**UNITEDSTATESSECURITIES AND 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, 2005** |
|                                                   |                                                                                              |
| **o**                                                  | **Transition report under Section 13 or  15(d) of the Exchange Act.**                   |

 

**For the transition period from         to         **

 

**Commissionfile number:  001-12531**

 

**ISONICSCORPORATION**

(Exact name of smallbusiness issuer as specified in its charter)

 
| **California**                                                 | ** ** | **77-0338561**                   |
|----------------------------------------------------------------|------------|----------------------------------|
| (State or other  jurisdiction ofincorporation or organization) |       | (IRS EmployerIdentification No.) |

 

**5906McIntyre Street**

**Golden,Colorado 80403**

(Address ofprincipal executive offices)

 

**(303)279-7900**

(Issuer’s telephonenumber)

 

**N/A**

(Former name, formeraddress and former

fiscal year, ifchanged since last report)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý  No  o

 

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

 

The number of shares outstanding of the registrant’sCommon Stock, no par value, was 30,508,701 at September 12, 2005.

 

Transitional Small Business Disclosure Format(check one):

Yes  o   No  ý

 

 

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**IsonicsCorporation and Subsidiaries**

 

**TABLEOF CONTENTS**

 

**FORM 10-QSB**

 
| Part I:  | Financial Information |                                                                                                            |
|---------------|-----------------------|-----------------------------------------------------------------------------------------------------------------|
|          |                  |                                                                                                            |   |
|          | Item 1:               | Financial Statements                                                                                            |   |
|          |                  |                                                                                                            |   |
|          |                  | Condensed Consolidated  Balance Sheets as of July 31, 2005 and April 30, 2005                         |   |
|          |                  | Condensed Consolidated  Statements of Operations for the Three Month Periods Ended July 31, 2005  and 2004 |   |
|          |                  | Condensed Consolidated  Statements of Cash Flows for the Three Month Periods Ended July 31, 2005  and 2004 |   |
|          |                  | 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 1:               | Legal  Proceedings                                                                                              |   |
|          |                  |                                                                                                            |   |
|          | Item 2:               | Unregistered Sales of Equity  Securities and Use of Proceeds                                                    |   |
|          |                  |                                                                                                            |   |
|          | Item 6:               | Exhibits                                                                                                        |   |
|          |                  |                                                                                                            |
| Signatures    |                  |

 

2

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**Part I:  Financial Information**

 

**Item1: Condensed Financial Statements**

 

**IsonicsCorporation and Subsidiaries**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(inthousands, except share amounts)**

** **

**ASSETS**

** **
| ** **                                                                  | ** ** | **(Unaudited)**         | ** ** | ** **               | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **                                                                  | ** ** | **July 31,  2005** | ** ** | **April 30,  2005** | ** ** |
| CURRENT ASSETS:                                                             |       |                    |       |                     |       |
| Cash and cash equivalents                                                   |       | $                       | 12,766     |                     | $          | 21,206 |   |
| Accounts  receivable (net of allowances of $81 and $59,  respectively) |       | 2,596                   |       | 935                      |       |
| Inventories                                                                 |       | 1,459                   |       | 1,550                    |       |
| Prepaid  expenses and other current assets                                  |       | 1,660                   |       | 153                      |       |
| Assets  held for sale                                                       |       | 628                     |       | —                   |       |
| Total  current assets                                                       |       | 19,109                  |       | 23,844                   |       |
|                                                                        |       |                    |       |                     |       |
| LONG-TERM ASSETS:                                                           |       |                    |       |                     |       |
| Property  and equipment, net                                                |       | 5,015                   |       | 5,589                    |       |
| Goodwill                                                                    |       | 3,593                   |       | —                   |       |
| Intangible  assets, net                                                     |       | 632                     |       | 241                      |       |
| Other  assets                                                               |       | 1,260                   |       | 1,507                    |       |
| Total  long-term assets                                                     |       | 10,500                  |       | 7,337                    |       |
|                                                                        |       |                    |       |                     |       |
| TOTAL ASSETS                                                                |       | $                       | 29,609     |                     | $          | 31,181 |   |

 

**LIABILITIES AND STOCKHOLDERS’EQUITY**

 
| ** **                                                                                                                                                                                                                                                                                         | ** ** | **(Unaudited)**         | ** ** | ** **               | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                         | ** ** | **July 31,  2005** | ** ** | **April 30,  2005** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                                                                                                               |       |                    |       |                     |       |
| Accounts  payable                                                                                                                                                                                                                                                                                  |       | $                       | 1,321      |                     | $          | 1,079 |   |
| Accrued  liabilities                                                                                                                                                                                                                                                                               |       | 1,560                   |       | 1,033                    |       |
| Current  portion of obligation under capital lease                                                                                                                                                                                                                                                 |       | 30                      |       | 44                       |       |
| Current  portion of note payable                                                                                                                                                                                                                                                                   |       | 801                     |       | 672                      |       |
| Current  portion of convertible debentures, net of discount                                                                                                                                                                                                                                        |       | 8,291                   |       | 3,025                    |       |
| Total  current liabilities                                                                                                                                                                                                                                                                         |       | 12,003                  |       | 5,853                    |       |
|                                                                                                                                                                                                                                                                                               |       |                    |       |                     |       |
| Obligations under capital lease, net of  current portion                                                                                                                                                                                                                                           |       | 44                      |       | 47                       |       |
| Note payable, net of current portion                                                                                                                                                                                                                                                               |       | 707                     |       | 653                      |       |
| Convertible debentures, net of current  portion and of discount                                                                                                                                                                                                                                    |       | 10,609                  |       | 15,040                   |       |
|                                                                                                                                                                                                                                                                                               |       |                    |       |                     |       |
| TOTAL LIABILITIES                                                                                                                                                                                                                                                                                  |       | 23,363                  |       | 21,593                   |       |
|                                                                                                                                                                                                                                                                                               |       |                    |       |                     |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                                                                                                         |       |                    |       |                     |       |
| Preferred  Stock; shares authorized: July 31, 2005-7,598,716; April 30,  2005-7,622,516                                                                                                                                                                                                  |       |                    |       |                     |       |
| Series A  Convertible Preferred Stock—no par value; 6,666 shares issued and outstanding  on July 31, 2005 and April 30, 2005, $10 liquidation preference on  July 31, 2005 and April 30, 2005                                                                        |       | 5                       |       | 5                        |       |
| Series D  Convertible Preferred Stock—no par value; zero and  800 shares issued  and outstanding on July 31, 2005 and April 30, 20045, respectively; zero  and $80 liquidation preference on July 31, 2005 and April 30, 2005, respectively           |       | —                  |       | 90                       |       |
| Series E  Convertible Preferred Stock—no par value; 10,000 and  33,000 shares  issued and outstanding on July 31, 2005 and April 30,  2005, respectively; $1,000 and $3,300 liquidation preference on  July 31, 2005 and April 30, 2005, respectively |       | 1,194                   |       | 3,938                    |       |
| Common  stock—no par value; shares authorized: July 31, 2005-75,000,000;  April 30, 2005-40,000,000; 30,431,701 and 27,696,800 shares issued and  outstanding on July 31, 2005 and April 30, 2005, respectively                                                           |       | 32,838                  |       | 28,401                   |       |
| Additional  paid in capital                                                                                                                                                                                                                                                                        |       | 13,363                  |       | 13,080                   |       |
| Deferred  compensation                                                                                                                                                                                                                                                                             |       | (54                     | )          | (64                      | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                               |       | (41,100                 | )          | (35,862                  | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                   |       | 6,246                   |       | 9,588                    |       |
|                                                                                                                                                                                                                                                                                               |       |                    |       |                     |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                                                    |       | $                       | 29,609     |                     | $          | 31,181 |   |

 

See notes tocondensed consolidated financial statements.

 

3

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**IsonicsCorporation and Subsidiaries**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

** **
| ** **                                                              | ** ** | **Three  Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                              | ** ** | **July 31,**       | ** ** |
| ** **                                                              | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Revenues                                                                |       | $                       | 5,074      |   | $ | 2,285 |   |
| Cost of revenues                                                        |       | 5,218                   |       | 2,587 |   |
| Gross  margin                                                           |       | (144                    | )          | (302 | ) |
|                                                                    |       |                    |       |   |   |
| Operating expenses:                                                     |       |                    |       |   |   |
| Selling,  general and administrative                                    |       | 2,732                   |       | 1,346 |   |
| Impairment  loss on assets held for sale                                |       | 398                     |       | — |   |
| Research  and development                                               |       | 454                     |       | 230 |   |
| Total  operating expenses                                               |       | 3,584                   |       | 1,576 |   |
|                                                                    |       |                    |       |   |   |
| Operating loss                                                          |       | (3,728                  | )          | (1,878 | ) |
|                                                                    |       |                    |       |   |   |
| Other income (expense):                                                 |       |                    |       |   |   |
| Amortization  of debt issuance costs                                    |       | (245                    | )          | — |   |
| Interest  and other income                                              |       | 118                     |       | 13 |   |
| Interest  expense                                                       |       | (1,317                  | )          | (19 | ) |
| Foreign  exchange                                                       |       | —                  |       | 12 |   |
| Total  other income (expense), net                                      |       | (1,444                  | )          | 6 |   |
| Loss before income taxes                                                |       | (5,172                  | )          | (1,872 | ) |
| Income tax benefit                                                      |       | —                  |       | — |   |
| NET LOSS                                                                |       | $                       | (5,172     | ) | $ | (1,872 | ) |
|                                                                    |       |                    |       |   |   |
| DIVIDENDS ON SERIES E CONVERTIBLE PREFERRED  STOCK                      |       | $                       | (66        | ) | $ | — |   |
|                                                                    |       |                    |       |   |   |
| NET LOSS ATTRIBUTABLE TO COMMON  STOCKHOLDERS                           |       | $                       | (5,238     | ) | $ | (1,872 | ) |
|                                                                    |       |                    |       |   |   |
| **Net loss per share—basic and diluted**                           |       |                    |       |   |   |
| Net loss per share attributable tocommon  stockholders                  |       | $                       | (.18       | ) | $ | (.11 | ) |
| Weighted average common shares used in  computing per share information |       | 28,468                  |       | 16,852 |   |

 

See notes tocondensed consolidated financial statements.

 

4

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**IsonicsCorporation and Subsidiaries**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(Unaudited)**

** **
| ** **                                                                    | ** ** | **Three  Months Ended July 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                                                          |       |                                  |       |   |   |
| Net cash used in operating activities                                         |       | $                                     | (5,240     | ) | $ | (2,341 | ) |
|                                                                          |       |                                  |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                         |       |                                  |       |   |   |
| Purchases  of property and equipment                                          |       | (725                                  | )          | (240 | ) |
| Acquisition  of business, net of cash acquired                                |       | (2,495                                | )          | (49 | ) |
| Cash  used in investing activities                                            |       | (3,220                                | )          | (289 | ) |
|                                                                          |       |                                  |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                         |       |                                  |       |   |   |
| Principal  payments under capital lease obligations                           |       | (17                                   | )          | (16 | ) |
| Principal  payments on borrowings                                             |       | (193                                  | )          | — |   |
| Proceeds  from issuance of common stock                                       |       | 296                                   |       | 751 |   |
| Preferred  stock dividends                                                    |       | (66                                   | )          | — |   |
| Cash  provided by financing activities                                        |       | 20                                    |       | 735 |   |
|                                                                          |       |                                  |       |   |   |
| NET DECREASE IN CASH AND CASHEQUIVALENTS:                                     |       | (8,440                                | )          | (1,895 | ) |
| Cash  and cash equivalents at beginning of period                             |       | 21,206                                |       | 3,691 |   |
| Cash  and cash equivalents at end of period                                   |       | $                                     | 12,766     |   | $ | 1,796 |   |
|                                                                          |       |                                  |       |   |   |
| Supplemental disclosure of cash flow  information:                            |       |                                  |       |   |   |
| Cash  paid during the period for:                                             |       |                                  |       |   |   |
| Interest                                                                      |       | $                                     | 486        |   | $ | 24 |   |
| Income  taxes                                                                 |       | $                                     | —     |   | $ | — |   |
|                                                                          |       |                                  |       |   |   |
| Supplemental disclosure of noncash  investing and financing  activities: |       |                                  |       |   |   |
| Capital  lease obligation for property and equipment                          |       | $                                     | —     |   | $ | 69 |   |
| Accruals  for property and equipment                                          |       | $                                     | 92         |   | $ | 281 |   |
| Stock  issued in connection with an acquisition                               |       | $                                     | 1,292      |   | $ | 1,171 |   |

 

In the quarter ended July 31,2005, we also issued 10,000 shares of common stock in a cashless exercise of acommon stock warrant and issued 1,927,565 shares of common stock uponconversion of convertible preferred stock.

 

See notes to condensedconsolidated financial statements.

 

5

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**Isonics Corporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1 - BASIS OF PRESENTATION**

 

The accompanying unaudited condensed consolidatedfinancial statements of Isonics Corporation and Subsidiaries as of July 31,2005, and for the three months ended July 31, 2005 and 2004, have beenprepared on the same basis as the annual audited financial statements.  In the opinion of management, such unauditedinformation includes all adjustments (consisting only of normal recurringaccruals) necessary for a fair presentation of this interim information.  Operating results and cash flows for interimperiods are not necessarily indicative of results for the entire year.  The information included in this reportshould be read in conjunction with our audited financial statements and notesthereto included in our Annual Report on Form 10-KSB for the year ended April 30,2005.

 

**NOTE 2 - SIGNIFICANT ACCOUNTINGPOLICIES**

 

***Accounting forStock-Based Compensation***

 

We account for stock-based compensation toemployees and directors using the intrinsic value method in accordance withAccounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*and relatedinterpretations, as permitted by SFAS No. 123 *Accounting for Stock-Based Compensation*, as amended by SFAS No. 148*Accounting for Stock-based Compensation –Transition and Disclosure*. Compensation expense for stock options is measured as the excess, ifany, of the quoted market price of our stock at the date of grant over theamount 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 (though we have recognized expense forwarrants granted to external parties for services).  We record compensation expense for restrictedstock awards based on the quoted market price of our stock at the date of thegrant and the vesting period.

 

The following table illustrates the effect on netloss and net loss per share if we had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based compensation (in thousands,except per share data):

 
| ** **                                                                                                                           | ** ** | **Three  Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                           | ** ** | **July 31,**       | ** ** |
| ** **                                                                                                                           | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Net loss attributable to common  stockholders, as reported                                                                           |       | $                       | (5,238     | ) | $ | (1,872 | ) |
| Add:  stock-based compensation costs included in reported net loss, net of related  tax effects                                      |       | 10                      |       | 10 |   |
| Deduct:  Total stock-based compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (229                    | )          | (55 | ) |
| Adjusted net loss                                                                                                                    |       | $                       | (5,457     | ) | $ | (1,917 | ) |

*** ***
| ** **                         | ** ** | **Three  Months Ended** | ** ** |
|------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **July 31,**       | ** ** |
|                               | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Net  loss per share                |       |                    |       |   |   |
| Basic  and diluted - as reported   |       | $                       | (.18       | ) | $ | (.11 | ) |
| Basic  and diluted – adjusted |       | $                       | (.19       | ) | $ | (.11 | ) |

 

6

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

 

Basic net loss per share is computed using theweighted average number of common shares outstanding during the period.  Contingently issuable shares are included inthe computation of basic net income (loss) per share when the relatedconditions are satisfied.  Diluted netincome (loss) per share is computed using the weighted average number of commonshares and potentially dilutive securities outstanding during the period.  Potentially dilutive securities consist ofcontingently issuable shares, the incremental common shares issuable uponconversion of preferred stock or convertible debt (using the “if converted”method) and shares issuable upon the exercise of stock options and warrants(using the “treasury stock” method). Potentially dilutive securities are excluded from the computation iftheir effect is anti-dilutive.

 

As of July 31, 2005, (a) a total of7,968,157 outstanding stock options and common stock warrants, (b) 6,666and 10,000 outstanding shares of Series A and E Convertible PreferredStock, respectively, and (c) the unissued shares underlying ouroutstanding convertible debentures were excluded from the diluted net loss pershare calculations, as their inclusion would be anti-dilutive.  As of July 31, 2004, (a) a total of9,880,958 outstanding stock options and common stock warrants and (b) 500,308,9,000 and 26,950 outstanding shares of Series A, C and D ConvertiblePreferred Stock, respectively, were excluded from the diluted net loss pershare calculation, as the inclusion would be anti-dilutive.

 

During the three month period ended July 31,2005, we issued the following shares of common stock:

 
| **Description**                                  | ** ** | **Number  of Common Stock Shares** | ** ** |
|--------------------------------------------------|------------|------------------------------------|------------|
| Balance as of April 30, 2005                |       | 27,696,800                         |       |
| Conversion of preferred stock                    |       | 1,927,565                          |       |
| Exercise of common stock warrants and  options   |       | 293,000                            |       |
| Shares issued from employee stock purchase  plan |       | 7,809                              |       |
| Shares issued for acquisition of business        |       | 506,527                            |       |
| Balance as of July 31, 2005                 |       | 30,431,701                         |       |

 

The aforementioned equity transactions increasedcommon stock in the accompanying condensed consolidated balance sheets by$4,437,000 for the three months ended July 31, 2005.

 

**NOTE 3 – FINANCIAL STATEMENTCOMPONENTS**

 

***Inventories***

 

Inventories consist of the following (inthousands):

 
| ** **             | ** ** | **July 31,  2005** | ** ** | **April 30,  2005** | ** ** |
|------------------------|------------|-------------------------|------------|--------------------------|------------|
| Finished goods         |       | $                       | 654        |                     | $          | 565 |   |
| Work in process        |       | 563                     |       | 701                      |       |
| Materials and supplies |       | 242                     |       | 284                      |       |
| Total  inventories     |       | $                       | 1,459      |                     | $          | 1,550 |   |

 

7

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***Property andequipment***

 

Property and equipment consist of the following (inthousands):

 
| ** **                                | ** ** | **July 31,  2005** | ** ** | **April 30,  2005** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| Office furniture and equipment            |       | $                       | 286        |                     | $          | 264 |   |
| Production equipment                      |       | 5,021                   |       | 5,579                    |       |
| Leasehold improvements                    |       | 396                     |       | 396                      |       |
| Construction in process                   |       | 1,043                   |       | 814                      |       |
|                                      |       | 6,746                   |       | 7,053                    |       |
| Accumulated depreciation and amortization |       | (1,731                  | )          | (1,464                   | )          |
| Total  property and equipment             |       | $                       | 5,015      |                     | $          | 5,589 |   |

 

**NOTE 4 –SEGMENT INFORMATION**

 

We currently have three reportable segments: lifesciences, homeland security and semiconductor materials and products.  Our life sciences segment sells stable andradioisotopes in elemental and simple compound forms for use in life sciencesapplications.  Our homeland securitysegment provides advanced security and investigative services and is currentlydeveloping certain trace and bulk detection technologies.  Our semiconductor materials and productssegment manufactures and reclaims silicon wafers, sells SOI wafers and isinvolved in several research and development projects including silicon-28.  Our segments are strategic business units,each of which consists of similar products or services.  They are managed separately because eachsegment requires different technology and marketing strategy and because eachsegment sells to different customers. The homeland security segment has been added as a reportable segment inthe quarter ended July 31, 2005, due to the acquisition of Protection PlusSecurity Consultants, Inc. (“PPSC”) on May 16, 2005.  In prior periods, the homeland securityoperations did not meet the requirements for a reportable segment as defined bySFAS No. 131 “Disclosures About Segments of an Enterprise and RelatedInformation”.  Reconciling items consistprimarily of corporate assets or expenses that have not been allocated to aspecific reportable segment.

 

Information by segment is set forth below (inthousands):

** **
| ** **                              | ** ** | **Three  Months Ended** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **July 31,**       | ** ** |
| ** **                              | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Segment revenues from external sources: |       |                    |       |   |   |
| Life  sciences                          |       | $                       | 1,597      |   | $ | 1,951 |   |
| Homeland  security                      |       | 2,672                   |       | — |   |
| Semiconductor  materials and products   |       | 805                     |       | 334 |   |
| Total                                   |       | $                       | 5,074      |   | $ | 2,285 |   |
|                                    |       |                    |       |   |   |
| Segment operating (loss) income:        |       |                    |       |   |   |
| Life  sciences                          |       | $                       | (149       | ) | $ | 164 |   |
| Homeland  security                      |       | (392                    | )          | — |   |
| Semiconductor  materials and products   |       | (2,054                  | )          | (1,040 | ) |
| Reconciling  amounts                    |       | (1,133                  | )          | (1,002 | ) |
| Total                                   |       | $                       | (3,728     | ) | $ | (1,878 | ) |

 

8

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| ** **                            | ** ** | **July 31,** | ** ** | **April 30,** |   |
|---------------------------------------|------------|-------------------|------------|--------------------|--------|
| ** **                            | ** ** | **2005**          | ** ** | **2005**           |   |
| Total assets:                         |       |              |       |               |   |
| Life  sciences                        |       | $                 | 2,684      |               | $      | 2,432 |   |
| Homeland  security                    |       | 6,806             |       | —             |   |
| Semiconductor  materials and products |       | 6,403             |       | 6,356              |   |
| Reconciling  amounts                  |       | 13,716            |       | 22,393             |   |
| Total                                 |       | $                 | 29,609     |               | $      | 31,181 |   |

 

**NOTE 5 – ACQUISITION OF PROTECTIONPLUS SECURITY CONSULTANTS, INC.**

 

On May 16, 2005, we signed and completed anagreement to acquire PPSC, a New York City based corporation that primarilyprovides armed and unarmed security personnel.  It also provideselectronic security systems, armed escort couriers, executive bodyguards,video/electronic surveillance, mobile vehicle patrols, special event securityand VIP escorts. PPSC’s investigative solutions include communicationssecurity, eavesdropping/espionage countermeasures, industrial sabotageinvestigations, employment investigations and a range of forensic services suchas voice and handwriting analysis, DNA testing and drug screening. Some of theservices are provided on an outsourced basis.

 

We acquired all of the outstanding equitysecurities of PPSC for a total price of $3,792,000.  Of the purchaseprice, we paid $2,500,000 in cash and issued 506,527 shares of our restricted stockto the sellers.  The number of shares issued was based on $1,125,000 (perthe stock purchase agreement) divided by the average closing bid price on theNasdaq Small Cap Market on each of the ten consecutive trading days ending fourbusiness days prior to the closing ($2.22 per share).  The issued shares were then valued underpurchase accounting using a measurement date of May 16, 2005, the day theacquisition was contractually agreed to and also consummated.  The closing bid price for our common stock onthe Nasdaq Small Cap Market on the measurement date was $2.55 per share,yielding a valuation of the shares issued for the acquisition of$1,292,000.  We paid the purchase priceto the two owners of PPSC, each of whom represented to us that he was an accreditedinvestor and was acquiring the shares for investment purposes only and withouta view toward further distribution.  In addition, we paid $98,000 in legaland accounting fees and we have a receivable from the seller for $48,000.  These payments, net of the sellerreimbursement, increased the effective purchase price that was allocated to theacquired tangible and intangible assets.

 

The stock is price protected for the benefit of theformer owners of PPSC.  The price protection provision will provide a cashbenefit to them if the as-defined market price of our common stock is less than$2.22 per share at the time they can first sell the shares (as defined, eitherdue to their inclusion in an effective registration statement or pursuant toSEC Rule 144).  If the as-defined market price is less than $2.22 pershare, we will be required to pay the former owners of PPSC the difference incash.  There are no registration rights associated with the shares issuedin the PPSC acquisition, although at our discretion we may include the sharesin a future registration statement.

 

In conjunction with the acquisition of PPSC, weretained the services of both the former owners in an employmentrelationship.  PPSC will continue tolease premises partially owned by one of these individuals.   As such, the premises lease is with arelated party.   The lease term is forthe four-year period ended May 15, 2009. Annual rent payments are $48,000 in each of the four years of the leaseterm.  Additionally, we will reimbursethe landlord 80% of the costs incurred by the landlord for taxes, maintenanceof common areas and fire and hazard insurance as well as the entire amount ofthe premium incurred for rental loss insurance.

 

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The following table summarizes (in thousands) theestimated fair values of the assets acquired and liabilities assumed at thedate of acquisition.  While we believethe purchase accounting associated with this transaction to essentially becomplete, there is always the possibility that it may be subject to refinement.

 
| Current  assets                   |   | $     | 1,454  |   |
|-----------------------------------|--------|-------|--------|--------|
| Property and equipment            |   | 11    |   |
| Intangible assets - customer base |   | 431   |   |
| Goodwill                          |   | 3,593 |   |
| Total  assets acquired            |   | 5,489 |   |
| Current liabilities               |   | 1,388 |   |
| Long-term liabilities             |   | 259   |   |
| Net  assets acquired              |   | $     | 3,842  |   |

 

The $3,593,000 of goodwill was assigned to thehomeland security segment and is expected to be deductible for taxpurposes.  The $431,000 of intangibleassets relates to the acquired customer base and will be amortized ratably overits estimated life of 3 years.  There wasno in-process research and development acquired in this transaction.

 

The following table summarizes our results ofoperations for the three months ended July 31, 2005 and 2004, as if theacquisition PPSC had occurred on May 1, 2005 and 2004, respectively.  There have been no adjustments made to thehistorical results of PPSC.

 
| ** **                                    | ** ** | **Three  Months  Ended** | ** ** | **Three  Months  Ended** | ** ** |
|-----------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                    | ** ** | **July 31,  2005**  | ** ** | **July 31,  2004**  | ** ** |
| Revenue                                       |       | $                        | 5,588      |                     | $          | 5,579 |   |
| Net loss attributable to common  stockholders |       | $                        | (5,222     | )                        | $          | (1,598 | ) |
| Net loss per share – basic and diluted   |       | $                        | (.18       | )                        | $          | (.09 | ) |

 

**NOTE 6 –ASSETS HELD FOR SALE**

 

During the first quarter of fiscal year 2006,management committed to a plan to sell specific production equipment in oursemiconductor materials and product segment. Based on ongoing analysis of the semiconductor operations, these assetswere deemed to be excess equipment or incompatible with the future direction ofthe segment’s operations.  We have listedthese assets for sale and are actively attempting to sell them.  Immediately prior to the decision to sell theassets, the equipment had a cumulative net book value of approximately$1,026,000.  Certain assets have beenwritten down to their fair value, less selling costs, yielding an impairmentloss on assets held for sale in the amount of $398,000.  The assets held for sale are now classifiedin current assets at the lower of their book value or fair value, less sellingcosts, in the cumulative amount of $628,000.

 

**NOTE 7 – EQUITY**

 

***Common SharesAuthorized***

 

On May 9, 2005, our Articles of Incorporationwere amended to increase the authorized number of Common Shares issuable from40,000,000 to 75,000,000.  Prior tofiling the Certificate of Amendment

 

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with the Secretary of State of the State ofCalifornia, the change to the authorized shares of common stock was firstapproved by a vote of the shareholders and by a vote of the Board of Directors.

 

***ConvertiblePreferred Stock***

 

On May 19, 2005, the remaining 800 shares of Series DConvertible Preferred Stock (“Series D Stock”) were converted into 72,727shares of common stock.  As a result, asof July 31, 2005, there were zero shares of Series D Stock outstanding.

 

On July 27, 2005, 23,000 shares of Series EConvertible Preferred Stock (“Series E Stock”) were converted into1,854,838 shares of common stock.  As aresult, as of July 31, 2005, there were 10,000 shares of Series EStock outstanding.

 

***Class B andC Warrants***

 

On June 17, 2005, we extended the expirationdate of the Class B and C Warrants from December 31, 2005, to December 29,2006, via an amendment to the warrant agreements.   There were no other changes made to theterms and conditions of the warrant agreements. The holders of these warrants were unable to exchange the warrants forregistered shares of our common stock between October 2004 (at which timethe underlying registration statement was no longer current) and August 24,2005 (at which time a post-effective amendment to the registration statementgained effectiveness).  In October 2004,we originally attempted to file a post-effective amendment to the respectiveregistration statement, but we were unable to do so because our former auditor,Grant Thornton LLP, was unwilling to consent to the inclusion of its report onour April 30, 2004 and 2003, financial statements in the post-effectiveamendment.  In the quarter ended July 31,2005, we recorded a non-cash operating expense in the statement of operationsin the amount of approximately $297,000, such charge representing the excess ofthe fair value of the amended warrant over the fair value of the originalwarrant immediately prior to amendment.

 

**NOTE 8 – COMMITMENTS ANDCONTINGENCIES**

 

As of July 31, 2005, we had commitmentsoutstanding for capital expenditures of approximately $92,000.

 

On March 25, 2005, Prime InternationalEquities, LLC (“the Plaintiff”) filed a complaint against us in the UnitedStates District Court for the District of Colorado (Civil Case No. 05-F-562(BNB).  In that complaint, the Plaintiffalleged (among other things) that it holds outstanding Class B commonstock warrants that are subject to our amended and restated warrantagreements.  The Plaintiff alleged thatwe failed to use our best efforts to keep effective a federal registrationstatement covering various of our securities. The Plaintiff also alleged that our failure to so use our best effortsimpaired the Plaintiff’s ability to exercise certain warrants it owns and toreceive shares of our stock.  ThePlaintiff further alleged that if the Plaintiff’s warrants are not exercised,they would expire by their terms at the end of 2005 and the Plaintiff wouldlose the ability to become an owner of our shares pursuant to the warrants. (Asnoted above, the expiration date of the warrants has been extended from December 31,2005, to December 29, 2006, and we have obtained effectiveness of theregistration statement required for the exercise of the Class B and Class Cwarrants).  The Plaintiff further allegedthat our continued failure to so use its best efforts has caused the Plaintiffto suffer substantial damages allegedly in excess of our financial ability tocompensate the Plaintiff, although the Plaintiff fails to quantify its damagesallegation.  The Plaintiff requestedspecific performance (which was completed on August 24, 2005) anddamages.  We answered the complaint filedagainst us by Prime International Equities, LLC on April 29, 2005, denyingthe material allegations of the complaint. We intend to vigorously contest any liability.  Neither party has completed any substantialdiscovery, and, as a result, it is not possible to predict the likelihood of afavorable or unfavorable result.

 

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Currently the trial is scheduled to be held in November 2006.  Legal costs related to litigationcontingencies are being expensed as incurred.

 

**NOTE 9 -  RELATED PARTY TRANSACTIONS**

 

We hold an 8% ownership interest in Institut furUmwelttechnologien GmbH (“IUT”), an entity located in Germany.  In June 2004, we entered into a researchand development agreement with IUT, which contemplated the funding of certainprojects of up to $4,000,000 over several years.  The work is to be funded in steps and isbased upon the completion of various milestones, as defined.  We have no obligation to fund any work underthis agreement unless we have approved such effort.  We funded approximately $200,000 under thisagreement during the three months ended July 31, 2005 (and a total of$830,000 since entering into the agreement in June 2004).  All funded amounts have been included asresearch and development in the consolidated statement of operations.  Additionally, IUT produces carbon-14 precursorsfor us that we resell in the market place. Total net purchases from IUT for this product during the three monthsended July 31, 2005 and 2004, were $162,122 and $180,609, respectively.

 

**NOTE 10 - SUBSEQUENT EVENTS**

 

On August 9, 2005, we elected to redeem theremaining 6,666 outstanding shares of the Series A Convertible PreferredStock (“Series A Stock”).  The Series AStock originally consisted of 1,850,000 shares issued with a liquidationpreference of $1.50 per share.  Theconversion rate is $0.75 per share, and, as a result, each share of the Series AStock is convertible into two shares of common stock.  The remaining shares of the Series AStock will be redeemed on the redemption date (September 30, 2005).  On or after the redemption date, the holdersof the Series A Stock shall be entitled to receive $1.50 for each share ofthe Series A Stock held and will no longer be able to convert theshares.  Further, on the redemption datethe rights and preferences associated with the Series A Stock will beterminated.  Prior to the redemptiondate, any holder of the Series A Stock may convert his or her Series AStock to common stock if we receive a notice of conversion before theredemption date.

 

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

 

*The statements contained in thisReport on Form 10-QSB that are not purely historical are forward lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934, includingstatements regarding our expectations, hopes, intentions or strategiesregarding the future.  Forward-lookingstatements include: statements regarding future products or productdevelopment; statements regarding future selling, general and administrativecosts and research and development spending and our product developmentstrategy; and statements regarding future capital expenditures and financingrequirements.  All forward-lookingstatements included in this document are based on information available to uson the date hereof, and we undertake no obligation to update any suchforward-looking statements.  It isimportant to note that our actual results could differ materially from those insuch forward-looking statements.*

 

***GeneralDiscussion***

 

Founded in 1992, we are an advanced materials andtechnology company focusing on the supply of isotopes for life sciences andhealth-care applications, homeland security and the manufacturing andreclamation of silicon wafers and the manufacturing of silicon-on-insulator (“SOI”)wafers to the semiconductor industry.

 

Our life sciences and health care applicationsdivision has historically been primarily a distribution business. We acquire isotopesfrom several manufacturers who are located primarily in republics that werepart of the former Soviet Union.  We buythese isotopes from the manufacturers and resell them in the form of commonchemical compounds.  For example, oxygen-18is sold as water, and zinc-68 is sold as zinc oxide.  We sell these isotopes for use in basicscientific research, medical diagnostics/therapy and industrialapplications.  An isotope is one of twoor more species (or nuclides) of the same chemical element that differ from oneanother only in the number of neutrons in the atom’s nucleus.  The different number of neutrons can createsignificantly different nuclear properties. The most well known of these properties is radioactivity.  Radioactive isotopes (or radioisotopes) canbe found in nature.  Most of ourradioisotopes, however, are man-made. Stable isotopes, as distinguished from radioisotopes, are notradioactive.  We continue to evaluatepossible applications for stable isotopes, radioisotopes and non-isotopic materials.

 

At the present time, our life sciences division isbeing adversely affected by increased domestic and internationalcompetition.  The oxygen-18 marketcontinues to be dynamic and volatile. Established suppliers have increased capacity and reputable suppliershave entered the market with a comparable high quality product.  The market is currently in a surplus stateand we expect it to be so for several years to come.  Prices have declined 50% from highs ofapproximately two years ago and additional price erosion may be expected.  Our average selling price for oxygen-18 inour first quarter of fiscal year 2006 has remained consistent with thatreceived during our previous quarter, the fourth quarter of fiscal year2005.  Compounding this problem, ourproduction partner’s current economics and operations are optimized forproduction that does not utilize used or recycled water.  We currently have a significant supply ofused water (valued at approximately $532,000 as compared to $660,000 at April 30,2005) but we have developed a plan with our production partner that will allowus to utilize this inventory in future production over the next twelvemonths.  In the meantime, as our currentcontracts with our customers expire, we are no longer offering our customersthe option of recycling their used oxygen-18. While this new policy will allow us to gradually decrease the used waterin our inventory, this approach does bear some commercial risk as one of ourlarge competitors continues to offer a recycling option to customers.  Consequently, our inability to recycle oxygen-18in the form of water may place us at a competitive disadvantage as compared tothose producers who continue to recycle used water.  In an attempt to offset the degradation ofthe oxygen-18 market, we are expanding into other areas, such as actinium-225and indium-111.  While we don’t expectthese to contribute materially to our revenues in fiscal year 2006, thisexpansion is indicative of our business goals.

 

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In October 2004, we formed a new subsidiary,Isonics Homeland Security and Defense Corporation (“HSDC”), to focus andconsolidate our efforts in the homeland security sector.  These efforts include entry into the securitymarket discussed below as well as the acquisition and development of certaintrace and bulk detection technology that can be used to detect various types ofexplosives.  Utilizing the acquired anddeveloped technology, we have developed a hand-held explosive detection devicenamed “NeutroTestTM.”   We hadearlier projected that we expected to have a NeutroTestTM productavailable for international sales in late second calendar quarter and forUnited States sales in the third calendar quarter of 2005, respectively.  As expected, we completed the sale of two,first-generation units to a German entity in June 2005.  Feedback on the performance of these twounits has been positive and has also included product enhancementrecommendations.  We have taken thefeedback from our initial international sales of the first-generationNeutroTestTM and have implemented them into of our second-generationunits, which will be offered for sale in the domestic marketplace.  Our marketing plan for the second-generationNeutroTestTM product includes targeting a limited, select group ofpotential United States based customers for participation in field trials todemonstrate the value of NeutroTestTM.  The development of second-generationfunctionality, implementation of the domestic marketing plan and addressingexisting regulatory requirements have been the focus of activities in thecalendar third quarter of 2005.  In thecalendar fourth quarter of 2005, we will continue to implement the domesticmarketing plan and aggressively pursue domestic sales of our second-generationNeutroTestTM products.

 

In May 2005, our homeland security segmentacquired PPSC, a provider of a wide range of security-related services,including armed escort personnel, electronic security systems, mobile vehiclecontrols, forensic analysis, communications security and other securityexpertise.  Since the effective date ofthe acquisition, PPSC has delivered significant revenue as well as net incometo the homeland security segment of our business.  Further, we believe that the acquisition ofPPSC provides us with a deep source of knowledge and contacts within thehomeland security space and that it is capable of providing key insight for thedevelopment of our next-generation products along with successful marketing andsales processes.

 

In August 2005, PPSC secured overapproximately $4,800,000 in cumulative new contracts for six private sectorcustomers for security services to be performed throughout the United States.  The contract terms range from one to threeyears in length and expected incremental revenue for fiscal year 2006 isapproximately $1,200,000.  Further,though currently PPSC does not have government service contracts, in July 2005PPSC was awarded a GSA federal supply schedule under which PPSC can andhas begun to pursue government service contracts.  While we believe that we will be successfulin acquiring government service contracts in fiscal year 2006, we can offer noassurance that we will be able to do so. Current PPSC business integration, customer retention and customerexpansion is on pace with our integration plan.

 

Our semiconductor operations, based in Vancouver,Washington continue to be problematic as a result of our June 2004acquisition of the business and assets of Encompass Materials Group, Ltd. (“EMG”).   After incurring integration costs whichproved to be more expensive and longer term than anticipated, the revenuescontinue to be significantly less than the historical run rates at EMG which wehad expected to maintain.  As a result,we continue to generate significant negative gross margins and have incurred anoperating loss of $2,054,000 in the segment for the first quarter of our fiscalyear 2006.

 

In an effort to reduce the operating losses in oursemiconductor operations, in April 2005 we began the process to realignour business whereby we plan to significantly reduce our reliance on low marginsmall diameter products and focus mainly on higher margin 300-millimeterlarge-diameter and silicon-on-insulator (“SOI”) products.  The large-diameter wafer segment has becomeone of the fastest growing segments of the silicon wafer market and therevenues and gross margins associated with the services are substantiallygreater than those associated with the small diameter market.  While it was not necessarily reflected in theoperating results, we made significant progress during the quarter ended July 31,2005, as we recorded our first 300-millimeter sale in May 2005 andrevenues have increased monthly through August 2005.  In

 

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addition we have gained several new customers andare in the process of qualifying our product at others.

 

We continue to monitor the situation closely and,while we believe that our realignment of the business greatly enhances ourchances to reach profitability in the future, the process will take time and,as a result, we may not see a significant positive impact in the financialresults until our third quarter of fiscal year 2006 (if ever).

 

As a result of the realignment of the semiconductoroperations, we committed to a plan to sell certain production equipment thatwas no longer necessary under the new business plan.  As a result, we incurred an impairment chargeof $398,000 related to this equipment, which has been included in the operatinglosses discussed above.

 

Our revenues in the future will depend on oursuccess in developing and selling products in the semiconductor, homelandsecurity and stable and radioactive isotope markets.  Our profitability will be dependent upon ourability to manage our costs and to increase our revenues in all of our businesssegments.  However, we can offer noassurance that we will be able to increase our revenue or our profitability.

 

***Results ofOperations***

 

The following table sets forth, for the periodsindicated, statement of operations data expressed as a percentage ofrevenues.  The table and the discussionbelow should be read in conjunction with the condensed consolidated financialstatements and the notes thereto appearing elsewhere in this report.

 
| ** **                                 | ** ** | **Three  Months Ended** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|
| ** **                                 | ** ** | **July 31,**       | ** ** |
| ** **                                 | ** ** | **2005**                | ** ** | **2004** | ** ** |
|                                       |       |                    |       |   |   |
| Revenues                                   |       | 100.0                   | %          | 100.0 | % |
| Cost of revenues                           |       | 102.8                   |       | 113.2 |   |
| Gross  margin                              |       | (2.8                    | )          | (13.2 | ) |
|                                       |       |                    |       |   |   |
| Operating expenses:                        |       |                    |       |   |   |
| Selling,  general and  administrative |       | 53.8                    |       | 58.9 |   |
| Impairment  loss on assets held for sale   |       | 7.8                     |       | — |   |
| Research  and development                  |       | 9.0                     |       | 10.1 |   |
| Total  operating expenses                  |       | 70.6                    |       | 69.0 |   |
| Operating loss                             |       | (73.4                   | )          | (82.2 | ) |
|                                       |       |                    |       |   |   |
| Other income (expense), net                |       | (28.5                   | )          | .3 |   |
| Loss before income taxes                   |       | (101.9                  | )          | (81.9 | ) |
| Income tax expense                         |       | —                  |       | — |   |
| NET LOSS                                   |       | (101.9                  | )%         | (81.9 | )% |

 

***Revenues***

 

Revenues increased the three months ended July 31,2005, as compared to the same period of our prior fiscal year.  Revenues from both our semiconductor materialsand products and homeland security segments did reflect an increase during thisperiod as compared to revenues from our life sciences segment which reflected adecrease, as described in the following table:

 

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| ** **                                 | ** ** | **Three  months ended July 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|
| ** **                                 | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Life sciences:                             |       |                                  |       |   |   |
| Domestic                                   |       | $                                     | 1,048,000  |   | $ | 1,248,000 |   |
| International                              |       | 549,000                               |       | 703,000 |   |
| Total  life sciences                       |       | 1,597,000                             |       | 1,951,000 |   |
| Homeland security                          |       | 2,672,000                             |       | — |   |
| Semiconductor  materials and products |       | 805,000                               |       | 334,000 |   |
| Total                                      |       | $                                     | 5,074,000  |   | $ | 2,285,000 |   |

 

As a result of the acquisition of PPSC, we havesignificantly increased our revenues during the three months ended July 31,2005, and thus we significantly decreased our reliance on a few customers for asignificant portion of our revenues. During the three months ended July 31, 2005, one customer comprisedapproximately 19% of revenue as compared to the three months ended July 3,2004, where two customers accounted for 24% and 18% of revenue,respectively.  However, significantreductions in sales to any of these large customers have had, and may in thefuture have, an adverse effect on us by reducing our revenues and our grossmargins.  Present or future customerscould terminate their purchasing patterns with us or significantly change,reduce or delay the amount of isotopes or other products or services orderedfrom us.

 

The decrease in revenues from domestic isotopeproduct sales for the three months ended July 31, 2005, was primarily theresult of a significant decrease in the unit price of our main isotope solddomestically, oxygen-18, which was partially offset by an increase involume.  As a result, in order toincrease our revenues from the sale of oxygen-18, we will need to increase ourvolume at a rate greater than any continuing decreases that may occur in thefuture market price for that product. The market for oxygen-18 in the United States is continuing to expandand we continue to actively bid to become the supplier for additionalcustomers. While we believe that we will be successful in increasing our grossrevenues and margin in sales of oxygen-18 in the future, we can offer noassurance that we will be able to do so in the face of the domestic andinternational competition in this market.

 

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.

 

In January 2005 we commenced supplying limitedquantities of actinium-225 for testing purposes.  Actinium-225 is a radioisotope that isbelieved to be valuable in the treatment of certain cancers.  Assuming our Russian business partners reachtarget production levels during fiscal year 2006, we believe that we will beable to nearly double the world’s supply of actinium-225 by the end of calendar2006 to the extent required by the market. Our first quarter of fiscal year 2006 included minimal sales of actinium-225.  In June 2005, we entered into anagreement with Central Radiopharmaceutical Services, Inc. of Buffalo, NewYork (“CRS”) for the joint production and marketing of certain radioisotopeswith the first expected to be indium-111. While the projected revenues for these two radioisotopes are expected tobe minimal (less than $300,000) for fiscal year 2006, we believe these to beimportant first steps in our effort to extend our distribution operations toprovide more value-added products and to increase our share of the domestic

 

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radioisotope market to a meaningful number.  We can, however, offer no assurance that wewill be able to do so.

 

The decrease in revenues from international isotopeproduct sales, for the three months ended July 31, 2005, was primarily dueto the decrease in sales of radioisotopes. In general, our German subsidiary has had difficulty entering the oxygen-18market in Europe as many of its potential customers are under long-term supplycontracts with their current suppliers and the market is relatively flat(unlike the United States where the volume of sales, although not the per-unitprice, is growing at a significant rate). As a result, we must wait until our potential customers’ current supplyagreements terminate before we will be able to bid on new supplycontracts.  Our ability to significantlyincrease the revenues in our German subsidiary (and ultimately its grossmargin) is directly related to how successful we can be in gaining market sharein the European oxygen-18 market.   Inthe first quarter of fiscal year 2006, European sales of oxygen-18 have notbeen material.  As such, while weanticipate that we will continue to obtain European oxygen-18 customers infiscal year 2006, the process is expected to be slow and we cannot provide anyassurance that we will be able to do so.

 

The increase in revenues from homeland securitysales for the three months ended July 31, 2005, was almost entirely due tothe purchase of PPSC in May 2005. On a pro forma basis, assuming the acquisition of PPSC had occurred on May 1,2005, homeland security revenue for the three months ended July 31, 2005,would have been approximately $3,186,000. While we anticipate that we will continue to grow revenue in thehomeland security segment through securing new security contracts in our PPSCsubsidiary, retaining existing customers under contract currently with PPSC andby increasing our sales of detection technology, we cannot provide anyassurance that we will be able to do so.

 

The increase in revenues from semiconductormaterials and products sales for the three months ended July 31, 2005, wasprimarily due to the additional revenues generated from the business and assetsacquired from EMG in June 2004.  Thethree months ended July 31, 2004, includes revenues and operating resultsfrom that business for only approximately 45 days during the quarter ascompared to a full quarter for 2006.  Ona pro forma basis, assuming acquisition of the business and assets of EMG on May 1,2004, the revenue increase from the first quarter of fiscal year 2005 to thecorresponding quarter of fiscal year 2006 would be approximately $100,000.  Though not yet significant in total, revenuesfor the three months ended July 31, 2005, includes the initial sales fromour new and growing 300mm test and reclaim wafer business as well as sales fromour growing SOI wafer business.    Thoughour ability to integrate the business and assets of EMG and successfullyoperate the consolidated semiconductor operations has been problematic to date,we are in the process of realigning our business to focus mainly on the growingmarket of higher margin 300-millimeter large-diameter and SOI products.  While we believe that expanded focus on thesemarkets will allow us to ultimately increase revenues in the future, we canprovide no assurance that we will be able to do so.

 

While we continue to move forward with ourdevelopment program and to pursue the establishment of a low cost supply ofsilicon-28, we did not receive significant revenues in our 2004 or 2005 fiscalyears or in the three months ended July 31, 2005, and we are not aware ofany plans by any company for the introduction of products based on silicon-28wafers.  Therefore we do not anticipatesignificant proceeds from silicon-28 product sales during fiscal year 2006,although we could respond to customer demand in a relatively short time frame.  Our goal ultimately is to produce bulksilicon-28 wafers at an acceptable cost, which will produce the maximumbenefits to the end user.  The costsassociated with maintaining this program are not significant.

 

***Gross Margin***

 

Our gross margin increased during the three monthsended July 31, 2005, 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:

 

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| ** **          | ** ** | **Three  months ended July 31,** | ** ** |
|---------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                     | (144,000   | ) | $ | (302,000 | ) |
| Percent of revenues |       | (2.8                                  | )%         | (13.2 | )% |
|                     |            |                                       |            |  |  |  |  |

 

The increase in gross margin is due mainly to theimpact of PPSC’s operations, which were acquired in May 2005.  In addition, the life sciences segment alsocontributed positive gross margin, with such gross margin as a percentage ofrevenue approximating that experienced in our first quarter of fiscal year2004.  The positive gross margin relatedto these two segments was offset by continued negative gross margin in oursemiconductor materials and products segment.

 

On a dollar basis, gross margin is expected toincrease correspondingly with increases in revenue, if any, with dependencieson customer and supplier pricing.  Ourability to positively impact consolidated gross margin will in a large part bedependent on our ability to grow sales in our 300-millimeter large diameter andSOI products.  With the realignment ofour business to focus on the higher margin 300-millimeter large diameter andSOI products, we believe that we have greatly enhanced our ability to increaseour sales and related gross margin in these areas.  As such, we anticipate that the gross marginfrom sales of semiconductor and materials and products (both in dollar valueand as a percentage of revenues) will increase over time, though we can offerno assurance that the gross margin increase will occur.

 

On a percentage basis, in general we anticipatethat the gross margin percentage in our homeland security and life sciencessegments will remain relatively stable, subject to any unexpected fluctuationsin isotope pricing.  The gross marginpercentage in the semiconductor operations is highly dependent on generatingsufficient revenue to cover our cost of sales. As such, the gross margin percentage for the semiconductor segment maybe volatile based upon revenue growth achieved, if any.

 

***Selling, Generaland Administrative Expenses***

 

Our selling, general and administrative expenses asa dollar amount increased during the three months ended July 31, 2005, ascompared to the same period of our prior fiscal year, though they decreased ona percentage of revenues basis as reflected in the following table:

 
| ** **          | ** ** | **Three  months ended July 31,** | ** ** |
|---------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                     | 2,732,000  |   | $ | 1,346,000 |   |
| Percent of revenues |       | 53.8                                  | %          | 58.9 | % |
|                     |            |                                       |            |  |  |  |  |

 

The dollar increase in selling, general and administrative expenses forthe three months ended July 31, 2005, is attributable to a combination offactors, including:

 

•      approximately$600,000 directly related to the addition of PPSC’s operations in May 2005;

•      anoncash charge in the amount of $297,000 related to the extension of theexpiration dates of the Class B and C warrants;

•      approximately$200,000 due to the inclusion of a full quarter of semiconductor operationsinclusive of the business and assets acquired from EMG (such operations wereincluded for only 45 days of the first quarter of fiscal year 2004);

•      approximately$150,000 due to the increase in staffing and operations in the homeland securitysegment;

•      approximately$100,000 due to increased legal and accounting fees related to the filing oftwo registration statements during the quarter and to the reaudit of the fiscalyear 2004 financial statements required due to Grant Thornton’s unwillingnessto consent to the inclusion of its report for that fiscal year.

 

The percentage decrease is due primarily to the acquisition of PPSC in May 2005,which increased revenue and also included selling, general and administrativeexpense at a lower percentage of related revenue than the percentage of revenuein the related existing operations.

 

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We anticipate that we will increase our selling,general and administrative expenses during the remainder of fiscal year 2006through anticipated increased marketing efforts for our homeland security andsemiconductor materials and products segments. There can be no assurance that our anticipated increased selling, generaland administrative expenses will result in increased revenues from productsales.

 

***Impairment Losson Assets Held for Sale***

 

Our impairment loss on assets held for saleincreased during the three months ended July 31, 2005, 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,** | ** ** |
|---------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                     | 398,000    |   | — |   |
| Percent of revenues |       | 7.8                                   | %          | — |   |
|                     |            |                                       |            |  |  |  |

 

The increase for the three months ended July 31,2005, resulted from operational decisions made related to the ongoing reviewand improvements underway in our semiconductor materials and productssegment.  As part of this ongoing reviewand resulting operational changes, certain equipment was identified as excessivefor our planned future operations.  As aresult, certain of the identified equipment whose book value exceeded estimatednet realizable were individually written down to estimated net realizablevalue, resulting in a cumulative impairment charge of $398,000.  We expect that the equipment will be soldwithin the upcoming twelve months.

 

***Research andDevelopment Expenses***

 

Our research and development expenses increased ona dollar basis during the three months ended July 31, 2005, as compared tothe same period of our prior fiscal year, though there was a decrease as apercentage of revenues basis as reflected in the following table:

 
| ** **          | ** ** | **Three  months ended July 31,** | ** ** |
|---------------------|------------|---------------------------------------|------------|
| ** **          | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                     | 454,000    |   | $ | 230,000 |   |
| Percent of revenues |       | 9.0                                   | %          | 10.1 | % |
|                     |            |                                       |            |  |  |  |  |

 

The dollar increase for the three months ended July 31,2005, is primarily related to an increase in research and development expensesassociated with our trace and bulk detection technology.  Consistent with our product developmentstrategy, we are seeking to identify and evaluate new products in the homelandsecurity segment as well as to bring existing technologies, such as NeutroTestTM,to a production-ready state.  Themajority of this research and development is being performed by IUT.  In June 2004, we entered into a researchand development agreement with IUT, which contemplated the funding of certainprojects of up to $4,000,000 over several years.  The work is to be funded in steps and isbased upon the completion of various milestones, as defined.  We have no obligation to fund any work underthis agreement unless we have approved such effort.  We funded approximately $200,000 under thisagreement during the three months ended July 31, 2005 (as compared to$100,000 in the three months ended July 31, 2004, and a total of $830,000since entering into the agreement in June 2004).  Additionally, we continue to negotiate withthe other shareholders of IUT about a potential acquisition of the outstandingshares not held by us.

 

We cannot offer any assurance that our current orfuture lines of business or products resulting from our research anddevelopment efforts will be profitable or generate significant revenues.

 

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We believe that the development and introduction ofnew product applications is critical to our future success.  We expect that research and developmentexpenses may increase assuming sufficient cash remains available and we areable to procure necessary materials and outside services.  It is likely that research and developmentexpenditures will continue to vary as a percentage of revenues because of thetiming and amount of future revenues. Except for work being performed on oursemiconductor products at our facilities in Vancouver, Washington, we operateno other facilities of our own for research and development.  All other research and development work isperformed by outside entities, none of which we control (however, we haveentered into a letter of intent to acquire IUT and if the acquisition iscompleted, we would own and control IUT at that point).  None of the companies that currently performresearch and development work for us does so on an exclusive basis.

 

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

 

Other Income (Expense), net decreased during thethree months ended July 31, 2005, as compared to the same period of ourprior fiscal year as reflected in the following table:

 
| ** **    | ** ** | **Three  months ended July 31,** | ** **       |
|---------------|------------|---------------------------------------|------------------|
| ** **    | ** ** | **2005**                              | ** **       | **2004** | ** ** |
| Dollar amount |       | $                                     |  (1,444,000 | ) | $ | 6,000 |   |
|               |            |                                       |                  |  |  |  |  |

 

The decrease for the three months ended July 31,2005, resulted primarily from interest charges and amortization of debtissuance costs related to our convertible debentures issued in February 2005.  Included in the amount for the three monthsended July 31, 2005, is a noncash interest charge of approximately$830,000 related to the amortization of the debt discount on the convertibledebentures.  Also included is interestincome in the amount of $118,000 that partially offsets the cash and noncash interestexpense. We expect that our other expenses will remain at the same level orincrease until either principal repayments on the convertible debenturescommence in March 2006 or until the convertible debentures are converted,if ever, to common stock.

 

***Income Taxes***

 

We currently operate at a loss and expect tooperate at a loss until the products currently under development begin togenerate sufficient revenue.  The losseswe anticipate incurring during the remaining portion of the current year arenot expected to generate an income tax benefit because of the uncertainty ofthe realization of the deferred tax asset. As such, we have also provided a valuation allowance against our netdeferred tax asset as realization is uncertain.

 

***Net Loss***

 

Our net loss increased during the three months endedJuly 31, 2005, as compared to the same period of our prior fiscal year, asreflected in the following table:

 
| ** **    | ** ** | **Three  months ended July 31** | ** ** |
|---------------|------------|--------------------------------------|------------|
| ** **    | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Dollar amount |       | $                                    | (5,172,000 | ) | $ | (1,872,000 | ) |
|               |            |                                      |            |  |  |  |  |

 

We anticipate that losses will continue until (if ever):(i) revenues from our current operations substantially increase or (ii) wegenerate substantial revenues from products introduced as a result of ourresearch and development projects. Further, the revenue increases must increase faster then any increasesin operating and research and development expenses.  We expect that our net loss will continueduring at least the short term as we continue to pursue new revenue streams inour semiconductor materials and products business

 

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and as we continue our marketing and researchefforts to expand sales and develop new products in the homeland securitybusiness segment, including the commercialization of the NeutroTestTMtechnology.

 

We anticipate thatour operations during the remainder of fiscal year 2006 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 and research and developmentexpenses.

 

***Liquidity andCapital Resources***

 

Our working capital and liquidity decreased byapproximately 60% during the three months ended July 31, 2005.  Working capital decreased $10,885,000, to$7,106,000 at July 31, 2005, from $17,991,000, at April 30,2005.   The decrease in working capitalis due to a combination of factors, including:

 

•     approximately$5,300,000 due to an increase in the current portion of the convertibledebentures (which are payable at our option in cash or common stock, assumingall contractual requirements for payment in common stock are met);

•     approximately$3,000,000 consumed in operating activities (calculated as $5,200,000 of cashused in operating activities, netted down by $2,200,000 of the cash impact ofchanges in other current assets or liabilities included in that $5,200,000total usage);

•     approximately$2,500,000 of cash paid as part of the acquisition of PPSC;

•     approximately $700,000 expended on purchasesof fixed assets;

•     an offsetting amountof approximately $600,000 related to assets held for sale that were reclassedto current assets from property and equipment.

 

Our principal source of funding for the threemonths ended July 31, 2005, was from the existing cash balance at April 30,2005, which amounted to approximately $21,000,000 derived from our convertibledebenture offering completed in February 2005.  Our principal source of funding for the threemonths ended July 31, 2004, was from the exercise of common stock optionsand warrants ($751,000 as compared to $296,000 during the comparable period offiscal year 2006).

 

We used cash in operating activities of $5,240,000and $2,341,000 during the three months ended July 31, 2005 and 2004,respectively.  Cash used in operatingactivities for the three months ended July 31, 2005 and 2004 wasprincipally the result of our ongoing business activities that resulted in anet loss attributable to common stockholders of $5,238,000 and $1,872,000,respectively.

 

Our investing activities used cash of $3,220,000and $289,000 for the three months ended July 31, 2005 and 2004,respectively.  Cash used in investingactivities for the three months ended July 31, 2005, consisted primarilyof the purchase of PPSC in May 2005 (for which we paid $2.5 million incash and issued 506,527 shares of our restricted stock at an agreed valuationof $1.125 million ($2.22 per share), and paid $98,000 in legal and accountingfees), along with a lesser amount expended on additions of property and equipment.  Our investing expenditures during the firstthree months of our 2005 fiscal year are comprised primarily of purchases ofproperty and equipment.

 

Financing activities provided cash of $20,000 and$735,000 for the three months ended July 31, 2005 and 2004,respectively.  Cash provided by financingactivities for the three months ended July 31, 2005, resulted primarilyfrom the exercise of common stock options and warrants ($296,000) which wasoffset primarily by debt repayments and dividend payments on our outstanding Series EStock.  Cash provided by financingactivities for the three months ended July 31, 2004, resulted primarilyfrom the exercise of common stock warrants.

 

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At July 31, 2005, we had $12,766,000 of cashand cash equivalents, a decrease of $8,440,000, compared to $21,206,000, at April 30, 2005.  We anticipate that our cash and cashequivalents, as well as our available working capital, will continue todecrease as we continue to use cash in operations and investing activities, anduntil (if ever) we achieve positive cash flow from our operations – dependenton our ability to increase our revenues significantly and to maintain controlover our expenses.

 

There are provisions associated with the Series AStock that, if triggered, would reduce the current conversion price andeffectively allow the preferred shares to convert to common stock at a morefavorable ratio.  The Series AConvertible Preferred Stock is convertible at two shares of common stock foreach share of Series A Convertible Preferred Stock outstanding.  As of July 31, 2005, there were 6,666shares of Series A Convertible Preferred Stock outstanding convertibleinto 13,332 shares of common stock based upon the current conversionratio.  In August 2005, we calledthese shares for redemption.  If suchshares are not converted into common stock, these shares will be redeemed (andno longer outstanding) as of September 30, 2005.

 

Effective June 17, 2005 the expiration date ofour Class B and C warrants was extended from December 31, 2005, to December 29,2006.  There were no other changes in theterms or conditions of the warrants.

 

As of July 31, 2005, we had commitmentsoutstanding for capital expenditures of approximately $77,000.

 

Historically and to the present, our workingcapital and our ability to finance our operations have been primarily dependenton financing received from accredited investors.  In general, we expect that our working capitalwill decrease over time as we continue to use our capital and cash flows fromrevenues for operations, research and development, and investing activities. Wedo not expect working capital to increase from activities other than ourfinancing activities or until (if ever) we are able to increase our revenues toexceed our cash out-flows (assuming we are able to increase our revenues).  However, as of July 31, 2005, we believewe have sufficient working capital to finance our anticipated operations andprojected negative cash flow through our 2006 fiscal year.

 

The assumptions underlying the above statementsinclude, among other things, that there will be no material adversedevelopments in the business or market in general.  There can be no assurances however that thoseassumed events will occur.  If our plansare not achieved, there may be further negative effects on the results ofoperations and cash flows, which could have a material adverse effect on ourfinancial position.

 

***Contractual CashObligations***

 

We have no material changes to the disclosure onthis matter made in our Annual Report on Form 10-KSB for the year ended April 30,2005.

 

***Off-BalanceSheet Arrangements***

 

We have no material changes to the disclosure onthis matter made in our Annual Report on Form 10-KSB for the year ended April 30,2005.

 

***CriticalAccounting Estimates***

 

We consider an accounting estimate to be criticalif 1) the accounting estimate requires us to make assumptions about mattersthat were highly uncertain at the time the accounting estimate was made, and 2)changes in the estimate that are reasonably likely to occur from period toperiod, or use of different estimates that we reasonably could have used in thecurrent period, would have a material impact on our financial condition orresults of operations.

 

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

 

*Goodwill and Intangible Assets*

 

Goodwill is recorded on our books for acquisitionswhere the purchase price is in excess of the cumulative fair values of theidentified tangible and intangible assets. The assignment of fair value to the identified tangible and intangibleassets requires significant judgment and may require independent valuations ofcertain identified assets.  Once goodwilland other intangible assets are established on our balance sheet, we evaluatethe assets for impairment as described in the following paragraphs.

 

In accordance with SFAS No. 142*Goodwill and Other Intangible Assets*,goodwill is not amortized, but instead is tested for impairment on an annualbasis or more frequently if the presence of certain circumstances indicatesthat impairment may have occurred.  Theimpairment review process, which is subjective and requires significantjudgment at many points during the analysis, compares the fair value of thereporting unit in which goodwill resides to its carrying value.  If the carrying value of a reporting unitexceeds its fair value, then the amount of the impairment loss must bemeasured. The impairment loss is calculated by comparing the implied fair valueof reporting unit goodwill to its carrying amount. In calculating the impliedfair value of reporting unit goodwill, the fair value of the reporting unit isallocated to all of the other assets and liabilities of that unit based ontheir fair values. The excess of the fair value of a reporting unit over theamount assigned to its other assets and liabilities is the implied fair valueof goodwill. An impairment loss would be recognized when the carrying amount ofgoodwill exceeds its implied fair value. We have goodwill in the amount of $3,593,000 on our balance sheet as of July 31,2005, related to the acquisition of PPSC in May 2005.

 

For intangible assets otherthan goodwill, SFAS No. 144 *Accountingfor the Impairment or Disposal of Long-Lived Assets* is theauthoritative standard on the accounting for the impairment of such intangibleassets.  As required, we perform testsfor impairment of intangible assets other than goodwill whenever events orcircumstances suggest that such assets may be impaired.  To evaluate potential impairment, SFAS No. 144requires us to assess whether the future cash flows related to these assetswill be greater than their carrying value at the time of the test. Accordingly,while our cash flow assumptions are consistent with the plans and estimates weare using to manage the underlying businesses, there is significant judgment indetermining the cash flows attributable to our other intangible assets overtheir respective estimated useful lives. We have remaining other net intangible assets in the amount of $632,000on our balance sheet as of July 31, 2005, comprised of our trace and bulkdetection technology acquired in December 2002, customer lists acquired inour acquisition of the business and assets of EMG in June 2004 and thecustomer base acquired in our acquisition of PPSC in May 2005.  We are required to periodically evaluate ourother intangible assets balances for impairments. If we were to incuradditional impairments to our other intangible assets, it could have an adverseimpact on our future earnings, if any.

 

*Valuation of 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 the agreement. Wevalue transactions associated with common stock warrants at the appropriatemeasurement date utilizing the Black-Scholes pricing model, with assumptions asto volatility (100% for fiscal years 2005 and 2006), risk-free interest rate(4.0%) and estimated life of the warrants based on historical information. Ifthe assumptions used, as they relate to volatility, risk-free interest rate andestimated life

 

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of the warrants, were materially different, theoverall valuation of these transactions could change significantly.

 

**Item3: Controls and Procedures**

 

As required by Rule 13a-15 under theSecurities Exchange Act of 1934, within the 90 days prior to the filing date ofthis report, we carried out an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures.  This evaluation was carried out under thesupervision and with the participation of our principal executive officer aswell as our principal financial officer, who concluded that our disclosurecontrols and procedures are effective. There have been no significant changes in our internal controls or inother factors, which could significantly affect internal controls subsequent tothe date we carried out our evaluation.

 

Disclosure controls and procedures are controls andother procedures that are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the Securities and Exchange Commission’s rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in our reports filed under theExchange Act is accumulated and communicated to management, including ourprincipal executive officer and our principal financial officer, asappropriate, to allow timely decisions regarding required disclosure.

 

**Part II:Other Information**

 

**Item1:  LegalProceedings**

 

See the description of the litigation brought byPrime International Equities, LLC above in Note 8 to the financial statementsin Part I.

 

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

 

**Acquisition of PPSC**

 

On May 16, 2005, we issued 506,527 shares ofour restricted common stock to the former shareholders of PPSC as partialconsideration for the completion of the transaction described above.  The shareholders represented that they wereaccredited investors.  The following setsforth the information required by Item 701 in connection with that transaction:

 

(a)                                 The transaction was completed effective May 16, 2005.

 

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

 

(c)                                 The shares were not sold for cash. The shares were issued in partial consideration for the purchase by ourwholly-owned subsidiary of the business described above.  At the time the number of shares wascalculated, the market price of our stock was approximately $2.22 per share.

 

(d)                                We relied on the exemption from registration provided by Sections 4(2) and4(6) under the Securities Act of 1933 for this transaction.  We did not engage in any public advertisingor general solicitation in connection with this transaction.  We provided the accredited investor with disclosureof all aspects of our business, including providing the accredited investorwith our reports filed with the Securities and Exchange Commission, our pressreleases, access to our auditors, and other financial, business, and corporateinformation.  Based on our investigation,we believe that the accredited investor obtained all

 

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information regarding Isonics it requested,received answers to all questions it posed, and otherwise understood the risksof accepting our securities for investment purposes.

 

(e)                                 The common stock issued in this transaction is not convertible orexchangeable.  No warrants were issued inthis transaction.

 

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

 

**Warrant Issuance to FormerEmployee**

 

On August 28, 2005, we resolved an employmentdispute with a former employer by issuing to him a warrant, exercisable throughJuly 31, 2006, to purchase 1,000 shares of our restricted common stock for$3.25 per share. The following sets forth the information required by Item 701in connection with that transaction:

 

(a)                                 The transaction was completed effective August 28, 2005.

 

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

 

(c)                                 The warrant was not issued for cash, but in settlement of an employmentdispute.

 

(d)                                We relied on the exemption from registration provided by Sections 4(2) and4(6) under the Securities Act of 1933 for this transaction.  We did not engage in any public advertisingor general solicitation in connection with this transaction.  The warrant recipient represented that he wasan accredited investor, and we received an opinion from his counsel that thetransaction was exempt under federal and applicable state law.  We provided the accredited investor withdisclosure of all aspects of our business, including providing the accreditedinvestor with our reports filed with the Securities and Exchange Commission,our press releases, access to our auditors, and other financial, business, and corporateinformation.  Based on our investigation,we believe that the accredited investor obtained all information regardingIsonics it requested, received answers to all questions it posed, and otherwiseunderstood the risks of accepting our securities for investment purposes.

 

(e)                                 The warrant is exercisable to purchase shares of our common stock at$3.25 per share through July 31, 2006.

 

(f)                                   We received no cash proceeds from the warrant grant.

 

**Exercise of Common Stock Warrants**

 

During the three months ended July 31, 2005,we issued 160,000 shares of common stock as a result of the exercise of commonstock warrants.  The following sets forththe information required by Item 701 in connection with these transactions:

 

(a)                                 The transactions were completed during the three months ended July 31,2005.

 

(b)                                There was no placement agent or underwriter for the transactions.

 

(c)                                 The total amount we received from the cash exercises during the threemonths ended July 31, 2005, was $187,500. Certain warrant holders completed cashless exercises.

 

(d)                                We relied on the exemption from registration provided by Sections3(a)(9), 4(2) and 4(6) under the Securities Act of 1933 for thesetransactions and Regulation D.  We didnot engage in any public advertising or general solicitation in connection withthe transactions.  The investors hadaccess to all of our reports filed with the Securities and Exchange Commission,our press releases and other financial, business and

 

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corporate information.  Based on our investigation, we believe thatthe investors obtained all information regarding Isonics that they requested,received answers to all questions they posed and otherwise understood the risksof accepting our securities for investment purposes.

 

(e)                                  The common stock is not convertible or exchangeable or exercisable forany other equity security.

 

(f)                                   We will use the proceeds for general working capital.

 

**Conversion of Preferred Stock**

 

During the three months ended July 31, 2005, (1) aholder of our Series D Stock (an accredited investor) converted 800 sharesof Series D Stock into 72,727 shares of common stock and (2) a holderof our Series E Stock (an accredited investor) converted 23,000 shares of Series DStock into 1,854,838 shares of common stock. The following sets forth the information required by Item 701 inconnection with that transaction:

 

(a)                                 The transactions were completed during the three months ended July 31,2005.

 

(b)                                There was no placement agent or underwriter for the transactions.

 

(c)                                 The shares were not sold for cash. The shares of common stock were issued in exchange for (and inconversion of) outstanding shares of Series D Stock and Series EStock, respectively.

 

(d)                                We relied on the exemption from registration provided by Sections 3(a)(9) underthe Securities Act of 1933 for these transactions and Regulation D.  We did not engage in any public advertisingor general solicitation in connection with the transactions.  The accredited investors had access to all ofour reports filed with the Securities and Exchange Commission, our pressreleases and other financial, business and corporate information.  Based on our investigation, we believe thatthe accredited investors obtained all information regarding Isonics that theyrequested, received answers to all questions they posed and otherwiseunderstood the risks of accepting our securities for investment purposes.

 

(e)                                 The common stock issued in these transactions is not convertible orexchangeable.  No warrants were issued inthese transactions.  The underlyingshares of common stock are included in a currently effective registrationstatement – shares underlying Series D stock in SEC file no. 333-114521and shares underlying Series E stock in SEC file no. 333-126231.

 

(f)                                   We received no cash proceeds from the issuance of the shares of commonstock.

 

**Item6: Exhibits**

 

 Exhibits.

 

31. Certification pursuantto Sarbanes-Oxley Section 302

32. Certification pursuantto 18 U.S.C. Section 1350

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized, in the City ofGolden, County of Jefferson, State of Colorado, on the 13th day of September 2005.

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

 

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