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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

(**Mark One)**

 

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

 

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

 

**or**

 

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

 

**For the transition period from              to              **

 

**Commission file number: 001-12531**

 

**ISONICS CORPORATION**

(Exact name of registrant as specified in its charter)

** **

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

 

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

**New York, NY 10018-2491**

(Address of principal executive offices with zip code)

 

**(212) 356-7400**

(Registrant’s telephone number, including area code)

 

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

 

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

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

 

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

 

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

 

| **Class**                        | ** ** | **Outstanding at  December 12, 2008** |
|----------------------------------|------------|--------------------------------------------|
| Common Stock – no par value |       | 27,998,252 shares                          |

 

 

 

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Tableof Contents

 

**Isonics Corporation and Subsidiaries**

** **

**TABLE OF CONTENTS**

 
| Part I:  | Financial  Information |                                                                                                                |   |
|---------------|------------------------|---------------------------------------------------------------------------------------------------------------------|--------|
|          |                   |                                                                                                                |   |   |
| Item 1:       |                   | Financial  Statements                                                                                               |   |   |
|          |                   |                                                                                                                |   |   |
|          |                   | Condensed Consolidated Balance Sheets as of  October 31, 2008 and April 30, 2008                          |   |   |
|          |                   | Condensed  Consolidated Statements of Operations for the Three and Six Months Ended  October 31, 2008 and 2007 |   |   |
|          |                   | Condensed Consolidated Statements of Cash Flows for  the Six Months Ended October 31, 2008 and 2007            |   |   |
|          |                   | Notes to Condensed Consolidated Financial Statements                                                                |   |   |
|          |                   |                                                                                                                |   |   |
| Item 2:       |                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |   |
|          |                   |                                                                                                                |   |   |
| Item 3:       |                   | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   |   |
|          |                   |                                                                                                                |   |   |
| Item 4T:      |                   | Controls and  Procedures                                                                                            |   |   |
|          |                   |                                                                                                                |   |   |
| Part II: | Other Information      |                                                                                                                |   |
|          |                   |                                                                                                                |   |   |
| Item 1:       |                   | Legal  Proceedings                                                                                                  |   |   |
|          |                   |                                                                                                                |   |   |
| Item 1A:      |                   | Risk  Factors                                                                                                       |   |   |
|          |                   |                                                                                                                |   |   |
| Item 2:       |                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                        |   |   |
|          |                   |                                                                                                                |   |   |
| Item 4:       |                   | Submission  of Matters to a Vote of Security Holders                                                                |   |   |
|          |                   |                                                                                                                |   |   |
| Item 5:       |                   | Other  Information                                                                                                  |   |   |
|          |                   |                                                                                                                |   |   |
| Item 6:       |                   | Exhibits                                                                                                            |   |   |
|          |                   |                                                                                                                |   |   |
| Signatures    |                   |                                                                                                                |   |   |
|               |                        |                                                                                                                     |        |  |  |  |

 

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Tableof Contents

 

**Part I:  FinancialInformation**

** **

**Item 1: Financial Statements**

** **

**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

 

**ASSETS**

 
| ** **                                                           | ** ** | **(Unaudited)**            | ** ** | ** **               | ** ** |
|----------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| ** **                                                           | ** ** | **October 31,  2008** | ** ** | **April 30,  2008** | ** ** |
| CURRENT ASSETS:                                                      |       |                       |       |                     |       |
| Cash and cash  equivalents                                           |       | $                          | 558        |                     | $          | 927 |   |
| Accounts  receivable (net of allowances of $80 and $58,respectively) |       | 2,217                      |       | 2,297                    |       |
| Inventories                                                          |       | 339                        |       | 394                      |       |
| Prepaid expenses  and other current assets                           |       | 417                        |       | 194                      |       |
| Assets held for  sale                                                |       | —                     |       | 212                      |       |
| Total current  assets                                                |       | 3,531                      |       | 4,024                    |       |
|                                                                 |       |                       |       |                     |       |
| LONG-TERM  ASSETS:                                                   |       |                       |       |                     |       |
| Property and  equipment, net                                         |       | 3,947                      |       | 4,682                    |       |
| Goodwill                                                             |       | 1,285                      |       | 3,631                    |       |
| Intangible  assets, net                                              |       | —                     |       | 6                        |       |
| Other assets                                                         |       | 287                        |       | 418                      |       |
| Total long-term  assets                                              |       | 5,519                      |       | 8,737                    |       |
|                                                                 |       |                       |       |                     |       |
| TOTAL ASSETS                                                         |       | $                          | 9,050      |                     |       | $ | 12,761 |   |   |
|                                                                      |            |                            |            |                          |            |  |  |  |  |

 

**LIABILITIES AND STOCKHOLDERS’ DEFICIT**

 
| ** **                                                                                                                                                                  | ** ** | **(Unaudited)**                | ** ** | ** **                   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **October 31, 2008** | ** ** | **April 30, 2008** | ** ** |
| CURRENT  LIABILITIES:                                                                                                                                                       |       |                           |       |                         |       |
| Accounts payable                                                                                                                                                            |       | $                              | 1,162      |                         | $          | 825 |   |
| Accrued  liabilities                                                                                                                                                        |       | 1,774                          |       | 2,262                        |       |
| Accrued interest                                                                                                                                                            |       | 4,192                          |       | 2,990                        |       |
| Current portion  of obligations under capital lease                                                                                                                         |       | 635                            |       | 550                          |       |
| Current portion  of notes payable, net of discount                                                                                                                          |       | 6,936                          |       | 10                           |       |
| Current portion  of convertible debentures, net of discount                                                                                                                 |       | 8,994                          |       | 10,515                       |       |
| Total current  liabilities                                                                                                                                                  |       | 23,693                         |       | 17,152                       |       |
|                                                                                                                                                                        |       |                           |       |                         |       |
| Obligations  under capital lease, net of current portion                                                                                                                    |       | 266                            |       | 591                          |       |
| Notes payable, net  of current portion                                                                                                                                      |       | 17                             |       | 22                           |       |
| Other long-term  liabilities                                                                                                                                                |       | 50                             |       | 45                           |       |
|                                                                                                                                                                        |       |                           |       |                         |       |
| TOTAL  LIABILITIES                                                                                                                                                          |       | 24,026                         |       | 17,810                       |       |
|                                                                                                                                                                        |       |                           |       |                         |       |
| Commitments and  Contingencies (See Notes 1, 6, 8,9 and 10)                                                                                                                 |       |                           |       |                         |       |
|                                                                                                                                                                        |       |                           |       |                         |       |
| STOCKHOLDERS’  DEFICIT:                                                                                                                                                |       |                           |       |                         |       |
| Common stock -  no par value; 175,000,000 shares authorized; shares issued and outstanding:  October 31, 2008 – 26,748,252; April 30, 2008 – 16,063,026 |       | 64,513                         |       | 64,448                       |       |
| Additional paid  in capital                                                                                                                                                 |       | 23,592                         |       | 23,186                       |       |
| Accumulated  deficit                                                                                                                                                        |       | (103,081                       | )          | (92,683                      | )          |
| Total stockholders’  deficit                                                                                                                                           |       | (14,976                        | )          | (5,049                       | )          |
|                                                                                                                                                                        |       |                           |       |                         |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                                           |       | $                              | 9,050      |                         | $          | 12,761 |   |

 

Seenotes to condensed consolidated financial statements.

 

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**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

** **
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                                                                 | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                  |       | $                                |       |                           | $          |   |   | $ |   |   | $ |   |   |
| Products                                                                   |       | 631                              |       | 1,145                          |       | 1,213 |   | 2,016 |   |
| Services                                                                   |       | 3,361                            |       | 4,910                          |       | 7,566 |   | 9,908 |   |
| Total revenues                                                             |       | 3,992                            |       | 6,055                          |       | 8,779 |   | 11,924 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Cost of  revenues:                                                         |       |                             |       |                           |       |   |   |   |   |
| Products                                                                   |       | 579                              |       | 1,476                          |       | 1,186 |   | 2,351 |   |
| Services                                                                   |       | 3,228                            |       | 4,096                          |       | 7,019 |   | 8,219 |   |
| Total cost of  revenues                                                    |       | 3,807                            |       | 5,572                          |       | 8,205 |   | 10,570 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Gross margin                                                               |       | 185                              |       | 483                            |       | 574 |   | 1,354 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                                       |       |                             |       |                           |       |   |   |   |   |
| Selling, general  and administrative                                       |       | 1,040                            |       | 1,864                          |       | 2,417 |   | 3,954 |   |
| Impairment of  goodwill                                                    |       | —                           |       | —                         |       | 2,346 |   | — |   |
| Impairment loss  on intangible assets                                      |       | —                           |       | 145                            |       | — |   | 145 |   |
| Research and  development                                                  |       | 25                               |       | 165                            |       | 60 |   | 1,182 |   |
| Total operating  expenses                                                  |       | 1,065                            |       | 2,174                          |       | 4,823 |   | 5,281 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating loss                                                             |       | (880                             | )          | (1,691                         | )          | (4,249 | ) | (3,927 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Other income  (expense):                                                   |       |                             |       |                           |       |   |   |   |   |
| Amortization of  debt issuance costs                                       |       | (68                              | )          | (46                            | )          | (131 | ) | (87 | ) |
| Interest and  other income                                                 |       | 1                                |       | 2                              |       | 2 |   | 99 |   |
| Interest expense                                                           |       | (1,338                           | )          | (1,497                         | )          | (4,639 | ) | (2,926 | ) |
| Foreign exchange                                                           |       | —                           |       | 7                              |       | — |   | 7 |   |
| Loss on  extinguishment of debt                                            |       | —                           |       | —                         |       | (1,381 | ) | — |   |
| Gain on  derivative instruments                                            |       | —                           |       | 491                            |       | — |   | 504 |   |
| Equity in net  loss of investee                                            |       | —                           |       | (38                            | )          | — |   | (80 | ) |
| Total other  income (expense), net                                         |       | (1,405                           | )          | (1,081                         | )          | (6,149 | ) | (2,483 | ) |
| Loss from  continuing operations before income taxes and minority interest |       | (2,285                           | )          | (2,772                         | )          | (10,398 | ) | (6,410 | ) |
| Income tax  expense                                                        |       | —                           |       | —                         |       | — |   | — |   |
| Minority  interest in operations of consolidated subsidiary                |       | —                           |       | 11                             |       | — |   | 111 |   |
| Loss from  continuing operations                                           |       | (2,285                           | )          | (2,761                         | )          | (10,398 | ) | (6,299 | ) |
| Discontinued  operations:                                                  |       |                             |       |                           |       |   |   |   |   |
| Gain on  operations of discontinued operations, net of income taxes        |       | —                           |       | —                         |       | — |   | 37 |   |
| Gain on disposal  of discontinued operations, net of income taxes          |       | —                           |       | —                         |       | — |   | 516 |   |
| Gain on  discontinued operations, net of income taxes                      |       | —                           |       | —                         |       | — |   | 553 |   |
| NET LOSS                                                                   |       | $                                | (2,285     | )                              | $          | (2,761 | ) | $ | (10,398 | ) | $ | (5,746 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| **Net  loss per share—basic and diluted**                             |       |                             |       |                           |       |   |   |   |   |
| Continuing operations                                                      |       | $                                | (.10       | )                              | $          | (.22 | ) | $ | (.51 | ) | $ | (.50 | ) |
| Discontinued  operations                                                   |       | $                                | (.00       | )                              | $          | (.00 | ) | $ | (.00 | ) | $ | .04 |   |
| Attributable to  common stockholders                                       |       | $                                | (.10       | )                              | $          | (.22 | ) | $ | (.51 | ) | $ | (.46 | ) |
| Weighted average  common shares used in computing per share information    |       | 22,636                           |       | 12,658                         |       | 20,506 |   | 12,656 |   |

 

Seenotes to condensed consolidated financial statements.

 

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**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands, except shareamounts)**

**(Unaudited)**

 
| ** **                                                                                         | ** ** | **Six Months Ended October 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
|                                                                                               |       |                                                 |       |   |   |
| Net cash used in  operating activities                                                             |       | $                                                    | (1,211     | ) | $ | (815 | ) |
|                                                                                               |       |                                                 |       |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                             |       |                                                 |       |   |   |
| Purchases of  property and equipment                                                               |       | (4                                                   | )          | (79 | ) |
| Proceeds from  the sale of assets held for sale, net of selling costs                              |       | 221                                                  |       | 60 |   |
| Proceeds from  sale of discontinued operations, net of selling costs                               |       | —                                               |       | 805 |   |
| Cash provided by  investing activities                                                             |       | 217                                                  |       | 786 |   |
|                                                                                               |       |                                                 |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                             |       |                                                 |       |   |   |
| Principal  payments under capital lease obligations                                                |       | (241                                                 | )          | (230 | ) |
| Principal  payments on borrowings                                                                  |       | (134                                                 | )          | (544 | ) |
| Proceeds from  the issuance of term debt and related common stock warrants, net of offering  costs |       | 1,000                                                |       | — |   |
| Cash provided by  (used in) financing activities                                                   |       | 625                                                  |       | (774 | ) |
|                                                                                               |       |                                                 |       |   |   |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                                         |       | (369                                                 | )          | (803 | ) |
| Cash and cash  equivalents at beginning of period                                                  |       | 927                                                  |       | 1,556 |   |
| Cash and cash  equivalents at end of period                                                        |       | $                                                    | 558        |   | $ | 753 |   |
|                                                                                               |       |                                                 |       |   |   |
| Supplemental  disclosure of cash flow information:                                                 |       |                                                 |       |   |   |
| Cash paid during  the period for:                                                                  |       |                                                 |       |   |   |
| Interest                                                                                           |       | $                                                    | 78         |   | $ | 139 |   |
| Income taxes                                                                                       |       | $                                                    | —     |   | $ | — |   |
|                                                                                               |       |                                                 |       |   |   |
| Supplemental  disclosure of noncash investing and financingactivities:                             |       |                                                 |       |   |   |
| Capital lease  obligation for property and equipment                                               |       | $                                                    | —     |   | $ | 628 |   |
| Payment in  common stock of principal due on convertible debentures                                |       | $                                                    | 73         |   | $ | — |   |

 

Seenotes to condensed consolidated financial statements.

 

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**Isonics Corporation andSubsidiaries**

** **

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**NOTE 1- BASIS OF PRESENTATION**

 

The accompanying condensed consolidated balancesheet as of April 30, 2008, has been derived from audited financialstatements. The accompanying unaudited interim condensed consolidated financialstatements of Isonics Corporation and Subsidiaries have been prepared on thesame basis as the annual audited financial statements and in accordance withaccounting principles generally accepted in the United States (“US GAAP”) forinterim financial information and the rules and regulations of theSecurities and Exchange Commission (“SEC”) for interim financial statements. Inthe opinion of management, such unaudited information includes all adjustments(consisting only of normal recurring accruals) necessary for a fair presentationof 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 in this report should be read inconjunction with our audited consolidated financial statements and notesthereto included in our Annual Report on Form 10-K for the year ended April 30,2008.

 

***Going Concern***

 

As of October 31,2008, we had a working capital deficit of $(20,162,000) and a stockholders’deficit of $(14,976,000).  Furthermore,included in current liabilities are $15,833,000 of convertible debentures andterm notes (both net of related discounts) for which we may not be in compliancewith certain covenants. As a result and as described in Note 6, the holder mayhave the right to call such debentures and term notes for the full-face amountof $19,003,900 plus accrued interest. In addition, we incurred significantlosses from operations and used significant cash flow to fund operations forthe periods presented. Historically, we have relied upon outside investor fundsto maintain our operations and develop our business. Although we raised anadditional $1,352,500 (net of expenses) through the issuance of $1,550,000 ofterm notes in June and November 2008 (see Note 6), we anticipate wewill continue to require funding from investors to finance our negative cashflow as well as business expansion during this fiscal year and we can provideno assurance that additional investor funds will be available on termsacceptable to us. These conditions raise substantial doubt about our ability tocontinue operations as a going concern.

 

In December 2008, asa result of a garnishment of our bank account, approximately $200,000 in fundsare not available to us, resulting in our inability to be able to meet certaincorporate obligations. This garnishment has exacerbated our liquidity shortage.We anticipate that YA Global will take action to enforce its security interestin those funds.

 

Our ability to continue as a going concern is dependent upon raisingcapital through debt or equity financing and by increasing revenue andultimately achieving positive cash flow and profitable operations. We havesubstantial limitations on our ability to raise additional financing, and wecan offer no assurance that we will be successful in our efforts to raiseadditional funds or achieve positive cash flow or profitable operations. Theaccompanying condensed consolidated financial statements have been prepared ona going concern basis, which contemplates the realization of assets and thesettlement of liabilities in the normal course of business.

 

**NOTE 2 - SIGNIFICANT ACCOUNTINGPOLICIES**

 

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

 

Basic net income (loss) per share is computed using the weightedaverage number of common shares outstanding during the period. Contingentlyissuable shares are included in the computation of basic net income (loss) pershare when the related conditions are satisfied. Diluted net income (loss) pershare is

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

computed using the weighted average number of commonshares and potentially dilutive securities outstanding during the period.  Potentially dilutive securities consist ofcontingently issuable shares, the incremental common shares issuable uponconversion of convertible debt (using the “if converted” method) and sharesissuable upon the exercise of stock options and warrants (using the “treasurystock” method).  Potentially dilutivesecurities are excluded from the computation if their effect is anti-dilutive.

 

As of October 31, 2008, (a) a total of31,481,500 outstanding stock options and common stock warrants and (b) theunissued shares underlying our outstanding convertible debentures (with acumulative outstanding face amount of $11,858,900 at October 31, 2008)were excluded from the diluted net loss per share calculation, as theirinclusion would be anti-dilutive.  As of October 31, 2007, (a) atotal of 5,112,125 outstanding stock options (excluding 3,550,000 stock optionsnot deemed granted under US GAAP because the underlying plan or increase to theunderlying plan had not been approved by our shareholders) and common stockwarrants and (b) the unissued shares underlying our outstandingconvertible debentures (with a cumulative outstanding face amount of$18,0000,000 at October 31, 2007) were excluded from the diluted net lossper share calculation, as their inclusion would be anti-dilutive.

 

During the six months ended October 31, 2008,we issued the following shares of common stock:

** **
| **Description**                                          | ** ** | **Number of Common Stock Shares** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Balance as of  April 30, 2008                       |       | 16,063,026                                            |       |
| Shares issued  upon conversion of convertible debentures |       | 10,685,226                                            |       |
| Balance as of  October 31, 2008                     |       | 26,748,252                                            |       |

 

The aforementioned equity transactions increasedcommon stock in the accompanying condensed consolidated balance sheets by$65,000 for the six months ended October 31, 2008.

 

***Recently Issued Accounting Standards***

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”).SFAS 157 provides guidance for using fair value to measure assets andliabilities.  The FASB believes thestandard also responds to investors’ requests for expanded information aboutthe extent to which companies measure assets and liabilities at fair value, theinformation used to measure fair value and the effect of fair valuemeasurements on earnings.  The provisionsof SFAS 157 are to be applied prospectively as of the beginning of the fiscalyear in which SFAS No. 157 is initially applied.  SFAS 157 applies whenever other standardsrequire (or permit) assets or liabilities to be measured at fair value but doesnot expand the use of fair value to any new circumstances.  SFAS 157 for financial assets and liabilitieswas effective for us on May 1, 2008. On May 1, 2009 SFAS 157 will also apply to non-financial assets andliabilities.  The adoption of SFAS 157for financial assets and liabilities did not have a material impact on ourfinancial position or results of operations. FASB Staff Position SFAS 157-2 *EffectiveDate FASB Statement No. 157*(“FSP FAS 157-2”) delays theeffective date of SFAS 157 for non-financial assets and liabilities, except foritems recognized or disclosed at fair value in the financial statements on arecurring basis (at least annually).  Wedo not expect the application of FSP FAS 157-2 will have a material impact onour financial position or results of operations.

 

In February 2007,the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS159”).  SFAS 159 provides the option toreport certain financial assets and liabilities at fair value, with the intentto mitigate volatility in financial reporting that can occur when relatedassets and liabilities are recorded on different bases.   SFAS 159also amends SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, by providingthe option to record unrealized gains

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

and losses onheld-for-sale and held-to-maturity securities currently.  SFAS 159was effective for us on May 1, 2008, including interim periods within thisfiscal year.  The implementation of FAS159 did not have a material impact on our financial position or results ofoperations.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS 141(R)”), which establishesprinciples and requirements for how an acquirer recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,and any noncontrolling interest in an acquiree, including the recognition andmeasurement of goodwill acquired in a business combination.  SFAS 141(R) is effective for our fiscalyear commencing May 1, 2009. Earlier adoption is prohibited. We are currently evaluating the impact of adopting SFAS 141(R) onour results of operations and financial condition.

 

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

 

**NOTE 3 – FINANCIAL STATEMENT COMPONENTS**

 

***Inventories***

 

Inventories consist of the following (in thousands):

 
| ** **              | ** ** | **October 31, 2008** | ** ** | **April 30, 2008** | ** ** |
|-------------------------|------------|--------------------------------|------------|------------------------------|------------|
| Finished goods          |       | $                              | 96         |                         | $          | 187 |   |
| Work in process         |       | 52                             |       | 25                           |       |
| Materials and  supplies |       | 191                            |       | 182                          |       |
| Total  inventories      |       | $                              | 339        |                         | $          | 394 |   |

 

***Property and equipment***

 

Property andequipment consist of the following (in thousands):

** **
| ** **                                 | ** ** | **October 31, 2008** | ** ** | **April 30, 2008** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| Office furniture  and equipment            |       | $                              | 276        |                         | $          | 351 |   |
| Production  equipment                      |       | 8,868                          |       | 8,822                        |       |
| Vehicles                                   |       | 204                            |       | 204                          |       |
| Construction in  process                   |       | 22                             |       | 66                           |       |
| Leasehold  improvements                    |       | 1,215                          |       | 1,215                        |       |
|                                       |       | 10,585                         |       | 10,658                       |       |
| Accumulated  depreciation and amortization |       | (6,638                         | )          | (5,976                       | )          |
| Total property  and equipment, net         |       | $                              | 3,947      |                         | $          | 4,682 |   |

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 4 –SEGMENT INFORMATION**

 

We currently have tworeportable segments: security services and silicon products and services.  Our security services segment providessecurity and investigative services and is substantially comprised of theoperations of Protection Plus Security Corporation (“PPSC”).  Our silicon products and services segmentprovides 300-millimeter(and smaller diameter) test wafers and reclamation services, wafer thinning andcustom wafer products and services for the silicon industry.  Our segments are strategic businessunits, each of which consists of similar products or services.  They are managed separately because eachsegment requires different technology and marketing strategy and because eachsegment sells to different customers from different locations.  Reconciling items consist primarily ofcorporate assets or expenses that have not been allocated to a specificreportable segment and the assets and results of operations of our formerhomeland security products segment.  Ourformer homeland security products segment included both the operations of ourIon Mobility Spectroscopy (“IMS”) technology and, through our 90%-owned subsidiarySenseIt Corp, the development of next-generation infrared imaging and nightvision technology through our Development and Licensing Agreement with LucentTechnologies, Inc. (“Lucent”).  Weno longer consider homeland security products to be a reportable segment due tothe suspension of these segment operations during our year ended April 30,2008.  Prior period amounts have beenreclassified to conform to the current period presentation.

 

Information by segment is set forth below (inthousands):

 
| ** **                     | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|--------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                           | ** ** | **2007**                                         | ** ** | **2008** | ** ** | **2007** | ** ** |
| Segment  revenues:             |       |                                               |       |                                             |       |   |   |   |   |
| Security  services             |       | $                                                  | 2,465      |                                             | $          | 3,866 |   | $ | 5,738 |   | $ | 7,622 |   |
| Silicon products  and services |       | 1,527                                              |       | 1,994                                            |       | 3,041 |   | 4,107 |   |
| Reconciling  amounts (1)       |       | —                                             |       | 195                                              |       | — |   | 195 |   |
| Total                          |       | $                                                  | 3,992      |                                             | $          | 6,055 |   | $ | 8,779 |   | $ | 11,924 |   |

 
| ** **                        | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **2008**                                 | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Segment  operating (loss) income: |       |                                     |       |                                   |       |   |   |   |   |
| Security  services                |       | $                                        | 36         |                                   | $          | 253 |   | $ | (2,203 | ) | $ | 323 |   |
| Silicon products  and services    |       | (538                                     | )          | (598                                   | )          | (1,094 | ) | (959 | ) |
| Reconciling  amounts (2)          |       | (378                                     | )          | (1,346                                 | )          | (952 | ) | (3,291 | ) |
| Total                             |       | $                                        | (880       | )                                      | $          | (1,691 | ) | $ | (4,249 | ) | $ | (3,927 | ) |

 
| ** **                     | ** ** | **October 31,** | ** ** | **April 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|----------------------|------------|--------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | **2008**             | ** ** | **2008**           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets:                  | ** ** | ** **           | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Security  services             |       | $                    | 3,607      |               | $          | 6,127      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Silicon products  and services |       | 5,034                |       | 5,964              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Reconciling  amounts (3)       |       | 409                  |       | 670                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total                          |       | $                    | 9,050      |               | $          | 12,761     | ** ** | ** ** | ** ** | ** ** | ** ** |

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

----

| (1)    |   | Reconciling amounts for revenues  information consists of revenue from our former homeland security products  segment.                                                                                                                                                                                                         |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                           |
| (2)    |   | Reconciling amounts for the operating  (loss) income information includes corporate expenses consisting primarily of  corporate salaries and benefits, professional and consulting fees, investor  relations costs, insurance, directors’ compensation and the results of our  former homeland security products segment. |
|   |   |                                                                                                                                                                                                                                                                                                                           |
| (3)    |   | Reconciling amounts for the total asset  information includes corporate assets consisting primarily of cash and cash  equivalents invested centrally, unamortized debt issuance costs and  miscellaneous prepaid items, as well as the assets of our former homeland  security products segment.                               |

 

**NOTE 5–IMPAIRMENT OF GOODWILL**

 

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

 

**NOTE 6 –BORROWINGS**

 

**June 2008Term Note**

 

On June 13, 2008, we completed a privateplacement pursuant to which we issued to one accredited investor, YA GlobalInvestments, L.P. (“YA Global”), a 13% term promissory note in the principalamount of $1,175,000 (the “June 2008 Term Note”), of which the entireamount remains outstanding as of October 31, 2008, but offset by adiscount of $306,000 for financial statement presentation.  In addition we issued to YA Global 13,000,0000common stock warrants which are exercisable at $.03 per share and expire on June 13,2015.

 

The June 2008 Term Note bears an interest rateof 13% per annum, is secured by individual security agreements with IsonicsCorporation, Isonics Vancouver, Inc. (“IVI”), Isonics Homeland Securityand Defense Corporation (“HSDC”) and PPSC and both interest and principal aredue in cash on October 31, 2009.  AtOctober 31, 2008, accrued interest payable on the June 2008 Term Notewas $59,000 and is included in the caption “accrued interest” in theaccompanying condensed consolidated balance sheets.

 

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

 

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

 

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** **

**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

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

 

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

 

We allocated the net proceeds received between the June 2008Term Note and the related warrant based on the relative fair value of eachinstrument.  The $227,000 allocated tothe warrant was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the June 2008 Term Note.  The cumulative discount in the amount of$402,000 (arising from the allocation of a portion of the proceeds to the relatedwarrants and the cash fees paid to YA Global) is being amortized to interestexpense over the term of the June 2008 Term Note using the effectiveinterest method at an effective interest rate of 44%.  During the six months ended October 31,2008, $96,000 of discount was amortized to interest expense.

 

**2006 ConvertibleDebentures**

 

In May, June and November 2006, we issuedto YA Global convertible debentures with a cumulative face amount of$16,000,000 (the “2006 Debentures”) along with detachable common stockwarrants.  During the six months ended October 31,2008, we issued 10,685,226 shares of common stock as repayment of $73,300 ofprincipal amount of the 2006 Debentures. In connection with the issuance of the June 2008 Term Notes,$5,970,000 of the 2006 Debentures were converted to term notes (the “ConvertedTerm Notes”) with the same terms and maturity date as the June 2008 TermNotes.  As a result, as of October 31,2008 we had outstanding 2006 Debentures with a face amount of $9,858,900 andConverted Term Notes with a face value of $5,970,000.  The 2006 Debentures and the Converted TermNotes are recorded in our condensed consolidated balance sheets at carryingamounts (net of discount) of $7,113,000 and $5,970,000, respectively.  Subsequent to October 31, 2008 we issuedan additional 2,604,167 shares of common stock as repayment of $2,400 of 2006Debentures principal.

 

In connection with the conversion of the 2006Debentures to Converted Term Notes, the remaining 2006 Debentures were amendedso that the maturity date was extended from May 31, 2009 to October 31,2009.  Furthermore, the conversion pricewas modified to be the lower of $0.03 or eighty percent of the lowest

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

volume weighted average price (as defined) in theten trading days prior to the conversion date along with the interest ratebeing increased to 13%.

 

As a result of the modification of the fixedconversion price on the remaining 2006 Debentures, we recorded a beneficialconversion feature of $110,000.  Thisamount was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the 2006 Debentures.  The discount related to this beneficialconversion feature is being amortized to interest expense over the remainingterm of the 2006 Debentures using the effective interest method which resultedin amortization of $30,000 for the six months ended October 31, 2008.  In addition, the original discount is beingamortized to interest expense through October 31, 2009 using the effectiveinterest method, which resulted in amortization of $1,413,000 for the sixmonths ended October 31, 2008.  Thecombined discounts on the 2006 Debentures are being amortized to interestexpense using the effective interest method at an effective interest rate of44%.

 

For the six months ended October 31, 2008, werecorded accrued interest associated with the 2006 Debentures of $623,000.  As a result, as of October 31, 2008,cumulative accrued interest associated with the 2006 Debentures is $2,302,000and is included in accrued interest in the accompanying condensed consolidatedbalance sheet.

 

**Converted TermNotes**

 

At the time of the conversion of $5,970,000 of 2006Debentures to Converted Term Notes, the original conversion option waseliminated and as a result, the remaining original discount associated with theConverted Term Notes of $1,546,000 was immediately charged to interestexpense.  For the six months ended October 31,2008, we recorded accrued interest associated with the Converted Term Notes of$377,000.  As a result, as of October 31,2008, cumulative accrued interest associated with the Converted Term Notes is$1,421,000 and is included in accrued interest in the accompanying condensedconsolidated balance sheet.

 

**April 2007Debenture**

 

In April 2007, we issued to YA Global aconvertible debenture with a face amount of $2,000,000 (the “April 2007Debenture”) along with detachable common stock warrants.  For the six months ended October 31,2008, using the effective interest method we amortized $63,000 of the discounton the April 2007 Debenture to interest expense.  As of October 31, 2008, the April 2007Debenture is recorded in our condensed consolidated balance sheet at a carryingamount (net of discount) of $1,881,000. We also recorded accrued interest on the April 2007 Debenture inthe amount of $131,000 for the six months ended October 31, 2008.  As of October 31, 2008, cumulativeaccrued interest is $406,000 and is included in accrued interest in theaccompanying condensed consolidated balance sheet.

 

In connection with the conversion of the 2006Debentures to Converted Term Notes, the April 2007 Debentures were amendedso that the maturity date was extended from May 31, 2009 to October 31,2009.  Furthermore, the conversion pricewas modified to be the lower of $0.03 or eighty percent of the lowest volumeweighted average price (as defined) in the ten trading days prior to theconversion date along with the interest rate being increased to 13%.  We did not record an additional beneficialconversion feature resulting from the modifications as it was not deemed to bematerial.  As a result of themodification of the fixed conversion feature, the discount associated with thebeneficial conversion feature of $1,381,000 was written off as a loss onextinguishment of debt.  As a result, weare now amortizing the remaining discount ($119,000 as of October 31, 2008) through October 31, 2009using the effective interest method at an effective interest rate of 19%.

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**Summary**

 

As of October 31, 2008, we had $8,994,000, netof discount of remaining convertible debentures (the 2006 Debentures and the April 2007Debenture, collectively the “13% Debentures”) and $6,839,000 in outstandingnon-convertible term debt (the June 2008 Term Note and the Converted TermNotes, collectively the “Term Notes”).

 

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

 

**November 2008Term Note**

 

In November 2008, we completed a privateplacement pursuant to which we issued to YA Global, a 13% term promissory notein the principal amount of $375,000 (the “November 2008 Term Note”).  The November 2008Term Note bears interest at 13% per annum, is secured by individual securityagreements with Isonics Corporation, IVI, HSDC and PPSC and both interest andprincipal are due on October 31, 2009. We had been using these funds for day-to-day corporate expenses,including salaries and other corporate expenses.  The funds were subject to the global securityinterest of the lender, YA Global. Nevertheless, a judgment creditor garnished the remaining portion ofthese funds in December 2008, and these funds are no longer available tous for use (see Note 8).  We anticipatethat YA Global will take action to enforce its security interest in thosefunds.

 

**NOTE 7 – ASSETS HELD FOR SALE**

 

During the fourth quarter of our year ended April 30,2008, we committed to a plan to sell one specific piece of production equipmentin our silicon products and services segment. Based on ongoing analysis of the silicon operations, this asset wasdeemed to be unnecessary to support our current operations.  This asset, with a net book value of $212,000as of April 30, 2008 was sold by our silicon products and servicessubsidiary, IVI in May 2008 for net proceeds of $221,000, resulting in anet gain of $9,000.  In addition, we areexploring the possibility of the sale of other corporate assets, in all casessubject to compliance with YA Global’s security interest in our assets.

 

**NOTE 8 – LEGAL CONTINGENCIES**

 

In February 2007, we entered into aSettlement Agreement and Mutual Release with James E. Alexander, our formerChief Executive Officer, President and Chairman of the Board of Directors (our “FormerCEO”) whereby he resigned his positions, terminated his employment agreementwith us and accepted specified cash-based and stock-based remuneration for theensuing twelve months.  During August 2007,due to a lack of sufficient liquidity and a working capital deficit, we stoppedmaking the contractually required payments to our Former CEO.  As a result, as of April 30, 2008 we hadan accrued liability in the amount of $118,000, which represented the remainderof the contractual amounts due.

 

On July 22, 2008 ourformer CEO filed a complaint against us in the Jefferson County, Colorado,District Court.  The complaint alleged that we breached the SettlementAgreement and Mutual General Release

 

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**IsonicsCorporation and Subsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

entered into by Mr. Alexanderand the Company in February 2007.  We did not contest thecomplaint.  As a result, Mr. Alexanderobtained a judgment of approximately $190,000 (including attorneys fees,statutory interest and statutory penalties). As a result of the judgment, we increased our accrued liability to $190,000,which resulted in a charge to selling, general and administrative expensesof  $72,000 during the six months ended October 31,2008.

 

In an effort to collect on his judgment, in December 2008our Former CEO garnished one of our bank accounts and has prevented our accessto approximately $200,000 of the funds we were using for our day-to-dayoperations, including salaries for our operating personnel.  We believe that the garnishment, whichattempts to take possession of assets in which YA Global has a securityinterest, is improper, and we anticipate that YA Global will seek to enforceits security interest.

 

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

 

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

 

**NOTE 9– COMMITMENTS AND CONTINGENCIES**

 

As of October 31, 2008, we had nocommitments outstanding for capital expenditures.

 

**NOTE 10- SUBSEQUENT EVENTS**

 

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

 

Effective October 31,2008 (and as reported in a Form 8-K as of that date), we terminatedvarious employment agreements with persons who were then our senior officers,and we entered into a new employment agreement with Christopher Toffales, thenour Chairman of the Board and Chief Executive Officer, who became ourPresident.  At the same time, George O’Leary,a member of the board of directors became our Chief Financial Officer.

 

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**Item 2:  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*Certainstatements in this report, other than purely historical information, includingestimates, projections, statements relating to our business plans, objectivesand expected operating results, and the assumptions upon which those statementsare based, are “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements generallyare identified by the words “believe,” “expect,” “intend,” “estimate,” “anticipate,”“project,” “will,” “plan,” “will continue,” “will likely result” and similarexpressions.  Forward-looking statementsare based on current expectations and assumptions that are subject to risks anduncertainties which may cause actual results to differ materially from theforward-looking statements.  A detaileddiscussion of these and other risks and uncertainties that could cause actualresults and events to differ materially from such forward-looking statements isincluded in the section entitled “Risk Factors” (refer to Item 1A of our Form 10-Kfor the year ended April 30, 2008 and the risks identified elsewhereherein).  **A significant risk of which all reading this report should be aware isthat we have significant cash shortages as a result of a garnishment, whichblocked our access to our principal bank account and has resulted in ourinability to meet certain corporate obligations.**  We undertake no obligation to update or revisepublicly any forward-looking statements, whether as a result of newinformation, future events or otherwise.*

 

***GeneralDiscussion***

 

Weare focused on the provision of security services and 300-millimeter (andsmaller diameter) test wafers and reclamation services, wafer thinning andcustom wafer products and services for the silicon industry.  As a result of working capital shortagespreviously reported in our quarterly and annual reports and the garnishmentresulting from a judgment, we have limited to no ability to finance ourday-to-day operations and we cannot offer any assurance that we will be able tocontinue operations into calendar year 2009 without the infusion of capitaland/or the sale of assets approved by YA Global.

 

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

 

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

 

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

 

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agreement for thedevelopment of next-generation infrared imaging and night vision surveillancetechnology.

 

Consistentwith management focus during the year ended April 30, 2008 and the sixmonths ended October 31, 2008, we continue to evaluate our operatingbusinesses and technology portfolio with the goal of operating our businessmore efficiently and monetizing assets as we deem to be appropriate and as oursenior secured creditor may consent. Additionally, we have considered and will continue to consider businessexpansion through merger, acquisition, joint venture or other means, althoughwe can offer no assurance as to our ultimate success in increasing the scope ofour business through such means.  Becausesubstantially all of our assets are subject to a perfected security interest,we have in the past, and will likely continue to engage in discussions on theseissues with YA Global as our primary debt holder.

 

Liquidity and Capital Resources

 

Wehave had liquidity shortages in the past and, although we raised $1,000,000(net of expenses) through the issuance of $1,175,000 of Term Notes to YA Globalin June 2008 and an additional $352,500 (net of expenses) through the issuanceof $375,000 of Term Notes to YA Global in November 2008, we have generatedsignificant losses, which have exacerbated our working capital deficit.  As of October 31, 2008, our condensedconsolidated balance sheet reflects a working capital deficit of$(20,162,000).  In addition, as a resultof our continued operating losses, working capital deficit and negative cashflow during the year ending April 30, 2008, the auditors report includedwith our financial statements for the year ended April 30, 2008 includesan explanatory paragraph indicating substantial doubt about our ability tocontinue as a going concern.  Thiscondition has continued since the date of those financial statements, and weexpect that these conditions will continue for the foreseeable future unless weare able to raise a substantial amount of additional financing (of which therecan be no assurance and which would be subject to the approval of YA Global).

 

Currently, we may not bein compliance with certain covenants of the remaining 13% Debentures and, inthe June financing, YA Global refused to waive any non-compliance with theearlier financing documents.  Inaddition, we have not been able to comply with certain financial covenants ofthe Term Notes during the six months ended October 31, 2008 and as aresult YA Global may, in its discretion, declare an event of default on thosenotes.  If YA Global were to declare anevent of default under the 13% Debentures or the Term Notes it would likelyhave the legal right to foreclose against its security interest and takecontrol of, and/or dispose of, the assets subject to its securityinterest.  Although YA Global has not yetdeclared an event of default, and although we are continuing to have discussionswith YA Global with the aim to further our business operations, we can offer noassurance that YA Global will not declare an event of default under the 13%Debentures or the Term Notes and seek to collect the amounts due by foreclosureon our assets.  In addition, a judgmentcreditor, our Former CEO, has sought to garnish approximately $200,000, whichhas resulted in our inability to meet certain corporate obligations andconsequently, we may not be able to continue operations into calendar year 2009without the infusion of capital and/or sale of assets approved by YA Global.

 

As a result of oursignificant working capital deficit and lack of operating funds resulting fromthe garnishment, we are financing our operations and negative cash flow fromour liquid assets, which we allocate to pay our most urgent obligations.  During the six months ended October 31,2008, we used $1,211,000 in operating activities.  At our current burn rate, it is unclear ifour remaining liquidity is sufficient to finance our anticipated operations andprojected negative cash flow into calendar year 2009.  In addition, it is unlikely that we will beable to continue the operations of the parent corporation beyond the nearfuture without immediate additional financing from the sale of assets or afurther investment by our principal creditor, YA Global, neither of which canbe assured.  If we are able to secure anoffer for asset based financing from a third party, YA Global has agreed toreview that proposed financing and, in its sole discretion, consider releasingits security interest in certain of our assets to secure that financing.  Because

 

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of theterms of the existing YA Global financing, we are unable to collateralize anyadditional financing without YA Global’s consent and approval.

 

See additional discussion of liquidity and capital resources in the Liquidityand Capital Resources section included further below in this Item 2: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.

 

Security Services

 

Since the effectivedate of our acquisition of PPSC in May 2005, PPSC has deliveredsignificant revenue to our condensed consolidated financial statements and hasprovided gross margins of approximately 22% and 23% of revenues for the sixmonths ended October 31, 2008 and 2007, respectively.

 

During the fourthquarter of our year ended April 30, 2007, and subsequently, we implementedcost cutting initiatives that have positively impacted the results of PPSC’soperations.  Additionally we initiatedplans (with limited success) to improve operating margins at PPSC by focusingon customers that are willing to pay for premium security services, a market inwhich we believe that PPSC is able to differentiate itself from its peers.  The segment generated an operating loss of$(2,203,000) for the six months ended October 31, 2008 as compared tooperating income of $323,000 for the six months ended October 31, 2007primarily due to the inclusion of a $2,346,000 non-cash writedown of goodwillduring the six months ended October 31, 2008 (see additional discussionbelow).

 

While these costcutting initiatives and focused sales and marketing efforts have enabled PPSCto positively impact its results for the six months ended October 31,2008, the industry is cost competitive and customers switch security serviceproviders on short notice.  In addition,effective August 1, 2008, one of our significant customers (who accountedfor $802,000 of revenue for the three months ended July 31, 2008) is nolonger using our services.  This customeraccounted for $1,459,000 of revenue for the six months ended October 31,2007.  As a result of these factors andthe $2,346,000 impairment of goodwill, it is unlikely that we will be able togenerate positive operating income in this segment for the year ending April 30,2009 even assuming that we are able to continue operations through that periodnotwithstanding our cash and working capital deficits.  In addition, we can offer no assurance thatPPSC will be able to contribute positive cash flow as well.

 

Silicon Products andServices

 

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

 

While we reported significantrevenue and operating income growth in our silicon operations for the yearended April 30, 2007, many of our top silicon customers experiencedweakened business results during our year ended April 30, 2008.  In addition, some customers reportedinventory buildup in reclaim and/or test products while one other top customerceased doing business with us as we could no longer meet the requiredspecifications for their product.  As aresult of these factors, during the year ended April 30, 2008, weexperienced a slowdown in orders and a reduction in average selling prices ofreclaim and test materials, which had a negative impact on our results.  This trend has continued through the sixmonths ended October 31, 2008.

 

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The slowdown significantlyimpacted our revenues, results of operations and cash flows from our siliconproducts and services segment for the six months ended October 31, 2008and 2007, in which we generated operating losses of $(1,094,000) and$(959,000), respectively.

 

In order to minimize the effectof the continuing slowdown, during our year ended April 30, 2008 weimplemented many cost cutting measures in our silicon operations and arecontinuing to do so.  We have alsoincreased our marketing efforts and are hopeful that we will see a recoveryduring the year ending April 30, 2009 if our cash resources allow us tocontinue operations through that period (which cannot be assured).  During the latter portion of our year ended April 30,2008 and into our six months ended October 31, 2008 we have started toobtain new customers (both large and smaller diameters) and are in the processof attempting to qualify our products at others.  In an effort to control our marketingexpenses, in August 2008 we entered into a distribution agreement withSilicon Quest International, Inc. (“SQI”), by which SQI agreed to act asan exclusive independent contractor to market, sell and distribute our siliconproducts and services to customers who are not previously our customers.  We continue to monitor our silicon operationclosely and while we are hopeful that we will see improving financial resultsin this operating segment over the long-term, we cannot offer any assurancethat we will be able to regain or sustain operating profitability in futureperiods.

 

***Results of Operations***

 

The following table sets forth, for the periodsindicated, condensed consolidated statements of operations data expressed as apercentage of revenues.  The table andthe discussion below should be read in conjunction with the condensedconsolidated financial statements and the notes thereto appearing elsewhere inthis report.  This should also be readwith an understanding of the significant cash shortages that we currently have,which are discussed more completely above in *Liquidityand Capital Resources*.

* *
|                                                                       |   | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|--------|----------------------------------|------------|--------------------------------|------------|
|                                                                       |   | **October 31,**             | ** ** | **October 31,**           | ** ** |
|                                                                       |   | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                       |   |                             |       |                           |       |   |   |   |   |
| Revenues                                                                   |   | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                                                           |   | 95.4                             |       | 92.0                           |       | 93.5 |   | 88.6 |   |
| Gross margin                                                               |   | 4.6                              |       | 8.0                            |       | 6.5 |   | 11.4 |   |
|                                                                       |   |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                                       |   |                             |       |                           |       |   |   |   |   |
| Selling, general  and administrative                                       |   | 26.1                             |       | 30.8                           |       | 27.5 |   | 33.2 |   |
| Impairment of  goodwill                                                    |   | —                           |       | —                         |       | 26.7 |   | — |   |
| Impairment loss  on intangible assets                                      |   | —                           |       | 2.4                            |       | — |   | 1.2 |   |
| Research and  development                                                  |   | 0.6                              |       | 2.7                            |       | 0.7 |   | 9.9 |   |
| Total operating  expenses                                                  |   | 26.7                             |       | 35.9                           |       | 54.9 |   | 44.3 |   |
| Operating loss                                                             |   | (22.1                            | )          | (27.9                          | )          | (48.4 | ) | (32.9 | ) |
|                                                                       |   |                             |       |                           |       |   |   |   |   |
| Other income  (expense), net                                               |   | (35.2                            | )          | (17.9                          | )          | (70.0 | ) | (20.8 | ) |
| Loss from  continuing operations before income taxes and minority interest |   | (57.3                            | )          | (45.8                          | )          | (118.4 | ) | (53.7 | ) |
| Income tax  expense                                                        |   | —                           |       | —                         |       | — |   | — |   |
| Minority  interest in operations of consolidated subsidiary                |   | —                           |       | 0.1                            |       | — |   | 0.9 |   |
| Loss from  continuing operations                                           |   | (57.3                            | )          | (45.7                          | )          | (118.4 | ) | (52.8 | ) |
| Gain on  discontinued operations, net of income taxes                      |   | —                           |       | —                         |       | — |   | 4.6 |   |
| NET LOSS                                                                   |   | (57.3                            | )%         | (45.7                          | )%         | (118.4 | )% | (48.2 | )% |

 

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***Revenues***

 

Revenues from oursecurity services and silicon products and services segments decreased for thethree and six months ended October 31, 2008, as compared to the sameperiods of our prior fiscal year, as described in the following table:

 
| ** **                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **October 31,**             | ** ** | **October 31,**           | ** ** |
| ** **                     | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Security  services             |       | $                                | 2,465,000  |                           | $          | 3,866,000 |   | $ | 5,738,000 |   | $ | 7,622,000 |   |
| Silicon products  and services |       | 1,527,000                        |       | 1,994,000                      |       | 3,041,000 |   | 4,107,000 |   |
| Reconciling  amounts (1)       |       | —                           |       | 195,000                        |       | — |   | 195,000 |   |
| Total                          |       | $                                | 3,992,000  |                           | $          | 6,055,000 |   | $ | 8,779,000 |   | $ | 11,924,000 |   |

 

----

(1) Reconcilingamounts for revenues information consists of revenue from our former homelandsecurity products segment.

 

The decrease in revenuefrom the security services segment for the three and six months ended October 31,2008, is due to the effect of the loss of several security services contractsduring the year ended April 30, 2008 and the six months ended October 31,2008 partially offset by the addition of new customers as well as by increasesin work performed at certain existing customers.  Effective August 1, 2008, one of oursignificant customers (who accounted for $802,000 of revenue for the threemonths ended July 31, 2008) ceased using our services.  This customer accounted for $1,459,000 ofrevenue for the six months ended October 31, 2007.   As a result, our revenue for the threemonths ended October 31, 2008 was lower than the revenue for both thethree months ended October 31, 2007 and the three months ended July 31,2008.  In an effort to increase ourrevenue, we continue to marketour services aggressively by seeking premiumaccounts that prefer higher quality of service.  While we are hopeful that in the long-term wewill be able to grow revenue in this segment by securing new security contractsin our PPSC subsidiary and retaining existing customers under contractcurrently with PPSC, we cannot provide any assurance that we will be able to doso and we may in the short-term fail to retain certain of our customers.

 

While we reported significantrevenue and operating income growth in our silicon operations for the yearended April 30, 2007, many of our top silicon customers experiencedweakened business results during our year ended April 30, 2008.  In addition, some customers reportedinventory buildup in reclaim and/or test products while one other top customerceased doing business with us as we could no longer meet the requiredspecifications for their product.  As aresult of these factors, during the year ended April 30, 2008, weexperienced a slowdown in orders and a reduction in average selling prices ofreclaim and test materials, which had a negative impact on our results.  This trend has also continued through the sixmonths ended October 31, 2008.

 

Although we have diversified our sources of revenue,we continue to have concentrations of revenue with certain customers.  For the six months ended October 31,2008, two security services customers accounted for 26% and 9% of revenues,respectively, and one silicon products and services customer accounted for 13%of revenues as compared to the six months ended October 31, 2007, in whichtwo security services customers accounted for 19% and 12% of revenues,respectively, and one silicon products and services customer accounted for 12%of revenues.  Significant reductions insales to any of our large customers have had, and may in the future have, amaterial adverse effect on us by reducing our revenues and our grossmargins.  Present or future customerscould terminate their purchasing patterns with us or significantly reduce ordelay the amount of products or services ordered from us.

 

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For the six months ended October 31, 2008, thesilicon products and services customer mentioned above accounted for 38% ofsilicon products and services revenue as compared to 34% for the six monthsended October 31, 2007.  Due to therelationship of revenues to the absorption of fixed facility costs, theelimination or even a significant reduction in sales to this customer wouldhave a material adverse effect on our silicon products and services operations.

 

***Gross Margin***

 

Our gross margindecreased for the three and six months ended October 31, 2008, as comparedto the same periods of our prior fiscal year, both on a dollar amount and on apercentage of revenues, as reflected in the following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                               | ** ** | **2007**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                                      | 185,000    |                                                 | $          | 483,000 |   | $ | 574,000 |   | $ | 1,354,000 |   |
| Percent of  revenues |       | 4.6                                                    | %          | 8.0                                                  | %          | 6.5 | % | 11.4 | % |
|                      |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

The decrease in grossmargin on a percentage basis is due primarily to the downturn in our siliconproducts and services segment resulting in a significant decrease in revenue,which has forced us to allocate our fixed facility costs over a lower revenuebase, correspondingly decreasing gross margins on a percentage basis.  To a lesser extent, the decrease on apercentage basis is also due to the provision of lower prices in order toobtain new or keep existing business. The decrease in gross margin on a dollar basis is due to the decrease inrevenue for both our silicon products and services and security servicessegments.

 

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

 

On a percentage ofrevenues basis, in general we anticipate that the gross margin percentage inour security services segment (within 1-2 percentage points) will remainrelatively stable.  However, as a resultof the ongoing downturn in our silicon products and services segment, we haveexperienced and expect to continue to experience increased competition andlower prices.  As a result, there has beena focus on operational efficiency and effectiveness, which has resulted inincreased productivity and processing yields in order to reduce our costs.  In addition, due to fixed facility costsincluded in cost of revenues in the silicon products and services segment, thegross margin percentage is particularly sensitive to volume and revenuechanges.

 

We have increased ourmarketing efforts and are hopeful that we will see a rebound in our customersdemand and we have (and are hopeful to continue to) added several new siliconproducts and services customers during the year ending April 30,2009.   Effective August 1, 2008, one of oursignificant security services customers (who accounted for $802,000 of revenuefor the three months ended July 31, 2008) ceased using our services.  As a result, our revenues and gross marginfor the three months ending October 31, 2008 was lower than the revenuesand gross margin for both the three months ended October 31, 2007 and July 31,2008. While we are hopefulthat revenues (and corresponding gross margins) will increase (as compared tothe year ended April 30, 2008) for the year ending April 30, 2009, wecan offer no assurance that this will actually occur.

 

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

 

Our selling, general andadministrative expenses decreased both as a dollar amount and as a percentageof revenue for the three and six months ended October 31, 2008, ascompared to the same respective periods of our prior fiscal year, as reflectedin the following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                               | ** ** | **2007**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                                      | 1,040,000  |                                                 | $          | 1,864,000 |   | $ | 2,417,000 |   | $ | 3,954,000 |   |
| Percent of  revenues |       | 26.1                                                   | %          | 30.8                                                 | %          | 27.5 | % | 33.2 | % |
|                      |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

The $1,537,000 decrease in selling, general andadministrative expenses for the six months ended October 31, 2008,compared to the six months ended October 31, 2007 is attributable to acombination of factors, including:

 

·                  approximately $300,000 due to a decrease in staffing and expenditures atthe corporate office,

·                  approximately $300,000 due to a decrease in staffing and expenditures inthe security services segment,

·                  approximately $650,000 due to a decrease in staffing and expenditures inour former homeland security products segment, and

·                  an approximate $270,000 decrease in staffing and expenditures at oursilicon products and services segment.

 

We continue to be actively focused on reducingselling, general and administrative expenses and are hopeful that we will beable to further reduce these expenses for the three months ending January 31,2009 as compared to the three months ended October 31, 2008.  However, any reduction in selling, generaland administrative expenses most likely would be less significant as comparedto the reductions realized for the three months ended October 31, 2008 ascompared to the three months ended October 31, 2007.

 

***Impairment of Goodwill***

 

Our impairment of goodwill increased on both a dollarand a percentage of revenues basis for the six months ended October 31,2008, as compared to the same periods of our prior fiscal year, as reflected inthe following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                               | ** ** | **2007**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                                      | —     |                                                 | $          | — |   | $ | 2,346,000 |   | $ | — |   |
| Percent of  revenues |       | —                                                 | %          | —                                               | %          | 26.7 | % | — | % |
|                      |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

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

 

***Impairment Loss on Intangible Assets***

 

Our impairment loss on intangible assets decreasedon both a dollar and a percentage of revenues basis for the three and sixmonths ended October 31, 2008, 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,** | ** ** |
|----------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                               | ** ** | **2007**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                                      | —     |                                                 | $          | 145,000 |   | $ | — |   | $ | 145,000 |   |
| Percent of  revenues |       | —                                                 | %          | 2.4                                                  | %          | — | % | 1.2 | % |
|                      |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

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The impairment loss for the three and six monthsended October 31, 2007 relates to a write off of the unamortized balanceof the trace and bulk detection technology intangible asset.  Due to suspension of development, manufactureand sale of our IMS-based products, we determined that the trace and bulkdetection technology intangible asset was fully impaired.

 

***Research and Development Expenses***

 

Our research and development expenses decreased onboth a dollar and a percentage of revenues basis for the three and six monthsended October 31, 2008, as compared to the same periods of our priorfiscal year, as reflected in the following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                               | ** ** | **2007**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                                      | 25,000     |                                                 | $          | 165,000 |   | $ | 60,000 |   | $ | 1,182,000 |   |
| Percent of  revenues |       | 0.6                                                    | %          | 2.7                                                  | %          | 0.7 | % | 9.9 | % |
|                      |            |                                                        |            |                                                      |            |  |  |  |  |  |  |  |  |

 

The majority of research and development expensesfor the three and six months ended October 31, 2007 related primarily to (1) thedevelopment of next-generation infrared imaging and night vision surveillancetechnology through our now-terminated Lucent relationship and (2) our IMSbased products.  Due to the terminationof our Lucent relationship and the suspension of development of our IMS-basedproducts, we did not incur material research and development expenses duringthe three and six months ended October 31, 2008 for these projects and wedo not expect to incur material additional research and development expense forany projects during the remainder of our year ending April 30, 2009.

 

Historically a significant amount of the researchand development on the IMS-based products was performed by Institut furUmwelttechnologien GmbH (“IUT”).  Wefunded $0 and $80,000 under our agreement with IUT for the six months ended October 31,2008 and 2007, respectively. As a result of the suspension of the development,manufacture and sale of our IMS-based products as described above, we intend toprovide no further funds pursuant to this agreement.

 

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

 

***Operating(Loss) Income***

 

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

 
| ** **                     | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                               | ** ** | **2007**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Security  services             |       | $                                                      | 36,000     |                                                 | $          | 253,000 |   | $ | (2,203,000 | ) | $ | 323,000 |   |
| Silicon products  and services |       | (538,000                                               | )          | (598,000                                             | )          | (1,094,000 | ) | (959,000 | ) |
| Reconciling  amounts (1)       |       | (378,000                                               | )          | (1,346,000                                           | )          | (952,000 | ) | (3,291,000 | ) |
| Total                          |       | $                                                      | (880,000   | )                                                    | $          | (1,691,000 | ) | $ | (4,249,000 | ) | $ | (3,927,000 | ) |

 

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----

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

 

During the fourth quarter of our year ended April 30, 2007, andsubsequently, we implemented cost cutting initiatives that have positivelyimpacted the results of PPSC’s operations. Additionally we initiated plans (with limited success) to improveoperating margins at PPSC by focusing on customers that are willing to pay forpremium security services, a market in which we believe that PPSC is able todifferentiate itself from its peers.  Thesegment generated an operating loss of $(2,203,000) for the six months ended October 31,2008 as compared to operating income of $323,000 for the six months ended October 31,2007 primarily due to the inclusion of a $2,346,000 non-cash writedown ofgoodwill during the six months ended October 31, 2008.

 

While these cost cutting initiatives and focused sales and marketingefforts have enabled PPSC to positively impact its results for the six monthsended October 31, 2008, the industry is cost competitive and customersswitch security service providers on short notice.  In addition, effective August 1, 2008,one of our significant customers (who accounted for $802,000 of revenue for thethree months ended July 31, 2008) is no longer using our services.  This customer accounted for $1,459,000 ofrevenue for the six months ended October 31, 2007.  As a result of these factors and the$2,346,000 impairment of goodwill, it is unlikely that we will be able togenerate positive operating income in this segment for the year ending April 30,2009 even assuming that we are able to continue operations through that periodnotwithstanding our cash position and working capital deficits.  In addition, we can offer no assurance thatPPSC will be able to contribute positive cash flow as well.

 

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

 

The slowdown significantlyimpacted our revenues, results of operations and cash flows from our siliconproducts and services segment for the six months ended October 31, 2008and 2007, in which we generated operating losses of $(1,094,000) and$(959,000), respectively.

 

In order to minimize theeffect of the continuing slowdown, during our year ended April 30, 2008 weimplemented many cost cutting measures in our silicon operations and arecontinuing to do so.  We have alsoincreased our marketing efforts and are hopeful that we will see a recoveryduring the year ending April 30, 2009 if our cash resources allow us tocontinue operations through that period (which cannot be assured).  During the latter portion of our year ended April 30,2008 and into our six months ended October 31, 2008 we have started toobtain new customers (both large and smaller diameters) and are in the processof attempting to qualify our products at others.  In an effort to control our marketingexpenses, in August 2008 we entered into a distribution agreement withSQI, by which SQI agreed to act as an exclusive independent contractor tomarket, sell and distribute our silicon products and services to customers whoare not previously our customers.  Wecontinue to monitor our silicon operation closely and while we are hopeful thatwe will see improving financial results in this operating segment over thelong-term, we cannot offer any assurance that we will be able to regain orsustain operating profitability in future periods.

 

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* *

***OtherIncome (Expense), net***

 

Other income (expense),net increased on both a dollar and a percentage of revenues basis for the threeand six months ended October 31, 2008, as compared to the same periods ofour prior fiscal year, as reflected in the following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2008**                                | ** ** | **2007**                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                       | (1,405,000 | )                                     | $          | (1,081,000 | ) | $ | (6,149,000 | ) | $ | (2,483,000 | ) |
| Percent of  revenues |       | (35.2                                   | )%         | (17.9                                 | )%         | (70.0 | )% | (20.8 | )% |
|                      |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

Forthe six months ended October 31, 2008, other income (expense), netconsists primarily of interest expense of $(4,639,000), a loss onextinguishment of debt $(1,381,000) and the amortization of debt issuance costsof $(131,000).  Included in interestexpense for the six months ended October 31, 2008 are non-cash charges of$4,528,000 related primarily to the amortization of the discount and theaccrual of interest on our outstanding term notes and convertible debentures.

 

Forthe six months ended October 31, 2007, other income (expense), netconsists of interest expense of $(2,926,000), the amortization of debt issuancecosts of $(87,000) and equity in the net loss of an investee of $(80,000)partially offset by interest and other income of $99,000 and a gain onderivative instruments of $504,000. Included in interest expense for the six months ended October 31,2007 are non-cash charges of $2,752,000 related primarily to the amortizationof the discount and the accrual of interest on our outstanding convertibledebentures.

 

Weexpect that our other expenses will be volatile based on the future timing ofrepayment, if ever, of the remaining convertible debentures and term notes (seethe Liquidity and Capital Resources discussion below).

 

***Income Taxes***

 

Wecurrently operate at a loss and expect to operate at a loss until (if ever) ouroperations begin to generate sufficient revenue. The losses incurred in thecurrent year are not expected to generate an income tax benefit because of theuncertainty of the realization of the deferred tax asset. As a result, we haveprovided a valuation allowance against our net deferred tax asset because,based on available evidence including our continued operating losses, it ismore likely than not that all of the deferred tax assets will not be realized.Additionally, due to certain “change in ownership” rules (as defined bythe IRS), utilization of our federal net operating losses may be subject tocertain annual limitations.

 

***MinorityInterest in Operations of Consolidated Subsidiary***

 

Minority interest in operationsof consolidated subsidiary for the three and six months ended October 31,2008 and 2007 is reflected in the following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2008**                                | ** ** | **2007**                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                       | —     |                                  | $          | 11,000 |   | $ |   |   | $ | 111,000 |   |
| Percent of  revenues |       | —                                  | %          | 0.1                                   | %          |   | % | 0.9 | % |
|                      |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

The amount of minorityinterest in operations of consolidated subsidiary recorded for the six monthsended October 31, 2007, relates to our purchase of a 90% interest inSenseIt Corp in October 2006 and the subsequent operation of thebusiness.  Due to the cancellation of theLucent Agreement, we do not expect minority interest in operations of SenseItto be material in future periods.

 

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***Gain onDiscontinued Operations, net of Income Taxes***

 

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

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2008**                                | ** ** | **2007**                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                       | —     |                                  | $          | — |   | $ | — |   | $ | 553,000 |   |
| Percent of  revenues |       | —                                  | %          | —                                | %          | — | % | 4.6 | % |
|                      |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

In January 2007, wedecided to discontinue the operation of our life sciences business and to putthe assets and business up for sale (which was sold in June 2007).  We decided to sell this business as it nolonger fit our long-term strategy and because of deteriorating businessconditions in the historical, revenue producing products in the segment.  Accounting rules required us to treatthe operations of the life sciences business as discontinued operations wherebythe net financial impact of the operations of the business is combined into asingle line item and prior periods are reclassified for this presentation.  The gain, net of income taxes, resulting fromoperations of the life sciences business was $37,000 for the six months ended October 31,2007.  The gain on sale of the lifesciences business was recorded in the six months ended October 31, 2007,in the amount of $516,000.  Revenue forthe life sciences business, reported in the single line item of gain onoperations of discontinued operations, net of income taxes, was $101,000 forthe six months ended October 31, 2007.

 

***Net Loss***

 

Net loss for the three andsix months ended October 31, 2008 and 2007 is reflected in the followingtable:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2008**                                | ** ** | **2007**                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount        |       | $                                       | (2,285,000 | )                                     | $          | (2,761,000 | ) | $ | (10,398,000 | ) | $ | (5,746,000 | ) |
| Percent of  revenues |       | (57.3                                   | )%         | (45.7                                 | )%         | (118.4 | )% | (48.2 | )% |
|                      |            |                                         |            |                                       |            |  |  |  |  |  |  |  |  |

 

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

 

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

 

**Liquidity and Capital Resources**

 

Given our significantworking capital deficit, we are dependent on our liquidity to fund ouroperations and to pay our vendors. A significant part of our working capitaldeficit includes 13% Debentures, Term Notes, and accrued interest due to YAGlobal.  Because the amounts are due October 31,2009 and with circumstances existing by which YA Global could declare an eventof default and accelerate the obligations, these amounts are characterized ascurrent liabilities.

 

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

 

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| ** **                                                  | ** ** | **As of**                        | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| **(in thousands)**                                          | ** ** | **October 31,********2008** | ** ** | **Change** | ** ** | **April 30,********2008** | ** ** |
| Cash and cash equivalents                                   |       | $                                | 558        |   | $ | (369 | ) | $ | 927 |   |
|                                                        |       |                             |       |   |   |   |   |
| Working capital  deficit                                    |       | (20,162                          | )          | (7,034 | ) | (13,128 | ) |
|                                                        |       |                             |       |   |   |   |   |
| Current portion  of notes payable, net of discount          |       | 6,936                            |       | 6,926 |   | 10 |   |
|                                                        |       |                             |       |   |   |   |   |
| Current portion  of convertible debentures, net of discount |       | 8,994                            |       | (1,521 | ) | 10,515 |   |
|                                                        |       |                             |       |   |   |   |   |
| Total  convertible debentures, face value outstanding       |       | 11,859                           |       | (6,043 | ) | 17,902 |   |
|                                                        |       |                             |       |   |   |   |   |
| Total term  notes, face value outstanding                   |       | $                                | 7,145      |   | 7,145 |   | $ | — |   |
|                                                             |            |                                  |            |  |  |  |  |  |  |  |

 
| ** **                                           | ** ** | **Six months ended**             | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **October 31,********2008** | ** ** | **Change** | ** ** | **October 31,********2007** | ** ** |
| ** **                                           | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash used in  operating activities               |       | $                                | (1,211     | ) | $ | (396 | ) | $ | (815 | ) |
| Net cash  provided by investing activities           |       | 217                              |       | (569 | ) | 786 |   |
| Net cash  provided by (used in) financing activities |       | 625                              |       | 1,399 |   | (774 | ) |
| Net decrease in  cash and cash equivalents           |       | $                                | (369       | ) | $ | 434 |   | $ | (803 | ) |

 

WorkingCapital Deficit

 

Our working capitaldeficit was $(20,162,000) as of October 31, 2008, as compared to a workingcapital deficit of $(13,128,000) as of April 30, 2008. This $7,034,000increase in working capital deficit for the six months ended October 31,2008, is due to a combination of factors, of which the significant factors areset out below:

 

Factors which reduced our working capitaldeficit

 

·      $214,000of unamortized prepaid insurance premiums in excess of the related notespayable;

·      $131,000representing the excess of the proceeds received over the carrying value of theJune 2008 Term Note of $869,000

 

Factors which increased our working capital deficit

 

·      $2,060,000of cash consumed directly in operating activities (calculated as $1,211,000 ofcash used in operating activities, increased by $849,000 of the cash impact ofnet changes in other current assets or liabilities included therein);

·      $3,340,000representing the amortization of the discount on the convertible debentures andterm debt;

·      $1,381,000representing the charge for the modification of the April 2007 Debenture,reflected as an increase in the book value of the April 2007 Debenture;

·      $203,000representing the reclassification of capital leases from long-term to current

 

Based on the amount ofcapital we have remaining, our expected negative cash flow from operations andinvesting activities and our obligations to YA Global, we anticipate that wewill not be able to positively impact our working capital unless we are able torestructure our current obligations due to YA Global.  In order to continue funding our operationsfrom liquidity, we must obtain additional financing (above and beyond the net$352,500 raised from the issuance of an additional Term Note in November 2008)which we 

 

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can obtain only with theconsent of YA Global, and ultimately substantially increase our revenues orreduce our expenses thereby generating positive cash flow from operations and(ultimately) operating income.

 

As a result of oursignificant working capital deficit and the lack of operating funds resultingfrom the garnishment, we are financing our operations and negative cash flowfrom our liquid assets, which we allocate to pay our most urgentobligations.  During the six months endedOctober 31, 2008, we used $1,211,000 in operating activities.  At our current burn rate, it is unclear ifour remaining liquidity is sufficient to finance our anticipated operations andprojected negative cash flow into calendar year 2009.  In addition, it is unlikely that we will beable to continue the operations of the parent corporation beyond the nearfuture without immediate additional financing from the sale of assets or afurther investment by our principal creditor, YA Global, neither of which canbe assured.  If we are able to secure anoffer for asset based financing from a third party, YA Global has agreed toreview that proposed financing and, in its sole discretion, consider releasingits security interest in certain of our assets to secure that financing.  Because of the terms of the existing YAGlobal financing, we are unable to collateralize any additional financingwithout YA Global’s consent and approval.

 

Convertible Debentures and TermNotes

 

In June 2008 we raised $1,000,000 (net ofexpenses) through the issuance of a $1,175,000 Term Note.  In November 2008, we raised anadditional $352,500 (net of expenses) through the issuance of a $375,000 TermNote.  The Term Notes mature on October 31,2009, bear interest at 13% per annum and are collateralized by substantiallyall of our assets.  The Term Notes arenot convertible into our common stock but only repayable in cash.

 

In June 2008, YA Global exchanged two ofthe 2006 Debentures having an aggregate principal balance of $5,970,000 intoTerm Notes.

 

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

 

·      $7,520,000in Term Notes; and

 

·      $11,857,800(net of conversions to common stock) of remaining 13% Debentures.

 

Currently, we may not bein compliance with certain covenants of the remaining 13% Debentures and, inthe June financing, YA Global refused to waive any non-compliance with theearlier financing documents.  Inaddition, we have not been able to comply with certain financial covenants ofthe Term Notes during the six months ended October 31, 2008 and as aresult YA Global may, in its discretion, declare an event of default on thosenotes.  If YA Global were to declare anevent of default under the 13% Debentures or the Term Notes it would likelyhave the legal right to foreclose against its security interest and take controlof, and/or dispose of, the assets subject to its security interest.  Although YA Global has not yet declared anevent of default, and although we are continuing to have discussions with YAGlobal with the aim to further our business operations, we can offer noassurance that YA Global will not declare an event of default under the 13%Debentures or the Term Notes and seek to collect the amounts due by foreclosureon our assets.

 

CashFlows

 

As of October 31, 2008, we had $558,000 ofcash and cash equivalents, a decrease of $369,000 as compared to $927,000 at April 30,2008. Our principal source of funding for the six months ended October 31,2008 was from our existing liquidity as of April 30, 2008 (which existednotwithstanding our significant working capital deficit), the issuance of aTerm Note in June 2008 (with a face value of $1,175,000) for which wereceived net proceeds of $1,000,000 and $221,000 in net proceeds received fromthe sale of assets held for 

 

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sale.  Ourprincipal source of funding for the six months ended October 31, 2007 was$805,000 (net of selling costs of $45,000) received for the sale of our lifesciences business in June 2007.

 

Cash used in operatingactivities of $(1,211,000) and $(815,000) for the six months ended October 31,2008 and 2007, respectively, was primarily the result of a net loss of$(10,398,000) (which included noncash expenses and gains in the net amount of a$(8,333,000) expense) and of $(5,746,000) (which included noncash expenses andgains in the net amount of a $(2,050,000), respectively.

 

Investing activitiesprovided cash of $217,000 and $786,000 for the six months ended October 31,2008 and 2007, respectively. Cash provided by investing activities for the sixmonths ended October 31, 2008, consisted of $221,000 (net of selling costsof $4,000) from the sale of assets held for sale offset by $4,000 expended onadditions of property and equipment. Cash provided by investing activities for the six months ended October 31,2007, consisted of $805,000 (net of selling costs of $45,000) received for thesale of our life sciences business in June 2007 and $60,000 from theassignment of our silicon-28 licenses offset by $79,000 expended on additionsof property and equipment.

 

Financing activitiesprovided cash of $625,000 and used cash of $(774,000) for the six months ended October 31,2008 and 2007, respectively. Cash provided by financing activities for the sixmonths ended October 31, 2008, was due to the issuance of a Term Note in June 2008(with a face value of $1,175,000) for which we received net proceeds of$1,000,000 partially offset by the payments of principal on capital leases andnotes payable in the amounts of $241,000 and 134,000, respectively.  Cash used in financing activities for the sixmonths ended October 31, 2007, consisted of payments of principal oncapital leases and notes payable in the amounts of $230,000 and $544,000,respectively.

 

AdditionalLiquidity Considerations

 

As of October 31,2008, we had no commitments outstanding for capital expenditures.

 

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

 

***Off-Balance Sheet Arrangements***

 

We have no material changes to the disclosure onthis matter made in our Annual Report on Form 10-K for the year ended April 30,2008.

 

***CriticalAccounting Estimates***

 

Our condensed consolidated financial statements areprepared in accordance with generally accepted accounting principles in theUnites States, which require management to make estimates, judgments andassumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes.  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.

 

Management has discussed the development andselection of these critical accounting estimates with our Board of Directorsand the Board of Directors has reviewed the foregoing disclosure.  In addition, there are other items within ourfinancial statements that require estimation, but are not deemed critical asdefined 

 

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above. Changes in estimates used in these and other items could have a materialimpact on our financial statements. We believe that our most criticalaccounting policies and estimates are as follows:

 

*Goodwill*

 

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

 

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

 

During the six months ended October 31, 2008, due to the loss of asignificant customer, we concluded there were sufficient indicators to requireus to perform an analysis to assess whether any portion of our goodwill balanceof $3,631,000 related to our acquisition of PPSC in May 2005 wasimpaired.  In completing our analysis ofthe security services reporting unit, we used the Discounted Cash Flow Method (“DCFMethod”) in which the reporting unit was valued by discounting the projectedcash flows to its present value based upon a risk adjusted discount rate.  As a result of the testing, we determinedthat $2,346,000 of the recorded goodwill had been impaired and was required tobe expensed as a non-cash charge to continuing operations during the six monthsended October 31, 2008.  Inperforming the calculation under SFAS No. 142, we made several assumptionsrequiring significant judgment, including the use of the DCF Method, the numberof years used in the projection, the discount rate and growth assumptions.  If we had elected to use different variables,the outcome of the calculation could have been different.  As of October 31, 2008, we have$1,285,000 of goodwill remaining on our condensed consolidated balance sheet.

 

*Valuation of Equity Transactions*

 

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

 

*Valuation of Convertible Debenture Transactions*

 

We enter into transactions that include debentures that are convertibleinto common stock at rates that may be fixed or variable and also includedetachable common stock warrants.  Weallocate the proceeds from the debenture transactions based on the estimatedfair values of the debentures and the warrants. If the assumptions used, as they relate to volatility, risk-freeinterest rate and estimated life of the warrants 

 

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(including any anti-dilution adjustment provisions) and the fair valueof the debentures (included the specific conversion features) were materiallydifferent, the overall allocation of proceeds for these transactions couldchange significantly.  Further, at timeswe have classified certain embedded conversion features or warrants issued inconvertible debenture transactions as derivative liabilities in accordance withUS GAAP.  The estimates of fair value ofthese derivative liabilities involve complex assumptions in the initial recordingof the liabilities and in the mark-to-market required for each reportingperiod.  If the assumptions used todetermine the fair value of these liabilities were materially different, thevaluation of the liabilities could change significantly.

 

*Stock-Based Compensation Expense*

 

We account for stock-based compensation in accordance with SFAS123(R).  Under the fair value recognitionprovisions of SFAS 123(R), stock-based compensation cost is estimated at thegrant date based on the fair value of the award and is recognized as expenseratably over the requisite service period of the award.  Determining the appropriate fair value modeland calculating the fair value of stock-based awards, which includes estimatesof stock price volatility, forfeiture rates and expected lives, requiresjudgment that could materially impact our operating results.

 

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

 

Not Applicable

 

**Item 4T:Controls and Procedures**

 

*Disclosure Controls and Procedures*

 

As required by Rule 13a-15 under the Securities Exchange Act of1934 (the “1934 Act”), as of October 31, 2008, we carried out anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures.  This evaluation was carried out under thesupervision and with the participation of our Chief Executive Officer (ourprincipal executive officer) and our Chief Financial Officer (our principalfinancial officer).  Based upon and as of the date of that evaluation, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were not effective because of theidentification of material weaknesses in our internal control over financialreporting which are identified in Item 9A(T) included with our AnnualReport on Form 10-K for the year ended April 30, 2008, which we viewas an integral part of our disclosure controls and procedures.

 

Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatinformation required to be disclosed in our reports filed or submitted underthe Securities Exchange Act of 1934 is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms.  Disclosure controls and proceduresinclude, without limitation, controls and procedures designed to ensure thatinformation required to be disclosed in our reports filed under the SecuritiesExchange Act of 1934 is accumulated and communicated to our management, includingour principal executive officer and our principal financial officer, asappropriate, to allow timely decisions regarding required disclosure.

 

*Internal Control Over Financial Reporting*

* *

There have not been anychanges in our internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) promulgated by the SEC under the Exchange Act) during the threemonths ended October 31, 2008 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.  Effective October 31, 2008, our Chief Financial Officerresigned as described in a Form 8-K dated October 31, 2008, filed on November 6,2008.  The board of directors appointed George O’Leary to succeed to theposition of Chief Financial Officer and he has assumed those duties effectiveas of October 31, 2008.  The Chief Executive Officer and the ChiefFinancial Officer are of 

 

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the opinion that thechange has not materially affected, and is not reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**Part II: Other Information**

** **

**Item 1:  Legal Proceedings**

 

On July 22,2008 James E. Alexander, our former CEO, filed a complaint against us in theJefferson County, Colorado, District Court (case no. 08cv3085).  Thecomplaint alleged that we breached the Settlement Agreement and Mutual GeneralRelease entered into by Mr. Alexander and the Company in February 2007. We did not contest the complaint.  As aresult, Mr. Alexander obtained a judgment of approximately $190,000(including attorneys fees, statutory interest and statutory penalties).  Subsequently Mr. Alexander has garnished ourprincipal bank account and has commenced other collection efforts. Weanticipate that YA Global will take action to enforce its security interest inthose funds.

 

**Item 1A: RiskFactors**

 

There are no material changes to the risk factorsset forth in Part I “Item 1A: Risk Factors” in our Annual Report on Form 10-Kfor the year ended April 30, 2008. As a result, we incorporate those risk factors by reference into thisreport.

 

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

 

During the six monthsended October 31, 2008 (and subsequently) we did not enter into anytransactions that were not registered under the Securities Act of 1933, asamended and were not previously reported on a Form 8-K.

 

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

 

None

 

**Item 5: OtherInformation**

 

None

 

**Item 6: Exhibits**

 
| **Exhibits.**                                                          | ** ** | ** **                                                                                                                                                                                                                           |
|------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                   |       |                                                                                                                                                                                                                                 |
|            3.1  | ** ** | Restated  articles of incorporation (incorporated by reference from our Current Report on Form 8-K (File  No. 001-12531), dated June 13, 2007 and filed on June 25,  2007, and incorporated herein by reference. |
|                                                                   |       |                                                                                                                                                                                                                                 |
|            3.2  | ** ** | Restated bylaws (incorporated by  reference from our Current Report on Form 8-K (File No. 001-12531),  dated March 27, 2006, and filed on March 31, 2006, and incorporated  herein by reference.                      |
|                                                                   |       |                                                                                                                                                                                                                                 |
|            10.1 | ** ** | Amended and restated employment  agreement with Christopher Toffales (incorporated by reference from our  current report on Form 8-K dated October 31, 2008 and filed on  November 6, 2008).                          |
|                                                                   |       |                                                                                                                                                                                                                                 |
|            31.1 | ** ** | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) of the  Exchange Act                                                                                                                                  |
|                                                                   |       |                                                                                                                                                                                                                                 |
|            31.2 | ** ** | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) of the  Exchange Act                                                                                                                                  |
|                                                                   |       |                                                                                                                                                                                                                                 |
|            32.1 | ** ** | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                    |
|                                                                   |       |                                                                                                                                                                                                                                 |
|            32.2 | ** ** | Certification  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                    |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized, in the City and County of New York,State of New York, on the 22nd day of December 2008.

 
| Isonics Corporation |
|---------------------|
|                | (Registrant) |
|                |
|                |
| By                  | /s/ Christopher Toffales |   |
|                | Christopher Toffales |
|                | Chief Executive Officer |
|                |   |
|                |   |
| By                  | /s/ George O’Leary |   |
|                | George O’Leary |
|                | Chief Accounting Officer and  Chief Financial Officer |
|                     |  |  |  |

 

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