been deferred. We are currently evaluating the impact of adopting SFAS 157 on our results of operations and financial condition.

 

In February 2007,the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS159”).  SFAS 159 provides the option toreport certain financial assets and liabilities at fair value, with the intentto mitigate volatility in financial reporting that can occur when relatedassets and liabilities are recorded on different bases.   SFAS 159also amends SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, by providingthe option to record unrealized gains and losses on held-for-sale andheld-to-maturity securities currently.  SFAS 159 is effective for ourfiscal year commencing May 1, 2008, including interim periods within thatfiscal year.  The implementation of FAS159 is not expected to have a material impact on our results of operations orfinancial position.

 

In December 2007,the FASB issued SFAS 141 (revised 2007), *BusinessCombinations*(“SFAS 141(R)”), which establishes principles andrequirements for how an acquirer recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in an acquiree, including the recognition andmeasurement of goodwill acquired in a business combination.  SFAS 141(R) is effective for our fiscalyear commencing May 1, 2009. Earlier adoption is prohibited.  We are currently evaluating the impact of adoptingSFAS 141(R) on our results of operations and financial condition.

 

In December 2007,the FASB issued SFAS No. 160 , *NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51*.  SFAS 160 amends ARB 51 to establishaccounting and reporting standards for the noncontrolling interest in asubsidiary and for the deconsolidation of a subsidiary.  It clarifies that a noncontrolling interestin a subsidiary, which is sometimes referred to as minority interest, is anownership interest in the consolidated entity that should be reported as equityin the consolidated financial statements. Among other requirements, this statement requires consolidated netincome to be reported at amounts that include the amounts attributable to boththe parent and the noncontrolling interest. It also requires disclosure, on the face of the consolidated incomestatement, of the amounts of consolidated net income attributable to the parentand to the noncontrolling interest.  SFAS 160 is effective for our fiscal year commencing May 1, 2009,including interim periods within that fiscal year. Earlier adoption isprohibited.  We are currently evaluating the impact of adopting SFAS 160 on ourresults of operations and financial condition.

 

8

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**NOTE 3 — FINANCIAL STATEMENT COMPONENTS**

 

***Inventories***

 

Inventoriesconsist of the following (in thousands):

 

| ** **             | ** ** | **October 31, 2007** | ** ** | **April 30, 2007** | ** ** |
|------------------------|------------|---------------------------|------------|-------------------------|------------|
| Finished goods         |       | $                         | 270        |                    | $          | 497 |   |
| Work in process        |       | 40                        |       | 47                      |       |
| Materials and supplies |       | 483                       |       | 715                     |       |
| Total  inventories     |       | $                         | 793        |                    | $          | 1,259 |   |

 

***Propertyand equipment***

 

Property and equipment consist of thefollowing (in thousands):

 

| ** **                                | ** ** | **October 31, 2007** | ** ** | **April 30, 2007** | ** ** |
|-------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| Office furniture and equipment            |       | $                         | 342        |                    | $          | 331 |   |
| Production equipment                      |       | 8,825                     |       | 7,613                   |       |
| Vehicles                                  |       | 191                       |       | 191                     |       |
| Construction in process                   |       | 314                       |       | 854                     |       |
| Leasehold improvements                    |       | 1,215                     |       | 1,215                   |       |
|                                      |       | 10,887                    |       | 10,204                  |       |
| Accumulated depreciation and amortization |       | (5,327                    | )          | (4,538                  | )          |
| Total property  and equipment, net        |       | $                         | 5,560      |                    | $          | 5,666 |   |

 

**NOTE 4 — SEGMENT INFORMATION**

 

We currently have threereportable segments: homeland security products, security services andsemiconductor products and services.  Ourhomeland security products segment includes both the remaining operationsregarding our IonMobility Spectroscopy (“IMS”) technology (see Note 9) and the remainingoperations of our 90%-owned subsidiary (SenseIt Corp, see Note 6).  Our security services segment providessecurity and investigative services and is substantially comprised of theoperations of Protection Plus Security Corporation (“PPSC”).  Our semiconductor products and servicessegment 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. Prior period amounts have been reclassified to conform to current periodpresentation.

 

        Informationby segment is set forth below (in thousands):

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **October 31,**   | ** ** | **October 31,** | ** ** |
| ** **                           | ** ** | **2007**               | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Segment revenues:                    |       |                   |       |                 |       |   |   |   |   |
| Homeland  security products          |       | $                      | 195        |                 | $          | — |   | $ | 195 |   | $ | — |   |
| Security  services                   |       | 3,866                  |       | 3,739                |       | 7,622 |   | 7,616 |   |
| Semiconductor  products and services |       | 1,994                  |       | 3,516                |       | 4,107 |   | 6,425 |   |
| Total                                |       | $                      | 6,055      |                 | $          | 7,255 |   | $ | 11,924 |   | $ | 14,041 |   |

 

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| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **October 31,**   | ** ** | **October 31,** | ** ** |
| ** **                           | ** ** | **2007**               | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Segment operating (loss) income:     |       |                   |       |                 |       |   |   |   |   |
| Homeland  security products          |       | $                      | (715       | )                    | $          | (2,124 | ) | $ | (2,036 | ) | $ | (4,071 | ) |
| Security  services                   |       | 253                    |       | (20                  | )          | 323 |   | (294 | ) |
| Semiconductor  products and services |       | (598                   | )          | 151                  |       | (959 | ) | (48 | ) |
| Reconciling  amounts (1)             |       | (631                   | )          | (1,091               | )          | (1,255 | ) | (2,624 | ) |
| Total                                |       | $                      | (1,691     | )                    | $          | (3,084 | ) | $ | (3,927 | ) | $ | (7,037 | ) |

 

| ** **                           | ** ** | **October 31,** | ** ** | **April 30,** | ** ** |
|--------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                           | ** ** | **2007**             | ** ** | **2007**           | ** ** |
| Total assets:                        |       |                 |       |               |       |
| Homeland  security products          |       | $                    | 356        |               | $          | 1,943 |   |
| Security  services                   |       | 6,599                |       | 6,127              |       |
| Semiconductor  products and services |       | 7,593                |       | 9,068              |       |
| Reconciling  amounts (2)             |       | 953                  |       | 1,822              |       |
| Total                                |       | $                    | 15,501     |               | $          | 18,960 |   |

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(1) Reconciling amounts for the operating (loss) incomeinformation includes corporate expenses consisting primarily of corporatesalaries and benefits, professional and consulting fees, investor relationscosts, insurance and directors’ compensation.

 

(2) Reconciling amounts for the total asset information includescorporate assets consisting primarily of cash and cash equivalents investedcentrally, unamortized debt issuance costs and miscellaneous prepaid items aswell as, for April 30, 2007, the assets of our former life sciencesbusiness which were categorized as discontinued operations prior to their salein June 2007.

 

**NOTE 5 — DISCONTINUEDOPERATIONS**

 

During the three months ended January 31,2007, we elected to discontinue the operation of our life sciences business andto put the assets and business up for sale. We decided to sell this business as it no longer fit our long-termstrategy and because of deteriorating business conditions in the historical,revenue producing products in the segment.  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. On June 19, 2007, we completed thesale of this business for total cash proceeds of $850,000, out of which we paida selling fee of $45,000 and repaid a loan underlying production equipment inthe amount of $40,000.

 

The business’ revenue, which is reported as discontinued operations inthe accompanying condensed consolidated statements of operations, for the sixmonths ended October 31, 2007 and 2006, was $101,000 and $616,000,respectively.  The business’ gain onoperations of discontinued operations, net of income taxes, for the six monthsended October 31, 2007 was $37,000, while the loss on operations ofdiscontinued operations, net of income taxes, for the six months ended October 31,2006, was $(12,000).

 

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Following is a summary of the net assets sold on the closing date of June 19,2007, and included in the condensed consolidated balance sheet as discontinuedoperations on April 30, 2007 (in thousands):

 

| ** **                  | ** ** | **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, weentered into a Class A Common Stock Purchase Agreement (the “PurchaseAgreement”) with SenseIt Corp, a Delaware corporation (“SenseIt”), with theintent of accelerating next generation infrared imaging and night visionsurveillance technology development and driving related commercializationactivities in connection with our Development & Licensing Agreementwith Lucent Technologies Inc. (currently known as Alcatel-Lucent), (the “LucentAgreement” and “Lucent,” respectively). The joint venture was established through our acquisition of an initial90% ownership interest in SenseIt in exchange for assigning to SenseIt all ofour interest under the Lucent Agreement, The assignment was approved byLucent.  The remaining 10% interest in SenseIt is owned by our chairman,Christopher Toffales, although we entered into that agreement with Mr. Toffalesbefore he became affiliated with Isonics Corporation.  We invested an approximate cumulative$7,000,000 in SenseIt and the Lucent Agreement.

 

We did not make the $1,000,000 payment that was due to Lucenton or before July 16, 2007.  As aresult of not making this payment, effective October 13, 2007, Lucentterminated the Lucent Agreement and our investment in SenseIt has becomevalueless.  We are in process of windingdown the operations of SenseIt.

 

**NOTE 7 — EQUITY**

** **

###### ***2005 Stock Option Plan***

###### * *

In May 2007, our Board of Directorsapproved a resolution increasing the shares available for issuance to2,875,000, an increase of 2,000,000 shares. Any options granted from this increased allotment will not be exercisableuntil approved by our shareholders.  Dueto a lack of working capital, we have decided to postpone our annual meeting ofshareholders from our earlier contemplated timing of November 2007 to alater period, if ever.  Consequently, anystock options issued from the increased allotment may never become effective.

 

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***Equity Instruments Issued for Services***

 

In May 2007, we entered into aconsulting agreement with CEOcast, Inc. to provide investor relationsservices.  The compensation terms of theagreement included the issuance of 18,750 shares of our common stock, which wasvalued at $29,000.  The common stock wasrecorded as prepaid consulting expense and will be amortized ratably over theservice period of six months.  For thesix months ended October 31, 2007, we recognized $25,000 of selling,general and administrative expense related to the shares of common stock issuedunder the agreement.

 

In June 2007, we granted options topurchase 200,000 shares of our common stock to Sound Business Solutions, Inc.,an entity whose principal has been providing management services to oursemiconductor products and services segment. This option was granted pursuant to our 2005 Stock Option Plan.  The stock options granted to Sound BusinessSolutions Inc. are subject to the following vesting schedule: 66,667 sharesvested immediately upon grant; 66,667 shares vested on September 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 pershare.  Options to purchase 50,000 shares(valued at $53,000 using the Black-Scholes pricing model) are currentlyexercisable while options to purchase 150,000 shares are subject to ourshareholders approving the aforementioned increase to the cumulative sharesissuable under the 2005 Stock Option Plan. A charge in the amount of $53,000 was recognized as a selling, generaland administrative expense during the six months ended October 31,2007.  This charge related to the portionof the fair value of the currently exercisable option to purchase 50,000 sharesthat is associated with work performed in the reporting period.  Under SFAS 123(R), a stock option is notconsidered granted for accounting purposes until stockholder approval isobtained (unless such approval is deemed a formality, which is not the case forthe proposed 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.  We currently have nodefinitive plan to hold a shareholder meeting and it is uncertain when our nextshareholder meeting will be held, if ever. Consequently, any stock options issued from the increased allotment maynever become effective.

 

**NOTE 8 — BORROWINGS**

** **

***Capital Lease***

 

In May 2007, we entered into a capitallease to finance equipment to be used in production by our semiconductorproducts and services segment.  The leaseis in the principal amount of $628,000, bears a nominal interest rate of 16%,has a term of 36 months and includes a bargain purchase option whereby we havethe right subsequent to the expiration of the lease term to purchase the assetunder lease for no more than 5% of the original equipment cost.  Additionally, we issued the lessor a commonstock warrant (valued at $39,000 using the Black-Scholes pricing model) topurchase 40,000 shares of common stock at $1.50 per share.  The common stock warrant vested immediately,expires on May 28, 2010, and is being amortized to interest expense overthe term of the lease.

 

***April 2007 Debenture***

 

In April 2007, we issued to YA GlobalInvestments, L.P. (“YA Global”), formerly known as Cornell Capital Partners,LP, a convertible debenture with a face amount of $2,000,000 (the “April 2007Debenture”) along with detachable common stock warrants.  For the six months ended October 31,2007, using the effective interest method we amortized $75,000 of the discounton the April 2007 Debenture to interest expense.  As of October 31, 2007, the April 2007Debenture has an outstanding face amount of $2,000,000 and is recorded in ourcondensed consolidated balance sheets at a carrying amount (net of discount) of$1,740,000.  

 

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We also recorded accrued interest on the April 2007Debenture in the amount of $131,000 for the six months ended October 31,2007.  As of October 31, 2007,cumulative accrued interest is $145,000; such accrued interest is included inother long-term liabilities in the condensed consolidated balance sheets and isdue upon maturity of the April 2007 Debenture in May 2009.

 

Subsequent to October 31, 2007, we didnot meet certain non-financial requirements under the April 2007 Debentureand its holder may potentially be able to, in its discretion, declare an Eventof Default.  Remedies for an Event ofDefault include the option to accelerate payment of the full principal amountof the April 2007 Debenture, together with interest and other amounts due(a cumulative amount of $2,145,000 at October 31, 2007), to the date ofacceleration and the holder will have the right to request such payment in cashor in shares of our common stock.  If theholder of the April 2007 Debenture declares an Event of Default, it ispossible that we will not 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.

 

***2006 Convertible Debentures***

 

In May, June and November 2006, weissued to YA Global convertible debentures with a cumulative face amount of$16,000,000 (the “2006 Debentures”) along with detachable common stockwarrants.  For the six months ended October 31,2007, using the effective interest method we amortized $1,497,000 of thediscount on the 2006 Debentures to interest expense.  As of October 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 $8,466,000.  We alsorecorded accrued interest on the 2006 Debentures in the amount of $1,048,000for the six months ended October 31, 2007. As of October 31, 2007, cumulative accrued interest is $1,899,000;such accrued interest is included in other long-term liabilities in thecondensed consolidated balance sheets and is due upon maturity of the 2006Debentures in May 2009.

 

Subsequent to October 31, 2007, we didnot meet certain non-financial requirements under the 2006 Debenturesand their holder may potentially be able to, in its discretion, declare anEvent of Default.  Additionally, if theholder of the April 2007 Debenture were to declare an Event of Defaultunder that debenture (which they may currently be able to do as discussedpreviously within this footnote), the holder of the 2006 Debentures coulddeclare 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 2006Debentures, together with interest and other amounts due (a cumulative amountof $17,899,000 at October 31, 2007), to the date of acceleration and theholder will have the right to request such payment in cash or in shares of ourcommon stock.  If the holder of the 2006Debentures declares an Event of Default, it is possible that we will not beable to cure the default or contest any efforts that the holder may take toforeclose against its security interest in substantially all of our assets.

 

**NOTE 9 — IMS-BASED PRODUCTS SUSPENSION**

 

InAugust 2007, we elected to suspend the development, manufacture and saleof 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 continue to seek alternatives towards finding a means of monetizingour IMS-based investment, including 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 technology investment.  Due to our election to suspend operationsregarding our IMS-based products, we reviewed for impairment the trace and bulkdetection technology intangible asset associated with the IMS technology.  We determined that the carrying amount of the

 

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intangibleasset is not recoverable and its carrying amount exceeds its fair value, asdetermined using the expected present value of future cash flows.  As such, during the three months ended October 31,2007, we recognized an impairment loss in the amount of $145,000, suchimpairment loss representing the full carrying value of the intangible assetprior to impairment.  The impairedintangible asset relates to the homeland security products reportable segment.

 

**NOTE 10 — LICENSE AGREEMENT**

 

InSeptember 2007, we assigned our existing exclusive rights regardingsilicon-28 patents (secured under the 1997 License Agreement with YaleUniversity) to an independent entity, such assignment receiving the consent andagreement of Yale University.  Silicon-28is a naturally occurring stable isotope of silicon which, in a nearisotopically-pure form, may have performance benefits as compared tomulti-isotopic materials currently prevalent in the semiconductormarketplace.  In periods presented, ourproceeds from the sale of silicon-28 based products have not been material andwe have not invested material resources in the program.

 

Inexchange for the assignment of our license, we received a cash payment in theamount of $60,000 and a Non-Recourse Promissory Note (the “Promissory Note”) inthe principal amount of $440,000.  Theoutstanding principal of the Promissory Note will be paid thirty days after theearlier of: (a) the date on which the counterparty first receives revenuesin consideration for the sale or licensing (or sublicensing) of the assignedpatents or (b) March 5, 2009. The Promissory Note is without recourse to any assets of thecounterparty except for the security interest held in the assigned patents andlicense.  Due to the non-recourse natureof the Promissory Note and the uncertainty surrounding receiving payment underit, the Promissory Note has not been recognized as an asset in our condensedconsolidated financial statements. Rather, any potential payments will be being treated as a gaincontingency and will be recognized in the financial statements uponrealization, if ever.

 

**NOTE 11 — COMMITMENTS AND CONTINGENCIES**

 

As of October 31, 2007, we had nocommitments outstanding for capital expenditures.

 

**NOTE 12 — RELATED PARTY TRANSACTIONS**

 

Wehave a research and development agreement with Institut fur UmwelttechnologienGmbH (“IUT”), an equity method investee of which we own 30%.  We funded $80,000 and $721,000 under thisagreement for the six months ended October 31, 2007 and 2006, respectively(and a total of $2,988,000 since entering into our first research anddevelopment agreement in June 2004). All funded payments have been included as research and development inthe accompanying condensed consolidated statements of operations.  Due to the aforementioned suspension of thedevelopment, manufacture and sale of our IMS-based products, we expect toprovide no future material funding to IUT so long as the suspension of work onthe IMS-based products continues.

 

**NOTE 13 — SUBSEQUENT EVENTS**

 

Certain events occurring subsequent to October 31, 2007, arediscussed within other notes to the condensed consolidated financial statements.

 

On December 6, 2007, we receivednotification from the Nasdaq Stock Market (“Nasdaq”) that it determined todelist our securities from Nasdaq. Trading of our shares on the Nasdaq Capital Market was suspendedeffective with the open of business on December 10, 2007.

 

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**Item 2:  Management’s Discussion and Analysis ofFinancial 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 SecuritiesAct of 1933 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 Part II).  We undertake no obligation to update orrevise publicly any forward-looking statements, whether as a result of newinformation, future events or otherwise.*

 

***General Discussion***

 

We are focused onthe provision of homeland security 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 core obligations to date, we have frequently been required to allocateour available cash among various obligations. During the six months ended October 31, 2007 and subsequently, wehave also refocused our operations and have attempted to reduce significantlyour expenses, including the cash flow necessary to pay our corporate anddivisional overhead.

 

During the year ended April 30, 2007, and the six months ended October 31,2007, we generated sales from stable and radioactive isotopes, silicon waferreclaim and test products, wafer thinning and custom wafer products for thesemiconductor industry, although sales from stable and radioactive isotopeswere reported as discontinued operations in the accompanying condensedconsolidated statements of operations as described below and during the quarterended October 31, 2007 we suspended operations in our homeland securityproducts segment.  During the year ended April 30,2006 and the six months ended October 31, 2007, we also generated revenuesfrom providing security services forleading businesses and institutions in healthcare, education, retail,manufacturing, banking and the art world. For information about segment revenue, refer to Note 4 (SegmentInformation) to the condensed consolidated financial statements located in Item1: Financial Statements.

 

In June 2007, we sold our life sciencesbusiness (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,reported in the single line item of gain on operations of discontinuedoperations, net of income taxes, was $101,000 and $1,193,000 for the six monthsended October 31, 2007 and 2006, respectively.

 

In August 2007, we elected to suspendthe 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 an outright sale of the technology. It is unclear as to when (if at all) we will resume activity on ourIMS-based products and we

 

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can offer no assurance that we will be ableto monetize any portion of our IMS technology investment.

 

In September 2007, we assigned ourexisting exclusive rights regarding silicon-28 patents (secured under the 1997License Agreement with Yale University) to an independent entity, suchassignment receiving the consent and agreement of Yale University.  Silicon-28 is a naturally occurring stableisotope of silicon which, in a near isotopically-pure form, may have performancebenefits as compared to multi-isotopic materials currently prevalent in thesemiconductor marketplace.  In periodspresented, proceeds from the sale of silicon-28 based products have beenimmaterial and we have not invested material resources in the program.

 

In October 2007, Lucent terminated our development project regardinga next-generation infrared imaging and night vision surveillance technology dueto our inability to make a required development payment which was due in July 2007.  As a result, our investment in SenseIt hasbecome valueless.  Weare in process of winding down the operations of SenseIt.

 

Consistent with management focus during the six months ended October 31,2007 and prior, we continue to evaluate our portfolio of operating businessesand technology with the goal of operating our business more efficiently andmonetizing non-core assets. Additionally, we have considered and will continue to consider businessexpansion through merger, acquisition, joint venture or other means, althoughwe can offer no assurance as to our ultimate success in increasing the scope ofour business through such means.

 

On December 6, 2007, we receivednotification from the Nasdaq stating that it determined to delist oursecurities from Nasdaq.  Trading in ourshares on the Nasdaq Capital Market was suspended effective with the open ofbusiness on December 10, 2007.  Nasdaq’sdecision was rendered following a hearing held before a Nasdaq ListingQualifications Panel on November 29, 2007. We are working with our market makers and are hopeful that our commonstock will be enabled for trading on the OTC Bulletin Board.

 

Liquidityand Capital Resources

 

We have had workingcapital shortages in the past and, although we raised capital totaling morethan $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, whichhave impacted working capital.  As of October 31,2007, our condensed consolidated balance sheet reflects working capital of$1,166,000.  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 withour financial statements for the year ended April 30, 2007, included anexplanatory paragraph indicating substantial doubt about our ability tocontinue as a going concern.

 

Based on the amountof capital we have remaining and our expected negative cash flow fromoperations and 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 ending April 30,2008, unless we are able to achieve significant additional financing.  Because of the potential dilution associatedwith the outstanding debentures and the holder’s security interest insubstantially all of our assets, we believe that it is unlikely that we will beable to obtain additional financing unless we are able to reach anaccommodation with our existing debenture holder.

 

We have not met certain of the requirementsunder the 2006 Debentures and the 2007 Debenture (together referred to as the “13%Debentures”) and their holder may be able to, in its discretion, declare anEvent of Default.  Additionally, an Eventof Default under any one of the 13% Debentures would allow the holder todeclare an Event of Default under all of the 13% Debentures.  Remedies for an 

 

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Event of Default include the option toaccelerate payment of the full principal amount of the 13% Debentures, togetherwith interest and other amounts due (a cumulative amount of $20,044,000 at October 31,2007), 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 13% Debentures declaresan Event of Default, it is possible that we will not 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.

 

See additionaldiscussion of liquidity and capitalresources in the Liquidity and Capital Resources section included further belowin this Item 2: Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

 

HomelandSecurity

 

Isonics HomelandSecurity and Defense Corporation (“HSDC”) focuses the majority of our effortsin the homeland security sector.  Theseefforts have included entry into the security services market through ouracquisition of PPSC in May 2005, acquisition and (prior to August 2007)development of our IMS detection technology and our entry into both anagreement (currently terminated) with Lucent and a 90% owned joint venturenamed SenseIt Corp to develop innovative infrared imaging and night vision surveillancetechnology.   HSDC’s assets also includeour 30% minority interest in IUT.

 

**SecurityServices** — Since the effective date of our acquisition ofPPSC in May 2005, PPSC has delivered significant revenue to our condensedconsolidated financial statements and has provided gross margin ofapproximately 23% of revenues for the six months ended October 31, 2007.

 

During the fourthquarter of the year ended April 30, 2007, and the six months ended October 31,2007, we implemented cost cutting initiatives that were expected to positivelyimpact the results of PPSC’s operations. Additionally we initiated plans to improve operating margins at PPSC byfocusing on customers that are willing to pay for premium security services, amarket in which we believe that PPSC is able to differentiate itself from itspeers.  As a result of the impact of ourongoing cost cutting initiatives, the segment generated operating income of$323,000 for the six months ended October 31, 2007, as compared to anoperating loss of $(294,000) for the six months ended October 31,2006.  For the six months ended October 31,2007 and 2006, the operating loss includes non-cash amortization ofacquisition-related customer intangibles and stock-based compensation expensein the aggregate amount of $97,000 and $137,000, respectively.

 

While we believethat these cost cutting initiatives and focused sales and marketing effortswill enable PPSC to report positive operating income for the year ending April 30,2008, the industry is cost competitive and customers switch security serviceproviders on short notice and, therefore, we can offer no assurance that thiswill actually occur.

 

**Detection Technology** — During our year ended April 30, 2007 and through August 2007,we offered our existing IMS-based products (the panel-mounted IMS andEnviroSecureTM), although we didnot engage in any significant marketing efforts for these products subsequentto late in calendar year 2006.  Althoughwe continued to offer EnviroSecureTM, a system that can monitor andidentify chemical weapons and toxic substances in the air in a variety ofvenues including airports, mass transit facilities, sports venues and publicand private sector office buildings, we did not make any sales of this productor engage in any significant marketing activities.  Our sales of the panel-mounted IMS productwere extremely limited and historically resulted in deferred revenue, althoughwe substantially recognized the deferred revenue during the three months ended October 31,2007, as a result of reaching an accord with our sole customer for thatproduct.  We do not intend to recommenceany marketing efforts until (if ever) we are adequately capitalized, have acommercial product and have identified a market.

 

17

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In August 2007, we elected to suspendthe 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 market space.  We will continue to seek alternatives towardsfinding a means of monetizing our IMS-based investment, including an outrightsale of the technology.  It is unclear asto when (if at all) we will resume activity on our IMS-based products and wecan offer no assurance that we will be able to monetize any portion of ourIMS-based investment.

 

**Infrared Imaging Technology** — In December, 2005, we approved a developmentplan that resulted in us becoming obligated under the Lucent Agreement weentered into with Lucent in September 2005 which, in October 2006, weassigned to our 90% owned subsidiary, SenseIt Corp.  Under the Lucent Agreement, we wereattempting to develop a next-generation infrared imaging and night visionsurveillance technology based on Lucent’s micro electro-mechanical systems (“MEMS”)technology under development at its nanotechnology fabrication facility.  Infrared technology, which converts infraredradiation in the non-visible spectrum, such as body heat, into a visible image,is commonly 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 development plan contemplated aproof-of-concept during calendar year 2007, followed by steps towards commercialization.

 

We did not make the $1,000,000 payment that was due to Lucent on orbefore July 16, 2007.  As a resultof not making this payment, effective October 13, 2007, Lucent terminatedthe Lucent Agreement.  Therefore, ourinvestment in SenseIt and the Lucent Agreement (in the cumulative amount ofapproximately $7,000,000) has become valueless. We are in process of winding down the operations of SenseIt.

 

SemiconductorProducts and Services

 

Our semiconductoroperations, based in Vancouver, Washington, showed continued operational andfinancial improvement during the years ended April 30, 2007 and 2006,although we have experienced a softening of demand for our products andservices during the six months ended October 31, 2007 and subsequently (asdiscussed further below).  The segmentgenerated operating income for the year ended April 30, 2007, in theamount of $326,000 (which includes a non-cash charge of $122,000 forstock-based compensation expense) as compared to an operating loss for the yearended April 30, 2006, in the amount of $(5,151,000).  The positive operating income resultedprimarily from our ongoing effort to reduce our reliance on low margin smalldiameter products and diversify into higher margin 300-millimeter products andservices, wafer thinning and custom wafer products.

 

The large-diameterwafer segment has become one of the fastest growing segments of the siliconwafer market and the revenues and gross margins associated with the servicesare greater than those 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 six months ended October 31, 2007 ($1,870,000 of revenue)and 54% of segment revenue for the year ended April 30, 2007 ($7,049,000of revenue), as compared to approximately 36% of segment revenue for the yearended April 30, 2006 ($2,053,000 of revenue).  At the same time, there has also been a focuson operational efficiency and effectiveness, which has resulted in increasedproductivity and processing yields. Further, we continue to gain new customers and are also in the processof attempting to qualify our product at others.

 

While we reported significant revenue and operating income growth in oursemiconductor operations for the year ended April 30, 2007, many of ourtop semiconductor customers experienced weakened business results in recentquarters.  In addition, some customersreported inventory buildup in reclaim and/or test products.  As a result of these two factors, during thesix months ended October 31, 2007, we have seen a slowdown in orders ofreclaim and test materials, which has had a negative impact on our operations.

 

The slowdown significantly impacted our revenues, results of operationsand cash flows for the six months ended October 31, 2007, in which wegenerated an 

 

18

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operating loss of $(959,000) as compared to $(48,000) for the six monthsended October 31, 2006.  The impactof the slowdown in orders on our business is magnified when the results arecompared to the three months ended April 30, 2007, whereby we generatedoperating income of $286,000.

 

In order to minimize the effect of the slowdown, we have implemented manycost cutting measures and are continuing to do so.  It is unclear as to when our customers’demand will rebound but we believe that this is a relatively short-termcondition and are hopeful that we will begin to see a recovery during the nextthree to six months.  While we continueto aggressively pursue and add new customers to mitigate the underlyinguncertainties with our existing customer base, we expect to reflect continueddecreased revenue for the three months ended January 31, 2008 (as comparedto the three months ended January 31, 2007) and the reporting of anoperating loss for the segment.  We continue to monitor the situation closely and while we believe that wewill 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.

 

***Results of Operations***

 

Our results of operations to date have notbeen profitable and, in fact, have resulted in significant losses.  Ourconsolidated revenues in the future will depend primarily on our success inselling products and services in the homeland security and semiconductormarkets.  Our profitability will be dependent uponour ability to manage our costs and to increase our revenues in all of ourbusiness segments.  However, we can offerno assurance that we will be able to increase our revenues or ourprofitability.

 

The following table sets forth, for theperiods 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 January 2007,we elected to discontinue the operation of our life sciences business and toput 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 to the current year presentation.

* *
| ** **                                                                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                | ** ** | **October 31,**   | ** ** | **October 31,** | ** ** |
| ** **                                                                                | ** ** | **2007**               | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues                                                                                  |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                                                                          |       | 92.0                   |       | 75.2                 |       | 88.6 |   | 78.5 |   |
| Gross margin                                                                              |       | 8.0                    |       | 24.8                 |       | 11.4 |   | 21.5 |   |
|                                                                                      |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                                                       |       |                   |       |                 |       |   |   |   |   |
| Selling, general  and administrative                                                      |       | 30.8                   |       | 56.5                 |       | 33.2 |   | 56.0 |   |
| Impairment loss  on intangible assets                                                     |       | 2.4                    |       | —               |       | 1.2 |   | — |   |
| Research and  development                                                                 |       | 2.7                    |       | 10.8                 |       | 9.9 |   | 15.6 |   |
| Total operating  expenses                                                                 |       | 35.9                   |       | 67.3                 |       | 44.3 |   | 71.6 |   |
| Operating loss                                                                            |       | (27.9                  | )          | (42.5                | )          | (32.9 | ) | (50.1 | ) |
|                                                                                      |       |                   |       |                 |       |   |   |   |   |
| Other income (expense), net                                                               |       | (17.9                  | )          | (7.0                 | )          | (20.8 | ) | 7.4 |   |
| Loss from continuing operations before income taxes  and elimination of minority interest |       | (45.8                  | )          | (49.5                | )          | (53.7 | ) | (42.7 | ) |
| Income tax expense                                                                        |       | —                 |       | —               |       | — |   | — |   |
| Minority interest in operations of consolidated  subsidiary                               |       | 0.1                    |       | 0.6                  |       | 0.9 |   | 0.3 |   |
| Loss from continuing operations                                                           |       | (45.7                  | )          | (48.9                | )          | (52.8 | ) | (42.4 | ) |
| Gain (loss) on discontinued operations, net of  income taxes                              |       | —                 |       | (0.7                 | )          | 4.6 |   | (0.1 | ) |
| NET LOSS                                                                                  |       | (45.7                  | )%         | (49.6                | )%         | (48.2 | )% | (42.5 | )% |

 

19

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***Revenues***

 

Revenues from oursecurity services and homeland security products segments increased slightlywhile revenues from our semiconductor products and services segments decreasedfor the three and six months ended October 31, 2007, as compared to thesame periods of our prior fiscal year, as described in the following table:

 

| ** **                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                         | ** ** | **October 31,**   | ** ** | **October 31,** | ** ** |
| ** **                         | ** ** | **2007**               | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Homeland security products         |       | 195,000                |       | —               |       | 195,000 |   | — |   |
| Security services                  |       | 3,866,000              |       | 3,739,000            |       | 7,622,000 |   | 7,616,000 |   |
| Semiconductor products andservices |       | 1,994,000              |       | 3,516,000            |       | 4,107,000 |   | 6,425,000 |   |
| Total                              |       | $                      | 6,055,000  |                 | $          | 7,255,000 |   | $ | 11,924,000 |   | $ | 14,041,000 |   |
|                                    |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

The slightincrease in revenue from the security services segment for the three and sixmonths ended October 31, 2007, is due to the net effect of the loss ofseveral mainly lower margin security services contracts during the currentperiod offset by the addition of new customers as well as by increases in workperformed at certain existing customers. We continue to market our services aggressively by seeking premiumaccounts that prefer higher quality of service.  While we are hopeful that in the long-term we will be able to grow revenuein this segment by securing additional new security contracts in our PPSCsubsidiary and retaining existing customers under contract currently with PPSC,we cannot provide any assurance that we will be able to do so and we may in theshort-term fail to retain certain of our customers.

 

While we reported significant revenue and operating income growth in oursemiconductor operations for the year ended April 30, 2007, many of ourtop semiconductor 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.

 

The slowdown in the semiconductor products and services segmentsignificantly impacted our revenues, which decreased by approximately 36% to$4,107,000 for the six months ended October 31, 2007, as compared to$6,425,000 for the six months ended October 31, 2006.  The impact of the slowdown in orders on ourbusiness is magnified when the results are compared to the three months ended April 30,2007, whereby we recorded revenues of $3,686,000.

 

In order to minimize the effect of the slowdown, we have implemented manycost cutting measures and are continuing to do so.  It is unclear as to when our customers’demand will rebound but we believe that this is a relatively short-term conditionand are hopeful that we will begin to see a recovery during the next three tosix months.  While we continue toaggressively pursue and add new customers to mitigate the underlyinguncertainties with our existing customer base, we expect to reflect continueddecreased revenue for the three months ended January 31, 2008 (as comparedto the three months ended January 31, 2007) and the reporting of anoperating loss for the segment.  We continue to monitor the situation closely and while we believe that wewill 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.

 

20

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Our homelandsecurity products segment recorded $195,000 of revenue for the three and sixmonths ended October 31, 2007, as compared to no revenue during the sameperiods of our prior fiscal year .  Therevenues relate to the installation of fifteen commercial units of ourpanel-mounted IMS-based product in the AirChxsystem manufactured by DualDraw, eight of which were installed during the sixmonths ended October 31, 2007, and seven of which were installed duringthe year ended April 30, 2007.  Theproceeds from the sale of the unitshad been classified as deferred revenue pending completion of certaintasks.  Based upon an agreement signedwith DualDraw during the three months ended October 31, 2007, ourobligations to DualDraw are materially fulfilled and we have recognized therevenue related to the sale of the IMS-based products.

 

In August 2007, we elected to suspendthe development, manufacture and sale of our IMS-based products and, as aresult, we do not anticipate any additional revenues from the sale of homelandsecurity products during our fiscal year ending April 30, 2008, orsubsequently.  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-basedproducts.

 

Although we have diversified our sources of revenue, we continue to haveconcentrations of revenue with certain customers.  For the six months ended October 31,2007, two security services customers accounted for 19% and 12% of revenues,respectively, and one semiconductor products and services customer accountedfor 12% of revenues as compared to the six months ended October 31, 2006,in which two security services customers accounted for 14% and 11% of revenues,respectively, and one semiconductor products and services customer accountedfor 25% of revenues.  Significantreductions in sales to any of these large customers have had, and may in thefuture have, an adverse effect by reducing our revenues and our gross margins.  Present or future customers could terminatetheir purchasing patterns with us or significantly change, reduce or delay theamount of products or services ordered from us.

 

***Gross Margin***

 

Our gross margindecreased for the three and six months ended October 31, 2007, as comparedto the same periods of our prior fiscal year, both on a dollar amount and on apercentage of revenues, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | 483,000    |                                  | $          | 1,797,000 |   | $ | 1,354,000 |   | $ | 3,016,000 |   |
| Percent of revenues |       | 8.0                                     | %          | 24.8                                  | %          | 11.4 | % | 21.5 | % |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

The decrease ingross margin on a percentage basis is due primarily to the downturn in oursemiconductor products and services segment whereby the downturn has lead to asignificant decrease in revenue which has forced us to allocate our fixedfacility costs over a lower base, correspondingly decreasing gross margins on apercentage basis.  To a lesser extent,the decrease on a percentage basis is also due to the provision of lower pricesin order to obtain new or keep existing business.

 

The decrease ingross margin on a dollar basis is due mainly to the decrease in revenue for oursemiconductor products and services segment. As a result of the slowdown in orders of reclaim and/or test wafersduring the six months ended October 31, 2007, and into the three monthsending January 31, 2008 (as discussed above) it is currently unclear if wewill be successful in maintaining or increasing quarterly gross margins (on adollar basis) in our semiconductor products and services segment for the yearending April 30, 2008.

 

21

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On a dollar basis,gross margin is expected to increase correspondingly with increases in revenue,if any, 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 ofrevenue basis, 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 ending April 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 and administrative expenses decreased both as a dollar amount and as apercentage of revenue for the three and six months ended October 31, 2007,as compared to the same respective periods of our prior fiscal year, asreflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | 1,864,000  |                                  | $          | 4,097,000 |   | $ | 3,954,000 |   | $ | 7,865,000 |   |
| Percent of revenues |       | 30.8                                    | %          | 56.5                                  | %          | 33.2 | % | 56.0 | % |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

The $3,911,000 decrease in selling, general and administrative expensesfor the six months ended October 31, 2007, compared to the same period inthe prior year is attributable to a combination of factors, including:

 

·                  approximately$760,000 due to a decrease in staffing and expenditures at the corporateoffice;

·                  approximately$690,000 due to a decrease in staffing and expenditures in the securityservices segment;

·                  approximately$1,220,000 due to a decrease in staffing and operations in the homelandsecurity products segment;

·                  approximately$340,000 due to a decrease in staffing and operations in the semiconductorproducts and services segment;

·                  inclusion inthe six months ended October 31, 2006, of a noncash charge in the amountof $357,000 related to the amendment to the number of shares issuable andexercise price of certain warrants with ratchet provisions;

·                  an approximate$450,000 decrease in noncash stock-based compensation expense.

 

Although we have reduced and are activelyfocused on continuing to reduce selling, general and administrativeexpenditures, we anticipate that our reported selling, general andadministrative expenses will increase during fiscal year 2008 or fiscal year2009 due primarily to stock-based incentive compensation issued as part of aseries of management changes made in February 2007.  No expense has been recognized to daterelated to the option grants made in February 2007 because the newunderlying stock option plan or the proposed increase to an existing underlyingstock option plan have not been approved by shareholders.  There can be no assurance that anticipatedselling, general and administrative expenses will result in increased revenuesfrom product sales.

 

22

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***Impairment Loss on Intangible Assets***

 

Our impairment loss on intangible assetsincreased on both a dollar and a percentage of revenues basis for the three andsix months ended October 31, 2007, as compared to the same periods of ourprior fiscal year, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | 145,000    |                                  | —     |   | $ | 145,000 |   | — |   |
| Percent of revenues |       | 2.4                                     | %          | —                                |       | 1.2 | % | — |   |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |

 

The impairment loss relates to a write off ofthe unamortized balance of the trace and bulk detection technology intangibleasset.  Due to suspension of development,manufacture and sale of our IMS-based products, we determined that the traceand bulk detection technology intangible asset was fully impaired.

 

***Research and Development Expenses***

 

Our research and development expensesdecreased on both a dollar and a percentage of revenues basis for the sixmonths ended October 31, 2007, as compared to the same period of our priorfiscal year, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | 165,000    |                                  | $          | 784,000 |   | $ | 1,182,000 |   | $ | 2,188,000 |   |
| Percent of revenues |       | 2.7                                     | %          | 10.8                                  | %          | 9.9 | % | 15.6 | % |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

The majority of research and developmentexpenses for the six months ended October 31, 2007 and 2006 relateprimarily to (1) the development of next-generation infrared imaging andnight vision surveillance technology through our Lucent relationship and (2) ourIMS technology.  However, due thetermination of the Lucent Agreement and the suspension of development of ourIMS technology, we did not incur material research and development expenseduring the three months ended October 31, 2007 for these projects and wedo not expect to incur material additional research and development expenserelated to these projects throughout the remainder of fiscal year 2008 andbeyond.

 

Historically a significant amount of theresearch and development on the IMS technology was performed by IUT.  We funded $80,000 and $721,000 under ouragreement with IUT for the six months ended October 31, 2007 and 2006,respectively.  As a result of thesuspension of the development, manufacture and sale of our IMS-based products asdescribed above, we expect that future research and development expense withIUT to be minimal.

 

Except for work being performed on oursemiconductor products at our facilities in Vancouver, Washington, we operateno other facilities of our own for research and development.  Although we have in the past expendedsignificant resources on research and development, we cannot offer anyassurance that we will receive future financial benefit from our research anddevelopment efforts made to date.

 

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***Operating(Loss) Income***

 

For the six monthsended October 31, 2007 and 2006, our operating segments incurred operating(loss) income as follows:

 
| ** **                          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|-------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Homeland security products          |       | $                                       | (715,000   | )                                     | $          | (2,124,000 | ) | $ | (2,036,000 | ) | $ | (4,071,000 | ) |
| Security services                   |       | 253,000                                 |       | (20,000                               | )          | 323,000 |   | (294,000 | ) |
| Semiconductor products and services |       | (598,000                                | )          | 151,000                               |       | (959,000 | ) | (48,000 | ) |
| Reconciling amounts (1)             |       | (631,000                                | )          | (1,091,000                            | )          | (1,255,000 | ) | (2,624,000 | ) |
| Total                               |       | $                                       | (1,691,000 | )                                     | $          | (3,084,000 | ) | $ | (3,927,000 | ) | $ | (7,037,000 | ) |

----

(1) Reconciling amounts for theoperating loss information includes corporate expenses consisting primarily ofcorporate salaries and benefits, professional and consulting fees, investorrelations costs, insurance and directors’ compensation. In January 2007, we elected to discontinue the operation of our lifesciences business and put the assets and business up for sale (which was soldin June 2007).  As a result, wereclassified the operations of our life sciences business as discontinuedoperations.  Prior year information hasbeen reclassified to conform to the current year presentation.

 

Our homeland security products segmentgenerated significant operating losses as our effort to develop andcommercialize our IMS technology and our effort to develop next generationinfrared imaging and night vision surveillance technology has not beensuccessful.  As a result of the suspensionof the development, manufacture and sale of our IMS-based products and thecancellation of the Lucent Agreement (both described above), we expect thatfuture operating losses will decrease significantly as we 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 wecan offer no assurance that we will be able to monetize any portion of our IMStechnology investment.

 

For the six monthsended October 31, 2007 and 2006, our security services segment deliveredrevenue of $7,622,000 and $7,616,000, respectively.  The operating income for the six months endedOctober 31, 2007, is due primarily to the benefits received from the costcutting initiatives we implemented at PPSC during the six months ended October 31,2007 (see below for additional discussion). The operating loss for the six months ended October 31, 2006 isinclusive of a write-off of a single customer’s accounts receivable balance inthe amount of $114,000.  Although wecontinue to pursue selected domestic government contracts, we have taken stepsto reduce our spending on sales and marketing in this area.

 

During the fourth quarter of the fiscal year ended April 30, 2007,and the six months ended October 31, 2007, we implemented significant costcutting initiatives that were expected to positively impact the results of PPSC’soperations.  Additionally we initiatedplans to improve operating margins at PPSC by focusing on customers that arewilling to pay for premium security services, where PPSC is able todifferentiate itself from its peers. While we believe that these cost cutting initiatives and refocused salesand marketing efforts will enable PPSC to report positive operating income forthe year ending April 30, 2008, the industry is cost competitive andcustomers switch security service providers on short notice and, therefore, wecan 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,although we have experienced a softening of demand for our products andservices during the six months ended October 31, 2007 and subsequently (asdiscussed further below).  The segmentgenerated operating income for the year ended April 30, 2007, in theamount of $326,000 (which includes a non-cash charge of $122,000 forstock-based compensation expense) as compared to an operating loss for the yearended April 30, 2006, in the amount of $(5,151,000).  The positive operating income resultsprimarily from our ongoing effort to reduce our reliance on low margin smalldiameter products and diversify into higher margin 300-millimeter products andservices, wafer thinning and custom wafer products.

 

24

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The large-diameterwafer segment has become one of the fastest growing segments of the siliconwafer market and the revenues and gross margins associated with the servicesare greater than those 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 six months ended October 31, 2007 ($1,870,000 of revenue)and 54% of segment revenue for the year ended April 30, 2007 ($7,049,000of revenue), as compared to approximately 36% of segment revenue for the yearended April 30, 2006 ($2,053,000 of revenue).  At the same time, there has also been a focuson operational efficiency and effectiveness, which has resulted in increasedproductivity and processing yields. Further, we continue to gain new customers and are also in the processof attempting to qualify our product at others.

 

While we reported significant revenue and operating income growth in oursemiconductor operations for the year ended April 30, 2007, many of ourtop semiconductor 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.

 

The slowdown significantly impacted our results of operations and cashflows for the six months ended October 31, 2007 in which we generated anoperating loss of $(959,000) as compared to an operating loss of $(48,000) forthe six months ended October 31, 2006. The impact of the slowdown in orders on our business is magnified whenthe results are compared to the three months ended April 30, 2007 wherebywe generated operating income of $286,000.

 

In order to minimize the effect of the slowdown, we have implemented manycost cutting measures and are continuing to do so.  It is unclear as to when our customers’demand will rebound but we believe that this is a relatively short-termcondition and are hopeful that we will begin to see a recovery during the nextthree to six months.  While we continueto aggressively pursue and add new customers to mitigate the underlyinguncertainties with our existing customer base, we expect to reflect a significantreduction in revenue for the three months ended January 31, 2008 (ascompared to the three months ended January 31, 2007) and the reporting ofan operating loss for that segment.  We continue to monitor the situation closely and while we believe that wewill 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), net decreased for thethree and six months ended October 31, 2007 and 2006 as both a dollaramount and as a percentage of revenues, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | (1,081,000 | )                                     | $          | (511,000 | ) | $ | (2,483,000 | ) | $ | 1,034,000 |   |
| Percent of revenues |       | (17.9                                   | )%         | (7.0                                  | )%         | (20.8 | )% | 7.4 | % |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

For the six monthsended October 31, 2007, other income (expense), net consists of interestexpense of $(2,926,000), the amortization of debt issuance costs of $(87,000)and equity in the net loss of an investee of $(80,000) partially offset byinterest and other income of $99,000 and a gain on derivative instruments of$504,000.  Included in interest expensefor the six months ended October 31, 2007 are non-cash charges of$2,752,000 related primarily to the amortization of the discount and theaccrual of interest on our outstanding convertible debentures.

 

For the six monthsended October 31, 2006, other income (expense), net consists of therecording of a gain on derivative instruments in the amount of $2,320,000related to the change in fair value of the two derivative liabilities which werecorded in our condensed consolidated balance sheets, equity in the net

 

25

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income of aninvestee of $10,000 and the recording of a gain on extinguishment of debt inthe amount of $227,000, which resulted from the retirement of $3,880,000 inprincipal amount of 8% Debentures partially offset by $(1,419,000) of interestexpense and $(159,000) of amortization of debt issuance costs.

 

We expect that ourother expenses will be volatile based on the future timing of repayment , ifever, of the remaining convertible debentures (see the Liquidity and CapitalResources discussion below) and the fluctuations in fair value of andclassification of the instruments underlying our derivative liabilities.

 

***Income Taxes***

 

We currentlyoperate at a loss and expect to operate at a loss until (if ever) ouroperations begin to generate sufficient revenue. The losses incurred in thecurrent year are not expected to generate an income tax benefit because of theuncertainty of the realization of the deferred tax asset. As a result, we haveprovided a valuation allowance against our net deferred tax asset because,based on available evidence including our continued operating losses, it ismore likely than 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 Operationsof Consolidated Subsidiary***

 

Minority interest in operations ofconsolidated subsidiary for the three and six months ended October 31,2007 and 2006 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | 11,000     |                                  | $          | 42,000 |   | $ | 111,000 |   | $ | 42,000 |   |
| Percent of revenues |       | 0.1                                     | %          | 0.6                                   | %          | 0.9 | % | 0.3 | % |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

The amount of minority interest in operationsof consolidated subsidiary recorded for the six months ended October 31,2007, relates to our purchase of a 90% interest in SenseIt in October 2006and the subsequent operation of the business. Due to the cancellation of the Lucent Agreement, we do not expectminority interest in operations of SenseIt to be material in future periods.

 

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

 

Gain on discontinued operations, net ofincome taxes increased on both a dollar and a percentage of revenues basis forthe six months ended October 31, 2007, as compared to the same period ofour prior fiscal year as reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | —                                  |       | $                                     | (48,000    | ) | $ | 553,000 |   | $ | (12,000 | ) |
| Percent of revenues |       | —                                  |       | (0.7                                  | )%         | 4.6 | % | (0.1 | )% |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |

 

In January 2007, we decided todiscontinue the operation of our life sciences business and to put the assetsand 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 treatthe operations of the life sciences business as discontinued operations wherebythe net 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 for the six months ended October 31,2007 as compared to a loss, net of income taxes, in 

 

26

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the amount of $(12,000) for the six monthsended October 31, 2006.  The gain onsale of the life sciences business was recorded in the six months ended October 31,2007, in the amount of $516,000.  Revenuefor the life sciences business, reported in the single line item of gain onoperations of discontinued operations, net of income taxes, was $101,000 and$1,193,000 for the six months ended October 31, 2007 and 2006,respectively.

 

***Net Loss***

 

Net loss for the three and six months ended October 31,2007 and 2006 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2007**                                | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                       | (2,761,000 | )                                     | $          | (3,601,000 | ) | $ | (5,746,000 | ) | $ | (5,973,000 | ) |
| Percent of revenues |       | (45.7                                   | )%         | (49.6                                 | )%         | (48.2 | )% | (42.5 | )% |
|                     |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

We anticipate that consolidated losses willcontinue until (if ever) revenues from our current operations substantiallyincrease or we increase the scope of our operations through merger, acquisitionor other means.  Further, the revenueincreases must increase faster than any increases in operating and research anddevelopment expenses.  Additionally, weexpect that our consolidated net loss will continue as we continue to workthrough the downturn in the semiconductor market.  As noted above, we have suspended developmentand marketing of our IMS-based products and we have suspended operations at ourSenseIt subsidiary due to the cancellation of the Lucent Agreement.  Therefore, we can offer no assurance that wewill be able to proceed with either of these projects or that the development andcommercialization of these technologies will ever occur.

 

We anticipate thatour operations during the remainder of fiscal year 2008 will result in a netloss since we are not likely to increase our revenues from our existingproducts or generate additional sales from the new products we may develop in asufficient amount (if at all) to offset our operating and research anddevelopment expenses.

 

**Liquidity and Capital Resources**

 

During the past several years, we have attimes had significant liquidity and working capital shortages, although we havebeen able to pay our core obligations as they have become due.  Included in the following table are condensedconsolidated balance sheet items as of October 31, 2007 and April 30,2007 and condensed consolidated cash flow items for the six months ended October 31,2007 and 2006:

 

| ** **                                                   | ** ** | **As of**                | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|
| **(in thousands)**                                           | ** ** | **October 31,2007** | ** ** | **Change** | ** ** | **April 30,2007** | ** ** |
| Cash and cash equivalents                                    |       | $                        | 753        |   | $ | (803 | ) | $ | 1,556 |   |
|                                                         |       |                     |       |   |   |   |   |
| Working capital                                              |       | $                        | 1,166      |   | (2,144 | ) | 3,310 |   |
|                                                         |       |                     |       |   |   |   |   |
| Current convertible debentures, net of discount              |       | $                        | —     |   | — |   | — |   |
| Convertible debentures, net of discount and current  portion |       | 10,206                   |       | 1,572 |   | 8,634 |   |
| Total  convertible debentures, net of discount               |       | $                        | 10,206     |   | $ | 1,572 |   | $ | 8,634 |   |
|                                                         |       |                     |       |   |   |   |   |
| Total  convertible debentures, face value outstanding        |       | $                        | 18,000     |   | $ | — |   | $ | 18,000 |   |

 

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| ** **                                           | ** ** | **Six months ended**      | ** ** |
|------------------------------------------------------|------------|---------------------------|------------|
| ** **                                           | ** ** | **October  31,2007** | ** ** | **Change** | ** ** | **October  31,  2006** | ** ** |
| Net cash used in operating activities                |       | $                         | (815       | ) | $ | 4,942 |   | $ | (5,757 | ) |
| Net cash provided by (used in) investing activities  |       | 786                       |       | 2,052 |   | (1,266 | ) |
| Net cash (used in) provided by financing activities  |       | (774                      | )          | (7,664 | ) | 6,890 |   |
| Net (decrease) increase in cash and cash equivalents |       | $                         | (803       | ) | $ | (670 | ) | $ | (133 | ) |

 

Working Capital

 

Our working capital was $1,166,000 as of October 31,2007, as compared to working capital of $3,310,000 as of April 30, 2007.This $2,144,000 decrease in working capital for the six months ended October 31,2007, is due to a combination of factors, of which the significant factors areset out below:

 

        Factors which increasedworking capital

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

·                  net cash of$60,000 received from the assignment of our silicon-28 license (see Note 10 tothe accompanying condensed consolidated financial statements).

 

Factorswhich decreased working capital

·                  $2,425,000 ofcash consumed directly in operating activities (calculated as $815,000 of cashused in operating activities, increased by $1,610,000 of the cash impact of netchanges in other current assets or liabilities included therein);

·                  $79,000 relatedto purchases of fixed assets;

·                  $152,000representing the current portion of capital lease entered into during the sixmonths ended October 31, 2007;

·                  $273,000 inreclassification of capital leases from long-term to current;

·                  $210,000 inpayments on notes payable entered into for insurance during the six monthsended October 31, 2007, in excess of the related unamortized prepaidinsurance balance.

 

Based on the amountof capital we have remaining and our expected negative cash flow fromoperations and investing activities, we anticipate that we will not be able topositively impact our working capital unless we are able to substantiallyincrease our revenues or reduce our expenses thereby generating positive cashflow from operations and (ultimately) operating income.   We believe we have sufficientworking capital to finance our anticipated operations and projected negativecash flow only into our quarter ending April 30, 2008, unless we are ableto achieve 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.

 

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Convertible Debentures

 

Selected information regarding the 13%Debentures follows (dollars in thousands):

 
| ** **                                        | ** ** | **2006  Debentures**                   | ** ** | **April 2007Debenture** | ** ** | **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 October 31, 2007: |       |                                   |       |                         |       |      |       |
| Face value                                        |       | $                                      | 16,000     |                         | $          | 2,000     |       | $ | 18,000 |   |
| Accrued interest                                  |       | 1,899                                  |       | 145                          |       | 2,044     |       |
| Total liability                                   |       | $                                      | 17,899     |                         | $          | 2,145     |       | $ | 20,044 |   |

 

Subsequent to October 31,2007, we did not meet certain non-financial requirements under the 13%Debentures and their holder may potentially be able to, in its discretion,declare an Event of Default. Additionally, an Event of Default under any one of the 13% Debentureswould allow the holder to declare an Event of Default under all of the 13%Debentures.  Remedies for an Event ofDefault include the option to accelerate payment of the full principal amountof the 13% Debentures, together with interest and other amounts due (acumulative amount of $20,044,000 at October 31, 2007), to the date ofacceleration and the holder will have the right to request such payment in cashor in shares of our common stock.  If theholder of the 13% Debentures declares an Event of Default, it is possible thatwe will not be able to cure the default or contest any efforts that the holdermay take to foreclose against its security interest in substantially all of ourassets.

 

Cash Flows

 

As of October 31, 2007, we had $753,000 of cash and cashequivalents, a decrease of $803,000 as compared to $1,556,000 at April 30,2007. Our principal source of funding for the six months ended October 31,2007 was from the existing working capital as of April 30, 2007, alongwith the $805,000 (net of selling costs of $45,000) received for the sale ofour life sciences business in June 2007.  Our principal source of funding for the six months ended October 31,2006 was from the issuance of the 2006 Debentures (with a face amount of$13,000,000) for which we received net proceeds of $12,270,000.

 

Cash used in operating activities of$(815,000) and $(5,757,000) for the six months ended October 31, 2007 and2006, respectively, was primarily the result of a net loss of $(5,746,000)(which included noncash expenses and gains in the net amount of a $2,050,000expense) and of $(5,973,000) (which included noncash expenses and gains in thenet amount of a $1,106,000 expense), respectively.

 

Investing activities provided cash of$786,000 and used cash of $(1,266,000) for the six months ended October 31,2007 and 2006, respectively. Cash provided by investing activities for the sixmonths ended October 31, 2007, consisted of $805,000 (net of selling costsof $45,000) received for the sale of our life sciences business in June 2007and $60,000 from the assignment of our silicon-28 licenses offset by $79,000expended on additions of property and equipment.  Cash used in investing activities for the sixmonths ended October 31, 2006, consisted of $1,166,000 expended onadditions of property and equipment and $100,000 expended on a 9% equityinvestment in a business (which investment was subsequently written off in itsentirety).

 

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Financing activities used cash of $(774,000)and provided cash of $6,890,000 for the six months ended October 31, 2007and 2006, respectively. Cash used in financing activities for the six monthsended October 31, 2007, consisted of payments of principal on capitalleases and notes payable in the amounts of $230,000 and $544,000,respectively.  Cash provided by financingactivities for the six months ended October 31, 2006, resulted primarilyfrom the issuance of the 6% Debentures, which yielded net proceeds of$12,270,000 offset primarily by principal payments on borrowings of $5,388,000.

 

Additional LiquidityConsiderations

 

As of October 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 if 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.   These warrants expire in February 2008.

 

As of October 31, 2007, we had no commitments outstanding forcapital expenditures.  Further, due tothe cancellation of the Lucent Agreement, wehave no further commitments under that contract.

 

On December 6, 2007, we received aletter from the Nasdaq stating that it had determined to delist our securitiesfrom Nasdaq.  Trading in our shares onthe Nasdaq Capital Market was suspended effective with the open of business on December 10,2007.  Nasdaq’s decision was rendered following a hearing held before a NasdaqListing Qualifications Panel on November 29, 2007.  We are working with our market makers and arehopeful that our common stock will be enabled for trading on the OTC BulletinBoard.

 

The assumptions underlying the abovestatements include, among other things, that there will be no material adversedevelopments in the business or market in general. There can be no assuranceshowever that those assumed events will occur. If our plans are not achieved,there may be further negative effects on the results of operations and cashflows, which could have a material adverse effect on our financial position.

 

***Off-Balance Sheet Arrangements***

 

We have no material changes to the disclosureon this matter made in our Annual Report on Form 10-K for the year ended April 30,2007.

 

***Critical Accounting Estimates***

 

We consider an accounting estimate to becritical if 1) the accounting estimate requires us to make assumptions aboutmatters that were highly uncertain at the time the accounting estimate wasmade, and 2) changes in the estimate that are reasonably likely to occur fromperiod to period, or use of different estimates that we reasonably could haveused in the current period, would have a material impact on our financialcondition or results of operations.

 

Management has discussed the development andselection of these critical accounting estimates with the Audit Committee ofour Board of Directors and the Audit Committee has reviewed the foregoingdisclosure.  In addition, there are otheritems within our financial statements that require estimation, but are notdeemed critical as defined above. Changes in estimates used in these and other items could have a materialimpact on our financial statements.

 

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*Goodwill and Intangible Assets*

 

Goodwill is recorded onour books for acquisitions where the purchase price is in excess of thecumulative fair values of the identified tangible and intangible assets.  The assignment of fair value to theidentified tangible and intangible assets requires significant judgment and mayrequire 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.

 

In accordance with SFAS No. 142*Goodwill and Other Intangible Assets*,goodwill is not amortized, but instead is tested for impairment on an annualbasis or more frequently if the presence of certain circumstances indicates thatimpairment may have occurred.  Theimpairment review process, which is subjective and requires significantjudgment at many points during the analysis, compares the fair value of thereporting unit in which goodwill resides to its carrying value.  If the carrying value of a reporting unitexceeds its fair value, then the amount of the impairment loss must bemeasured. The impairment loss is calculated by comparing the implied fair valueof reporting unit goodwill to its carrying amount. In calculating the impliedfair value of reporting unit goodwill, the fair value of the reporting unit isallocated to all of the other assets and liabilities of that unit based ontheir fair values. The excess of the fair value of a reporting unit over theamount assigned to its other assets and liabilities is the implied fair valueof goodwill. An impairment loss would be recognized when the carrying amount ofgoodwill exceeds its implied fair value. We have goodwill in the amount of$3,631,000 on our condensed consolidated balance sheet as of October 31,2007, related to the acquisition of PPSC in May 2005.  During the three months ended January 31,2007, we performed our annual impairment review on the aforementioned goodwilland concluded that the goodwill is not impaired.

 

For intangible assetsother than goodwill, SFAS No. 144 *Accountingfor the Impairment or Disposal of Long-Lived Assets* (“SFAS 144”) is the authoritative standard on theaccounting for the impairment of such intangible assets.  As required, we perform tests for impairmentof intangible assets other than goodwill whenever events or circumstancessuggest that such assets may be impaired. To evaluate potential impairment, SFAS No. 144 requires us toassess whether the future cash flows related to these assets will be greaterthan their carrying value at the time of the test. Accordingly, while our cashflow assumptions are consistent with the plans and estimates we are using tomanage the underlying businesses, there is significant judgment in determiningthe cash flows attributable to our other intangible assets over theirrespective estimated useful lives.  Wehave remaining other net intangible assets in the amount of $78,000 on ourcondensed consolidated balance sheet as of October 31, 2007, comprised of  the customer base acquired in our acquisitionof PPSC in May 2005.  We arerequired to periodically evaluate our other intangible assets balances forimpairments.  Dueto our election to suspend operations regarding our IMS-based products, duringthe three months ended October 31, 2007, we reviewed for impairment thetrace and bulk detection technology intangible asset associated with the IMStechnology.  We determined that thecarrying amount of the intangible asset was not recoverable and its carryingamount exceeded its fair value, as determined using the expected present valueof future cash flows.  As such, duringthe three months ended October 31, 2007, we recognized an impairment lossin the amount of $145,000, such impairment loss representing the full carryingvalue of the intangible asset prior to impairment.  If we were to incur additional impairments to ourother intangible assets, it could have an adverse impact on our futureearnings, if any.

 

*Valuationof Equity Transactions*

 

We value transactionsassociated with common or preferred stock that is convertible into common stockbased on the market value of the underlying common stock on the date of thesigning of the agreement (or, sometimes, at the date of conversion). We valuetransactions associated with common stock warrants at the appropriatemeasurement date utilizing at a minimum, the Black-Scholes pricing model, withassumptions as to volatility, risk-free interest rate and estimated life of thewarrants based on historical information related to the life of the underlyingwarrant. If the assumptions used, as they relate to volatility, risk-freeinterest rate and estimated life of the warrants, were materially different,the overall valuation of these transactions could change significantly.

 

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*Valuationof Convertible Debenture Transactions*

 

We enter intotransactions that include debentures that are convertible into common stock atrates that may be fixed or variable and also include detachable common stockwarrants.  We allocate the proceeds fromthe debenture transactions based on the estimated fair values of the debenturesand the warrants.  If the assumptionsused, as they relate to volatility, risk-free interest rate and estimated lifeof the warrants (including any anti-dilution adjustment provisions) and thefair value of the debentures (included the specific conversion features) werematerially different, the overall allocation of proceeds for these transactionscould change significantly.  Further, attimes we have classified certain embedded conversion features or warrantsissued in convertible debenture transactions as derivative liabilities inaccordance with US GAAP.  The estimatesof fair value of these derivative liabilities involve complex assumptions inthe initial recording of the liabilities and in the mark-to-market required foreach reporting period.  If theassumptions used to determine the fair value of these liabilities were materiallydifferent, the valuation of the liabilities could change significantly.

 

*Stock-BasedCompensation Expense*

 

We account forstock-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 pricevolatility, forfeiture rates and expected lives, requires judgment that couldmaterially impact our operating results.

 

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

 

We are exposed to market risk related tochanges in interest rates, equity security market values, foreign currencyrates and the market price of our common stock.

 

Interest Rates

 

Our investment portfolio consists of cash andcash equivalents (in the amount of $753,000 as of October 31, 2007), allof 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 approximately 0.5% at October 31,2007) may vary based on fluctuations in the prevailing interest rate.

 

Equity Securities

 

We do not hold any investments in marketableequity securities.  However, we holdinterests in various wholly- and partially-owned subsidiaries.  These securities are non-marketable.  Our investment in these subsidiaries may beimpacted by the underlying economic conditions of the entity, including theability to raise additional capital and the likelihood of our being able torealize our investments through liquidity events such as initial publicofferings, mergers or private sales. These investments involve a great deal of market risk, and there can beno assurance that a specific company will grow or become successful.  Consequently, we could lose all or part ofour investment.  Additionally, becauseIUT is located in Germany, our investment in the entity (and our share of theirearnings or losses) may be impacted by changes in foreign currency rates.  The carrying amount of this investment is $303,000as of October 31, 2007.

 

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DerivativeInstruments

 

We do not purchase derivative instruments onthe open market.  However, in accordancewith current US GAAP, we have classified certain warrants as derivativeinstruments (a $517,000 current liability at October 31, 2007).  Classification as derivative liabilities wasrequired because there is a possibility that the instruments could be requiredto be settled on a net cash basis.  Weare required to mark these instruments to market as of the end of eachreporting period and to recognize the change in fair value in our condensedconsolidated statements of operations. Our stock price has been historically volatile and the fair values ofthese instruments are sensitive to changes in our underlying stock price.  As such, the carrying amount of theseinstruments may be volatile from period to period.  For the six months ended October 31,2007, we recorded a gain on derivative instruments in the aggregate amount of$504,000 such amount representing the change in fair value between April 30,2007, and October 31, 2007.  SeeNote 9 to the consolidated financial statements located in Item 8. “FinancialStatements and Supplementary Data” of our Form 10-K for the year ended April 30,2007, for a more detailed discussion of the derivative instruments.

 

**Item 4: Controls and Procedures**

 

Our management, with the participation of ourprincipal executive officer and our principal financial officer have evaluatedthe effectiveness of our disclosure controls and procedures as required byExchange Act Rule 13a-15(b) as of October 31, 2007 (the end ofthe period 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 and procedures arecontrols and other procedures that are designed to ensure that informationrequired to be disclosed in our reports filed or submitted under the SecuritiesExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms.  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.

 

There were nochanges in our internal control over financial reporting during the threemonths ended October 31, 2007, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**Part II: Other Information**

** **

**Item 1:  Legal Proceedings**

** **

None.

** **

**Item 1A: Risk Factors**

** **

*In addition**to the other information set forth in this report, youshould carefully consider the following factors, which could materially affectour business, financial condition or future results.  The risks described below are not the onlyrisks we face.  Additional risks and uncertaintiesnot currently known to us or that we currently deem to be immaterial also maymaterially adversely affect our business, financial condition or results ofoperations.*

 

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**We have historically had workingcapital shortages, even following significant financing transactions and wereceived an opinion from our auditors indicating a substantial doubt regardingour ability to continue as a going concern.**

 

We have had workingcapital shortages in the past and, although we raised capital totaling morethan $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, whichhave impacted working capital.  As of October 31,2007, our condensed consolidated balance sheet reflects working capital of$1,166,000.  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 withour financial statements for the year ended April 30, 2007 included anexplanatory paragraph indicating substantial doubt about our ability tocontinue as a going concern.

 

Based on the amountof capital we have remaining and our expected negative cash flow fromoperations and investing activities, we anticipate that we will not be able topositively impact our working capital unless we are able to substantiallyincrease our revenues or reduce our expenses thereby generating positive cashflow from operations and (ultimately) operating income.  We believe we have sufficientworking capital to finance our anticipated operations and projected negativecash flow only into our quarter ending April 30, 2008, unless we are ableto achieve 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.

 

**If the holder of our April 2007 Debenture or2006 Debentures declares an Event of Default we may not be able to cure orcontest such a default**

 

Subsequent to October 31,2007, we did not meet certain non-financial requirements under the 13%Debentures and their holder may potentially be able to, in its discretion,declare an Event of Default. Additionally, an Event of Default under any one of the 13% Debentureswould allow the holder to declare an Event of Default under all of the 13%Debentures.  Remedies for an Event ofDefault include the option to accelerate payment of the full principal amountof the 13% Debentures, together with interest and other amounts due (acumulative amount of $20,044,000 at October 31, 2007), to the date ofacceleration and the holder will have the right to request such payment in cashor in shares of our common stock.  If theholder of the 13% Debentures declares an Event of Default, it is possible thatwe will not be able to cure the default or contest any efforts that the holdermay take to foreclose against its security interest in substantially all of ourassets.

 

**Ourability to obtain further necessary financing is limited.**

 

We havehistorically financed our operating losses and cash flow deficits throughprivate placements of our equity and debt securities.  Our outstanding 13% Debentures containsignificant restrictions on our ability to raise any additional capital for solong as the convertible debentures are outstanding.  While ultimately our ability to finance ouroperations will depend on our ability to generate revenues that exceed ourexpenses, we have short-term needs for significant additional financing whichmay not be available because of the outstanding debentures, as well as thesignificant number of outstanding options and warrants which contain adjustmentprovisions should we issue shares of our common stock at prices below thecurrent exercise prices.  We do notbelieve that we will be able to obtain additional financing without thecooperation of our principal debenture holder. Although we have had numerous discussions with our principal debentureholder, we cannot offer any assurance that it will take the steps necessary forus to obtain the financing we need to continue our business operations throughthe current fiscal year.  Ultimately ouronly source of additional capital may be the holder of our outstandingdebentures, and if that holder declines (for any reason) to invest additionalamounts into Isonics, we may not be able to continue as a going concern.

 

**Oursecurities were delisted from the Nasdaq Capital Market and such delisting mayadversely impact our ability to raise capital.**

 

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On December 6, 2007, we received aletter from the Nasdaq stating that it had determined to delist our securitiesfrom Nasdaq.  Trading in our shares onthe Nasdaq Capital Market was suspended effective with the open of business on December 10,2007.  Nasdaq’s decision was rendered following a hearing held before a NasdaqListing Qualifications Panel on November 29, 2007.  Because our financingactivities are dependent to a large extent on eventual liquidity for theinvestors, the delisting will make future financing activities significantlymore difficult and may raise liquidity issues for current investors.

 

**We have three business segmentsand, for the six months ended October 31, 2007, two of our three segmentsoperated at a loss.**

 

For the six monthsended October 31, 2007 and 2006, our operating segments incurred operating(loss) income as follows:

 

| ** **                          | ** ** | **Six months ended October 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|
| ** **                          | ** ** | **2007**                              | ** ** | **2006** | ** ** |
| Homeland security products          |       | $                                     | (2,036,000 | ) | $ | (4,071,000 | ) |
| Security services                   |       | 323,000                               |       | (294,000 | ) |
| Semiconductor products and services |       | (959,000                              | )          | (48,000 | ) |
| Reconciling amounts                 |       | (1,255,000                            | )          | (2,624,000 | ) |
| Total                               |       | $                                     | (3,927,000 | ) | $ | (7,037,000 | ) |

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(1) Reconcilingamounts for the operating loss information includes corporate expensesconsisting primarily of corporate salaries and benefits, professional andconsulting fees, investor relations 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 thatthese losses (on a consolidated basis) will continue for the foreseeablefuture.  As described in the next riskfactor, unless we are able to sell new products and services profitably, we maybe unable to remain competitive and it is likely that our losses and negativecash flow will continue.

 

**Unless we are able to sell ourproducts and services profitably, we may be unable to remain competitive,furthering the likelihood that our losses and negative cash flow will continue.**

 

Our ability togenerate positive cash flow, additional revenues, and ultimately net income, isdependent upon the success of our homeland security services and semiconductoroperations.  We have discontinueddevelopment of our IMS-based products and our agreement with Lucent has beencancelled.

 

While we reported significant revenue and operating income growth in oursemiconductor operations for the year ended April 30, 2007, many of ourtop semiconductor 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.

 

The slowdown significantly impacted our results of operations and cashflows for the six months ended October 31, 2007, in which we generated anoperating loss of $(959,000) as compared to $(48,000) for the six months ended October 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.  Wecontinue to monitor the situation closely and while we believe that we will seeimproving financial results in this operating segment

 

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(over thelong-term), we cannot offer any assurance that we will be able to regain orsustain operating profitability in future periods.

 

Wehave had minimal success in marketing our homeland security products, havingsold to date only fifteen units of our panel-mounted IMS-based product.  In August 2007, we elected to suspendthe 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-basedinvestment.

 

**We have issued securities during the years ended April 30, 2007,2006 and 2005, and subsequently which has resulted (and will in the future whenwarrant exercises or conversions occur) in dilution to our existingshareholders.  This was accomplished toprovide necessary working capital or obtain assets and services.  We will likely issue more securities to raiseadditional capital or to obtain other services or assets, any of which mayresult in substantial additional dilution.**

 

During the course of the last threefiscal years, we have raised in excess of $45,800,000 (net of expenses and$4,100,000 of payments related to our 8% Debentures) to finance our businessoperations and acquisitions. We have also issued a number of shares, options,and warrants, to acquire services and assets from third parties and pursuant toour stock option plans.  If possibleunder terms that we believe to be appropriate given our financial condition andother circumstances (including our existing capital structure), we hope toraise additional financing 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 former holders of a portionof the then outstanding 8% Debentures have asserted that a default existed.**

 

Two entities who held 8% Debentures (whichwere paid in full as of February 1, 2007) have previously asserted thatthe issuance of the 13% Debentures constituted a default (due to a potentialvariable conversion provision contained within the 13% Debentures which givesthe 13% Debenture holder the right to convert the 13% Debentures into commonstock at the lower of $5.00 or at a discount to market, subject to certainlimitations 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 in court ifnecessary.  Although we have not had anyfurther communication from the former holders regarding this issue other thanthe allegation of default, any litigation would be time consuming and expensiveand, although we believe that we have significant grounds to contest theexistence 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 $1,225,000,including accrued interest).

 

**Accounting charges result******ing from ourissuance of the 13% Debentures may lead to significant non-cash charges whichwould adversely impact future interest expense, net income and earnings pershare and may also lead to future volatility in our financial statementcomponents.****

 

As a result of the issuance of the 13%Debentures, we will be required to record significant non-cash interest chargesover the life of the 13% Debentures 

 

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(in addition to interest expense relating tothe 13% interest rate borne by the 13% Debentures which will be paid in cash orshares of our common stock, at our option).  This will likely result in asignificant adverse impact to future net income and earnings per share and willlikely introduce additional volatility to our future operating results.

 

**Historically we depended upon fewcustomers for a significant portion of our revenues and our business could havebeen materially and adversely affected if we lost any one of those customers.**

 

We have been dependent ona few significant customers who have purchased our products or services inamounts greater than 10% of our consolidated revenues.  A decision by any significant customer tosubstantially decrease or delay purchases from us or an inability to collectsignificant amounts owed to us could have a material adverse effect on ourconsolidated financial condition and results of operations.

 

**We realized increased expenses,reduced revenues and longer than anticipated delays in integrating pastbusiness acquisitions into our operations, and we may face similar difficultieswith future acquisitions as well.**

 

We experiencedincreased costs and delays in integrating the operations of the business andassets we acquired from EnCompass Materials Group, Ltd. (“EMG”) in June 2004,and we also realized revenues that were significantly reduced from that whichwe had anticipated which adversely affected the operations of our semiconductordivision.  Regardless of the extent ofour planning, we may recognize increased costs and delays, and reducedrevenues, when integrating future business acquisitions into our business operationsand strategy.  While we believe that wehave and will continue to plan for integration of acquired business operationsto the best of our ability, we cannot offer any assurance that any or all suchefforts will proceed as anticipated.

 

**If demand for any of our productsgrows suddenly, we may lack the resources to meet demand or we may be requiredto increase our capital spending significantly.**

 

If we are able todevelop and market our products successfully, we may experience periods ofrapid growth that place a significant strain on our financial and managerialresources.  Our ability to manage growtheffectively will require us to continue to implement and improve ourmanagement, operational and financial information systems, and will require usto develop the management skills of our personnel and to train, motivate andmanage our employees.  Our failure toeffectively manage growth could increase our costs of operations and reduce ourmargins and liquidity, which could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

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

 

Our future success will depend in significantpart upon the continued service of our key technical, sales and seniormanagement personnel and consultants, including Christopher Toffales, ourChairman of the Board. Currently Mr. Toffales is covered by a two-yearemployment agreement that is renewable on an annual basis.  Webelieve that our future success will also depend upon our ability to attractand retain other qualified personnel for our operations.  The failure to attract or retain such personscould materially adversely affect our business, financial condition and resultsof operations.

 

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

 

We rely primarily on acombination of trade secrets, confidentiality procedures, contractualprovisions to protect our technology and patents and patent applications.  Despite our efforts to protect ourtechnology, unauthorized parties may attempt to copy aspects of 

 

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our products or toobtain 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 the patents licensedto us, or that may in the future be owned by us, may not be upheld ifchallenged 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 bematerially and adversely affected.

 

**We face technological change and intensecompetition both domestically and internationally which may adversely affectour ability to sell our products profitably.**

 

The markets for our homeland security andsemiconductor products and services are characterized by rapidly evolvingtechnology and a continuing process of development. Our future success willdepend 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.

 

**Our semiconductor products and services segment isdependent on the performance of several key pieces of equipment.  If any of these items were not to perform totheir ability or were taken out of service for any significant amount of time,our ability to produce product would be severely compromised.**

 

The performance of our semiconductor productsand services segment is directly tied to the performance of several key piecesof equipment, which are typically intricate and expensive.  The average time between failures istypically long and the corresponding time for repair is typically short; as aresult, most of the time the issues are routine and are quickly repaired.However, this is not always the case and there have been times in the past whencritical tools have been out of service for a period of time, which had anegative impact on revenues in the short term. Further, due to our historical working capital shortages and thesignificant historical net losses, we are unable to purchase the necessaryequipment redundancy.  Any futureequipment issues could have a significant impact on our ability to produce andship the products to our customers, thereby potentially impacting both ourrevenues and related cash flows.

 

**We could be subject toenvironmental regulation by federal, state and local agencies, including lawsthat impose liability without fault, which could produce working capitalshortages and lessen stockholders’ equity.**

 

Our IMS-based productsuse radioactive sources.  As a result, weare subject to a variety of federal, state, and local environmental regulationsrelating to the use, storage, discharge and disposal of hazardous chemicalsused during manufacturing processes. Regulations that become applicable to our operations in the future couldrestrict our ability to expand our facilities or could require us to acquirecostly equipment or to incur other significant expenses to comply withgovernmental regulations.  Historically,our costs of compliance with environmental regulations have not beensignificant because we use licensed 

 

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manufacturers inconnection with the manufacture of these products.

 

**We are controlled by our Board ofDirectors; individual purchasers of our shares will have little ability toelect directors or control our management.**

 

Our shares are widely-held, and our managementbeneficially owns our securities in an amount less than 10% of the outstandingvotes at any shareholders’ meeting. Nevertheless, it is likely that the Board of Directors will be able toinfluence all matters submitted to stockholders for approval, including theelection and removal of directors and any merger, consolidation or sale ofsubstantially all of our assets, and to control our management andaffairs.  Such control may have theeffect of delaying, deferring or preventing a change in control, impeding amerger, consolidation or takeover or other business combination involving us ordiscouraging a potential acquirer from making a tender offer or otherwiseattempting to obtain control of our business, even if such a transaction wouldbe beneficial to other stockholders.

 

**We risk exposing ourselves to anabove-policy limit product liability claim, which could adversely affect ourworking capital, shareholders’ equity and profitability.**

 

Our prior sale and use of explosive and chemical detection products mayexpose us to potential liability risks that are inherent with the operation ofthese types of products (including, but not limited to failed detection).  We currently have product liabilityinsurance; however, there is a risk that our insurance would not covercompletely or would fail to cover a claim, in which case we may not have thefinancial 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 topricing and purchasing actions that are beyond our control and, therefore,persons acquiring or holding our shares or warrants may be unable to reselltheir shares at a profit as a result of this volatility.**

 

The trading priceof our securities has been subject to wide fluctuations in response toquarter-to-quarter variations in our operating results, our announcements oftechnological innovations or new products by us or our competitors, delays inour product development and marketing, and other events and factors over whichwe have no influence or control. The securities markets themselves haveexperienced significant price and volume fluctuations that may be unrelated tothe operating performance of particular companies. Regulatory developments inthe United States and foreign countries, public concern as to the safety ofproducts containing radioactive compounds, economic and other external factors,all affect the market price of our securities. *Inaddition, the realization of any of the risks described in these “Risk Factors”could have a significant and adverse impact on such market prices*.

 

**SEC pennystock regulations may limit the ability to trade our securities.**

 

Because Nasdaq delistedour securities from the Nasdaq Capital Market, our common stock is 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. Our stock is includedwithin the SEC Rule 3a-51 definition of a penny stock and, as such,trading is covered by Rule 15g-9 promulgated under the Securities ExchangeAct of 1934, adding a significant amount of broker-dealer compliance totransactions in penny stocks.  Manybrokers are unwilling to engage in transactions in penny stocks and, therefore,the marketability of our securities may weaken significantly.

 

Wecannot give any assurance that  a stabletrading market will develop for our stock. See “Oursecurities were delisted from the Nasdaq Capital Market and such delisting mayadversely impact our ability to raise 

 

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capital” for additional riskfactors associated with potential Nasdaq listing deficiencies.

 

**Future sales of our common stockmay cause our stock price to decline.**

 

Our stock price has declined from a price ofapproximately $24.00 (adjusted for the reverse split) per share at thebeginning of 2005 to prices of less than $0.25 (adjusted for the reverse split)at various times since May 2006. Our stock price may decline further as aresult of future sales of our shares, the perception that such sales may occur,our financial or operational performance, or other reasons.  As of December 12, 2007, less than650,000 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 95% of the restricted shares ofour common stock are either eligible for sale pursuant to Rule 144 or havebeen registered under the Securities Act for resale by the holders.  We are unable to estimate the amount, 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 have never paid any cash dividends on ourcommon stock and we do not anticipate paying cash dividends on our common stockin the foreseeable future.**

 

We have never declared or paid a cashdividend on our common stock.  Wepresently intend to retain our earnings, if any, to fund development and growthof our business and, therefore, we do not anticipate paying cash dividends in theforeseeable future.  Additionally, theterms of the 13% Debentures contain restrictions on our ability to paydividends to holders of our common stock.

 

**If we fail to effect and maintainregistration of the common stock issued or issuable pursuant to conversion ofour convertible debentures, or certain of our outstanding common stockwarrants, we may be obligated to pay the investors of those securitiesliquidated damages.**

 

We have various obligations to file andobtain the effectiveness of certain registration statements which includecertain outstanding common stock and common stock underlying outstandingconvertible 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 public company, we are subject to asignificant amount of regulation.  In thepast we have received requests for information from the Securities and ExchangeCommission and from Nasdaq.  Any suchinquiry or investigation that may result may adversely affect the market forour stock or our Company.**

 

Regulators of public companies such asIsonics have the authority to commence inquiries and investigations where theregulators have concerns.  Theinvestigations, while involving the company, may not have anything to do withactions taken by the company or our failure to act.  Furthermore, the regulators may not inform uswhen the issues they were addressing are resolved.  From October 2004 through February 2005,both Nasdaq and the SEC requested documents from us with respect to inquiriesthey were undertaking (related primarily to questions regarding our pressreleases, public relations advisors, certain other disclosures that were madepublicly and the termination of Grant Thornton LLP as our independentauditor).   We also met withrepresentatives of Nasdaq to 

 

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discuss issues related to market activity,press announcements, SEC filings, status of our business and other issues.   We provided information, which we believe tobe responsive to all of the questions posed in the Nasdaq inquiry and to theSEC.  We have not received any requestsfor additional information from either the SEC or Nasdaq relating to thoseearlier inquiries since February 2005 and while we believe these issuesare behind us, if any action resulted from these inquiries in the future, itmay adversely impact us, and our ability to carry on our business.

 

**Provisions****in our charter documents could prevent or delay a change in control,which could delay or prevent a takeover.**

 

Our Articles of Incorporation authorize theissuance of “blank check” preferred stock with such designations, rights, andpreferences, as may be determined by our Board of Directors.  Accordingly, the Board of Directors may,without shareholder approval, issue shares of preferred stock with dividend,liquidation, conversion, voting, or other rights that could adversely affectthe voting power or other rights of the holders of our common stock.  Preferred stock could also be issued todiscourage, delay, or prevent a change in our control, although we do notcurrently intend to issue any additional series of our preferred stock.

 

**Provisions in our bylaws provide forindemnification of officers and directors to the full extent permitted byCalifornia law, which could require us to direct funds away from our businessand products.**

 

Our Bylaws provide for indemnification ofofficers and directors to the full extent permitted by California law, ourstate of incorporation.  We may berequired to pay judgments, fines, and expenses incurred by an officer ordirector, including reasonable attorneys’ fees, as a result of actions orproceedings in which such officers and directors are involved by reason ofbeing or having been an officer or director. Funds paid in satisfaction ofjudgments, fines and expenses may be funds we need for the operation of ourbusiness and the development of our products, thereby affecting our ability toattain profitability.  This could causeour stock price to drop.

 

**We will need to make substantial financial andman-power investments in order to assess our internal controls over financialreporting and our internal controls over financial reporting may be found to bedeficient.**

 

Section 404 of the Sarbanes-Oxley Act of2002 requires management to assess our internal controls over financialreporting and requires auditors to attest to that assessment. Currentregulations of the Securities and Exchange Commission require us to include management’sassessment and attestation in our Annual Report on Form 10-K commencingwith the annual report for our fiscal year ending April 30, 2008.  We have incurred significant costs inimplementing and responding to these requirements and, to the extent ourworking capital permits, we will have to incur additional expenses to completethe implementation and to maintain those controls.  Because of our working capital and liquidityshortages, we may not be able to complete the implementation of all aspects of Section 404regarding internal controls over financial reporting.  If we fail to complete this implementation,investors may lose confidence in the reliability of our financial statements.

 

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

 

No unregistered sales of equity securities wereeffected subsequent to the filing of our Form 10-Q for the quarter ended July 31,2007.

 

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

 

None

 

**Item 5: Other Information**

 

Departure of Directors

 

On December 12, 2007, Russell W. Weissinformed us that he has decided to retire from our Board of Directors effectiveimmediately.   Mr. Weiss has servedon our Board of Directors since January 2004 and at the time of hisretirement served as a member of the Audit Committee, the Nominating Committee,the Compensation Committee, and the Management Development Committee of ourBoard of Directors.

 

Also on December 12, 2007, RichardParker informed us that he has decided to retire from our Board of Directorseffective immediately.  Mr. Parkerhas served on our Board of Directors since August 1998 and at the time ofhis retirement served as a member of the Audit Committee, the NominatingCommittee, the Compensation Committee, and the Management Development Committeeof our Board of Directors.

 

Neither Mr. Weiss nor Mr. Parkercited any disagreement with management or our practices or policies as theirdecision to retire.  Instead, both citedpersonal reasons and their desire to pursue other interests as the reason fortheir retirement. A copy of the disclosure in this Form 10-Q was providedto Mr. Weiss and Mr. Parker on December 13, 2007.  Neither has expressed any disagreement withthe disclosure contained herein.

 

Our Board of Directors now consists of Messrs. Toffales,Sakys, Hagman and Verdery.  Neither Dr. Hagmannor Mr. Verdery are officers or directors of Isonics and both areconsidered independent as that term is defined by Nasdaq Marketplace Rule 4200(a)(15).  The committees of the Board of Directors arenow comprised of the following directors:

 

| Audit Committee:                                                  | Richard H. Hagman and John  Sakys                   |
|-------------------------------------------------------------------|-----------------------------------------------------|
|                                                              |                                                |
| Compensation, Nominating  and  Management Development Committees: | Richard H. Hagman and C.  Stewart Verdery, Jr. |

 

Regulation FD Disclosure

 

On December 6, 2007, we received aletter from Nasdaq stating that it determined to delist our securities (whichwere suspended from trading on the Nadaq Capital Market effective December 10,2007).  The delisting of our securitiesconstitutes a failure of one of the conditions precedent to the mergercontemplated by that certain non-binding term sheet executed by Isonics andUniversal Guardian Holdings, Inc. (“UGHO”) dated November 16, 2007,as amended on November 26, 2007 (the “Term Sheet”).  We have since advised UGHO that we will notproceed with the merger under the terms of the Term Sheet, although we continueto negotiate a potential transaction.  Wecan offer no assurance that any transaction with UGHO will be consummated.

 

**Item 6: Exhibits**

 

Exhibits.

 

3.1                                 Restated articles of incorporation (incorporated by reference from our CurrentReport on Form 8-K (File No. 001-12531), dated June 13, 2007 andfiled 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 incorporatedherein by reference.

 

31.1                           Certification of ChiefExecutive Officer pursuant to Rule 13a-14(a) of the Exchange Act

 

31.2                           Certificationof Chief Financial Officer pursuant to Rule 13a-14(a) of the ExchangeAct

 

32.1                           Certificationof Chief Executive Officer pursuant to 18 U.S.C. Section 1350

 

32.2                           Certificationof Chief Financial Officer pursuant to 18 U.S.C. Section 1350

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Golden, County of Jefferson, State of Colorado,on the 17th day of December 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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