Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

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** **

**FORM 10-Q**

 

(**Mark One)**

 

**x****     ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the quarterly period ended July 31, 2008**

 

**or**

 

**o****        ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the transition period from              to         **

 

**Commission file number:  001-12531**

 

**ISONICS CORPORATION**

(Exact name of registrant as specified in its charter)

** **

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

incorporation or organization) |       | (IRS Employer

Identification No.) |

 

**535 8th Avenue, 3rd Floor**

**New York, NY 10018-2491**

(Address of principal executive offices with zip code)

 

**(303) 279-7900**

(Registrant’s telephone number, including area code)

 

**5906 McIntyre Street**

**Golden, CO 80403**

(Former name, former address and former

fiscal year, if changed since last report)

 

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

 

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

 

| Large accelerated filer o

  |   | Accelerated filer o         |   | Non-accelerated filer o |
|----------------------------------------|--------|-----------------------------|--------|-------------------------|
|                                   |   | Smaller reporting company x |   |                    |

 

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

 

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

 

| **Class**                        | ** ** | **Outstanding at September 12, 2008** |
|----------------------------------|------------|--------------------------------------------|
| Common Stock – no par value |       | 22,244,789 shares                          |

 

 

 

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Table of Contents

 

**Isonics Corporation and Subsidiaries**

** **

**TABLE OF CONTENTS**

 
| Part I:  | Financial Information |                                                                                                     |
|---------------|-----------------------|----------------------------------------------------------------------------------------------------------|
|          |                  |                                                                                                     |   |
|          | Item 1:               | Financial Statements                                                                                     |   |
|          |                  |                                                                                                     |   |
|          |                  | Condensed  Consolidated Balance Sheets as of July 31, 2008 and April 30, 2008                  |   |
|          |                  | Condensed  Consolidated Statements of Operations for the Three Months Ended  July 31, 2008 and 2007 |   |
|          |                  | Condensed  Consolidated Statements of Cash Flows for the Three Months Ended  July 31, 2008 and 2007 |   |
|          |                  | 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 4T:              | 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    |                  |

 

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Table of Contents

 

**Part I:  FinancialInformation**

** **

**Item 1: Financial Statements**

** **

**Isonics Corporation andSubsidiaries**

** **

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 

**ASSETS**

 
|                                                                  |   | **(Unaudited)**             | ** ** | ** **                   |   |
|-----------------------------------------------------------------------|--------|-----------------------------|------------|------------------------------|--------|
|                                                                  |   | **July 31, 2008** | ** ** | **April 30, 2008** |   |
| CURRENT ASSETS:                                                       |   |                        |       |                         |   |
| Cash and cash  equivalents                                            |   | $                           | 954        |                         | $      | 927 |   |
| Accounts  receivable (net of allowances of $111 and $58,respectively) |   | 2,818                       |       | 2,297                        |   |
| Inventories                                                           |   | 233                         |       | 394                          |   |
| Prepaid expenses  and other current assets                            |   | 564                         |       | 194                          |   |
| Assets held for  sale                                                 |   | —                      |       | 212                          |   |
| Total current  assets                                                 |   | 4,569                       |       | 4,024                        |   |
|                                                                  |   |                        |       |                         |   |
| LONG-TERM  ASSETS:                                                    |   |                        |       |                         |   |
| Property and  equipment, net                                          |   | 4,306                       |       | 4,682                        |   |
| Goodwill                                                              |   | 1,285                       |       | 3,631                        |   |
| Intangible  assets, net                                               |   | —                      |       | 6                            |   |
| Other assets                                                          |   | 355                         |       | 418                          |   |
| Total long-term  assets                                               |   | 5,946                       |       | 8,737                        |   |
|                                                                  |   |                        |       |                         |   |
| TOTAL ASSETS                                                          |   | $                           | 10,515     |                         | $      | 12,761 |   |

 

**LIABILITIESAND STOCKHOLDERS’ DEFICIT**

 
| ** **                                                                                                                                                               | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                               | ** ** | **July 31, 2008** | ** ** | **April 30, 2008** | ** ** |
| CURRENT  LIABILITIES:                                                                                                                                                    |       |                        |       |                         |       |
| Accounts payable                                                                                                                                                         |       | $                           | 1,066      |                         | $          | 825 |   |
| Accrued  liabilities                                                                                                                                                     |       | 2,221                       |       | 2,262                        |       |
| Accrued interest                                                                                                                                                         |       | 3,557                       |       | 2,990                        |       |
| Current portion  of obligations under capital lease                                                                                                                      |       | 566                         |       | 550                          |       |
| Current portion  of notes payable, net of discount                                                                                                                       |       | 6,933                       |       | 10                           |       |
| Current portion  of convertible debentures, net of discount                                                                                                              |       | 8,403                       |       | 10,515                       |       |
| Total current  liabilities                                                                                                                                               |       | 22,746                      |       | 17,152                       |       |
|                                                                                                                                                                     |       |                        |       |                         |       |
| Obligations  under capital lease, net of current portion                                                                                                                 |       | 432                         |       | 591                          |       |
| Notes payable,  net of current portion                                                                                                                                   |       | 19                          |       | 22                           |       |
| Other long-term  liabilities                                                                                                                                             |       | 47                          |       | 45                           |       |
|                                                                                                                                                                     |       |                        |       |                         |       |
| TOTAL  LIABILITIES                                                                                                                                                       |       | 23,244                      |       | 17,810                       |       |
|                                                                                                                                                                     |       |                        |       |                         |       |
| Commitments and  Contingencies (See Notes 1, 6 and 8)                                                                                                                    |       |                        |       |                         |       |
|                                                                                                                                                                     |       |                        |       |                         |       |
| STOCKHOLDERS’  DEFICIT:                                                                                                                                             |       |                        |       |                         |       |
| Common stock -  no par value; 175,000,000 shares authorized; shares issued and outstanding:  July 31, 2008 – 20,335,698; April 30, 2008 – 16,063,026 |       | 64,504                      |       | 64,448                       |       |
| Additional paid  in capital                                                                                                                                              |       | 23,563                      |       | 23,186                       |       |
| Accumulated  deficit                                                                                                                                                     |       | (100,796                    | )          | (92,683                      | )          |
| Total  stockholders’ deficit                                                                                                                                        |       | (12,729                     | )          | (5,049                       | )          |
|                                                                                                                                                                     |       |                        |       |                         |       |
| TOTAL LIABILITIES  AND STOCKHOLDERS’ DEFICIT                                                                                                                        |       | $                           | 10,515     |                         | $          | 12,761 |   |

 

Seenotes to condensed consolidated financial statements.

 

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**Isonics Corporation andSubsidiaries**

** **

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands,except per share data)**

**(Unaudited)**

** **
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                 | ** ** | **July 31,**                | ** ** |
| ** **                                                                 | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenues:                                                                  |       |                             |       |   |   |
| Products                                                                   |       | $                                | 582        |   | $ | 871 |   |
| Services                                                                   |       | 4,205                            |       | 4,998 |   |
| Total revenues                                                             |       | 4,787                            |       | 5,869 |   |
|                                                                       |       |                             |       |   |   |
| Cost of  revenues:                                                         |       |                             |       |   |   |
| Products                                                                   |       | 607                              |       | 875 |   |
| Services                                                                   |       | 3,791                            |       | 4,123 |   |
| Total cost of  revenues                                                    |       | 4,398                            |       | 4,998 |   |
|                                                                       |       |                             |       |   |   |
| Gross margin                                                               |       | 389                              |       | 871 |   |
|                                                                       |       |                             |       |   |   |
| Operating  expenses:                                                       |       |                             |       |   |   |
| Selling, general  and administrative                                       |       | 1,377                            |       | 2,090 |   |
| Impairment of  goodwill                                                    |       | 2,346                            |       | — |   |
| Research and  development                                                  |       | 35                               |       | 1,017 |   |
| Total operating  expenses                                                  |       | 3,758                            |       | 3,107 |   |
|                                                                       |       |                             |       |   |   |
| Operating loss                                                             |       | (3,369                           | )          | (2,236 | ) |
|                                                                       |       |                             |       |   |   |
| Other income  (expense):                                                   |       |                             |       |   |   |
| Amortization of  debt issuance costs                                       |       | (63                              | )          | (41 | ) |
| Interest and  other income                                                 |       | 1                                |       | 97 |   |
| Interest expense                                                           |       | (3,301                           | )          | (1,429 | ) |
| Loss on  extinguishment of debt                                            |       | (1,381                           | )          | — |   |
| Gain on  derivative instruments                                            |       | —                           |       | 13 |   |
| Equity in net  loss of investee                                            |       | —                           |       | (42 | ) |
| Total other  income (expense), net                                         |       | (4,744                           | )          | (1,402 | ) |
| Loss from  continuing operations before income taxes and minority interest |       | (8,113                           | )          | (3,638 | ) |
| Income tax  expense                                                        |       | —                           |       | — |   |
| Minority  interest in operations of consolidated subsidiary                |       | —                           |       | 100 |   |
| Loss from continuing  operations                                           |       | (8,113                           | )          | (3,538 | ) |
| Discontinued  operations:                                                  |       |                             |       |   |   |
| Gain on  operations of discontinued operations, net of income taxes        |       | —                           |       | 37 |   |
| Gain on disposal  of discontinued operations, net of income taxes          |       | —                           |       | 516 |   |
| Gain on  discontinued operations, net of income taxes                      |       | —                           |       | 553 |   |
| NET LOSS                                                                   |       | $                                | (8,113     | ) | $ | (2,985 | ) |
|                                                                       |       |                             |       |   |   |
| **Net  income (loss) per share – basic and diluted:**                 |       |                             |       |   |   |
| Continuing operations                                                      |       | $                                | (.44       | ) | $ | (0.28 | ) |
| Discontinued  operations                                                   |       | $                                | —     |   | $ | 0.04 |   |
| Attributable to  common stockholders                                       |       | $                                | (.44       | ) | $ | (0.24 | ) |
| Weighted average  common shares used in computing per share information    |       | 18,376                           |       | 12,654 |   |

 

Seenotes to condensed consolidated financial statements.

 

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**Isonics Corporation andSubsidiaries**

** **

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

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

**(Unaudited)**

 
|                                                                                               |   | **Three Months Ended July 31,** |       |
|----------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|------------|
|                                                                                               |   | **2008**                                            | ** ** | **2007** |   |
|                                                                                               |   |                                                |       |   |   |
| Net cash used in  operating activities                                                             |   | $                                                   | (975       | ) | $ | (453 | ) |
|                                                                                               |   |                                                |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                             |   |                                                |       |   |   |
| Purchases of  property and equipment                                                               |   | (4                                                  | )          | (96 | ) |
| Proceeds from  the sale of assets held for sale, net of selling costs                              |   | 221                                                 |       | — |   |
| Proceeds from  sale of discontinued operations, net of selling costs                               |   | —                                              |       | 805 |   |
| Cash provided by  investing activities                                                             |   | 217                                                 |       | 709 |   |
|                                                                                               |   |                                                |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                             |   |                                                |       |   |   |
| Principal  payments under capital lease obligations                                                |   | (143                                                | )          | (106 | ) |
| Principal  payments on borrowings                                                                  |   | (72                                                 | )          | (224 | ) |
| Proceeds from  the issuance of term debt and related common stock warrants, net of offering  costs |   | 1,000                                               |       | — |   |
| Cash provided by  (used in) financing activities                                                   |   | 785                                                 |       | (330 | ) |
|                                                                                               |   |                                                |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                              |   | 27                                                  |       | (74 | ) |
| Cash and cash  equivalents at beginning of period                                                  |   | 927                                                 |       | 1,556 |   |
| Cash and cash  equivalents at end of period                                                        |   | $                                                   | 954        |   | $ | 1,482 |   |
|                                                                                               |   |                                                |       |   |   |
| Supplemental  disclosure of cash flow information:                                                 |   |                                                |       |   |   |
| Cash paid during  the period for:                                                                  |   |                                                |       |   |   |
| Interest                                                                                           |   | $                                                   | 49         |   | $ | 71 |   |
| Income taxes                                                                                       |   | $                                                   | —     |   | $ | — |   |
|                                                                                               |   |                                                |       |   |   |
| Supplemental  disclosure of noncash investing and financingactivities:                             |   |                                                |       |   |   |
| Capital lease  obligation for property and equipment                                               |   | $                                                   | —     |   | $ | 628 |   |
| Payment in  common stock of principal due on convertible debentures                                |   | $                                                   | 64         |   | $ | — |   |

 

Seenotes to condensed consolidated financial statements.

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1- BASIS OF PRESENTATION**

 

The accompanying condensed consolidated balancesheet as of April 30, 2008, has been derived from audited financialstatements.  The accompanying unauditedinterim condensed consolidated financial statements of Isonics Corporation andSubsidiaries have been prepared on the same basis as the annual auditedfinancial statements and in accordance with accounting principles generallyaccepted in the United States (“US GAAP”) for interim financial information andthe rules and regulations of the Securities and Exchange Commission (“SEC”)for interim financial statements.  In theopinion of management, such unaudited information includes all adjustments(consisting only of normal recurring accruals) necessary for a fairpresentation of this interim information. Operating results and cash flows for interim periods are not necessarilyindicative of results that can be expected for the entire year.  The information included in this reportshould be read in conjunction with our audited consolidated financial statementsand notes thereto included in our Annual Report on Form 10-K for the yearended April 30, 2008.

 

***Going Concern***

 

As of July 31, 2008,we had a working capital deficit of $(18,177,000) and a stockholders’ deficitof  $(12,729,000).  Furthermore, included in current liabilitiesare $15,178,000 of convertible debentures and term notes (both net of relateddiscounts) for which we may not be in compliance with certain covenants.  As a result and as described in Note 6, theholder may have the right to call such debentures and term notes for the full-faceamount of $19,013,400 plus accrued interest. In addition, we incurred significant losses from operations and usedsignificant cash flow to fund operations for the periods presented.  Historically, we have relied upon outsideinvestor funds to maintain our operations and develop our business. Although weraised an additional $1,000,000 (net of expenses) through the issuance of$1,175,000 of term notes in June 2008 (see Note 6), we anticipate we willcontinue to require funding from investors to finance our negative cash flow aswell as business expansion during this fiscal year and we can provide noassurance that additional investor funds will be available on terms acceptableto us.  These conditions raise substantialdoubt about our ability to continue operations as a going concern.

 

Our ability to continue as a going concern is dependent upon raisingcapital through debt or equity financing and by increasing revenue andultimately achieving positive cash flow and profitable operations. We havesubstantial limitations on our ability to raise additional financing, and wecan offer no assurance that we will be successful in our efforts to raiseadditional funds or achieve positive cash flow or 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 ACCOUNTINGPOLICIES**

** **

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

 

Basic net income (loss) per share is computed using the weightedaverage number of common shares outstanding during the period.  Contingently issuable shares are included inthe computation of basic net income (loss) per share when the relatedconditions are satisfied.  Diluted netincome (loss) per share is computed using the weighted average number of commonshares and potentially dilutive 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.

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

As of July 31, 2008, (a) a total of32,522,000 outstanding stock options and common stock warrants and (b) theunissued shares underlying our outstanding convertible debentures (with acumulative outstanding face amount of $11,868,000 at July 31, 2008) wereexcluded from the diluted net loss per share calculation, as their inclusionwould be anti-dilutive.  As of July 31, 2007, (a) atotal of 5,119,000 outstanding stock options (excluding 3,550,000 stock optionsnot deemed granted under US GAAP because the underlying plan or increase to theunderlying plan had not been approved by our shareholders) and common stockwarrants and (b) the unissued shares underlying our outstandingconvertible debentures (with a cumulative outstanding face amount of$18,0000,000 at July 31, 2007) were excluded from the diluted net loss pershare calculation, as their inclusion would be anti-dilutive.

 

During the three months ended July 31, 2008, weissued the following shares of common stock:

 
| **Description**                                          | ** ** | **Number of Common Stock Shares** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Balance as of  April 30, 2008                       |       | 16,063,026                                            |       |
| Shares issued  upon conversion of convertible debentures |       | 4,272,672                                             |       |
| Balance as of  July 31, 2008                        |       | 20,335,698                                            |       |

 

The aforementioned equity transactions increasedcommon stock in the accompanying condensed consolidated balance sheets by$56,000 for the three months ended July 31, 2008.

 

***Recently Issued Accounting Standards***

 

In September 2006, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”). SFAS 157 provides guidance forusing fair value to measure assets and liabilities.  The FASB believes the standard also respondsto investors’ requests for expanded information about the extent to whichcompanies measure assets and liabilities at fair value, the information used tomeasure fair value and the effect of fair value measurements on earnings.  The provisions of SFAS 157 are to be appliedprospectively as of the beginning of the fiscal year in which SFAS No. 157is initially applied.  SFAS 157 applieswhenever other standards require (or permit) assets or liabilities to bemeasured at fair value but does not expand the use of fair value to any newcircumstances.  SFAS 157 for financialassets and liabilities was effective for us on May 1, 2008.  On May 1, 2009 SFAS 157 will also applyto non-financial assets and liabilities. The adoption of SFAS 157 for financial assets and liabilities did nothave a material impact on our financial position or results of operations.  FASB Staff Position SFAS 157-2 *Effective Date FASB Statement No. 157*(“FSPFAS 157-2”) delays the effective date of SFAS 157 for non-financial assets andliabilities, except for items recognized or disclosed at fair value in thefinancial statements on a recurring basis (at least annually).  We do not expect the application of FSP FAS157-2 will have a material impact on our financial position or results ofoperations.

 

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS 159”). SFAS 159 provides the option to report certain financial assets andliabilities at fair value, with the intent to mitigate volatility in financialreporting that can occur when related assets and liabilities are recorded ondifferent bases.   SFAS 159 also amends SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*, by providing the option to record unrealized gains andlosses on held-for-sale and held-to-maturity securities currently. SFAS 159 was effective for us on May 1, 2008, including interimperiods within this fiscal year.  Theimplementation of FAS 159 did not have a material impact on our financialposition or results of operations.

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007),*Business Combinations*(“SFAS141(R)”), which establishes principles and requirements for how an acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in anacquiree, including the recognition and measurement of goodwill acquired in abusiness combination.  SFAS 141(R) iseffective for our fiscal year commencing May 1, 2009.  Earlier adoption is prohibited.  We are currently evaluating the impact ofadopting SFAS 141(R) on our results of operations and financialcondition.

 

In December 2007, the FASB issued SFAS No. 160 , *Noncontrolling Interests in Consolidated FinancialStatements — an amendment of ARB No. 51(*“SFAS 160”).  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 an ownershipinterest in the consolidated entity that should be reported as equity in theconsolidated financial statements.  Amongother requirements, this statement requires consolidated net income to bereported at amounts that include the amounts attributable to both the parentand the noncontrolling interest.  It alsorequires disclosure, on the face of the consolidated income statement, of theamounts of consolidated net income attributable to the parent and to the noncontrollinginterest.   SFAS 160 is effective for ourfiscal year commencing May 1, 2009, including interim periods within thatfiscal year. Earlier adoption is prohibited. We are currently evaluating the impact of adopting SFAS 160 on ourresults of operations and financial condition.

 

**NOTE 3 – FINANCIAL STATEMENT COMPONENTS**

 

***Inventories***

 

Inventories consist of the following (in thousands):

 
| ** **              | ** ** | **July 31, 2008** | ** ** | **April 30, 2008** | ** ** |
|-------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Finished goods          |       | $                           | 85         |                         | $          | 187 |   |
| Work in process         |       | 9                           |       | 25                           |       |
| Materials and  supplies |       | 139                         |       | 182                          |       |
| Total  inventories      |       | $                           | 233        |                         | $          | 394 |   |

 

***Property and equipment***

 

Property andequipment consist of the following (in thousands):

** **
| ** **                                 | ** ** | **July 31, 2008** | ** ** | **April 30, 2008** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Office furniture  and equipment            |       | $                           | 353        |                         | $          | 351 |   |
| Production  equipment                      |       | 8,868                       |       | 8,822                        |       |
| Vehicles                                   |       | 204                         |       | 204                          |       |
| Construction in  process                   |       | 22                          |       | 66                           |       |
| Leasehold  improvements                    |       | 1,215                       |       | 1,215                        |       |
|                                       |       | 10,662                      |       | 10,658                       |       |
| Accumulated  depreciation and amortization |       | (6,356                      | )          | (5,976                       | )          |
| Total property  and equipment, net         |       | $                           | 4,306      |                         | $          | 4,682 |   |

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 4 –SEGMENT INFORMATION**

 

We currently have two reportable segments: security services andsilicon products and services.  Oursecurity services segment provides security and investigative services and issubstantially comprised of the operations of Protection Plus Security Corporation(“PPSC”).  Our silicon products andservices segment provides 300-millimeter(and smaller diameter) test wafers and reclamation services, wafer thinning andcustom wafer products and services for the silicon industry.  Our segments are strategic businessunits, 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 from different locations.  Reconciling items consist primarily of corporateassets or expenses that have not been allocated to a specific reportablesegment and the assets and results of operations of our former homelandsecurity products segment.  Our formerhomeland security products segment included both the operations of our IonMobility Spectroscopy (“IMS”) technology and, through our 90%-owned subsidiarySenseIt Corp, the development of next-generation infrared imaging and nightvision technology through our Development and Licensing Agreement with LucentTechnologies, Inc. (“Lucent”).  Weno longer consider homeland security products to be a reportable segment due tothe suspension of these segment operations during our year ended April 30,2008.  Prior period amounts have beenreclassified to conform to the current period presentation.

 

Information by segment is set forth below (inthousands):

 
| ** **                     | ** ** | **Three Months Ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **July 31,**                | ** ** |
| ** **                     | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Segment  revenues:             |       |                             |       |   |   |
| Security  services             |       | $                                | 3,273      |   | $ | 3,756 |   |
| Silicon products  and services |       | 1,514                            |       | 2,113 |   |
| Total                          |       | $                                | 4,787      |   | $ | 5,869 |   |

 
| ** **                        | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **July 31,**                | ** ** |
| ** **                        | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Segment  operating (loss) income: |       |                             |       |   |   |
| Security  services                |       | $                                | (2,239     | ) | $ | 70 |   |
| Silicon products  and services    |       | (556                             | )          | (361 | ) |
| Reconciling  amounts (1)          |       | (574                             | )          | (1,945 | ) |
| Total                             |       | $                                | (3,369     | ) | $ | (2,236 | ) |

 
| ** **                     | ** ** | **July 31,** | ** ** | **April 30,** | ** ** |
|--------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                     | ** ** | **2008**          | ** ** | **2008**           | ** ** |
| Total assets:             |       |              |       |               |       |
| Security  services             |       | $                 | 4,068      |               | $          | 6,127 |   |
| Silicon products  and services |       | 5,461             |       | 5,964              |       |
| Reconciling  amounts (2)       |       | 986               |       | 670                |       |
| Total                          |       | $                 | 10,515     |               | $          | 12,761 |   |

 

----

(1)           Reconciling amounts for the operating (loss) income informationincludes corporate expenses consisting primarily of corporate salaries andbenefits, professional and consulting fees, investor relations costs,insurance, directors’ compensation and the results of our former homelandsecurity products segment.

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

(2)           Reconciling amounts for the total asset information includes corporateassets consisting primarily of cash and cash equivalents invested centrally,unamortized debt issuance costs and miscellaneous prepaid items, as well as theassets of our former homeland security products segment.

 

**NOTE 5–IMPAIRMENT OF GOODWILL**

 

Goodwillrelated to our security services segment resulted from the acquisition of PPSCin May 2005.  Due to the loss of asignificant customer during the three months ended July 31, 2008, wedetermined that there had been a significant adverse change to thatbusiness.  We determined that the$3,631,000 of goodwill associated with our security services segment had beenimpaired and as a result,  $2,346,000 ofthe goodwill was written off to reflect impairment of goodwill during the threemonths ended July 31, 2008.  Thefair value of the reporting unit was estimated using the expected present valueof future cash flows.

 

**NOTE 6 –BORROWINGS**

 

**June 2008Term Note**

 

On June 13, 2008, we completed a privateplacement pursuant to which we issued to one accredited investor, YA GlobalInvestments, L.P. (“YA Global”), a 13% term promissory note in the principalamount of $1,175,000 (the “June 2008 Term Note”), of which the entireamount remains outstanding as of July 31, 2008, but offset by a discountof $370,000 for financial statement presentation.  In addition we issued to YA Global13,000,0000 common stock warrants which are exercisable at $.03 per share andexpire on June 13, 2015.

 

The June 2008 Term Note bears an interest rateof 13% per annum, is secured by individual security agreements with IsonicsCorporation, Isonics Vancouver, Inc. (“IVI”), Isonics Homeland Securityand Defense Corporation (“HSDC”) and PPSC and both interest and principal aredue in cash on October 31, 2009.  AtJuly 31, 2008, accrued interest payable on the June 2008 Term Notewas $20,000 and is included in the caption “accrued interest” in theaccompanying condensed consolidated balance sheets.

 

In accordance with the transaction, we paidYorkville Advisors, LLC, an affiliate of YA Global, a structuring andmonitoring fee in the total amount of $175,000.

 

Under the terms of June 2008 Term Note, weagreed not to issue or sell any common stock or preferred stock, or anyderivative security exercisable or convertible into shares of common stock, ata price that is less than the current bid price of our common stock without theprior consent of YA Global.  However thiscovenant does not apply to certain excluded securities, as defined.  In addition, we agreed to several covenantsincluding that we will not permit our revenues to fall more than 10% below theprojections provided to YA Global for our three months ended July 31, 2008or for any monthly period thereafter.  Asdiscussed below, we failed to meet this covenant for the three months ended July 31,2008 and as a result YA Global could declare an event of default.  Remedies for an event of default, include theoption to accelerate payment of the full principal amount of the June 2008Term Note, together with interest to the date of acceleration.

 

While the June 2008 Term Note is outstanding,YA Global has a first right of refusal to participate in any future financingsto raise equity.  We also agreed to notgrant any security interests in any or all of our assets or file a Form S-8registration statements without the consent of YA Global as long as the June 2008Term Note is outstanding.

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

We have the right to prepay the principal amount ofthe June 2008 Term Note at any time upon not less than ten trading daysnotice.  If we prepay the June 2008Term Note, we are obligated to pay 120% of the outstanding principal amount.

 

The warrant issued to YA Global is exercisable forcash only unless there in no effective underlying registration statement or anevent of default exists under the transaction documents, at which point theholder can elect a cashless exercise. Under certain circumstances, the warrant’s exercise price may beadjusted to correspond to common stockholders’ rights to any stock dividend,stock split, stock combination or reclassification of shares.  Additionally if we issue common stock oroptions or other derivative securities that are exercisable or convertible at aprice less than the then current warrant exercise price, both the warrant’sexercise price and the number of shares the warrant may be exercisable intowill be proportionately adjusted.  Thisadjustment does not apply to certain excluded securities, as defined in thewarrant agreement.

 

We have an obligation to register the common stockunderlying the warrant upon receiving a request from YA Global.  We are required to file the relatedregistration statement within 30 days of receiving the request and having it bedeclared effective within 120 days of the filing date.  Our obligation to file and obtaineffectiveness of a registration statement is contingent on us being eligible tofile a registration statement under the rules and regulations of theSecurities and Exchange Commission.

 

We allocated the net proceeds received between the June 2008Term Note and the related warrant based on the relative fair value of eachinstrument.  The $227,000 allocated tothe warrant was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the June 2008 Term Note.  The cumulative discount in the amount of$402,000 (arising from the allocation of a portion of the proceeds to therelated warrants and the cash fees paid to YA Global) is being amortized tointerest expense over the term of the June 2008 Term Note using theeffective interest method at an effective interest rate of 44%.  During the three months ended July 31,2008, $32,000 of discount was amortized to interest expense.

 

**2006 ConvertibleDebentures**

 

In May, June and November 2006, we issuedto YA Global convertible debentures with a cumulative face amount of$16,000,000 (the “2006 Debentures”) along with detachable common stockwarrants.  During the three months ended July 31,2008, we issued 4,272,672 shares of common stock as repayment of $63,800 ofprincipal amount of the 2006 Debentures. In connection with the issuance of the June 2008 Term Notes,$5,970,000 of the 2006 Debentures were converted to term notes (the “ConvertedTerm Notes”) with the same terms and maturity date as the June 2008 TermNotes.  As a result, as of July 31,2008 we had outstanding 2006 Debentures with a face amount of $9,868,400 andConverted Term Notes with a face value of $5,970,000.  The 2006 Debentures and the Converted TermNotes are recorded in our condensed consolidated balance sheets at carryingamounts (net of discount) of $6,551,000 and $5,970,000, respectively.  Subsequent to July 31, 2008 we issued anadditional 1,909,091 shares of common stock as repayment of $2,100 of 2006Debentures principal.

 

In connection with the conversion of the 2006Debentures to Converted Term Notes, the remaining 2006 Debentures were amendedso that the maturity date was extended from May 31, 2009 to October 31,2009.  Furthermore, the conversion pricewas modified to be the lower of $0.03 or eighty percent of the lowest volumeweighted average price (as defined) in the ten trading days prior to theconversion date along with the interest rate being increased to 13%.

 

As a result of the modification of the fixed conversionprice on the remaining 2006 Debentures, we recorded a beneficial conversionfeature of $110,000.  This amount wasrecorded as additional paid-in capital and as a corresponding reduction to thecarrying value of the 2006 Debentures. The discount related to this 

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

beneficial conversion feature is being amortized tointerest expense over the remaining term of the 2006 Debentures using theeffective interest method which resulted in amortization of $10,000 for thethree months ended July 31, 2008. In addition, the original discount is being amortized to interestexpense through October 31, 2009 using the effective interest method whichresulted in amortization of $865,000 for the three months ended July 31,2008.  The combined discounts on the 2006Debentures are being amortized to interest expense using the effective interestmethod at an effective interest rate of 44%.

 

For the three months ended July 31, 2008, werecorded accrued interest associated with the 2006 Debentures of $300,000.  As a result, as of July 31, 2008,cumulative accrued interest associated with the 2006 Debentures is $1,971,000and is included in accrued interest in the accompanying condensed consolidatedbalance sheet.

 

**Converted TermNotes**

 

At the time of the conversion of $5,970,000 of 2006Debentures to Converted Term Notes, the original conversion option waseliminated and as a result, the remaining original discount associated with theConverted Term Notes of $1,546,000 was immediately charged to interest expense.  For the three months ended July 31,2008, we recorded accrued interest associated with the Converted Term Notes of$181,000.  As a result, as of July 31,2008, cumulative accrued interest associated with the Converted Term Notes is$1,226,000 and is included in accrued interest in the accompanying condensedconsolidated balance sheet.

 

**April 2007Debenture**

 

In April 2007, we issued to YA Global aconvertible debenture with a face amount of $2,000,000 (the “April 2007Debenture”) along with detachable common stock warrants.  For the three months ended July 31,2008, using the effective interest method we amortized $206,000 of the discounton the April 2007 Debenture to interest expense.  As of July 31, 2008, the April 2007Debenture is recorded in our condensed consolidated balance sheet at a carryingamount (net of discount) of $1,852,000. We also recorded accrued interest on the April 2007 Debenture inthe amount of $66,000 for the three months ended July 31, 2008.  As of July 31, 2008, cumulative accruedinterest is $340,000 and is included in accrued interest in the accompanyingcondensed consolidated balance sheet.

 

In connection with the conversion of the 2006Debentures to Converted Term Notes, the April 2007 Debentures were amendedso that the maturity date was extended from May 31, 2009 to October 31,2009.  Furthermore, the conversion pricewas modified to be the lower of $0.03 or eighty percent of the lowest volumeweighted average price (as defined) in the ten trading days prior to theconversion date along with the interest rate being increased to 13%.  We did not record an additional beneficialconversion feature resulting from the modifications as it was not deemed to bematerial.  As a result of the modificationof the fixed conversion feature, the discount associated with the beneficialconversion feature of $1,381,000 was written off as a loss on extinguishment ofdebt.  As a result, we are now amortizingthe remaining discount  ($148,000 as of July 31,2008) through October 31, 2009 using the effective interest method at an effectiveinterest rate of 19%.

 

**Summary**

 

As of July 31, 2008, we had $8,403,000, net ofdiscount of remaining convertible debentures (the 2006 Debentures and the April 2007Debenture, collectively the “13% Debentures”) and $6,775,000 in outstandingnon-convertible term debt (the June 2008 Term Note and the Converted TermNotes, collectively the “Term Notes”).

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

Currently, we may not bein compliance with certain covenants of the remaining 13% Debentures and, inthe June financing, YA Global refused to waive any non-compliance with theearlier financing documents.  Inaddition, we have not been able to comply with certain financial covenants ofthe Term Notes during the three months ended July 31, 2008 and as a resultYA Global may, in its discretion, declare an Event of Default on thosenotes.  If YA Global were to declare anevent of default under the 13% Debentures or the Term Notes it would likelyhave the legal right to foreclose against its security interest and takecontrol of, and/or dispose of, the assets subject to its securityinterest.  Although YA Global has not yetdeclared an event of default, and although we are continuing to havediscussions with YA Global with the aim to further our business operations, wecan offer no assurance that YA Global will not declare an event of defaultunder the 13% Debentures or the Term Notes and seek to collect the amounts dueby foreclosure on our assets.

 

**NOTE 7 – ASSETS HELD FOR SALE**

 

During the fourth quarter of our year ended April 30,2008, we committed to a plan to sell one specific piece of production equipmentin our silicon products and services segment. Based on ongoing analysis of the silicon operations, this asset wasdeemed to be unnecessary to support our current operations.  This asset, with a net book value of $212,000as of April 30, 2008 was sold by our silicon products and servicessubsidiary, IVI in May 2008 for net proceeds of $221,000, resulting in anet gain of $9,000.

 

**NOTE 8 – LEGAL CONTINGENCIES**

 

In February 2007, we entered into aSettlement Agreement and Mutual Release with our former Chief ExecutiveOfficer, President and Chairman of the Board of Directors (our “Former CEO”)whereby he resigned his positions, terminated his employment agreement with usand accepted specified cash-based and stock-based remuneration for the ensuingtwelve months.  During August 2007,due to a lack of sufficient liquidity and a working capital deficit, we stoppedmaking the contractually required payments to our Former CEO.  As a result, as of April 30, 2008 we hadan accrued liability in the amount of $118,000, which represented the remainderof the contractual amounts due.  In July 2008,our Former CEO filed a lawsuit demanding payment of the remaining outstandingamounts plus statutory interest and penalties, totaling approximately$190,000.  As we believe it is probablethat the courts will issue a judgment in the amount of at least $190,000, weincreased our accrued liability to $190,000, which resulted in a charge toselling, general and administrative expenses of $72,000 during the three months ended July 31, 2008.  Inasmuch as all of our assets arecollateralized to secure repayment of amounts due to YA Global, it is unclearif we will be able to satisfy any judgment that our Former CEO may obtain.

 

In February through April 2007, wealso entered into Settlement Agreements and Mutual Releases with otherofficers.  In order to conserve liquidityand with their consent, in August 2007 we reduced the amount payable tothem.  Commencing in August 2008,because of our liquidity limitations, we were unable to continue payments fortheir benefit.  It is currently unclearas to when, if ever we will be able to resume payments.  They have not commenced or threatenedlitigation, but may do so in the future.

 

On September 12, 2008 we receivednotification from a former customer claiming approximately $1,000,000 indamages it had suffered from several alleged breaches of contract.  Wehave only begun to review the underlying facts and have not had a chance todiscuss them with our legal counsel or the former customer and therefore we areunable to determine the probability of an unfavorable outcome at this time.

 

**NOTE 9– COMMITMENTS AND CONTINGENCIES**

 

As of July 31, 2008, we had no commitmentsoutstanding for capital expenditures.

 

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 10- SUBSEQUENT EVENTS**

 

Certain events occurringsubsequent to July 31, 2008, are discussed within other notes to thecondensed consolidated financial statements.

 

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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 our Form 10-Kfor the year ended April 30, 2008 and the risks identified elsewhereherein).  We undertake no obligation toupdate or revise publicly any forward-looking statements, whether as a resultof new information, future events or otherwise.*

 

***GeneralDiscussion***

 

Weare focused on the provision of security services and 300-millimeter (andsmaller diameter) test wafers and reclamation services, wafer thinning andcustom wafer products and services for the silicon industry.

 

Duringthe year ended April 30, 2008, and the three months ended July 31,2008, we generated sales from 300-millimeter (and smaller diameter) test wafersand reclamation services, wafer thinning and custom wafer products and servicesfor the silicon industry and the provision of security services for leadingbusinesses and institutions in healthcare, education, retail, manufacturing,banking and art industries.  In addition,during the three months ended July 31, 2007 we also generated sales fromstable and radioactive isotopes, although these sales were reported asdiscontinued operations in the accompanying condensed consolidated statementsof operations as described below.

 

In June 2007, we soldour life sciences business (which supplied isotopes for life sciences andhealth-care applications) as it no longer fit our long-term strategy forbuilding a sustainable and profitable security and silicon company and becauseof deteriorating business conditions in the historical revenue producingproducts in this business.  Accounting rules requiredus to treat the operations of the life sciences business as discontinuedoperations whereby the net financial impact of the operations of the business(including revenue) was combined into a single line item and prior periods arereclassified for this presentation. Revenue for the life sciences business, reported in the single line itemof gain on operations of discontinued operations, net of income taxes, was$101,000 for the three months ended July 31, 2007.

 

In August 2007, weelected to suspend the development, manufacture and sale of our IMS basedproducts.  The suspension was dueprimarily to our limited success in completing any sales of our IMS basedproducts and a lack of working capital to sustain our efforts in the marketspace.  We continue to seek alternativesto finding a means of monetizing our investment in this product line, includingan outright sale of the technology.  Itis unclear as to when (if at all) we will resume activity on our IMS-basedproducts and we can offer no assurance that we will be able to monetize anyportion of our IMS technology investment. In October 2007, as a result of our inability to meet our financialcommitments, Lucent terminated our agreement for the development ofnext-generation infrared imaging and night vision surveillance technology.

 

Consistentwith management focus during the year ended April 30, 2008 and the threemonths ended July 31, 2008, we continue to evaluate our operatingbusinesses and technology portfolio with the goal of operating our businessmore efficiently and monetizing assets as we deem to be appropriate and as oursenior secured creditor may consent. Additionally, we have considered and will continue to consider 

 

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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.  Becausesubstantially all of our assets are subject to a perfected security interest,we have in the past, and will likely continue to engage in discussions on theseissues with YA Global as our primary debt holder.

 

Liquidity and Capital Resources

 

Wehave had liquidity shortages in the past and, although we raised $1,000,000(net of expenses) through the issuance of $1,175,000 of Term Notes to YA Globalin June 2008, we have generated significant losses, which have exacerbatedour working capital deficit.  As of July 31,2008, our condensed consolidated balance sheet reflects a working capitaldeficit of $(18,177,000).  In addition,as a result of our continued operating losses, working capital deficit andnegative cash flow during the year ending April 30, 2008, the auditorsreport included with our financial statements for the year ended April 30,2008 includes an explanatory paragraph indicating substantial doubt about ourability to continue as a going concern. This condition has continued since the date of those financialstatements, and we expect that these conditions will continue for theforeseeable future unless we are able to raise a substantial amount ofadditional financing (of which there can be no assurance and which would besubject to the approval of YA Global).

 

Currently, we may not bein compliance with certain covenants of the remaining 13% Debentures and, inthe June financing, YA Global refused to waive any non-compliance with theearlier financing documents.  Inaddition, we have not been able to comply with certain financial covenants ofthe Term Notes during the three months ended July 31, 2008 and as a resultYA Global may, in its discretion, declare an event of default on thosenotes.  If YA Global were to declare anevent of default under the 13% Debentures or the Term Notes it would likelyhave the legal right to foreclose against its security interest and takecontrol of, and/or dispose of, the assets subject to its securityinterest.  Although YA Global has not yetdeclared an event of default, and although we are continuing to havediscussions with YA Global with the aim to further our business operations, wecan offer no assurance that YA Global will not declare an event of defaultunder the 13% Debentures or the Term Notes and seek to collect the amounts dueby foreclosure on our assets.

 

As a result of oursignificant working capital deficit, we are financing our operations andnegative cash flow from our liquid assets, which we allocate to pay our mosturgent obligations.  During the threemonths ended July 31, 2008, we used $975,000 in operating activities.  At our current burn rate, our remainingliquidity should be sufficient to finance our anticipated operations andprojected negative cash flow into (and potentially through) our quarter ending October 31,2008.  It is unlikely that we will beable to continue the operations of the parent corporation beyond October 31,2008 without a significant improvement in the operating results of oursubsidiaries or additional financing, neither of which can be assured.  If we are able to secure an offer for assetbased financing from a third party, YA Global has agreed to review thatproposed financing and, in its sole discretion, consider releasing its securityinterest in certain of our assets to secure that financing.  If we are successful at obtaining a minimumof $1,000,000 of additional financing, we believe we could have enoughliquidity to finance our anticipated operations and projected negative cashflow into our fiscal year ending April 30, 2010.  Because of the terms of the existing YAGlobal financing, we are unable to collateralize any additional financingwithout YA Global’s consent and approval.

 

See additional discussionof liquidity and capital resources in the Liquidity andCapital Resources section included further below in this Item 2: Management’s Discussionand Analysis of Financial Condition and Results of Operations.

 

Security Services

 

Since the effective date of our acquisition of PPSC in May 2005,PPSC has delivered significant revenue to our condensed consolidated financialstatements and has provided gross margins of approximately 22% of revenues forboth the three months ended July 31, 2008 and 2007.

 

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During the fourth quarter ofour year ended April 30, 2007, and through our year ended April 30,2008, we implemented cost cutting initiatives that have positively impacted theresults of PPSC’s operations. Additionally we initiated plans (with limited success) to improveoperating margins at PPSC by focusing on customers that are willing to pay forpremium security services, a market in which we believe that PPSC is able todifferentiate itself from its peers.  Thesegment generated an operating loss of $(2,239,000) for the three months ended July 31,2008 as compared to operating income of $70,000 for the three months ended July 31,2007 primarily due to the inclusion of a $2,346,000 non-cash writedown ofgoodwill during the three months ended July 31, 2008 (see additionaldiscussion below).

 

While these cost cuttinginitiatives and focused sales and marketing efforts have enabled PPSC topositively impact its results for the three months ended July 31, 2008,the industry is cost competitive and customers switch security serviceproviders on short notice.  In addition,effective August 1, 2008, one of our significant customers (who accountedfor $802,000 of revenue for the three months ended July 31, 2008) is nolonger using our services.  As a resultof these factors and the $2,346,000 impairment of goodwill, it is unlikely thatwe will be able to generate positive operating income in this segment for theyear ending April 30, 2009.  Inaddition, we can offer no assurance that PPSC will be able to contributepositive cash flow as well.

 

Silicon Products andServices

 

Our silicon operations,based in Vancouver, Washington, continue to focus on the provision of 300-millimeter(and smaller diameter) test wafers and reclamation services, wafer thinning andcustom wafer products and services for the silicon industry.  We are particularly focused on the300-millimeter segment of the market. This large-diameter wafer segment has become one of the fastest growingsegments of the silicon wafer market and the revenues and gross marginsassociated with the services are greater than those associated with the smalldiameter market.   At the same time, wehave also been focused on operational efficiency and effectiveness, which hasresulted in increased productivity and processing yields.  Further, we continue to gain new customers(both large and smaller diameter) and are also in the process of attempting toqualify our products at others.

 

While we reportedsignificant revenue and operating income growth in our silicon operations forthe year ended April 30, 2007, many of our top silicon customersexperienced weakened business results during our year ended April 30,2008.  In addition, some customersreported inventory buildup in reclaim and/or test products while one other topcustomer ceased doing business with us as we could no longer meet the requiredspecifications for their product.  As aresult of these factors, during the year ended April 30, 2008, weexperienced a slowdown in orders and a reduction in average selling prices ofreclaim and test materials, which had a negative impact on our results.  This trend has continued through the threemonths ended July 31, 2008.

 

The slowdown significantlyimpacted our revenues, results of operations and cash flows from our siliconproducts and services segment for the three months ended July 31, 2008 and2007, in which we generated operating losses of $(556,000) and $(361,000),respectively.

 

In order to minimize theeffect of the continuing slowdown, during our year ended April 30, 2008 weimplemented many cost cutting measures in our silicon operations and arecontinuing to do so.  We have alsoincreased our marketing efforts and are hopeful that we will see a recoveryduring the year ending April 30, 2009. During the latter portion of our year ended April 30, 2008 and intoour three months ended July 31, 2008 we have started to obtain newcustomers (both large and smaller diameters) and are in the process ofattempting to qualify our products at others. In an effort to control our marketing expenses, in August 2008 weentered into a distribution agreement with Silicon Quest International, Inc.(“SQI”), by which SQI agreed to act as an exclusive independent contractor tomarket, sell and distribute our silicon products and services to customers whoare not previously our customers.  Wecontinue to monitor our silicon operation closely and while we are hopeful thatwe will see improving financial results in this operating segment over

 

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the long-term, we cannotoffer any assurance that we will be able to regain or sustain operatingprofitability in future periods.

 

***Results of Operations***

 

The following table setsforth, for the periods indicated, condensed consolidated statements ofoperations data expressed as a percentage of revenues.  The table and the discussion below should beread in conjunction with the condensed consolidated financial statements andthe notes thereto appearing elsewhere in this report.

*** ***
| ** **                                                                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                | ** ** | **July 31,**                | ** ** |
| ** **                                                                                | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                                                                      |       |                             |       |   |   |
| Revenues                                                                                  |       | 100.0                            | %          | 100.0 | % |
| Cost of revenues                                                                          |       | 91.9                             |       | 85.2 |   |
| Gross margin                                                                              |       | 8.1                              |       | 14.8 |   |
|                                                                                      |       |                             |       |   |   |
| Operating expenses:                                                                       |       |                             |       |   |   |
| Selling, general and administrative                                                       |       | 28.8                             |       | 35.6 |   |
| Impairment of goodwill                                                                    |       | 49.0                             |       | — |   |
| Research and development                                                                  |       | 0.7                              |       | 17.3 |   |
| Total operating expenses                                                                  |       | 78.5                             |       | 52.9 |   |
| Operating loss                                                                            |       | (70.4                            | )          | (38.1 | ) |
|                                                                                      |       |                             |       |   |   |
| Other income (expense), net                                                               |       | (99.1                            | )          | (23.9 | ) |
| Loss from continuing operations before income taxes and elimination  of minority interest |       | (169.5                           | )          | (62.0 | ) |
| Income tax expense                                                                        |       | —                           |       | — |   |
| Minority interest in operations of consolidated subsidiary                                |       | —                           |       | 1.7 |   |
| Loss from continuing operations                                                           |       | (169.5                           | )          | (60.3 | ) |
| Gain on discontinued operations, net of income taxes                                      |       | —                           |       | 9.4 |   |
| NET LOSS                                                                                  |       | (169.5                           | )%         | (50.9 | )% |

 

***Revenues***

 

Revenues from our securityservices and silicon products and services segments decreased for the threemonths ended July 31, 2008, as compared to the same period of our priorfiscal year, as described in the following table:

 
| ** **                    | ** ** | **Three Months Ended** | ** ** |
|-------------------------------|------------|----------------------------------|------------|
| ** **                    | ** ** | **July 31,**                | ** ** |
| ** **                    | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Security services             |       | $                                | 3,273,000  |   | $ | 3,756,000 |   |
| Silicon products and services |       | 1,514,000                        |       | 2,113,000 |   |
| Total                         |       | $                                | 4,787,000  |   | $ | 5,869,000 |   |

 

The decrease in revenue fromthe security services segment for the three months ended July 31, 2008, isdue to the effect of the loss of several security services contracts during theyear ended April 30, 2008 partially offset by the addition of newcustomers as well as by increases in work performed at certain existing

 

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customers.  Effective August 1, 2008, one of oursignificant customers (who accounted for $802,000 of revenue for the threemonths ended July 31, 2008) will no longer use our services.  As a result, it is likely that our revenuefor the three months ending October 31, 2008 will be lower than therevenue from the three months ended July 31, 2008. We continue to marketour services aggressively by seeking premium accounts that prefer higherquality of service.  While we are hopefulthat in the long-term we will be able to grow revenue in this segment bysecuring new security contracts in our PPSC subsidiary and retaining existingcustomers under contract currently with PPSC, we cannot provide any assurancethat we will be able to do so and we may in the short-term fail to retaincertain of our customers.

 

While we reportedsignificant revenue and operating income growth in our silicon operations forthe year ended April 30, 2007, many of our top silicon customersexperienced weakened business results during our year ended April 30,2008.  In addition, some customersreported inventory buildup in reclaim and/or test products while one other topcustomer ceased doing business with us as we could no longer meet the requiredspecifications for their product.  As aresult of these factors, during the year ended April 30, 2008, weexperienced a slowdown in orders and a reduction in average selling prices ofreclaim and test materials, which had a negative impact on our results.  This trend also continued through the threemonths ended July 31, 2008.

 

Although we have diversifiedour sources of revenue, we continue to have concentrations of revenue withcertain customers.  For the three monthsended July 31, 2008, two security services customers accounted for 24% and17% of revenues, respectively, and one silicon products and services customeraccounted for 12% of revenues as compared to the three months ended July 31,2007, in which two security services customers accounted for 18% and 13% ofrevenues, respectively, and one silicon products and services customeraccounted for 11% of revenues. Significant reductions in sales to any of our large customers have had,and may in the future have, a material adverse effect on us by reducing ourrevenues and our gross margins.  Presentor future customers could terminate their purchasing patterns with us orsignificantly reduce or delay the amount of products or services ordered fromus.

 

For the three months ended July 31,2008, the silicon products and services customer mentioned above accounted for39% of silicon products and services revenue as compared to 31% for the threemonths ended July 31, 2007.  Due tothe relationship of revenues to the absorption of fixed facility costs, theelimination or even a significant reduction in sales to this customer wouldhave a material adverse effect on our silicon products and services operations.

 

***Gross Margin***

 

Our gross margin decreasedfor the three months ended July 31, 2008, as compared to the three monthsended July 31, 2007, both on a dollar amount and on a percentage ofrevenues, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | 389,000    |   | $ | 871,000 |   |
| Percent of revenues |       | 8.1                                                 | %          | 14.8 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The decrease in gross marginon a percentage basis is due primarily to the downturn in our silicon productsand services segment resulting in a significant decrease in revenue, which hasforced us to allocate our fixed facility costs over a lower revenue base,correspondingly decreasing gross margins on a percentage basis.  To a lesser extent, the decrease on apercentage basis is also due to the provision of lower prices in order to obtainnew or keep existing business.  Thedecrease in gross margin on a dollar basis is due to the decrease in revenuefor both our silicon products and services and security services segments.

 

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On a dollar basis, grossmargin is expected to increase correspondingly with increases in revenue, ifany, with dependencies on customer and supplier pricing.  Our ability to positively impact consolidatedgross margin will in a large part be dependent upon our ability to grow salesin our security service segment through increased sales of security servicesand in our silicon products and services segment through increased sales of300-millimeter products and services and wafer thinning services.

 

On a percentage of revenuesbasis, in general we anticipate that the gross margin percentage in oursecurity services segment (within 1-2 percentage points) will remain relativelystable.  However, as a result of the ongoingdownturn in our silicon products and services segment, we have experienced andexpect to continue to experience increased competition and lower prices.  As a result, there has been a focus onoperational efficiency and effectiveness, which has resulted in increasedproductivity and processing yields in order to reduce our costs.  In addition, due to fixed facility costsincluded in cost of revenues in the silicon products and services segment, thegross margin percentage is particularly sensitive to volume and revenuechanges.

 

We have increased ourmarketing efforts and are hopeful that we will see a rebound in our customersdemand and we have (and are hopeful to continue to) added several new siliconproducts and services customers during the year ending April 30,2009.   Effective August 1, 2008,one of our significant security services customers (who accounted for $802,000of revenue for the three months ended July 31, 2008) is no longer usingour services.  As a result, it is likelythat our revenues and gross margin for the three months ending October 31,2008 will be lower than the revenues and gross margin for the three monthsended July 31, 2008. While we are hopeful that revenues (and correspondinggross margins) will increase (as compared to the year ended April 30,2008) for the year ending April 30, 2009, we can offer no assurance thatthis will actually occur.

 

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

 

Our selling, general andadministrative expenses decreased both as a dollar amount and as a percentageof revenue for the three months ended July 31, 2008, as compared to thethree months ended July 31, 2007, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | 1,377,000  |   | $ | 2,090,000 |   |
| Percent of revenues |       | 28.8                                                | %          | 35.6 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The$713,000 decrease in selling, general and administrative expenses for the threemonths ended July 31, 2008, compared to the three months ended July 31,2007 is attributable to a combination of factors, including:

 

·                  approximately $50,000 due toa decrease in staffing and expenditures at the corporate office,

·                  approximately $130,000 dueto a decrease in staffing and expenditures in the security services segment,

·                  approximately $360,000 dueto a decrease in staffing and expenditures in our former homeland securityproducts segment, and

·                  an approximate $170,000decrease in staffing and expenditures at our silicon products and servicessegment.

 

We continue to be activelyfocused on reducing selling, general and administrative expenses and arehopeful that we will be able to further reduce these expenses for the threemonths ending October 31, 2008 as compared to the three months ended July 31,2008.  However, any reduction in selling,general and administrative expenses most likely would be less significant ascompared to the reductions realized for the three months ended July 31,2008 as compared to the three months ended July 31, 2007.

 

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***Impairment of Goodwill***

 

Impairment of goodwillincreased on both a dollar and a percentage of revenues basis for the threemonths ended July 31, 2008, as compared to the three months ended July 31,2007, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | 2,346,000  |   | $ | — |   |
| Percent of revenues |       | 49.0                                                | %          | — | % |
|                     |            |                                                     |            |  |  |  |  |

 

Due to the loss of asignificant security services customer during the three months ended July 31,2008, we determined that there had been a significant adverse change to thesecurity services business.  Wedetermined that the $3,631,000 of goodwill associated with our securityservices segment had been impaired and as a result, $2,346,000 of the goodwillwas written off to reflect impairment of goodwill during the three months endedJuly 31, 2008.

 

***Research and Development Expenses***

 

Our research and developmentexpenses decreased on both a dollar and a percentage of revenues basis for thethree months ended July 31, 2008, as compared to the three months ended July 31,2007, as reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | 35,000     |   | $ | 1,017,000 |   |
| Percent of revenues |       | 0.7                                                 | %          | 17.3 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The majority of research anddevelopment expenses for the three months ended July 31, 2007 relatedprimarily to (1) the development of next-generation infrared imaging andnight vision surveillance technology through our now-terminated Lucentrelationship and (2) our IMS based products.  Due to the termination of our Lucentrelationship and the suspension of development of our IMS-based products, wedid not incur material research and development expense during the three monthsended July 31, 2008 for these projects and we do not expect to incurmaterial additional research and development expense for any projects duringthe remainder of our year ending April 30, 2009.

 

Historically a significantamount of the research and development on the IMS-based products was performedby Institut fur Umwelttechnologien GmbH (“IUT”).  We funded $0 and $78,000 under our agreementwith IUT for the three months ended July 31, 2008 and 2007, respectively.As a result of the suspension of the development, manufacture and sale of ourIMS-based products as described above, we intend to provide no further fundspursuant to this agreement.

 

Except for work beingperformed on our silicon products at our facilities in Vancouver, Washington,we operate no 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.

 

***Operating (Loss) Income***

 

For the three months ended July 31,2008 and 2007, our operating segments incurred operating (loss) income asfollows:

 
| ** **                    | ** ** | **Three months ended July 31,** | ** ** |
|-------------------------------|------------|-----------------------------------------------------|------------|
| ** **                    | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Security services             |       | $                                                   | (2,239,000 | ) | $ | 70,000 |   |
| Silicon products and services |       | (556,000                                            | )          | (361,000 | ) |
| Reconciling amounts (1)       |       | (574,000                                            | )          | (1,945,000 | ) |
| Total                         |       | $                                                   | (3,369,000 | ) | $ | (2,236,000 | ) |

 

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(1) Reconciling amountsfor the operating (loss) income information includes corporate expensesconsisting primarily of corporate salaries and benefits, professional andconsulting fees, investor relations costs, insurance, directors’ compensationand the results of our former homeland security products segment.

 

During the fourth quarter ofour year ended April 30, 2007, and through our year ended April 30,2008, we implemented cost cutting initiatives that have positively impacted theresults of PPSC’s operations. Additionally we initiated plans (with limited success) to improveoperating margins at PPSC by focusing on customers that are willing to pay forpremium security services, a market in which we believe that PPSC is able todifferentiate itself from its peers.  Thesegment generated an operating loss of $(2,239,000) for the three months ended July 31,2008 as compared to operating income of $70,000 for the three months ended July 31,2007 primarily due to the inclusion of a $2,346,000 non-cash writedown ofgoodwill during the three months ended July 31, 2008.

 

While these cost cuttinginitiatives and focused sales and marketing efforts have enabled PPSC topositively impact its results for the three months ended July 31, 2008,the industry is cost competitive and customers switch security serviceproviders on short notice.  In addition,effective August 1, 2008, one of our significant customers (who accountedfor $802,000 of revenue for the three months ended July 31, 2008) is nolonger using our services.  As a resultof these factors and the $2,346,000 impairment of goodwill, it is unlikely thatwe will be able to generate positive operating income in this segment for theyear ending April 30, 2009.  Inaddition, we can offer no assurance that PPSC will be able to contributepositive cash flow as well.

 

While we reportedsignificant revenue and operating income growth in our silicon operations forthe year ended April 30, 2007, many of our top silicon customersexperienced weakened business results during our year ended April 30,2008.  In addition, some customersreported inventory buildup in reclaim and/or test products while one other topcustomer ceased doing business with us as we could no longer meet the requiredspecifications for their product.  As aresult of these factors, during the year ended April 30, 2008, weexperienced a slowdown in orders and a reduction in average selling prices ofreclaim and test materials, which had a negative impact on our results.  This trend has continued through the threemonths ended July 31, 2008.

 

The slowdown significantlyimpacted our revenues, results of operations and cash flows from our siliconoperations for the three months ended July 31, 2008 and 2007, in which wegenerated operating losses of $(556,000) and $(361,000), respectively.

 

In order to minimize theeffect of the continuing slowdown, during our year ended April 30, 2008 weimplemented many cost cutting measures in our silicon operations and arecontinuing to do so.  We have alsoincreased our marketing efforts and are hopeful that we will see a recoveryduring the year ending April 30, 2009. During the latter portion of our year ended April 30, 2008 and intoour three months ended July 31, 2008 we have started to obtain newcustomers (both large and smaller diameters) and are in the process ofattempting to qualify our products at others. In an effort to control our marketing expenses, in August 2008 weentered into a distribution agreement with SQI, by which SQI agreed to act asan exclusive independent contractor to market, sell and distribute our siliconproducts and services to customers who are not previously our customers.  We continue to monitor our silicon operationclosely and while we are hopeful that we will see improving financial resultsin this operating segment over the long-term, we cannot offer any assurancethat we will be able to regain or sustain operating profitability in futureperiods.

 

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

 

Other income (expense), netdecreased for the three months ended July 31, 2008 and 2007 as both adollar amount and as a percentage of revenues, as reflected in the followingtable:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | (4,744,000 | ) | $ | (1,402,000 | ) |
| Percent of revenues |       | (99.1                                               | )%         | (23.9 | )% |
|                     |            |                                                     |            |  |  |  |  |

 

For the three months ended July 31,2008, other income (expense), net consists primarily of interest expense of$(3,301,000), a loss on extinguishment of debt $(1,381,000) and theamortization of debt issuance costs of $(63,000).  Included in interest expense for the threemonths ended July 31, 2008 are non-cash charges of $3,226,000 relatedprimarily to the amortization of the discount and the accrual of interest onour outstanding term notes and convertible debentures.

 

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

 

We expect that our otherexpenses will be volatile based on the future timing of repayment, if ever, ofthe remaining convertible debentures and term notes (see the Liquidity andCapital Resources discussion below).

 

***Income Taxes***

 

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

 

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

 

Minority interest inoperations of consolidated subsidiary for the three months ended July 31,2008 and 2007 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | —     |   | $ | 100,000 |   |
| Percent of revenues |       | —                                              | %          | 1.7 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The amount of minorityinterest in operations of consolidated subsidiary recorded for the three monthsended July 31, 2007, relates to our purchase of a 90% interest in SenseItCorp in October 2006 and the subsequent operation of the business.  Due to the cancellation of the LucentAgreement, we do not expect minority interest in operations of SenseIt to bematerial in future periods.

 

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

 

Gain on discontinuedoperations, net of income taxes for the three months ended July 31, 2008and 2007 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | —     |   | $ | 553,000 |   |
| Percent of revenues |       | —                                              | %          | 9.4 | % |
|                     |            |                                                     |            |  |  |  |  |

 

In January 2007, wedecided to discontinue the operation of our life sciences business and to putthe assets and business up for sale (which was sold in June 2007).  We decided to sell this business as it nolonger fit our long-term strategy and because of deteriorating businessconditions in the historical revenue producing products in the segment.  Accounting rules required us to 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 three months endedJuly 31, 2007. The gain on sale of the life sciences business was recordedin the three months ended July 31, 2007, in the amount of $516,000.  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 for the three months ended July 31,2007.

 

***Net Loss***

 

Net loss for the threemonths ended July 31, 2008 and 2007 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                                   | (8,113,000 | ) | $ | (2,985,000 | ) |
| Percent of revenues |       | (169.5                                              | )%         | (50.9 | )% |
|                     |            |                                                     |            |  |  |  |  |

 

We anticipate thatconsolidated losses will continue until (if ever) revenues from our currentoperations substantially increase or we increase the scope of our operationsthrough a merger, acquisition or other means.  Further, the revenue increases must increasefaster than any increases in operating and research and development expenses.

 

We anticipate that ouroperations during the remainder of the year ending April 30, 2009 willresult in a net loss since we are not likely to increase our revenues from ourexisting products or generate additional sales from the new products we maydevelop in a sufficient amount (if at all) to offset our operating and interestexpenses and the non-cash writedown of goodwill.

 

**Liquidityand Capital Resources**

 

Given our significantworking capital deficit, we are dependent on our liquidity to fund ouroperations and to pay our vendors. A significant part of our working capitaldeficit includes 13% Debentures, Term Notes, and accrued interest due to YAGlobal.  Although the amounts are not dueuntil October 31, 2009, because circumstances exist by which YA Globalcould declare an event of default and accelerate the obligations, we havecharacterized these amounts as a current liabilities.

 

Included in the followingtable are condensed consolidated balance sheet items as of July 31, 2008and April 30, 2008 and condensed consolidated cash flow items for thethree months ended July 31, 2008 and 2007:

 

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| ** **                                                 | ** ** | **As of**          | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|
| **(in thousands)**                                    | ** ** | **July 31,  2008** | ** ** | **Change** | ** ** | **April 30,  2008** | ** ** |
| Cash and cash equivalents                                  |       | $                       | 954        |   | $ | 27 |   | $ | 927 |   |
|                                                       |       |                    |       |   |   |   |   |
| Working capital (deficit)                                  |       | (18,177                 | )          | (5,049 | ) | (13,128 | ) |
|                                                       |       |                    |       |   |   |   |   |
| Current portion of notes payable, net of discount          |       | 6,933                   |       | 6,923 |   | 10 |   |
|                                                       |       |                    |       |   |   |   |   |
| Current portion of convertible debentures, net of discount |       | 8,403                   |       | (2,112 | ) | 10,515 |   |
|                                                       |       |                    |       |   |   |   |   |
| Total convertible debentures, face value outstanding       |       | 11,868                  |       | (6,034 | ) | 17,902 |   |
|                                                       |       |                    |       |   |   |   |   |
| Total term notes, face value outstanding                   |       | $                       | 7,145      |   | 7,145 |   | $ | — |   |
|                                                            |            |                         |            |  |  |  |  |  |  |  |

 
| ** **                                           | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **July 31,  2008**          | ** ** | **Change** | ** ** | **July 31,  2007** | ** ** |
|                                                 |       |                             |       |   |   |   |   |
| Net cash used in operating activities                |       | $                                | (975       | ) | $ | (522 | ) | $ | (453 | ) |
| Net cash provided by investing activities            |       | 217                              |       | (492 | ) | 709 |   |
| Net cash provided by (used in) financing activities  |       | 785                              |       | 1,115 |   | (330 | ) |
| Net increase (decrease) in cash and cash equivalents |       | $                                | 27         |   | $ | 101 |   | $ | (74 | ) |

 

Working Capital Deficit

 

Our working capital deficitwas $(18,177,000) as of July 31, 2008, as compared to a working capitaldeficit of $(13,128,000) as of April 30, 2008. This $5,049,000 increase inworking capital deficit for the three months ended July 31, 2008, is due toa combination of factors, of which the significant factors are set out below:

 

Factorswhich reduced our working capital deficit

 

·                  $316,000 of unamortized prepaid insurancepremiums in excess of the related notes payable;

·                  $195,000 representing theexcess of the proceeds received over the carrying value of the June 2008Term Note of $805,000

 

Factorswhich increased our working capital deficit

 

·                  $957,000 of cash consumeddirectly in operating activities (calculated as $976,000 of cash used inoperating activities, increased by $19,000 of the cash impact of net changes inother current assets or liabilities included therein);

·                  $2,627,000 representing theamortization of the discount on the convertible debentures;

·                  $1,381,000 representing thecharge for the modification of the April 2007 Debenture, reflected as anincrease in the book value of the April 2007 Debenture

 

Based on the amount ofcapital we have remaining, our expected negative cash flow from operations andinvesting activities and our obligations to YA Global, we anticipate that wewill not be able to positively impact our working capital unless we are able torestructure our current obligations due to YA Global.  In order to continue funding our operationsfrom liquidity, we must obtain additional financing (which we can

 

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obtain only with the consentof YA Global), and ultimately substantially increase our revenues or reduce ourexpenses thereby generating positive cash flow from operations and (ultimately)operating income.

 

As a result of oursignificant working capital deficit, we are financing our operations andnegative cash flow from our liquid assets, which we allocate to pay our mosturgent obligations.  During the threemonths ended July 31, 2008, we used $975,000 in operating activities.  At our current burn rate, our remainingliquidity should be sufficient to finance our anticipated operations andprojected negative cash flow into (and potentially through) our quarter ending October 31,2008.  It is unlikely that we will beable to continue the operations of the parent corporation beyond October 31,2008 without a significant improvement in the operating results of oursubsidiaries or additional financing, neither of which can be assured.  If we are able to secure an offer for assetbased financing from a third party, YA Global has agreed to review thatproposed financing and, in its sole discretion, consider releasing its securityinterest in certain of our assets to secure that financing.  If we are successful at obtaining a minimumof $1,000,000 of additional financing, we believe we could have enoughliquidity to finance our anticipated operations and projected negative cashflow into our fiscal year ending April 30, 2010.  Because of the terms of the existing YA Globalfinancing, we are unable to collateralize any additional financing without YAGlobal’s consent and approval.

 

Convertible Debentures

 

In June 2008 we raised$1,000,000 (net of expenses) through the issuance of a $1,175,000 TermNote.  The Term Note matures October 31,2009, bears interest at 13% per annum and is collateralized by substantiallyall of our assets.  The Term Note is notconvertible into our common stock but only repayable in cash.

 

In June 2008, YA Globalexchanged two of the 2006 Debentures having an aggregate principal balance of$5,970,000 into Term Notes.

 

As a result, we now have(face value):

 

·                  $7,145,000 in Term Notes;and

 

·                  $11,866,300 (net ofconversions to common stock) of remaining 13% Debentures.

 

In conjunction with itspurchase of the Term Note, YA Global agreed to purchase an additional two notesfrom us, one in the principal amount of $50,000 and the second in the principalamount of $275,000.  However, YA Global’sobligation to purchase these notes is either conditioned on the occurrence ofcertain events or is in the sole discretion of YA Global and as such it isuncertain when or if either of these additional notes will be issued.

 

Currently, we may not be incompliance with certain covenants of the remaining 13% Debentures and, in the June financing,YA Global refused to waive any non-compliance with the earlier financingdocuments.  In addition, we have not beenable to comply with certain financial covenants of the Term Notes during thethree months ended July 31, 2008 and as a result YA Global may, in itsdiscretion, declare an event of default on those notes.  If YA Global were to declare an event ofdefault under the 13% Debentures or the Term Notes it would likely have thelegal right to foreclose against its security interest and take control of,and/or dispose of, the assets subject to its security interest.  Although YA Global has not yet declared anevent of default, and although we are continuing to have discussions with YA Globalwith the aim to further our business operations, we can offer no assurance thatYA Global will not declare an event of default under the 13% Debentures or theTerm Notes and seek to collect the amounts due by foreclosure on our assets.

 

Cash Flows

 

As of July 31, 2008, wehad $954,000 of cash and cash equivalents, an increase of $27,000 as comparedto $927,000 at April 30, 2008. Our principal source of funding for thethree months ended July 31, 2008 was

 

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from our existing liquidityas of April 30, 2008 (which existed notwithstanding our significantworking capital deficit), the issuance of a Term Note in June 2008 (with aface value of $1,175,000) for which we received net proceeds of $1,000,000 and$221,000 in net proceeds received from the sale of assets held for sale.  Our principal source of funding for the threemonths ended July 31, 2007 was $805,000 (net of selling costs of $45,000)received for the sale of our life sciences business in June 2007.

 

Cash used in operatingactivities of $(975,000) and $(453,000) for the three months ended July 31,2008 and 2007, respectively, was primarily the result of a net loss of$(8,113,000) (which included noncash expenses and gains in the net amount of a$(7,056,000) expense) and of $(2,985,000) (which included noncash expenses andgains in the net amount of a $(935,000), respectively.

 

Investing activitiesprovided cash of $217,000 and $709,000 for the three months ended July 31,2008 and 2007, respectively. Cash provided by investing activities for thethree months ended July 31, 2008, consisted of $221,000 (net of sellingcosts of $4,000) from the sale of assets held for sale offset by $4,000expended on additions of property and equipment.  Cash provided by investing activities for thethree months ended July 31, 2007, consisted of $805,000 (net of sellingcosts of $45,000) received for the sale of our life sciences business in June 2007offset by $96,000 expended on additions of property and equipment.

 

Financing activitiesprovided cash of $785,000 and used cash of $(330,000) for the three monthsended July 31, 2008 and 2007, respectively. Cash provided by financingactivities for the three months ended July 31, 2008, was due to theissuance of a Term Note in June 2008 (with a face value of $1,175,000) forwhich we received net proceeds of $1,000,000 partially offset by the paymentsof principal on capital leases and notes payable in the amounts of $143,000 and72,000, respectively.  Cash used infinancing activities for the three months ended July 31, 2007, consistedof payments of principal on capital leases and notes payable in the amounts of$106,000 and $224,000, respectively.

 

Additional Liquidity Considerations

 

As of July 31, 2008, wehad no commitments outstanding for capital expenditures.

 

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

 

***Off-Balance Sheet Arrangements***

 

We have no material changesto the disclosure on this matter made in our Annual Report on Form 10-Kfor the year ended April 30, 2008.

 

***Critical Accounting Estimates***

 

Our condensed consolidatedfinancial statements are prepared in accordance with generally acceptedaccounting principles in the Unites States, which require management to makeestimates, judgments and assumptions that affect the amounts reported in theconsolidated financial statements and accompanying notes.  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 thedevelopment and selection of these critical accounting estimates with the AuditCommittee of our Board of Directors and the Audit Committee has reviewed theforegoing disclosure.

 

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Inaddition, there are other items within our financial statements that requireestimation, but are not deemed critical as defined above.  Changes in estimates used in these and otheritems could have a material impact on our financial statements. We believe thatour most critical accounting policies and estimates are as follows:

 

*Goodwill*

 

Goodwillis recorded on our books when the purchase price paid for an acquisitionexceeds the estimated fair value of the net identified tangible and intangibleassets acquired.  The assignment of fairvalue to the identified tangible and intangible assets requires significantjudgment and may require independent valuations of certain identifiedassets.  Once goodwill and otherintangible assets are established on our balance sheet, we evaluate the assetsfor impairment as described in the following paragraphs.

 

Inaccordance with SFAS No. 142 *Goodwilland Other Intangible Assets*(“SFAS 142”), goodwill is not amortized,but instead is tested for impairment on an annual basis or more frequently ifthe presence of certain circumstances indicates that impairment may haveoccurred.  The impairment review process,which is subjective and requires significant judgment at many points during theanalysis, compares the fair value of the reporting unit in which goodwillresides to its carrying value.  If thecarrying value of a reporting unit exceeds its fair value, then the amount ofthe impairment loss must be measured. The impairment loss is calculated bycomparing the implied fair value of reporting unit goodwill to its carryingamount. In calculating the implied fair value of reporting unit goodwill, thefair value of the reporting unit is allocated to all of the other assets andliabilities of that unit based on their fair values. The excess of the fairvalue of a reporting unit over the amount assigned to its other assets andliabilities is the implied fair value of goodwill. An impairment loss would berecognized when the carrying amount of goodwill exceeds its implied fair value.

 

During the three months ended July 31, 2008,due to the loss of a significant customer, we concluded there were sufficientindicators to require us to perform an analysis to assess whether any portionof our goodwill balance of $3,631,000 related to our acquisition of PPSC inMay 2005 was impaired.  Incompleting our analysis of the security services reporting unit, we used theDiscounted Cash Flow Method (“DCF Method”) in which the reporting unit wasvalued by discounting the projected cash flows to its present value based upona risk adjusted discount rate.  As aresult of the testing, we determined that $2,346,000 of the recorded goodwillhad been impaired and was required to be expensed as a non-cash charge tocontinuing operations during the three months ended July 31, 2008.  In performing the calculation under SFASNo. 142, we made several assumptions requiring significant judgment,including the use of the DCF Method, the number of years used in theprojection, the discount rate and growth assumptions.  If we had elected to use different variables,the outcome of the calculation could have been different.  As of July 31, 2008, we have $1,285,000of goodwill remaining on our condensed consolidated balance sheet.

 

*Valuation of Equity Transactions*

 

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

 

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*Valuation of Convertible Debenture Transactions*

 

Weenter into transactions that include debentures that are convertible intocommon stock at rates that may be fixed or variable and also include detachablecommon stock warrants.  We allocate theproceeds from the debenture transactions based on the estimated fair values ofthe debentures and the warrants.  If theassumptions used, as they relate to volatility, risk-free interest rate andestimated life of the warrants (including any anti-dilution adjustmentprovisions) and the fair value of the debentures (included the specificconversion features) were materially different, the overall allocation ofproceeds for these transactions could change significantly.  Further, at times we have classified certainembedded conversion features or warrants issued in convertible debenturetransactions as derivative liabilities in accordance with US GAAP.  The estimates of fair value of thesederivative liabilities involve complex assumptions in the initial recording ofthe liabilities and in the mark-to-market required for each reportingperiod.  If the assumptions used todetermine the fair value of these liabilities were materially different, thevaluation of the liabilities could change significantly.

 

*Stock-Based Compensation Expense*

 

Weaccount for stock-based compensation in accordance with SFAS 123(R).  Under the fair value recognition provisionsof SFAS 123(R), stock-based compensation cost is estimated at the grantdate based on the fair value of the award and is recognized as expense ratablyover the 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 AboutMarket Risk**

 

NotApplicable

 

**Item 4T: Controls and Procedures**

 

*Disclosure Controls and Procedures*

 

Asrequired by Rule 13a-15 under the Securities Exchange Act of 1934 (the“1934 Act”), as of July 31, 2008, we carried out an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures.  This evaluation was carriedout under the supervision and with the participation of our Chief ExecutiveOfficer (our principal executive officer) and our Chief Financial Officer (ourprincipal financial officer).  Based uponand as of the date of that evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures werenot effective because of the identification of material weaknesses in ourinternal control over financial reporting which are identified in Item 9A(T) includedwith our Annual Report on Form 10-K for the year ended April 30,2008, which we view as an integral part of our disclosure controls andprocedures.

 

Disclosurecontrols and procedures are controls and other procedures that are designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed inour reports filed under the Securities Exchange Act of 1934 is accumulated andcommunicated to our management, including our principal executive officer andour principal financial officer, as appropriate, to allow timely decisionsregarding required disclosure.

 

## ***Internal Control Over Financial Reporting***

## *** ***

Therehave not been any changes in our internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) promulgated by the SEC underthe Exchange Act) during the three months ended July 31, 2008 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**Part II: Other Information**

 

**Item 1:  LegalProceedings**

 

OnJuly 22, 2008 James E. Alexander, our former Chief Executive Officer andChairman of the Board of Directors, filed a complaint against us in theJefferson County, Colorado, District Court (case no. 08cv3085).  Thecomplaint alleges that we breached the Settlement Agreement and Mutual GeneralRelease entered into by Mr. Alexander and the Company in February 2007. In his complaint, Mr. Alexander is seeking amounts allegedly due under theagreement, monetary damages and penalties.  Contemporaneously with hiscomplaint Mr. Alexander filed a motion to compel arbitration of thematter.  Isonics has determined not to file any responsive pleading to Mr. Alexander’scomplaint, which will likely result in a default judgment against IsonicsCorporation.  Mr. Alexander’s is currently seeking judgment which weexpect to be approximately $190,000 (including attorneys fees, statutoryinterest and statutory penalties).

 

**Item 1A: Risk Factors**

 

Thereare no material changes to the risk factors set forth in Part I “Item 1A:Risk Factors” in our Annual Report on Form 10-K for the year ended April 30,2008.  As a result, we incorporate thoserisk factors by reference into this report.

 

**Item 2: Unregistered Sales of Equity Securities andUse of Proceeds**

 

Duringthe three months ended July 31, 2008 (and subsequently) we did not enterinto any transactions that were not registered under the Securities Act of1933, as amended and were not previously reported on a Form 8-K.

 

**Item 4: Submission of Matters to a Vote of Security Holders**

 

None

 

**Item 5: Other Information**

 

Departureof Directors

 

OnSeptember 16, 2008, Richard H. Hagman informed us that he has decided toretire from our Board of Directors effective immediately.  Dr. Hagman has served on our Board ofDirectors since July 2005 and at the time of his retirement served as theChairman of the Audit Committee and a member of the Management DevelopmentCommittee of our Board of Directors.

 

Dr. Hagmandid not cite any disagreement with management or our practices or policies ashis decision to retire.  Instead, hecited personal reasons and his desire to pursue other interests as the reasonfor his retirement.  A copy of thedisclosure in the Form 10-Q was provided to Dr. Hagman on September 16,2008.  Dr. Hagman did not expressany disagreement with the disclosure contained herein.

 

**Item 6: Exhibits**

 

Exhibits.

 

3.1           Restated articles of incorporation(incorporated by reference from our Current Report on Form 8-K (File No. 001-12531), dated June 13, 2007 and filed on June 25, 2007, andincorporated herein by reference.

 

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3.2           Restated bylaws (incorporated by referencefrom our Current Report on Form 8-K (File No. 001-12531), dated March 27,2006, and filed on March 31, 2006, and incorporated herein by reference.

31.1         Certification of Chief Executive Officerpursuant to Rule 13a-14(a) of the Exchange Act

31.2         Certification of Chief Financial Officerpursuant to Rule 13a-14(a) of the Exchange Act

32.1         Certification of Chief Executive Officerpursuant to 18 U.S.C. Section 1350

32.2         Certification of Chief Financial Officerpursuant to 18 U.S.C. Section 1350

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized, in the City of Golden, County of Jefferson, State ofColorado, on the 18th day of September 2008.

 
|   | Isonics  Corporation                 |
|--------|--------------------------------------|
|   |     (Registrant) |
|   |                                 |
|   |                                 |
|   | By                                   | /s/  Christopher Toffales |   |
|   |                                 | Christopher  Toffales |
|   |                                 | Chief  Executive Officer |
|   |                                 |
|   |                                 |
|   | By                                   | /s/  Gregory A. Meadows |   |
|   |                                 | Gregory  A. Meadows |
|   |                                 | Chief  Accounting Officer and Chief Financial Officer |

 

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