**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-QSB**

 

**(Mark One)**

 

| **ý**                                                                                                                                                                                 |   | **Quarterly report under Section 13 or 15(d) of the  Securities Exchange Act of 1934.** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                       |   |                                                                                         |
| **For  the quarterly period ended July 31, 2004**                                                                                                                                     |
|                                                                                                                                                                                       |   |                                                                                         |
| **o**                                                                                                                                                                                      |   | **Transition report under Section 13 or 15(d) of the  Exchange Act.**                   |
|                                                                                                                                                                                       |   |                                                                                         |
| **For  the transition period from                  to           ** |
|                                                                                                                                                                                       |   |                                                                                         |
| **Commission  file number:  001-12531**                                                                                                                                               |

 

**ISONICSCORPORATION**

(Exact name ofsmall business issuer as specified in its charter)

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

 

**5906 McIntyre Street**

**Golden, Colorado 80403**

(Address ofprincipal executive offices)

 

**(303) 279-7900**

(Issuer’stelephone number)

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes   ý  No o

 

The number of sharesoutstanding of the registrant’s Common Stock, no par value, was 19,574,986 atSeptember 10, 2004.

 

Transitional SmallBusiness Disclosure Format (check one):

Yes   o  No ý

 

 

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**Isonics Corporation and Subsidiaries**

 

**TABLE OF CONTENTS**

 

**FORM 10-QSB**

 
| Part I:    | Financial Information |                                                                                                            |
|------------|-----------------------|-----------------------------------------------------------------------------------------------------------------|
|       |                  |                                                                                                            |   |
|       | Item 1:               | Financial  Statements                                                                                           |   |
|       |                  |                                                                                                            |   |
|       |                  | Condensed  Consolidated Balance Sheets as of July 31, 2004 and April 30, 2004                         |   |
|       |                  | Condensed  Consolidated Statements of Operations for the Three Month Periods Ended  July 31, 2004 and 2003 |   |
|       |                  | Condensed  Consolidated Statements of Cash Flows for the Three Month Periods Ended  July 31, 2004 and 2003 |   |
|       |                  | Notes  to Condensed Consolidated Financial Statements                                                           |   |
|       |                  |                                                                                                            |   |
|       | Item  2:              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                     |   |
|       |                  |                                                                                                            |   |
|       | Item 3:               | Controls and Procedures                                                                                         |   |
|       |                  |                                                                                                            |   |
| Part II:   | Other Information     |                                                                                                            |
|       |                  |                                                                                                            |   |
|       | Item  2:              | Unregistered  Sales of Equity Securities and Use of Proceeds                                                    |   |
|       |                  |                                                                                                            |   |
|       | Item 6:               | Exhibits                                                                                                        |   |
|       |                  |                                                                                                            |   |
| Signatures |                  |                                                                                                            |

 

2

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**PartI:  Financial Information**

 

**Item1: Condensed Financial Statements**

 

**ISONICS CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 

**ASSETS**

 
|                                                                  |   | **(Unaudited)  July 31, 2004** |   | **April 30,  2004** |   |
|-----------------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------|--------|
| CURRENT  ASSETS:                                                      |   |                                |   |                     |   |
| Cash  and cash equivalents                                            |   | $                                   | 1,796  |                     | $      | 3,691 |   |
| Accounts  receivable (net of allowances of $56 and $16, respectively) |   | 1,041                               |   | 851                      |   |
| Inventories                                                           |   | 1,879                               |   | 985                      |   |
| Prepaid  expenses and other current assets                            |   | 323                                 |   | 143                      |   |
| Total  current assets                                                 |   | 5,039                               |   | 5,670                    |   |
|                                                                  |   |                                |   |                     |   |
| LONG-TERM  ASSETS                                                     |   |                                |   |                     |   |
| Property  and equipment, net                                          |   | 3,352                               |   | 471                      |   |
| Goodwill                                                              |   | 2,254                               |   | 1,807                    |   |
| Intangible  assets, net                                               |   | 732                                 |   | 706                      |   |
| Other  assets                                                         |   | 120                                 |   | 27                       |   |
| Total  long-term assets                                               |   | 6,458                               |   | 3,011                    |   |
|                                                                  |   |                                |   |                     |   |
| TOTAL  ASSETS                                                         |   | $                                   | 11,497 |                     | $      | 8,681 |   |

 

**LIABILITIESAND STOCKHOLDERS’ EQUITY**

 
|                                                                                                                                                                                                                                                                                  |   | **(Unaudited)  July 31, 2004** |   | **April 30,  2004** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|--------------------------|--------|
| CURRENT  LIABILITIES:                                                                                                                                                                                                                                                                 |   |                                |   |                     |   |
| Current  portion of obligation under capital leases                                                                                                                                                                                                                                   |   | $                                   | 66     |                     | $      | 54 |   |
| Accounts  payable                                                                                                                                                                                                                                                                     |   | 1,453                               |   | 628                      |   |
| Accrued  liabilities                                                                                                                                                                                                                                                                  |   | 434                                 |   | 256                      |   |
| Current  portion of note payable                                                                                                                                                                                                                                                      |   | 539                                 |   | —                   |   |
| Total  current liabilities                                                                                                                                                                                                                                                            |   | 2,492                               |   | 938                      |   |
|                                                                                                                                                                                                                                                                                  |   |                                |   |                     |   |
| OBLIGATION  UNDER CAPITAL LEASES, net of current portion                                                                                                                                                                                                                              |   | 73                                  |   | 32                       |   |
|                                                                                                                                                                                                                                                                                  |   |                                |   |                     |   |
| NOTE  PAYABLE, net of current portion                                                                                                                                                                                                                                                 |   | 1,161                               |   | —                   |   |
|                                                                                                                                                                                                                                                                                  |   |                                |   |                     |   |
| TOTAL  LIABILITIES                                                                                                                                                                                                                                                                    |   | 3,726                               |   | 970                      |   |
|                                                                                                                                                                                                                                                                                  |   |                                |   |                     |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                                                                                                           |   |                                |   |                     |   |
| Preferred  Stock; 10,000,000 shares authorized                                                                                                                                                                                                                                        |   |                                |   |                     |   |
| Series  A Convertible Preferred Stock—no par value; 500,308 and 963,666 shares issued  and outstanding on July 31, 2004 and April 30, 2004, respectively;  $750,462 and $1,445,499 liquidation preference on July 31, 2004 and  April 30, 2004, respectively |   | 386                                 |   | 745                      |   |
| Series  C Convertible Preferred Stock-no par value; 9,000 shares issued and outstanding  on July 31, 2004 and April 30, 2004; $900,000 liquidation  preference on July 31, 2004 and April 30, 2004                                                                |   | 1,141                               |   | 1,141                    |   |
| Series  D Convertible Preferred Stock-no par value; 26,950 and 32,950 shares issued  and outstanding on July 31, 2004 and April 30, 2004, respectively;  $2,695,000 and $3,295,000 liquidation preference on July 31, 2004 and  April 30, 2004, respectively      |   | 3,050                               |   | 3,727                    |   |
| Common  stock—no par value; 40,000,000 shares authorized; 18,173,073 and 15,344,913  shares issued and outstanding on July 31, 2004 and April 30, 2004,  respectively                                                                                                  |   | 17,775                              |   | 14,817                   |   |
| Additional  paid in capital                                                                                                                                                                                                                                                           |   | 6,732                               |   | 6,732                    |   |
| Deferred  compensation                                                                                                                                                                                                                                                                |   | (94                                 | )      | (104                     | )      |
| Accumulated  deficit                                                                                                                                                                                                                                                                  |   | (21,219                             | )      | (19,347                  | )      |
| Total  stockholders’ equity                                                                                                                                                                                                                                                      |   | 7,771                               |   | 7,711                    |   |
|                                                                                                                                                                                                                                                                                  |   |                                |   |                     |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                                      |   | $                                   | 11,497 |                     | $      | 8,681 |   |

 

See notes tocondensed consolidated financial statements.

 

3

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**ISONICS CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(Unaudited)**

 
|                                                                    |   | **Three  Months Ended  July 31,** |   |
|-------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                    |   | **2004**                               |   | **2003** |   |
| Revenues                                                                |   | $                                      | 2,285  |   | $ | 2,285 |   |
| Cost  of revenues                                                       |   | 2,587                                  |   | 1,730 |   |
| Gross  margin                                                           |   | (302                                   | )      | 555 |   |
|                                                                    |   |                                   |   |   |   |
| Operating  expenses:                                                    |   |                                   |   |   |   |
| Selling,  general and administrative                                    |   | 1,346                                  |   | 1,083 |   |
| Research  and development                                               |   | 230                                    |   | 65 |   |
| Total  operating expenses                                               |   | 1,576                                  |   | 1,148 |   |
|                                                                    |   |                                   |   |   |   |
| Operating  loss                                                         |   | (1,878                                 | )      | (593 | ) |
|                                                                    |   |                                   |   |   |   |
| Other  income (expense):                                                |   |                                   |   |   |   |
| Foreign  exchange                                                       |   | 12                                     |   | (15 | ) |
| Interest  and other income                                              |   | 13                                     |   | 24 |   |
| Interest  expense                                                       |   | (19                                    | )      | (7 | ) |
| Total  other income (expense), net                                      |   | 6                                      |   | 2 |   |
| Loss  before income taxes                                               |   | (1,872                                 | )      | (591 | ) |
| Income  tax expense                                                     |   | —                                 |   | — |   |
| NET  LOSS                                                               |   | $                                      | (1,872 | ) | $ | (591 | ) |
|                                                                    |   |                                   |   |   |   |
| **Net loss per share-basic and diluted**                                |   |                                   |   |   |   |
| Net  loss per share attributable to common stockholders                 |   | $                                      | (.11   | ) | $ | (.05 | ) |
| Weighted  average common shares used in computing per share information |   | 16,852                                 |   | 12,115 |   |

 

See notes tocondensed consolidated financial statements.

 

4

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**ISONICS CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
|                                                                    |   | **Three  Months Ended July 31,** |   |
|-------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                    |   | **2004**                              |   | **2003** |   |
|                                                                    |   |                                  |   |   |   |
| Net  cash used in operating activities                                  |   | $                                     | (2,341 | ) | $ | (298 | ) |
|                                                                    |   |                                  |   |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                  |   |                                  |   |   |   |
| Purchases  of property and equipment                                    |   | (240                                  | )      | — |   |
| Acquisition  of business, net of cash acquired                          |   | (49                                   | )      |   |   |
| Cash  used in investing activities                                      |   | (289                                  | )      | — |   |
|                                                                    |   |                                  |   |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                  |   |                                  |   |   |   |
| Proceeds  from issuance of notes payable                                |   | —                                |   | 170 |   |
| Proceeds  from issuance of common stock                                 |   | 751                                   |   | 4 |   |
| Principal  payments under capital lease obligations                     |   | (16                                   | )      | (12 | ) |
| Cash  provided by financing activities                                  |   | 735                                   |   | 162 |   |
|                                                                    |   |                                  |   |   |   |
| NET  DECREASE IN CASH AND CASH EQUIVALENTS:                             |   | (1,895                                | )      | (136 | ) |
| Cash  and cash equivalents at beginning of period                       |   | 3,691                                 |   | 742 |   |
| Cash  and cash equivalents at end of period                             |   | $                                     | 1,796  |   | $ | 606 |   |
|                                                                    |   |                                  |   |   |   |
| Supplemental  disclosure of cash flow information:                      |   |                                  |   |   |   |
| Cash  paid during the period for:                                       |   |                                  |   |   |   |
| Interest                                                                |   | $                                     | 24     |   | $ | 4 |   |
| Income  taxes                                                           |   | $                                     | — |   | $ | — |   |
|                                                                    |   |                                  |   |   |   |
| Supplemental  disclosure of noncash investing and financing activities: |   |                                  |   |   |   |
| Capital  lease obligation for property and equipment                    |   | $                                     | 69     |   | $ | — |   |
| Accruals  for property and equipment                                    |   | $                                     | 281    |   | $ | — |   |

 

See notes tocondensed consolidated financial statements.

 

5

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**ISONICS CORPORATION AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

***Basis of Presentation***

 

The accompanyingunaudited condensed consolidated financial statements of Isonics Corporationand Subsidiaries as of July 31, 2004, and for the three months endedJuly 31, 2004 and 2003 have been prepared on the same basis as the annualaudited 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 for the entire year. The information included in this report should be read in conjunctionwith our audited financial statements and notes thereto included in our AnnualReport on Form 10-KSB for the year ended April 30, 2004.

 

***Realization of Assets and Liquidity***

 

Theaccompanying condensed consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America, which contemplates our continuation as a going concern.  However, we have sustained substantiallosses from operations in recent years, and such losses have continued throughAugust 31, 2004.  In view of thismatter, recoverability of a major portion of the recorded asset amounts shownin the accompanying condensed consolidated balance sheet is dependent upon ourcontinued operations, which in turn is dependent upon our ability to meet ourfinancing requirements on a continuing basis, to maintain present financing andto succeed in our future operations. The condensed consolidated financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classification of liabilities that might be necessaryshould we be unable to continue in existence.

 

Asof July 31, 2004, we had cash and cash equivalents of $1,796,000 andworking capital of $2,547,000.  OnJune 11, 2004, we acquired the silicon wafer manufacturing and recyclingassets of EnCompass Materials Group, Ltd. (“EMG”) (See *Acquisition of Business and Assets ofEncompass Materials Group, Ltd*.).  While we believe this acquisition will nowprovide the platform for us to not only continue and improve the EMG legacymanufacturing and reclamation of silicon wafers business, but to also launch afull scale silicon-on-insulator (“SOI”) operation, we will need to raisesignificant additional capital in fiscal year 2005 if we are to successfullyimplement our current business plan for the acquired assets.  With our anticipated revenues fromoperations during the period and projecting our cash flow on the basis of ourhistorical expenditures, we have sufficient cash available to fund ourshort-term working capital requirements through October 31, 2004.  As a result, we are currently working withseveral different sources, including both strategic and financial investors, inorder to raise the capital necessary to finance both our continuing operationsand our newly acquired assets from EMG. If we are unable to raise the necessary capital, we will implement variouscost saving measures that would allow us to continue into the new calendaryear.

 

Theassumptions underlying the above statements include, among other things, thatthere will be no material adverse developments in the business or market ingeneral.  There can be no assuranceshowever that those assumed events will occur. If our plans are not achieved, there may be further negative effects onthe results of operations and cash flows, which could have a material adverseeffect on our financial position.

 

6

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***Accounting for Stock-Based Compensation***

 

Weaccount for stock-based compensation to employees and directors using theintrinsic value method in accordance with Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued toEmployees* and relatedinterpretations, as permitted by SFAS No. 123 *Accountingfor Stock-Based Compensation*, as amended.  Compensation expense for stock options ismeasured as the excess, if any, of the quoted market price of our stock at thedate of grant over the amount an employee must pay to acquire the stock.  No stock-based employee compensation costsrelating to options is reflected within our net loss as all options granted hadan exercise price equal to or greater than the market value of the underlyingcommon stock on the date of grant.  Werecord compensation expense for restricted stock awards based on the quotedmarket price of our stock at the date of the grant and the vesting period.

 

Thefollowing table illustrates the effect on net loss and net loss per share if wehad applied the fair value recognition provisions of SFAS No. 123 tostock-based compensation (in thousands, except per share data):

 
|                                                                                                                                 |   | **Three  Months Ended  July 31,** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                                                                                 |   | **2004**                               |   | **2003** |   |
| Net  loss, as reported                                                                                                               |   | $                                      | (1,872 | ) | $ | (591 | ) |
| Deduct:  Total stock-based compensation expense determined under fair value based  method for all awards, net of related tax effects |   | (45                                    | )      | (60 | ) |
| Adjusted  net loss                                                                                                                   |   | $                                      | (1,917 | ) | $ | (651 | ) |

 
|                             |   | **Three  Months Ended  July 31,** |   |
|----------------------------------|--------|----------------------------------------|--------|
|                             |   | **2004**                               |   | **2003** |   |
| Net loss per share               |   |                                   |   |   |   |
| Basic  and diluted - as reported |   | $                                      | (.11   | ) | $ | (.05 | ) |
| Basic  and diluted - adjusted    |   | $                                      | (.11   | ) | $ | (.05 | ) |

 

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

 

Basic net income (loss)per share is computed using the weighted average number of common sharesoutstanding during the period. Contingently issued shares are included in the computation of basic netincome (loss) per share when the related conditions are satisfied.  Diluted net income (loss) per share iscomputed using the weighted average number of common shares and potentiallydilutive securities outstanding during the period.  Potentially dilutive securities consist of contingently issuedshares, the common shares issuable upon conversion of preferred stock orconvertible debt (using the “if converted” method) and shares issuable upon theexercise of stock options and common stock warrants (using the “treasury stock”method).  Potentially dilutivesecurities are excluded from the computation if their effect is anti-dilutive.

 

7

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Asof July 31, 2004, a total of 9,880,958 outstanding stock options andcommon stock warrants and 500,308, 9,000 and 26,950 outstanding shares ofSeries A, C and D Convertible Preferred Stock, respectively were excluded fromthe diluted net income (loss) per share calculation, as the inclusion would beanti-dilutive.  As of July 31,2003, a total of 5,182,840 outstanding stock options and common stock warrantsand 963,666 outstanding shares of Series A Convertible Preferred Stock wereexcluded from the diluted net income (loss) per share calculation, as theinclusion would be anti-dilutive.

 

During the three monthperiod ended July 31, 2004, we issued the following shares of commonstock:

 
| **Description**                                  |   | **Number of  Common Stock Shares** |   |
|--------------------------------------------------|--------|------------------------------------|--------|
| Balance  as of April 30, 2004               |   | 15,344,913                         |   |
| Conversion  of preferred stock                   |   | 1,472,171                          |   |
| Exercise  of common stock warrants               |   | 620,000                            |   |
| Shares  issued from employee stock purchase plan |   | 4,059                              |   |
| Shares  issued for acquisition of assets         |   | 731,930                            |   |
| Balance  as of July 31, 2004                |   | 18,173,073                         |   |

 

Theaforementioned equity transactions increased common stock in the accompanyingcondensed consolidated balance sheets by $2,958,000 for the three months endedJuly 31, 2004.

 

***Inventories***

 

Inventories consist of thefollowing (in thousands):

 
|                    |   | **July 31,  2004** |   | **April 30,  2004** |   |
|-------------------------|--------|-------------------------|--------|--------------------------|--------|
| Finished  goods         |   | $                       | 792    |                     | $      | 407 |   |
| Work  in process        |   | 677                     |   | 508                      |   |
| Materials  and supplies |   | 410                     |   | 70                       |   |
| Total  inventories      |   | $                       | 1,879  |                     | $      | 985 |   |

 

***Property and equipment***

 

Property and equipment consist of the following (inthousands):

 
|                                       |   | **July 31,  2004** |   | **April 30,  2004** |   |
|--------------------------------------------|--------|-------------------------|--------|--------------------------|--------|
| Office  furniture and equipment            |   | $                       | 376    |                     | $      | 304 |   |
| Production  equipment                      |   | 2,901                   |   | 648                      |   |
| Leasehold  improvements                    |   | 261                     |   | 30                       |   |
| Construction  in process                   |   | 505                     |   | —                   |   |
|                                       |   | 4,043                   |   | 982                      |   |
| Accumulated  depreciation and amortization |   | (691                    | )      | (511                     | )      |
| Total  property and equipment              |   | $                       | 3,352  |                     | $      | 471 |   |

 

8

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***Accrued liabilities***

 

Accrued liabilitiesconsist of the following (in thousands):

 
|                            |   | **July 31,  2004** |   | **April 30,  2004** |   |
|---------------------------------|--------|-------------------------|--------|--------------------------|--------|
| Compensation                    |   | $                       | 113    |                     | $      | 103 |   |
| Customer  advances and deposits |   | 57                      |   | 67                       |   |
| Inventories                     |   | 74                      |   | —                   |   |
| Other                           |   | 190                     |   | 86                       |   |
| Total  accrued liabilities      |   | $                       | 434    |                     | $      | 256 |   |

 

***Significant customers***

 

Asof July 31, 2004, three customers accounted for approximately 45% of totalnet accounts receivable.  Threecustomers accounted for approximately 34% of total net accounts receivable atApril 30, 2004.  Two customers(Eastern Isotopes and Perkin Elmer Life Sciences) accounted for approximately24% and 18%, respectively, of revenues for the three months ended July 31,2004.  Two customers (Eastern Isotopesand Perkin Elmer Life Sciences) accounted for approximately 31% and 11%,respectively, of revenues for the three months ended July 31, 2003.  Three customers (Perkin Elmer Life Sciences,IBT SA, and International Isotopes ) accounted for 58%, 11% and 10%,respectively of the German operation’s revenues for the three months endedJuly 31, 2004.  Three customers(Perkin Elmer Life Sciences, IBT SA, and International Isotopes) accounted forapproximately 44%, 24%, and 15%, respectively, of the German operation’srevenues for the three months ended July 31, 2003.  Two customers accounted for approximately72% of the German operation’s accounts receivable at July 31, 2004.  Two customers accounted for approximately49% of the German operation’s accounts receivable at April 30, 2004.

 

***Business Segments and Foreign Operations***

 

Wecurrently have two reportable segments: life sciences and semiconductormaterials and products.  Our lifesciences segment sells stable and radioisotopes in elemental and simplecompound forms for use in life sciences applications.  Our semiconductor materials and products segment manufactures andreclaims silicon wafers, sells SOI wafers and is involved in several researchand development projects including silicon-28. Reconciling items consist primarily of corporate expenses that have notbeen allocated to a specific reportable segment.

 

Information by segment isset forth below (in thousands):

 
|                                  |   | **Three  Months Ended  July 31,** |   |
|---------------------------------------|--------|----------------------------------------|--------|
|                                  |   | **2004**                               |   | **2003** |   |
| Segment  revenues:                    |   |                                   |   |   |   |
| Life  sciences                        |   | $                                      | 1,951  |   | $ | 2,022 |   |
| Semiconductor  materials and products |   | 334                                    |   | 263 |   |
| Total                                 |   | $                                      | 2,285  |   | $ | 2,285 |   |

 

9

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|                                  |   | **Three  Months Ended  July 31,** |   |
|---------------------------------------|--------|----------------------------------------|--------|
|                                  |   | **2004**                               |   | **2003** |   |
| Segment  operating (loss) income:     |   |                                   |   |   |   |
| Life  sciences                        |   | $                                      | 164    |   | $ | 166 |   |
| Semiconductor  materials and products |   | (1,040                                 | )      | (132 | ) |
| Reconciling  amounts                  |   | (1,002                                 | )      | (627 | ) |
| Total                                 |   | $                                      | (1,878 | ) | $ | (593 | ) |

 
|                                  |   | **July 31,  2004** |   | **April 30,  2004** |   |
|---------------------------------------|--------|-------------------------|--------|--------------------------|--------|
| Total  assets:                        |   |                    |   |                     |   |
| Life  sciences                        |   | $                       | 4,389  |                     | $      | 4,066 |   |
| Semiconductor  materials and products |   | 5,359                   |   | 1,037                    |   |
| Reconciling  amounts                  |   | 1,749                   |   | 3,578                    |   |
| Total                                 |   | $                       | 11,497 |                     | $      | 8,681 |   |

 

A summary of operationsby geographic area is as follows:

 

 
|           |   | **Three  Months Ended  July 31,** |   |
|----------------|--------|----------------------------------------|--------|
|           |   | **2004**                               |   | **2003** |   |
| Revenues:      |   |                                   |   |   |   |
| United  States |   | $                                      | 1,582  |   | $ | 1,731 |   |
| Germany        |   | 703                                    |   | 554 |   |
| Total          |   | $                                      | 2,285  |   | $ | 2,285 |   |

 
|             |   | **Three  Months Ended  July 31,** |   |
|------------------|--------|----------------------------------------|--------|
|             |   | **2004**                               |   | **2003** |   |
| Operating  loss: |   |                                   |   |   |   |
| United  States   |   | $                                      | (1,860 | ) | $ | (579 | ) |
| Germany          |   | (18                                    | )      | (14 | ) |
| Total            |   | $                                      | (1,878 | ) | $ | (593 | ) |

 
|           |   | **July 31,  2004** |   | **April 30,  2004** |   |
|----------------|--------|-------------------------|--------|--------------------------|--------|
| Total  assets: |   |                    |   |                     |   |
| United  States |   | $                       | 8,690  |                     | $      | 5,914 |   |
| Germany        |   | 2,807                   |   | 2,767                    |   |
| Total          |   | $                       | 11,497 |                     | $      | 8,681 |   |

 

10

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***Acquisition of Business and Assets ofEncompass Materials Group, Ltd.***

 

On June 11, 2004, weacquired the silicon wafer manufacturing and recycling assets of EMG.  The results of the operations associatedwith the acquired assets have been included in the condensed consolidatedfinancial statements since that date. EMG was engaged in the business of manufacturing and reclamation ofsilicon wafers.  As a result of theacquisition, we not only have entered into the business of manufacturing andreclamation of silicon wafers but we also expect to use the acquired assets asa platform to launch our full scale SOI operations.  In conjunction with this acquisition, in May 2004 we establishedour wholly owned subsidiary Isonics Vancouver, Inc. (“Isonics Vancouver”).  Isonics Vancouver is a Washington basedentity that now conducts our SOI and manufacturing and reclamation of siliconwafer operations.

 

The aggregate purchaseprice was $2,920,000, which consisted of a $1,700,000 promissory note (securedby the assets acquired and certain other assets owned by us relating to our SOIbusiness) payable over 33 months with an interest rate of 6%, 731,930 shares ofour restricted common stock (valued at $1,171,000 based upon the fair marketvalue of the common stock on June 11, 2004) and $49,000 of legal andaccounting fees.  In addition, weassumed operating leases (that expire in various years through fiscal year2011) with future commitments of approximately $1,200,000.

 

The following tablesummarizes the estimated fair values of the assets acquired and liabilitiesassumed at the date of acquisition including property and equipment, which wasbased on an independent third party valuation. While we believe the purchase accounting associated with thistransaction to essentially be complete, there is always the possibility that itmay be subject to refinement.

 
| Current  assets         |   | $         | 604,000   |   |
|-------------------------|--------|-----------|-----------|--------|
| Property  and equipment |   | 2,497,000 |      |
| Other  assets           |   | 16,000    |      |
| Intangible  assets      |   | 50,000    |      |
| Goodwill                |   | 447,000   |      |
| Total  assets acquired  |   | 3,614,000 |      |
| Current  liabilities    |   | (694,000  | )         |
| Net  assets acquired    |   | $         | 2,920,000 |   |

 

The $447,000 of goodwillwas assigned to the semiconductor materials and products segment which isexpected to be deductible for tax purposes. The $50,000 of intangible assets relates to customer lists and will beamortized ratably over its estimated life of 3 years.  There was no in-process research and development acquired in thistransaction.

 

The $1,700,000 promissorynote is payable by our subsidiary, Isonics Vancouver.  In accordance with the terms of the acquisition of the businessand assets of EMG, we have guaranteed all payments (totaling $1,854,000including interest) of such loan should Isonics Vancouver be in default at anypoint over the life of the loan.

 

11

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The following tablesummarizes our results of operations for the three months ended July 31,2004 and 2003 as if the acquisition of the business and assets of EMG hadoccurred on May 1, 2004 and 2003, respectively.  There have been no adjustments made to the historical results ofEMG.

 
|                                         |   | **Three  months  ended  July 31, 2004** |       | **Three  months  ended  July 31, 2003** |   |
|----------------------------------------------|--------|----------------------------------------------|------------|----------------------------------------------|--------|
| Revenue                                      |   | $                                            | 2,661,000  |                                         | $      | 3,147,000 |   |
| Net  loss                                    |   | $                                            | (2,234,000 | )                                            | $      | (868,000 | ) |
| Net  loss per share – basic and diluted |   | $                                            | (.13       | )                                            | $      | (.07 | ) |

 

***Convertible Preferred Stock***

 

Thereare provisions associated with the Series A Convertible Preferred Stock(“Series A Stock”) that if triggered, would reduce the current conversion priceand effectively allow the preferred shares to convert to common stock at a morefavorable ratio.  The Series A Stock isconvertible at two shares of common stock for each share of Series A Stockoutstanding.  On May 3, 2004, 463,358 sharesof Series A Stock were converted into 926,716 shares of common stock.  As of September 10, 2004, there were500,308 shares of Series A Stock outstanding convertible into 1,000,616 sharesof common stock based upon the current conversion ratio.

 

OnMay 20, 2004, 6,000 shares of Series D Convertible Preferred Stock (“Series DStock”) were converted into 545,455 shares of common stock.  On September 10, 2004, 5,000 shares ofSeries D Stock were converted into 454,545 shares of common stock.  As a result, as of September 10, 2004,there were 21,950 shares of Series D Stock outstanding convertible into1,995,455 shares of common stock.

 

OnAugust 23, 2004, 3,000 shares of Series C Convertible Preferred Stock(“Series C Stock”) were converted into 315,789 shares of common stock.  On September 10, 2004, 6,000 shares ofSeries C Stock were converted into 631,579 shares of common stock.  As a result, as of September 10, 2004,there were zero shares of Series C Stock outstanding.

 

***Commitments***

 

InJune 2004, we entered into an agreement with IUT whereby we agreed to fund$275,000 of research and development expenses on behalf of IUTDT during theyear ending April 30, 2005.  Theresearch and development work will be completed by IUT and will be funded insteps based upon completion of various milestones.  We funded the first $100,000 of this commitment in June 2004(which was recorded as research and development expense on the accompanyingcondensed consolidated statement of operations).

 

Asof July 31, 2004, we had commitments outstanding for capital expendituresof approximately $800,000.

 

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

 

*Thestatements contained in this Report on Form 10-QSB that are not purelyhistorical are forward looking statements within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934, including statements regarding ourexpectations, hopes, intentions or strategies regarding the future.  Forward-looking statements include:statements regarding future products or product development; statementsregarding future selling, general and administrative costs and research anddevelopment spending and our product development strategy; and statementsregarding future capital expenditures and financing requirements.  All forward-looking statements included inthis document are based on information available to us on the date hereof, andwe undertake no obligation to update any such forward-looking statements.  It is important to note that our actualresults could differ materially from those in such forward-looking statements.*

 

***General Discussion***

 

Foundedin 1992, we are an advanced materials and technology company focusing on thesupply of isotopes for life sciences and health-care applications andsilicon-on-insulator (“SOI”) wafers to the semiconductor industry.  Most recently, in June 2004 we acquiredthe business and assets of EMG, which was engaged in the business of manufacturingand reclamation of silicon wafers.  Inaddition, we continue to develop additional products created from materialswhose natural isotopic ratios have been modified as well as non-isotopic(natural) materials.  An isotope is oneof two or more species (or nuclides) of the same chemical element that differfrom one another only in the number of neutrons in the atom’s nucleus.  The different number of neutrons can createsignificantly different nuclear properties. Radioactivity is the most well known of these properties.  Radioactive isotopes (or radioisotopes) canbe found in nature.  Most of ourradioisotopes, however, are man-made. Stable isotopes, as distinguished from radioisotopes, are notradioactive.

 

Severalmanufacturers, located primarily in republics that once were part of the SovietUnion, produce radioactive and stable isotopes.  We buy these isotopes from the manufacturers and resell them inthe form of common chemical compounds. For example, oxygen-18 is sold as water, and zinc-68 is sold as zincoxide.  Today our business addresses thematerial needs of two primary markets:

 

•                  Life sciences (involving isotopic materials)and

•                  Semiconductor materials and products(including both isotopic and non-isotopic materials).

 

Whilewe currently are focusing on these two markets, we continue to evaluate otherapplications for stable isotopes, radioisotopes and non-isotopicmaterials.  In December 2002, weacquired certain isotope-based trace detection technology that can be used todetect explosives and chemical and biological weapons.  We acquired this technology through our85%-owned subsidiary, IUT Detection Technology, Inc. (“IUTDT”) from Institut ofUmwelttechnologien GmbH (“IUT”), an entity in which we hold a 6% ownershipinterest.  (IUT owns the remaining 15%of IUTDT.)  If and when we begin salesof these detection products, we expect these products to constitute a thirdmarket (the homeland security market) for our products.  We are continuing to pursue research anddevelopment opportunities with respect to the technology we acquired from IUTunder a research and development agreement we entered into with IUT, as well ascontinuing research and development of our silicon-28 semiconductor materials.

 

Wealso sell isotopes for use in basic scientific research and industrialapplications.  We believe our corecompetency is our ability to identify, develop, source, and commercializeproducts and services based on isotopically engineered materials as well asnon-isotopic semiconductor materials.

 

13

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Priorto our acquisition of the business and assets of EMG, we developed anintegration plan which was predicated on making numerous changes to the relatedbusiness that we believed if made, would result in significant productivityimprovements and cost reductions.  Ourplan required a structured three-five month implementation process, and wasstarted within the first three weeks after the acquisition of the business andassets of EMG in June 2004.  Whilewe don’t anticipate to start seeing the benefits of our cost reduction programuntil the end of our second fiscal quarter, we did incur costs associated withthe integration of the business, establishing processes and procedures (aimedat lowering the overall future costs of the operation) within the plant andhiring the proper personnel necessary to bring the assets to their fulloperating capacity.  In addition, ourrevenues during the quarter ended July 31, 2004 were significantly lessthan the historical run rates at EMG (due mainly to the unavailability of a keyproduction tool, which has since been corrected).  These integration expenses, reduced revenues and the fact that wewon’t begin to see the results of our cost savings program until the end of oursecond fiscal quarter have generated significant losses (including negativegross margins) during the three months ended July 31, 2004.

 

Withthe successful implementation of our plan (which we believe will besubstantially completed by the end of our second fiscal quarter), we expect togradually increase our revenues (through increased sales to both current andnew customers) and lower our operating costs (through the implementation of newproduction processes).  As a result, weanticipate that our gross margin will gradually begin to improve during thequarter ending October 31, 2004 and will continue to do so through the endof our year ending April 30, 2005. We cannot however provide any assurance that this will come to fruition.

 

Wehave been required to make significant cash investments in our SOI wafermanufacturing operations, our newly-acquired wafer manufacturing andreclamation operations, and for research and development of our homelandsecurity and silicon-28 semiconductor technology.  We anticipate that we will be required to make significantadditional investments of cash, personnel, and materials in these operations inthe future.  In addition, as a result ofour acquisition of the silicon wafer manufacturing and recycling assets of EMGin June 2004, we will need to raise significant additional capital infiscal year 2005 if we are to successfully implement our current business planfor the acquired assets.   With ouranticipated revenues from operations during the period and projecting our cashflow on the basis of our historical expenditures, we have sufficient cashavailable to fund our short-term working capital requirements throughOctober 31, 2004.  As a result, weare currently working with several different sources, including both strategicand financial investors, in order to raise the capital necessary to financeboth our continuing operations and our newly acquired assets from EMG.  If we are unable to raise the necessarycapital, we will implement various cost saving measures that would allow us tocontinue into the new calendar year.

 

Theassumptions underlying the above statements include, among other things, thatthere will be no material adverse developments in the business or market ingeneral.  There can be no assuranceshowever that those assumed events will occur. If our plans are not achieved, there may be further negative effects onthe results of operations and cash flows, which could have a material adverseeffect on our financial position.

 

Ourrevenues in the future will depend on our success in developing and sellingproducts in the semiconductor and stable and radioactive isotope markets.  Consistent with our historical experience,our quarterly results have been materially affected by the size, timing, andquantity of orders and product shipments during a given quarter.

 

14

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***Results of Operations***

 

Thefollowing table sets forth, for the periods indicated, statement of operationsdata expressed as a percentage of net sales. The table and the discussion below should be read in conjunction withthe condensed consolidated financial statements and the notes thereto appearingelsewhere in this report.

 
|                                 |   | **Three  Months Ended  July 31,** |   |
|--------------------------------------|--------|----------------------------------------|--------|
|                                 |   | **2004**                               |   | **2003** |   |
|                                 |   |                                   |   |   |   |
| Revenues                             |   | 100.0                                  | %      | 100.0 | % |
| Cost  of revenues                    |   | 113.2                                  |   | 75.7 |   |
| Gross  margin                        |   | (13.2                                  | )      | 24.3 |   |
|                                 |   |                                   |   |   |   |
| Operating  expenses:                 |   |                                   |   |   |   |
| Selling,  general and Administrative |   | 58.9                                   |   | 47.4 |   |
| Research  and development            |   | 10.1                                   |   | 2.8 |   |
| Total  operating expenses            |   | 69.0                                   |   | 50.2 |   |
| Operating  loss                      |   | (82.2                                  | )      | (25.9 | ) |
|                                 |   |                                   |   |   |   |
| Other  income (expense), net         |   | .3                                     |   | — |   |
| Loss  before income taxes            |   | (81.9                                  | )      | (25.9 | ) |
| Income  tax expense                  |   | —                                 |   | — |   |
| NET  LOSS                            |   | (81.9                                  | )%     | (25.9 | )% |

 

***Revenues***

 

Revenues remained flat during the three monthsended July 31, 2004 as compared to the same period of our prior fiscal year,although our revenues from our semiconductor materials and products segment didreflect an increase during this period as compared to revenues from our lifesciences segment which reflected a decrease, as described in the followingtable:

 
|                                  |   | **Three  months ended July 31,** |      |
|---------------------------------------|--------|---------------------------------------|-----------|
|                                  |   | **2004**                              |      | **2003** |   |
| Life sciences                         |   |                                  |      |   |   |
| Domestic                              |   | $                                     | 1,248,000 |   | $ | 1,468,000 |   |
| International                         |   | $                                     | 703,000   |   | $ | 554,000 |   |
|                                  |   |                                  |      |   |   |
| Semiconductor materials  and products |   | $                                     | 334,000   |   | $ | 263,000 |   |
|                                  |   |                                  |      |   |   |
| Total                                 |   | $                                     | 2,285,000 |   | $ | 2,285,000 |   |

 

Asa significant portion of our revenues are derived from a small concentration ofcustomers (see *Significant Customers*), if one or more of these customerswere to discontinue or reduce their purchases of our isotope products, theresult could have a material effect on both our revenues and related cashflows.

 

15

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The decrease in revenues from domestic isotopeproduct sales for the three months ended July 31, 2004 was primarily theresult of a significant decrease in the unit price of oxygen-18, which waspartially offset by an increase in volume.

 

While the substantial majority of our revenues atour German subsidiary are derived from the sale of radioisotopes, we have haddifficulty in the United States with our ability to enter the radioisotopemarket.  The difficulty arises from thefact that our potential customers have long established relationships withtheir suppliers (who are mostly foreign) and as a result they are hesitant tochange.  While we continue to worktowards increasing our share in the domestic radioisotope market to ameaningful number, we can offer no assurances that we will be able to do so.

 

The substantial majority of our domestic isotopeproduct sales result from the sale of oxygen-18.  Our sales volume continues to increase, but because the per-unitprice of oxygen-18 has been decreasing as a result of increasing competition,we have not been able to increase total sales revenue in this market.   As a result, in order to increase our revenuesfrom the sale of oxygen-18, we will need to increase our volume at a rategreater than the continuing decreases in the anticipated future market pricefor that product.  The market foroxygen-18 in the United States is continuing to expand and we are activelybidding to become the supplier for additional customers. While we believe thatwe will be successful in increasing our gross revenues and margin in sales ofoxygen-18 in the future (notwithstanding the decreasing per-unit margins), we can offer noassurance that we will be able to do so in the face of the domestic andinternational competition in this market.

 

The increase in revenues from international isotopeproduct sales for the three months ended July 31, 2004 was primarily theresult of a significant increase in sales of radioisotopes.

 

In general, our German subsidiary has haddifficulty entering the oxygen-18 market in Europe as many of its potentialcustomers are under long-term supply contracts with their current suppliers andthe market is relatively flat (unlike the United States where the volume ofsales (although not the per-unit price) is growing at a significant rate).  The quality of our product is high but wemust wait until our potential customers’ current supply agreements terminatebefore we will be able to bid on new supply contracts.  Our ability to significantly increase therevenues in our German subsidiary (and ultimately its gross margin) is directlyrelated to how successful we can be in gaining market share in the Europeanoxygen-18 market.  While we anticipatethat we will continue to obtain European oxygen-18 customers in fiscal year2005 (we have obtained two new customers as of September 10, 2004), theprocess is expected to be slow and we cannot provide any assurance that we willbe able to do so.

 

The increase in revenues from semiconductormaterials and products sales for the three months ended July 31, 2004 wasprimarily due to the additional revenues generated from the business and assetsacquired from EMG in June 2004.  Weonly included revenues and operating results from that business forapproximately 45 days during the quarter. In addition, although revenues increased as a result of the acquisitionof the EMG business and assets, the increase was not as large as we hadanticipated (due mainly to the unavailability of a key production tool, whichhas since been corrected).  Included inrevenues for the three months ended July 31, 2003 was $200,000 related tothe sale of silicon-28 as a bulk isotope.

 

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As a result of our acquisition of the business andassets of EMG in June 2004, we believe we now have the platform to notonly continue and improve the EMG legacy manufacturing and reclamation ofsilicon wafers business but also to launch a full scale SOI operation.  Although we are currently in the process ofintegrating the acquired business and assets with our own semiconductormaterials and products operations, we anticipate a significant increase insemiconductor materials and products sales for the year ending April 30,2005, however we cannot provide any assurance that this will come tofruition.  Results for the first sixweeks of the second quarter of our fiscal year ending April 30, 2005indicate that sales from our semiconductor materials and products operations(which includes the business and assets acquired from EMG) are beginning theexpansion we had earlier contemplated. It is premature, however, to project the results of that expansioneither for the entire current quarter or during the current fiscal year.

 

We do not anticipate significant revenues fromsales of silicon-28 based products during the remainder of fiscal year2005.  We are collaborating withacademia and industry to evaluate the benefits of isotopically puresilicon-28.  We believe that ifevaluations demonstrate the commercial feasibility of one or more products,demand could emerge in the high-performance microprocessor segment of thesemiconductor market.  We can offer noassurance, however that these evaluations will demonstrate the commercialfeasibility of any products, that we will be able to commercialize any suchproducts, or that a market will emerge for any such products.

 

***Gross Margin***

 

Our gross margins decreased during the three monthsended July 31, 2004 as compared to the same period of our prior fiscalyear, both on a dollar amount and on a percentage of revenues as reflected inthe following table:

 
|                |   | **Three  months ended July 31,** |     |
|---------------------|--------|---------------------------------------|----------|
|                |   | **2004**                              |     | **2003** |   |
| Dollar amount       |   | $                                     | (302,000 | ) | $ | 555,000 |   |
| Percent of revenues |   | (13.2%                                | )        | 24.3 | % |
|                     |        |                                       |          |  |  |  |  |

 

The decrease in gross margin is due mainly to thenegative margins generated by the business and assets acquired from EMG inJune 2004 and partially by a continuing degradation of the price ofoxygen-18.

 

In general, we anticipate that our margins willcontinue to decline as oxygen-18 prices decrease and until we can generate apositive margin for the semiconductor materials and products segment.  With the acquisition of the business andassets of EMG in June 2004, we believe we now have the platform to notonly continue and improve the EMG legacy manufacturing and reclamation ofsilicon wafers business but to launch a full scale SOI operation and as aresult, we anticipate that the gross margin from sales of semiconductor andmaterials and products (both in dollar value and as a percentage of revenues)will increase over time.

 

We have begun to implement our integration planwhich was predicated on making numerous changes to the related business that webelieved if made, would result in significant productivity improvements andcost reductions. This process is currently ongoing and, although we believe itwill reflect beneficial results and a reduction in overall expenses (and,therefore, an improvement of our margins), it is premature to make anydefinitive prediction.

 

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***Selling, General and AdministrativeExpenses***

 

Our selling, general and administrative expensesincreased during the three months ended July 31, 2004 as compared to thesame period of our prior fiscal year, both on a dollar amount and on apercentage of revenues basis as reflected in the following table:

 
|                |   | **Three  months ended July 31,** |      |
|---------------------|--------|---------------------------------------|-----------|
|                |   | **2004**                              |      | **2003** |   |
| Dollar amount       |   | $                                     | 1,346,000 |   | $ | 1,083,000 |   |
| Percent of revenues |   | 58.9                                  | %         | 47.4 | % |
|                     |        |                                       |           |  |  |  |  |

 

Both the dollar and percentage increase for thethree months ended July 31, 2004 is attributable primarily to an increasein consulting and other professional services expenses and an increase inheadcount and facility costs related to the expansion of our SOI operations(primarily due to the acquisition of the business and assets of EMG inJune 2004).

 

Asa result of the financings we completed during the year ended April 30,2004 and our acquisition of the business and assets of EMG in June 2004,we anticipate that we will increase our selling, general and administrativeexpenses during the remainder of fiscal year 2005 through anticipated increasedmarketing efforts for our semiconductor materials and products segment.  In addition, if we are able to obtain thenecessary funding, we will increase our selling, general and administrativeexpenses during the remainder of fiscal year 2005 in an effort to market theisotope-based trace detection technology that we acquired from IUT if productsattractive to the market can be developed and then successfully manufacturedusing that technology.  There can be noassurance that our anticipated increased selling, general and administrativeexpenses will result in increased revenues from product sales.

 

***Research and Development Expenses***

 

Ourresearch and development expenses increased during the three months endedJuly 31, 2004 as compared to the same period of our prior fiscal year,both on a dollar amount and on a percentage of revenues basis as reflected inthe following table:

 
|                |   | **Three  months ended July 31,** |    |
|---------------------|--------|---------------------------------------|---------|
|                |   | **2004**                              |    | **2003** |   |
| Dollar amount       |   | $                                     | 230,000 |   | $ | 65,000 |   |
| Percent of revenues |   | 10.1                                  | %       | 2.8 | % |
|                     |        |                                       |         |  |  |  |  |

 

Boththe dollar and percentage increases for the three months ended July 31,2004 are primarily related to an increase in research and development expensesassociated with our isotope-based detection technology.

 

18

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Consistentwith our product development strategy, we are seeking to identify and evaluatenew stable and radioactive isotope products, SOI products and potential marketsfor economic and technical feasibility. In June 2004, we entered into an agreement with IUT to fund$275,000 of research and development expenses on behalf of IUTDT in fiscal 2005(of which $100,000 has been funded as of September 10, 2004) and weanticipate that if we obtain additional financing, we may incur additionalresearch and development costs associated with the detection technology that weacquired from IUT. We will, in addition, continue funding research anddevelopment to improve technologies for isotope separation and materialprocessing technologies and our SOI processes. Because of the uniqueness of our business, the unique chemicals andprocesses we deal with and the handling precautions required, these expensescan be significant.  We cannot offer anyassurance that our current or future lines of business or products resultingfrom our research and development efforts will be profitable or generatesignificant revenues.

 

Webelieve that the development and introduction of new product applications iscritical to our future success.  Weexpect that research and development expenses may increase assuming sufficientcash remains available and we are able to procure necessary materials andoutside services.  It is likely thatresearch and development expenditures will continue to vary as a percentage ofrevenues because of the timing and amount of future revenues. Except for workbeing performed on our SOI thin-film product at our facilities in Vancouver,Washington, we operate no other facilities of our own for research anddevelopment.  All other research anddevelopment work is performed by outside entities, none of which wecontrol.  None of the companies thatcurrently perform research and development work for us does so on an exclusivebasis.

 

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

 

OtherIncome (Expense), net increased during the three months ended July 31,2004 as compared to the same period of our prior fiscal year as reflected inthe following table:

 
|          |   | **Three  months ended July 31,** |   |
|---------------|--------|---------------------------------------|--------|
|          |   | **2004**                              |   | **2003** |   |
| Dollar amount |   | $                                     | 6,000  |   | $ | 2,000 |   |
|               |        |                                       |        |  |  |  |  |

 

Forthe three months ended July 31, 2004 and 2003, other income (expense), netincludes interest income and expense and foreign currency gains and losses.

 

***Income Taxes***

 

Wecurrently operate at a loss and expect to operate at a loss until the productscurrently under development begin to generate sufficient revenue.  The losses we anticipate incurring duringthe remaining portion of the current year are not expected to generate anincome tax benefit because of the uncertainty of the realization of thedeferred tax asset.  As such, we havealso provided a valuation allowance against our net deferred tax asset asrealization is uncertain.

 

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***Net Loss***

 

Ournet losses increased during the three months ended July 31, 2004 ascompared to the same period of our prior fiscal year, as reflected in thefollowing table:

 
|          |   | **Three  months ended July 31** |       |
|---------------|--------|--------------------------------------|------------|
|          |   | **2004**                             |       | **2003** |   |
| Dollar amount |   | $                                    | (1,872,000 | ) | $ | (591,000 | ) |
|               |        |                                      |            |  |  |  |  |

 

Weanticipate that losses will continue until (if ever): (i) revenues from ourcurrent operations (including our newly acquired assets from EMG) substantiallyincrease or (ii) we generate substantial revenues from products introduced as aresult of our research and development projects.  We expect that our net loss will continue during at least theshort term as we continue to incorporate and integrate the business and assetsacquired from EMG into our operations, as we continue our marketing andresearch efforts to expand sales and develop new products in our life sciencessegment and as we continue research and development efforts to commercializethe NeutroTest technology for the homeland security market.

 

Net income in futureyears will be dependent upon our ability to increase net revenues (and relatedmargins) faster than we increase our operating expenses.  As a result of our acquisition of thebusiness and assets of EMG in June 2004, we believe we now have theplatform to not only continue and improve the EMG legacy manufacturing andreclamation of silicon wafers business but to launch a full scale SOIoperation.  However, we anticipate thatour operations during the remainder of fiscal year 2005 will result in a losssince we are not likely to increase our revenues from our existing products orgenerate additional sales from the new products we may develop in a sufficientamount (if at all) to offset our operating expenses.

 

***Liquidity and Capital Resources***

 

Ourworking capital and liquidity have eroded significantly during the three monthsended July 31, 2004.  Workingcapital decreased $2,185,000, to $2,547,000 at July 31, 2004, from$4,732,000, at April 30, 2004.

 

Ourprincipal source of funding for the three months ended July 31, 2004 wasfrom the exercise of common stock warrants. Our principal source of funding for the three months ended July 31,2003 was from short- term loans.  Weused cash in operating activities of $2,341,000 and $298,000 during the threemonths ended July 31, 2004 and 2003, respectively.  Cash used in operating activities for thethree months ended July 31, 2004 and 2003 was principally the result of anet loss of $1,872,000 and $591,000, respectively.

 

Asa significant portion of our revenues and accounts receivable are derived froma small concentration of customers (see *Significant Customers*), if one or more ofthese customers were to discontinue or reduce their purchases of our isotopeproducts or fail to pay our accounts receivable, the result could have amaterial effect on both our revenues and related cash flows.

 

Ourinvesting activities used cash of $289,000 and $0 for the three months endedJuly 31, 2004 and 2003, respectively. Cash used in investing activities for the three months endedJuly 31, 2004 resulted from purchases of property and equipment and theacquisition of the business and assets of EMG.

 

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Financingactivities provided cash of $735,000 and $162,000 for the three months endedJuly 31, 2004 and 2003, respectively. Cash provided by financingactivities for the three months ended July 31, 2004 resulted primarilyfrom the exercise of common stock warrants. Cash provided by financing activities for the three months endedJuly 31, 2003 resulted primarily from short-term loans.

 

AtJuly 31, 2004, we had $1,796,000 of cash and cash equivalents, a decreaseof  $1,895,000, compared to $3,691,000,at April 30, 2004.

 

On June 11, 2004, weacquired the silicon wafer manufacturing and recycling assets of EMG.

 

The aggregate purchaseprice was $2,920,000 which consisted of a $1,700,000 promissory note (securedby the assets acquired and certain other assets owned by us relating to our SOIbusiness) payable over 33 months with an interest rate of 6%, 731,930 shares ofour restricted common stock (valued at $1,171,000 based upon the fair marketvalue of the common stock on June 11, 2004) and $49,000 of legal andaccounting fees.  In addition, we assumedoperating leases (that expire in various years through fiscal year 2011) withfuture commitments of approximately $1,200,000.

 

Thereare provisions associated with the preferred stock private placement completedon July 29, 1999 that if triggered, would reduce the current conversionprice and effectively allow the preferred shares to convert to common stock ata more favorable ratio.  The Series AStock is convertible at two shares of common stock for each share of Series AStock outstanding.  On May 3, 2004,463,358 shares of Series A Stock were converted into 926,716 shares of commonstock.  As of August 31, 2004 therewere 500,308 shares of Series A Stock outstanding convertible into 1,000,616shares of common stock based upon the current conversion ratio.

 

Asof July 31, 2004, we had commitments outstanding for capital expendituresof approximately $800,000.

 

Although we are currently in full compliance withNasdaq requirements, our stock was trading at prices significantly below the$1.00 per share Nasdaq minimum bid price requirement at times during calendar2004.  The volatility of our stockprice, our current price and our financial condition may result in our failingto meet Nasdaq’s requirements.  As aresult, we could potentially be at risk of Nasdaq action to remove oursecurities from its SmallCap market.  Wecannot give any assurance that we will be able to meet the Nasdaq requirementsto maintain our SmallCap listing, or that if we do, a stable trading marketwill develop for our stock.

 

At the present time, our working capital isprimarily dependent on financing received from accredited investors.  In general, we expect that our workingcapital will decrease over time as we continue to use our capital and cashflows from revenues for operations, research and development, and investingactivities. We do not expect working capital to increase from activities otherthan our financing activities until (if ever) we are able to increase ourrevenues to exceed our cash out-flows (assuming we are able to increase ourrevenues) or complete a financing arrangement.

 

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At the end of our mostrecent fiscal year we had sufficient working capital to finance our anticipatedoperations and projected negative cash flow into our 2006 fiscal year.  However, on June 11, 2004 we acquiredthe silicon wafer manufacturing and recycling assets of EMG.  While we believe this acquisition will nowprovide the platform for us to not only continue and improve the EMG legacymanufacturing and reclamation of silicon wafers business, but to also launch afull scale SOI operation, we will need to raise significant additional capitalin fiscal year 2005 if we are to successfully implement our current businessplan for the acquired assets.  With ouranticipated revenues from operations during the period and projecting our cashflow on the basis of our historical expenditures, we have sufficient cashavailable to fund our short-term working capital requirements throughOctober 31, 2004.  As a result, weare currently working with several different sources, including both strategicand financial investors, in order to raise the capital necessary to financeboth our continuing operations and our newly acquired assets from EMG.  If we are unable to raise the necessarycapital, we will implement various cost saving measures that would allow us tocontinue into the new calendar year.

 

Theassumptions underlying the above statements include, among other things, thatthere will be no material adverse developments in the business or market ingeneral.  There can be no assuranceshowever that those assumed events will occur. If our plans are not achieved, there may be further negative effects onthe results of operations and cash flows, which could have a material adverseeffect on our financial position.

 

***Contractual CashObligations***

 

Wehave no material changes to the disclosure on this matter made in our AnnualReport on Form 10-KSB for the year ended April 30, 2004.

 

***Critical Accounting Policies***

 

Thematerial accounting policies that we believe are the most critical to aninvestor’s understanding of our financial results and condition and requirecomplex management judgment have been expanded and are discussed below.

 

*Goodwilland Intangible Assets*

 

Effective May 1, 2002 we adopted SFAS No. 142 *Goodwill andOther Intangible Assets*.  SFAS No. 142 addresses the methods used toamortize intangible assets and to assess impairment of those assets, includinggoodwill resulting from business combinations accounted for under the purchasemethod.  Although we adopted SFAS No.142 effective May 1, 2002, goodwill and intangible assets other than goodwillacquired after June 30, 2001 have been amortized or not amortized inaccordance with SFAS 142.  We acquiredintangible assets from Silicon Evolution, Inc. (“SEI”), IUT and EMG subsequentto June 30, 2001, and have accounted for those assets in accordance withthe requirements of SFAS No. 142. Included in our assets at July 31, 2004, is goodwill related to theacquisition of Chemotrade in 1998 and the business and assets of EMG inJune 2004 with a net carrying value of $1,807,000 and $447,000,respectively.

 

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In accordance with SFAS No. 142, we have completedour annual impairment test (as of April 30, 2004) on our life sciencesreporting unit, which has recorded goodwill. In completing our analysis of the life sciences reporting unit, we usedthe Discounted 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 there is no impairment of goodwill.  We are required to assess goodwill for impairmentat least annually, or when circumstances indicate that impairment may haveoccurred.  We expect to complete ourannual impairment test on our semiconductor materials and products reportingunit as of April 30, 2005 (unless circumstances suggest the need forearlier testing).

 

In performing the calculation under SFAS No. 142, wemade several assumptions, including the use of the DCF Method, the number ofyears used in the projection, the discount rate and growth assumptions.  If we had elected to use differentvariables, the outcome of the calculation could have been different.

 

We utilized the DCF Method in order to calculate thefair value of our life sciences reporting unit.  We had the option to utilize the market capitalization method butgiven the complexity of our business, we determined that we couldn’t reasonablybifurcate the market value of the life sciences reporting unit from our otheroperations based upon our market value as a whole.  In utilizing the DCF method, we based our calculation over aconservative six-year life with no projected growth over the final fouryears.  The final four years were keptconstant in order to ensure that we did not overestimate the potential of thereporting unit.  The six-year life wasutilized as a result of the fact that the life sciences reporting unit has beenselling isotopes for over sixteen years and that demand for isotopes isprojected to increase over the next ten years. Given the history of the reporting unit and the projected future of theindustry, we determined that it was reasonable to utilize a six-year life.  Had we utilized a life of less than sixyears, the calculation may have suggested that impairment was present.  In addition, we discounted the projectedcash flows at a rate of 12%.  The 12%was deemed reasonable given the current low market interest rate and theextremely low risk of the life sciences business offset by the higher cost ofcapital for a small company and the related difficulties we have had in raisingnecessary capital over the years.  Hadwe utilized a discount rate that was substantially larger than 12%, thecalculation may have suggested that impairment was present.

 

Our intangible assets result from the perpetual,exclusive technology license agreement with SEI that we entered into onSeptember 14, 2001, the isotope-based trace detection technology weacquired from IUT in December 2002 and customer lists associated with theacquisition of the business and assets of EMG in June 2004.  We initially determined that the intangibleassets acquired from SEI had an indefinite useful life as they were not boundby any legal time periods or otherwise limited due to competing technologiesand, therefore in accordance with SFAS No. 142 they were not amortized butrather tested annually for impairment. During the year ended April 30, 2003, upon further evaluation ofthe uses and applications of the acquired technology and the advancement of thedevelopment of our SOI business plan, we determined that the intangible assetsno longer had an indefinite life and as a result, the assets are now beingamortized over their estimated useful life of ten years.  The isotope-based trace detection technologyis also being amortized over its estimated useful life of ten years (which isbased upon many factors including the time it will take to develop thetechnology, the expected life of the finalized product(s) and the estimatedlives of similar products) while the customer list is being amortized over itsestimated useful life of three years .  We will continue to evaluate each reporting period whether eventsand circumstances continue to support our assessment of useful lives for theseintangible assets.  Additionally, ifindicators of impairment do arise in the future, the intangible assets will betested for impairment and may result in an impairment charge in the future.

 

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*Valuationof Equity Transactions*

 

We value transactions associated with common orpreferred stock that is convertible into common stock based on the market valueof the underlying common stock on the date of the signing of theagreement.  We value transactionsassociated with common stock warrants at the appropriate measurement date utilizingthe Black-Scholes pricing model, with assumptions as to volatility (100%),risk-free interest rate (4.0%) and estimated life of the warrants based onhistorical information.  If theassumptions used, as they relate to volatility, risk-free interest rate andestimated life of the warrants, were materially different, the overallvaluation of these transactions could change significantly.

 

**Item 3: Controls and Procedures**

 

As required by Rule13a-15 under the Securities Exchange Act of 1934, within the 90 days prior tothe filing date of this report, 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 principal executiveofficer as well as our principal financial officer, who concluded that ourdisclosure controls and procedures are effective.  There have been no significant changes in our internal controlsor in other factors, which could significantly affect internal controlssubsequent to the date we carried out our evaluation.

 

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

 

PART II

OTHERINFORMATION

 

**Item2: Unregistered Sales of Equity Securities and Use of Proceeds**

 

**Acquisition of Business and Assets of EMG**

 

On June 11, 2004, we issued 731,930 shares ofour restricted common stock to EMG as partial consideration for the completionof the transaction described above.  EMGrepresented that it, and its two equity holders, were accreditedinvestors.  The following sets forth theinformation required by Item 701 in connection with that transaction:

 

(a)                                  The transaction wascompleted effective June 11, 2004.

 

(b)                                 There was noplacement agent or underwriter for the transaction.

 

(c)                                  The shares were notsold for cash.  The shares were issuedin partial consideration for the purchase by our wholly-owned subsidiary ofassets as described above.  At the timethe number of shares was calculated, the market price of our stock wasapproximately $1.06 per share.

 

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(d)                                 We relied on theexemption from registration provided by Sections 4(2) and 4(6) under theSecurities Act of 1933 for this transaction. We did not engage in any public advertising or general solicitation inconnection with this transaction.  Weprovided the accredited investor with disclosure of all aspects of ourbusiness, including providing the accredited investor with our reports filedwith the Securities and Exchange Commission, our press releases, access to ourauditors, and other financial, business, and corporate information.  Based on our investigation, we believe thatthe accredited investor obtained all information regarding Isonics itrequested, received answers to all questions it posed, and otherwise understoodthe risks of accepting our securities for investment purposes.

 

(e)                                  The common stockissued in this transaction is not convertible or exchangeable.  No warrants were issued in thistransaction.  We did grant the holdercertain registration rights, including piggy-back registration rights for theshares issued, and the right to demand registration if the shares have not beenregistered before December 11, 2004.

 

(f)                                    We received no cashproceeds from the issuance of the shares.

 

**Exercise of Common Stock Warrants**

 

During the quarter ended July 31, 2004, weissued 620,000 shares of common stock as a result of the exercise of commonstock warrants (at an average exercise price of $1.20 per share).

 

**Item 6:Exhibits**

 

Exhibits.

 

31.Certification pursuant to Sarbanes-Oxley Section 302

32.Certification pursuant to 18 U.S.C. Section 1350

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Golden, County of Jefferson, State of Colorado,on the 20th day of September 2004.

 
|   | Isonics Corporation |
|--------|---------------------|
|   |                | (Registrant) |
|   |                |   |
|   |                |   |
|   | By                  |   | /s/James E. Alexander |   |
|   |                | James E. Alexander |
|   |                | President, Chief  Executive Officer and Director |
|   |                |   |
|   |                |   |
|   | By                  |   | /s/John V. Sakys |   |
|   |                | John V. Sakys |
|   |                | Chief Accounting  Officer and Chief Financial Officer |
|        |                     |  |  |  |  |  |

 

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