**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-QSB/A**

 

(**Mark One)**

 
| **ý**                                                                                                                                                       | ** ** | **Quarterly report under Section  13 or 15(d) of the Securities Exchange Act of 1934.** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|
|                                                                                                                                                             |       |                                                                                    |
| **For the quarterly period  ended October 31, 2005**                                                                                                             |
|                                                                                                                                                             |       |                                                                                    |
| **o**                                                                                                                                                            | ** ** | **Transition report under Section  13 or 15(d) of the Exchange Act.**                   |
|                                                                                                                                                             |       |                                                                                    |
| **For the transition period  from            to           ** |

** **

**Commission file number: 001-12531**

 

**ISONICS CORPORATION**

(Exact name of small business issuer as specified in its charter)

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

 

**5906 McIntyre Street**

**Golden, Colorado 80403**

(Address of principal executive offices)

 

**(303) 279-7900**

(Issuer’s telephone number)

 

**N/A**

(Former name, former address and former

fiscal year, if changed since last report)

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the past 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 ý  No o

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act.)  Yes o  No ý

 

Thenumber of shares outstanding of the registrant’s Common Stock, no par value,was 32,498,024 at December 14, 2005.

 

TransitionalSmall Business Disclosure Format (check one):

Yes o  No ý

 

 

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This amendment to the Form 10-QSB of Isonics Corporation is being filedsolely to add Exhibit 10.1, being incorporated by reference from Isonics’ Form8-K reporting an event of December 5, 2005, as amended.

 

2

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**Isonics Corporation and Subsidiaries**

 

**TABLE OF CONTENTS**

 

**FORM 10-QSB**

 
| Part I:    | Financial  Information |                                                                                                                  |
|------------|------------------------|-----------------------------------------------------------------------------------------------------------------------|
|       |                   |                                                                                                                  |   |
|       | Item  1:               | Financial  Statements                                                                                                 |   |
|       |                   |                                                                                                                  |   |
|       |                   | Condensed  Consolidated Balance Sheets as of October 31, 2005 and April 30, 2005                                      |   |
|       |                   | Condensed Consolidated  Statements of Operations for the Three and Six Month Periods Ended October  31, 2005 and 2004 |   |
|       |                   | Condensed Consolidated  Statements of Cash Flows for the Six Month Periods Ended October 31, 2005 and  2004           |   |
|       |                   | Notes to Condensed  Consolidated Financial Statements                                                                 |   |
|       |                   |                                                                                                                  |   |
|       | Item 2:                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                           |   |
|       |                   |                                                                                                                  |   |
|       | Item 3:                | Controls and  Procedures                                                                                              |   |
|       |                   |                                                                                                                  |   |
| Part  II:  | Other  Information     |                                                                                                                  |
|       |                   |                                                                                                                  |   |
|       | Item  1:               | Legal  Proceedings                                                                                                    |   |
|       |                   |                                                                                                                  |   |
|       | Item 2:                | Unregistered  Sales of Equity Securities and Use of Proceeds                                                          |   |
|       |                   |                                                                                                                  |   |
|       | Item 6:                | Exhibits                                                                                                              |   |
|       |                   |                                                                                                                  |   |
| Signatures |                   |                                                                                                                  |

 

3

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**Part I:  Financial Information**

** **

**Item 1:Financial Statements**

 

**IsonicsCorporation and Subsidiaries**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 

**ASSETS**

 
| ** **                                                            | ** ** | **(Unaudited)**      | ** ** | ** **         | ** ** |
|-----------------------------------------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                                                            | ** ** | **October 31, 2005** | ** ** | **April 30, 2005** | ** ** |
| CURRENT ASSETS:                                                       |       |                 |       |               |       |
| Cash and cash  equivalents                                            |       | $                    | 9,559      |               | $          | 21,206 |   |
| Accounts  receivable (net of allowances of $74 and $59, respectively) |       | 2,745                |       | 935                |       |
| Inventories                                                           |       | 1,456                |       | 1,550              |       |
| Prepaid expenses  and other current assets                            |       | 1,806                |       | 153                |       |
| Assets held for  sale                                                 |       | 628                  |       | —             |       |
| Total current  assets                                                 |       | 16,194               |       | 23,844             |       |
|                                                                  |       |                 |       |               |       |
| LONG-TERM ASSETS:                                                     |       |                 |       |               |       |
| Property and  equipment, net                                          |       | 4,970                |       | 5,589              |       |
| Goodwill                                                              |       | 3,593                |       | —             |       |
| Intangible  assets, net                                               |       | 585                  |       | 241                |       |
| Other assets                                                          |       | 1,004                |       | 1,507              |       |
| Total long-term  assets                                               |       | 10,152               |       | 7,337              |       |
|                                                                  |       |                 |       |               |       |
| TOTAL ASSETS                                                          |       | $                    | 26,346     |               | $          | 31,181 |   |

 

**LIABILITIES AND STOCKHOLDERS’EQUITY**

 
| ** **                                                                                                                                                                                                                                                  | ** ** | **(Unaudited)**      | ** ** | ** **         | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                                                                                  | ** ** | **October 31, 2005** | ** ** | **April 30, 2005** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                                                                        |       |                 |       |               |       |
| Accounts payable                                                                                                                                                                                                                                            |       | $                    | 1,306      |               | $          | 1,079 |   |
| Accrued  liabilities                                                                                                                                                                                                                                        |       | 1,458                |       | 1,033              |       |
| Current portion  of obligation under capital lease                                                                                                                                                                                                          |       | 16                   |       | 44                 |       |
| Current portion  of notes payable                                                                                                                                                                                                                           |       | 813                  |       | 672                |       |
| Current portion  of convertible debentures, net of discount                                                                                                                                                                                                 |       | 13,574               |       | 3,025              |       |
| Total current  liabilities                                                                                                                                                                                                                                  |       | 17,167               |       | 5,853              |       |
|                                                                                                                                                                                                                                                        |       |                 |       |               |       |
| Obligations under capital lease, net of current  portion                                                                                                                                                                                                    |       | 44                   |       | 47                 |       |
| Notes payable, net of current portion                                                                                                                                                                                                                       |       | 499                  |       | 653                |       |
| Convertible debentures, net of current portion and  of discount                                                                                                                                                                                             |       | 6,199                |       | 15,040             |       |
|                                                                                                                                                                                                                                                        |       |                 |       |               |       |
| TOTAL LIABILITIES                                                                                                                                                                                                                                           |       | 23,909               |       | 21,593             |       |
|                                                                                                                                                                                                                                                        |       |                 |       |               |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                                                                  |       |                 |       |               |       |
| Preferred Stock;  shares authorized: October 31, 2005-7,582,050; April 30, 2005-7,622,516                                                                                                                                                                   |       |                 |       |               |       |
| Series A  Convertible Preferred Stock—no par value; zero and 6,666 shares issued and  outstanding on October 31, 2005 and April 30, 2005, respectively; zero and  $10 liquidation preference on October 31, 2005 and April 30, 2005,  respectively     |       | —               |       | 5                  |       |
| Series D  Convertible Preferred Stock—no par value; zero and 800 shares issued and  outstanding on October 31, 2005 and April 30, 2005, respectively; zero and  $80 liquidation preference on October 31, 2005 and April 30, 2005,  respectively       |       | —               |       | 90                 |       |
| Series E  Convertible Preferred Stock—no par value; zero and 33,000 shares issued and  outstanding on October 31, 2005 and April 30, 2005, respectively; zero and  $3,300 liquidation preference on October 31, 2005 and April 30, 2005,  respectively |       | —               |       | 3,938              |       |
| Common stock—no  par value; shares authorized: October 31, 2005-75,000,000; April 30,  2005-40,000,000; 31,932,879 and 27,696,800 shares issued and outstanding on  October 31, 2005 and April 30, 2005, respectively                                  |       | 35,171               |       | 28,401             |       |
| Additional paid  in capital                                                                                                                                                                                                                                 |       | 13,697               |       | 13,080             |       |
| Deferred  compensation                                                                                                                                                                                                                                      |       | (44                  | )          | (64                | )          |
| Accumulated  deficit                                                                                                                                                                                                                                        |       | (46,387              | )          | (35,862            | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                            |       | 2,437                |       | 9,588              |       |
|                                                                                                                                                                                                                                                        |       |                 |       |               |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                             |       | $                    | 26,346     |               | $          | 31,181 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**IsonicsCorporation and Subsidiaries**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                              | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                                                              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                                                                |       | $                      | 5,832      |                 | $          | 3,065 |   | $ | 10,906 |   | $ | 5,350 |   |
| Cost of revenues                                                        |       | 5,763                  |       | 3,907                |       | 10,981 |   | 6,494 |   |
| Gross margin                                                            |       | 69                     |       | (842                 | )          | (75 | ) | (1,144 | ) |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                                     |       |                   |       |                 |       |   |   |   |   |
| Selling, general  and administrative                                    |       | 2,987                  |       | 1,475                |       | 5,719 |   | 2,821 |   |
| Impairment loss  on assets held for sale                                |       | —                 |       | —               |       | 398 |   | — |   |
| Research and  development                                               |       | 757                    |       | 138                  |       | 1,211 |   | 368 |   |
| Total operating  expenses                                               |       | 3,744                  |       | 1,613                |       | 7,328 |   | 3,189 |   |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| Operating loss                                                          |       | (3,675                 | )          | (2,455               | )          | (7,403 | ) | (4,333 | ) |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| Other income (expense):                                                 |       |                   |       |                 |       |   |   |   |   |
| Amortization of  debt issuance costs                                    |       | (256                   | )          | —               |       | (501 | ) | — |   |
| Interest and  other income                                              |       | 93                     |       | 12                   |       | 211 |   | 25 |   |
| Interest expense                                                        |       | (1,408                 | )          | (30                  | )          | (2,725 | ) | (49 | ) |
| Foreign exchange                                                        |       | (6                     | )          | 5                    |       | (6 | ) | 17 |   |
| Total other  expense, net                                               |       | (1,577                 | )          | (13                  | )          | (3,021 | ) | (7 | ) |
| Loss before income taxes                                                |       | (5,252                 | )          | (2,468               | )          | (10,424 | ) | (4,340 | ) |
| Income tax expense                                                      |       | —                 |       | —               |       | — |   | — |   |
| NET LOSS                                                                |       | $                      | (5,252     | )                    | $          | (2,468 | ) | $ | (10,424 | ) | $ | (4,340 | ) |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| DEEMED DIVIDEND  ON SERIES E CONVERTIBLE PREFERRED STOCK                |       | $                      | —     |                 | $          | (1,206 | ) | $ | — |   | $ | (1,206 | ) |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| DIVIDEND ON  SERIES E CONVERTIBLE PREFERRED STOCK                       |       | $                      | (35        | )                    | $          | — |   | $ | (101 | ) | $ | — |   |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| NET LOSS  ATTRIBUTABLE TO COMMON STOCKHOLDERS                           |       | $                      | (5,287     | )                    | $          | (3,674 | ) | $ | (10,525 | ) | $ | (5,546 | ) |
|                                                                    |       |                   |       |                 |       |   |   |   |   |
| **Net loss per share—basic and diluted**                           |       |                   |       |                 |       |   |   |   |   |
| Net loss per  share attributable to common stockholders                 |       | $                      | (.17       | )                    | $          | (.20 | ) | $ | (.35 | ) | $ | (.31 | ) |
| Weighted average  common shares used in computing per share information |       | 30,867                 |       | 18,746               |       | 29,667 |   | 17,799 |   |

 

See notes to condensedconsolidated financial statements.

 

5

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**IsonicsCorporation and Subsidiaries**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

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

**(Unaudited)**

 
| ** **                                                              | ** ** | **Six Months Ended October 31,** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **2005**                         | ** ** | **2004** | ** ** |
|                                                                    |       |                             |       |   |   |
| Net cash used in operating activities                                   |       | $                                | (8,428     | ) | $ | (4,965 | ) |
|                                                                    |       |                             |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                   |       |                             |       |   |   |
| Purchases of  property and equipment                                    |       | (1,165                           | )          | (517 | ) |
| Acquisition of  business, net of cash acquired                          |       | (2,460                           | )          | (49 | ) |
| Cash used in  investing activities                                      |       | (3,625                           | )          | (566 | ) |
|                                                                    |       |                             |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                   |       |                             |       |   |   |
| Principal  payments under capital lease obligations                     |       | (35                              | )          | (31 | ) |
| Principal  payments on borrowings                                       |       | (388                             | )          | (53 | ) |
| Proceeds from  issuance of common stock                                 |       | 930                              |       | 5,479 |   |
| Proceeds from  issuance of preferred stock                              |       | —                           |       | 3,069 |   |
| Preferred stock  dividends                                              |       | (101                             | )          | — |   |
| Cash provided by  financing activities                                  |       | 406                              |       | 8,464 |   |
|                                                                    |       |                             |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                    |       | (11,647                          | )          | 2,933 |   |
| Cash and cash  equivalents at beginning of period                       |       | 21,206                           |       | 3,691 |   |
| Cash and cash  equivalents at end of period                             |       | $                                | 9,559      |   | $ | 6,624 |   |
|                                                                    |       |                             |       |   |   |
| Supplemental disclosure of cash flow information:                       |       |                             |       |   |   |
| Cash paid during  the period for:                                       |       |                             |       |   |   |
| Interest                                                                |       | $                                | 507        |   | $ | 41 |   |
| Income taxes                                                            |       | $                                | —     |   | $ | — |   |
|                                                                    |       |                             |       |   |   |
| Supplemental disclosure of noncash investing and  financing activities: |       |                             |       |   |   |
| Capital lease  obligation for property and equipment                    |       | $                                | —     |   | $ | 69 |   |
| Accruals for  property and equipment                                    |       | $                                | —     |   | $ | 1,542 |   |
| Stock issued in  connection with an acquisition                         |       | $                                | 1,292      |   | $ | 1,171 |   |

 

During the six monthsended October 31, 2005, we also issued 10,000 shares of common stock in acashless exercise of a common stock warrant and issued 2,734,017 shares ofcommon stock upon conversion of convertible preferred stock.

 

See notes to condensedconsolidated financial statements.

 

6

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**Isonics Corporation andSubsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**NOTE 1 - BASIS OF PRESENTATION**

 

Theaccompanying unaudited condensed consolidated financial statements of IsonicsCorporation and Subsidiaries as of October 31, 2005, and for the three and sixmonths ended October 31, 2005 and 2004, have been prepared on the same basis asthe annual audited financial statements. In the opinion of management, such unaudited information includes alladjustments (consisting only of normal recurring accruals) necessary for a fairpresentation of this interim information. Operating results and cash flows for interim periods are not necessarilyindicative of results that can be expected for the entire year.  The information included in this reportshould be read in conjunction with our audited financial statements and notesthereto included in our Annual Report on Form 10-KSB for the year ended April30, 2005.

 

**NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES**

*** ***

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

 

Weaccount for stock-based compensation to employees and directors using theintrinsic value method in accordance with Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued toEmployees*and related interpretations, as permitted by SFAS No. 123 *Accounting for Stock-Based Compensation*,as amended by SFAS No. 148 *Accounting forStock-based Compensation – Transition and Disclosure*.  Compensation expense for stock options ismeasured as the excess, if any, of the quoted market price of our stock at thedate of grant over the amount an employee must pay to acquire the stock.  No stock-based employee compensation costsrelating to options is reflected within our net loss as all options granted hadan exercise price equal to or greater than the market value of the underlyingcommon stock on the date of grant (though we have recognized expense forwarrants granted to external parties for services).  We record compensation expense for restrictedstock awards based on the quoted market price of our stock at the date of thegrant and the vesting period.

 

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

** **
| ** **                                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                           | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                                                                                                                           | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss attributable to common stockholders, as  reported                                                                           |       | $                      | (5,287     | )                    | $          | (3,674 | ) | $ | (10,525 | ) | $ | (5,546 | ) |
| Add: stock-based  compensation costs included in reported net loss, net of related tax effects                                       |       | 10                     |       | 10                   |       | 20 |   | 20 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (362                   | )          | (103                 | )          | (591 | ) | (158 | ) |
| Adjusted net loss attributable to common  stockholders                                                                               |       | $                      | (5,639     | )                    | $          | (3,767 | ) | $ | (11,096 | ) | $ | (5,684 | ) |

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                              | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                                              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss per share  attributable to common stockholders | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic and  diluted – as reported                   |       | $                      | (.17       | )                    | $          | (.20 | ) | $ | (.35 | ) | $ | (.31 | ) |
| Basic and  diluted – adjusted                      |       | $                      | (.18       | )                    | $          | (.20 | ) | $ | (.37 | ) | $ | (.32 | ) |

 

7

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

 

Basicnet loss per share is computed using the weighted average number of commonshares outstanding during the period. Contingently issuable shares are included in the computation of basicnet income (loss) per share when the related conditions are satisfied.  Diluted net income (loss) per share iscomputed using the weighted average number of common shares and potentiallydilutive securities outstanding during the period.  Potentially dilutive securities consist of contingentlyissuable shares, the incremental common shares issuable upon conversion ofpreferred stock or convertible debt (using the “if converted” method) andshares issuable upon the exercise of stock options and warrants (using the“treasury stock” method).  Potentiallydilutive securities are excluded from the computation if their effect isanti-dilutive.

 

Asof October 31, 2005, (a) a total of 8,268,442 outstanding stock options andcommon stock warrants and (b) the unissued shares underlying our outstandingconvertible debentures were excluded from the diluted net loss per sharecalculations, as their inclusion would be anti-dilutive.  As of October 31, 2004, (a) a total of7,371,458 outstanding stock options and common stock warrants and (b) 6,666, 5,000and 33,000 outstanding shares of Series A, D and E Convertible Preferred Stock,respectively, were excluded from the diluted net loss per share calculation, asthe inclusion would be anti-dilutive.

 

Duringthe six month period ended October 31, 2005, we issued the following shares ofcommon stock:

 
| **Description**                                                 | ** ** | **Number of Common Stock Shares** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------|------------|
| Balance as of April 30, 2005                                    |       | 27,696,800                        |       |
| Conversion of preferred stock                                   |       | 2,734,017                         |       |
| Exercise of common stock warrants and options                   |       | 787,126                           |       |
| Shares issued from employee stock purchase plan                 |       | 7,809                             |       |
| Shares issued in payment of interest on convertible  debentures |       | 200,600                           |       |
| Shares issued for acquisition of business                       |       | 506,527                           |       |
| Balance as of October 31, 2005                                  |       | 31,932,879                        |       |

 

Theaforementioned equity transactions increased common stock in the accompanyingcondensed consolidated balance sheets by $6,770,000 for the six months endedOctober 31, 2005.

 

***New Accounting Standards***

 

InSeptember 2005, the Financial Accounting Standards Board (“FASB”) ratifiedthe consensus reached by the Emerging Issues Task Force (“EITF”) on EITF IssueNo. 05-08, *Income Tax Consequences ofIssuing Convertible Debt with a Beneficial Conversion Feature* (“EITF05-08”).  The EITF consensus noted thatfor the purpose of applying SFAS No. 109, *Accountingfor Income Taxes*, (1) the issuance of convertible debt with abeneficial conversion feature results in a basis difference, (2) the basisdifference is a temporary difference and (3) the recognition of deferred taxesfor the temporary difference of the convertible debt with a beneficialconversion feature should be recorded as an adjustment to additional paid-incapital.  The EITF also reached aconsensus that the guidance in EITF 05-08 should be applied to financialstatements beginning in the first interim or annual reporting period beginningafter December 15, 2005.

 

8

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Theguidance should be applied by retrospective application pursuant to SFAS No.154, *Accounting Changes and ErrorCorrections*, to all instruments with a beneficial conversion featureaccounted for under EITF Issue No. 00-27, *Applicationof Issue No. 98-5 to Certain Convertible Instruments*.   We will adopt the guidance in EITF 05-08 forour quarter ending April 30, 2006.  Weare currently assessing the impact that adoption of EITF 05-08 will have on ourconsolidated financial statements.

 

**NOTE 3 – FINANCIAL STATEMENT COMPONENTS**

 

***Inventories***

 

Inventoriesconsist of the following (in thousands):

** **
| ** **             | ** ** | **October 31, 2005** | ** ** | **April 30, 2005** | ** ** |
|------------------------|------------|----------------------|------------|--------------------|------------|
| Finished goods         |       | $                    | 748        |               | $          | 565 |   |
| Work in process        |       | 450                  |       | 701                |       |
| Materials and supplies |       | 258                  |       | 284                |       |
| Total  inventories     |       | $                    | 1,456      |               | $          | 1,550 |   |

 

***Property and equipment***

 

Propertyand equipment consist of the following (in thousands):

 
| ** **                                | ** ** | **October 31, 2005** | ** ** | **April 30, 2005** | ** ** |
|-------------------------------------------|------------|----------------------|------------|--------------------|------------|
| Office furniture and equipment            |       | $                    | 325        |               | $          | 264 |   |
| Production equipment                      |       | 5,057                |       | 5,579              |       |
| Leasehold improvements                    |       | 643                  |       | 396                |       |
| Construction in process                   |       | 1,033                |       | 814                |       |
|                                      |       | 7,058                |       | 7,053              |       |
| Accumulated depreciation and amortization |       | (2,088               | )          | (1,464             | )          |
| Total property  and equipment             |       | $                    | 4,970      |               | $          | 5,589 |   |

 

**NOTE 4 –SEGMENT INFORMATION**

 

Wecurrently have three reportable segments: homeland security, semiconductormaterials and products and life sciences. Our homeland security segment provides advanced security andinvestigative services and is currently developing certain trace and bulkdetection technologies.  Oursemiconductor materials and products segment manufactures and reclaims siliconwafers, sells SOI wafers and is involved in several research and developmentprojects including silicon-28.  Our lifesciences segment sells stable and radioisotopes in elemental and simplecompound forms for use in life sciences applications.  Our segments are strategic business units,each of which consists of similar products or services.  They are managed separately because eachsegment requires different technology and marketing strategy and because eachsegment sells to different customers.  Thehomeland security segment was added as a reportable segment in the quarterended July 31, 2005, due to the acquisition of Protection Plus SecurityCorporation (“PPSC,” formally Protection Plus Security Consultants, Inc.) onMay 16, 2005.  In prior periods, thehomeland security operations did not meet the requirements for a reportablesegment as defined by SFAS No. 131 “Disclosures About Segments of an Enterpriseand Related Information”.  Reconcilingitems consist primarily of corporate assets or expenses that have not beenallocated to a specific reportable segment.

 

9

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Informationby segment is set forth below (in thousands):

** **
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                            | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Segment revenues:                     |       |                   |       |                 |       |   |   |   |   |
| Homeland  security                    |       | $                      | 2,996      |                 | $          | — |   | $ | 5,668 |   | $ | — |   |
| Semiconductor  materials and products |       | 1,217                  |       | 909                  |       | 2,022 |   | 1,243 |   |
| Life sciences                         |       | 1,619                  |       | 2,156                |       | 3,216 |   | 4,107 |   |
| Total                                 |       | $                      | 5,832      |                 | $          | 3,065 |   | $ | 10,906 |   | $ | 5,350 |   |

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                            | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Segment operating loss:               |       |                   |       |                 |       |   |   |   |   |
| Homeland  security                    |       | $                      | (974       | )                    | $          | — |   | $ | (1,366 | ) | $ | — |   |
| Semiconductor  materials and products |       | (1,420                 | )          | (1,568               | )          | (3,474 | ) | (2,608 | ) |
| Life sciences                         |       | (60                    | )          | (199                 | )          | (209 | ) | (35 | ) |
| Reconciling  amounts                  |       | (1,221                 | )          | (688                 | )          | (2,354 | ) | (1,690 | ) |
| Total                                 |       | $                      | (3,675     | )                    | $          | (2,455 | ) | $ | (7,403 | ) | $ | (4,333 | ) |

 
| ** **                            | ** ** | **October 31,** | ** ** | **April 30,** | ** ** |
|---------------------------------------|------------|-----------------|------------|---------------|------------|
| ** **                            | ** ** | **2005**        | ** ** | **2005**      | ** ** |
| Total assets:                         |       |            |       |          |       |
| Homeland  security                    |       | $               | 6,559      |          | $          | — |   |
| Semiconductor  materials and products |       | 6,620           |       | 6,356         |       |
| Life sciences                         |       | 2,790           |       | 2,432         |       |
| Reconciling  amounts                  |       | 10,377          |       | 22,393        |       |
| Total                                 |       | $               | 26,346     |          | $          | 31,181 |   |

 

**NOTE 5 – ACQUISITION OF PROTECTION PLUS SECURITY CORPORATION**

 

OnMay 16, 2005, we signed and completed an agreement to acquire PPSC, a New YorkCity based corporation that primarily provides armed and unarmed securitypersonnel.  It also provides electronic security systems, armed escortcouriers, executive bodyguards, video/electronic surveillance, mobile vehiclepatrols, special event security and VIP escorts. PPSC’s investigative solutionsinclude communications security, eavesdropping/espionage countermeasures,industrial sabotage investigations, employment investigations and a range offorensic services such as voice and handwriting analysis, DNA testing and drugscreening. Some of the services are provided on an outsourced basis.

 

Weacquired all of the outstanding equity securities of PPSC for a total price of$3,792,000.  Of the purchase price, we paid $2,500,000 in cash and issued506,527 shares of our restricted stock to the sellers.  The number ofshares issued was based on $1,125,000 (per the stock purchase agreement)divided by the average closing bid price on the Nasdaq Small Cap Market on eachof the ten consecutive trading days ending four business days prior to theclosing ($2.22 per share).  The issuedshares were then valued under purchase accounting using a measurement date ofMay 16, 2005, the day the

 

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acquisitionwas contractually agreed to and also consummated.  The closing bid price for our common stock onthe Nasdaq Small Cap Market on the measurement date was $2.55 per share,yielding a valuation of the shares issued for the acquisition of$1,292,000.  We paid the purchase priceto the two owners of PPSC, each of whom represented to us that he was anaccredited investor and was acquiring the shares for investment purposes onlyand without a view toward further distribution.  In addition, we paid$98,000 in legal and accounting fees and we have a remaining receivable fromthe seller for $41,000.  These payments,net of the seller reimbursement, increased the effective purchase price thatwas allocated to the acquired tangible and intangible assets.

 

Thestock is price protected for the benefit of the former owners of PPSC. The price protection provision will provide a cash benefit to them if theas-defined market price of our common stock is less than $2.22 per share at thetime they can first sell the shares (as defined, either due to their inclusionin an effective registration statement or pursuant to SEC Rule 144).  Ifthe as-defined market price is less than $2.22 per share, we will be requiredto pay the former owners of PPSC the difference in cash.  There are no registrationrights associated with the shares issued in the PPSC acquisition, although atour discretion we may include the shares in a future registration statement.

 

Inconjunction with the acquisition of PPSC, we retained the services of both theformer owners in an employment relationship. PPSC will continue to lease premises partially owned by one of theseindividuals.   As such, the premiseslease is with a related party.   Thelease term is for the four-year period ended May 15, 2009.  Annual rent payments are $48,000 in each ofthe four years of the lease term. Additionally, we will reimburse the landlord 80% of the costs incurredby the landlord for taxes, maintenance of common areas and fire and hazardinsurance as well as the entire amount of the premium incurred for rental lossinsurance.

 

Thefollowing table summarizes (in thousands) the estimated fair values of theassets acquired and liabilities assumed at the date of acquisition.  While we believe the purchase accountingassociated with this transaction to essentially be complete, there is alwaysthe possibility that it may be subject to refinement.

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

 

The$3,593,000 of goodwill was assigned to the homeland security segment and isexpected to be deductible for tax purposes. The $431,000 of intangible assets relates to the acquired customer baseand is being amortized ratably over its estimated life of three years.  As of October 31, 2005, the unamortizedbalance of the intangible asset is $365,000. There was no in-process research and development acquired in this transaction.

 

Thefollowing table summarizes our results of operations for the three and sixmonths ended October 31, 2005 and 2004, as if the acquisition of PPSC hadoccurred on May 1, 2005 and 2004, respectively. There have been no adjustments made to the historical results of PPSC.

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                       | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                                                                       | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                                                                         |       | $                      | 5,832      |                 | $          | 6,508 |   | $ | 11,420 |   | $ | 12,087 |   |
| Net loss attributable to common stockholders                                     |       | $                      | (5,287     | )                    | $          | (3,841 | ) | $ | (10,509 | ) | $ | (5,439 | ) |
| Net loss per  share attributable to common stockholders – basic and diluted |       | $                      | (.17       | )                    | $          | (.20 | ) | $ | (.35 | ) | $ | (.30 | ) |

 

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**NOTE 6 –ASSETS HELD FOR SALE**

** **

Duringthe first quarter of fiscal year 2006, management committed to a plan to sellspecific production equipment in our semiconductor materials and productssegment.  Based on ongoing analysis ofthe semiconductor operations, these assets were deemed to be excess equipmentor incompatible with the future direction of the segment’s operations.  We have listed these assets for sale and areactively attempting to sell them. Immediately prior to the decision to sell the assets, the equipment hada cumulative net book value of approximately $1,026,000.  Certain assets have been written down totheir fair value, less selling costs, yielding an impairment loss on assetsheld for sale in the amount of $398,000. The assets held for sale are now classified in current assets at thelower of their book value or fair value, less selling costs, in the cumulativeamount of $628,000.  During the sixmonths ended October 31, 2005, none of the assets held for sale were sold.

 

**NOTE 7 – EQUITY**

 

***Common Shares Authorized***

 

OnMay 9, 2005, our Articles of Incorporation were amended to increase theauthorized number of common shares issuable from 40,000,000 to 75,000,000.  Prior to filing the Certificate of Amendmentwith the Secretary of State of the State of California, the change to theauthorized shares of common stock was first approved by a vote of theshareholders and by a vote of the Board of Directors.

 

***Convertible Preferred Stock***

 

OnAugust 9, 2005, we redeemed the remaining 6,666 outstanding shares of theSeries A Convertible Preferred Stock (“Series A Stock”).  The Series A Stock originally consisted of1,850,000 shares issued with a liquidation preference of $1.50 per share.  As a result, the holder no longer is able toconvert the shares and the rights and preferences associated with the Series AStock have been terminated.  The holderis entitled to receive $1.50 for each share of the Series A Stock, an amount ofapproximately $10,000.

 

OnMay 19, 2005, the remaining 800 shares of Series D Convertible Preferred Stock(“Series D Stock”) were converted into 72,727 shares of common stock.  As a result, as of October 31, 2005, therewere zero shares of Series D Stock outstanding.

 

OnJuly 27, 2005, 23,000 shares of Series E Convertible Preferred Stock (“Series EStock”) were converted into 1,854,838 shares of common stock.  On October 19, 2005, the remaining 10,000 shares of Series EStock were converted into 806,452 shares of common stock.  As a result, as of October 31, 2005, therewere zero shares of Series E Stock outstanding.

 

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***Class B and C Warrants***

 

OnJune 17, 2005, we extended the expiration date of the Class B and C Warrantsfrom December 31, 2005, to December 29, 2006, via an amendment to the warrantagreements.   There were no other changesmade to the terms and conditions of the warrant agreements.  The holders of these warrants were unable toexchange the warrants for registered shares of our common stock between October2004 (at which time the underlying registration statement was no longercurrent) and August 24, 2005 (at which time a post-effective amendment to theregistration statement gained effectiveness). In October 2004, we originally attempted to file a post-effectiveamendment to the respective registration statement, but we were unable to do sobecause our former auditor, Grant Thornton LLP, was unwilling to consent to theinclusion of its report on our April 30, 2004 and 2003, financial statements inthe post-effective amendment.  In thequarter ended July 31, 2005, we recorded a non-cash operating expense in thestatement of operations in the amount of approximately $297,000, such chargerepresenting the excess of the fair value of the amended warrant over the fairvalue of the original warrant immediately prior to amendment.

 

Duringthe six months ended October 31, 2005, 362,011 Class B Warrants were exercisedwhich yielded proceeds of $543,000.  Uponexercise of a Class B Warrant, a holder is provided one share of common stockand one Class C Warrant.  No Class CWarrants were exercised during the six months ended October 31, 2005.

 

**NOTE 8 – EQUITY INSTRUMENTS ISSUED FORSERVICES**

 

In September 2005, we entered into a financial advisoryservices agreement with Clayton Dunning Capital Partners, Inc., whereby weissued a common stock warrant  (valued at$152,000 using the Black-Scholes pricing model) to purchase 100,000 shares ofcommon stock at $2.81 per share.  Thecommon stock warrant vested immediately, expires on September 8, 2007, and wasrecorded as prepaid consulting expense, to be amortized ratably over theexpected service period of one year.  Asof October 31, 2005, $25,000 has been expensed to selling, general andadministrative expenses.

 

In September 2005, we entered into a consultingagreement with an individual to provide management services in oursemiconductor materials and products segment, whereby we issued a common stockwarrant  (valued at $75,000 using theBlack-Scholes pricing model) to purchase 50,000 shares of common stock at $2.84per share.  The common stock warrantvested immediately, expires on August 16, 2007, and was recorded as prepaidconsulting expense, to be amortized ratably over the expected service period ofeight months.  As of October 31, 2005,$19,000 has been expensed to selling, general and administrative expenses.

 

**NOTE 9 – CONVERTIBLE DEBENTURES**

 

Interest payments on our 8% Convertible Debentures arepayable, at our option, in common stock or cash, subject to variousrequirements.  Having met allrequirements to allow us to do so, we elected to make the quarterly interestpayment due on September 30, 2005, in shares of our common stock.  The conversion price was calculated per thedebenture agreement as 90% of the average of the twenty closing prices endingon the trading day immediately prior to the applicable interest paymentdate.  Accordingly, we issued 200,600shares of common stock in settlement of our interest obligation for the quarterended September 30, 2005.  A charge in theamount of $506,000 was recorded as interest expense related to the share issuance,an amount that represents the fixed monetary amount of the interestobligation.  We have notified the 8%Convertible Debenture holders that we intend to pay the December 31, 2005,interest payment in cash.

 

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**NOTE 10 – COMMITMENTS AND CONTINGENCIES**

 

As of October 31, 2005, we had commitments outstandingfor capital expenditures of approximately $64,000.

 

On March 25, 2005, Prime International Equities, LLC (“the Plaintiff”)filed a complaint against us in the United States District Court for theDistrict of Colorado (Civil Case No. 05-F-562 (BNB).  On October 31, 2005, a settlement agreementwas signed in which no liability or wrongdoing was admitted.  In return for dismissal of the complaint, wepaid the Plaintiff $50,000 and issued a common stock warrant (valued $109,000 using the Black-Scholespricing model) to purchase120,000 shares of common stock at $2.40 per share.  The common stock warrant vested immediately,expires on December 29, 2006, and was recorded as a selling, general andadministrative expense in the three months ended October 31, 2005.  Further,the common stock warrant includes a registration rights clause whereby we haveagreed to use our best efforts to include the common stock underlying thewarrant in a registration statement by not later than May 31, 2006.

 

**NOTE 11 - RELATED PARTY TRANSACTIONS**

 

Asof October 31, 2005, we held an 8% ownership interest in Institut furUmwelttechnologien GmbH (“IUT”), an entity located in Germany.  As described in note 12 below, in December2005 we increased our ownership interest to 30%.  In June 2004, we entered into a research anddevelopment agreement with IUT, which contemplated the funding of certainprojects of up to $4,000,000 over several years.  The work is being funded in steps and isbased upon the completion of various milestones, as defined.  We have no obligation to fund any work underthis agreement unless we have approved such effort.  We funded approximately $324,000 and $657,000under this agreement during the three and six months ended October 31, 2005,respectively (and a total of $1,154,000 since entering into the agreement inJune 2004).  All funded amounts have beenincluded as research and development in the consolidated statement ofoperations.  Additionally, IUT producescarbon-14 precursors for us that we resell in the market place.  Total purchases from IUT for this productduring the three and six months ended October 31, 2005 and 2004, were $150,000and $312,000 and $125,000 and $306,000, respectively.

 

**NOTE 12 - SUBSEQUENT EVENTS**

 

OnDecember 1, 2005, we increased our equity ownership in IUT to 30% in exchangefor cash consideration of approximately $345,000.  The Share Transfer Agreement alsocontemplates a potential further capital increase for IUT in the amount ofapproximately $230,000, of which approximately $70,000 would be required to becontributed by us in order to retain our 30% ownership interest.  If the IUT shareholders approve the potentialcapital increase, we would have the right to fulfill our obligation bycontribution of our common stock in lieu of cash.  The other IUT shareholders would have theright to fulfill their respective obligations by contribution of theirrespective outstanding shareholder loans in lieu of cash.  As we are now able to exert significantinfluence, but not control, over the operations of IUT, we will apply theequity method of accounting for the investment commencing in the three-monthperiod ending January 31, 2006.

 

OnDecember 5, 2005, we approved a development plan which resulted in us becomingobligated under a Development & Licensing Agreement (the “Agreement”)entered into with Lucent Technologies, Inc. (“Lucent”) in September 2005.  Under that Agreement, the two companies willendeavor to develop a next-generation infrared imaging and night visionsurveillance technology at Lucent’s micro electro-mechanical systems andnanotechnology fabrication facility.  TheAgreement provides for us to receive an exclusive right, except for certainrights reserved by Lucent, to make, use and sell licensed products arising fromtechnology developed under the Agreement. In exchange for this license, we will fund

 

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Lucent’s development effortsfor the project through the periodic payment over a two and one-half yearperiod of a development fee totaling $12,000,000.  Of this amount, $1,000,000 was paid (although$900,000 was fully-refundable) upon commencing discussions with Lucent in July2005 and was included in prepaid expenses at October 31, 2005, the next$1,000,000 will be paid in December 2005 as a result of our acceptance of thedevelopment plan on December 5, 2005 (when the previous payment becamenon-refundable), and the balance will be paid in $1,000,000 increments everythree months thereafter.  Thesedevelopment payments will be expensed to research and development expense asthe expenses are incurred, commencing in the quarter ending January 31,2006.  We have the right to terminate thedevelopment project for any reason from time-to-time, so long as termination isprior to the first commercial sale of a licensed product.  When, if ever, commercial sales of developedproducts commence, a royalty payment based on revenue will be due Lucent(subject to a minimum semi-annual cumulative royalty payment amount).  Additionally, if Lucent expends substantialsales effort to accomplish a sale, we will also pay them a sales referral feebased on revenue.  Lastly, in order toretain the exclusivity of our license for the developed technology, we haveagreed to pay an annual exclusivity payment commencing the October 1 nextfollowing the first commercial sale or the end of the development project.

 

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**Item 2: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

*The statements contained in thisReport on Form 10-QSB that are not purely historical are forward lookingstatements within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934, including statementsregarding our expectations, hopes, intentions or strategies regarding thefuture.  Forward-looking statementsinclude: statements regarding future products or product development, includingour ability to leverage existing research and development efforts intocommercially viable products; statements regarding future selling, general andadministrative costs and research and development spending and our productdevelopment strategy; and statements regarding future capital expenditures,commitments and financing requirements. All forward-looking statements included in this document are based oninformation available to us on the date hereof, and we undertake no obligationto update any such forward-looking statements. It is important to note that our actual results could differ materiallyfrom those in such forward-looking statements.*

 

***GeneralDiscussion***

 

Founded in 1992, we are an advanced materials andtechnology company focused on the development and provision of homelandsecurity products and services, the manufacturing and reclamation of siliconwafers and the manufacturing of silicon-on-insulator (“SOI”) wafers to thesemiconductor industry and the supply of isotopes for life sciences andhealth-care applications.

 

Liquidity and Capital Resources

 

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

 

Homeland Security

 

In October 2004, we formed a new subsidiary, IsonicsHomeland Security and Defense Corporation (“HSDC”), to focus and consolidateour efforts in the homeland security sector. These efforts include entry into the security service market,acquisition and development of certain trace and bulk detection technology thatcan be used to detect various types of explosives and/or chemical agents andthe entering into an agreement with an established partner to developinnovative infrared imaging technology.  Each of these efforts are discussed below:

 

•      Security Services - In May 2005, we acquiredPPSC, a provider of a wide range of security-related services, including armedescort personnel, electronic security systems, mobile vehicle controls,forensic analysis, communications security and other security expertise.  Since the effective date of the acquisition,PPSC has delivered significant revenue (approximately $5,630,000, although the pro forma amount would have beenapproximately $6,150,000 if the acquisition had occurred on May 1, 2005) and grossmargin (approximately 24%) as well as positive operating income (approximately$40,000, inclusive of amortization of acquisition-related customer intangiblesin the amount of $65,000) to the homeland security segment of our business.  Further, we believe that the acquisition ofPPSC provides us with a deep source of knowledge and contacts within thehomeland security space and that it is capable of providing key insight for thedevelopment of our next-generation products along with successful marketing andsales processes.

 

In August 2005, PPSC securedover approximately $4,800,000 in cumulative new contracts for six privatesector customers for security services to be performed throughout the UnitedStates.

 

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The contract terms rangefrom one to three years in length and expected incremental revenue for fiscalyear 2006 is approximately $1,200,000. Further, though currently PPSC does not have government servicecontracts, in July 2005 PPSC was awarded a GSA federal supply schedule underwhich PPSC can and has begun to pursue government service contracts.  While we believe that we will be successfulin acquiring government service contracts in fiscal year 2006, we can offer noassurance that we will be able to do so. Current PPSC activities in business integration, customer retention,customer solicitation and customer expansion are on pace with our integrationplan.

 

•      Detection Technology – Our efforts arecurrently focused on two detection technologies, as follows:

 

Ion Mobility Spectroscopy(“IMS”) – IMS is a “sniffer” technology originally developed by IUT, the Germanentity in which we recently increased our minority ownership position to30%.  In the three months ended October31, 2005, we launched marketing and sales efforts of EnviroSecureTM, a newsystem that can monitor and identify chemical weapons and toxic substances inthe air in a variety of venues including airports, mass transit facilities,sports venues and public and private sector office buildings.  Available for immediate sale andinstallation, our system is designed to continuously monitor the air andimmediately detect and identify harmful substances at the parts per billion(ppb) level, providing warning of a possible attack in a matter of minutes.  Earlier generations of this product have beenin continuous use at the German parliament building since 1999, effectivelymonitoring the air for toxic substances and chemical weapons.  This turnkey solution would include systemdesign, engineering, hardware, software, installation, training andmaintenance.  It is anticipated that theEnviroSecureTM system could be installed and become fully operational withinfour to twelve months, though the time frame will vary depending on the sizeand complexity of each installation. While we have not yet made any sales of this product, the product isavailable for sale, and we continue to focus our efforts on marketing andcustomer engagement.

 

Through our ongoing fundingof research and development efforts at IUT, we continue to explore othercommercial applications for the IMS technology, including efforts to decreasethe size and weight of the IMS units to a form factor that would allowportability.  Additionally, in November2005 we signed a development agreement with DualDraw LLC (“DualDraw”), amanufacturer of air quality equipment. We have jointly agreed to create and test a prototype that combines IMSbased technology with DualDraw’s Mailroom Inspection Workstations, a downdraftworkstation that keeps toxic substances away from the breathing zone ofmailroom workers who are sorting or opening mail and captures such substanceswith a HEPA filtration system.  Theincorporation of our IMS capability would provide an alarm if toxic orexplosive substances are detected. Though our intention is to introduce additional commercial IMS productsin calendar 2006, we can offer no assurances that we will be able to do so.

 

Neutron based detection - Wehave developed a hand-held explosive detection device named “NeutroTestTM.”  We had earlier projected that weexpected to have a NeutroTestTM product available for internationalsales in late second calendar quarter and for United States sales in the thirdcalendar quarter of 2005, respectively. As expected, we completed the sale of two, first-generation units to aGerman entity in June 2005, although we have not completed any subsequent salesin Europe or the United States.  Feedbackon the performance of these two units has been positive and has also includedproduct enhancement recommendations.  Wehave taken the feedback from our initial international sales of thefirst-generation NeutroTestTM and have implemented them into oursecond-generation units, which will be offered for sale in the domesticmarketplace once the enhancements are technically complete.  Our marketing plan for the second-generationNeutroTestTM product includes targeting potential United Statesbased 

 

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customers to which we willdemonstrate the value of NeutroTestTM.  To facilitate this plan, we have reached anagreement with a third party to establish a fully licensed customerdemonstration and training facility in the United States.  The development of second-generationfunctionality, implementation of the domestic marketing plan and addressingexisting regulatory requirements have been the focus of activities in the thirdand fourth quarters of calendar year 2005, and we expect to continue theseefforts in the first quarter of calendar year 2006.

 

•      Infrared Imaging Technology – On December 5,2005, we approved a development plan which resulted in us becoming obligatedunder a Development & Licensing Agreement entered into with Lucent inSeptember 2005.  Under this Agreement,the two companies will endeavor to develop a next-generation infrared imagingand night vision surveillance technology based on research by Lucent’s BellLabs micro electro-mechanical systems (“MEMS”) and nanotechnology fabricationfacility.  Infrared technology, whichconverts infrared radiation in the non-visible spectrum, such as body heat,into a visible image, is commonly found in both commercial andmilitary/homeland security applications including night vision goggles andcameras, rifle scopes, and threat detection devices used to identify concealedweapons or explosives.  The MEMS approachto infrared imaging, if successful, may lead to products which are higherperformance at a lower power consumption than products currently available in themarketplace today.  Additionally, a MEMS-basedproduct may also provide for cost efficiencies in the manufacturingprocess.  The development plancontemplates a proof-of-concept within 12 months, followed by steps towardscommercialization, though we can provide no assurances that a commerciallyattractive product will ultimately be available.

 

The Agreement provides forus to receive an exclusive right, except for certain rights reserved by Lucent,to make, use and sell licensed products arising from technology developed underthe Agreement.  In exchange for thislicense, we will fund Lucent’s development efforts for the project through theperiodic payment over a two and one-half year period of a development feetotaling $12,000,000.  Of this amount,$1,000,000 was paid upon commencing discussions with Lucent in July 2005(although $900,000 was fully-refundable), the next $1,000,000 will be paid inDecember 2005 as a result of our acceptance of the development plan on December5, 2005 (when the previous payment became non-refundable), and the balance willbe paid in $1,000,000 increments every three months thereafter.  We have the right to terminate thedevelopment project for any reason (including if the development work is notproceeding up to our expectations) from time-to-time, so long as termination isprior to the first commercial sale of a licensed product.  Additionally, upon the commencement ofcommercial sales, if ever, we would be obligated to pay royalties based onrevenue, potentially a sales referral fee based on revenue and also an annualexclusivity payment to maintain our exclusive rights to the developedtechnology.

 

Semiconductor Materials and Products

 

Our semiconductor operations, based in Vancouver,Washington, showed substantial operational and financial improvement for thethree months ended October 31, 2005, though still generating an operating lossand negative cash flow.   In an effort toreduce historical negative financial results, in April 2005 we began theprocess to realign our business whereby we planned to significantly reduce ourreliance on low margin small diameter products and focus mainly on highermargin 300-millimeter large-diameter and silicon-on-insulator (“SOI”)products.  The large-diameter wafersegment has become one of the fastest growing segments of the silicon wafermarket and the revenues and gross margins associated with the services aresubstantially greater than those associated with the small diametermarket.   As a result of our strategicrealignment, revenue from 300-millimeter services comprised approximately 31%of segment revenue in the second quarter of our fiscal year 2006 (approximately$370,000 in revenue), an increase from approximately 1% of segment revenue inthe first quarter of our fiscal year 2006. Additionally, there has been a focus on processing efficiency andeffectiveness, which has resulted in increased processing yields.

 

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Further, we have continued to gain new customers andare also in the process of attempting to qualify our product at others.

 

As a result, though the segment generated anoperating loss of $1,420,000 for the three months ended October 31, 2005, thisoperating loss is approximately 9% less than that experienced in thecomparative quarter of our fiscal year 2005. The operating loss of $3,474,000 for the six months ended October 31,2005, is approximately 33% higher than the comparable period in fiscal 2005($2,608,000), but includes an impairment charge of $398,000 related to certainproduction equipment that was no longer necessary under the new businessplan.  We continue to monitor thesituation closely and, while we believe that our realignment of the businesshas enhanced our chances to reach profitability in the future and that we willcontinue to see improving financial results in the segment, the overall processwill take time and there are no assurances that profitability will be reached.

 

Life Sciences

 

Our life sciences division has historically beenprimarily a distribution business. We acquire isotopes from severalmanufacturers who are located primarily in republics that were part of theformer Soviet Union.  We buy theseisotopes from the manufacturers and resell them in the form of common chemicalcompounds.  For example, oxygen-18 issold as water, and zinc-68 is sold as zinc oxide.  We sell these isotopes for use in basicscientific research, medical diagnostics/therapy and industrialapplications.  An isotope is one oftwo or more species (or nuclides) of the same chemical element that differ fromone another only in the number of neutrons in the atom’s nucleus.  The different number of neutrons can createsignificantly different nuclear properties. The most well known of these properties is radioactivity.  Radioactive isotopes (or radioisotopes) canbe found in nature.  Most of ourradioisotopes, however, are man-made. Stable isotopes, as distinguished from radioisotopes, are notradioactive.  We continue to evaluate possible applicationsfor stable isotopes, radioisotopes and non-isotopic materials.

 

At the present time, our life sciences division isbeing adversely affected by increased domestic and internationalcompetition.  The oxygen-18 marketcontinues to be dynamic and volatile. Established suppliers have increased capacity and reputable suppliershave entered the market with a comparable high quality product.  The market is currently in a surplus stateand we expect it to be so for several years to come.  Prices have declined 50% from highs ofapproximately two and one-half years ago, though our average selling price foroxygen-18 in our second quarter of fiscal year 2006 has remained relativelyconsistent with that received during our previous two quarters, the firstquarter of fiscal year 2006 and the fourth quarter of fiscal year 2005.  However, this average selling price is likelyin excess of the spot rate in the market due to the advanced pricing agreementswe have with certain customers.  As such,additional price erosion may be expected. Compounding this problem, our production partner’s current economics andoperations are optimized for production that does not utilize used or recycledwater.  We currently have a significantsupply of used water (valued at approximately $384,000 as compared to $660,000at April 30, 2005) but we have developed a plan with our production partnerthat will allow us to utilize this inventory in future production over the nextnine months.  In the meantime, as ourcurrent contracts with our customers expire, we are no longer offering ourcustomers the option of recycling their used oxygen-18.  While this new policy will allow us togradually decrease the used water in our inventory, this approach does bearsome commercial risk as one of our large competitors continues to offer arecycling option to customers. Consequently, our inability to recycle oxygen-18 in the form of watermay place us at a competitive disadvantage as compared to those producers whocontinue to recycle used water.  In anattempt to offset the degradation of the oxygen-18 market, we are expandinginto other areas, such as actinium-225 and indium-111.  While we don’t expect these isotopes tocontribute materially to our revenues in fiscal year 2006, this expansion isindicative of our business goal to broaden revenue beyond the concentrationfound in a few, core products (mainly oxygen-18).

 

In addition, our international radioisotope businessis experiencing rising supplier prices in a market that is highlyprice-sensitive.  In an effort to reducecosts, we have taken steps to transfer the international sales 

 

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responsibilities to our domestic office and willclose our European trading office in the quarter ending April 30, 2006.   It is possible that our ability to pass onthe increasing supply prices to our customers may be limited and may have anadverse impact on future revenue in this business as our customers have accessto radioisotope supply from other entities. As with all our reportable segments, we continually monitor businessconditions and marketplace changes and evaluate all investment, divestiture andother strategic options.

 

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

 

Wehave not received any requests for additional information from either the SECor NASDAQ during the last ten months and to the best of our knowledge, theseissues are behind us and we are moving forward.

 

***Results ofOperations***

 

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.

*** ***
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                               | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                               | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Revenues                                 |       | 100.0                  | %          | 100.0                | %          | 100.0 |   | 100.0 | % |
| Cost of revenues                         |       | 98.8                   |       | 127.5                |       | 100.7 |   | 121.4 |   |
| Gross margin                             |       | 1.2                    |       | (27.5                | )          | (.7 | ) | (21.4 | ) |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Operating  expenses:                     |       |                   |       |                 |       |   |   |   |   |
| Selling, general  and administrative     |       | 51.2                   |       | 48.1                 |       | 52.5 |   | 52.7 |   |
| Impairment loss  on assets held for sale |       | —                 |       | —               |       | 3.6 |   | — |   |
| Research and  development                |       | 13.0                   |       | 4.5                  |       | 11.1 |   | 6.9 |   |
| Total operating  expenses                |       | 64.2                   |       | 52.6                 |       | 67.2 |   | 59.6 |   |
| Operating loss                           |       | (63.0                  | )          | (80.1                | )          | (67.9 | ) | (81.0 | ) |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Other expense,  net                      |       | (27.0                  | )          | (.4                  | )          | (27.7 | ) | (.1 | ) |
| Loss before  income taxes                |       | (90.0                  | )          | (80.5                | )          | (95.6 | ) | (81.1 | ) |
| Income tax  expense                      |       | —                 |       | —               |       | — |   | — |   |
| NET LOSS                                 |       | (90.0                  | )%         | (80.5                | )%         | (95.6 | ) | (81.1 | )% |

 

***Revenues***

 

Revenues increased during both the three and sixmonths ended October 31, 2005, as compared to the same periods of our priorfiscal year.  Revenues from both ourhomeland security and semiconductor materials and products segments did reflectan increase during these periods as compared to revenues from our life sciencessegment which reflected a decrease, as described in the following table:

 
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **October 31,**        | ** ** | **October 31,**      | ** ** |
| ** **                            | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Life sciences:                        |       | $                      |       |                 | $          |   |   | $ |   |   | $ |   |   |
| Domestic                              |       | 985                    |       | 1,461                |       | 2,033 |   | 2,709 |   |
| International                         |       | 634                    |       | 695                  |       | 1,183 |   | 1,398 |   |
| Total life  sciences                  |       | 1,619                  |       | 2,156                |       | 3,216 |   | 4,107 |   |
| Homeland  security                    |       | 2,996                  |       | —               |       | 5,668 |   | — |   |
| Semiconductor  materials and products |       | 1,217                  |       | 909                  |       | 2,022 |   | 1,243 |   |
| Total                                 |       | $                      | 5,832      |                 | $          | 3,065 |   | $ | 10,906 |   | $ | 5,350 |   |

 

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As a result of the acquisition of PPSC, we havesignificantly increased our revenues during the three and six months endedOctober 31, 2005, and thus we significantly decreased our reliance on a fewlife sciences customers for a significant portion of our revenues.

 

•      During the three months ended October 31,2005, one homeland security customer comprised approximately 17% of revenue ascompared to the three months ended October 31, 2004, in which one life sciencescustomer accounted for 18% of revenue.

 

•      During the six months ended October 31, 2005,one homeland security customer comprised approximately 18% of revenue ascompared to the six months ended October 31, 2004, in which one life sciencescustomer accounted for 21% of revenue.

 

Significant reductions in sales to any of theselarge customers have had, and may in the future have, an adverse effect on usby reducing our revenues and our gross margins. Present or future customers could terminate their purchasing patternswith us or significantly change, reduce or delay the amount of products orservices ordered from us.

 

The increase in revenues from homeland securitysales for the three and six months ended October 31, 2005, was almost entirelydue to the purchase of PPSC in May 2005. On a pro forma basis, assuming the acquisition of PPSC had occurred onMay 1, 2005, homeland security revenue for the six months ended October 31,2005, would have been approximately $6,182,000. While we anticipate that we will continue to grow revenue in the homelandsecurity segment through new contracts signed by PPSC in the three months endedOctober 31, 2005 and subsequently, securing additional new security contractsin our PPSC subsidiary, retaining existing customers under contract currentlywith PPSC and by increasing our sales of detection technology, we cannotprovide any assurance that we will be able to do so.

 

The increase in revenues from semiconductormaterials and products sales for the three and six months ended October 31,2005, was primarily due to the additional revenues generated from the businessand assets acquired from EMG in June 2004 and 300-millimeter sales ofapproximately $370,000 in the three months ended October 31, 2005.  The six months ended October 31, 2004,includes revenues and operating results from that business for onlyapproximately 135 days during the six-month period as compared to a full sixmonths for the related period in fiscal year 2006.  On a pro forma basis, assuming acquisition ofthe business and assets of EMG on May 1, 2004, the revenue for the first six monthsof fiscal year 2005 was approximately $376,000 higher.  Though our ability to integrate the businessand assets of EMG and successfully operate the consolidated semiconductoroperations has been problematic to date, we are in the process of realigningour business to focus mainly on the growing market of higher margin300-millimeter large-diameter and SOI products. For the three months ended October 31, 2005, revenue from 300-millimeterservices comprised 31% of semiconductor revenue for that period.  While we believe that continued expandedfocus on these markets will allow us to ultimately increase revenues in thefuture, we can provide no assurances that we will be able to do so.

 

While we continue to move forward with ourdevelopment program and to pursue the establishment of a low cost supply ofsilicon-28, we did not receive a material amount of revenues in our 2004 or2005 fiscal years or in the six months ended October 31, 2005, and we are notaware of any plans by any company for the introduction of products based onsilicon-28 wafers.  Therefore we do notanticipate any material amount of proceeds from silicon-28 product sales duringfiscal year 2006, although we could respond to customer demand in a relativelyshort time frame.  Our goal ultimately isto profitably (1) license our proprietary technology to other entities and/or(2) sell chemicals required for the production of epitaxial or 

 

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bulk silicon-28 wafers and/or (3) produce epitaxialor bulk silicon-28 wafers for resale. The costs associated with maintaining this program are not significant.

 

The decrease in revenues from domestic isotopeproduct sales for the three and six months ended October 31, 2005, wasprimarily the result of a significant decrease in the unit price of our mainisotope sold domestically, oxygen-18, which was partially offset by an increasein volume.  As a result, in order toincrease our revenues from the sale of oxygen-18, we will need to increase ourvolume at a rate greater than any continuing decreases that may occur in thefuture market price for that product. The market for oxygen-18 in the United States is continuing to expandand we continue to actively bid to become the supplier for additional customers.However, we can offer no assurance that we will be able to increase oxygen-18revenue in the face of the domestic and international competition in thismarket.

 

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

 

In January 2005 we commenced supplying limitedquantities of actinium-225 for testing purposes.  Actinium-225 is a radioisotope that isbelieved to be valuable in the treatment of certain cancers.  Assuming our Russian business partners reachtarget production levels during fiscal year 2006, we believe that we will beable to nearly double the world’s supply of actinium-225 by the end of calendar2006 to the extent required by the market. The six months ended October 31, 2005, included minimal sales ofactinium-225.  In June 2005, we enteredinto an agreement with Central Radiopharmaceutical Services, Inc. of Buffalo,New York (“CRS”) for the joint production and marketing of certainradioisotopes with the first expected to be indium-111.  While the projected revenues for these tworadioisotopes are expected to be minimal (less than $100,000) for fiscal year2006, we believe these to be important first steps in our effort to extend ourdistribution operations to provide more value-added products and to increaseour share of the domestic radioisotope market to a meaningful number.  We can, however, offer no assurance that wewill be able to do so.

 

The decrease in revenues from international isotopeproduct sales, for the three and six months ended October 31, 2005, wasprimarily due to the decrease in sales of radioisotopes and our inability toreplace the decrease with increased sales of other isotopic products.  Due to increases in our radioisotope supplycosts, our competitive position with our existing customer base is under pressure.  Though we will endeavor to retain ourexisting customers, we are experiencing difficulty in increasing our prices tothem and we can offer no assurances that we will be able to retain thecustomers that are highly sensitive to radioisotope pricing.   In addition, our German subsidiary has haddifficulty entering the oxygen-18 market. During the six months ended October 31, 2005, European sales ofoxygen-18 have not been material.  Assuch, while we continue to pursue the addition of European oxygen-18 customersin fiscal year 2006, the process is expected to be slow and we cannot provideany assurance that we will be able to do so.

 

***Gross Margin***

 

Our gross margin increased during the three and sixmonths ended October 31, 2005, as compared to the same periods of our priorfiscal year, both on a dollar amount and on a percentage of revenues asreflected in the following table:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                  | 69,000     |                             | $          | (842,000 | ) | $ | (75,000 | ) | $ | (1,144,000 | ) |
| Percent of revenues |       | 1.2                                | %          | (27.5                            | )%         | (.7 | )% | (21.4 | )% |
|                     |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

 

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For the three months ended October 31, 2005, werealized our first quarter of positive gross margin since our acquisition ofthe assets and business of EMG in June 2004. The increase in gross margin is due mainly to two factors:  (1) the impact of PPSC’s operations, whichwere acquired in May 2005 and (2) improved operations in our semiconductormaterials and products segment where there were improvements to gross margin ona dollar amount and on a percentage of revenues basis, though both metricsremain negative.  In addition, the lifesciences segment also contributed positive gross margin, though such grossmargin as a percentage of revenue was reduced two absolute percentage pointsfrom that experienced in the six months ended October 31, 2004.

 

On a dollar basis, gross margin is expected toincrease correspondingly with increases in revenue, if any, with dependencieson customer and supplier pricing.  Ourability to positively impact consolidated gross margin will in a large part bedependent upon our ability to grow sales in our homeland security segmentthrough increased sales of security services and detection products and in oursemiconductor materials and products segment through increased sales of300-millimeter large diameter and SOI products. With the realignment of our business to focus on the higher margin300-millimeter large diameter and SOI products, we believe that we have greatlyenhanced our ability to increase our sales and related gross margin in theseareas.  As such, we anticipate that thegross margin from sales of semiconductor and materials and products (both indollar value and as a percentage of revenues) will increase over time, thoughwe can offer no assurance that the gross margin increase will occur.

 

On a percentage of revenue basis, in general weanticipate that the gross margin percentage in our homeland security and lifesciences segments will remain relatively stable (to slightly lower for lifesciences), subject to any unexpected fluctuations in isotope pricing.  The gross margin percentage in thesemiconductor operations is highly dependent on generating sufficient revenueto cover the fixed portion of our cost of sales.  As such, the gross margin percentage for thesemiconductor segment may be volatile based upon revenue growth achieved, ifany.  Thought there can be no assurances,we hope to see continued improvement in the gross margin performance of thesemiconductor segment.

 

***Selling, Generaland Administrative Expenses***

 

Our selling, general and administrative expenses asa dollar amount approximately doubled for the three and six months endedOctober 31, 2005, as compared to the same respective periods of our priorfiscal year.  As a percentage of revenue,selling, general and administrative expenses has remained relatively flatbetween the six month periods ended October 31, 2005 and 2004, respectively,while the percentage of revenue has increased for the three months endedOctober 31, 2005 as compare to the same period of our prior fiscal year:

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                  | 2,987,000  |                             | $          | 1,475,000 |   | $ | 5,719,000 |   | $ | 2,821,000 |   |
| Percent of revenues |       | 51.2                               | %          | 48.1                             | %          | 52.5 | % | 52.7 | % |
|                     |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

 

The approximate $2,900,000 dollar increase inselling, general and administrative expenses for the six months ended October31, 2005, compared to the same period in the prior year is attributable to acombination of factors, including:

 

•      approximately $1,300,000 directly related tothe addition of PPSC’s profitable operations in May 2005;

•      a charge in the amount of $202,000 (of which$152,000 is a noncash item) related to the settlement of a lawsuit;

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

 

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•      approximately $200,000 due to the inclusionof a full six months of semiconductor operations inclusive of the business andassets acquired from EMG (such operations were included for only approximately135 days of the six months ended October 31, 2004);

•      approximately $500,000 due to the increase instaffing and operations in the homeland security segment;

•      approximately $100,000 due to increased legaland accounting fees related to the filing of two registration statements duringthe six months ended October 31, 2005, and to the reaudit of the fiscal year 2004financial statements (the work was performed in fiscal year 2006) required dueto Grant Thornton’s unwillingness to consent to the inclusion of its report forthat fiscal year;

•      approximately $300,000 due to the increase inother corporate headquarters expenses.

 

We anticipate that we will increase our selling,general and administrative expenses during the remainder of fiscal year 2006through anticipated increased marketing efforts for and operations in ourhomeland security and semiconductor materials and products segments.  There can be no assurance that ouranticipated increased selling, general and administrative expenses will resultin increased revenues from product sales.

 

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

 

Our impairment loss on assets held for saleincreased during the six months ended October 31, 2005, as compared to the sameperiod of our prior fiscal year, both on a dollar amount and on a percentage ofrevenues basis as reflected in the following table (while there was no suchcharge in the three months ended October 31, 2005 and 2004, respectively):

 
| ** **          | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dollar amount       |       | —                             |       | —                           |       | $ | 398,000 |   | — |   |
| Percent of revenues |       | —                             |       | —                           |       | 3.6 | % | — |   |
|                     |            |                                    |            |                                  |            |  |  |  |  |  |

 

The increase for the six months ended October 31,2005, resulted from operational decisions made related to the ongoing reviewand improvements underway in our semiconductor materials and productssegment.  As part of this ongoing reviewand resulting operational changes, certain equipment was identified asexcessive for our planned future operations. As a result, certain of the identified equipment whose book valueexceeded estimated net realizable were individually written down to estimatednet realizable value, resulting in a cumulative impairment charge of$398,000.  The equipment has not yet beensold, but we expect that the equipment will be sold within the upcoming ninemonths.

 

***Research andDevelopment Expenses***

 

Our research and development expenses increased on adollar basis and on a percentage of revenue basis during the three and sixmonths ended October 31, 2005, 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,** | ** ** |
|---------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dollar amount       |       | $                                  | 757,000    |                             | $          | 138,000 |   | $ | 1,211,000 |   | $ | 368,000 |   |
| Percent of revenues |       | 13.0                               | %          | 4.5                              | %          | 11.1 | % | 6.9 | % |
|                     |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

 

The dollar increase for the three and six monthsended October 31, 2005, is primarily related to an increase in research anddevelopment expenses associated with our trace and bulk detection technology,although approximately $300,000 has been expended on semiconductor research anddevelopment work related mainly to various SOI processes.  Consistent with our product developmentstrategy, we are seeking to identify and evaluate new products in the homelandsecurity segment as well as to bring existing 

 

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technologies, including IMS-based products and NeutroTestTM,to a production-ready state.  Themajority of this research and development is being performed by IUT and isrelated to IMS and neutron-based detection. In June 2004, we entered into a research and development agreement withIUT, which contemplated the funding of certain projects of up to $4,000,000over several years.  The work is beingfunded in steps and is based upon the completion of various milestones, asdefined.  We have no obligation to fundany work under this agreement unless we have approved such effort.  We funded approximately $657,000 under thisagreement during the six months ended October 31, 2005 (as compared to $100,000during the six months ended October 31, 2004, and a total of $1,154,000 sinceentering into the agreement in June 2004).

 

In December 2005, we approved a development planwith Lucent which obligated us under a Development & LicensingAgreement.  Under that Agreement, we willendeavor to develop a next-generation imaging and night vision surveillancetechnology.  The development plancontemplates a proof-of-concept within 12 months followed by steps towardscommercialization, although we can provide no assurances that a commerciallyattractive product will ultimately be available.  We have paid Lucent $1,000,000 (which was inprepaid expenses at October 31, 2005), will pay the next $1,000,000 in December2005 and we may be obligated to pay an additional $1,000,000 per quarter indevelopment funding for the next ten quarters. We have the right to terminate the development project for any reasonfrom time-to-time, so long as termination is prior to the first commercial saleof a licensed product.  As such, assumingwe continue with the development program, we expect our quarterly research anddevelopment expense to significantly increase due to this agreement, commencingwith the quarter ending January 31, 2006.

 

We believe that the development and introduction ofnew product applications is critical to our future success.  We expect that research and developmentexpenses may increase assuming sufficient cash remains available and we areable to procure necessary materials and outside services.  It is likely that research and developmentexpenditures will continue to vary as a percentage of revenues because of thetiming and amount of future revenues. Except for work being performed on oursemiconductor products at our facilities in Vancouver, Washington, we operateno other facilities of our own for research and development.  Significantly all other research and developmentwork is performed by outside entities, none of which we control (although wehave increased our minority ownership position in IUT to 30%).  Although we expend significant resources onresearch and development, we cannot offer any assurance that our current orfuture lines of business or products resulting from our research anddevelopment efforts will be profitable or generate significant revenues.

 

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

 

Other Income (Expense), net decreased during thethree and six months ended October 31, 2005, 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,** | ** ** |
|---------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **    | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dollar amount |       | $                                  | (1,577,000 | )                                | $          | (13,000 | ) | $ | (3,021,000 | ) | $ | (7,000 | ) |
|               |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

 

The decrease for the three and six months endedOctober 31, 2005, resulted primarily from interest charges and amortization ofdebt issuance costs related to our convertible debentures issued in February2005.  Included in the amount for the sixmonths ended October 31, 2005, is a noncash interest charge of approximately$1,700,000 related to the amortization of the debt discount on the convertibledebentures and a noncash charge for amortization of debt issuance costs ofapproximately $500,000.  Also included isthe nominal 8% interest expense on the convertible debentures, of which$506,000 was paid in common stock and $455,000 was paid in cash.  Lastly, interest income in the amount of$211,000 was earned that partially offsets the cash and noncash interestexpense. We expect that our other expenses will remain at the same quarterlylevel or increase until either principal repayments on the convertibledebentures commence in March 2006 or until the convertible debentures areconverted, if ever, to common stock.

 

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***Income Taxes***

 

We currently operate at a loss and expect to operateat a loss until the products currently under development begin to generatesufficient revenue.  The losses we anticipateincurring during the remaining portion of the current year are not expected togenerate an income tax benefit because of the uncertainty of the realization ofthe deferred tax asset.  As such, we havealso provided a valuation allowance against our net deferred tax asset asrealization is uncertain.

 

***Net Loss***

 

Our net loss increased during the three and sixmonths ended October 31, 2005, 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,** | ** ** |
|---------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **    | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dollar amount |       | $                                  | (5,252,000 | )                                | $          | (2,468,000 | ) | $ | (10,424,000 | ) | $ | (4,340,000 | ) |
|               |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

 

We anticipate that losses will continue until (ifever): (i) revenues from our current operations substantially increase or (ii)we generate substantial revenues from products introduced as a result of ourresearch and development projects. Further, the revenue increases must increase faster than any increasesin operating and research and development expenses.  We expect that our net loss will continueduring at least the short term as we continue to pursue new revenue streams inour semiconductor materials and products business and as we continue ourmarketing and research efforts to expand sales and develop new products in thehomeland security business segment, including the commercialization of the IMSand NeutroTestTM technology.

 

We anticipate that our operations during theremainder of fiscal year 2006 will result in a loss since we are not likely toincrease our revenues from our existing products or generate additional salesfrom the new products we may develop in a sufficient amount (if at all) tooffset our operating and research and development expenses.

 

***Liquidity andCapital Resources***

 

Working Capital

 

Our working capital decreased by approximately$18,964,000 during the six months ended October 31, 2005, from a workingcapital surplus of $17,991,000 at April 30, 2005, to a working capital deficitof $(973,000) at October 31, 2005.   Thedecrease in working capital is due to a combination of factors, including:

 

•      approximately $10,500,000 due to an increasein the current portion of the convertible debentures (which are payable at ouroption in cash or common stock, assuming all contractual requirements forpayment in common stock are met);

•      approximately $6,000,000 of cash consumeddirectly in operating activities (calculated as $8,400,000 of cash used inoperating activities, netted down by $2,400,000 of the cash impact of changesin other current assets or liabilities included in that $8,400,000 totalusage);

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

•      approximately $1,200,000 expended onpurchases of fixed assets;

•      an offsetting amount of approximately $600,000related to assets held for sale that were reclassed to current assets fromproperty and equipment

 

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•      an offsetting amount of approximately$400,000 related to the net impact of proceeds from common stock exceedingprincipal repayments on debt and preferred stock dividends paid.

 

Cash Flows

 

At October 31, 2005, we had $9,559,000 of cash andcash equivalents, a decrease of $11,647,000 as compared to $21,206,000 at April 30, 2005.  Our principal source of funding for the sixmonths ended October 31, 2005, was from the existing cash balance at April 30,2005, which was derived from our convertible debenture offering completed inFebruary 2005.  Our principal source offunding for the six months ended October 31, 2004, was from the issuance ofpreferred stock ($3,049,000 net of due diligence fees and related expenses ascompared to $0 during the comparable period of fiscal year 2006) and theexercise of common stock options and warrants ($5,479,000 as compared to$930,000 during the comparable period of fiscal year 2006).

 

We used cash in operating activities of $8,428,000and $4,965,000 during the six months ended October 31, 2005 and 2004,respectively.  Cash used in operatingactivities for the six months ended October 31, 2005 and 2004 was principallythe result of our ongoing business activities that resulted in a net lossattributable to common stockholders of $10,525,000 and $5,546,000,respectively.  Activity during the sixmonths ended October 31, 2005, also included a $1,000,000 prepayment to Lucentin relation to the development plan signed in December 2005.

 

Our investing activities used cash of $3,625,000 and$566,000 for the six months ended October 31, 2005 and 2004, respectively.  Cash used in investing activities for the sixmonths ended October 31, 2005, consisted primarily of the purchase of PPSC inMay 2005 (for which we paid approximately $2,500,000 in cash and issued 506,527shares of our restricted stock at an agreed valuation of $1,125,000 ($2.22 pershare), and paid $98,000 in legal and accounting fees), along with $1,165,000expended on additions of property and equipment.  Our investing expenditures during the firstsix months of our 2005 fiscal year are comprised primarily of purchases ofproperty and equipment.

 

Financing activities provided cash of $406,000 and$8,464,000 for the six months ended October 31, 2005 and 2004,respectively.  Cash provided by financingactivities for the six months ended October 31, 2005, resulted primarily fromthe exercise of common stock options and warrants ($930,000) which was offsetprimarily by debt repayments and dividend payments on our then outstandingSeries E Stock.  Cash provided byfinancing activities for the six months ended October 31, 2004, resultedprimarily from the exercise of common stock warrants ($5,428,000) along withthe issuance of preferred stock ($3,049,000 net of due diligence fees andrelated expenses) during that period.

 

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

 

Additional LiquidityConsiderations

 

As of October 31, 2005, we hadcommitments outstanding for capital expenditures of approximately $64,000.

 

Our future commitments have increased due to theAgreement and development plan with Lucent, under which we endeavor to developa next-generation imaging and night vision surveillance technology (although wecan provide no assurances that a commercially attractive product willultimately be available).  We have paidLucent $1,000,000 (which was in prepaid expenses at October 31, 2005), will paythe next $1,000,000 in December 2005 and we may be obligated to pay anadditional $1,000,000 per quarter in development funding for the next tenquarters.  We have the right to terminatethe development project for any reason from time-to-time, so long astermination is prior to the first commercial sale of a licensed product.  As such, assuming we continue the developmentprogram, we expect our quarterly 

 

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research and development funding to significantlyincrease due to this agreement, commencing with the quarter ending January 31,2006.

 

The first of twelve monthly principal payments (eachmonthly payment in the amount of approximately $1,900,000) on our 8%Convertible Debentures (the “Debentures”) becomes due in March 2006.  We currently do not have sufficient cash andcash equivalents on hand to make these cumulative payments in cash.  However, both the principal and interest arepayable, at our option, in common stock , subject to various requirements(which we currently meet).  If we chooseto make a scheduled principal payment by issuing common stock, and allrequirements to do so are met, the conversion price will be the lesser of thethen Conversion Price (currently $5.00 per share) or 88% of the average of theten closing prices ending on the trading day immediately prior to the monthlyredemption date.   The Debentures and therelated warrants have certain limitations on our ability to issue shares to theholders of the Debentures and warrants (the “Holders”). Under the terms of theDebentures and the warrants, we are prohibited from issuing shares of ourcommon stock to the holders of the Debentures (upon conversion, in payment ofinterest, or in redemption or payment of the Debentures) and the relatedwarrants (upon exercise) if:  (a) theissuance would result in any Holder owning more than 4.99% of our outstandingcommon stock (although the holders can waive this provision upon more than60 days’ notice to us) or  (b) theissuance would result in more than 5,514,601 shares having been issued pursuantto the Debentures and the Warrants (19.999% of the total number of sharesoutstanding on February 24, 2005) unless our shareholders approved thetransaction as required by the Nasdaq rules.  In our shareholder meeting on October 25, 2005, the shareholders votedto approve the removal of share issuance limitations associated with theDebentures and related warrants.  Assuch, the 19.999% share issuance limitation is no longer applicable, althoughthe 4.99% limitation will continue to be applicable until (if ever) waived bythe respective Holder.  It is likelythat, if the Debentures are not modified and if we continue to meet allrequirements to allow us to do so, we will issue shares of our common stock inpayment of a portion of or all of our Debenture obligation.

 

We anticipate that without entering into anotherfinancing transaction, our cash and cash equivalents will continue to decreaseas we continue to use cash in operations and investing activities, and until(if ever) we achieve positive cash flow from our operations – dependent on ourability to increase our revenues significantly and to maintain control over ourexpenses.  As of October 31, 2005, webelieve we have sufficient working capital to finance our anticipatedoperations and projected negative cash flow through our 2006 fiscal year, butwe will need a significant amount of additional financing to meet ourobligations during our 2007 fiscal year. We continue to explore economically viable financing arrangement options,which, if available, will likely be implemented.

 

The warrants that were issued with the Debentures(“Debenture Warrants”), which grant the right to purchase a total of 1,540,000common shares at an exercise price of $6.25 per share, include a provisionwhich would decrease the exercise price of the Debenture Warrants to that ofany subsequent equity sale and increase the number of common shares issuablesuch that the aggregate exercise price remains equal to that in existencecurrently ($9,625,000).  Upon entering afuture financing arrangement, it is highly likely (given the current price ofour common stock) that this warrant provision would be activated which wouldresult in a greater number of outstanding Debenture Warrants at a lowerexercise price.

 

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

 

***Contractual CashObligations***

 

We have no material changes to the disclosure onthis matter made in our Annual Report on Form 10-KSB for the year ended April30, 2005, except for the agreement with Lucent under which we became obligatedupon approval of the development plan on December 5, 2005.  As discussed in Note 12 to the financial 

 

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statements in Part I, in exchange for an exclusiveright, except for certain rights reserved by Lucent, to make, use and selllicensed products arising from technology developed under the agreement, wehave agreed to fund Lucent’s development efforts for the project through theperiodic payment over a two and one-half year period of a development feetotaling $12,000,000.  Of this amount,$1,000,000 was paid upon commencing discussions with Lucent in July 2005  (although $900,000 was fully-refundable), thenext $1,000,000 will be paid in December 2005 as a result of our acceptance ofthe development plan on December 5, 2005 (when the previous payment becamenon-refundable), and the balance will be paid in $1,000,000 increments everythree months thereafter.  However, wehave the right to terminate the development project for convenience fromtime-to-time, so long as termination is prior to the first commercial sale of alicensed product.  As such, thecontractual cash obligation is contingent on our decision to continue with eachfunding payment throughout the development timeline.

 

***Off-Balance Sheet Arrangements***

 

Wehave no material changes to the disclosure on this matter made in our AnnualReport on Form 10-KSB for the year ended April 30, 2005.

 

***CriticalAccounting Estimates***

 

We consider an accounting estimate to be critical if1) the accounting estimate requires us to make assumptions about matters thatwere highly uncertain at the time the accounting estimate was made, and 2)changes in the estimate that are reasonably likely to occur from period toperiod, or use of different estimates that we reasonably could have used in thecurrent period, would have a material impact on our financial condition orresults of operations.

 

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

 

*Goodwill and Intangible Assets*

 

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

 

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

 

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For intangible assets other than goodwill, SFAS No.144 *Accounting for the Impairment orDisposal of Long-Lived Assets* is the authoritative standard on theaccounting for the impairment of such intangible assets.  As required, we perform tests for impairmentof intangible assets other than goodwill whenever events or circumstancessuggest that such assets may be impaired. To evaluate potential impairment, SFAS No. 144 requires us to assesswhether the future cash flows related to these assets will be greater thantheir carrying value at the time of the test. Accordingly, while our cash flowassumptions are consistent with the plans and estimates we are using to managethe underlying businesses, there is significant judgment in determining thecash flows attributable to our other intangible assets over their respectiveestimated useful lives.  We haveremaining other net intangible assets in the amount of $585,000 on ourcondensed consolidated balance sheet as of October 31, 2005, comprised of ourtrace and bulk detection technology acquired in December 2002, customer listsacquired in our acquisition of the business and assets of EMG in June 2004 andthe customer base acquired in our acquisition of PPSC in May 2005.  We are required to periodically evaluate ourother intangible assets balances for impairments. If we were to incuradditional impairments to our other intangible assets, it could have an adverseimpact on our future earnings, if any.

* *

*Valuation of Equity Transactions*

 

We value transactions associated with common orpreferred stock that is convertible into common stock based on the market valueof the underlying common stock on the date of the signing of the agreement. Wevalue transactions associated with common stock warrants at the appropriatemeasurement date utilizing the Black-Scholes pricing model, with assumptions asto volatility (100% for fiscal years 2005 and 2006), risk-free interest rate(4.0%) and estimated life of the warrants based on historical information.During the six months ended October 31, 2005, we issued common stock warrantsfor services and in settlement of a lawsuit in the cumulative amount of$338,000.  If the assumptions used, asthey relate to volatility, risk-free interest rate and estimated life of thewarrants, were materially different, the overall valuation of these and anyfuture equity based transactions could change significantly.

 

**Item 3: Controls and Procedures**

 

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

 

Disclosure controls and procedures are controls andother procedures that are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed in our reports filed under the Exchange Act isaccumulated and communicated to management, including our principal executiveofficer and our principal financial officer, as appropriate, to allow timelydecisions regarding required disclosure.

 

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**Part II: Other Information**

 

**Item 1:  LegalProceedings**

 

See Note 10 to the financial statements in Part Ifor the description of the litigation brought by Prime International Equities,LLC in March 2005 and settled in October 2005.

 

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

 

**Acquisitionof PPSC**

 

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

 

(a)           The transaction was completed effective May16, 2005.

 

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

 

(c)           The shares were not sold for cash.  The shares were issued in partialconsideration for the purchase by our wholly-owned subsidiary of the businessdescribed above.  At the time the numberof shares was calculated, the market price of our stock was approximately $2.22per share.

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction.  We did not engage in anypublic advertising or general solicitation in connection with this transaction.  We provided the accredited investor withdisclosure of all aspects of our business, including providing the accreditedinvestor with our reports filed with the Securities and Exchange Commission,our press releases, access to our auditors, and other financial, business, andcorporate information.  Based on ourinvestigation, we believe that the accredited investor obtained all informationregarding Isonics it requested, received answers to all questions it posed, andotherwise understood the risks of accepting our securities for investment purposes.

 

(e)           The common stock issued in this transactionis not convertible or exchangeable.  Nowarrants were issued in this transaction.

 

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

 

**Payment ofConvertible Debenture Interest in Common Stock**

 

On September 30, 2005, we issued 200,600 shares ofour restricted common stock to holders of our Convertible Debentures in paymentof our interest obligation for the quarter ended September 30, 2005.  The following sets forth the information requiredby Item 701 in connection with that transaction:

 

(a)           The transaction was completed effectiveSeptember 30, 2005.

 

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

 

(c)           The shares were not sold for cash.

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction.  We did not engage in anypublic advertising or general solicitation in connection with this transaction.  The investors had access to all of ourreports filed with the Securities and Exchange Commission, our press releasesand other financial, business and corporate information.  Based on our investigation, we believe thatthe investors obtained all information regarding Isonics that they requested,received answers to all questions they posed and otherwise understood the risksof accepting our securities for investment purposes.

 

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(e)           The common stock issued in this transactionis not convertible or exchangeable.  Nowarrants were issued in this transaction.

 

(g)           We received no cash proceeds from theissuance of the shares.

 

**Warrant Issuances**

 

During the six months ended October 31, 2005, weissued warrants (other than registered issuances) to purchase a cumulative271,000 shares of our common stock, including: (1) an August 2005 grant to a former employee, exercisable through July31, 2006, to purchase 1,000 shares of our restricted common stock for $3.25 pershare, (2) a September 2005 grant to a financial advisor, exercisable throughSeptember 8, 2007, to purchase 100,000 shares of our restricted common stockfor $2.81 per share, (3) a September 2005 grant to a management consultant,exercisable through August 16, 2007, to purchase 50,000 shares of ourrestricted common stock for $2.84 per share and (4) an October 2005 grant, insettlement of a lawsuit, exercisable through December 29, 2006, to purchase120,000 shares of our restricted common stock for $2.40 per share.  The following sets forth the informationrequired by Item 701 in connection with that transaction:

 

(a)           The transactions were completed during thesix months ended October 31, 2005.

 

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

 

(c)           The warrants were not issued for cash, but insettlement of an employment dispute.

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction.  We did not engage in anypublic advertising or general solicitation in connection with thistransaction.  The investors had access toall of our reports filed with the Securities and Exchange Commission, our pressreleases and other financial, business and corporate information.  Based on our investigation, we believe thatthe investors obtained all information regarding Isonics it requested, receivedanswers to all questions it posed, and otherwise understood the risks ofaccepting our securities for investment purposes.

 

(e)           The warrants are exercisable to purchaseshares of our common stock at $2.40 to $3.25 per share with expiration dates ofJuly 31, 2006, to September 8, 2007 (such information provided in detailabove).

 

(f)            We received no cash proceeds from the warrantgrants.

 

**Exercise of Common Stock Warrants**

 

During the six months ended October 31, 2005, weissued 522,011 shares of common stock as a result of the exercise of commonstock warrants.  The following sets forththe information required by Item 701 in connection with these transactions:

 

(a)           The transactions were completed during thesix months ended October 31, 2005.

 

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

 

(c)           The total amount we received from the cashexercises during the six months ended October 31, 2005, was $730,517.  Certain warrant holders completed cashlessexercises.

 

(e)           We relied on the exemption from registrationprovided by Sections 3(a)(9), 4(2) and 4(6) under the Securities Act of 1933for these transactions and Regulation D. We did not engage in any public advertising 

 

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or general solicitation in connection with thetransactions.  The investors had accessto all of our reports filed with the Securities and Exchange Commission, ourpress releases and other financial, business and corporate information.  Based on our investigation, we believe thatthe investors obtained all information regarding Isonics that they requested,received answers to all questions they posed and otherwise understood the risksof accepting our securities for investment purposes.

 

(f)            The common stock is not convertible orexchangeable or exercisable for any other equity security.

 

(f)            We will use the proceeds for general workingcapital.

 

**Conversion of Preferred Stock**

 

During the six months ended October 31, 2005, (1) aholder of our Series D Stock (an accredited investor) converted 800 shares ofSeries D Stock into 72,727 shares of common stock and (2) a holder of ourSeries E Stock (an accredited investor) converted 33,000 shares of Series DStock into 2,661,290 shares of common stock. The following sets forth the information required by Item 701 inconnection with that transaction:

 

(a)           The transactions were completed during thesix months ended October 31, 2005.

 

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

 

(c)           The shares were not sold for cash.  The shares of common stock were issued inexchange for (and in conversion of) outstanding shares of Series D Stock andSeries E Stock, respectively.

 

(d)           We relied on the exemption from registrationprovided by Sections 3(a)(9) under the Securities Act of 1933 for thesetransactions and Regulation D.  We didnot engage in any public advertising or general solicitation in connection withthe transactions.  The accreditedinvestors had access to all of our reports filed with the Securities andExchange Commission, our press releases and other financial, business andcorporate information.  Based on ourinvestigation, we believe that the accredited investors obtained allinformation regarding Isonics that they requested, received answers to allquestions they posed and otherwise understood the risks of accepting oursecurities for investment purposes.

 

(e)           The common stock issued in these transactionsis not convertible or exchangeable.  Nowarrants were issued in these transactions. The underlying shares of common stock are included in a currentlyeffective registration statement – shares underlying Series D stock in SEC fileno. 333-114521 and shares underlying Series E stock in SEC file no. 333-126231.

 

(f)            We received no cash proceeds from theissuance of the shares of common stock.

 

**Item 6: Exhibits**

 

Exhibits.

 
| 10.1 |   | Development and Licensing Agreement dated September  28, 2005, by and between Lucent Technologies, Inc. and Insonics Corporation  (confidential treatment requested). Incorporated by reference from Form 8-K  reporting an event of December 5, 2005. |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.  |   | Certification pursuant to  Sarbanes-Oxley Section 302                                                                                                                                                                                                  |
| 32.  |   | Certification pursuant to  18 U.S.C. Section 1350                                                                                                                                                                                                      |

 

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**SIGNATURES**

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized, in the City ofGolden, County of Jefferson, State of Colorado, on the 15th day of December2005.

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

 

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