**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-Q**

 

**(MarkOne)**

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

**For the quarterly periodended October 31, 2006**

 

**Or**

 

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

**For the transition periodfrom              to              **

 

**Commissionfile number:  001-12531**

**ISONICS CORPORATION**

(Exact name of registrant as specified in its charter)

 

| **California**                                             |   | **77-0338561**       |
|------------------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of                           |   | (IRS Employer        |
| incorporation or  organization)                            |   | Identification  No.) |
|                                                       |   |                 |
| **5906  McIntyre Street**                                  |
| **Golden,  Colorado 80403**                                |
| (Address of  principal executive offices with zip code)    |
|                                                       |   |                 |
| **(303)  279-7900**                                        |
| (Registrant’s  telephone number, including area code) |
|                                                       |   |                 |
| **N/A**                                                    |
| (Former name,  former address and former                   |
| fiscal year, if  changed since last report)                |

 

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

Indicate by check mark whether the Registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.

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

 

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

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

| **Class**                         | ** ** | **Outstanding at December 14, 2006** |
|-----------------------------------|------------|--------------------------------------|
| Common Stock —  no par value |       | 47,802,474  shares                   |

 

 

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**Isonics Corporation andSubsidiaries**

**TABLE OF CONTENTS**
|                                           | ** ** | ** **                                                                                                     | ** **                                                                                  | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|------------|
| Part  I:  Financial Information |       |                                                                                                           |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item 1:    |                                                                                                           | Financial Statements                                                                        |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |
|                                      |       | Condensed  Consolidated Balance Sheets as of October 31, 2006 and April 30, 2006                               |                                                                                        |       |
|                                      |       | Condensed  Consolidated Statements of Operations for the Three and Six Months Ended  October 31, 2006 and 2005 |                                                                                        |       |
|                                      |       | Condensed  Consolidated Statements of Cash Flows for the Six Months Ended October 31,  2006 and 2005           |                                                                                        |       |
|                                      |       | Notes to Condensed Consolidated Financial Statements                                                           |                                                                                        |       |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item 2:    |                                                                                                           | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item 3:    |                                                                                                           | Quantitative  and Qualitative Disclosures About Market Risk                                 |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item 4:    |                                                                                                           | Controls and  Procedures                                                                    |       |   |
|                                      |       |                                                                                                           |
| Part II:  Other  Information    |       |                                                                                                           |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item  1:   |                                                                                                           | Legal  Proceedings                                                                          |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item  1A:  |                                                                                                           | Risk  Factors                                                                               |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item 2:    |                                                                                                           | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item 4:    |                                                                                                           | Submission of  Matters to a Vote of Security Holders                                        |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |   |
|                                      | Item  6:   |                                                                                                           | Exhibits                                                                                    |       |   |
|                                      |       |                                                                                                           |                                                                                        |       |
| Signatures                                |       |                                                                                                           |                                                                                        |       |

 

2

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**Part I:  Financial Information**

**Item 1: FinancialStatements**

**IsonicsCorporation and Subsidiaries**

**CONDENSEDCONSOLIDATED BALANCE SHEETS(in thousands, except share amounts)**

**ASSETS**
| ** **                                                             | ** ** | **October 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **(Unaudited)**                | ** ** | ** **                   | ** ** |
| CURRENT ASSETS:                                                        |       |                           |       |                         |       |
| Cash and cash  equivalents                                             |       | $                              | 1,566      |                         | $          | 2,117 |   |
| Accounts  receivable (net of allowances of $187 and $67, respectively) |       | 4,037                          |       | 3,410                        |       |
| Inventories                                                            |       | 1,269                          |       | 1,077                        |       |
| Prepaid expenses  and other current assets                             |       | 1,951                          |       | 1,142                        |       |
| Assets held for  sale                                                  |       | 225                            |       | 560                          |       |
| Total current  assets                                                  |       | 9,048                          |       | 8,306                        |       |
|                                                                   |       |                           |       |                         |       |
| LONG-TERM ASSETS:                                                      |       |                           |       |                         |       |
| Property and  equipment, net                                           |       | 6,554                          |       | 4,854                        |       |
| Goodwill                                                               |       | 3,631                          |       | 3,631                        |       |
| Intangible  assets, net                                                |       | 397                            |       | 491                          |       |
| Equity in net  assets of investee                                      |       | 396                            |       | 386                          |       |
| Other assets                                                           |       | 667                            |       | 195                          |       |
| Total long-term  assets                                                |       | 11,645                         |       | 9,557                        |       |
|                                                                   |       |                           |       |                         |       |
| TOTAL ASSETS                                                           |       | $                              | 20,693     |                         | $          | 17,863 |   |

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**
| ** **                                                                                                                                                                 | ** ** | **October 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(Unaudited)**                | ** ** | ** **                   | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                       |       |                           |       |                         |       |
| Accounts payable                                                                                                                                                           |       | $                              | 2,818      |                         | $          | 2,175 |   |
| Accrued  liabilities                                                                                                                                                       |       | 2,217                          |       | 1,606                        |       |
| Derivative  liabilities                                                                                                                                                    |       | 7,406                          |       | —                       |       |
| Current portion  of obligation under capital lease                                                                                                                         |       | 15                             |       | 14                           |       |
| Current portion  of notes payable                                                                                                                                          |       | 569                            |       | 786                          |       |
| Current portion  of convertible debentures, net of discount                                                                                                                |       | 4,997                          |       | 10,432                       |       |
| Total current  liabilities                                                                                                                                                 |       | 18,022                         |       | 15,013                       |       |
|                                                                                                                                                                       |       |                           |       |                         |       |
| Obligation under  capital lease, net of current portion                                                                                                                    |       | 26                             |       | 34                           |       |
| Notes payable, net of  current portion                                                                                                                                     |       | 103                            |       | 173                          |       |
|                                                                                                                                                                       |       |                           |       |                         |       |
| TOTAL LIABILITIES                                                                                                                                                          |       | 18,151                         |       | 15,220                       |       |
|                                                                                                                                                                       |       |                           |       |                         |       |
| Minority interest in  consolidated subsidiary                                                                                                                              |       | 25                             |       | —                       |       |
|                                                                                                                                                                       |       |                           |       |                         |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                 |       |                           |       |                         |       |
| Common stock -  no par value; shares authorized: 75,000,000; 47,008,821 and 42,071,119 shares  issued and outstanding on October 31, 2006 and April 30, 2006, respectively |       | 62,306                         |       | 57,061                       |       |
| Additional paid  in capital                                                                                                                                                |       | 14,488                         |       | 13,910                       |       |
| Deferred compensation                                                                                                                                                      |       | —                         |       | (24                          | )          |
| Accumulated  deficit                                                                                                                                                       |       | (74,277                        | )          | (68,304                      | )          |
| Total  stockholders’ equity                                                                                                                                           |       | 2,517                          |       | 2,643                        |       |
|                                                                                                                                                                       |       |                           |       |                         |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                            |       | $                              | 20,693     |                         | $          | 17,863 |   |

 

See notes to condensedconsolidated financial statements.

3

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**IsonicsCorporation and Subsidiaries**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share data)(Unaudited)**
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                              | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                                                              | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                                |       | $                                | 7,832      |                           | $          | 5,832 |   | $ | 15,234 |   | $ | 10,906 |   |
| Cost of revenues                                                        |       | 5,896                            |       | 5,763                          |       | 11,907 |   | 10,981 |   |
| Gross margin                                                            |       | 1,936                            |       | 69                             |       | 3,327 |   | (75 | ) |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                                    |       |                             |       |                           |       |   |   |   |   |
| Selling, general and administrative                                     |       | 4,244                            |       | 2,987                          |       | 8,121 |   | 5,719 |   |
| Impairment loss on assets held for sale                                 |       | —                           |       | —                         |       | — |   | 398 |   |
| Research and development                                                |       | 819                              |       | 757                            |       | 2,255 |   | 1,211 |   |
| Total operating expenses                                                |       | 5,063                            |       | 3,744                          |       | 10,376 |   | 7,328 |   |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| Operating loss                                                          |       | (3,127                           | )          | (3,675                         | )          | (7,049 | ) | (7,403 | ) |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| Other income  (expense):                                                |       |                             |       |                           |       |   |   |   |   |
| Amortization of debt issuance costs                                     |       | (44                              | )          | (256                           | )          | (159 | ) | (501 | ) |
| Interest and other income                                               |       | 13                               |       | 93                             |       | 54 |   | 211 |   |
| Interest expense                                                        |       | (768                             | )          | (1,408                         | )          | (1,419 | ) | (2,725 | ) |
| Foreign exchange                                                        |       | (4                               | )          | (6                             | )          | 1 |   | (6 | ) |
| Gain on extinguishment of debt                                          |       | —                           |       | —                         |       | 227 |   | — |   |
| Gain on derivative instruments                                          |       | 189                              |       | —                         |       | 2,320 |   | — |   |
| Equity in net income of investee                                        |       | 98                               |       | —                         |       | 10 |   | — |   |
| Total other income (expense), net                                       |       | (516                             | )          | (1,577                         | )          | 1,034 |   | (3,021 | ) |
| Loss before  income taxes and minority interest                         |       | (3,643                           | )          | (5,252                         | )          | (6,015 | ) | (10,424 | ) |
| Income tax  expense                                                     |       | —                           |       | —                         |       | — |   | — |   |
| Minority  interest in operations of consolidated subsidiary             |       | 42                               |       | —                         |       | 42 |   | — |   |
| NET LOSS                                                                |       | $                                | (3,601     | )                              | $          | (5,252 | ) | $ | (5,973 | ) | $ | (10,424 | ) |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| DIVIDEND ON  SERIES E CONVERTIBLE PREFERRED STOCK                       |       | $                                | —     |                           | $          | (35 | ) | $ | — |   | $ | (101 | ) |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| NET LOSS  ATTRIBUTABLE TO COMMON STOCKHOLDERS                           |       | $                                | (3,601     | )                              | $          | (5,287 | ) | $ | (5,973 | ) | $ | (10,525 | ) |
|                                                                    |       |                             |       |                           |       |   |   |   |   |
| **Net  loss per share—basic and diluted**                          | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss per  share attributable to common stockholders                 |       | $                                | (0.08      | )                              | $          | (0.17 | ) | $ | (0.13 | ) | $ | (0.35 | ) |
| Weighted average common  shares used in computing per share information |       | 46,674                           |       | 30,867                         |       | 46,072 |   | 29,667 |   |

 

See notes to condensedconsolidated financial statements.

4

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**IsonicsCorporation and Subsidiaries**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands, except share amounts)(Unaudited)**
| ** **                                                                                           | ** ** | **Six Months Ended October 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Net cash used in  operating activities                                                               |       | $                                                    | (6,172     | ) | $ | (8,428 | ) |
|                                                                                                 |       |                                                 |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                               |       |                                                 |       |   |   |
| Purchases of property and equipment                                                                  |       | (1,166                                               | )          | (1,165 | ) |
| Equity investment in a business                                                                      |       | (100                                                 | )          | — |   |
| Acquisition of business, net of cash acquired                                                        |       | —                                               |       | (2,460 | ) |
| Cash used in investing activities                                                                    |       | (1,266                                               | )          | (3,625 | ) |
|                                                                                                 |       |                                                 |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                               |       |                                                 |       |   |   |
| Principal payments under capital lease obligations                                                   |       | (7                                                   | )          | (35 | ) |
| Principal payments on borrowings                                                                     |       | (5,391                                               | )          | (388 | ) |
| Proceeds from issuance of common stock                                                               |       | 15                                                   |       | 930 |   |
| Proceeds from the issuance of convertible debentures  and related warrants, net of offering costs    |       | 12,270                                               |       | — |   |
| Preferred stock dividends                                                                            |       | —                                               |       | (101 | ) |
| Cash provided by financing activities                                                                |       | 6,887                                                |       | 406 |   |
|                                                                                                 |       |                                                 |       |   |   |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                                           |       | (551                                                 | )          | (11,647 | ) |
| Cash and cash equivalents at beginning of period                                                     |       | 2,117                                                |       | 21,206 |   |
| Cash and cash equivalents at end of period                                                           |       | $                                                    | 1,566      |   | $ | 9,559 |   |
|                                                                                                 |       |                                                 |       |   |   |
|                                                                                                 |       |                                                 |       |   |   |
| Supplemental  disclosure of cash flow information:                                                   |       |                                                 |       |   |   |
| Cash paid during the period for:                                                                     |       |                                                 |       |   |   |
| Interest                                                                                             |       | $                                                    | 99         |   | $ | 507 |   |
| Income taxes                                                                                         |       | $                                                    | —     |   | $ | — |   |
|                                                                                                 |       |                                                 |       |   |   |
| Supplemental  disclosure of noncash investing and financing activities:                              |       |                                                 |       |   |   |
| Accruals for property and equipment                                                                  |       | $                                                    | 1,385      |   | $ | — |   |
| Capitalized debt issuance costs associated with  issuance of common stock in a financing transaction |       | $                                                    | 601        |   | $ | — |   |
| Payment in common stock of principal due on  convertible debentures                                  |       | $                                                    | 4,511      |   | $ | — |   |
| Stock issued in  connection with an acquisition                                                      |       | $                                                    | —     |   | $ | 1,292 |   |

 

During the six months endedOctober 31, 2005, we issued 10,000 shares of common stock in a cashlessexercise of acommon stock warrant and issued 2,734,017 shares of common stock uponconversion of convertible preferred stock.

 

See notes to condensedconsolidated financial statements.

5

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**IsonicsCorporation and Subsidiaries**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 — BASIS OFPRESENTATION**

The accompanying unaudited condensed consolidatedfinancial statements of Isonics Corporation and Subsidiaries have been preparedon the same basis as the annual audited financial statements and in accordancewith accounting principles generally accepted in the United States (“US GAAP”)for interim financial information and the rules and regulations of the Securitiesand Exchange Commission (“SEC”) for interim financial statements.  In the opinion of management, such unauditedinformation includes all adjustments (consisting only of normal recurringaccruals) necessary for a fair presentation of this interim information.  Operating results and cash flows for interimperiods are not necessarily indicative of results that can be expected for theentire year.  The information included inthis report should be read in conjunction with our audited financial statementsand notes thereto included in our Annual Report on Form 10-KSB, as amended, forthe year ended April 30, 2006.

We incurred significant losses from operations for thefiscal periods presented and, as of October 31, 2006, have a working capitaldeficit of $(8,974,000).  Additionally,barring a restructuring of our company, it is likely that we will continue toincur operating losses throughout the remainder of fiscal year 2007 as wecontinue to fund research and development of new and existing products and coveroperating costs.  Should losses begreater than anticipated, we may encounter liquidity problems which couldrequire us to curtail development projects, seek joint venture partners, sellassets and/or obtain additional financing with terms that may not be asfavorable as might otherwise be available. However, we raised additional financing (see Note 9), through long-termconvertible debentures with a single investor, in the amount of $16,000,000(including $3,000,000 issued subsequent to October 31, 2006).  We believe that based on our financialposition at October 31, 2006, and our projections of future operations, we willbe able to continue operations into fiscal year 2008.

**NOTE 2 —SIGNIFICANT ACCOUNTING POLICIES**

***Minority Interest in Consolidated Subsidiary***

The portion of income or loss attributable to theminority interest in a consolidated subsidiary, not to exceed the minorityinterest’s equity in the consolidated entity, is eliminated in the line item inthe condensed consolidated statements of operations entitled “minority interestin operations of consolidated subsidiary.” All material intercompany balancesand transactions have been eliminated.

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

Basic net income (loss) per share is computed usingthe weighted average number of common shares outstanding during theperiod.  Contingently issuable shares areincluded in the computation of basic net income (loss) per share when therelated conditions are satisfied. Diluted net income (loss) per share is computed using the weightedaverage number of common shares and potentially dilutive securities outstandingduring the period.  Potentially dilutivesecurities consist of contingently issuable shares, the incremental commonshares issuable upon conversion of 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 October 31, 2006, (a) a total of 23,188,042outstanding stock options and common stock warrants and (b) the unissued sharesunderlying our outstanding 6% and 8% convertible debentures were excluded fromthe diluted net loss per share calculation, as their inclusion would beanti-dilutive.  As of October 31, 2005, (a) a total of 8,268,442outstanding stock options and commonstock warrants and (b) the unissued shares 

6

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underlying our outstanding8% convertible debentures were excluded from the diluted net loss per sharecalculation, as their inclusion would be anti-dilutive.

During the six month period ended October 31, 2006, weissued the following shares of common stock:
| **Description**                                                                      | ** ** | **Number of Common Stock Shares** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Balance as of  April 30, 2006                                                        |       | 42,071,119                                            |       |
| Shares issued  from employee stock purchase plan                                     |       | 13,227                                                |       |
| Shares issued in  payment of principal and interest on the 8% convertible debentures |       | 4,264,475                                             |       |
| Shares issued  related to the 6% convertible debenture financing                     |       | 660,000                                               |       |
| Balance as of October  31, 2006                                                      |       | 47,008,821                                            |       |

** **

The aforementioned equity transactions increasedcommon stock in the accompanying condensed consolidated balance sheets by$5,245,000 for the six months ended October 31, 2006.

***Recently Issued Accounting Standards***

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 123 (revised 2004) *Share-Based Payments*(“SFAS 123(R)”).  This statement requires that we record allshare-based payment expense in our financial statements based on a fair valuemethodology.   Additionally, in March2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB No. 107”), whichsummarizes the staff’s views regarding share-based payment arrangements forpublic companies.  We selected theBlack-Scholes option pricing model as the most appropriate fair-value methodfor our awards and will recognize compensation cost on a straight-line basisover our awards’ vesting periods. We adopted SFAS 123(R) commencing May 1,2006. See Note 7 for further detail.

In September 2005, the FASB staff reported that theEmerging Issues Task Force (“EITF”) postponed further deliberations on IssueNo. 05-04 *The Effect of a LiquidatedDamages Clause on a Freestanding Financial Instrument Subject to Issue No.00-19* (“EITF 05-04”) pending the FASB reaching a conclusion as towhether a registration rights agreement meets the definition of a derivativeinstrument.  The legal agreements relatedto both our 8% convertible debentures and 6% convertible debentures include afreestanding registration rights agreement. Once the FASB concludes the standard setting process regarding thisissue (a proposed FASB Staff Position, EITF 00-19-b, *Accounting for Registration Payment Arrangements* has beenissued on this topic), we will assess the impact on our consolidated financialstatements of adopting the standard and, if an impact exists, follow thetransition guidance for implementation.

In July 2006, the FASB issued Interpretation No. 48, **Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109****(“FIN48”).  This interpretation clarifies theapplication of SFAS No. 109,****Accounting for Income Taxes,****by defining a criterion than an individual taxposition must meet for any part of the benefit of that position to berecognized in an enterprise’s financial statements and also provides guidanceon measurement, derecognition, classification, interest and penalties,accounting in interim periods and disclosure. FIN 48 is effective for our fiscal year commencing May 1, 2007. **At this time, we havenot completed our review and assessment of the impact of adoption ofFIN 48.

In September 2006, the SEC released StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*

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(“SAB 108”). SAB 108 provides interpretiveguidance on the SEC’s views regarding the process of quantifying materiality offinancial statement misstatements. SAB 108 is effective for fiscal yearsending after November 15, 2006, and early application for the firstinterim period of the same fiscal year is encouraged. The application ofSAB 108 in the first quarter of fiscal 2007 would not have a materialeffect on our results of operations or financial position.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS 157”).SFAS 157 defines fair value, establishes a framework and gives guidanceregarding the methods used for measuring fair value, and expands disclosuresabout fair value measurements. SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. We are currently evaluating theimpact of adopting SFAS 157 on our consolidated financial statements.

In November 2006, the FASB ratified the consensusreached by the EITF on EITF Issue No. 06-7, *Issuer’s Accounting for aPreviously Bifurcated Conversion Option in a Convertible Debt Instrument Whenthe Conversion Option No Longer Meets the Bifurcation Criteria in FASBStatement No. 133, Accounting for Derivative Instruments and Hedging Activities*(“EITF 06-07”).  The consensus providesthat a previously bifurcated conversion option in a convertible debt instrumentfor which the embedded conversion option no longer meets the bifurcation criteriain SFAS No. 133, *Accounting for Derivative Instruments andHedging Activities* (“SFAS 133”), should be reclassified (at its fairvalue on the date of reclassification) to stockholders’ equity. Any debtdiscount recognized when the conversion option was bifurcated from theconvertible debt instrument should continue to be amortized. EITF 06-07 shouldbe applied to all previously bifurcated conversion options in convertible debtinstruments that no longer meet the bifurcation criteria in SFAS 133, in interimor annual periods beginning after December 15, 2006.  We have a bifurcated conversion option in aconvertible debt instrument and will apply this consensus at such time, ifever, when the conversion option no longer requires classification as a derivativeliability in accordance with SFAS 133.

**NOTE 3 — FINANCIALSTATEMENT COMPONENTS**

***Inventories***

Inventories consist of the following (in thousands):

|                         | ** ** | **October 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|-------------------------|------------|--------------------------------|------------|------------------------------|------------|
| Finished goods          |       | $                              | 602        |                         | $          | 604 |   |
| Work in process         |       | 57                             |       | 40                           |       |
| Materials and  supplies |       | 610                            |       | 433                          |       |
| Total  inventories      |       | $                              | 1,269      |                         | $          | 1,077 |   |

 

***Property and equipment***

Property and equipment consist of the following (inthousands):

|                                            | ** ** | **October 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| Office furniture  and equipment            |       | $                              | 363        |                         | $          | 322 |   |
| Production  equipment                      |       | 6,677                          |       | 5,941                        |       |
| Vehicles                                   |       | 191                            |       | 175                          |       |
| Construction in  process                   |       | 1,939                          |       | 608                          |       |
| Leasehold  improvements                    |       | 1,027                          |       | 653                          |       |
|                                       |       | 10,197                         |       | 7,699                        |       |
| Accumulated  depreciation and amortization |       | (3,643                         | )          | (2,845                       | )          |
| Total property and  equipment, net         |       | $                              | 6,554      |                         | $          | 4,854 |   |

 

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**NOTE 4 — SEGMENTINFORMATION**

We currently have four reportable segments: homelandsecurity products, security services, semiconductor products and services andlife sciences.  Our homeland securityproducts segment includes the marketing and development of our Ion Mobility Spectroscopy (“IMS”)technology and includes, through our 90%-owned subsidiary (SenseIt Corp,see Note 6), the development of next-generation infrared imaging and nightvision technology through our Development & Licensing Agreement with LucentTechnologies, Inc.  Our security servicessegment provides security and investigative services and is substantiallycomprised of the operations of Protection Plus Security Corporation (“PPSC”),which was acquired in May 2005.  Oursemiconductor products and services segment provides small and large diameter test and reclaim siliconwafers, silicon-on-insulator (“SOI”) wafers and wafer thinning and othersemiconductor services.  Our lifesciences segment sells stable and radioisotopes in elemental and simplecompound forms for use in life sciences applications.  Our segments are strategic business units,each of which consists of similar products or services.  They are managed separately because eachsegment requires different technology and marketing strategy and because eachsegment sells to different customers. Reconciling items consist primarily of corporate assets or expenses thathave not been allocated to a specific reportable segment.  Prior period amounts have been reclassifiedto conform to current period presentation.

Information by segment isset forth below (in thousands):

|                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                          | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Segment  revenues:                  |       |                             |       |                           |       |   |   |   |   |
| Homeland security products          |       | $                                | —     |                           | $          | — |   | $ | — |   | $ | 35 |   |
| Security services                   |       | 3,739                            |       | 2,996                          |       | 7,616 |   | 5,633 |   |
| Semiconductor products and services |       | 3,516                            |       | 1,217                          |       | 6,425 |   | 2,022 |   |
| Life sciences                       |       | 577                              |       | 1,619                          |       | 1,193 |   | 3,216 |   |
| Total                               |       | $                                | 7,832      |                           | $          | 5,832 |   | $ | 15,234 |   | $ | 10,906 |   |

 

|                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                          | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Segment  operating (loss) income:   |       |                             |       |                           |       |   |   |   |   |
| Homeland security products          |       | $                                | (2,124     | )                              | $          | (1,569 | ) | $ | (4,071 | ) | $ | (2,071 | ) |
| Security services                   |       | (20                              | )          | (72                            | )          | (294 | ) | 38 |   |
| Semiconductor products and services |       | 151                              |       | (1,420                         | )          | (48 | ) | (3,474 | ) |
| Life sciences                       |       | (43                              | )          | (60                            | )          | (12 | ) | (209 | ) |
| Reconciling amounts (1)             |       | (1,091                           | )          | (554                           | )          | (2,624 | ) | (1,687 | ) |
| Total                               |       | $                                | (3,127     | )                              | $          | (3,675 | ) | $ | (7,049 | ) | $ | (7,403 | ) |

 

 

9

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|                                     | ** ** | **October 31,** | ** ** | **April 30,** | ** ** |
|-------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                          | ** ** | **2006**             | ** ** | **2006**           | ** ** |
| Total assets:                       |       |                 |       |               | ** ** |
| Homeland security products          |       | $                    | 1,927      |               | $          | 1,300 | ** ** |
| Security services                   |       | 6,275                |       | 5,992              | ** ** |
| Semiconductor products and services |       | 9,561                |       | 7,027              | ** ** |
| Life sciences                       |       | 1,300                |       | 1,713              | ** ** |
| Reconciling amounts (2)             |       | 1,630                |       | 1,831              | ** ** |
| Total                               |       | $                    | 20,693     |               | $          | 17,863 | ** ** |

----

(1)             Reconciling amountsfor the operating (loss) income information includes corporate expensesconsisting primarily of corporate salaries and benefits, professional andconsulting fees, investor relations costs, warrant amendment expense, insuranceand directors’ compensation.

(2)             Reconciling amountsfor the total asset information includes corporate assets consisting primarilyof cash and cash equivalents invested centrally, unamortized debt issuancecosts and miscellaneous prepaid items.

 

**NOTE 5— INVESTMENT IN ISCON VIDEO IMAGING, INC.**

ISCONVideo Imaging, Inc. (“ISCON”) is a company that is attempting to developpatent-pending infrared imaging-based technologies for the non-invasive detectionof objects hidden under clothing as well as technology for the determination ofthe chemical composition of such objects to identify explosives andnarcotics.  On May 12, 2006, we signed astock purchase agreement with ISCON that provided us the option, but not theobligation, to purchase authorized but unissued shares of Series B common stockfrom ISCON at five intervals based on successful completion of developmentaland commercial milestones.  If ISCONsucceeded in meeting all five milestones and if we had chosen to exercise ouroption to purchase shares for each completed milestone, we would have owned 51%of ISCON for a cumulative investment of $1,750,000.  On June 9, 2006, we made our first investmentin the amount of $100,000, which was being accounted for using the costmethod.  Although ISCON achieved its nextmilestone, we declined to exercise our option to purchase the relatedadditional shares and, consequently, we have not made any subsequent investmentin ISCON.  Based on our decision not tocontinue funding and the inability of ISCON to obtain funding from othersources, ISCON began the process of shutting down its business in December2006.  As a result, while we currentlyown 9% of ISCON, we determined the investment to be fully impaired and thusincurred an impairment charge of $100,000 during the six months ended October31, 2006.

**NOTE 6 —INVESTMENT IN SENSEIT CORP**

**On October 26, 2006, weentered into a Class A Common Stock Purchase Agreement (the “Purchase Agreement”)with SenseIt Corp, a Delaware corporation (“SenseIt”), with the intent ofaccelerating next generation infrared imaging and night vision surveillancetechnology development and driving related commercialization activities inconnection with our Development & Licensing Agreement with LucentTechnologies Inc., (the “Lucent Agreement” and “Lucent,” respectively).  The joint venture was established through ouracquisition of an initial 90% ownership interest in SenseIt in exchange forassigning to SenseIt all of our interest under the Lucent Agreement, althoughwe will continue to be jointly and severally liable with SenseIt to Lucent foramounts due to Lucent under the assigned Lucent Agreement.  The assignmentwas approved by Lucent.**

**Pursuant to the Purchase Agreement, on October 27, 2006, we purchasedshares of the Class A common stock of SenseIt in exchange for cash and otherconsideration, including, but not limited to, an assignment of all of ourrights, title and interest in the Lucent Agreement.  As described above,we now**

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**have a 90% ownership interest in SenseIt.  Our ownership interestwill be adjusted if SenseIt receives additional financing from third parties,and upon the occurrence of a Threshold Event.  The term “Threshold Event”is described in SenseIt’s Certificate of Incorporation, as amended, as thereceipt by SenseIt of $20 million in certain equity financing.  At thattime, the Class A common stock and Class B common stock will be converted intocommon stock, and the holder of the Class B common stock (held by the chiefexecutive officer of SenseIt) will be entitled to a 10% ownershipinterest.  The remaining 90% of the common stock outstanding will beallocated among the prior holders of common stock and Class A common stock.**

**Under the PurchaseAgreement, we acquired 450,000 shares of Class A common stock of SenseIt fortotal consideration of $4.5 million paid as follows:**

**·**                  Wereceived a $4 million credit for payments made to Lucent, as required by theLucent Agreement and for the assignment of our rights, title and interest inthe Lucent Agreement, for 400,000 shares of Class A common stock; and

**·**                  $250,000working capital was paid to SenseIt upon signing the Purchase Agreement for25,000 shares of Class A common stock; and

**·**                  $250,000working capital was paid to SenseIt in November 2006 for 25,000 shares of ClassA common stock, which payment we were obligated to make no later than December31, 2006.

**Additionally, we have anobligation to fund at least one additional $1 million payment under the LucentAgreement, to be made to SenseIt in January 2007, and to make an additional$500,000 payment to SenseIt in March 2007 (against which we can credit legalcosts incurred related to entering into the SenseIt joint venture).  Ineach case, we will be entitled to receive one share of Class A common stock foreach $10 investment.**

**In connection with thePurchase Agreement, we also entered into a Stockholders’ Agreement with SenseItand its chief executive officer.  The Stockholders’ Agreement includescertain share transfer restrictions such as right of first refusal, as well asdrag-along and tag-along rights.  The Stockholders’ Agreement does notcurrently impose any material obligations on us.  If at some time in thefuture (after we meet our initial remaining $1.5 million obligation), SenseItneeds additional funding, we will have the right, but not the obligation, toprovide that additional funding.**

**At the closing of thePurchase Agreement, SenseIt entered into an amended and restated employmentagreement with the chief executive officer of SenseIt (the “EmploymentAgreement”).  The Employment Agreement has an initial term of two years,plus automatic two year extensions unless SenseIt or the chief executiveofficer chooses not to renew. The Employment Agreement sets forth thecompensation payable to the chief executive officer and the time that he isrequired to devote to the business of SenseIt.  If termination occursafter SenseIt has made a commercial sale of a Lucent product, as described inthe Lucent Agreement, or has acquired a business having revenues of $10 millionor more in any one year, termination without cause will result in SenseIt’sobligation to pay the chief executive officer a two-year severance based on therespective annualized salary over the previous five years.  The Employment Agreement is between SenseItand its chief executive officer; we have no obligation under the contract.**

**The results of SenseIt have been included in our consolidated results asof the exercise date of the Purchase Agreement. The minority interest held in the net assets of SenseIt is included inthe caption “minority**

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**interest in consolidated subsidiary” in our condensed consolidatedbalance sheet.  Additionally, thecondensed consolidated statements of operations include a noncash chargerecognized by SenseIt related to the chief executive officer’s 10% ownershipinterest in SenseIt (see Note 8).**

**NOTE 7 —STOCK-BASED COMPENSATION**

**OnMay 1, 2006, we adopted the provisions of SFAS 123(R), requiring us torecognize expense related to the fair value of our stock-based compensationawards.  We elected to use the modifiedprospective transition method as permitted by SFAS 123(R) and therefore havenot restated our financial results for prior periods.  Under this transition method, stock-basedcompensation expense for the six months ended October 31, 2006, includescompensation expense for all stock-based compensation awards granted prior to,but not yet vested as of May 1, 2006, based on the grant-date fair valueestimated in accordance with the original provisions of SFAS No. 123 *Accounting for Stock-BasedCompensation* (“SFAS 123”).  Stock-based compensation expense for allstock-based compensation awards granted subsequent to May 1, 2006, was based onthe grant-date fair value estimated in accordance with the provisions of SFAS123(R).  We recognize compensationexpense for stock option awards on a straight-line basis over the requisiteservice period of the award.**

**Optionscurrently granted to employees generally expire ten years from the grant dateand vest over a three year period, with 25% of the stock option vestingimmediately and 25% vesting on the anniversary date of the grant date for eachof the subsequent three years.  Optionscurrently granted to external members of our board of directors generallyexpire five years from the grant date and vest immediately.  As of October 31, 2006, we have 2,011,000shares issuable under the 2005 Stock Option Plan.  The Directors’ Stock Option Plan does nothave an explicit cap as to the number of shares issuable under the plan.  It is our current policy to issue new sharesout of our authorized but unissued shares upon exercise of a stock option by aholder.**

**Thefollowing table sets forth the total stock-based compensation expense resultingfrom stock options included in our condensed consolidated statements ofoperations (in thousands):**

|                                                           | ** ** | **Six Months**            | ** ** |
|-----------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **Ended**                      | ** ** |
| ** **                                                | ** ** | **October 31, 2006** | ** ** |
| Cost of revenues                                          |       | $                              | 46         |   |
| Selling, general and  administrative                      |       | 545                            |       |
| Research and development                                  |       | 5                              |       |
| Stock-based  compensation expense before income taxes     |       | 596                            |       |
| Income tax benefit                                        |       | —                         |       |
| Total stock-based compensation expense after income taxes |       | $                              | 596        |   |

** **

**Netcash proceeds from the exercise of stock options were $0 and $184,000 for thesix months ended October 31, 2006 and 2005, respectively.  In accordance with SFAS 123(R), we presentexcess tax benefits from the exercise of stock options, if any, as financingcash flows rather than operating cash flows. We have not realized excess tax benefits in any period presented.  There was no share-based compensation costcapitalized as part of an asset as of October 31, 2006.**

**Wepreviously accounted for awards granted under our equity incentive plans underthe intrinsic value method prescribed by Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued to Employees*and related interpretations, as permitted bySFAS 123, as amended by SFAS No. 148 *Accounting for Stock-basedCompensation — Transition and Disclosure,*and provided pro forma**

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**disclosure required by those statements, as if thefair value based method defined in SFAS 123 had been applied.*** *The respective exerciseprices of stock options granted were equal to the market price of our commonstock on the respective dates of grant. Accordingly, no share-based compensation, other than for instrumentsissued to outside parties for services, was recognized in our condensedconsolidated financial statements in prior periods.  Thefollowing table illustrates the effect on net loss attributable to commonstockholders and net loss per share attributable to common stockholders if wehad applied the fair value recognition provisions of SFAS No. 123 tostock-based compensation (in thousands, except per share data):

|                                                                                                                                     | ** ** | **Six Months**            | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                          | ** ** | **Ended**                      | ** ** |
| ** **                                                                                                                          | ** ** | **October 31, 2005** | ** ** |
| Net loss  attributable to common stockholders, as reported                                                                          |       | $                              | (10,525    | ) |
| Add: stock-based  compensation costs included in reported net loss, net of related tax effects                                      |       | 20                             |       |
| Deduct: total stock-based compensation expense determined  under fair value based method for all awards, net of related tax effects |       | (591                           | )          |
| Adjusted net  loss attributable to common stockholders                                                                              |       | $                              | (11,096    | ) |
|                                                                                                                                |       |                           |       |
| Net loss per  share attributable to common stockholders                                                                             |       |                           |       |
| Basic and diluted — as reported                                                                                                |       | $                              | (0.35      | ) |
| Basic and  diluted — adjusted                                                                                                  |       | $                              | (0.37      | ) |

** **

**Share-basedcompensation recognized for the six months ended October 31, 2006, as a resultof the adoption of SFAS 123(R) as well as pro forma disclosures according tothe original provisions of SFAS 123 for periods prior to the adoption of SFAS123(R) use the Black-Scholes option pricing model for estimating fair value ofoptions granted under our equity incentive plans.  The following table sets out the weighted-averageassumptions used for calculating the fair value of options granted during thesix months ended October 31, 2006 and 2005, respectively:**

|                           | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **October 31,**           | ** ** |
| ** **                | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Expected life  (in years) |       | 5.7                            |       | 4.2 |   |
| Interest rate             |       | 5.0                            | %          | 4.0 | % |
| Volatility                |       | 85                             | %          | 100 | % |
| Dividend yield            |       | —                         |       | — |   |

** **

**Expectedvolatility is based on historical volatility for a period at least equal to theexpected life of the option under evaluation. The expected life of an option is calculated using the simplifiedcalculation of expected life, described in the SAB No. 107.  The interest rate is based on the U.S.Treasury yield curve in effect at the time of grant.**

**Stockoption activity for the six months ended October 31, 2006, is as follows:**

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** **
| ** **                         | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|------------------------------------|------------|--------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                         | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                         | ** ** | ** **         | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Shares**         | ** ** | **Price**    | ** ** | **Term (years)** | ** ** | **Value**     | ** ** |
|                               |       |               |       |         |       |                  |       |          |       |
| Outstanding, April  30,2006        |       | 2,933,932          |       | $            | 2.12       |                  |       |          |       |   |
| Granted                            |       | 979,000            |       | $            | 1.09       |                  |       |          |       |   |
| Exercised                          |       | —             |       | $            | —     |                  |       |          |       |   |
| Forfeitures or  expirations        |       | (123,000           | )          | $            | 1.46       |                  |       |          |       |   |
|                               |       |               |       |         |       |                  |       |          |       |
| Outstanding, October  31, 2006     |       | 3,789,932          |       | $            | 1.88       |                  | 6.5        |          | $          | — |   |
|                               |       |               |       |         |       |                  |       |          |       |
| Exercisable, October  31, 2006     |       | 2,380,682          |       | $            | 1.77       |                  | 5.0        |          | $          | — |   |
|                               |       |               |       |         |       |                  |       |          |       |
| Expected to vest, October 31, 2006 |       | 1,047,533          |       | $            | 2.10       |                  | 9.0        |          | $          | — |   |

** **

**Theaggregate intrinsic value in the table above represents the total pretaxintrinsic value (i.e. the difference between our closing stock price on October31, 2006, and the exercise price, times the number of shares) that would havebeen received by the option holders had all option holders exercised theiroptions on October 31, 2006.  This amountchanges based on the fair market value of our common stock.  Total intrinsic value of options exercised is$0 and $573,000 for the six months ended October 31, 2006 and 2005,respectively.**

**Theweighted average grant-date fair value of options granted during the six monthsended October 31, 2006 and 2005, were $0.80 and $1.83, respectively.  As of October 31, 2006, $1,700,000 of totalunrecognized compensation cost related to stock options is expected to berecognized over a weighted-average period of 1.1 years.**

**NOTE 8 —EQUITY INSTRUMENTS ISSUED FOR SERVICES**

In October 2006, in connection with enteringthe SenseIt joint venture (see Note 6), the individual who is the chiefexecutive officer of SenseIt retained a 10% ownership interest in SenseItthrough ownership of  shares of Class Bcommon stock.  This 10% equity interest wasvalued at $667,000 and the noncash charge is included in selling, general andadministrative expense in our condensed consolidated statements of operationsfor the six months ended October 31, 2006.

In August 2006, we entered into a consultingagreement with an individual to provide management services in oursemiconductor products and services segment, whereby we issued a common stockwarrant  (valued at $20,000 using theBlack-Scholes pricing model) to purchase 50,000 shares of common stock at $0.67per share.  The common stock warrantvested immediately, expires on July 31, 2008, and was recorded as prepaidconsulting expense, to be amortized ratably over the expected service period offive months.  During the six months endedOctober 31, 2006, $12,000 was expensed to selling, general andadministrative expenses.

In May 2006, we entered into a financialadvisory services agreement with Clayton Dunning Capital Partners, Inc.,whereby we issued a common stock warrant (valued at $28,000 using the Black-Scholes pricing model) to purchase50,000 shares of common stock at $1.05 per share.  The common stock warrant vested immediately,expires on May 17, 2008, and was recorded as prepaid consulting expense, to beamortized ratably over the expected service period of four months.  During the six months ended October 31, 2006,$28,000 was expensed to selling, general and administrative expenses.

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**NOTE 9 — BORROWINGS**

***8% Convertible Debentures***

**On May 18, 2006, we made an offer to the holders of our outstanding 8%convertible debentures (the “8% Debentures”) to pay in cash the principalbalance remaining immediately subsequent to making the monthly paymentscheduled June 1, 2006, plus a 5% premium and accrued interest, both items toalso be paid in cash.  On May 19, 2006, approximately $5.0 million out ofthe then-outstanding $8.2 million 8% Debentures accepted our offer.  The offer was made and accepted contingentupon the cash payment being made to the accepting holders on or before June 1,2006, from the proceeds of a financing that we were then working to completeand which is discussed below.   Inaccepting our offer, the holders agreed to limit the anti-dilution provision ontheir warrants originally issued with their debentures such that the warrantswould fully ratchet based upon the financing completed on May 31, 2006, andthen the ratchet would be converted to a price-only ratchet whereby theexercise price would still be reduced to the effective price per share (oreffective exercise price per share) of the subsequent equity sale but where thenumber of shares purchasable under the warrant would be fixed.  The holders also agreed to waive certainprovisions of the Securities Purchase Agreement entered into concurrently withthe 8% Debentures which relate to entering into a future financing with variableconversion terms (such contractual terms we do not believe to be inforce).  In accordance with this offerand subsequently to closing the financing on May 31, 2006, we paidapproximately $4.1 million from the proceeds of the financing to the holdersaccepting our offer (such payment was calculated after including the impact ontheir outstanding principal balance of the normal monthly amortization paymentmade to them on June 1, 2006).   Thispayment resulted in a reduction in the principal balance of the 8% Debenturesof $3,880,000.**

**In accounting for the offer and subsequent payment, we allocated betweenthree components the $4.1 million paid to certain holders of the 8%Debentures:  the interest due at the timeof payment, the amendment to the terms of certain outstanding warrants and the principalreduction of the 8% Debentures.  Werecorded an expense in the amount of $357,000 (included in selling, general andadministrative expenses) related to the amendment to the terms of certainoutstanding warrants originally issued with the 8% Debentures, such chargerepresenting the decrease in the fair value of the amended warrants as comparedto the fair value of the warrants immediately prior to amendment.  We recorded a gain in the amount of $227,000on the extinguishment of debt (included as a line item in other income(expense)), such amount calculated as the difference between the reacquisitionprice and the net carrying amount of the extinguished debt, which bore anominal principal amount of $3,880,000. Additionally, we wrote off capitalized debt issuance costs related tothe extinguished debt in the amount of $44,000 (included in amortization ofdebt issuance costs).**

**As a result of entering the financing transaction with Cornell CapitalPartners, L.P. discussed below, which includes a fixed conversion price of$1.25, the warrants associated with the 8% Debentures were amended per thewarrant such that the warrant exercise price was reduced from $6.25 per shareof common stock to $1.25 per share of common stock.  Simultaneously, the number of sharespurchasable under the warrants increased from 1,593,900 to 7,969,500.  Due to our offer made on May 18, 2006, to theholders of the 8% Debentures and the acceptance of the offer by certainholders, of the currently outstanding warrants associated with the 8%Debentures, warrants to purchase 4,557,000 shares of common stock have a priceratchet only whereby no change to the number of shares purchasable will occurand warrants to purchase 3,412,500 shares of common stock continue to retainthe original ratchet provisions.**

**Upon issuance of the financing transaction with Cornell Capital Partners,L.P. discussed below, which has a variable pricing component, we reevaluatedthe classification of the aforementioned 3,412,500 warrants originally issuedwith the 8% Debentures and which still contain a full ratchet provision.  We evaluated the**

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**warrants in accordance with the provisions of SFAS 133 and EITF Issue No.00-19 *Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock*(“EITF 00-19”) which provide guidance, among other topics, as to whether equityor derivative liability classification is appropriate for freestandingwarrants.  Because of the issuance of thevariable rate financing, we no longer have control over the ratchet of thefully ratcheting warrants.  Therefore,there is a possibility (and per EITF 00-19, we are not allowed to consider inour evaluation the likelihood of such an event occurring) that the number ofshares issuable related to the warrant could exceed our authorized but unissuedshares if the warrant were to ratchet to a sufficiently low exerciseprice.  If we did not have sufficientauthorized but unissued shares to satisfy the number of shares issuable underthe warrant if exercised, we may have to net cash settle a portion or all ofthe warrant.  Accordingly, we havereclassified the aforementioned warrants from equity to derivative liabilitiesin the amount of $1,773,000, which represents the estimated fair value of thewarrants at the date of reclassification. Further, we are required to recognize in earnings at each reporting datethe gain or loss on our derivative instruments. We recorded a gain on derivatives for the six months ended October 31,2006, in the amount of $580,000, such amount representing the estimated changein fair value of the warrants between the date the warrants were classified asliabilities and October 31, 2006.**

**Having met all requirements to allow us to do so, we elected to make themonthly principal and interest payments due for our 8% Debentures on May 1,2006, and June 1, 2006, in shares of our common stock.  Accordingly, we issued a total of 1,616,433and 1,997,265 shares of common stock, respectively, in settlement of (1)principal amounts owed on the 8% Debentures in the nominal amounts of$1,822,500 and $1,647,500, respectively and (2) interest obligations for themonths of April 2006 and May 2006 in the nominal amounts of $66,500 and$21,250, respectively.  As the paymentswere made in stock in lieu of cash, the fixed monetary amounts of the principaland interest payments will have a larger impact on the condensed consolidatedfinancial statements as compared to the nominal amounts disclosed.  This difference is due to application of thefixed discount applied to the price of our common stock in the calculation ofthe number of common shares due for each principal payment and interest paymentwhen made in shares of our common stock, as defined.**

**We elected to make our monthly principal and interest payments due onJuly 1, 2006, and August 1, 2006 in cash. Each payment included a reduction to outstanding principal of $562,000and interest relating to the calendar month preceding each respective payment.**

**Having met all requirements to allow us to do so, we elected to make themonthly principal and interest payments due for our 8% Debentures on September1, 2006, October 1, 2006, November 1, 2006 and December 1, 2006, in shares ofour common stock.  Accordingly, we issued296,855, 353,922, 437,315 and 356,338 shares of common stock, respectively, insettlement of the principal amount owed on the 8% Debentures in the nominalamount of $250,000 for each respective payment and interest relating to thecalendar month preceding each respective payment.  Subsequent to these payments, the outstandingprincipal balance on the 8% Debentures is $500,000.**

**The cumulative discount on the 8% Debentures (arising from the allocationof a portion of the proceeds to the related warrants) is being amortized tointerest expense over the term of the 8% Debentures using the effectiveinterest method.  During the six monthsended October 31, 2006, $239,000 of this discount was amortized to interestexpense.**

In June 2006, one of the three remaining holders ofour 8% Debentures, with no currently remaining principal outstanding, assertedthat the issuance of the 6% convertible debentures (see discussion below)constituted a default (due to a potential variable conversion provisioncontained within the 6% convertible debenture agreement) under the 8%Debentures.  We have contested that allegationon several bases and

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will defend against any further allegation ofdefault as necessary.   Remedies for anevent of default include the option to accelerate payment of the full principalamount of the debentures, together with interest and other amounts due, to thedate of acceleration.  The principalamount of the debentures shall be equal to 130% of the then-principal amount ofthe debentures plus all interest and other amounts due or a conversioncalculation, whichever is higher.  If they prove a default, we could be liablefor an amount of approximately $1,100,000, including accrued interest, inaddition to the current outstanding principal of $500,000.

***6% Convertible Debentures***

**On May 31, 2006, we completed a private placement pursuant to whichwe issued to one accredited investor, Cornell Capital Partners, L.P. (“Cornell”)a 6% secured convertible debenture with a principal amount of $10,000,000,which was the first of three 6% secured convertible debentures (cumulatively,the “6% Debentures”), for which the aggregate principal amount issued was$16,000,000.  On June 5, 2006 (twotrading days prior to the filing of a registration statement contemplated inthe transaction documents correlated with the 6% Debentures), we issued thesecond of the three 6% Debentures. This 6% Debenture has a principal amount of$3,000,000.  The final 6% Debenture witha principal amount of $3,000,000 was issued on November 16, 2006, two tradingdays prior to a registration statement being declared effective by theSEC.  The 6% Debentures are convertibleinto shares of our common stock at the lesser of $1.25 (the “Fixed ConversionPrice”) or 80% of the average of the two lowest daily volume weighted averageprices of our stock during the five trading days immediately preceding theconversion date (the “Market Conversion Price”).  The 6% Debentures mature on May 31, 2009 (the“Maturity Date”).  In addition to the 6%Debentures, we issued three warrants (the “6% Debenture Warrants”) to purchasea total of 8,000,000 shares of our common stock at exercise prices of $1.25 pershare (2,000,000 warrants), $1.75 per share (3,000,000 warrants) and $2.00 pershare (3,000,000 warrants). Each of the warrants can be exercised for a periodof three years.**

**The then-effective conversion price will be adjusted upon the occurrenceof any stock dividends, stock splits, pro rata distributions, or fundamentaltransactions as described in the 6% Debenture agreement.  Additionally, the Fixed Conversion Price willbe reduced if we issue shares of stock or other instruments that areexchangeable into or convertible into common stock at an effective price lessthan the Fixed Conversion Price.  The FixedConversion Price will be adjusted to mirror the conversion, exchange orpurchase price at issue.  Our issuanceand exercise of options which are compensatory and pursuant to our stock optionor stock purchase plans will not cause an adjustment under this provision.**

**Interest accrues on the outstanding principal balance at the annual rateof 6%.  Interest is payable on theMaturity Date in cash or shares of our common stock, at our option.  At October 31, 2006, accrued interest expenseon the 6% Debentures was $335,000.  If wechoose to pay accrued interest in shares of our common stock, the number ofshares to be issued will be calculated as the amount of interest due divided by88% of the volume weighted average price of our common stock for the fivetrading days preceding the Maturity Date.**

**The investor and an unaffiliated party provided us services in connectionwith completing the transaction. To compensate these entities for thoseservices, we issued them 660,000 shares of our common stock (the “Buyers Shares”).  We also paid Cornell or its affiliates feesin the cumulative amount of $900,000.**

We were contractually required to seek shareholderapproval of this transaction by no later than October 31, 2006, (exclusive ofany shares acquired in this transaction or related transactions), including theability to issue a maximum of 64 million shares upon conversion of the 6%Debentures and to approve an increase in authorized shares of common stock toat least 175 million shares.  On October30, 2006, we held our annual meeting of shareholders.  Although more shareholders voted in favor ofamending our articles of

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incorporation to increase our authorized commonstock, we did not receive the number of votes for the proposal required byCalifornia law to complete the amendment as required.  Under the terms of both the 6% Debentures andthe related warrants, if we have insufficient authorized capitalization afterDecember 31, 2006, we have an obligation to call and hold a special meeting ofits stockholders within 60 days for the sole purpose of increasing ourauthorized capitalization.  We havecalled a special meeting of shareholders to be held January 2, 2007 toreconsider a proposal for an increase in our authorized capitalization and hopeto obtain the required approval at that time. If we are unable to obtain the required approval, Cornell will belimited in the number of shares it can acquire upon conversion of the 6%Debenture or exercise of the related warrants. If we fail to obtain shareholder approval to the extent required underCalifornia law for the increase in authorized capitalization, we may be indefault under the terms of the 6% Debentures and related warrants as well aspursuant to certain other obligations.

**The 6% Debentures, the 6% Debenture Warrants and the Buyers Shares havecertain limitations on our ability to issue shares to the holders of theinstruments and impose certain limitations on Cornell’s ability to sell shares.**

**·**                  Weare prohibited from issuing shares of our common stock to the holders of the 6%Debentures (upon conversion or payment of interest) and the 6% DebentureWarrants (upon exercise) if the issuance would result in Cornell beneficiallyowning more than 4.99% of our outstanding common stock (although Cornell canwaive this provision upon more than 65 days notice to us).

**·**                  Through January 26, 2007, if converting using theMarket Conversion Price, Cornell is limited to converting no more than $200,000of the principal or accrued interest on the 6% Debentures into shares of ourcommon stock in any seven calendar day period.  Subsequent to January 26, 2007, if converting using the MarketConversion Price, Cornell is limited to converting no more than $400,000 of theprincipal or accrued interest on the 6% Debentures into shares of our commonstock in any seven calendar day period.

**·**                  The maximum number of shares that may be issued uponconversion of the principal amount of the 6% Debentures is contractuallylimited to 64 million shares.

** **

**If after December 31, 2006, we have insufficient shares authorized butunissued and unreserved to convert principal and pay interest in common stock,our stock is not listed or quoted on a market, we have not timely satisfied anyconversion obligations or the issuance of shares would violate certain otherdefined sections of the agreement, the holder has a right to request net cashsettlement of the conversion based upon a defined calculation.**

**If there is an effective underlying registration statement and if thevolume weighted average price of our common stock is equal to or greater than$2.50 for twenty consecutive trading days, we may force Cornell to convert theoutstanding principal and any accrued interest, subject to the share issuancelimitations discussed above.**

**We have the right, after providing ten trading days advance writtennotice, to redeem in cash a portion or all amounts outstanding under the 6%Debentures prior to the Maturity Date provided the closing bid price of ourcommon stock is less than $2.50 at the time the redemption notice is provided.  If we exercise this redemption right, aredemption premium in the amount of 20% of the principal amount being redeemedwill be due.  During the ten daynotification period, Cornell may elect to convert any portion or all of theoutstanding 6% Debenture amount.**

**For a period of one year subsequent to entering into the 6% Debentureagreements on May 31, 2006, we have granted Cornell the right to participate inany allowed capital raise up to 50% of the raise.  After that**

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**one year period expires and until such time no portion of the principaland interest due on the 6% Debentures is outstanding, we have granted Cornellthe right to participate in any allowed capital raise up to 25% of the raise.**

**As a result of a freestanding registration rights agreement, we have anobligation to register the shares underlying the 6% Debentures, Buyers Sharesand 6% Debenture Warrants.  We wererequired to file an initial registration statement to register 8,735,785 sharesof common stock (related to the Buyers Shares, the 6% Debenture Warrant exercisablefor 2,000,000 shares at $1.25 per share and 6,075,785 shares to be issued uponconversion of the 6% Debentures) no later than August 7, 2006 (a registrationstatement was filed on June 7, 2006) and to have the initial registrationstatement declared effective by September 28, 2006 (the registration statementwas declared effective on November 20, 2006). Because we failed to meet our effectiveness deadline, we could haveincurred liquidated damages of one percent of the outstanding balance of the 6%Debentures for each thirty-day period, prorated by day, subsequent to the dateof the deadline missed until such time as the registration statement wasdeclared effective.  However, Cornellwaived the penalty in respect to obtaining effectiveness of the originalregistration statement.**

**As a result of our shareholders approving the Cornell transaction onOctober 30, 2006, we were obligated to file an amended registration statementby November 30, 2006, to register the full number of shares required under the 6%Debenture transaction documents (representing the Buyers Shares, sharesunderlying the 6% Debenture Warrants and shares upon the conversion of the 6%Debentures based on a defined formula but in an amount not to exceed 64 millionshares) and obtain effectiveness of the registration statement by January 15,2007.  Due to the aforementioned currentinability to amend our articles of incorporation to increase our authorizedshares of common stock, we are unable to file the required registrationstatement until such time as our shareholders approve, if ever, a proposedincrease in authorized shares of common stock (such proposal being presented toour shareholders in a meeting to be held on January 2, 2007).   C**onsequently, we will be obligated to pay the holder of the 6%Debentures liquidated damages equal to 1% of the liquidated value of the 6%Debentures outstanding ($160,000 assuming no conversions by Cornell) for each30 day period until such time, if ever, that we become in compliance with ourcontractual obligation to Cornell.  Additionally,once effectiveness of both the initial and the amended registration statementis achieved and until such time that all eligible shares have been sold underthe registration statements, if sales are not able to be made under theregistration statement (due to failure to keep the registration statementeffective or failure to register sufficient shares or otherwise), Cornell willhave recourse to the aforementioned one percent per thirty-day liquidateddamages penalty.  We are contractuallynot obligated to pay liquidated damages for more than a total of 365 calendardays.  We may elect to pay any liquidated damages in cash or shares of ourcommon stock if registered.   Failureto comply with our registration obligations may, subsequent to any graceperiods and opportunities to cure, be deemed an event of default.

**Additionally, other events, as defined in the 6% Debenture agreement, mayalso allow the 6% Debenture holders to declare us in default.  Remedies for an event of default, include theoption to accelerate payment of the full principal amount of the Debentures,together with interest and other amounts due, to the date of acceleration andCornell will have the right to request such payment in cash or in shares of ourcommon stock.**

**So long as principal amounts are outstanding under the 6% Debentures, wehave agreed to not sell capital stock or grant security interests which meetcertain defined characteristics without the prior consent of Cornell.  However, certain transactions defined asExcluded Securities are exempted from this prior consent provision.  Excluded Securities include (1) securitiesissued in connection with a strategic partnership or joint venture, (2)securities issued as consideration for a merger or consolidation or theacquisition of a business, product, license or other asset of another person orentity, (3) options (priced not less than at the**

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**market) provided to employees within the first thirty days of employment,(4) securities issued pursuant to an approved stock plan, (5) up to 1 millionshares (priced not less than market) which may be issued as long as noregistration rights are included and as long as not pursuant to a Form S-8 and(6) any other issuances to holders of other pre-existing securities if suchissuances are provided for in the terms of such instrument.**

**The 6% Debenture Warrants are exercisable for cash only, unless afterJanuary 15, 2007, there is no effective underlying registration statement, atwhich point a cashless exercise can be elected by the holder.  The then-effective warrant exercise pricewill be adjusted upon the occurrence of any stock dividends, stock splits, prorata distributions, or fundamental transactions as described in the 6%Debenture Warrant agreements.  Additionally,the exercise price and number of shares upon issuance of common stock aresubject to adjustment in cases where we issue shares of common stock (otherthan Excluded Securities or issuances in connection with other components ofthe 6% Debenture documents) for consideration per share less than thethen-existing warrant exercise price.  Ifan adjustment is triggered, the warrant exercise price for the warrant for2,000,000 shares at an exercise price of $1.25 per share and the warrant for3,000,000 shares at an exercise price of $1.75 per share will be adjusted to aprice determined by multiplying such exercise price by a fraction of which (a)the numerator shall be the number of shares of common stock outstandingimmediately before such issuance plus the number of shares of common stock thatthe aggregate consideration received by us for such issuance would purchase atthe warrant exercise price then in effect and (b) the denominator shall be thenumber of shares of common stock outstanding immediately prior to such issuanceplus the number of new shares to be issued in the triggering event.  Concurrently, the number of shares issuableupon exercise of the warrant will be adjusted such that the aggregate exerciseprice would be equal to the aggregate exercise price prior to adjustment.  The warrant for 3,000,000 shares exercisableat $2.00 per share has a different adjustment calculation whereby a subsequenttriggering equity issuance would lead to a reduction in the warrant exerciseprice per share equal to the price per share (or effective exercise price pershare) of the subsequent equity issuance. There would be no change to the number of shares issuable under thewarrant.**

**The 6% Debentures are secured by individual security agreements with IsonicsVancouver, Inc. (“IVI”),**Isonics Homeland Security and Defense Corporation (“HSDC”) andPPSC.

**We allocated the net proceeds received between the 6% Debentures and therelated warrants based on the relative fair value of each instrument.  The $2,718,000 allocated to the warrants wasrecorded as additional paid-in capital and as a corresponding reduction to thecarrying value of the 6% Debentures.  Weevaluated the embedded conversion feature in the 6% Debentures in accordancewith the provisions of SFAS 133 and EITF 00-19 and concluded that, due tocertain provisions which could result in net cash settlement, the featureshould be classified as a derivative instrument and should be recorded as aliability in our condensed consolidated financial statements.  Accordingly, we recorded the aforementionedembedded conversion feature as a derivative liability in the amount of$6,342,000 (which represents the estimated fair value of the feature at thedate the financing was consummated) and as a corresponding reduction in thecarrying value of the 6% Debentures. Further, we are required to recognize in earnings at each reporting datethe gain or loss on our derivative instruments. We recorded a gain on derivatives for the six months ended October 31,2006, in the amount of $1,703,000, such amount representing the estimatedchange in fair value of the embedded conversion feature between the date thefinancing transaction was consummated and October 31, 2006.**

**The cumulative discount on the 6% Debentures (arising from the allocationof a portion of the proceeds to the related warrants and the classification ofthe embedded conversion feature as a derivative liability) is being amortizedto interest expense over the term of the 6% Debentures using the effective interestmethod at an effective interest rate of 49%. During the six months ended October 31, 2006, $697,000 of this discountwas amortized to interest expense.**

 

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** **

**We capitalized as debt issuance costs the fair value of the 660,000Buyers shares (an amount of $601,000) and $28,000 of costs directly incurred inconsummating the financing and these capitalized costs are being amortized toamortization of debt issuance costs over the life of the 6% Debenture using theeffective interest method.  For the sixmonths ended October 31, 2006, $45,000 of the capitalized debt issuance costswas amortized to expense.**

**The 6%Debenture Warrants with an exercise price of**$1.75per share (3,000,000 warrants) and $2.00 per share (3,000,000 warrants) werenot exercisable until after our shareholders approved the issuance of these twowarrants (as part of the total transaction shares, as defined) in ashareholders’ meeting.  On October 30,2006, our shareholders approved the transaction with Cornell and accordinglythese two warrants became exercisable. Upon becoming exercisable, we re-evaluated the classification of thewarrants in accordance with the provisions of SFAS 133 and EITF 00-19 andconcluded that, due to having an insufficient number of authorized shares(including all other commitments which may require the issuance of stock) topotentially settle the warrants, the warrants should be classified as aderivative instrument and should be recorded as a liability in our condensedconsolidated financial statements. Accordingly, we reclassified the aforementioned warrants out of equityand as a derivative liability in the amount of $1,611,000 (which represents theestimated fair value of the warrants at the date the warrants becameexercisable).  Further, we are requiredto recognize in earnings at each reporting date the gain or loss on ourderivative instruments.  We recorded again on derivatives for the six months ended October 31, 2006, in the amount of$37,000, such amount representing the estimated change in fair value of thewarrants between the date the warrants were classified as derivativeliabilities and October 31, 2006.

**NOTE 10 — COMMITMENTS AND CONTINGENCIES**

As of October 31, 2006, we had commitmentsoutstanding for capital expenditures of approximately $1,064,000.

**NOTE 11 — RELATED PARTY TRANSACTIONS**

**Inconjunction with the acquisition of PPSC, we retained the services of both theformer owners in an employment relationship. Subsequent to the acquisition, PPSC continued to lease premisespartially owned by one of these individuals.  However, this lease was terminated effective August 31, 2006.**

**We have aresearch and development agreement with Institut fur Umwelttechnologien GmbH (“IUT”),an equity method investee of which we own 30%. We funded $721,000 and $657,000 under this agreement during the sixmonths ended October 31, 2006 and 2005, respectively (and a total of $2,530,000since entering into our first research and development agreement in June2004).  All funded payments have beenincluded as research and development in the condensed consolidated statementsof operations.**

**NOTE  12 — SUBSEQUENT EVENTS**

***Capital Lease***

In November 2006, we entered into a capitallease to finance equipment to be used in production by our semiconductorproducts and services segment.  The leaseis in the amount of approximately $1,200,000, bears a nominal interest rate of16%, has a term of 36 months and includes a bargain purchase option whereby wehave the right subsequent to the expiration of the lease term to purchase theasset under lease for no more than 5% of the original equipment cost.  Additionally, we issued the lessor a commonstock warrant (valued at $66,000 using the Black-Scholes pricing model) to purchase125,000 shares of common

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stock at $0.84 per share.  The common stock warrant vested immediately,expires on November 28, 2009, and will be amortized to interest expense overthe term of the lease.

***Special Meeting of Shareholders***

**As discussed in Note 9, we have called a special meeting of shareholdersto be held on January 2, 2007.  Underconsideration will be two proposals.  Inthe first proposal, our shareholders will be asked to approve a**n amendment to ourarticles of incorporation to increase our authorized common stock to175,000,000 shares, as required by our agreement with Cornell.  In the second proposal, our shareholders willbe asked to approve an amendment to our articles of incorporation to give ourboard of directors the discretion to effect a reverse stock split within arange to be approved by our shareholders with the ultimate ratio to be selectedby our board of directors.

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

*The statements contained in thisReport on Form 10-Q that are not purely historical are forward lookingstatements within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934, including statementsregarding our expectations, hopes, intentions or strategies regarding thefuture. **Forward looking statementsinclude: statements regarding future products or  product development efforts; statementsregarding future selling, general and administrative costs and research anddevelopment spending  and our productdevelopment and marketing strategies; statements regarding future capitalexpenditures and financing requirements; and similar forward looking statements. **Allforward-looking statements included in this document are based on informationavailable to us on the date hereof, and we undertake no obligation to updateany such forward-looking statements.  Itis important to note that our actual results could differ materially from thosein such forward-looking statements.*

***General Discussion***

We are an advanced materials and technology companyfocused on the development and provision of homeland security products andservices, the manufacture and reclamation of silicon wafers and the manufactureof SOI wafers to the semiconductor industry, and the supply of isotopes forlife sciences and health-care applications.

**OnJuly 10, 2006, we received a letter from Nasdaq that advised us that theminimum bid price of our common stock had closed at less than $1.00 per shareover the previous 30 consecutive business days, and, as a result, did notcomply with Marketplace Rule 4310(c)(4). Therefore, in accordance withMarketplace Rule 4310(c)(8)(D), we were provided 180 calendar days, or untilJanuary 8, 2007, to regain compliance with the Rule (which consists of the bidprice of our common stock closing at $1.00 per share or more for a minimum of10 consecutive business days).  If wefail to obtain compliance, as long as we meet the Nasdaq Capital Market initiallisting criteria as set forth in Marketplace Rule 4310(c), except for the bidprice requirement, we will be granted an additional 180 calendar days to obtaincompliance.  We do not meet this initiallisting standard as of the date of this report, and we cannot give anyassurance that we will be able to meet the Nasdaq requirements to maintain ourNasdaq Capital Market listing, or that if we do, a stable trading market willdevelop for our stock or our warrants.  We have called a special meeting of shareholdersto be held on January 2, 2007.  Underconsideration will be two proposals.  Inthe first proposal, our shareholders will be asked to approve anamendment to our articles of incorporation to increase our authorized commonstock to 175,000,000 shares, as required by our agreement with Cornell.  In the second proposal, our shareholders willbe asked to approve an amendment to our articles of incorporation to effect areverse stock split within a range to be approved by our shareholders with theultimate ratio to be selected by our board of directors.  If the second proposal is passed by ourshareholders and if our board of directors deems it an advisable course ofaction required to potentially cure the minimum bid price deficiency, the boardof directors may authorize a reverse stock split.**

Our outstanding Class B Warrants and Class CWarrants (both of which expire on December 29, 2006) are no longer exercisablefor registered shares of our common stock pursuant to the existing registrationstatement (SEC file no. 333-110032) which became stale in July 2006.  We have chosen not to update the existingregistration statement because the low market price for our common stock makesit non-economical for any holder to exercise our Class B Warrants or Class CWarrants.

Liquidity and Capital Resources

As a result of our ongoing operating losses andfinancial commitments, including both borrowings and research and developmentfunding, see our discussion of liquidity and capital resources in the Liquidityand Capital Resources section included further below in this Item 2: Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.

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Overview

During fiscal year 2006 andthe six months ended October 31, 2006, our revenues were generated from salesof stable and radioactive isotopes, small and large diameter test and reclaimsilicon wafers, SOI wafers and wafer thinning and other semiconductorservices.  Additionally, as a result ofthe acquisition of PPSC in May 2005, we also generated revenues from providing security servicesfor leading businesses and institutions in healthcare, education, retail,manufacturing and the art world.  We expect that sales from our semiconductoroperations will continue to increase during the remainder of our 2007 fiscalyear due mainly to the growth of our 300-millimeter large-diameter siliconwafer and wafer thinning product lines. Since the acquisition of PPSC, we have increased revenues for thesecurity services business, and we continue to pursue additional customers inboth the commercial and government markets. In addition, we have focused our efforts in the homeland securitysegment on our products with the potential for higher margin sales and havereduced the scope of our product development activities to those products basedon our IMS technology and, via our 90% owned joint venture created in October2006 (SenseIt), with development activity related to our agreement withLucent.  We are hopeful that we willcontinue to generate revenue from our IMS technology during the remainder offiscal year 2007, having completed initial commercial installations of theproduct prior to the date of this report, although we can offer no assuranceswe will be able to do so.  We are hopefulthat SenseIt will begin to generate revenue from the next-generation infraredimaging and night vision surveillance technology in fiscal year 2008, althoughwe can offer no assurances that a marketable product will be developed .

As evidenced by our homelandsecurity operations and the introduction of new products into our semiconductorproducts and services segment, we are attempting to bring our recentlydeveloped product lines to market, which we expect to add to our revenue streamin the future.  The following is a morespecific discussion of our current operations.

Homeland Security

**HSDCfocuses the majority of our efforts in the homeland security sector.  These efforts include entry into the securityservices market through our acquisition of PPSC in May 2005, acquisition anddevelopment of our IMS technology that can be used to detect various types ofexplosives and/or chemical agents and our entry into an agreement with Lucentand a 90% owned joint venture named SenseIt to develop innovative infraredimaging and night vision surveillance technology.   HSDC’s ownership also includes our 30%minority interest in IUT.  The followingis a detail of each of our product lines within our homeland securityoperations:**

**SecurityServices** - In May 2005, weacquired PPSC, a provider of security services located in New York, NewYork.  Since the effective date of theacquisition, PPSC has delivered significant revenue to our consolidatedfinancial statements and has provided gross margin of approximately 24% ofrevenues for the six months ended October 31, 2006.   The segment has, however, generated anoperating loss for the three and six months ended October 31, 2006, of$(20,000) and $(294,000), respectively. During the three month period, the operating loss includes amortizationof acquisition-related customer intangibles in the amount of $36,000 andstock-based compensation expense of $10,000.

**PPSChas successfully obtained its Government Contract Schedule (“GSA Schedule”) forsecurity services.  Although we haveselectively pursued and continue to selectively pursue government contracts inaddition to commercial contracts, we have not acquired any government securitycontracts to date and we can offer no assurances that we will be able to do so.**

**Detection Technology****—**Our efforts in the detection technology area havebeen refocused during the current fiscal year, and through the date of thisreport, to our panel mounted IMS product, as follows:

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*Ion Mobility Spectroscopy*— IMS is a “sniffer” technology, originallydeveloped by IUT, which is designed to continuously monitor the air and almostimmediately detect and identify harmful substances at the parts per billion(ppb) level, providing, in a matter of minutes, warning of a possibleattack.  Through both our ongoing fundingof research and development efforts at IUT and related development andcommercialization efforts in the United States, we are currently in the processof taking the IMS technology and miniaturizing and re-designing it forlow-cost, high-volume manufacturing in the United States.  Additionally, we have pursued receipt ofrequired regulatory licenses and we have now received all regulatory licensesrequired for domestic sales of such products.

InNovember 2005, we signed a development agreement with DualDraw LLC (“DualDraw’),a manufacturer of air quality equipment. Under this agreement, we have been working to incorporate our panelmounted IMS system into the DualDraw mailroom inspection workstation, adowndraft workstation that keeps toxic substances away from the breathing zoneof mailroom workers who are sorting or opening mail and captures suchsubstances with a HEPA filtration system. The incorporation of our IMS capability provides an alarm if certaintoxic or explosive substances are detected. In November and December 2006 we completed our first commercialinstallations of our IMS system into existing DualDraw workstations at customersites.  Although (as is typical with newtechnology) some issues have arisen at customer installations, we are workingthrough those issues with DualDraw and its customers, and we believe that wewill be able to resolve these issues in the near future.  While we are hopeful to have additionalinstallations during the remainder of fiscal year 2007, we can offer noassurance that we will be able to do so.

Thoughwe are currently focused on our panel mounted IMS product, we have alsoinvestigated our ability to package our IMS technology in a hand-held “sniffer”designed for military and first responder use. Although we are not actively developing a final product for thehand-held product, we may do so in the future when we determine that marketconditions for such a product are favorable and provided we have sufficientresources to do so.  While we continue tooffer EnviroSecureTM, a system that can monitor and identify chemical weaponsand toxic substances in the air in a variety of venues including airports, masstransit facilities, sports venues and public and private sector officebuildings, we have chosen to focus our resources on the panel mounted IMSproduct, which we believe to have the potential for more profitable sales.

*Neutron based detection* — We have developed a hand-held explosivedetection device named NeutroTestTM.   However, we have not made anysales of our NeutroTestTM product after the initial salesmade in June 2005.  One issue that hasimpeded the sales process is the regulatory and licensing requirementsregarding the neutron-generation source, whereby both our company and the customermust meet certain criteria in order to possess and use the radioisotope for itsintended purpose.  Though we believe theregulatory and licensing requirements can be met by both, these requirementslikely limited the customer base for our NeutroTestTM product to government and military entitiesand, possibly, large organizations with the resources to meet the licensingrequirements.  Consequently, during thethree months ended October 31, 2006, we transferred the NeutroTestTM product to IUT and have provided them theoption of whether to continue to work through the remaining licensing issues ofthe product and/or to pursue sales in jurisdictions with lower levels ofregulatory requirements.  We do notexpect to reintroduce this product domestically and can offer no assurancesthat IUT will decide to pursue further development effort and internationalsales of the technology.

**InfraredImaging Technology****—**On December 5, 2005, we approved a development planthat resulted in us becoming obligated under the Lucent Agreement entered intowith Lucent in September 2005 which, in October 2006, we assigned to our 90%owned subsidiary, SenseIt, which is described in more detail below.  Under the Lucent Agreement, we are attemptingto develop a next-generation infrared imaging and night vision surveillancetechnology based on Lucent’s micro electro-mechanical systems (“MEMS”) at itsnanotechnology fabrication facility. Infrared technology, which converts infrared radiation in thenon-visible spectrum, such as body heat, into a visible image, is commonlyfound in both commercial and military/homeland security applications includingnight vision goggles and cameras, rifle scopes, and threat

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detection devices used to identify concealed weaponsor explosives.  The MEMS approach toinfrared imaging, if successful, may lead to products, which are at least equalin performance with a lower power consumption and price than products currentlyavailable in the marketplace today. Additionally, a MEMS-based product may also provide for costefficiencies in the manufacturing process. The development plan contemplates a proof-of-concept during calendaryear 2007, followed by steps towards commercialization, though we can provideno assurances that a commercially attractive product will ultimately beavailable.

The Lucent Agreement provides for SenseIt to receivean exclusive right, except for certain rights reserved by Lucent, to make, useand sell licensed products arising from technology developed under the LucentAgreement.  In exchange for this license,we (through our obligations to SenseIt) are funding certain of Lucent’sdevelopment efforts for the project through the periodic payment over a two andone-half year period of a development fee totaling $12,000,000.  We paid $4,000,000 of the original$12,000,000 obligation under this agreement through the date of this report (inaddition to another $333,000). The remaining balance will be paid in $1,000,000increments commencing in January 2007 and approximately every three monthsthereafter.  SenseIt has the right toterminate the development project for any reason (including if the developmentwork is not proceeding up to our expectations) from time-to-time, so long astermination is prior to the first commercial sale of a licensed product.  Additionally, upon the commencement ofcommercial sales, if ever, we would be obligated to pay royalties based onrevenue, potentially a sales referral fee based on revenue and also an annualexclusivity payment to maintain our exclusive rights to the developedtechnology.

In October 2006, we acquired a 90% interest inSenseIt in exchange for assigning to SenseIt all of our interest under theLucent Agreement (such assignment was approved by Lucent), although we willcontinue to be jointly and severally liable with SenseIt to Lucent for amountsdue to Lucent under the assigned Lucent Agreement. In addition, we also enteredinto a new statement of work with Lucent (which was also subsequentlytransferred to SenseIt).  The remaining10% of SenseIt is held by Mr. Chris Toffales, a seasoned and successfulindustry veteran, who is serving as President and Chief Executive Officer ofSenseIt.  SenseIt will continue to workwith Lucent to develop prototypes of its first product line, “direct view” thermalimagers for weapons sights and night vision goggles and anticipates completingthese prototypes within the next twelve months. In addition, SenseIt, in conjunction with Lucent, is also pursuing amore traditional focal plane array product suitable for integration intothermal imaging cameras, as well as an advanced solid state imager approach tocreate a “Multi-Spectral Sensor” which can detect infrared and visible light(or two spectra of infrared light) simultaneously.

Concurrent with and subsequent to the acquisition ofthe interest in SenseIt, we made contractually required investments in SenseIt(to provide working capital) in a cumulative amount of $500,000 and areobligated to invest another $500,000 for working capital purposes in March 2007(against which we can credit legal costs incurred in entering into the SenseItjoint venture).  Additionally, asdescribed above, we have agreed to invest an additional $1,000,000 into SenseItin January 2007 so that it can make the payment then due to Lucent.  In each case, we received or will receive oneshare of SenseIt Class A common stock for each $10 investment.  We do not currently have sufficient fundingto meet our current payment obligations to SenseIt and to fund theremaining  subsequent developmentpayments to Lucent (for which we would receive additional Class A common stockshares in SenseIt) under the Lucent Agreement. If we fail to make payments when due, Lucent may cancel the LucentAgreement or cease working on the project and then assess us a “start-up” feeif funding was to resume.  We cannotoffer any assurance that we will be able to make all of the required paymentsto Lucent, or that the technology will be developed to a point where we want tocontinue to make such payments when due.  Additionally, SenseIt may need to seek outsidefinancing to make payments to Lucent, if so elected, and such outside financingwould dilute our ownership interest in SenseIt. Lastly, although we are hopeful of that outcome, we can offer noassurances that the development activity underway with Lucent and SenseIt willyield technologically relevant or commercially viable products.

26

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On May 12, 2006, we entered into an agreement withISCON, (a company that is attempting to develop patent-pending infrared imaging-basedtechnologies for the non-invasive detection of objects hidden under clothing aswell as technology for the determination of the chemical composition of suchobjects to identify explosives and narcotics) that provided us the option, butnot the obligation to purchase shares of ISCON common stock based upon thesuccessful completion of developmental and commercial milestones.  If ISCON succeeded in meeting all fivemilestones and if we had chosen to exercise our option to purchase shares foreach completed milestone, we would have then owned 51% of ISCON for acumulative investment of $1,750,000.  OnJune 9, 2006, we made our first investment in the amount of $100,000 for anownership interest of 9%.  Although ISCONachieved its next milestone, we declined to exercise our option to purchaseadditional shares in ISCON and do not currently intend to pursue furtherinvestment in the entity.  Based on ourdecision not to continue funding and the inability of ISCON to obtain fundingfrom other sources, ISCON began the process of shutting down its business inDecember 2006.  It is currently unclearas to what value, if any, we may be able to realize from this investment.

Semiconductor Products and Services

Our semiconductor operations, based in Vancouver, Washington,showed continued operational and financial improvement for the year ended April30, 2006, and through the six months ended October 31, 2006, generating itsfirst quarterly operating income for the three months ended October 31, 2006.   The positive operating income results fromour ongoing effort to reduce our reliance on low margin small diameter productsand focus mainly on higher margin 300-millimeter products and services, waferthinning and SOI products.  Thelarge-diameter wafer segment has become one of the fastest growing segments ofthe silicon wafer market and the revenues and gross margins associated with theservices are greater than those associated with the small diameter market.   As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 61% of segmentrevenue for the six months ended October 31, 2006 ($3,900,000 in revenue), ascompared to approximately 36% of segment revenue for the year ended April 30,2006 ($2,053,000 in revenue) and 19% of segment revenue for the six monthsended October 31, 2005 ($381,000 in revenue). There has also been a focus on operational efficiency and effectiveness,which has resulted in increased productivity and processing yields.  Further, we continue to gain new customersand are also in the process of attempting to qualify our product at others.

As a result, for the three months ended October 31,2006, the segment generated its first quarterly operating income in the amountof $151,000, which includes stock-based compensation of $24,000.  This operating income is an increase of  approximately $1,571,000 as compared to theoperating loss of $(1,420,000) experienced for the three months ended October31, 2005.  We continue to monitor thesituation closely and, while our realignment of the business has resulted inreaching positive quarterly operating income and  we believe that we will continue to seeimproving financial results in the segment, there are no assurances thatoperating profitability can be sustained in every period, if at all.

Life Sciences

Our life sciences division has historically beenprimarily a distribution business. We acquire isotopes from severalmanufacturers who are located primarily in republics that were part of theformer Soviet Union.  At the presenttime, our life sciences division is being significantly and adversely affectedby increased domestic and international competition.  The market for the product responsible forthe vast majority of segment revenue, oxygen-18 , continues to degrade due toan abundance of global supply of the isotope. Recently, the spot price for oxygen-18 has decreased below the level ofour cost for the product.  Consequently,we have ceased purchasing additional quantities of oxygen-18 for resale and willfulfill our existing contracts with our customers (the majority of which aregross margin positive) with our existing inventory of oxygen-18.   In the prior year, our internationalradioisotope business also experienced rising supplier prices in a market thatis highly price-sensitive.  In an effortto reduce costs, we closed our European trading office (Chemotrade) during thesecond half of fiscal year 2006.

27

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In anticipation of the degradation in the oxygen-18market, we previously commenced expanding into other areas, such asactinium-225 and indium-111 (through our June 2005 joint production andmarketing agreement with Central Radiopharmaceutical Services, Inc. (“CRS”)).  Sales of these products have not contributedsignificantly to the revenue of the life sciences segment, though we expectrevenue from these products to increase in calendar year 2007.   However, due to the deteriorating businessconditions in the historical revenue producing products in the segment and theearly state of development for the markets in actinium-225 and indium-111, weare in process of evaluating all strategic options regarding this line ofbusiness.

General

Our consolidatedrevenues in the future will depend primarily on our success in developing andselling products in the homeland security and semiconductor markets.  Our profitability will be dependent upon our ability to manage ourcosts and to increase our revenues in all of our business segments.  However, we can offer no assurance that wewill be able to increase our revenue or our profitability.

Wehave not received since February 2005 any requests for additional informationfrom either the SEC or Nasdaq relating to their inquiries of October 2004 toFebruary 2005 and, to the best of our knowledge, these issues are behind us andwe are moving forward.

***Results ofOperations***

Thefollowing table sets forth, for the periods indicated, condensed consolidatedstatements of operations data expressed as a percentage of revenues.  The table and the discussion below should be readin conjunction with the condensed consolidated financial statements and thenotes thereto appearing elsewhere in this report.

* *
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                     | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                                                     | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                       |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                                               |       | 75.3                             |       | 98.8                           |       | 78.2 |   | 100.7 |   |
| Gross margin                                                   |       | 24.7                             |       | 1.2                            |       | 21.8 |   | (0.7 | ) |
|                                                           |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                           |       |                             |       |                           |       |   |   |   |   |
| Selling, general and administrative                            |       | 54.2                             |       | 51.2                           |       | 53.3 |   | 52.5 |   |
| Impairment loss on assets held for sale                        |       | —                           |       | —                         |       | — |   | 3.6 |   |
| Research and development                                       |       | 10.5                             |       | 13.0                           |       | 14.8 |   | 11.1 |   |
| Total operating expenses                                       |       | 64.7                             |       | 64.2                           |       | 68.1 |   | 67.2 |   |
| Operating loss                                                 |       | (40.0                            | )          | (63.0                          | )          | (46.3 | ) | (67.9 | ) |
|                                                           |       |                             |       |                           |       |   |   |   |   |
| Other income  (expense), net                                   |       | (6.6                             | )          | (27.0                          | )          | 6.9 |   | (27.7 | ) |
| Loss before  income taxes and elimination of minority interest |       | (46.6                            | )          | (90.0                          | )          | (39.4 | ) | (95.6 | ) |
| Income tax  expense                                            |       | —                           |       | —                         |       | — |   | — |   |
| Minority  interest in operations of consolidated subsidiary    |       | 0.5                              |       | —                         |       | 0.3 |   | — |   |
| NET LOSS                                                       |       | (46.1                            | )%         | (90.0                          | )%         | (39.1 | )% | (95.6 | )% |

 

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***Revenues***

Revenues increased for both the three and sixmonths ended October 31, 2006, as compared to the same periods of our priorfiscal year.  Revenues from both oursecurity services and semiconductor products and services segments did reflectan increase during these periods as compared to revenues from our life sciencesand homeland security products segments which reflected a decrease, asdescribed in the following table:

** **
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                           | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Life sciences:                       |       |                             |       |                           |       |   |   |   | ** ** |
| Domestic                             |       | $                                | 577,000    |                           | $          | 985,000 |   | $ | 1,193,000 |   | $ | 2,033,000 | ** ** |
| International                        |       | —                           |       | 634,000                        |       | — |   | 1,183,000 | ** ** |
| Total life  sciences                 |       | 577,000                          |       | 1,619,000                      |       | 1,193,000 |   | 3,216,000 | ** ** |
| Homeland  security products          |       | —                           |       | —                         |       | — |   | 35,000 | ** ** |
| Security  services                   |       | 3,739,000                        |       | 2,996,000                      |       | 7,616,000 |   | 5,633,000 | ** ** |
| Semiconductor  products and services |       | 3,516,000                        |       | 1,217,000                      |       | 6,425,000 |   | 2,022,000 | ** ** |
| Total                                |       | $                                | 7,832,000  |                           | $          | 5,832,000 |   | $ | 15,234,000 |   | $ | 10,906,000 | ** ** |

 

Therevenue for our security services segment is generated by PPSC, a business thatwe acquired in May 2005.  Pro formarevenue for the six months ended October 31, 2005 would have been approximately$6,180,000 if the PPSC acquisition had occurred on the first day of thatquarter.  The increase in revenue from the security services segment for both thethree and six months ended October 31, 2006, is due to the net addition ofadditional security services contracts since the acquisition of PPSC.  While we anticipate that we will continue togrow revenue in this segment by securing additional new security contracts inour PPSC subsidiary and retaining existing customers under contract currentlywith PPSC, we cannot provide any assurance that we will be able to do so.

Our semiconductor products and services segment hasexperienced a rapid increase in revenue during the prior six fiscalquarters.  Revenue for the three monthsended October 31, 2006, was 189% higher than revenue for the three months endedOctober 31, 2005, and 21% higher than revenues for the three months ended July31, 2006.  The increase is predominatelydue to the expansion of sales of higher-margin 300-millimeter products andservices.  Our 300-millimeter businessprovided revenue of $2,119,000 for the three months ended October 31, 2006, ascompared to $373,000 and $1,781,000 for the three months ended October 31, 2005and July 31, 2006, respectively.  Whilewe believe that continued expanded focus on the 300-millimeter, wafer thinningand other semiconductor services markets will allow us to continue to increaserevenues in the future, we can provide no assurances that we will be able to doso.

While we continue to monitor the establishment of alow cost supply of silicon-28, we did not receive a material amount of revenuein our 2005 or 2006 fiscal years or for the six months ended October 31, 2006,and we are not aware of any plans by any company for the introduction ofproducts based on silicon-28 wafers. Therefore we do not anticipate any material amount of proceeds from silicon-28product sales during the remainder of fiscal year 2007, although we couldrespond to customer demand in a relatively short time frame.  Our goal ultimately is to profitably (1)license our proprietary technology to other entities and/or (2) sell chemicalsrequired for the production of epitaxial or bulk silicon-28 wafers and/or (3)produce epitaxial or bulk silicon-28 wafers for resale.  The costs associated with maintaining thisprogram are not significant.

The decrease in revenue from domestic isotopeproduct sales for the three and six months ended October 31, 2006, was theresult of a significant decrease in the unit price of our main isotope solddomestically, oxygen-18, combined with a decrease in sales volume of thatproduct.  Our average sales price foroxygen-18 for the six months ended October 31, 2006 was approximately 28% lessthan the same period in the prior fiscal year, and approximately 10% less thanthat experienced in the prior sequential quarter.  Due to the

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continued degradation to the spot price in themarket for this product, this average selling price is well in excess of thespot rate in the market due to the advanced pricing agreements we have withcertain customers.  The supply ofoxygen-18 in the market has continued to expand, both in the prior fiscal yearsas well as into the six months ended October 31, 2006, which has led to aprice-driven market.  Although we have successfullylowered our acquisition price of oxygen-18, the acquisition price is now inexcess of the spot price for the product in the marketplace.  As such, we ceased purchases of new oxygen-18from our supplier and will fulfill our existing contracts with our customers(the majority of which are gross margin positive) into fiscal year 2008 frominventory currently held.  Revenue fromother isotopes, such as actinium-225 and indium-111 (through our June 2005joint production and marketing agreement with CRS), have not been material inany period.  Consequently, we expect ourrevenue from domestic life sciences sales to continue to decrease throughoutthe remaining fiscal year 2007 and into fiscal year 2008.

Our international radioisotope business alsoexperienced rising supplier prices and in an effort to reduce costs, we closedour European trading office (Chemotrade) during the second half of fiscal year2006.  Revenue from our internationalisotope trading business was $0 for the six months ended October 31, 2006.  We do not anticipate any revenue from thisbusiness during the remainder of fiscal year 2007 and beyond.  For our life sciences business in theaggregate, as with all our reportable segments, we continually monitor businessconditions and marketplace changes and evaluate all investment, divestiture andother strategic options.

Our homeland security products segment has recordedminimal or no revenue for the six months ended October 31, 2006 and 2005.  See the update provided for this segment inthe General Discussion section of this Item 2: Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

Althoughwe have diversified our sources of revenue, we continue to have concentrationsof revenue with certain customers.  Forthe six months ended October 31, 2006, two security services customersaccounted for 13% and 10% of revenues, respectively, and one semiconductorproducts and services customer accounted for 23% of revenues as compared to thesix months ended October 31, 2005, in which one security services customeraccounted for 18% of revenues. Significant reductions in sales to any of these large customers havehad, and may in the future have, an adverse effect by reducing our revenues andour gross margins.  Present or futurecustomers could terminate ** **their purchasing patterns with usor significantly change, reduce or delay the amount of products or servicesordered from us.

***GrossMargin***

Our gross margin increased for the three and sixmonths ended October 31, 2006, as compared to the same respective periods ofour prior fiscal year, both on a dollar amount and on a percentage of revenuesas reflected in the following table:

** **
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                      | 1,936,000  |                                                 | $          | 69,000 |   | $ | 3,327,000 |   | $ | (75,000 | ) |
| Percent of revenues |       | 24.7                                                   | %          | 1.2                                                  | %          | 21.8 | % | (0.7 | )% |
|                     |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

The increase in gross margin is due mainly to twofactors:  (1) the majority of theincrease is due to continued improvement in operations in our semiconductorproducts and services segment where there were significant improvements togross margin on a dollar amount and on a percentage of revenues basis and (2)to a lesser extent, improvements in life sciences margins on a percentagebasis.

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 upon our ability to grow sales in our homeland security segmentsthrough increased sales of security services and detection products and in oursemiconductor products and

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services segment through increased sales of300-millimeter products and services, wafer thinning and SOI products.  With the realignment of our semiconductorproducts and services business to focus on the higher margin products andservices, we believe that we have greatly enhanced our ability to increase oursales and related gross margin in these areas. As such, we anticipate that the gross margin from sales of semiconductorproducts and services (both in dollar value and as a percentage of revenues)will increase over time, though we can offer no assurance that the gross marginincrease will occur.

On a percentage of revenue basis, in general weanticipate that the gross margin percentage in our security services segmentwill remain relatively stable.  The grossmargin percentage in our semiconductor products and services segment may bevolatile based upon revenue growth achieved, if any.  Due to fixed facility costs included in costof revenues in the semiconductor products and services segment, the grossmargin percentage is particularly sensitive to changes in revenue.  The gross margin percentage in the lifesciences segment is expected to also be somewhat volatile due to the continuedpricing pressure on oxygen-18 and on the substantial cessation of sales in theinternational isotope business.  Lastly,the gross margin percentage on our homeland security products segment is likelyalso to be volatile as well as we attempt to increase revenue in that segment,though we can offer no assurances that we will be able to do so.

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

Our selling, general and administrative expensesincreased as a dollar amount and as a percentage of revenue for the three andsix months ended October 31, 2006, as compared to the same respective periodsof our prior fiscal year, as reflected in the following table:

** **
| ** **          | ** ** | **Three months ended October 31, ** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                                     | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                            | 4,244,000  |                                                 | $          | 2,987,000 |   | $ | 8,121,000 |   | $ | 5,719,000 |   |
| Percent of revenues |       | 54.2                                                         | %          | 51.2                                                 | %          | 53.3 | % | 52.5 | % |
|                     |            |                                                              |            |                                                      |            |  |  |  |  |  |  |  |  |

 

Theapproximate $2,400,000 increase in selling, general and administrative expensesfor the six months ended October 31, 2006, compared to the same period in theprior year is attributable to a combination of factors, including:

·                  approximately $775,000 directly related toPPSC, such increase resulting primarily from an impact of approximately$100,000 due to the inclusion of less than a full two quarters of expense beingincluded in the six months ended October 31, 2005 (due to the acquisitionoccurring on May 16, 2005), a write-off of a specific customer receivable of$114,000 and increased staffing due to the pursuit of new contracts for the sixmonths ended October 31, 2006;

·                  approximately $400,000 due to increase instaffing and operations in the homeland security products segment;

·                  approximately $200,000 due to variousincreases in corporate expenditures;

·                  approximately $100,000 due to increase inoperations in the semiconductor products and services segment;

·                  approximately $100,000 due to the impairmentof our 9% interest in ISCON;

·                  a noncash charge in the amount of $357,000related to the amendment to the number of shares issuable and exercise price ofcertain warrants with ratchet provisions;

·                  a noncash charge in the amount of $667,000related to the retention of a 10% equity interest in our consolidatedsubsidiary, SenseIt, by its chief executive officer;

·                  cumulative noncash charges of $596,000related to stock-based compensation expense associated with our adoption ofSFAS 123(R) in the six months ended October 31, 2006;

·                  offset by approximately $340,000 in reduced life sciences expense due toscaled back operations in the segment, $200,000 in cash and noncash expenseincurred in settlement of a lawsuit and by approximately $300,000 due to theinclusion in the six months ended October 31, 2005, of a charge related to theextension of the expiration date of certain warrants.

 

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We anticipate that we will increase our core selling,general and administrative expenses during the remainder of fiscal year 2007through anticipated increased marketing efforts for and operations in ourhomeland security products operations and semiconductor products and servicessegment.  There can be no assurance thatour anticipated increased selling, general and administrative expenses willresult in increased revenues from product sales.

***Impairment Loss on Assets Held for Sale***

Our impairment loss on assets held for sale decreasedfor the six months ended October 31, 2006, as compared to the same period ofour prior fiscal year, both on a dollar amount and on a percentage of revenuesbasis as reflected in the following table:

|                     | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | —                                                 |       | —                                               |       | — |   | $ | 398,000 |   |
| Percent of revenues |       | —                                                 |       | —                                               |       | — |   | 3.6 | % |
|                     |            |                                                        |            |                                                      |            |  |  |  |  |  |

 

During the six months ended October 31, 2005, as partof a review of our semiconductor products and services segment that resulted inoperational changes, certain equipment was identified as unnecessary for ourplanned future operations.  As a result,certain of the identified equipment whose book value exceeded estimated netrealizable were individually written down to estimated net realizable value,resulting in a cumulative impairment charge of $398,000.  As of October 31, 2006, equipment with a bookvalue of $225,000 remains unsold, but we expect that the equipment will be soldwithin the upcoming year.

***Research and Development Expenses***

Our research and development expenses increased onboth a dollar and a percentage of revenues basis for the six months endedOctober 31, 2006, as compared to the same periods of our prior fiscal year, andincreased on a dollar basis but decreased on a percentage of revenues basis forthe three months ended October 31, 2006, as reflected in the following table:

|                     | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                      | 819,000    |                                                 | $          | 757,000 |   | $ | 2,255,000 |   | $ | 1,211,000 |   |
| Percent of revenues |       | 10.5                                                   | %          | 13.0                                                 | %          | 14.8 | % | 11.1 | % |
|                     |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

The dollar increase for both the three and six monthsended October 31, 2006, is primarily related to an increase in research anddevelopment expenses associated with payments made to Lucent under the LucentAgreement  as well as, to a lesserextent, cost associated with the development of our IMS technology .  Consistent with our product development strategy, we are seeking to identifyand evaluate new products in the homeland security operations (includingnext-generation infrared technology through our Lucent relationship and SenseItsubsidiary) as well as to bring existing technologies (including IMS-basedtechnology) to a production-ready state.  A significant amount of this research anddevelopment on IMS technology is being performed by IUT.  We funded $261,000 and $721,000 under thisagreement during the three and six months ended October 31, 2006, respectively,as compared to funding of $324,000 and $657,000 during the three and six monthsended October 31, 2005, respectively (and a total of $2,530,000 since enteringinto our first research and development agreement in June 2004).

In December 2005, we approved a development plan withLucent that obligated us under the Lucent Agreement.  Under the Lucent Agreement, we will endeavorto develop a next-generation imaging and night vision surveillance technology.  In October 2006, we acquired a 90% interestin SenseIt in exchange for 

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assigningto SenseIt all of our interest under the Lucent Agreement (such assignment wasapproved by Lucent) and we also entered into a new statement of work withLucent (which was also transferred to SenseIt). SenseIt will coordinate thedevelopment of the next-generation infrared imaging technology and work towardscommercialization of any resultant products. The development plan contemplates for prototype products to beavailable within twelve months, although we can provide no assurances that acommercially attractive product will ultimately be available. For the sixmonths ended October 31, 2006, we recorded research and development expenseof  $1,000,000 (as compared to expense of$667,000 recognized in the comparable period of the prior year) and we areobligated to invest an additional $1,000,000 in January 2007 in SenseIt inorder for SenseIt to make the Lucent payment then due. Under the Lucentagreement, we (through SenseIt) may be obligated to provide funding of$1,000,000 per quarter in development funding for the next eight quarters.  We have the right to terminate thedevelopment project for any reason from time-to-time, so long as termination isprior to the first commercial sale of a licensed product.  As such, assuming we continue with thedevelopment program, we expect our quarterly research and development expensefor this purpose to remain elevated.  If we are unable tomake desired quarterly Lucent payments in the future on behalf of SenseIt (forwhich we would receive additional Class A common stock in SenseIt), SenseIt maybe required to seek funding from outside sources, which would dilute ourcurrent 90% ownership of the entity.

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.  Significantly all other research anddevelopment work is performed by outside entities, none of which we control(although we have an ownership position in IUT of 30%).  Although we expend significant resources onresearch and development, 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.

***Operating Loss***

Our operating losses (in total) increased for the threeand six months ended October 31, 2006, as compared to the same periods of ourprior fiscal year, as reflected in the following table:

|                                      | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Homeland security  products          |       | $                                                      | (2,124,000 | )                                                    | $          | (1,569,000 | ) | $ | (4,071,000 | ) | $ | (2,071,000 | ) |
| Security services                    |       | (20,000                                                | )          | (72,000                                              | )          | (294,000 | ) | 38,000 |   |
| Semiconductor products  and services |       | 151,000                                                |       | (1,420,000                                           | )          | (48,000 | ) | (3,474,000 | ) |
| Life Sciences                        |       | (43,000                                                | )          | (60,000                                              | )          | (12,000 | ) | (209,000 | ) |
| Reconciling amounts                  |       | (1,091,000                                             | )          | (554,000                                             | )          | (2,624,000 | ) | (1,687,000 | ) |
| Total                                |       | $                                                      | (3,127,000 | )                                                    | $          | (3,675,000 | ) | $ | (7,049,000 | ) | $ | (7,403,000 | ) |

 

Our homeland security products segment generated asignificant operating loss in an effort to develop and commercialize our IMStechnology into products that can be used to detect various types of explosivesand/or chemical agents and innovative infrared imaging technology.  While we generated no revenue in this segmentfor the six months ended October 31, 2006, we have completed our initialcommercial installations of IMS product and are hopeful that we will generateadditional revenue in this segment during the remainder of our fiscal yearending April 30, 2007. The increase in operating loss for the three months 

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ended October 31, 2006, as compared to the same periodin the prior year is due substantially to a $667,000 noncash charge incurred inour 90% owned subsidiary, SenseIt, which relates to the 10% equity interest inSenseIt retained by it chief executive officer. The increase in operating lossfor the six months ended October 31, 2006, as compared to the same period inthe prior year is due substantially to the aforementioned noncash chargerelated to SenseIt as well as increased research & development expenserelated to payments under the Lucent Agreement.

Our security services segment consists of PPSC, whichwas acquired in May 2005.  For the sixmonths ended October 31, 2006, the segment delivered significant revenuetotaling $7,616,000 and gross margin of approximately 24.2%, as compared to$5,633,000 and 23.7% for the six months ended October 31, 2005.  The operating loss for the six months endedOctober 31, 2006, is due primarily to an increase in selling, general andadministrative expenses as compared to the comparable period in the prioryear.  This increase is due to increasedmarketing spending, a write-off of a single customer’s accounts receivablebalance in the amount of $114,000, the inclusion of a $65,000 noncash chargerelated to stock-based compensation expense (due to our adoption of SFAS 123(R)in the six months ended October 31, 2006) and incremental investment in personnel specifically focused on selling tothe domestic government.  Although wecontinue to pursue selected domestic government contracts, we have taken stepsto reduce our spending on sales and marketing in this area.

Our semiconductor products and services segment showedcontinued operational and financial improvement (due mainly to the realignmentof our business to significantly reduce our reliance on low margin smalldiameter products and focus mainly on higher margin 300-millimeter products andservices, wafer thinning and SOI products) for the six months ended October 31,2006, recording our first quarterly operating income for the three months endedOctober 31, 2006.  Additionally, theoperating (loss) income has increased each sequential quarter during fiscalyear 2006 and in the six months ended October 31, 2006, as reflected in thefollowing table:

|                                      | ** ** | **Semiconductor products**       | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **and services**                 | ** ** |
| ** **                           | ** ** | **operating income (loss)** | ** ** |
| Three months ended July  31, 2005    |       | $                                     | (2,054,000 | )(1) |
| Three months ended  October 31, 2005 |       | $                                     | (1,420,000 | ) |
| Three months ended  January 31, 2006 |       | $                                     | (900,000   | ) |
| Three months ended  April 30, 2006   |       | $                                     | (777,000   | ) |
| Three months ended July  31, 2006    |       | $                                     | (199,000   | ) |
| Three months ended October 31, 2006  |       | $                                     | 151,000    |   |

----

(1)             Includesan impairment charge on assets held for sale of approximately $400,000.

We expect continued improvement to the operatingresults of our semiconductor products and services segment during the remainderof our fiscal year ending April 30, 2007.

Our life sciences segmentgenerated an operating loss in all periods presented.  The market for the product responsiblefor the vast majority of segment revenue, oxygen-18, continues to degrade dueto an abundance of global supply of the isotope.  Recently, the spot price for oxygen-18 hasdecreased below the level of our cost for the product.  Consequently, we have ceased purchasingadditional quantities of oxygen-18 for resale and will fulfill our existingcontracts with our customers (the majority of which are gross margin positive)with our existing inventory of oxygen-18. In the prior year, our internationalradioisotope business also experienced rising supplier prices in a market thatis highly price-sensitive.  In an effortto reduce costs, we closed our European trading office (Chemotrade) during thesecond half of fiscal year 2006.  Due tothe deteriorating business conditions in the historical revenue producingproducts in the segment and the early state of development for the markets inactinium-225 and indium-111, we are in process of evaluating all 

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strategic options regarding this line of business anddo not expect this segment to materially contribute to our net operating income(loss) through the remainder of our fiscal year ending April 30, 2007.

Reconciling amounts for the operating loss informationincludes corporate expenses consisting primarily of corporate salaries andbenefits, professional and consulting fees, investor relations costs, warrantamendment expense, insurance and directors’ compensation.

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

Other income (expense), net increased on both a dollarand a percentage of revenues basis for the three and six months ended October31, 2006, as compared to the same periods of our prior fiscal year as reflectedin the following table:

|                     | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                      | (516,000   | )                                                    | $          | (1,577,000 | ) | $ | 1,034,000 |   | $ | (3,021,000 | ) |
| Percent of revenues |       | (6.6                                                   | )%         | (27.0                                                | )%         | 6.9 | % | (27.7 | )% |
|                     |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

The increase for the six months ended October 31,2006, as compared to the same period in the prior fiscal year resultedprimarily from three items:  (1) adecrease in interest expense and amortization of debt issuance costs in thecombined amount of approximately $1,650,000, which is reflective of a loweroutstanding convertible debenture balance through the duration of therespective periods, (2) the recording of a gain on extinguishment of debt inthe amount of $227,000, which resulted from the retirement of $3,880,000 inprincipal amount of  8% Debentures in May2006 (as discussed in the Liquidity and Capital Resources section below) and(3) the recording of a gain on derivative instruments in the amount of$2,320,000 related to the change in the fair value of the three derivativeliabilities which we have recorded in our condensed consolidated balance sheets(as discussed in the Liquidity and Capital Resources section below).  Lastly, interest income decreased $157,000due to a lower cash and cash equivalent balance carried for the six monthsended October 31, 2006, as compared to such balance carried in the comparableperiod in the prior fiscal year.

The increase for the three months ended October 31,2006, as compared to the same period in the prior fiscal year resultedprimarily from three items:  (1) adecrease in interest expense and amortization of debt issuance costs in thecombined amount of approximately $850,000, which is reflective of a loweroutstanding convertible debenture balance through the duration of therespective periods, (2) an increase in the equity in net income of IUT in theamount of $98,000 and (3) the recording of a gain on derivative instruments inthe amount of $189,000 related to the change in the fair value of the threederivative liabilities which we have recorded in our condensed consolidatedbalance sheets.  Lastly, interest incomedecreased $80,000 due to a lower cash and cash equivalent balance carried forthe three months ended October 31, 2006, as compared to such balance carried inthe comparable period in the prior fiscal year.

We expect that our other expenses will be volatilebased on the future timing of repayment , if ever, of the remaining convertibledebentures (see the Liquidity and Capital Resources discussion below) and thefluctuations in fair value of and classification of the instruments underlyingour derivative liabilities.

***Income Taxes***

We currently operate at a loss and expect to operateat a loss until the products currently under development begin to generatesufficient revenue. The losses incurred in the current year are not expected togenerate an income tax benefit because of the uncertainty of the realization ofthe deferred tax asset. As a result, we have provided a valuation allowanceagainst our net deferred tax asset because, based on available evidenceincluding our continued operating losses, it is more likely than not, that allof the deferred tax assets will not 

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be realized. Additionally, due to certain “change inownership” rules (as defined by the IRS), utilization of our federal netoperating losses may be subject to certain annual limitations.

***Minority Interest in Operations of ConsolidatedSubsidiary***

Minority interest in operations of consolidatedsubsidiary increased on both a dollar and a percentage of revenues basis forthe three and six months ended October 31, 2006, as compared to the sameperiods of our prior fiscal year as reflected in the following table:

|                     | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                      | 42,000     |                                                 | —     |   | $ | 42,000 |   | — |   |
| Percent of revenues |       | 0.5                                                    | %          | —                                               |       | 0.3 | % | — |   |
|                     |            |                                                        |            |                                                      |            |  |  |  |  |  |  |

 

The amount of minority interest in operations ofconsolidated subsidiary recorded for the three and six months ended October 31,2006, relates to our purchase of a 90% interest in SenseIt in October 2006 andthe amount is expected to fluctuate in future periods dependent upon thedevelopment and, potentially, financing activities of SenseIt in futurereporting periods.

***Net Loss***

Our net loss decreased on both a dollar and apercentage of revenues basis for the three and six months ended October 31,2006, as compared to the same period of our prior fiscal year, as reflected inthe following table:

|                     | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                      | (3,601,000 | )                                                    | $          | (5,252,000 | ) | $ | (5,973,000 | ) | $ | (10,424,000 | ) |
| Percent of revenues |       | (46.1                                                  | )%         | (90.0                                                | )%         | (39.1 | )% | (95.6 | )% |
|                     |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

We anticipate that losses will continue until (ifever): (i) revenues from our current operations substantially increase or (ii)we generate substantial revenues from products introduced as a result of ourresearch and development projects. Further, the revenue increases must increase faster than 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 products and services segment and as we continue ourmarketing and research efforts to expand sales and develop new products in thehomeland security business, including the commercialization of the IMStechnology and, eventually, the infrared imaging technology based on the LucentAgreement and the operations of our 90% owned subsidiary, SenseIt. However, wecan offer no assurances that the development and commercialization of thesetechnologies will occur.

We anticipate that our operations during the remainderof fiscal year 2007 will result in a loss since we are not likely to increaseour revenues from our existing products or generate additional sales from thenew products we may develop in a sufficient amount (if at all) to offset ouroperating and research and development expenses.

**Liquidity andCapital Resources**

Working Capital

Our working capital deficit increased by $2,267,000during the six months ended October 31, 2006, from a working capital deficit of$(6,707,000) at April 30, 2006, to a working capital deficit of$(8,974,000) at 

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October 31, 2006. The decrease in working capitaldeficit for the six months ended October 31, 2006, is due to a combination offactors, of which the significant factors are set out below:

Factors which increasedworking capital

·                  approximately $2,718,000 due to the issuance of the 6% Debentures(calculated as net proceeds of $12,270,000 less (a) $3,210,000, the amount ofthe 6% Debentures initially included in current liabilities and (b) $6,342,000,the initial amount of the conversion feature associated with the 6% Debenturesrecorded as a current derivative liability);

·                  approximately $4,500,000 due to a decrease in the current portion of the8% Debentures related to principal payments made in shares of our common stock(see discussion of 8% Debenture repayment below);

·                  $2,320,000 decrease to the initial recording of derivative liabilitiesdue to the change in fair value of such derivative liabilities during the sixmonths ended October 31, 2006;

Factors which decreasedworking capital

·                  approximately $4,820,000 of cash consumed directly in operatingactivities (calculated as approximately $6,170,000 of cash used in operatingactivities, netted down by approximately $1,350,000 of the cash impact ofchanges in other current assets or liabilities included therein);

·                  $3,383,000 due to initial reclassification of certain warrants fromequity to current derivative liabilities (see discussion of warrantclassification below);

·                  approximately $930,000 due to a cumulative increase in the currentportion of convertible debentures related to amortization of the debt discountson each related series of debenture;

·                  $1,166,000 related to purchases of fixed assets;

·                  approximately $70,000 in reclassification of notes payable from long termto current;

·                  $100,000 related to an investment in a business;

·                  approximately $1,400,000 of fixed assets additions accrued at October 31,2006.

As a result of the recent financing, including thesubsequent purchase of an additional $3,000,000 6% Debenture by Cornell inNovember 2006, we believe we have enough cash to finance our anticipatedoperations and projected negative cash flow into our 2008 fiscal year.

We have satisfied our working capital requirementsprimarily through financing activities in the past, including the issuance ofthe 8% Debentures in February 2005 and the 6% Debentures in May,June and November 2006. As described above, we have recently received anotification from Nasdaq identifying a listing deficiency, which, if not curedtimely, may result in our delisting from the Nasdaq Capital Market. Any suchdelisting, if it should occur, will make future financing activitiessignificantly more difficult.

8% Convertible Debentures

The first of twelve monthly principal payments on our8% Debentures became due in March 2006. However, both the principal andinterest are payable, at our option, in common stock, subject to variousrequirements (which we believe we currently meet). If we choose to make ascheduled principal payment by issuing common stock, and all requirements to doso are met, the conversion price will be the lesser of the then conversionprice (currently $5.00 per share) or 88% of the average of the ten closingprices ending on the trading day immediately prior to the monthly redemptiondate.  During the six months endedOctober 31, 2006 and subsequently, there has been substantial activity inreducing the outstanding principal balance on the 8% Debentures.  Having met all requirements to do so, we madeseveral interest and principal payments on the 8% Debentures in shares of ourcommon stock, as follows:

| Payment date | ** ** | **Nominal principal  repaid** | ** ** | **Nominal interest  repaid** | ** ** | **Number shares of  common stock issued** | ** ** |
|-------------------|------------|------------------------------------|------------|-----------------------------------|------------|---------------------------------------------------------------|------------|
| May 1, 2006       |       | $                                  | 1,822,500  |                              | $          | 66,500                                                        |       | 1,616,433 |   |
| June 1, 2006      |       | $                                  | 1,647,500  |                              | $          | 21,250                                                        |       | 1,997,265 |   |
| September 1, 2006 |       | $                                  | 250,000    |                              | $          | 10,000                                                        |       | 296,855 |   |
| October 1, 2006   |       | $                                  | 250,000    |                              | $          | 8,333                                                         |       | 353,922 |   |
| November 1, 2006  |       | $                                  | 250,000    |                              | $          | 6,667                                                         |       | 437,315 |   |
| December 1, 2006  |       | $                                  | 250,000    |                              | $          | 5,000                                                         |       | 356,338 |   |

 

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Additionally, we repaid a portion of the principal ofthe 8% Debentures in cash, as follows:

·                  In connection with the financing transaction discussed in “AdditionalLiquidity Considerations” below, on May 19, 2006 we entered into anagreement with certain of the 8% Debenture holders to pay their remainingprincipal balance after June 1, 2006, along with a 5% premium in cash. Inaccepting our offer, these Holders also agreed to limit the anti-dilutionprovision on their warrants originally issued with the 8% Debentures and towaive certain provisions of the 8% Debentures as they related to the completionof our 6% Debentures (although we believe such contractual terms not to be inforce). Approximately $5,000,000 of the then outstanding $8,200,000 8%Debentures accepted our offer. As a result, we paid these holders $4,107,102(which resulted in a reduction of principal outstanding of $3,880,000).

·                  On July, 1 2006, we made our monthly payment on the 8% Debentures incash, reducing the principal balance outstanding by $562,500.

·                  On August 1, 2006, we made our monthly payment on the 8% Debentures incash, reducing the principal balance outstanding by $562,500.

As of the date of this report, there are two remainingholders of our 8% Debentures outstanding with a cumulative principal balanceoutstanding of $500,000, an amount which will be paid in either cash or stockin two monthly amortization payments of $250,000.

In June 2006, one of the holders of the 8%Debentures, with a remaining principal balance of $0 as of the date of thisreport, informed us of its belief that the issuance of the 6% Debentures (asdiscussed above) constituted a default (due to a potential variable conversionprovision contained within the 6% Debenture) under the 8% Debentures. Remediesof such default (if actual) include the option to accelerate payment of thefull principal amount of the remaining 8% Debentures, together with interestand other amounts due, to the date of acceleration. The principal amount of the8% Debentures shall be equal to 130% of the then-principal amount of the 8%Debentures at the time of default plus all interest and other amounts due or aconversion calculation, whichever is higher. The holder had approximately$937,000 due on its debenture at the time we entered into the 6% Debenture. Wehave contested that allegation (based among other things that such clause didnot survive the final agreement) and will defend it in court, if necessary.

6% Convertible Debentures

On May 31, 2006, we completed a private placementby which we issued to an accredited investor 6% Debentures in the aggregateprincipal amount of $16,000,000 (including debentures of $3,000,000 eachpurchased in June and November 2006) and warrants to purchase a total of8,000,000 shares of our common stock at exercise prices of $1.25 per share(2,000,000 warrants), $1.75 per share (3,000,000 warrants) and $2.00 per share(3,000,000 warrants) for a period of three years.  The 6%Debentures mature on May 31, 2009.  Theaccredited investor and an unaffiliated third party provided us services inconnection with completing the transaction (which were valued at $825,000) andas a result, we issued 660,000 shares of restricted common stock ascompensation. The accredited investor may convert the 6% Debenture into sharesof our common stock at any time at a conversion price of $1.25 per share.  The holder may convert the 6% Debentures intocommon stock at the lesser of $1.25 or 80%of the average of the two lowest daily volume weighted average prices of ourstock during the five trading days immediately preceding the conversion date(the “Market Conversion Price”), subject to certain conversion limitations(see Note 9 to the accompanying condensed consolidated financial statements). Onesubstantial potential limitation is that 

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through January 26, 2007, if converting using theMarket Conversion Price, the holder is limited to converting no more than $200,000of the principal or accrued interest on the 6% Debentures into shares of ourcommon stock in any seven calendar day period. Thereafter, if converting usingthe Market Conversion Price, the holder is limited to converting no more than$400,000 of the principal or accrued interest on the 6% Debentures into sharesof our common stock in any seven calendar day period.

Interest accrues on the outstanding principal balanceat the annual rate of 6%.  Interest ispayable on May 31, 2009, in cash or shares of our common stock, at ouroption.  If we choose to pay accruedinterest in shares of our common stock, the number of shares to be issued willbe calculated as the amount of interest due divided by 88% of the volume weightedaverage price of our common stock for the five trading days preceding theMaturity Date.

If after December 31, 2006, we have insufficientshares authorized but unissued and unreserved to convert principal and payinterest in common stock, our stock is not listed or quoted on a market, we havenot timely satisfied any conversion obligations or the issuance of shares wouldviolate certain other defined sections of the agreement, the holder has a rightto request net cash settlement of the conversion based upon a definedcalculation.

We were contractually required to seek shareholderapproval of this transaction by no later than October 31, 2006, (exclusive ofany shares acquired in this transaction or related transactions), including theability to issue a maximum of 64 million shares upon conversion of the 6%Debentures and to approve an increase in authorized shares of common stock toat least 175 million shares.  On October30, 2006, we held our annual meeting of shareholders.  The proposal to approve the transaction wasapproved.  Although more shareholdersvoted in favor of the proposal for amending our articles of incorporation toincrease our authorized common stock, we did not receive the number of votesfor the proposal required by California law to complete the amendment asrequired.  Under the terms of both the 6%Debentures and the related warrants, if we have insufficient authorizedcapitalization after December 31, 2006, we have an obligation to call and holda special meeting of its stockholders within 60 days for the sole purpose ofincreasing our authorized capitalization. We have called a special meeting of shareholders to be held on January2, 2007 to reconsider a proposal for an increase in our authorizedcapitalization and hope to obtain the required approval at that time.  If we are unable to obtain the requiredapproval, Cornell will be limited in the number of shares it can acquire uponconversion of the 6% Debenture or exercise of the related warrants.  If we fail to obtain shareholder approval tothe extent required under California law for the increase in authorizedcapitalization, we may be in default under the terms of the 6% Debentures andrelated warrants as well as pursuant to certain other obligations.

As a result of our shareholders approving the Cornelltransaction on October 30, 2006, we were obligated to file an amendedregistration statement by November 30, 2006, to register the full number ofshares required under the 6% Debenture transaction documents (representing theBuyers Shares, shares underlying the 6% Debenture Warrants and shares upon theconversion of the 6% Debentures based on a defined formula but in an amount notto exceed 64 million shares) and obtain effectiveness of the registrationstatement by January 15, 2007.  Due tothe aforementioned current inability to amend our articles of incorporation toincrease our authorized shares of common stock, we are unable to file therequired registration statement until such time as our shareholders approve, ifever, a proposed increase in authorized shares of common stock (such proposalbeing presented to our shareholders in a meeting to be held on January 2,2007). Consequently, we will be obligated to pay the holder of the 6%Debentures liquidated damages equal to 1% of the liquidated value of the 6%Debentures outstanding ($160,000 assuming no conversions by Cornell) for each30 day period until such time, if ever, that we become in compliance with ourcontractual obligation to Cornell. Additionally, once effectiveness of both the initial and the amended registrationstatement is achieved and until such time that all eligible shares have beensold under the registration statements, if sales are not able to be made underthe registration statement (due to failure to keep the registration statementeffective or failure to register sufficient shares or otherwise), Cornell willhave recourse to the aforementioned one percent per thirty-day liquidateddamages penalty. We are 

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contractually not obligated to pay liquidated damagesfor more than a total of 365 calendar days. We may elect to pay any liquidated damages in cash or shares of ourcommon stock if registered. Failure to comply with our registration obligationsmay, subsequent to any grace periods and opportunities to cure, be deemed anevent of default.

Additionally, other events, as defined in the 6%Debenture agreement, may also allow the 6% Debenture holders to declare us indefault.  Remedies for an event ofdefault, include the option to accelerate payment of the full principal amountof the Debentures, together with interest and other amounts due, to the date ofacceleration and Cornell will have the right to request such payment in cash orin shares of our common stock.

Cash Flows

As of October 31, 2006, we had $1,566,000 of cashand cash equivalents, a decrease of $551,000 as compared to $2,117,000 atApril 30, 2006. Our principal source of funding for the six months endedOctober 31, 2006 was from the issuance of the 6% Debentures for which wereceived net proceeds of $12,270,000. Our principal source of funding for thesix months ended October 31, 2005 was from cash and cash equivalents on hand atthe start of the period related to the issuance of 8% Debentures completed inFebruary 2005 whereby we received $22,000,000 ($21,340,000 net of placementfees).

Cash used in operating activities of $6,172,000 and$8,428,000 for the six months October 31, 2006 and 2005, respectively, wasprimarily the result of a net loss attributable to common stockholders of$5,973,000 (which included noncash expenses and gains in the net amount ofapproximately a $200,000 expense) and $10,525,000 (which included noncashexpenses in the aggregate amount of approximately $4,400,000), respectively.

Investing activities used cash of $1,266,000 and$3,625,000 for the six months ended October 31, 2006 and 2005, respectively.Cash used in investing activities for the six months ended October 31, 2006,consisted of $1,166,000 expended on additions of property and equipment and$100,000 expended on a 9% equity investment in a business.  Cash used in investing activities for the sixmonths ended October 31, 2005 resulted primarily from the purchase of PPSC inMay 2005 (which purchase price included a net cash outflow of $2,460,000) aswell as purchases of property and equipment of $1,165,000.

Financing activities provided cash of $6,887,000 and$406,000 for the six months ended October 31, 2006 and 2005, respectively. Cashprovided by financing activities for the six months ended October 31, 2006resulted primarily from the issuance of the 6% Debentures which yielded netproceeds of $12,270,000 offset by principal payments on borrowings of$5,391,000. Cash provided by financing activities for the six months endedOctober 31, 2005 resulted primarily the exercise of common stock warrantsoffset primarily by debt repayments and dividend payments on our outstandingSeries E Convertible Preferred Stock.

Additional Liquidity Considerations

As a result of the 6% Debenture transaction,anti-dilution provisions associated with the 1,593,900 common stock warrantsissued in the 8% Debenture transaction were triggered whereby we issued anadditional 6,375,600 common stock warrants to these holders and reduced theexercise price on all related warrants to $1.25. As a result, as ofDecember 14, 2006 we have 7,969,500 common stock warrants exercisable at$1.25 related to the 8% Debenture transaction. As a result of the May 18, 2006 agreement (as discussed above),4,557,000 of these common stock warrants have been modified to reduce theiranti-dilution provisions to a price-protection provision only. If we were toenter into a financing agreement in the future with an effective price lessthen $1.25 (or of the holder of our 6% Debentures was to convert a portion ofthe outstanding debenture at a conversion rate less than $1.25), the remaining3,412,500 common stock warrants that have a full anti-dilution provision, wouldratchet into a great number of common stock warrants at a lower exerciseprice.  There were no other changes inthe terms or conditions of the warrants.

 

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Asof October 31, 2006, we had commitments outstanding for capitalexpenditures of $1,064,000.  We areattempting to secure lease financing for a portion of the assets included inthe commitment at October 31, 2006.

Ourother future commitments have increased due to the Lucent Agreement, underwhich we endeavor to develop a next-generation imaging and night visionsurveillance technology and the related investment in SenseIt, in which we acquired a 90%interest in exchange for assigning to SenseIt all of our interest under theLucent Agreement.  For information regarding the LucentAgreement and SenseIt, see Note 6 to the condensed consolidated financialstatements and also the information in the General Discussion section of thisItem 2:  Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

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

***Off-Balance Sheet Arrangements***

Wehave no material changes to the disclosure on this matter made in our AnnualReport on Form 10-KSB for the year ended April 30, 2006.

***Critical Accounting Estimates***

Weconsider an accounting estimate to be critical if 1) the accounting estimaterequires us to make assumptions about matters that were highly uncertain at thetime the accounting estimate was made, and 2) changes in the estimate that arereasonably likely to occur from period to period, or use of different estimatesthat we reasonably could have used in the current period, would have a materialimpact on our financial condition or results of operations.

Managementhas discussed the development and selection of these critical accountingestimates with the Audit Committee of our Board of Directors and the AuditCommittee has reviewed the foregoing disclosure.  In addition, there are other items within ourfinancial statements that require estimation, but are not deemed critical asdefined above.  Changes in estimates usedin these and other items could have a material impact on our financialstatements.

*Goodwill and Intangible Assets*

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

Inaccordance with SFAS No. 142 *Goodwilland Other Intangible Assets*, goodwill is not amortized, but insteadis tested for impairment on an annual basis or more frequently if the presenceof certain circumstances indicates that impairment may have occurred.  The impairment review process, which issubjective and requires significant judgment at many points during the analysis,compares the fair value of the reporting unit in which goodwill resides to itscarrying value.  If the carrying value ofa reporting unit exceeds its fair value, then the amount of the impairment lossmust be measured. The impairment loss is calculated by comparing the impliedfair value of reporting unit goodwill to its carrying amount. In calculatingthe implied fair value of reporting unit goodwill, the fair value of thereporting unit is allocated to all of the other assets and liabilities of thatunit based on their fair values. The excess of the fair value of a

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reportingunit over the amount assigned to its other assets and liabilities is theimplied fair value of goodwill. An impairment loss would be recognized when thecarrying amount of goodwill exceeds its implied fair value.  We have goodwill in the amount of $3,631,000on our condensed consolidated balance sheet as of October 31, 2006, related tothe acquisition of PPSC in May 2005. During the three months ended January 31, 2006, we performed our annualimpairment review on the aforementioned goodwill and concluded that thegoodwill was not impaired.

Forintangible assets other than goodwill, SFAS No. 144 *Accounting for the Impairment or Disposal ofLong-Lived Assets* is the authoritative standard on theaccounting for the impairment of such intangible assets.  As required, we perform tests for impairmentof intangible assets other than goodwill whenever events or circumstancessuggest that such assets may be impaired. To evaluate potential impairment, SFAS No. 144 requires us to assesswhether the future cash flows related to these assets will be greater thantheir carrying value at the time of the test. Accordingly, while our cash flowassumptions are consistent with the plans and estimates we are using to managethe underlying businesses, there is significant judgment in determining thecash flows attributable to our other intangible assets over their respectiveestimated useful lives.  We haveremaining other net intangible assets in the amount of $397,000 on ourcondensed consolidated balance sheet as of October 31, 2006, comprised of ourIMS technology, acquired in December 2002, customer lists acquired in ouracquisition of the business and assets of EMG in June 2004 and the customerbase 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.

*Stock-based Compensation*

Forour employees, our stock-option program is a broad-based, long-term retentionprogram that is intended to attract and retain talented employees and alignstockholder and employee interests.  OnMay 1, 2006, we adopted the provisions of SFAS 123(R), requiring us torecognize expense related to the fair value of our stock-based compensationawards.  We elected the modifiedprospective transition method as permitted by SFAS 123(R).  Under this transition method, stock-basedcompensation expense for the six months ended October 31, 2006, includescompensation expense for all stock-based compensation awards granted prior to,but not yet vested as of May 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of SFAS 123 andcompensation expense for all stock-based compensation awards granted subsequentto May 1, 2006, based on the grant date fair value estimated in accordance withthe provisions of SFAS 123(R).  See Note7 to our condensed consolidated financial statements for further detail,including the impact of the adoption to our condensed consolidated statementsof operations.  We assess the fair valueof option awards using the Black-Scholes option pricing model, a model whichrequires several estimates including stock price volatility, risk-free interestrate and expected term of the option. Additionally, we must estimate the number of options we expect to beforfeited prior to vesting in future periods. As of October 31, 2006, $1,700,000 of total unrecognized compensationcost related to stock options is expected to be recognized over aweighted-average period of 1.1 years.  Ifthe assumptions used, as they relate to volatility, risk-free interest rate, estimatedterm of the options and forfeiture rate, were materially different, the overallvaluation of these and any future stock-based awards and the timing ofrecognition of related expense could change significantly.

Additionally,we similarly evaluate the financial statement impact of stock-based grants madeto external parties for services and in settlement of litigation by using theBlack-Scholes model, which also requires several estimates including stockprice volatility, risk-free interest rate and expected term of the option.  If the assumptions used, as they relate tovolatility, risk-free interest rate and estimated term of the warrants, werematerially different, the overall valuation of these and any future stock-basedawards could change significantly.

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***Initial and Continuing Valuation of Financing Transactions***

Wevalue transactions associated convertible debentures or preferred stock thatare convertible into common stock based on the market conditions existing onthe date the agreement is signed.  Inallocating the 6% Debenture financing proceeds between the freestandingwarrants, the convertible debenture and the embedded conversion feature withinthe convertible debenture, we were required to estimate the fair values of eachof the components.  If the assumptionsused, as they relate to volatility, risk-free interest rate, estimated term ofthe warrants, probability-weighted exercise patterns of the debentures and fairvalue of the embedded conversion feature (accounted for as a derivativeliability) were materially different, there could be a material financialimpact to our condensed consolidated financial statements.  Additionally, all derivative liabilities mustbe marked to then-current fair value at the end of each reporting period with thechange in fair value being included in our condensed consolidated statements ofoperations.  Due to the fair value of thederivative liability being highly sensitive to the market price of our commonstock, changes in other estimates associated with estimating the end-of-periodfair value of the derivative instrument could have a material impact on ourfinancial statements.

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

Weare exposed to market risk related to changes in interest rates, equitysecurity market values, foreign currency rates and the market price of ourcommon stock.

InterestRates

Ourinvestment portfolio consists of cash and cash equivalents (in the amount of$1,566,000 at October 31, 2006), all of which is exposed to interest ratefluctuations.  The primary objective ofour investments is to earn a market rate of return while preserving principaland maximizing liquidity.  The interestearned on these investments (with a blended yield of 0.5% at October 31, 2006)may vary based on fluctuations in the prevailing interest rate.

EquitySecurities

Wedo not hold any investments in marketable equity securities.  However, we hold a 30% interest in IUT, whichis a non-marketable equity security.  Ourstrategic investment in this entity may be impacted by the underlying economicconditions of the entity, including the ability to raise additional capital andthe likelihood of our being able to realize our investments through liquidityevents such as initial public offerings, mergers or private sales.  This investment involves a great deal ofmarket risk, and there can be no assurances that a specific company will growor become successful.  Consequently, wecould lose all or part of our investment. Additionally, because IUT is located in Germany, our investment in the entity(and our share of their earnings or losses) may be impacted by changes inforeign currency rates.  The carryingamount of this investment was $396,000 as of October 31, 2006.

Derivative Instruments

Wedo not purchase derivative instruments on the open market.  However, in accordance with current US GAAP,we have classified certain warrants and the embedded conversion feature in our6% Debentures as derivative instruments (a combined $7,406,000 currentliability at October 31, 2006). Classification as derivative liabilities was required because, for eachinstrument, there is a possibility that the instrument could be required to besettled on a net cash basis.  We arerequired to mark these instruments to market as of the end of each reportingperiod and to recognize the change in fair value in our condensed consolidatedstatements of operations.  Our stockprice has been historically volatile and the fair values of these instrumentsare sensitive to changes in our underlying stock price.  As such, the carrying amount of theseinstruments may be volatile from period to period.  For the six months ended October 31, 2006, werecorded a gain on derivative instruments in the aggregate amount of$2,320,000, such amount representing the change in fair value between therespective initial recording of the derivatives and October 31, 2006.

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**Item 4: Controls and Procedures**

**With the participation of ourmanagement, including the Chief Executive Officer and Chief Financial Officer,we have evaluated the effectiveness of our disclosure controls and proceduresas required by Exchange Act Rule 13a-15(b) as of the end of the period coveredby this report. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer have concluded that these disclosure controls and proceduresare effective. There were no changes in our internal control over financialreporting during the three months ended October 31, 2006, that havematerially affected, or are reasonably likely to materially affect, our internalcontrol over financial reporting.**

**Disclosure controls and procedures are controls and otherprocedures 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 SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed inour reports filed under the Exchange Act is accumulated and communicated tomanagement, including our principal executive officer and our principalfinancial officer, as appropriate, to allow timely decisions regarding requireddisclosure.**

**Part II: Other Information**

**Item1:  Legal Proceedings**

None.

**Item 1A:Risk Factors**

*An investment in and ownership of our common stock,Class B or Class C Warrants, or any other of our convertible securities is oneof high risk.  You should carefully consider therisks described below before deciding whether to exercise your warrants, or toinvest in or continue to hold our common stock.  If any of thecontingencies discussed in the following paragraphs or other materially adverseevents actually occur, the business, financial condition and results ofoperations could be materially and adversely affected.  In such case, the trading price of our commonstock could decline, and you could lose all or part of your investment.*

**We havehistorically had severe working capital shortages, even following significantfinancing transactions.**

Although we raised capital totaling more than$32,900,000 (net of expenses) during the last two fiscal years and issued 6%Debentures aggregating $13,000,000 in May and June 2006 (which nettedapproximately $8,170,000 in proceeds after expenses and $4,100,000 of paymentsrelated to our 8% Debentures), we have had working capital shortages in thepast and our consolidated financial statements as of October 31, 2006, indicatethat we have a working capital deficit of $(8,974,000).

Weissued an additional $3,000,000 6% Debenture on November 16, 2006 (from whichwe received net proceeds of  $2,835,000after payment of a commitment fee in the amount of $165,000 to YorkvilleAdvisors, LLC).  Based on the amount of capital we have remaining, our current negativecash flow from operations and investing activities, we anticipate that we maycontinue to incur a working capital deficit unless we are able to substantiallyincrease our revenue or reduce our expenses thereby generating positive cashflow from operations and (ultimately) operating income.   Nevertheless, as a result of the November 2006 investment, we believe we have sufficient working capitalto finance our anticipated operations and projected negative cash flow into our2008 fiscal year.

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**Our ability to obtain further financing when necessary is limited andwe may be delisted from the Nasdaq Capital Market.**

We have historically financed our operating lossesand cash flow deficits through private placements of our equity and debtsecurities.  Both of our outstanding 8%and 6% Debentures contain significant restrictions on our ability to raise anyadditional capital for so long as the convertible debentures are outstanding andultimately, our ability to finance our operations will depend on our ability togenerate revenues that exceed our expenses. Although we believe we are on a path to that end, we cannot offer anyassurance that we will be able to succeed in reaching that goal.

In addition, as described above in June and July 2006 we received three notificationsfrom Nasdaq identifying listing deficiencies, which, if not cured timely, mayresult in our delisting from the Nasdaq Capital Market.  We have cured the deficiencies identified intwo of those three notifications.  Nasdaqdescribed the third deficiency as a failure to meet the minimum bid pricerequirements set forth in Marketplace Rule 4310(c)(4). Therefore, in accordancewith Marketplace Rule 4310(c)(8)(D), Nasdaq provided us 180 calendar days(until January 8, 2007) to regain compliance with the Rule (which requires thatthe bid price of our common stock closing at $1.00 per share or more for aminimum of 10 consecutive business days). If we fail to obtain compliance with the minimum bid price requirementbut we meet the other Nasdaq Capital Market initial listing criteria as setforth in Marketplace Rule 4310(c), Nasdaq will grant us an additional 180calendar days to obtain compliance. Additionally, we have called for a special meeting of our shareholdersto be held on January 2, 2007 to grant authority to the Board of Directors toapprove a reverse stock split, if necessary in order to achieve the $1.00minimum bid price requirement.  We do notmeet this initial listing requirement as of the date of this report, and wecannot give any assurance that we will be able to meet the Nasdaq requirementsto maintain our Nasdaq Capital Market listing, or that if we do, a stabletrading market will develop for our stock or our warrants.

Becauseour financing activities are dependent to a large extent on eventual liquidityfor the investors, any such delisting, if it should occur, will make futurefinancing activities significantly more difficult and may raise liquidityissues for current investors.

**We havefour business segments and, for the six months ended October 31, 2006, all foursegments operated at a loss, in some cases significant losses.**

For the six months ended October 31, 2006, and asreflected in the following table, our condensed consolidated financialstatements show that all four operating segments have been operating at a loss(amounts in thousands):

** **

|                                     | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **October 31,**           | ** ** |
| ** **                          | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Segment  operating (loss) income:   |       |                           |       |   | ** ** |
| Homeland security products          |       | $                              | (4,071     | ) | $ | (2,071 | **)** |
| Security services                   |       | (294                           | )          | 38 | ** ** |
| Semiconductor products and services |       | (48                            | )          | (3,474 | **)** |
| Life sciences                       |       | (12                            | )          | (209 | **)** |
| Reconciling amounts                 |       | (2,624                         | )          | (1,687 | **)** |
| Total                               |       | $                              | (7,049     | ) | $ | (7,403 | **)** |

 

We expect that these losses (on a consolidatedbasis) will continue through the remainder of our 2007 fiscal year.  As described in the next risk factor, unlesswe are able to develop and sell new products profitably, we may be unable toremain competitive and it is likely that our losses and negative cash flow willcontinue.  Reconciling amounts includecorporate expenses consisting primarily of corporate salaries and benefits,

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professional and consulting fees, investor relationscosts, warrant amendment expense, insurance and directors’ compensation.

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

We have not operatedprofitably since our 1996 fiscal year, and as discussed in the preceding riskfactor, all four of our segments were not operating profitably for the sixmonths ended October 31, 2006.  Werecognized net income for the year ended April 30, 2000, only because of thegain recognized on the sale of our depleted zinc assets to Eagle-PicherTechnologies, LLC.

Our ability to generate additional revenues (andultimately net income) is dependent upon the success of our homeland securityproducts, security services and semiconductor operations and our ability todevelop new products, including those that use stable and radioactive isotopes,while marketing and selling those products profitably.  Historically, our semiconductor operationshave been a significant cash drain and, although the segment recorded its firstpositive quarterly operating income for the three months ended October 31, 2006as a result of successful steps taken to reduce costs and increase revenue, wecannot offer any assurance that the measures we have taken will continue to besuccessful. In addition, because of competitive conditions and, due to the lossof substantially all of our former Chemotrade radioisotope customers in January2006, it will be difficult for our life sciences operations to becomesignificantly profitable in the future.

We have had limited success in marketing ourhomeland security products, having sold our first units of our IMS technologyfor the detection of chemical weapons and other toxic substances in November2006 and only two units of the first generation of our NeutroTestTM portable, neutron-based explosive detectiondevice and no units of our second generation NeutroTestTM device.  Although we continue to market products based on our IMS technology, wecannot offer any assurance that our marketing efforts will result in anyadditional sales or that additional sales would result in significant revenuesto us.

**We are currently dependent on our continuingrevenues and increasing orders to improve our operating results, and cashpayments from our customers to provide working capital.  To the extent orders and deliveries arereduced because of changing customer needs or our inability to supply product,or to the extent payments from customers are reduced because of adversefinancial conditions affecting our customers, our financial condition will beadversely affected.**

It is possible that the following circumstances maydevelop and may adversely impact our available working capital and materiallyimpact our ability to continue our business operations:

·                  unanticipatedexpenses in developing our new products or in producing or marketing ourexisting products;

·                  the necessity of having to protect and enforce ourintellectual property rights;

·                  technological and market developments; or

·                  a corporate decision to expand our production capacitythrough capital investment or acquisition.

We may not be able to obtain equity or debtfinancing on reasonable terms when we need such financing.  Theunavailability of additional financing, when needed, could have a materialadverse effect on our business.

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**We have raised capital and issued securitiesduring the years ended April 30, 2006 and 2005, and subsequently which hasresulted (and will in the future when warrant exercises or conversions occurresult) in dilution to our existing shareholders.  This was accomplished to provide necessaryworking capital or obtain assets and services. We will likely issue more securities to raise additional capital or toobtain other services or assets, any of which may result in substantialadditional dilution.**

Duringthe course of the last two fiscal years and the current 2007 fiscal year,we have raised in excess of $43,800,000 (net of expenses and $4,100,000 ofpayments related to our 8% Debentures) to finance our business operations andacquisitions. We have raised this capital by issuing convertible debentures,shares of common stock, convertible preferred stock, common stock warrants toaccredited investors and as compensation to investment bankers makingintroductions to the accredited investors and the exercise of previously issuedcommon stock warrants and stock options. During this same period of time, weissued common stock warrants and shares of common stock to several persons inexchange for their promises to perform investment banking and financial advisoryservices to us. In many cases, these issuances were below the then-currentmarket prices and can be considered dilutive to our existing shareholders—bothas a reduction of their percentage ownership in Isonics and because ofissuances that will be, when warrants are exercised or debentures areconverted, at prices below the market.

The8% Debentures issued in February 2005 and the 6% Debentures issued duringfiscal year 2007, have significant restrictions on our ability to raise anyadditional capital.  If we raiseadditional working capital, we will likely have to issue additional shares ofour common stock and common stock warrants at prices that may dilute theinterests of our existing shareholders.

**Aholder of a portion of the remaining 8% Debentures has asserted that a defaultexists.**

Oneof the remaining two holders of the 8% Debentures (an assignee of one of theoriginal holders that did not accept our prior offer to all holders) hasasserted that the issuance of the 6% Debentures constituted a default (due to apotential variable conversion provision contained within the 6% Debentureswhich gives the 6% Debenture holder the right to convert the 6% Debentures intocommon stock at the lower of $1.25 or at a discount to market, subject tocertain limitations and as defined) under the 8% Debentures.  We have contested that allegation (based onsuch clause not surviving the final agreement and a defense of *in pari delicto*), and will defend it in court ifnecessary.  Any such litigation will betime consuming and expensive and, although we believe that we have significantgrounds to contest the existence of any default, we cannot be assured ofsuccess.  If they prove a default, wecould be liable for 130% of the principal amount of their 8% debentures on theclosing date of the 6% Debenture transaction (an amount of approximately$1,100,000, including accrued interest, in addition to the current outstandingprincipal of $500,000).

**We have insufficient authorizedcapital to meet our share issuance obligations.**

We currently have 75,000,000 shares of common stockauthorized, but that number is insufficient for us to meet our obligations tocertain persons, including the holders of our 6% Debentures and relatedwarrants.  We had agreed to seekshareholder approval of an increase in our authorized capitalization to atleast 175,000,000 by October 31, 2006, but we were unable to meet thisrequirement (although more votes approved our increase in authorizedcapitalization than disapproved it at our shareholders’ meeting held on October30, 2006, we did not receive sufficient votes necessary to complete theincrease under California law).  We havecalled a special meeting for a reconsideration of this matter to be held on January2, 2007, but cannot provide any assurance that we will then be able to obtainthe necessary shareholder approval.  Ifwe fail to obtain shareholder approval to the extent required under Californialaw for the increase in authorized capitalization, we may be in default underthe terms of the 6% Debentures and related warrants as well as pursuant tocertain other obligations.

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**Accounting charges result****ing from our issuance of the 6% Debenturesmay lead to significant non-cash charges which would adversely impact futureinterest expense, net income and earnings per share and may also lead to futurevolatility in our financial statement components.******

Theissuance of the 6% Debentures during fiscal year 2007 has resulted in theclassification of certain warrants and the conversion feature embedded in the6% Debentures as derivative liability instruments (a combined $7,406,000current liability at October 31, 2006). We are required to mark these instruments to market as of the end ofeach reporting period and to recognize the change in fair value in ourconsolidated statements of operations. Additionally, we will be required to record significant non-cashinterest charges over the life of the 6% Debentures (in addition to interestexpense relating to the 6% interest rate borne by the 6% Debentures which willbe paid in cash or shares of our common stock, at our option).  Thecombination of these two factors will likely result in a significant adverseimpact to future net income and earnings per share and will likely introduceadditional volatility to our future operating results.

**Operations in Russia may bedisrupted because of a volatile political and economic climate beyond ourcontrol, which could adversely affect our supply of raw materials.**

Operations in Russia entailrisks.  The former republics of theSoviet Union from time to time experience political, social and economic changeas they adjust to independence from the former central government in Moscow.Some of the republics, including Russia are attempting to transition from acentral-controlled economy toward a market-based economy.  These changes have involved, in some cases,armed conflict, and the risk of continued instability has increased since theterrorist attacks on the United States of September 11, 2001 and thecommencement of the wars in Iraq and Afghanistan.  Political or economic instability in theserepublics may continue or worsen.  Theprice, availability, quality, quantity, ability to export and supply of stableand radioactive isotopes could be directly affected by political and economicconditions in Russia.

**We are dependent on suppliersfrom Russia for substantially all of our stable isotopes and ourradioisotopes.  Accordingly, ouroperations could be materially adversely affected if hostilities in Russiashould occur, if trade between Russia and the United States were interrupted orceased, if political conditions in Russia disrupt transportation or processingof our goods, if laws or government policies concerning foreign businessoperations in Russia change substantially, or if tariffs are introduced.**

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

As a result of the acquisitionof PPSC, we have significantly increased our revenues for the six months endedOctober 31, 2006 as compared to the six months ended October 31, 2005. As aresult, we decreased our reliance on a few customers for a significant portionof our revenues.  For the six monthsended October 31, 2006, two security services customers accounted for 13% and10% of revenues, respectively, and one semiconductor materials and productscustomer accounted for 23% of revenues, while one security services customeraccounted for 18% of revenues for the six months ended October 31, 2005.  However, significant reductions in sales toany of these large customers have had, and may in the future have, an adverseeffect on us by reducing our revenues and our gross margins.  Present or future customers could terminatetheir purchasing patterns with us or significantly change, reduce or delay theamount of isotopes or other products ordered from us.

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

We experienced increased costsand delays in integrating the operations of the business and assets we acquiredfrom EMG, in June 2004, and we also realized revenues that were significantlyreduced from that which we had anticipated. Regardless of the extent of our planning, we may recognize increasedcosts and delays, and reduced revenues, when integrating future business acquisitionsinto our business operations and strategy. While we believe that we have and will continue to plan for integrationof business operations to the best of our ability, we cannot offer anyassurance that any or all such efforts will proceed as anticipated.  While the integration of PPSC (acquired inMay 2005) has been more successful than that of EMG, if efforts at integratingother businesses and assets that we may acquire in the future achieve similardifficulties as we realized in the integration of the EMG business and assets,we may have unanticipated expenses, delays and revenue reductions.

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

If we are able to develop andmarket our products successfully, we may experience periods of rapid growththat place a significant strain on our financial and managerial resources.  Through our research and development effortswe are also attempting to develop additional products and lines ofbusiness.  Our ability to manage growtheffectively, particularly given our increasing scope of operations, willrequire us to continue to implement and improve our management, operational andfinancial information systems, and will require us to develop the managementskills of our personnel and to train, motivate and manage our employees.  Our failure to effectively manage growthcould increase our costs of operations and reduce our margins and liquidity,which could have a material adverse effect on our business, financial conditionand results of operations.

**Because weare dependent upon our key personnel for our future success, if we fail toretain or attract key personnel, our business will be adversely affected.**

Our future success will depend in significant partupon the continued service of our key technical, sales and senior managementpersonnel, including James E. Alexander, our President and Chief ExecutiveOfficer and Boris Rubizhevsky, our Senior Vice President and President ofHSDC.  Currently both Mr. Alexanderand Mr. Rubizhevsky are covered by employment agreements that arerenewable on an annual basis.

We believe that our futuresuccess will also depend upon our ability to attract and retain other qualifiedpersonnel for our operations.  Thefailure to attract or retain such persons could materially adversely affect ourbusiness, financial condition and results of operations.

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

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

Thevalidity of any of the patents licensed to us, or that may in the future beowned by us, may not be upheld if challenged by others in litigation.  Further, our products or technologies, evenif covered by our patents, may infringe upon patents owned by others.  We could incur substantial costs in defendingsuits

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broughtagainst us, or any of our licensors, for infringement, in suits by us againstothers for infringement, or in suits contesting the validity of a patent.  Any such proceeding may be protracted.  In any suit contesting the validity of apatent, the patent being contested would be entitled to a presumption ofvalidity and the contesting party would be required to demonstrate invalidityof such patent by clear and convincing evidence.  If the outcome of any such litigation wereadverse to our interests, our liquidity and business operations would bematerially and adversely affected.

**We face technological change andintense competition both domestically and internationally which may adverselyaffect our ability to sell our products profitably.**

Althoughwe do not believe that any entity produces a complete range of stable enrichedisotopes for commercial sale, many of our competitors have significantlygreater funding than do we and may be able to develop products which arecompetitive with our products.

Further,it is possible that future technological developments may occur.  The market for our homeland security,semiconductor and isotope products is characterized by rapidly evolvingtechnology and a continuing process of development. Our future success willdepend upon our ability to develop and market products that meet changingcustomer and technological needs on a cost effective and timely basis.  If we fail to remain competitive byanticipating the needs of our customers and our customers contract with othersuppliers, our revenues and resulting cash flow could be materially andadversely affected.

**We could be subject toenvironmental regulation by federal, state and local agencies, including lawsthat********impose liability without fault, which couldproduce working capital shortages and lessen shareholders’ equity.**

We could become subject to avariety of federal, state, and local environmental regulations relating to theuse, storage, discharge and disposal of hazardous chemicals used duringmanufacturing processes, although we do not believe that there is any suchregulation directly applicable to our current operations.  Regulations that become applicable to ouroperations in the future could restrict our ability to expand our facilities orcould require us to acquire costly equipment or to incur other significantexpenses to comply with governmental regulations.  Historically, our costs of compliance withenvironmental regulations have not been significant.

**We are controlled by only a fewofficers and directors and, consequently, purchasers of our shares will havelittle ability to elect or control our management.**

Our shares are widely-held.  Even though our management beneficially owns(as of November 30, 2006) our securities equivalent to approximately 12% of theoutstanding votes at any shareholders’ meeting (assuming no exercises of commonstock warrants or options by any person other than management or conversions ofthe 6% or 8% Debentures), it is likely that they will be able to continue tosubstantially influence all matters submitted to stockholders for approval,including the election and removal of directors and any merger, consolidationor sale of substantially all of our assets, and to control our management andaffairs.  Such concentration of ownershipmay have the effect of delaying, deferring or preventing a change in control,impeding a merger, consolidation or takeover or other business combinationinvolving us or discouraging a potential acquirer from making a tender offer orotherwise attempting to obtain control of our business, even if such a transactionwould be beneficial to other stockholders.

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

The use of ourradioisotopes in radiopharmaceuticals and in clinical trials may expose us topotential product liability risks that are inherent in the testing,manufacture, marketing, and sale of human diagnostic

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and therapeutic products.  Additionally, the sale and use of explosiveand chemical detection products may expose us to potential liability risks thatare inherent with the operation of these types of products (including, but notlimited to failed detection).  Wecurrently have product liability insurance; however, there is a risk that ourinsurance would not cover completely or would fail to cover a claim, in whichcase we may not have the financial resources to satisfy such claims, and thepayment of claims would require us to use funds that are otherwise needed toconduct our business and make our products.

**Our common stock is vulnerable topricing and purchasing actions that are beyond our control and, therefore,persons acquiring or holding our shares or warrants may be unable to reselltheir shares at a profit as a result of this volatility.**

Thetrading price of our securities has been subject to wide fluctuations inresponse to quarter-to-quarter variations in our operating results, ourannouncements of technological innovations or new products by us or ourcompetitors, and other events and factors. The securities markets themselveshave from time to time and recently experienced significant price and volumefluctuations that may be unrelated to the operating performance of particularcompanies. Announcements of delays in our testing and development schedules,technological innovations or new products by us or our competitors anddevelopments or disputes concerning patents or proprietary rights could have asignificant and adverse impact on such market prices. Regulatory developmentsin the United States and foreign countries, public concern as to the safety ofproducts containing radioactive compounds, economic and other external factors,all affect the market price of our securities. *Inaddition, the realization of any of the risks described in these “Risk Factors”could have a significant and adverse impact on such market prices*

**SEC penny stockregulations may limit the ability to trade our securities on the Nasdaq CapitalMarket.**

Although our common stock iscurrently quoted on the Nasdaq Capital Market, our common stock has in the pastbeen subject to additional disclosure requirements for penny stocks mandated bythe Securities Enforcement Remedies and Penny Stock Reform Act of 1990.  The SEC Regulations generally define a pennystock to be an equity security that is not traded on the Nasdaq Stock Marketand has a market price of less than $5.00 per share. We have, at times in thepast, been included within the SEC Rule 3a-51 definition of a penny stock, andwe are currently subject to one remaining notification from Nasdaq which mayplace us in that status again.  When ourcommon stock is considered to be a “penny stock,” trading is covered by Rule15g-9 promulgated under the Securities Exchange Act of 1934, for non-Nasdaq andnon-national securities exchange listed securities.

Under this rule,broker-dealers who recommend such securities to persons other than establishedcustomers and accredited investors must make a special written disclosure to,and suitability determination for, the purchaser and receive the purchaser’swritten agreement to a transaction prior to sale.  The regulations on penny stocks limit theability of broker-dealers to sell our common stock and thus the ability ofpurchasers of our common stock to sell their securities in the secondarymarket.  To the extent we are able tomaintain our listing on the Nasdaq Capital Stock Market, we will not be subjectto these penny stock rules.  Reasons forbeing unable to maintain our listing on the Nasdaq Capital Market include:

·      the inability tomaintain a bid price for our common stock of $1.00 for the requisite period oftime, and

·      the inability tomaintain either the minimum stockholders’ equity, market capitalization or netincome along with the required number of market makers and shareholdersnecessary for listing.

 

Wecannot give any assurance that we will be able to meet the Nasdaq requirementsto maintain our Capital Market listing, or that if we do, a stable tradingmarket will develop for our stock or our warrants. See “our ability to obtainfurther financing when necessary is limited and we may be delisted from theNasdaq Capital Market” for additional risk factors associated with our currentNasdaq listing deficiencies.

 

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If our shares are removed fromthe Nasdaq Capital Market because of our failure to meet the minimum pricerequirement or for other reasons, the ability of holders of our common stock tosell the shares they hold will likely be adversely affected because the lowertier markets (such as the OTC Bulletin Board and the Pink Sheets) do notprovide shareholder liquidity as do the higher tier markets (such as the NasdaqCapital Market).  In addition, unlesstraded on Nasdaq Capital Market or other higher tier markets (such as theAmerican Stock Exchange), our common stock will be subject to the penny stockrules, and many stock brokers will not make a market in those shares, furtherreducing the marketability of our shares.

**Futuresales of our common stock may cause our stock price to decline.**

Ourstock price has declined from a price of approximately $6.00 per share at thebeginning of 2005 to prices of less than $1.00 at various times since May 2006.Our stock price may decline further as a result of future sales of our shares,the perception that such sales may occur or other reasons.  As of November 30, 2006, approximately5,700,000 shares of common stock held by existing stockholders constitute “restrictedshares” as defined in Rule 144 under the Securities Act.  The restricted shares may only be sold ifthey are registered under the Securities Act, or sold under Rule 144, oranother exemption from registration under the Securities Act.

Approximately85% of the restricted shares of our common stock are either eligible for salepursuant to Rule 144 or have been registered under the Securities Act forresale by the holders.  We are unable toestimate the amount, timing, or nature of future sales of outstanding commonstock.  Sales of substantial amounts ofour common stock in the public market may cause the stock’s market price todecline.

**We have never paid any cashdividends on our common stock and we do not anticipate paying cash dividends onour common stock in the foreseeable future.**

Wehave never declared or paid a cash dividend on our common stock.  We presently intend to retain our earnings,if any, to fund development and growth of our business and, therefore, we donot anticipate paying cash dividends in the foreseeable future.  Additionally, the terms of the 6% and 8%Debentures contain restrictions on our ability to pay dividends to holders ofour common stock.

**Outstanding6% and 8% Debentures, options and warrants may make it difficult for us toobtain additional capital on reasonable terms.**

As of November 30, 2006, wehad the following debentures and debenture obligations outstanding:

·                  8% Debentures aggregating $750,000 in principal amount; and

·                  6% Debentures aggregating $16,000,000 in principal amount

 

The 8% Debentures areconvertible (at our election through our monthly amortization payments) into1,056,338 shares of common stock, assuming a conversion price of $.71 (based upona 12% discount to the closing price of $.81 on November 30, 2006 which is lowerthan the fixed conversion price of $5.00). The aggregate $16,000,000 in principal of the 6% Debentures isconvertible (at the election of the 6%Debenture holder, subject to certain weekly limitations) into 24,615,385shares of common stock, assuming a conversion price of $.65 (based upon a 20%discount to the closing price of $.81 on November 30, 2006 which is lower thanthe fixed conversion price of $1.25). The holders’ rights to convert the 8% and 6% Debentures and associatedwarrants are, however, subject to certain share issuance limitations.  Inaddition, as of November 30, 2006, we had outstanding options and common stockwarrants for the purchase of up to 23,193,042 shares of common stock at anaverage exercise price of approximately $1.60 per share.  If all of the outstanding options,debentures and common stock warrants were to be converted, they would representapproximately 51% of our outstanding common shares on a fully diluted basis.  Future investors will likely

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recognize that the holders of the options andwarrants will only exercise their rights to acquire our common stock when it isto their economic advantage to do so. Therefore, even with lower current market prices for our common stock,the market overhang of such a large number of warrants, options, andconvertible preferred stock may adversely impact our ability to obtainadditional capital because any new investors will perceive that the securitiesoffer a risk of substantial potential future dilution.

****The continuously adjustable conversion price feature of our 6%Debentures could require us to issue a large number of shares, which wouldcause dilution to our existing stockholders and may encourage investors to makeshort sales of our common stock, which could depress the price of our commonstock.****

We may be obligated to issue an extremely largenumber of shares upon the conversion of the 6% Debentures we have issued (orhave agreed to issue) to Cornell because the conversion price is to be thelower of (a) $1.25 per share or (b) 80% of the average of the two lowest daily volume weightedaverage price (“VWAP”) of our commonstock during the five trading days immediately preceding the conversiondate.  Hence, the number of shares of our commonstock issuable upon conversion of the 6% Debentures will increase if the marketprice of our stock declines, which may cause dilution to our existingstockholders.  Furthermore, thesignificant downward pressure on the price of the common stock as Cornellconverts and sells material amounts of common stock could encourage short salesby investors. This could place further downward pressure on the price of thecommon stock, which in turn would lead to further dilution. In addition, notonly the sale of shares issued upon conversion or exercise of debentures orwarrants, but also the mere perception that these sales could occur, mayadversely affect the market price of the common stock.

**If wefail to effect and maintain registration of the common stock issued or issuablepursuant to conversion of our convertible debentures, or certain of our outstandingcommon stock warrants, we may be obligated to pay the investors of thosesecurities liquidated damages.**

Wehave various obligations to file and obtain the effectiveness of certainregistration statements which include certain outstanding common stock andcommon stock underlying outstanding convertible debentures and common stockwarrants.  Once effective, the prospectuscontained within a registration statement can only be used for a period of timeas specified by statute without there being a post-effective amendment filedthat has become effective under the Securities Act of 1933.  One of those obligations relates to arequirement to file a new registration for more than 50,000,000 additionalshares by November 30, 2006 and to achieve effectiveness of that registrationstatement by January 15, 2007.   We wereunable to meet the November 30, 2006 filing obligation and will not be able tomeet the January 15, 2007 effectiveness obligation; consequently, we will beobligated to pay the holder of the 6% Debentures liquidated damages equal to 1%of the liquidated value of the 6% Debentures outstanding ($160,000 assuming noconversions by Cornell) for each 30 day period after the applicable date as thecase may be.  The liquidated damages willbe pro rated for each day, and in no case will we be obligated to payliquidated damages for more than a total of 365 calendar days.  We may elect to pay any liquidated damages incash or shares of our common stock if registered.  In connection with this additional filingobligation, we have been advised by the Securities and Exchange Commission thatit may not grant effectiveness to the additional registration statement becauseof its interpretation of SEC Rule 415. In that case, we will be obligated to pay liquidated damages to Cornellfor the entire 365 day period unless Cornell waives the obligation.

Ifwe fail to meet any obligations we have to have effective and currentregistration statements available (including the current registration statementrelated to the common stock underlying our Class B and C warrants), we maybecome obligated to pay damages to investors to the extent they may be entitledto damages.  We cannot offer anyassurances that we will be able to maintain the currency of the informationcontained in a prospectus or to obtain the effectiveness of any registrationstatement or post-effective amendments that we may file.

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**As a public company, we aresubject to a significant amount of regulation. In the past we have received requests for information from theSecurities and Exchange Commission and from Nasdaq.  Any such inquiry or investigation that mayresult may adversely affect the market for our stock or our Company.**

Regulatorsof public companies such as Isonics have the authority to commence inquiriesand investigations where the regulators have concerns.  The investigations, while involving thecompany, may not have anything to do with actions taken by the company or ourfailure to act.  Furthermore, theregulators may not inform us when the issues they were addressing areresolved.  From October 2004 throughFebruary 2005, both Nasdaq and the SEC requested documents from us with respectto inquiries they were undertaking (related primarily to questions regardingour press releases, public relations advisors, certain other disclosures thatwere made publicly and the termination of Grant Thornton LLP as our independentauditor).   We also met withrepresentatives of Nasdaq to discuss issues related to market activity, pressannouncements, SEC filings, status of our business and other issues.   We provided information, which we believe tobe responsive to all of the questions posed in the Nasdaq inquiry and to theSEC.  We have not received any requestsfor additional information from either the SEC or Nasdaq relating to thoseearlier inquiries since February 2005 and while we believe these issues arebehind us, if any action resulted from these inquiries in the future, it mayadversely impact us, and our ability to carry on our business.  As discussed above, we have one remainingnotification from Nasdaq advising us that we are not in compliance with Nasdaq’slisting standards.

**Provisions in our charterdocuments could prevent or delay a change in control, which could delay orprevent a takeover.**

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

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

OurBylaws provide for indemnification of officers and directors to the full extentpermitted by California law, our state of incorporation.  We may be required to pay judgments, fines,and expenses incurred by an officer or director, including reasonable attorneys’fees, as a result of actions or proceedings in which such officers anddirectors are involved by reason of being or having been an officer ordirector. Funds paid in satisfaction of judgments, fines and expenses may befunds we need for the operation of our business and the development of ourproducts, thereby affecting our ability to attain profitability.  This could cause our stock price to drop.

**We will need to make substantialfinancial and man-power investments in order to assess our internal controlsover financial reporting and our internal controls over financial reporting maybe found to be deficient.**

Section 404of the Sarbanes-Oxley Act of 2002 requires management to assess our internalcontrols over financial reporting and requires auditors to attest to thatassessment. Current regulations of the Securities and Exchange Commission, orSEC, will require us to include this assessment and attestation in our AnnualReport on Form 10-K commencing with the annual report for our fiscal yearending April 30, 2008.   We will incursignificant increased costs in implementing and responding to theserequirements. In particular,

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therules governing the standards that must be met for management to assess itsinternal controls over financial reporting under Section 404 are complex,and require significant documentation, testing and possible remediation. Ourprocess of reviewing, documenting and testing our internal controls over financialreporting may cause a significant strain on our management, information systemsand resources. We may have to invest in additional accounting and softwaresystems. We may be required to hire additional personnel and to use outsidelegal, accounting and advisory services. In addition, we will incur additionalfees from our auditors as they perform the additional services necessary forthem to provide their attestation. If we are unable to favorably assess theeffectiveness of our internal control over financial reporting when we arerequired to, or if our independent auditors are unable to provide anunqualified attestation report on such assessment (if applicable for the fiscalyear ending April 30, 2008), we may be required to change our internal controlover financial reporting to remediate deficiencies. In addition, investors maylose confidence in the reliability of our financial statements causing ourstock price to decline.

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

**Payment ofConvertible Debenture Principal and Interest in Common Stock**

From May 1, 2006 through December 1, 2006 wehave issued various shares of common stock to holders of our 8% Debentures inpayment of our monthly principal and interest obligations.  The following table summarizes such paymentsthrough December 1, 2006:

** **
| **For Month  Ended** | ** ** | **Effective Date of Transaction** | ** ** | **Number of Shares Issued** |
|----------------------|------------|-----------------------------------|------------|-----------------------------|
| April 30, 2006       |       | May 1, 2006                       |       | 1,616,433                   |
| May 31, 2006         |       | June 1, 2006                      |       | 1,997,265                   |
| August 31, 2006      |       | September 1,  2006                |       | 295,855                     |
| September 30, 2006   |       | October 1, 2006                   |       | 353,922                     |
| October 31, 2006     |       | November 1, 2006                  |       | 437,315                     |
| November 30, 2006    |       | December 1, 2006                  |       | 356,338                     |

 

The following sets forth the information required byItem 701 in connection with the above stated transactions:

(a)           Thetransactions were completed effective as stated in the above table.

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

(c)           Theshares were not sold for cash.

(d)           Werelied on the exemption from registration provided by Sections 4(2) and 4(6)under the Securities Act of 1933 for these transactions.  We did not engage in any public advertisingor general solicitation in connection with these transactions.  The investors had access to all of ourreports filed with the Securities and Exchange Commission, our press releasesand other financial, business and 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 issued in these transactionsis not convertible or exchangeable.  Nowarrants were issued in these transactions.

(f)            We received no cash proceeds from the issuance of theshares.  We did receive a relief fromindebtedness as described above.

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**Warrant Issuances**

From May 1, 2006 through December 1, 2006 wehave issued variouswarrants (other than registered issuances) for services provided to us.  The following table summarizes such warrantissuances through December 1, 2006

** **
| **Effective  Date of Issuance** | ** ** | **Number of shares purchasable** | ** ** | **Exercise price** | ** ** | **Expiration Date** |
|---------------------------------|------------|----------------------------------|------------|--------------------|------------|---------------------|
| May 18, 2006                    |       | 50,000                           |       | $                  | 1.05       |                | May 17, 2008 |
| August 1, 2006                  |       | 50,000                           |       | $                  | 0.67       |                | July 31, 2008 |
| November 29, 2006               |       | 125,000                          |       | $                  | 0.84       |                | November 28,  2009 |

 

The following sets forth the information required byItem 701 in connection with the above stated transactions:

(a)           Thetransactions were completed effective as stated in the above table.

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

(c)           Thewarrants were not issued for cash, but for services provided to us.

(d)           Werelied on the exemption from registration provided by Sections 4(2) and 4(6)under the Securities Act of 1933 for these transactions.  We did not engage in any public advertisingor general solicitation in connection with this transaction.  The investors had access to all of our reports filed with the Securitiesand Exchange Commission, our press releases and other financial, business andcorporate information.  Based on ourinvestigation, we believe that the investors 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)           Thewarrants are exercisable to purchase shares of our common stock at therespective prices and with the respective expiration dates as stated in theabove table.

(f)            Wereceived no cash proceeds from the warrant grants.

**Issuance of Buyers Sharesassociated with the 6% Debentures**

OnMay 31, 2006, we entered into a financing agreement with Cornell. Thetransaction documents provided for the issuance of 660,000 shares of restrictedcommon stock as follows:  560,000 sharesto Cornell for services renderedin connection with the purchase of the 6% Debentures and 100,000 shares to Roadrunner Capital Group, LLC (“Roadrunner”),as consideration for assistance in the issuance of the 6% Debentures.  The following sets forth the informationrequired by Item 701 in connection with that transaction:

(a)           The transaction was effective May 31,2006. We issued an aggregate 660,000 shares of restricted common stock.

(b)           No underwriters were involved in thetransaction. The only entities who received securities from us in thistransaction were Cornell and Roadrunner.

(c)           The securities were not sold forcash. The securities were issued to Cornell and Roadrunner as consideration forservices rendered in issuing the 6% Debentures..

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(d)           The issuance of the restricted commonstock was accomplished pursuant to the exemptions from registration containedin Sections 4(2) and 4(6) of the Securities Act of 1933. We did not engage inany public advertising or general solicitation in connection with thistransaction. We provided Cornell and Roadrunner with disclosure of all aspectsof our business, including providing Cornell and Roadrunner and its managementwith 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 management and theboard of directors of Cornell and Roadrunner obtained all information regardingIsonics they requested, received answers to all questions they posed, andotherwise understood the risks of accepting our securities in exchange forservices to be provided.

(e)           The common stock issued in this transaction is notconvertible or exchangeable.

(f)            We received no proceeds from theissuance of the restricted common stock and, therefore, we have no use ofproceeds.

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

Asreported in our Form 8-K reporting an event of October 30, 2006 (filed October31, 2006), on October 30, 2006, we held our annual meeting ofshareholders in Denver, Colorado.  Three proposals were submitted to theshareholders for approval as set forth in our proxy statement dated September29, 2006:

1                                          Theelection of seven directors to serve until the next annual meeting ofshareholders and until their successors have been elected and qualified.

2.                                       Anamendment to our Articles of Incorporation to increase our authorized commonstock to 175,000,000 shares.

3.                                       Theapproval of a financing transaction completed in May and June 2006 with CornellCapital Partners, L.P. (“Cornell”) and the resulting potential issuance ofshares exceeding 19.99% of the number of shares then outstanding, whichissuance will be accomplished pursuant to a financing transaction with Cornell,which approval is being sought in accordance with Nasdaq Marketplace Rule4350(i)(1)(D)(ii).

There was no solicitationcontrary to our proxy statement. 38,480,817 shares were present at the meeting and constituted aquorum.  The names of the directorselected to serve until the next annual meeting of shareholders and until theirsuccessors have been elected and qualified, and the number of votes cast forand against were as follows.  Our common stock voted as a single class inthe election of directors.

** **
| **Name of Director** | ** ** | **Shares FOR** | ** ** | **Shares WITHHELD** |
|--------------------------------|------------|---------------------|------------|--------------------------|
| James E.  Alexander            |       | 37,526,596          |       | 954,221                  |
| Boris  Rubizhevsky             |       | 37,662,415          |       | 818,402                  |
| Lindsay A.  Gardner            |       | 37,705,217          |       | 775,600                  |
| Richard H.  Hagman             |       | 37,706,787          |       | 774,030                  |
| C. Stewart  Verdery, Jr.       |       | 37,705,142          |       | 775,675                  |
| Richard L.  Parker             |       | 37,713,937          |       | 766,880                  |
| Russell W. Weiss               |       | 37,706,667          |       | 774,150                  |

 

Abstentions and brokernon-votes were not counted for the purposes of determining the outcome of thevote on the election of directors.  They are included within the total of “shareswithheld,” above.

Although more votes votedto approve an amendment to our Articles of Incorporation to increase ourauthorized common stock to 175,000,000 than to disapprove the amendment, aninsufficient number of votes were cast to meet the requirements underCalifornia law.  5,919,799 shares voting voted for such approval and1,387,160 shares voting against such approval.  31,093,858 shares werewithheld.  Under the

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terms of the Cornellfinancing transaction, we are now required to call and hold a specialshareholders meeting for the sole purpose of increasing our authorizedcapitalization.  Accordingly, we have called a special meeting of theshareholders to be held on January 2, 2007 to reconsider a proposal for anincrease in our authorized capitalization and hope to obtain the requiredapproval at that time.

The shareholders approveda financing transaction completed in May and June 2006 with Cornell and theresulting potential issuance of shares exceeding 19.99% of the number of sharesthen outstanding, which issuance will be accomplished pursuant to a financingtransaction with Cornell, which approval is being sought in accordance withNasdaq Marketplace Rule 4350(i)(1)(D)(ii), as described in the proxystatement.  6,257,963 shares voting voted for such approval and 1,024,436shares voting against such approval.  31,093,858 shares were withheld.

**Item 6:Exhibits**

** **Exhibits.

3.01          Registrant’s Amendedand Restated Articles of Incorporation (dated May 5, 1997) (1)

3.02          Registrant’s Amendedand Restated Bylaws (2)

3.03          Certificate ofAmendment to Articles of Incorporation (dated November 15, 2001) (3)

3.04          Certificate ofAmendment to Articles of Incorporation (dated April 29, 2005) (4)

10.01        6%Secured Convertible Debenture no. CCP-5: $3,000,000 principal (5)

10.02        ClassA Common Stock Purchase Agreement, dated as of October 26, 2006 (6)

10.03        EmploymentAgreement with Christopher Toffales, dated as of October 27, 2006 (6)

10.04        Stockholders’Agreement between Isonics, SenseIt, and Mr. Toffales, dated as of October 27,2006 (6)

31.1          Certificationof Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act

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

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

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

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(1)          Incorporated herein by reference to exhibit 3.03filed with Isonics’ Registration Statement on Form SB-2 (“RegistrationStatement”) (Commission file No. 333-13289).

(2)          Filed with Isonics’ Current Report on Form8-K (File No. 001-12531) dated March 27, 2006, and filed March 31, 2006, andincorporated herein by reference.

(3)          Filed with Isonics’ current report on Form8-K (File No. 001-12531) dated January 8, 2002 and incorporated herein byreference.

(4)          Incorporatedby reference from Isonics’ annual report on Form 10-KSB for the year endedApril 30, 2005.

(5)          Incorporated herein byreference to exhibit 10.1 to the Form 8-K reporting an event of November 14,2006, filed on November 17, 2006.

(6)          Incorporated herein by reference toexhibits 10.1 through 10.3 to the Form 8-K reporting an event of October 26,2006, filed on November 1, 2006

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Golden, County of Jefferson, State of Colorado,on the 15th day of December 2006.
| 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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