** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-Q**

(**Mark One)**

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

**Forthe quarterly period ended January 31, 2007**

**or**

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

**Forthe transition period from             to**

**Commissionfile number:  001-12531**

**ISONICS CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

**5906 McIntyre Street**

**Golden,Colorado 80403**

(Address of principal executive offices with zip code)

**(303)279-7900**

(Registrant’s telephone number, including area code)

**N/A**

(Former name,former address and former

fiscal year, if changed since last report)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes  x    No  o

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated fileror a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

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

 

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

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

| Class                             |   | **Outstanding at March 12,  2007** |
|-----------------------------------|--------|------------------------------------|
| Common Stock —  no par value |   | 12,637,887  shares                 |

** **

 

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**Isonics Corporation andSubsidiaries**

**TABLE OF CONTENTS**
| Part I:    | Financial Information |
|------------|-----------------------|
|       |                  |
|       | Item 1:               | Financial Statements |
|       |                  |   |
|       |                  | Condensed Consolidated Balance Sheets as of January  31, 2007 and April 30, 2006 |
|       |                  | Condensed Consolidated Statements of Operations for  the Three and Nine Months Ended January 31, 2007 and 2006 |
|       |                  | Condensed Consolidated Statements of Cash Flows for  the Nine Months Ended January 31, 2007 and 2006 |
|       |                  | Notes to Condensed Consolidated Financial Statements |
|       |                  |   |
|       | Item 2:               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|       |                  |   |
|       | Item 3:               | Quantitative  and Qualitative Disclosures About Market Risk |
|       |                  |   |
|       | Item 4:               | Controls and  Procedures |
|       |                  |   |
| Part  II:  | Other  Information    |
|       |                  |
|       | Item  1:              | Legal  Proceedings |
|       |                  |   |
|       | Item  1A:             | Risk  Factors |
|       |                  |   |
|       | Item 2:               | Unregistered  Sales of Equity Securities and Use of Proceeds |
|       |                  |   |
|       | Item 4:               | Submission of  Matters to a Vote of Security Holders |
|       |                  |   |
|       | Item 6:               | Exhibits |
|       |                  |   |
| Signatures |                  |

** **

2

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**Part I: Financial Information**

**Item 1: Financial Statements**

**Isonics Corporation andSubsidiaries**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(inthousands, except share amounts)**

**ASSETS**
| ** **                                                             | ** ** | **(Unaudited)**                | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **January 31, 2007** | ** ** | **April 30, 2006** | ** ** |
| CURRENT ASSETS:                                                        |       |                           |       |                         |       |
| Cash and cash  equivalents                                             |       | $                              | 1,854      |                         | $          | 1,586 |   |
| Accounts  receivable (net of allowances of $173 and $67, respectively) |       | 3,196                          |       | 3,066                        |       |
| Inventories                                                            |       | 1,424                          |       | 630                          |       |
| Prepaid expenses  and other current assets                             |       | 1,707                          |       | 1,046                        |       |
| Long lived  assets held for sale                                       |       | 225                            |       | 560                          |       |
| Assets of  discontinued operations                                     |       | 791                            |       | 1,713                        |       |
| Total current  assets                                                  |       | 9,197                          |       | 8,601                        |       |
|                                                                   |       |                           |       |                         |       |
| LONG-TERM ASSETS:                                                      |       |                           |       |                         |       |
| Property and  equipment, net                                           |       | 6,060                          |       | 4,562                        |       |
| Goodwill                                                               |       | 3,631                          |       | 3,631                        |       |
| Intangible  assets, net                                                |       | 350                            |       | 491                          |       |
| Equity in net  assets of investee                                      |       | 460                            |       | 386                          |       |
| Other assets                                                           |       | 626                            |       | 192                          |       |
| Total long-term  assets                                                |       | 11,127                         |       | 9,262                        |       |
|                                                                   |       |                           |       |                         |       |
| TOTAL ASSETS                                                           |       | $                              | 20,324     |                         | $          | 17,863 |   |

 

**LIABILITIES AND STOCKHOLDERS’EQUITY**
| ** **                                                                                                                                                                                                               | ** ** | **(Unaudited)**                | ** ** | ** **                   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                               | ** ** | **January 31, 2007** | ** ** | **April 30, 2006** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                                     |       |                           |       |                         |       |
| Accounts payable                                                                                                                                                                                                         |       | $                              | 1,395      |                         | $          | 2,169 |   |
| Accrued  liabilities                                                                                                                                                                                                     |       | 2,957                          |       | 1,598                        |       |
| Current portion  of obligation under capital lease                                                                                                                                                                       |       | 327                            |       | 14                           |       |
| Current portion  of notes payable                                                                                                                                                                                        |       | 269                            |       | 772                          |       |
| Current portion  of convertible debentures, net of discount                                                                                                                                                              |       | 284                            |       | 10,432                       |       |
| Liabilities of  discontinued operations                                                                                                                                                                                  |       | 50                             |       | 61                           |       |
| Total current  liabilities                                                                                                                                                                                               |       | 5,282                          |       | 15,046                       |       |
|                                                                                                                                                                                                                     |       |                           |       |                         |       |
| Obligation under  capital lease, net of current portion                                                                                                                                                                  |       | 801                            |       | 34                           |       |
| Derivative liabilities                                                                                                                                                                                                   |       | 5,583                          |       | —                       |       |
| Convertible debentures,  net of discount and current portion                                                                                                                                                             |       | 6,352                          |       | —                       |       |
| Notes payable, net of  current portion                                                                                                                                                                                   |       | 34                             |       | 140                          |       |
|                                                                                                                                                                                                                     |       |                           |       |                         |       |
| TOTAL LIABILITIES                                                                                                                                                                                                        |       | 18,052                         |       | 15,220                       |       |
|                                                                                                                                                                                                                     |       |                           |       |                         |       |
| Minority interest in  consolidated subsidiary                                                                                                                                                                            |       | 123                            |       | —                       |       |
|                                                                                                                                                                                                                     |       |                           |       |                         |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                               |       |                           |       |                         |       |
| Common stock -  no par value; shares authorized: January 31, 2007-175,000,000; April 30,  2006-75,000,000; 12,070,881 and 10,517,780 shares issued and outstanding on  January 31, 2007 and April 30, 2006, respectively |       | 63,175                         |       | 57,061                       |       |
| Additional paid  in capital                                                                                                                                                                                              |       | 15,628                         |       | 13,910                       |       |
| Deferred  compensation                                                                                                                                                                                                   |       | —                         |       | (24                          | )          |
| Accumulated deficit                                                                                                                                                                                                      |       | (76,654                        | )          | (68,304                      | )          |
| Total  stockholders’ equity                                                                                                                                                                                         |       | 2,149                          |       | 2,643                        |       |
|                                                                                                                                                                                                                     |       |                           |       |                         |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                          |       | $                              | 20,324     |                         | $          | 17,863 |   |

 

See notes tocondensed consolidated financial statements.

3

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**Isonics Corporation andSubsidiaries**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per sharedata)**

**(Unaudited)**
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                 | ** ** | **January 31,**             | ** ** | **January 31,**            | ** ** |
| ** **                                                                 | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues                                                                   |       | $                                | 6,535      |                            | $          | 5,260 |   | $ | 20,576 |   | $ | 12,950 |   |
| Cost of revenues                                                           |       | 5,139                            |       | 4,926                           |       | 16,164 |   | 13,182 |   |
| Gross margin                                                               |       | 1,396                            |       | 334                             |       | 4,412 |   | (232 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                                                       |       |                             |       |                            |       |   |   |   |   |
| Selling, general and administrative                                        |       | 3,150                            |       | 2,651                           |       | 11,015 |   | 7,771 |   |
| Impairment loss on assets held for sale                                    |       | —                           |       | —                          |       | — |   | 398 |   |
| Research and development                                                   |       | 1,442                            |       | 2,563                           |       | 3,630 |   | 3,673 |   |
| Total operating expenses                                                   |       | 4,592                            |       | 5,214                           |       | 14,645 |   | 11,842 |   |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating loss                                                             |       | (3,196                           | )          | (4,880                          | )          | (10,233 | ) | (12,074 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense):                                                   |       |                             |       |                            |       |   |   |   |   |
| Amortization of debt issuance costs                                        |       | (38                              | )          | (272                            | )          | (197 | ) | (773 | ) |
| Interest and other income                                                  |       | —                           |       | 60                              |       | 54 |   | 260 |   |
| Interest expense                                                           |       | (928                             | )          | (2,307                          | )          | (2,347 | ) | (5,026 | ) |
| Foreign exchange                                                           |       | 3                                |       | —                          |       | 4 |   | (6 | ) |
| Gain on extinguishment of debt                                             |       | —                           |       | —                          |       | 227 |   | — |   |
| Gain on derivative instruments                                             |       | 1,903                            |       | —                          |       | 4,223 |   | — |   |
| Equity in net income of investee                                           |       | 63                               |       | 28                              |       | 73 |   | 28 |   |
| Total other income (expense), net                                          |       | 1,003                            |       | (2,491                          | )          | 2,037 |   | (5,517 | ) |
| Loss from  continuing operations before income taxes and minority interest |       | (2,193                           | )          | (7,371                          | )          | (8,196 | ) | (17,591 | ) |
| Income tax  expense                                                        |       | —                           |       | —                          |       | — |   | — |   |
| Minority interest  in operations of consolidated subsidiary                |       | (97                              | )          | —                          |       | (55 | ) | — |   |
| Loss from  continuing operations                                           |       | (2,290                           | )          | (7,371                          | )          | (8,251 | ) | (17,591 | ) |
| Loss from  discontinued operations, net of income taxes                    |       | (87                              | )          | (290                            | )          | (99 | ) | (494 | ) |
| NET LOSS                                                                   |       | $                                | (2,377     | )                               | $          | (7,661 | ) | $ | (8,350 | ) | $ | (18,085 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| DIVIDEND ON  SERIES E CONVERTIBLE PREFERRED STOCK                          |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | (101 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| NET LOSS  ATTRIBUTABLE TO COMMON STOCKHOLDERS                              |       | $                                | (2,377     | )                               | $          | (7,661 | ) | $ | (8,350 | ) | $ | (18,186 | ) |
|                                                                       |       |                             |       |                            |       |   |   |   |   |
| **Net  loss per share—basic and diluted**                             |       |                             |       |                            |       |   |   |   |   |
| Continuing operations                                                      |       | $                                | (0.19      | )                               | $          | (0.91 | ) | $ | (0.71 | ) | $ | (2.30 | ) |
| Discontinued operations                                                    |       | $                                | (0.01      | )                               | $          | (0.04 | ) | $ | (0.01 | ) | $ | (0.06 | ) |
| Attributable to common stockholders                                        |       | $                                | (0.20      | )                               | $          | (0.95 | ) | $ | (0.72 | ) | $ | (2.38 | ) |
| Weighted average common  shares used in computing per share information    |       | 11,962                           |       | 8,105                           |       | 11,666 |   | 7,646 |   |

 

See notes tocondensed consolidated financial statements.

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**Isonics Corporation andSubsidiaries**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands, except shareamounts)**

**(Unaudited)**
| ** **                                                                                           | ** ** | **Nine Months Ended January 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2007**                                              | ** ** | **2006** | ** ** |
| ** **                                                                                           | ** ** | ** **                                            | ** ** | ** ** | ** ** |
| Net cash used in  operating activities                                                               |       | $                                                     | (7,361     | ) | $ | (12,635 | ) |
|                                                                                                 |       |                                                  |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                               |       |                                                  |       |   |   |
| Purchases of property and equipment                                                                  |       | (1,615                                                | )          | (1,488 | ) |
| Equity investment in a business                                                                      |       | (100                                                  | )          | (336 | ) |
| Acquisition of business, net of cash acquired                                                        |       | —                                                |       | (2,440 | ) |
| Cash used in investing activities                                                                    |       | (1,715                                                | )          | (4,264 | ) |
|                                                                                                 |       |                                                  |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                               |       |                                                  |       |   |   |
| Principal payments under capital lease obligations                                                   |       | (58                                                   | )          | (41 | ) |
| Principal payments on borrowings                                                                     |       | (5,718                                                | )          | (583 | ) |
| Proceeds from issuance of common stock                                                               |       | 15                                                    |       | 1,758 |   |
| Proceeds from the issuance of convertible debentures  and related warrants, net of offering costs    |       | 15,105                                                |       | — |   |
| Preferred stock dividends                                                                            |       | —                                                |       | (101 | ) |
| Cash provided by financing activities                                                                |       | 9,344                                                 |       | 1,033 |   |
|                                                                                                 |       |                                                  |       |   |   |
| NET INCREASE (DECREASE)  IN CASH AND CASH EQUIVALENTS                                                |       | 268                                                   |       | (15,866 | ) |
| Cash and cash equivalents at beginning of period                                                     |       | 1,586                                                 |       | 20,598 |   |
| Cash and cash equivalents at end of period                                                           |       | $                                                     | 1,854      |   | $ | 4,732 |   |
|                                                                                                 |       |                                                  |       |   |   |
| Supplemental  disclosure of cash flow information:                                                   |       |                                                  |       |   |   |
| Cash paid during the period for:                                                                     |       |                                                  |       |   |   |
| Interest                                                                                             |       | $                                                     | 141        |   | $ | 988 |   |
| Income taxes                                                                                         |       | $                                                     | —     |   | $ | — |   |
|                                                                                                 |       |                                                  |       |   |   |
| Supplemental  disclosure of noncash investing and financing activities:                              |       |                                                  |       |   |   |
| Capital lease obligation for property and equipment                                                  |       | $                                                     | 1,138      |   | $ | — |   |
| Accruals for property and equipment                                                                  |       | $                                                     | 32         |   | $ | 31 |   |
| Capitalized debt issuance costs associated with  issuance of common stock in a financing transaction |       | $                                                     | 601        |   | $ | — |   |
| Payment in common stock of principal due on convertible  debentures                                  |       | $                                                     | 5,363      |   | $ | — |   |
| Stock issued in  connection with an acquisition                                                      |       | $                                                     | —     |   | $ | 1,292 |   |

 

During the nine months ended January 31,2006, we issued 2,500 shares of common stock in a cashless exercise of a commonstock warrant and issued 683,505 shares of common stock upon conversion ofconvertible preferred stock.

See notes tocondensed consolidated financial statements.

5

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**Isonics Corporation andSubsidiaries**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**NOTE 1 - BASIS OF PRESENTATION**

The accompanyingunaudited condensed consolidated financial statements of Isonics Corporationand Subsidiaries have been prepared on the same basis as the annual auditedfinancial statements and in accordance with accounting principles generallyaccepted in the United States (“US GAAP”) for interim financial information andthe rules and regulations of the Securities and Exchange Commission (“SEC”) forinterim financial statements.  In theopinion of management, such unaudited information includes all adjustments(consisting only of normal recurring accruals) necessary for a fairpresentation of this interim information. Operating results and cash flows for interim periods are not necessarilyindicative of results 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, as amended, for the yearended April 30, 2006.

We incurred significantlosses from operations and used significant working capital in operations forthe fiscal periods presented. Additionally, it is likely that we will continueto incur operating losses throughout the remainder of fiscal year 2007 as wecontinue to fund research and development of new and existing products andcover operating costs.  We haveencountered and we anticipate that we will continue to encounter liquidityproblems which could require us to curtail development projects, seek jointventure partners, sell assets and/or obtain additional financing with termsthat may not be as favorable as might otherwise be available.  However, we raised additional financing (seeNote 9), through long-term convertible debentures with a single investor, inthe amount of $16,000,000, which has resulted in having positive workingcapital at January 31, 2007, of $3,915,000. We believe that based on our financial position at January 31, 2007, andour projections of future operations, we will be able to continue operationsinto fiscal year 2008.

On February 13, 2007, weeffected a one-for-four reverse stock split (see Note 12).  All impacted amounts included in the condensedconsolidated financial statements and notes thereto have been restated for thestock split.  Impacted amounts includeshares outstanding, share issuances, shares underlying stock options and stockwarrants, loss per share and the fair value of equity-based instruments.

During the three monthsended January 31, 2007, we reclassified the operations of our life sciencesbusiness as discontinued operations in accordance with SFAS No. 144, *Accounting for the impairment or Disposal ofLong-Lived Assets* (“SFAS 144”). Prior year condensed consolidated financial statements have beenrestated to present the operations of the life sciences business asdiscontinued operations.  See Note 5 foradditional information.

**NOTE 2 - SIGNIFICANT ACCOUNTINGPOLICIES**

***MinorityInterest in Consolidated Subsidiary***

The portion ofincome or loss attributable to the minority interest in a consolidatedsubsidiary, not to exceed the minority interest’s equity in the consolidatedentity, is eliminated in the line item in the condensed consolidated statementsof operations entitled “minority interest in operations of consolidatedsubsidiary.” All material intercompany balances and transactions have beeneliminated.

***NetIncome (Loss) Per Share***

Basic net income (loss)per share is computed using the weighted average number of common sharesoutstanding 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 is

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computed using theweighted average number of common shares and potentially dilutive securitiesoutstanding during the period. Potentially dilutive securities consist of contingently issuable shares,the incremental common shares issuable upon conversion of convertible debt(using the “if converted” method) and shares issuable upon the exercise ofstock options and warrants (using the “treasury stock” method).  Potentially dilutive securities are excludedfrom the computation if their effect is anti-dilutive.

As of January 31, 2007,(a) a total of 5,088,733 outstanding stock options and common stock warrantsand (b) the unissued shares underlying our outstanding 6% and 8% convertibledebentures were excluded from the diluted net loss per share calculation, astheir inclusion would be anti-dilutive.  As of January 31, 2006, (a) a total of 1,903,986outstanding stock options and commonstock warrants and (b) the unissued shares underlying our outstanding 8%convertible debentures were excluded from the diluted net loss per sharecalculation, as their inclusion would be anti-dilutive.

During the nine monthperiod ended January 31, 2007, we issued the following shares of common stock:
| **Description**                                                                      | ** ** | **Number of Common Stock Shares** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Balance as of  April 30, 2006                                                        |       | 10,517,780                                            |       |
| Shares issued  from employee stock purchase plan                                     |       | 3,307                                                 |       |
| Shares issued in  payment of principal and interest on the 8% convertible debentures |       | 1,384,794                                             |       |
| Shares issued  related to the 6% convertible debenture financing                     |       | 165,000                                               |       |
| Balance as of January  31, 2007                                                      |       | 12,070,881                                            |       |

 

The aforementioned equity transactionsincreased common stock in the accompanying condensed consolidated balancesheets by $6,114,000 for thenine months ended January 31, 2007.

***RecentlyIssued Accounting Standards***

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004) Share-Based Payments (“SFAS 123(R)”). This statement requires that we record all share-based payment expensein our financial statements based on a fair value methodology.   Additionally, in March 2005, the SEC issuedStaff Accounting Bulletin No. 107 (“SAB No. 107”), which summarizes the staff’sviews regarding share-based payment arrangements for public companies.  We selected the Black-Scholes option pricingmodel as the most appropriate fair-value method for our awards and willrecognize compensation cost on a straight-line basis over our awards’ vestingperiods. We adopted SFAS 123(R) commencing May 1, 2006. See Note 7 for furtherdetail.

In December 2006, theFASB issued FASB Staff Position EITF 00-19-2, *Accounting**for Registration Payment Arrangements* (“FSPEITF 00-19-2”). FSP EITF 00-19-2 specifies that the contingent obligation tomake future payments or otherwise transfer consideration under a registrationpayment arrangement, whether issued as a separate agreement or included as aprovision of a financial instrument or other agreement, should be separatelyrecognized and measured in accordance with FASB Statement No. 5, *Accounting for Contingencies*. A registration paymentarrangement is defined in FSP EITF 00-19-2 as an arrangement with both of thefollowing characteristics: (1) the arrangement specifies that the issuerwill endeavor (a) to file a registration statement for the resale of specifiedfinancial instruments and/or for the resale of equity shares that are issuableupon exercise or conversion of specified financial instruments and for thatregistration statement to be declared effective by the Securities and ExchangeCommission (“SEC”) within a specified grace period, and/or (b) to maintainthe effectiveness of the registration statement for a specified period of time(or in perpetuity); and (2) the arrangement requires the issuer to

7

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transfer consideration tothe counterparty if the registration statement for the resale of the financialinstrument or instruments subject to the arrangement is not declared effectiveor if effectiveness of the registration statement is not maintained. FSP EITF00-19-2 is effective for registration payment arrangements and the financialinstruments subject to those arrangements that are entered into or modifiedsubsequent to December 21, 2006. For registration payment arrangements andfinancial instruments subject to those arrangements that were entered intoprior to the issuance of FSP EITF 00-19-2, early adoption for interim or annualperiods for which financial statements or interim reports have not been issuedis permitted.  As allowed, we adopted FSPEITF 00-19-2 in the quarter ended January 31, 2007.  The adoption of FSP EITF 00-19-2 did not havea material effect on our results of operations or financial position.

In July 2006, the FASBissued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes—an interpretation of FASB Statement No. 109* (“FIN 48”).  This interpretation clarifies the applicationof SFAS No. 109, *Accounting for Income Taxes*, bydefining a criterion than an individual tax position must meet for any part ofthe benefit of that position to be recognized in an enterprise’s financial statementsand also provides guidance on measurement, derecognition, classification,interest and penalties, accounting in interim periods and disclosure.  FIN 48 is effective for our fiscal yearcommencing May 1, 2007.  We are currentlyevaluating the impact of adopting FIN 48 on our consolidated financialstatements.

In September 2006,the SEC released Staff Accounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements* (“SAB 108”). SAB 108 providesinterpretive guidance on the SEC’s views regarding the process of quantifyingmateriality of financial statement misstatements. SAB 108 is effective forfiscal years ending after November 15, 2006, and early application for thefirst interim period of the same fiscal year is encouraged. The application ofSAB 108 in the first quarter of fiscal 2007 did not have a material effecton our results of operations or financial position.

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a frameworkand gives guidance regarding the methods used for measuring fair value, andexpands disclosures about fair value measurements. SFAS 157 is effectivefor financial statements issued for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years. We arecurrently evaluating the impact of adopting SFAS 157 on our consolidatedfinancial statements.

In November 2006, theFASB ratified the consensus reached by the EITF on EITF Issue No. 06-7, *Issuer’s Accounting for a Previously Bifurcated Conversion Option in aConvertible Debt Instrument When the Conversion Option No Longer Meets theBifurcation Criteria in FASB Statement No. 133, Accounting for DerivativeInstruments and Hedging Activities* (“EITF 06-07”).  The consensus provides that a previouslybifurcated conversion option in a convertible debt instrument for which theembedded conversion option no longer meets the bifurcation criteria in SFAS No.133, *Accounting for Derivative Instruments and HedgingActivities*(“SFAS 133”), should be reclassified (at its fair value onthe date of reclassification) to stockholders’ equity. Any debt discountrecognized when the conversion option was bifurcated from the convertible debtinstrument should continue to be amortized. EITF 06-07 should be applied to all previously bifurcated conversionoptions in convertible debt instruments that no longer meet the bifurcationcriteria in SFAS 133, in interim or annual periods beginning after December 15,2006.  We have a bifurcated conversionoption in a convertible debt instrument and will apply this consensus at suchtime, if ever, when the conversion option no longer requires classification asa derivative liability in accordance with SFAS 133.

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In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities* (“SFAS 159”).  SFAS 159 provides the option to reportcertain financial assets and liabilities at fair value, with the intent tomitigate volatility in financial reporting that can occur when related assetsand liabilities are recorded on different bases.   SFAS 159 alsoamends SFAS No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*,” by providing the optionto record unrealized gains and losses on held-for-sale and held-to-maturitysecurities currently.  The implementation of FAS 159 is not expected tohave a material impact on our results of operations or financial position.

**NOTE 3 — FINANCIALSTATEMENT COMPONENTS**

***Inventories***

Inventories consist of the following (in thousands):
| ** **              | ** ** | **January 31, 2007** | ** ** | **April 30, 2006** | ** ** |
|-------------------------|------------|--------------------------------|------------|------------------------------|------------|
| Finished goods          |       | $                              | 465        |                         | $          | 163 |   |
| Work in process         |       | 75                             |       | 34                           |       |
| Materials and  supplies |       | 884                            |       | 433                          |       |
| Total  inventories      |       | $                              | 1,424      |                         | $          | 630 |   |

 

***Property and equipment***

Property andequipment consist of the following (in thousands):
| ** **                                 | ** ** | **January 31, 2007** | ** ** | **April 30, 2006** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| Office furniture  and equipment            |       | $                              | 182        |                         | $          | 126 |   |
| Production  equipment                      |       | 7,596                          |       | 5,673                        |       |
| Vehicles                                   |       | 191                            |       | 175                          |       |
| Construction in  process                   |       | 967                            |       | 608                          |       |
| Leasehold  improvements                    |       | 1,020                          |       | 646                          |       |
|                                       |       | 9,956                          |       | 7,228                        |       |
| Accumulated  depreciation and amortization |       | (3,896                         | )          | (2,666                       | )          |
| Total property  and equipment, net         |       | $                              | 6,060      |                         | $          | 4,562 |   |

 

**NOTE 4 —SEGMENTINFORMATION**

We currently have threereportable segments: homeland security products, security services andsemiconductor products and services.  Ourhomeland security products segment includes both the marketing and developmentof our Ion Mobility Spectroscopy (“IMS”) technology and, through our 90%-owned subsidiary(SenseIt Corp, see Note 6), the development of next-generation infrared imagingand night vision technology through our Development & Licensing Agreementwith Lucent Technologies, Inc.  Oursecurity services segment provides security and investigative services and issubstantially comprised of the operations of Protection Plus SecurityCorporation (“PPSC”), which was acquired in May 2005.  Our semiconductor products and servicessegment provides small and large diameter test and reclaim silicon wafers,silicon-on-insulator (“SOI”) wafers and wafer thinning and other semiconductorservices.  Our segments are strategicbusiness units, each of which consists of similar products or services.  They are managed separately because eachsegment requires different technology and marketing strategy and because eachsegment sells to different customers. Reconciling items consist primarily of corporate assets or expenses thathave not been allocated to a specific reportable segment

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and the assets of ourformer life sciences operation which is now categorized as discontinuedoperations.  Prior period amounts havebeen reclassified to conform to current period presentation.

Information by segment is set forth below (inthousands):
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **January 31,**             | ** ** | **January 31,**            | ** ** |
| ** **                          | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Segment  revenues:                  |       |                             |       |                            |       |   |   |   |   |
| Homeland security products          |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | 35 |   |
| Security services                   |       | 3,625                            |       | 3,457                           |       | 11,241 |   | 9,090 |   |
| Semiconductor products and services |       | 2,910                            |       | 1,803                           |       | 9,335 |   | 3,825 |   |
| Total                               |       | $                                | 6,535      |                            | $          | 5,260 |   | $ | 20,576 |   | $ | 12,950 |   |

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **January 31,**             | ** ** | **January 31,**            | ** ** |
| ** **                          | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Segment  operating (loss) income:   |       |                             |       |                            |       |   |   |   |   |
| Homeland security products          |       | $                                | (1,983     | )                               | $          | (2,183 | ) | $ | (6,054 | ) | $ | (4,254 | ) |
| Security services                   |       | (83                              | )          | (117                            | )          | (377 | ) | (79 | ) |
| Semiconductor products and services |       | 88                               |       | (900                            | )          | 40 |   | (4,374 | ) |
| Reconciling amounts (1)             |       | (1,218                           | )          | (1,680                          | )          | (3,842 | ) | (3,367 | ) |
| Total                               |       | $                                | (3,196     | )                               | $          | (4,880 | ) | $ | (10,233 | ) | $ | (12,074 | ) |

 

|                                     | ** ** | **January 31,** | ** ** | **April 30,** | ** ** |
|-------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                          | ** ** | **2007**             | ** ** | **2006**           | ** ** |
| Total assets:                       |       |                 |       |               |       |
| Homeland security products          |       | $                    | 2,324      |               | $          | 1,300 |   |
| Security services                   |       | 6,452                |       | 5,992              |       |
| Semiconductor products and services |       | 9,337                |       | 7,027              |       |
| Reconciling amounts (2)             |       | 2,211                |       | 3,544              |       |
| Total                               |       | $                    | 20,324     |               | $          | 17,863 |   |
|                                     |            |                      |            |                    |            |  |  |  |  |

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(1)          Reconciling amounts for the operating(loss) income information includes corporate expenses consisting primarily ofcorporate salaries and benefits, professional and consulting fees, investorrelations costs, warrant amendment expense, insurance and directors’compensation.

(2)          Reconciling amounts for the total assetinformation includes corporate assets consisting primarily of cash and cashequivalents invested centrally, unamortized debt issuance costs andmiscellaneous prepaid items as well as the assets of our former life sciencesoperation which is now categorized as discontinued operations.

**NOTE 5—DISCONTINUED OPERATIONS**

Duringthe three months ended January 31, 2007, we elected to discontinue theoperation of our life sciences business and to put the assets and business upfor sale.  We decided to sell thisbusiness as it no longer fits our long-term strategy and because ofdeteriorating business conditions in the historical revenue producing productsin the segment.  We expect to disposeof this business by July 31, 2007.  Revenue and pretax loss from the life sciences business, reported asdiscontinued operations, are as follows (in thousands):

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| ** **  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **  | ** ** | **January 31,**             | ** ** | **January 31,**            | ** ** |
| ** **  | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|        |       |                             |       |                            |       |   |   |   |   |
| Revenues    |       | $                                | 466        |                            | $          | 1,220 |   | $ | 1,659 |   | $ | 4,436 |   |
| Pretax loss |       | $                                | (87        | )                               | $          | (290 | ) | $ | (99 | ) | $ | (494 | ) |

 

In accordance with SFAS144, the life sciences operation has been classified as a disposal group heldfor sale and has been presented as a discontinued operation in the condensedconsolidated financial statements and footnotes thereto.  Prior year financial statements have beenrestated to present the operations of the life sciences disposal group as a discontinuedoperation.  We evaluated the carryingamount of the life sciences disposal group and determined that the recording ofa loss for impairment was not warranted. The assets and liabilities of the discontinued operation are presentedseparately under the captions “assets of discontinued operations” and “liabilitiesof discontinued operations,” respectively, in the condensed consolidatedbalance sheets, and consist of the following (in thousands):
| ** **                          | ** ** | **January 31,** | ** ** | **April 30,** | ** ** |
|-------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                          | ** ** | **2007**             | ** ** | **2006**           | ** ** |
| Assets of  discontinued operations: |       |                 |       |               |       |
| Cash                                |       | $                    | 107        |               | $          | 531 |   |
| Accounts receivable                 |       | 269                  |       | 344                |       |
| Inventory                           |       | 123                  |       | 447                |       |
| Property and equipment, net         |       | 229                  |       | 292                |       |
| Other assets                        |       | 63                   |       | 99                 |       |
| Total                               |       | $                    | 791        |               | $          | 1,713 |   |

 
| ** **                               | ** ** | **January 31,** | ** ** | **April 30,** | ** ** |
|------------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                               | ** ** | **2007**             | ** ** | **2006**           | ** ** |
| Liabilities of  discontinued operations: |       |                 |       |               |       |
| Accounts payable and accrued liabilities |       | 8                    |       | 14                 |       |
| Note payable                             |       | 42                   |       | 47                 |       |
| Total                                    |       | $                    | 50         |               | $          | 61 |   |
|                                          |            |                      |            |                    |            |  |  |

 

**NOTE 6 —INVESTMENT IN SENSEIT CORP**

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

**Pursuant to the PurchaseAgreement, on October 27, 2006, we purchased shares of the Class A common stockof SenseIt in exchange for cash and other consideration, including, but notlimited to, an assignment of all of our rights, title and interest in theLucent Agreement.  As described above, we now**

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**have a 90% ownershipinterest in SenseIt.  Our ownership interest will be adjusted if SenseItreceives additional financing from third parties, and upon the occurrence of aThreshold Event.  The term “Threshold Event” is described in SenseIt’sCertificate of Incorporation, as amended, as the receipt by SenseIt ofcumulative $20 million in certain equity financing.  At that time, theClass A common stock and Class B common stock will be converted into commonstock, and the holder of the Class B common stock (held by the ChristopherToffales, chief executive officer of SenseIt and Chairman of the Board ofIsonics Corporation) will be entitled to a 10% ownership interest.  Theremaining 90% of the common stock outstanding will be allocated among the priorholders of common stock and Class A common stock.**

**Under the PurchaseAgreement, we acquired 550,000 shares of Class A common stock of SenseIt fortotal consideration of $5.5 million paid as follows:**

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

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

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

**·**                  $1,000,000was paid to SenseIt in January 2007 for 100,000 shares of Class A common stock,which payment was subsequently made to Lucent by SenseIt as required under theLucent Agreement.

**Additionally, we have anobligation to make an additional $500,000 payment to SenseIt in March 2007(against which we can credit legal costs in the amount of approximately$120,000 incurred related to entering into the SenseIt joint venture).  We will be entitled to receive one share ofClass A common stock for each $10 investment.**

**In connection with thePurchase Agreement, we also entered into a Stockholders’ Agreement with SenseItand its chief executive officer.  The Stockholders’ Agreement includescertain share transfer restrictions such as right of first refusal, as well asdrag-along and tag-along rights.  The Stockholders’ Agreement does notcurrently impose any material obligations on us.  If at some time in thefuture (after we meet our initial remaining $500,000 obligation), SenseIt needsadditional funding, we will have the right, but not the obligation, to providethat additional funding.**

**At the closing of thePurchase Agreement, SenseIt entered into an amended and restated employmentagreement with the chief executive officer of SenseIt (the “EmploymentAgreement”).  The Employment Agreement has an initial term of two years,plus automatic two year extensions unless SenseIt or the chief executiveofficer chooses not to renew. The Employment Agreement sets forth thecompensation payable to the chief executive officer and the time that he isrequired to devote to the business of SenseIt.  If termination occursafter SenseIt has made a commercial sale of a Lucent product, as described inthe Lucent Agreement, or has acquired a business having revenues of $10 millionor more in any one year, termination without cause will result in SenseIt’sobligation to pay the chief executive officer a two-year severance based on therespective annualized salary over the previous five years.  The**

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**Employment Agreement isbetween SenseIt and its chief executive officer; Isonics Corporation has noobligation under the contract.**

**The results of SenseIt have been included in our consolidated results asof the exercise date of the Purchase Agreement. The minority interest held in the net assets of SenseIt is included inthe caption “minority interest in consolidated subsidiary” in our condensedconsolidated balance sheet. Additionally, the condensed consolidated statements of operationsinclude a noncash charge recognized by SenseIt related to the chief executiveofficer’s 10% ownership interest in SenseIt (see Note 8).**

**NOTE 7 —STOCK-BASED COMPENSATION**

**On May1, 2006, we adopted the provisions of SFAS 123(R), requiring us to recognizeexpense related to the fair value of our stock-based compensation awards.  We elected to use the modified prospectivetransition method as permitted by SFAS 123(R) and therefore have not restatedour financial results for prior periods. Under this transition method, stock-based compensation expense for thenine months ended January 31, 2007, includes compensation expense for allstock-based compensation awards granted prior to, but not yet vested as of May1, 2006, based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS No. 123 *Accounting for Stock-Based Compensation* (“SFAS 123”).  Stock-based compensation expense for allstock-based compensation awards granted subsequent to May 1, 2006, was based onthe grant-date fair value estimated in accordance with the provisions of SFAS123(R).  We recognize compensation expensefor stock option awards on a straight-line basis over the requisite serviceperiod of the award.**

**Optionscurrently granted to employees generally expire ten years from the grant dateand vest over a three year period, with 25% of the stock option vestingimmediately and 25% vesting on the anniversary date of the grant date for eachof the subsequent three years.  Optionscurrently granted to external members of our board of directors generallyexpire five years from the grant date and vest immediately.  As of January 31, 2007, we have 511,000shares issuable under the 2005 Stock Option Plan.  The Directors’ Stock Option Plan does nothave an explicit cap as to the number of shares issuable under the plan.  It is our current policy to issue new sharesout of our authorized but unissued shares upon exercise of a stock option by aholder.**

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

|                                                            | ** ** | **Nine Months**           | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **Ended**                      | ** ** |
| ** **                                                 | ** ** | **January 31, 2007** | ** ** |
| Cost of revenues                                           |       | $                              | 64         |   |
| Selling, general  and administrative                       |       | 729                            |       |
| Research and  development                                  |       | 7                              |       |
| Stock-based  compensation expense before income taxes      |       | 800                            |       |
| Income tax  benefit                                        |       | —                         |       |
| Total stock-based  compensation expense after income taxes |       | $                              | 800        |   |

 

**Netcash proceeds from the exercise of stock options were $0 and $351,000 for thenine months ended January 31, 2007 and 2006, respectively.  In accordance with SFAS 123(R), we presentexcess tax benefits from the exercise of stock options, if any, as financingcash flows rather than operating cash flows. We have not realized excess tax benefits in any period presented.  There was no share-based compensation costcapitalized as part of an asset as of January 31, 2007.**

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**Wepreviously accounted for awards granted under our equity incentive plans underthe intrinsic value method prescribed by Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued to Employees*and related interpretations, as permitted bySFAS 123, as amended by SFAS No. 148 *Accounting for Stock-basedCompensation — Transition and Disclosure,*and provided pro forma disclosure required by those statements, as ifthe fair value based method defined in SFAS 123 had been applied.* *The respective exercise prices of stockoptions granted were equal to the market price of our common stock on therespective dates of grant.  Accordingly,no share-based compensation, other than for instruments issued to outsideparties for services, was recognized in our condensed consolidated financialstatements in prior periods.  Thefollowing table illustrates the effect on net loss attributable to commonstockholders and net loss per share attributable to common stockholders if wehad applied the fair value recognition provisions of SFAS No. 123 tostock-based compensation (in thousands, except per share data):**

|                                                                                                                                     | ** ** | **Nine Months**           | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                          | ** ** | **Ended**                      | ** ** |
| ** **                                                                                                                          | ** ** | **January 31, 2006** | ** ** |
|                                                                                                                                |       |                           |       |
| Net loss  attributable to common stockholders, as reported                                                                          |       | $                              | (18,186    | ) |
| Add: stock-based  compensation costs included in reported net loss, net of related tax effects                                      |       | 30                             |       |
| Deduct: total stock-based compensation expense determined  under fair value based method for all awards, net of related tax effects |       | (818                           | )          |
| Adjusted net  loss attributable to common stockholders                                                                              |       | $                              | (18,974    | ) |
|                                                                                                                                |       |                           |       |
| Net loss per  share attributable to common stockholders                                                                             |       |                           |       |
| Basic and diluted — as reported                                                                                                |       | $                              | (2.38      | ) |
| Basic and  diluted — adjusted                                                                                                  |       | $                              | (2.48      | ) |

 

**Share-basedcompensation recognized for the nine months ended January 31, 2007, as a resultof the adoption of SFAS 123(R) as well as pro forma disclosures according tothe original provisions of SFAS 123 for periods prior to the adoption of SFAS123(R) use the Black-Scholes option pricing model for estimating fair value ofoptions granted under our equity incentive plans.  The following table sets out theweighted-average assumptions used for calculating the fair value of optionsgranted during the nine months ended January 31, 2007 and 2006, respectively:**

|                           | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **January 31,**            | ** ** |
| ** **                | ** ** | **2007**                        | ** ** | **2006** | ** ** |
|                      |       |                            |       |   |   |
| Expected life  (in years) |       | 5.7                             |       | 4.2 |   |
| Interest rate             |       | 5.0                             | %          | 4.0 | % |
| Volatility                |       | 85                              | %          | 100 | % |
| Dividend yield            |       | —                          |       | — |   |

 

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

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**Stockoption activity for the nine months ended January 31, 2007, is as follows:**
| ** **                         | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|------------------------------------|------------|--------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                         | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                         | ** ** | ** **         | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Shares**         | ** ** | **Price**    | ** ** | **Term (years)** | ** ** | **Value**     | ** ** |
| Outstanding, April 30,  2006       |       | 733,483            |       | $            | 8.48       |                  |       |          |       |   |
| Granted                            |       | 255,750            |       | $            | 4.25       |                  |       |          |       |   |
| Exercised                          |       | —             |       | $            | —     |                  |       |          |       |   |
| Forfeitures or  expirations        |       | (155,000           | )          | $            | 5.00       |                  |       |          |       |   |
|                               |       |               |       |         |       |                  |       |          |       |
| Outstanding, January  31, 2007     |       | 834,233            |       | $            | 7.84       |                  | 7.0        |          | $          | — |   |
|                               |       |               |       |         |       |                  |       |          |       |
| Exercisable, January  31, 2007     |       | 483,421            |       | $            | 7.59       |                  | 5.7        |          | $          | — |   |
|                               |       |               |       |         |       |                  |       |          |       |
| Expected to vest, January 31, 2007 |       | 231,349            |       | $            | 8.34       |                  | 8.8        |          | $          | — |   |

 

**Theaggregate intrinsic value in the table above represents the total pretaxintrinsic value (i.e. the difference between our closing stock price on January31, 2007, and the exercise price, times the number of shares) that would havebeen received by the option holders had all option holders exercised theiroptions on January 31, 2007.  This amountchanges based on the fair market value of our common stock.  Total intrinsic value of options exercised is$0 and $725,000 for the nine months ended January 31, 2007 and 2006,respectively.**

**Theweighted average grant-date fair value of options granted during the ninemonths ended January 31, 2007 and 2006, were $3.12 and $7.32,respectively.  As of January 31, 2007,$1,514,000 of total unrecognized compensation cost related to stock options isexpected to be recognized over a weighted-average period of 0.9 years.**

**NOTE 8 — EQUITY**

***Expiration of Class B and C Warrants***

On December 29, 2006, the publicly traded Class B and Class C commonstock warrants expired.

***Common Shares Authorized***

On January 2,2007, at a special meeting of shareholders, our shareholders approved anamendment to our Articles of Incorporation to increase our authorized capitalfrom 75,000,000 shares of common stock to 175,000,000 shares.  On January2, 2007 we filed a Certificate of Amendment to our Articles of Incorporationincreasing our authorized capital with the California Secretary of State. The amendment became effective on January 3, 2007.

***Equity Instruments Issued for Services***

In October 2006, in connection with entering the SenseIt joint venture(see Note 6), the individual who is the chief executive officer of SenseItretained a 10% ownership interest in SenseIt through ownership of

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shares of Class B common stock. This 10% equity interest was valued at $667,000 and the noncash chargeis included in selling, general and administrative expense in our condensedconsolidated statements of operations for the nine months ended January 31,2007.

In August 2006, we entered into a consulting agreement with an individualto provide management services in our semiconductor products and servicessegment, whereby we issued a common stock warrant  (valued at $20,000 using the Black-Scholespricing model) to purchase 12,500 shares of common stock at $2.68 pershare.  The common stock warrant vestedimmediately, expires on July 31, 2008, and was recorded as prepaid consultingexpense which was amortized ratably over the service period of fivemonths.  During the nine months endedJanuary 31, 2007, we recognized $20,000 of selling, general and administrativeexpense related to this agreement.

In May 2006, we entered into a financial advisory services agreement withClayton Dunning Capital Partners, Inc., whereby we issued a common stockwarrant  (valued at $28,000 using theBlack-Scholes pricing model) to purchase 12,500 shares of common stock at $4.20per share.  The common stock warrantvested immediately, expires on May 17, 2008, and was recorded as prepaidconsulting expense which was amortized ratably over the service period of fourmonths.  During the nine months endedJanuary 31, 2007, we recognized $28,000 of selling, general and administrativeexpense related to this agreement.

**NOTE 9 —BORROWINGS**

***Capital Lease***

In November 2006, we entered into a capital lease to finance equipment tobe used in production by our semiconductor products and services segment.  The lease is in the principal amount of$1,138,000, bears a nominal interest rate of 16%, has a term of 36 months andincludes a bargain purchase option whereby we have the right subsequent to theexpiration of the lease term to purchase the asset under lease for no more than5% of the original equipment cost. Additionally, we issued the lessor a common stock warrant (valued at$66,000 using the Black-Scholes pricing model) to purchase 31,250 shares ofcommon stock at $3.36 per share.  Thecommon stock warrant vested immediately, expires on November 28, 2009, and isbeing amortized to interest expense over the term of the lease.

***8% Convertible Debentures***

**On May18, 2006, we made an offer to the holders of our outstanding 8% convertibledebentures (the “8% Debentures”) to pay in cash the principal balance remainingimmediately subsequent to making the monthly payment scheduled June 1, 2006,plus a 5% premium and accrued interest, both items to also be paid incash.  On May 19, 2006, approximately $5.0 million out of thethen-outstanding $8.2 million 8% Debentures accepted our offer.  The offer was made and accepted contingentupon the cash payment being made to the accepting holders on or before June 1,2006, from the proceeds of a financing that we were then working to completeand which is discussed below.   Inaccepting our offer, the holders agreed to limit the anti-dilution provision ontheir warrants originally issued with their debentures such that the warrantswould fully ratchet based upon the financing completed on May 31, 2006, and thenthe ratchet would be converted to a price-only ratchet whereby the exerciseprice would still be reduced to the effective price per share (or effectiveexercise price per share) of the subsequent equity sale but where the number ofshares purchasable under the warrant would be fixed.  The holders also agreed to waive certainprovisions of the Securities Purchase Agreement entered into concurrently withthe 8% Debentures which relate to entering into a future financing withvariable conversion terms (such contractual terms we do not believe to be inforce).  In accordance with this offerand subsequent to closing the financing on May 31, 2006, we paid approximately$4.1 million from the proceeds of the financing to the holders accepting ouroffer (such payment was**

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**calculatedafter including the impact on their outstanding principal balance of the normalmonthly amortization payment made to them on June 1, 2006).   This payment resulted in a reduction in theprincipal balance of the 8% Debentures of $3,880,000.**

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

**As aresult of entering into the financing transaction with Cornell CapitalPartners, L.P. discussed below, which includes a fixed conversion price of$5.00, the warrants associated with the 8% Debentures were amended per thewarrant agreement such that the warrant exercise price was reduced from $25.00per share of common stock to $5.00 per share of common stock.  Simultaneously, the number of sharespurchasable under the warrants increased from 398,475 to 1,992,377.  Due to our offer made on May 18, 2006, to theholders of the 8% Debentures and the acceptance of the offer by certainholders, of the currently outstanding warrants associated with the 8%Debentures, warrants to purchase 1,139,251 shares of common stock have a priceratchet only whereby no change to the number of shares purchasable will occurand warrants to purchase 853,126 shares of common stock continue to retain theoriginal ratchet provisions.**

**Uponconclusion of the financing transaction with Cornell Capital Partners, L.P.discussed below, which has a variable pricing component, we reevaluated theclassification of the aforementioned 853,126 warrants originally issued withthe 8% Debentures and which still contain a full ratchet provision.  We evaluated the warrants in accordance withthe provisions of SFAS 133 and EITF Issue No. 00-19 *Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock* (“EITF 00-19”) which provideguidance, among other topics, as to whether equity or derivative liabilityclassification is appropriate for freestanding warrants.  Because of the issuance of the variable ratefinancing, we no longer have control over the ratchet of the fully ratchetingwarrants.  Therefore, there is apossibility (and per EITF 00-19, we are not allowed to consider in ourevaluation the likelihood of such an event occurring) that the number of sharesissuable related to the warrant could exceed our authorized but unissued sharesif the warrant were to ratchet to a sufficiently low exercise price.  If we did not have sufficient authorized butunissued shares to satisfy the number of shares issuable under the warrant ifexercised, we may have to net cash settle a portion or all of the warrant.  Accordingly, we reclassified theaforementioned warrants from equity to derivative liabilities in the amount of$1,773,000, which represents the estimated fair value of the warrants at thedate of reclassification.  Further, weare required to recognize in earnings at each reporting date the gain or losson our derivative instruments.  We recordeda gain on derivative instruments for the nine months ended January 31, 2007, inthe amount of $703,000, such amount representing the estimated change in fairvalue of the warrants between the date the warrants were classified asliabilities and January 31, 2007.**

**Havingmet all requirements to allow us to do so, we elected to make the monthlyprincipal and interest payments due for our 8% Debentures on May 1, 2006, andJune 1, 2006, in shares of our common stock. Accordingly, we issued a total of 404,110 and 499,318 shares of commonstock, respectively, in settlement**

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**of (1) principalamounts owed on the 8% Debentures in the nominal amounts of $1,822,500 and$1,647,500, respectively and (2) interest obligations for the months of April2006 and May 2006 in the nominal amounts of $66,500 and $21,250, respectively.  As the payments were made in stock in lieu ofcash, the fixed monetary amounts of the principal and interest payments willhave a larger impact on the condensed consolidated financial statements ascompared to the nominal amounts disclosed. This difference is due to application of the fixed discount applied tothe price of our common stock in the calculation of the number of common sharesdue for each principal payment and interest payment when made in shares of ourcommon stock, as defined.**

**Weelected to make our monthly principal and interest payments due on July 1,2006, and August 1, 2006 in cash.  Eachpayment included a reduction to outstanding principal of $562,000 and interestrelating to the calendar month preceding each respective payment.**

**Havingmet all requirements to allow us to do so, we elected to make the monthlyprincipal and interest payments due for our 8% Debentures on September 1, 2006,October 1, 2006, November 1, 2006, December 1, 2006, January 1, 2007, andFebruary 1, 2007, in shares of our common stock.  Accordingly, we issued 74,215, 88,481,109,329, 89,085, 120,262 and 117,732 shares of common stock, respectively, insettlement of the principal amount owed on the 8% Debentures in the nominalamount of $250,000 for each respective payment and interest relating to thecalendar month preceding each respective payment.  Subsequent to these payments, there is nooutstanding principal balance on the 8% Debentures.**

**Thecumulative discount on the 8% Debentures (arising from the allocation of aportion of the proceeds to the related warrants) is being amortized to interestexpense over the term of the 8% Debentures using the effective interestmethod.  During the nine months endedJanuary 31, 2007, $287,000 of this discount was amortized to interest expense.**

Twoformer holders of the 8% Debentures have at various times asserted that theissuance of the 6% Debentures constituted a default (due to a potentialvariable conversion provision contained within the 6% Debentures) under the 8%Debentures.  We have contested thatallegation on several bases and will defend against any further allegation ofdefault as necessary.   Remedies for anevent of default include the option to accelerate payment of the full principalamount of the debentures, together with interest and other amounts due, to thedate of acceleration.  The principalamount of the debentures shall be equal to 130% of the then-principal amount ofthe debentures plus all interest and other amounts due or a conversioncalculation, whichever is higher.  Ifthey prove a default, we could be liable for an amount of approximately$1,150,000, including accrued interest.

***6% Convertible Debentures***

**OnMay 31, 2006, we completed a private placement pursuant to which we issuedto one accredited investor, Cornell Capital Partners, L.P. (“Cornell”) a 6%secured convertible debenture with a principal amount of $10,000,000, which wasthe first of three 6% secured convertible debentures (cumulatively, the “6%Debentures”), for which the aggregate principal amount issued was$16,000,000.  On June 5, 2006 (twotrading days prior to the filing of a registration statement contemplated inthe transaction documents correlated with the 6% Debentures), we issued thesecond of the three 6% Debentures. This 6% Debenture has a principal amount of$3,000,000.  The final 6% Debenture witha principal amount of $3,000,000 was issued on November 16, 2006, two tradingdays prior to a registration statement being declared effective by the SEC.  The 6% Debentures are convertible into sharesof our common stock at the lesser of $5.00 (the “Fixed Conversion Price”) or80% of the average of the two lowest daily volume weighted average prices (“VWAP”)of our stock during the five trading days immediately preceding the conversiondate (the “Market Conversion Price”). The 6% Debentures mature on May 31, 2009 (the “Maturity Date”).  In addition to the 6%**

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**Debentures,we issued three warrants (the “6% Debenture Warrants”) to purchase a total of2,000,000 shares of our common stock at exercise prices of $5.00 per share(500,000 warrants), $7.00 per share (750,000 warrants) and $8.00 per share(750,000 warrants). Each of the warrants can be exercised for a period of threeyears.**

**Thethen-effective conversion price will be adjusted upon the occurrence of anystock dividends, stock splits, pro rata distributions, or fundamentaltransactions as described in the 6% Debenture agreement.  Additionally, the Fixed Conversion Price willbe reduced if we issue shares of stock or other instruments that are exchangeableinto or convertible into common stock at an effective price less than the FixedConversion Price.  The Fixed ConversionPrice will be adjusted to mirror the conversion, exchange or purchase price atissue.  Our issuance and exercise ofoptions which are compensatory and pursuant to our stock option plans will notcause an adjustment under this provision.**

**Interestaccrues on the outstanding principal balance at the annual rate of 6%.  Interest is payable on the Maturity Date incash or shares of our common stock, at our option.  At January 31, 2007, accrued interest expenseon the 6% Debentures was $536,000.  If wechoose to pay accrued interest in shares of our common stock, the number ofshares to be issued will be calculated as the amount of interest due divided by88% of the volume weighted average price of our common stock for the fivetrading days preceding the Maturity Date.**

**Theinvestor and an unaffiliated party provided us services in connection withcompleting the transaction. To compensate these entities for those services, weissued them 165,000 shares of our common stock (the “Buyers Shares”).  We also paid Cornell or its affiliates feesin the cumulative amount of $900,000.**

Wewere contractually required to seek shareholder approval of this transaction byno later than January 31, 2007, (exclusive of any shares acquired in thistransaction or related transactions), including the ability to issue a maximumof 16 million shares upon conversion of the 6% Debentures and to approve anincrease in authorized shares of common stock to at least 175 millionshares.  On October 30, 2006, we held ourannual meeting of shareholders whereby the shareholders approved the totalnumber of shares issuable under the transaction documents.  Although more shareholders voted in favor ofamending our articles of incorporation to increase our authorized common stock,we did not receive the number of votes for the proposal required by Californialaw to complete the amendment as required. Under the terms of both the 6% Debentures and the related warrants, ifwe had insufficient authorized capitalization after December 31, 2006, we hadan obligation to call and hold a special meeting of its stockholders within 60days for the sole purpose of increasing our authorized capitalization.  As aforementioned, an increase in authorizedcapitalization from 75 million shares of common stock to 175 million shares ofcommon stock was approved at a special meeting of shareholders on January 2,2007.  As part of a waiver agreement enteredinto with Cornell in February 2007 (discussed below), Cornell waived theoriginal compliance period.

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

**·**                  We are prohibited fromissuing shares of our common stock to the holders of the 6% Debentures (uponconversion or payment of interest) and the 6% Debenture Warrants (upon exercise)if the issuance would result in Cornell beneficially owning more than 4.99% ofour outstanding common stock (although Cornell can waive this provision uponmore than 65 days notice to us).

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**·**                  If converting using the Market Conversion Price,Cornell is limited to converting no more than $400,000 of the principal oraccrued interest on the 6% Debentures into shares of our common stock in anyseven calendar day period.

**·**                  The maximum number of shares that may be issued uponconversion of the principal amount of the 6% Debentures is contractuallylimited to 16 million shares.

**If at aconversion event, we have insufficient shares authorized but unissued andunreserved to convert principal and pay interest in common stock, our stock isnot listed or quoted on a market (as defined), we have not timely satisfied anyconversion obligations or the issuance of shares would violate certain otherdefined sections of the agreement, the holder has a right to request net cashsettlement of the conversion based upon a defined calculation.**

**If thereis an effective underlying registration statement and if the volume weightedaverage price of our common stock is equal to or greater than $10.00 for twentyconsecutive trading days, we may force Cornell to convert the outstandingprincipal and any accrued interest, subject to the share issuance limitationsdiscussed above.**

**We havethe right, after providing ten trading days advance written notice, to redeemin cash a portion or all amounts outstanding under the 6% Debentures prior tothe Maturity Date provided the closing bid price of our common stock is lessthan $10.00 at the time the redemption notice is provided.  If we exercise this redemption right, aredemption premium in the amount of 20% of the principal amount being redeemedwill be due.  During the ten daynotification period, Cornell may elect to convert any portion or all of theoutstanding 6% Debenture amount.**

**ThroughMay 31, 2007, we have granted Cornell the right to participate in any allowedcapital raise up to 50% of the raise. Subsequently and until such time no portion of the principal andinterest due on the 6% Debentures is outstanding, we have granted Cornell theright to participate in any allowed capital raise up to 25% of the raise.**

**The 6%Debenture Warrants are exercisable for cash only unless there is no effectiveunderlying registration statement, at which point a holder can elect a cashlessexercise.  As the shares underlying the$7.00 and $8.00 warrants, each exercisable for 750,000 shares of our commonstock, are not currently registered, the holder of the warrants currently has aright of cashless exercise for these two warrants.  The then-effective warrant exercise pricewill be adjusted upon the occurrence of any stock dividends, stock splits, prorata distributions, or fundamental transactions as described in the 6%Debenture Warrant agreements. Additionally, the exercise price and number of shares upon issuance ofcommon stock are subject to adjustment in cases where we issue shares of commonstock (other than Excluded Securities or issuances in connection with othercomponents of the 6% Debenture documents) for consideration per share less thanthe then-existing warrant exercise price. If an adjustment is triggered, the warrant exercise price for thewarrant for 500,000 shares at an exercise price of $5.00 per share and thewarrant for 750,000 shares at an exercise price of $7.00 per share will beadjusted to a price determined by multiplying such exercise price by a fractionof which (a) the numerator shall be the number of shares of common stockoutstanding immediately before such issuance plus the number of shares ofcommon stock that the aggregate consideration received by us for such issuancewould purchase at the warrant exercise price then in effect and (b) thedenominator shall be the number of shares of common stock outstandingimmediately prior to such issuance plus the number of new shares to be issuedin the triggering event.  Concurrently,the number of shares issuable upon exercise of the warrant will be adjustedsuch that the aggregate exercise price would be equal to the aggregate exerciseprice prior to adjustment.  The warrantfor 750,000 shares exercisable at $8.00 per share has a different adjustmentcalculation whereby a subsequent triggering equity issuance would lead to areduction in the warrant exercise price per share equal to the price per share(or effective**

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**exerciseprice per share) of the subsequent equity issuance.  There would be no change to the number ofshares issuable under the warrant.**

**OnFebruary 19, 2007, we entered into a waiver agreement (the “Waiver Agreement”)with Cornell that, among other terms, waived certain deficiencies in compliancewith and amended certain clauses of the 6% Debenture transaction documents.  In return for the waivers granted and otheramendments to the transaction documents, we agreed to provide a one-timeratchet to the $7.00 warrant and the $8.00 warrant, each exercisable for750,000 shares.  The one-time ratchetwill occur upon the first conversion by a holder of the 6% Debentures and theexercise price of the aforementioned warrants will be automatically adjusted tothe average of the two lowest daily VWAP’s of our common stock during the fivetrading days prior to such conversion (to the extent that the new exerciseprice is lower than the then existing exercise price).  Additional terms included in the WaiverAgreement are discussed  in variousplaces below.  Due to the waiver ofcertain deficiencies, we believe we are now in compliance with all obligationsunder the 6% Debenture transaction documents and, accordingly, have classifiedthe 6% Debentures as a noncurrent liability.**

**As aresult of a freestanding registration rights agreement, we had severalobligations to register the shares underlying the 6% Debentures, Buyers Sharesand 6% Debenture Warrants.  Theaforementioned Waiver Agreement included waiver of certain deficiencies andamended certain clauses of the original registration rights agreement.  A discussion of the registration rightsfollows:**

**·**                  Initial registrationstatement - We were required to file an initial registration statement toregister 2,183,947 shares of common stock (related to the Buyers Shares, the 6%Debenture Warrant exercisable for 500,000 shares at $1.25 per share and1,518,947 shares to be issued upon conversion of the 6% Debentures) no laterthan August 7, 2006 (a registration statement was filed on June 7, 2006) and tohave the initial registration statement declared effective by September 28,2006 (the registration statement was declared effective on November 20,2006).  Because we failed to meet oureffectiveness deadline, we could have incurred liquidated damages of onepercent of the outstanding balance of the 6% Debentures for each thirty-dayperiod, prorated by day, subsequent to the date of the deadline missed untilsuch time as the registration statement was declared effective.  However, in November 2006 Cornell waived thepenalty in respect to obtaining effectiveness of the original registration statement.  No concession was given by us in return forthe waiver.

**·**                  Subsequent registrationstatement - As a result of our shareholders approving the Cornell transactionon October 30, 2006, we were obligated to file an amended registrationstatement by November 30, 2006, to register the full number of shares requiredunder the 6% Debenture transaction documents (representing the Buyers Shares,shares underlying the 6% Debenture Warrants and shares upon the conversion ofthe 6% Debentures based on a defined formula but in an amount not to exceed 16million shares) and obtain effectiveness of the registration statement byJanuary 15, 2007.  We are unable to fileany additional registration statement until our shareholders approved theincrease in authorized shares of common stock on January 2, 2007.   Additionally, current interpretation by theSEC of registration rules regarding financing structures with market-basedconversion features precludes us from registering at one time the full numberof shares required by the 6% Debenture transaction documents.  Consequently, we had a contractual obligationto pay Cornell liquidated damages equalto 1% of the liquidated value of the 6% Debentures outstanding ($160,000assuming no conversions by Cornell) for each 30 day period until such time, ifever, that we became in compliance with our contractual obligation toCornell.  In the Waiver Agreement,Cornell waived the damages incurred under this provision.  Although the payment of this specific amountin cash or common stock was waived, the concession to

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**                       **allow a one-time ratchet granted to Cornell in theWaiver Agreement has a charge associated with it and, as such, we incurred acost to obtain the waiver.  Accordingly,we recorded a selling, general and administrative expense in the amount of$320,000 for the three months ended January 31, 2007, related to this damagesprovision

**Further,the Waiver Agreement provides that we must file a registration statement within60 calendar days of receipt of written notification by the holder requestingthat the registration statement be filed. This registration statement must include the total transaction sharesunregistered at that time (or the maximum shares that may be registered as advisableby the SEC if less than the total transaction shares unregistered).  After filing, we must use our best efforts togain effectiveness of the registration statement within 45 days of filing.  On February 21, 2007, Cornell providedwritten notification of their request that we file an additional registrationstatement within 60 days (by April 22, 2007).**

**·**                  Continued effectiveness -Once effectiveness of both the initial and the amended registration statementis achieved and until such time that all eligible shares have been sold underthe registration statements, if sales are not able to be made under theregistration statement (due to failure to keep the registration statementeffective or failure to register sufficient shares or otherwise), Cornell willhave recourse to the aforementioned one percent per thirty-day liquidateddamages penalty.

**We arenot obligated to pay liquidated damages for more than a total of 365 calendardays. **We may elect to pay any liquidated damages in cashor shares of our common stock if registered.  Failureto comply with our registration obligations may, subsequent to any graceperiods and opportunities to cure, be deemed an event of default.

**Additionally,other events, as defined in the 6% Debenture agreement, may also allow the 6%Debenture holders to declare us in default. Remedies for an event of default, include the option to acceleratepayment of the full principal amount of the Debentures, together with interestand other amounts due, to the date of acceleration and Cornell will have theright to request such payment in cash or in shares of our common stock.**

**So longas principal amounts are outstanding under the 6% Debentures, we have agreed tonot sell capital stock or grant security interests which meet certain definedcharacteristics without the prior consent of Cornell.  However, certain transactions defined asExcluded Securities are exempted from this prior consent provision.  Excluded Securities include (1) securitiesissued in connection with a strategic partnership or joint venture, (2)securities issued as consideration for a merger or consolidation or theacquisition of a business, product, license or other asset of another person orentity, (3) options (priced not less than at the market) provided to employeeswithin the first thirty days of employment, (4) securities issued pursuant toan approved stock plan, (5) up to 250,000 shares (priced not less than market)which may be issued as long as no registration rights are included and as longas not pursuant to a Form S-8 and (6) any other issuances to holders of otherpre-existing securities if such issuances are provided for in the terms of suchinstrument.**

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

**Weallocated the net proceeds received between the first $13,000,000 6% Debenturesand the related warrants based on the relative fair value of eachinstrument.  The $2,718,000 allocated tothe warrants was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the 6% Debentures.  We evaluated the embedded conversion featurein the 6% Debentures in accordance with the**

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**provisionsof SFAS 133 and EITF 00-19 and concluded that, due to certain provisions whichcould result in net cash settlement, the feature should be classified as aderivative instrument and should be recorded as a liability in our condensedconsolidated financial statements. Accordingly, we recorded the aforementioned embedded conversion featureas a derivative liability in the amount of $6,342,000 (which represents theestimated fair value of the feature at the date the financing was consummated)and as a corresponding reduction in the carrying value of the 6% Debentures.  We also recorded the embedded conversionfeature related to the $3,000,000 debenture issued in November 2006 as aderivative liability in the amount of $949,000 and as a corresponding reductionto the carrying value of that debenture. Further, we are required to recognize in earnings at each reporting datethe gain or loss on our derivative instruments. We recorded a gain on derivative instruments for the nine months endedJanuary 31, 2007, in the amount of $2,778,000, such amount representing theestimated change in fair value of the embedded conversion feature between thedate the financing transactions were consummated and January 31, 2007.**

**Thecumulative discount on the first $13,000,000 of the 6% Debentures in the amountof $9,786,000 (arising from the allocation of a portion of the proceeds to therelated warrants, the classification of the embedded conversion feature as aderivative liability and the cash fee paid to Cornell) and the discount on thefinal $3,000,000 of the 6% Debentures in the amount of $1,114,000 (arising fromthe classification of the embedded conversion feature as a derivative liabilityand the cash fee paid to Cornell) are being amortized to interest expense overthe term of the 6% Debentures using the effective interest method at aneffective interest rate of 49% and 19%, respectively.  During the nine months ended January 31,2007, $1,256,000 of discount was amortized to interest expense.**

**Wecapitalized as debt issuance costs the fair value of the 165,000 Buyers shares(an amount of $601,000) and $28,000 of costs directly incurred in consummatingthe financing and these capitalized costs are being amortized to amortizationof debt issuance costs over the life of the 6% Debenture using the effectiveinterest method.  For the nine monthsended January 31, 2007, $76,000 of the capitalized debt issuance costs wasamortized to expense.**

**The 6%Debenture Warrants with an exercise price of**$7.00 per share (750,000warrants) and $8.00 per share (750,000 warrants) were not exercisable untilafter our shareholders approved the issuance of these two warrants (as part ofthe total transaction shares, as defined) in a shareholders’ meeting.  On October 30, 2006, our shareholdersapproved the transaction with Cornell and accordingly these two warrants becameexercisable.  Upon becoming exercisable,we re-evaluated the classification of the warrants in accordance with theprovisions of SFAS 133 and EITF 00-19 and concluded that, due to having aninsufficient number of authorized shares (including all other commitments whichmay require the issuance of stock) to potentially settle the warrants, thewarrants should be classified as a derivative instrument and should be recordedas a liability in our condensed consolidated financial statements.  Accordingly, we reclassified theaforementioned warrants out of equity and as a derivative liability in theamount of $1,611,000 (which represents the estimated fair value of the warrantsat the date the warrants became exercisable). At a shareholder meeting on January 2, 2007, the shareholders approvedthe increase in authorized capital to 175 million shares and we amended ourArticles of Incorporation accordingly. At that time, we then had a sufficient number of authorized shares topotentially settle the warrants and the warrants were reclassified back toequity at their fair value on January 2, 2007, which is an amount of$869,000.  We recorded a gain onderivative instruments for the nine months ended January 31, 2007, in theamount of $742,000, such amount representing the estimated change in fair valueof the warrants between the date the warrants were classified as derivativeliabilities and the date reclassified back to equity on January 2, 2007.

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**NOTE 10 —COMMITMENTS AND CONTINGENCIES**

As of January 31, 2007, we had commitments outstanding for capitalexpenditures of approximately $2,470,000.

**NOTE 11 - RELATED PARTYTRANSACTIONS**

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

**We have aresearch and development agreement with Institut fur Umwelttechnologien GmbH (“IUT”),an equity method investee of which we own 30%. We funded $915,000 and $1,192,000 under this agreement during the ninemonths ended January 31, 2007 and 2006, respectively (and a total of $2,724,000since entering into our first research and development agreement in June2004).  All funded payments have beenincluded as research and development in the condensed consolidated statementsof operations.**

**NOTE  12 — SUBSEQUENT EVENTS**

***Reverse Stock Split***

On February 13, 2007, we effected a one-for-four reverse stock split ofour common shares upon the filing of a Certificate of Amendment to our Articlesof Incorporation with the California Secretary of State.  The reversestock split was approved by our shareholders in the special meeting of shareholdersheld on January 2, 2007.  As a result ofthe reverse stock split, effective February 13, 2007, every four shares of ourissued and outstanding common stock was automatically combined into one issuedand outstanding share without any change in the par value of such shares. No fractional shares were issued in connection with the reverse stocksplit.  Shareholders who were entitled to a fractional share received awhole share.  The reverse split affectedall of the holders of our common stock uniformly and did not affect anyshareholder’s percentage of ownership interest, except to the extent that thereverse split resulted in any holder being granted a whole share for anyfractional share that resulted from the reverse split.  Any shares of our common stock or shares ofcommon stock underlying options, warrants and convertible debentures wereproportionately reduced and the exercise prices of any warrants or options andthe conversion prices of any convertible debentures were proportionatelyincreased by the reverse stock split. All impacted amounts included in thecondensed consolidated financial statements and notes thereto have beenrestated for the stock split.

***Management Changes and Related Stock Based CompensationEvents***

**InFebruary 2007, we entered into a Settlement Agreement and Mutual Release withboth (a) the former chief executive officer, president and chairman of theBoard of Directors and (b) the former senior vice president and vice chairmanof the Board of Directors whereby the individuals resigned those positions,terminated their employment contract with us, and accepted specified cash-basedand stock-based remuneration (from the 2005 Stock Option Plan) for continuingemployment as non-officer, non-director, consulting employees.   Subsequent to the resignation of theaforementioned executives, the Board of Directors appointed ChristopherToffales, the chief executive officer of SenseIt, as the new Chairman of theBoard and entered into an employment agreement with the individual.  Additionally, changes in position were madewith certain individuals of the remaining management team.   The Board approved a new stock option plan,the 2007 Restructuring Equity Plan (the “2007 Plan”), which authorizes thegrant to our key employees, officers, consultants or advisors of incentive andnonqualified stock options to purchase shares of our authorized but unissuedcommon stock.  The maximum number ofshares of our common stock available for issuance under this plan is 3.5million shares, of which 3.25 million were included in stock**

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**optiongrants associated with the management changes. Under the aforementioned employment agreement, we are required to seekshareholder approval of the 2007 Plan at either the annual meeting ofshareholders expected to be held in October 2007 or earlier at a specialmeeting of shareholders under certain conditions.  For additional detail about these managementchanges, see the information in the Form 8-K filed February 20, 2007.  We have not completed our assessment of the financialstatement impact of these events, although we expect to record a significantcharge for the year ended April 30, 2007.**

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

*The statements contained in thisReport on Form 10-Q that are not purely historical are forward lookingstatements within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934, including statementsregarding our expectations, hopes, intentions or strategies regarding thefuture. **Forward looking statementsinclude: statements regarding future products or  product development efforts; statementsregarding future selling, general and administrative costs and research anddevelopment spending  and our productdevelopment and marketing strategies; statements regarding future capitalexpenditures and financing requirements; and similar forward lookingstatements. **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.*

***General Discussion***

We are an advanced materials and technology companyfocused on the development and provision of homeland security products andservices, the manufacture and reclamation of silicon wafers and the manufactureof SOI wafers to the semiconductor industry. In January 2007, we decided to sell our life sciences business (whichsupplies isotopes for life sciences and health-care applications) as it nolonger fits our long-term strategy for building a sustainable and profitablehomeland security and semiconductor company and because of the deteriorating businessconditions in the historical revenue producing products in the segment.  We are currently marketing the business tointerested buyers and are working to complete the disposal by July 31, 2007.

**EffectiveFebruary 14, 2007, our Chairman of the Board and Chief Executive Officer JamesE. Alexander and our Senior Vice President Boris Rubizhevsky resigned boththeir executive management positions and Board seats in order to pursue otherentrepreneurial interests.  ChristopherToffales was named as Chairman of the Board and John Sakys, our Chief FinancialOfficer was also named a Board member and was promoted to President and ChiefOperating Officer, and is serving as our interim Chief Executive Officer.  Kenneth J. Deane was promoted to the positionof Chief Financial Officer.  Additionallyour Vice President of Corporate Development, Lindsay Gardner resigned as aDirector in order to allow for a greater concentration of independentdirectors.  Ms. Gardner remains employedas an officer of Isonics.**

Our outstanding Class B and Class C common stockwarrants expired on December 29, 2006, and as a result are no longerexercisable for shares of common stock.

Liquidity and Capital Resources

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

Overview

During fiscal year 2006 and the nine months endedJanuary 31, 2007, our revenues were generated from sales of stable andradioactive isotopes (although these will continue to decrease as we arewinding down our isotope trading business and are currently marketing thebusiness for sale), small and large diameter test and reclaim silicon wafers,SOI wafers and wafer thinning and other semiconductor services.  Additionally, as a result of the acquisitionof PPSC in May 2005, we also generated revenues from providing securityservices for leading businesses and institutions in healthcare, education,retail, manufacturing and the art world.

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We expect that sales from our semiconductoroperations will continue to increase during the remainder of our 2007 fiscalyear due mainly to the growth of our 300-millimeter large-diameter siliconwafer and wafer thinning product lines. Since the acquisition of PPSC, we have increased revenues for thesecurity services business, and we continue to pursue additional customers in boththe commercial and selective government markets.

In addition, we have focused our efforts in thehomeland security segment on our products with the potential for higher marginsales and have reduced the scope of our product development activities to thoseproducts based on our IMS technology and, via our 90% owned joint venturecreated in October 2006 (SenseIt), with development activity related to ouragreement with Lucent.  We have completedour initial commercial installations of our IMS products in the AirChx systemmanufactured by DualDraw (discussed more fully below), the proceeds fromwhich are being classified as deferred revenue pending completion of certaintasks.  We have not receivedany subsequent purchase commitments and we do not expect to receive any furtherpurchase commitments pending improvements to the IMS product that isincorporated into the AirChx system. Consequently it is not likely that we will receive any significantrevenues from the IMS products during the remainder of our fiscal 2007,although we are hopeful that our fiscal 2008 will reflect greater revenues fromIMS products (although we cannot offer any assurance that this will, in fact,be the case).

We are also hopeful that SenseIt will begin togenerate revenue from the next-generation infrared imaging and night visionsurveillance technology in fiscal year 2008, although we can offer no assurancethat a marketable product will be developed .

As evidenced by the introduction of new productsinto our semiconductor products and services segment and by our homelandsecurity operations, we are attempting to bring our recently developed productlines to market, which we expect to add to our revenue stream in thefuture.  The following is a more specificdiscussion of our current operations.

Homeland Security

**HSDCfocuses the majority of our efforts in the homeland security sector.  These efforts include entry into the securityservices market through our acquisition of PPSC in May 2005, acquisition and developmentof our IMS technology that can be used to detect various types of explosivesand/or chemical agents and our entry into an agreement with Lucent and a 90%owned joint venture named SenseIt to develop innovative infrared imaging andnight vision surveillance technology.  HSDC’s ownership also includes our 30% minority interest in IUT.  The following is a detail of each of ourproduct lines within our homeland security operations:**

**SecurityServices** — In May 2005, weacquired PPSC, a provider of security services located in New York, NewYork.  Since the effective date of theacquisition, PPSC has delivered significant revenue to our consolidatedfinancial statements and has provided gross margin of approximately 24% ofrevenues for the nine months ended January 31, 2007.   The segment has, however, generated an operatingloss for the three and nine months ended January 31, 2007, of $(83,000) and$(377,000), respectively.  During thethree and nine month periods, the operating loss includes amortization ofacquisition-related customer intangibles in the amount of $36,000 and $108,000,respectively, and stock-based compensation expense of $10,000 and $75,000,respectively.  Included in the operatingloss for the nine months ended January 31, 2007, is enhanced staffing for growthin the business as well as the costs incurred in relocating the office of PPSC.

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

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**Detection Technology** — Our efforts in the detection technologyarea have been refocused during the current fiscal year, and through the dateof this report, to our panel mounted IMS product, as follows:

*Ion Mobility Spectroscopy *— IMS is a “sniffer”technology, originally developed by IUT, which is designed to continuouslymonitor the air and almost immediately detect and identify harmful substancesat the parts per billion (ppb) level, providing, in a matter of minutes,warning of a possible attack.  Throughboth our ongoing funding of research and development efforts at IUT and relateddevelopment and commercialization efforts in the United States, we arecurrently in the process of taking the IMS technology and miniaturizing andre-designing it for low-cost, high-volume manufacturing in the UnitedStates.  Additionally, we have pursuedreceipt of required regulatory licenses and we have now received all regulatorylicenses required for domestic sales of such products.

InNovember 2005, we signed a development agreement with DualDraw LLC (“DualDraw’),a manufacturer of air quality equipment. Under this agreement, we have been working to incorporate our panelmounted IMS system into the DualDraw mailroom inspection workstation, adowndraft workstation that keeps toxic substances away from the breathing zoneof mailroom workers who are sorting or opening mail and captures suchsubstances with a HEPA filtration system. The incorporation of our IMS capability provides an alarm if certaintoxic or explosive substances are detected. In November and December 2006 we completed our first seven commercialinstallations of our IMS system into existing DualDraw workstations at customersites.  Although (as is typical with newtechnology) there were some issues at the customer installations, we haveworked through the majority of those issues with DualDraw and its customers, andwe believe that we will be able to resolve the remaining few issues in the nearfuture.  We have taken the feedback fromthese initial installations and are continuing to refine, tune and third-partytest the capabilities of our product.  It is not likelythat we will receive any significant revenues from the IMS products during theremainder of our fiscal 2007, although we are hopeful that our fiscal 2008 willreflect greater revenues from IMS products (although we cannot offer anyassurance that this will, in fact, be the case).

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

**InfraredImaging Technology** — On December 5, 2005, we approved a developmentplan that resulted in us becoming obligated under the Lucent Agreement enteredinto with Lucent in September 2005 which, in October 2006, we assigned to our90% owned subsidiary, SenseIt, which is described in more detail below.  Under the Lucent Agreement, we are attemptingto develop a next-generation infrared imaging and night vision surveillancetechnology based on Lucent’s micro electro-mechanical systems (“MEMS”)technology under development at its nanotechnology fabrication facility.  Infrared technology, which converts infraredradiation in the non-visible spectrum, such as body heat, into a visible image,is commonly found in both commercial and military/homeland securityapplications including night vision goggles and cameras, rifle scopes, andthreat detection devices used to identify concealed weapons or explosives.  The MEMS approach to infrared imaging, ifsuccessful, may lead to products, which are at least equal in performance witha lower power consumption and price than products currently available in themarketplace today.  Additionally, aMEMS-based product may also provide for cost efficiencies in the manufacturingprocess.  The development plancontemplates a proof-of-concept during calendar year 2007, followed by stepstowards commercialization, though we can provide no assurance that acommercially attractive product will

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ultimately be available.

The Lucent Agreement provides for SenseIt to receivean exclusive right, except for certain rights reserved by Lucent, to make, useand sell licensed products arising from technology developed under the LucentAgreement.  In exchange for this license,we (through our obligations to SenseIt) are funding certain of Lucent’sdevelopment efforts for the project through the periodic payment over a two andone-half year period of a development fee totaling $12,000,000.  We paid $5,000,000 of the original$12,000,000 obligation under this agreement through the date of this report (inaddition to another $333,000). The remaining balance will be paid in $1,000,000increments commencing in April 2007 and approximately every three monthsthereafter.  SenseIt has the right toterminate the development project for any reason (including if the developmentwork is not proceeding up to our expectations) from time-to-time, so long astermination is prior to the first commercial sale of a licensed product.  Additionally, upon the commencement ofcommercial sales, if ever, we would be obligated to pay royalties based onrevenue, potentially a sales referral fee based on revenue and also an annualexclusivity payment to maintain our exclusive rights to the developedtechnology.

In October 2006, we acquired a 90% interest inSenseIt in exchange for assigning to SenseIt all of our interest under theLucent Agreement (such assignment was approved by Lucent), although we willcontinue to be jointly and severally liable with SenseIt to Lucent for amountsdue to Lucent under the assigned Lucent Agreement. In addition, we also enteredinto a new statement of work with Lucent (which was also subsequentlytransferred to SenseIt).  The remaining10% of SenseIt is held by Christopher Toffales (our Chairman of the Board), aseasoned and successful industry veteran, who also serves as President andChief Executive Officer of SenseIt. SenseIt will continue to work with Lucent to develop prototypes of itsfirst product line, “direct view” thermal imagers for weapons sights and nightvision goggles and anticipates completing these prototypes within the next nineto twelve months.  In addition, SenseIt,in conjunction with Lucent, is also pursuing a more traditional focal planearray product suitable for integration into thermal imaging cameras, as well asan advanced solid state imager approach to create a “Multi-Spectral Sensor”which can detect infrared and visible light (or two spectra of infrared light)simultaneously.

Concurrent with and subsequent to the acquisition ofthe interest in SenseIt, we made contractually required investments in SenseIt(to provide working capital) in a cumulative amount of $500,000 and areobligated to invest another $500,000 for working capital purposes in March 2007(against which we can credit legal costs incurred in entering into the SenseItjoint venture).  Additionally, asdescribed above, we  invested anadditional $1,000,000 into SenseIt in January 2007 so that it could make thepayment then due to Lucent.  In eachcase, we received or will receive one share of SenseIt Class A common stock foreach $10 investment.  We do not currentlyhave sufficient funding to meet our current payment obligations to SenseIt andto fund the remaining subsequent development payments to Lucent (for which wewould receive additional Class A common stock shares in SenseIt) under theLucent Agreement.  If we fail to makepayments when due, Lucent may cancel the Lucent Agreement or cease working onthe project and then assess us a “start-up” fee if funding was to resume.  We are currently seeking additional financingto allow us to fund SenseIt so that SenseIt can make its contractualdevelopment payments to Lucent.  Wecannot offer any assurance that we will be able to raise the funds necessary tomake all of the required payments to Lucent, or that the technology will bedeveloped to a point where we want to continue to make such payments whendue.  Additionally, SenseIt may need toseek outside financing to make payments to Lucent and, if so elected, suchoutside financing would dilute our ownership interest in SenseIt.  Lastly, although we are hopeful of a positiveoutcome, we can offer no assurance that the development activity underway withLucent and SenseIt will yield technologically relevant or commercially viableproducts.

On May 12, 2006, we entered into an agreement withISCON, (a company that is attempting to develop patent-pending infraredimaging-based technologies for the non-invasive detection of objects hiddenunder clothing as well as technology for the determination of the chemicalcomposition of such objects to identify explosives and narcotics) that providedus the option, but not the obligation to purchase shares of ISCON common stockbased upon the successful completion of developmental and commercialmilestones.  If

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ISCON succeeded in meeting all five milestones andif we had chosen to exercise our option to purchase shares for each completedmilestone, we would have then owned 51% of ISCON for a cumulative investment of$1,750,000.  On June 9, 2006, we made ourfirst investment in the amount of $100,000 for an ownership interest of9%.  Although ISCON achieved its nextmilestone, we declined to exercise our option to purchase additional shares inISCON and do not currently intend to pursue further investment in theentity.  Based on our decision not tocontinue funding and the inability of ISCON to obtain funding from othersources, ISCON began the process of shutting down its business in December2006. ISCON continues to seek additional funding and it is currently unclear asto what value, if any, we may be able to realize from this investment.  We wrote off our entire $100,000 investment inISCON to selling, general and administrative expense during the nine monthsended January 31, 2007.

Semiconductor Products and Services

Our semiconductor operations, based in Vancouver,Washington, showed continued operational and financial improvement for the yearended April 30, 2006, and through the nine months ended January 31, 2007,generating its second consecutive quarterly operating income for the threemonths ended January 31, 2007.   Thepositive operating income results primarily from our ongoing effort to reduceour reliance on low margin small diameter products and focus mainly on highermargin 300-millimeter products and services, wafer thinning and SOIproducts.  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 aregreater than those associated with the small diameter market.   As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 54% of segmentrevenue for the nine months ended January 31, 2007 ($5,021,000 of revenue), ascompared to approximately 32% of segment revenue for the nine months endedJanuary 31, 2006 ($1,241,000 of revenue). There has also been a focus on operational efficiency and effectiveness,which has resulted in increased productivity and processing yields.  Further, we continue to gain new customersand are also in the process of attempting to qualify our product at others.

As a result, for the three and nine months endedJanuary 31, 2007, the segment generated operating income in the amount of$88,000 and $40,000, which includes stock-based compensation expense of $29,000and $109,000, respectively.  Thisoperating income is an increase of $988,000 and $4,414,000 as compared tooperating losses of $(900,000) and $(4,374,000) for the three and nine monthsended January 31, 2006, respectively. We continue to monitor the situationclosely and, while our realignment of the business has resulted in reachingpositive quarterly operating income and while we believe that we will continueto see improving financial results in the segment, there are no assurances thatoperating profitability can be sustained in every period, if at all.

Life Sciences

Our life sciences division has historically beenprimarily a distribution business, is currently being offered for sale and wehave treated it for the purpose of the financial statements as discontinuedoperations.  At the present time, ourlife sciences division is being significantly and adversely affected byincreased domestic and international competition.  The market for the product responsible forthe vast majority of segment revenue, oxygen-18 , continues to degrade due toan abundance of global supply of the isotope. Recently, the spot price for oxygen-18 has decreased below the level ofour cost for the product.  Consequently,we have ceased purchasing additional quantities of oxygen-18 for resale andwill fulfill our existing contracts with our customers (the majority of whichare gross margin positive) with our existing inventory of oxygen-18.   In the prior year, our internationalradioisotope business also experienced rising supplier prices in a market thatis highly price-sensitive.  In an effortto reduce costs, we closed our European trading office (Chemotrade) during thesecond half of fiscal year 2006.

In anticipation of the degradation in the oxygen-18market, we previously commenced expanding into other areas, such asactinium-225 and indium-111 (through our June 2005 joint production and marketing

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agreement with Central Radiopharmaceutical Services,Inc. (“CRS”)).  Sales of these productshave not contributed significantly to the revenue of the life sciences segment,though we expect revenue from these products to increase in calendar year 2007.   However, due to the deteriorating businessconditions in the historical revenue producing products in the segment and theearly state of development for the markets in actinium-225 and indium-111, wehave elected to sell the life sciences business.  We are currently marketing the business tointerested buyers and are working to complete the disposal by July 31, 2007.

General

Our consolidatedrevenues in the future will depend primarily on our success in developing andselling products in the homeland security and continued performance in thesemiconductor markets.  Our profitabilitywill 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 revenues or our profitability.

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

***Results ofOperations***

Thefollowing table sets forth, for the periods indicated, condensed consolidatedstatements of operations data expressed as a percentage of revenues.  The table and the discussion below should beread in conjunction with the condensed consolidated financial statements andthe notes thereto appearing elsewhere in this report.  In January 2007, we elected to discontinuethe operation of our life sciences business and to put the assets and businessup for sale.  As a result, wereclassified the operations of our life sciences business as discontinuedoperations.  Prior year information hasbeen restated to conform with the current year presentation.
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **January 31,**             | ** ** | **January 31,**            | ** ** |
| ** **                                                                                 | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                       |       |                             |       |                            |       |   |   |   |   |
| Revenues                                                                                   |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                                                                           |       | 78.6                             |       | 93.7                            |       | 78.6 |   | 101.8 |   |
| Gross margin                                                                               |       | 21.4                             |       | 6.3                             |       | 21.4 |   | (1.8 | ) |
|                                                                                       |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                                                                       |       |                             |       |                            |       |   |   |   |   |
| Selling, general and administrative                                                        |       | 48.2                             |       | 50.4                            |       | 53.5 |   | 60.0 |   |
| Impairment loss on assets held for sale                                                    |       | —                           |       | —                          |       | — |   | 3.1 |   |
| Research and development                                                                   |       | 22.1                             |       | 48.7                            |       | 17.6 |   | 28.3 |   |
| Total operating expenses                                                                   |       | 70.3                             |       | 99.1                            |       | 71.1 |   | 91.4 |   |
| Operating loss                                                                             |       | (48.9                            | )          | (92.8                           | )          | (49.7 | ) | (93.2 | ) |
|                                                                                       |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense), net                                                               |       | 15.3                             |       | (47.3                           | )          | 9.9 |   | (42.6 | ) |
| Loss from  continuing operations before income taxes and elimination of minority  interest |       | (33.6                            | )          | (140.1                          | )          | (39.8 | ) | (135.8 | ) |
| Income tax  expense                                                                        |       | —                           |       | —                          |       | — |   | — |   |
| Minority  interest in operations of consolidated subsidiary                                |       | (1.5                             | )          | —                          |       | (0.3 | ) | — |   |
| Loss from  continuing operations                                                           |       | (35.1                            | )          | (140.1                          | )          | (40.1 | ) | (135.8 | ) |

 

 
| Loss on  discontinued operations, net of income taxes |   | (1.3  | )  | (5.5   | )  | (0.5  | )  | (3.9   | )  |
|-------------------------------------------------------|--------|-------|----|--------|----|-------|----|--------|----|
| NET LOSS                                              |   | (36.4 | )% | (145.6 | )% | (40.6 | )% | (139.7 | )% |

 

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***Revenues***

Revenues increased for both the three and ninemonths ended January 31, 2007, as compared to the same periods of our priorfiscal year.  Revenue from both oursecurity services and semiconductor products and services segments did reflect anincrease during these periods as compared to revenue from our homeland securityproducts segments which were flat or reflected a decrease, as described in thefollowing table:
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **January 31,**             | ** ** | **January 31,**            | ** ** |
| ** **                           | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Homeland  security products          |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | 35,000 |   |
| Security  services                   |       | 3,625,000                        |       | 3,457,000                       |       | 11,241,000 |   | 9,090,000 |   |
| Semiconductor  products and services |       | 2,910,000                        |       | 1,803,000                       |       | 9,335,000 |   | 3,825,000 |   |
| Total                                |       | $                                | 6,535,000  |                            | $          | 5,260,000 |   | $ | 20,576,000 |   | $ | 12,950,000 |   |

 

Therevenue for our security services segment is generated by PPSC, a business thatwe acquired in May 2005.  Pro formarevenue for the nine months ended January 31, 2006 would have beenapproximately $9,637,000 if the PPSC acquisition had occurred on the first dayof that quarter.  The increase in revenue from the security services segment for both thethree and nine months ended January 31, 2007, is due to the net addition ofadditional security services contracts since the acquisition of PPSC.  While we anticipate that we will continue togrow revenue in this segment by securing additional new security contracts inour PPSC subsidiary and retaining existing customers under contract currentlywith PPSC, we cannot provide any assurance that we will be able to do so.

Our semiconductor products and services segment hasexperienced a rapid increase in revenue during the past two years.  Revenue for the three and nine months endedJanuary 31, 2007, was 61% and 144% higher than revenue for the three and ninemonths ended January 31, 2006, respectively. The increases are predominately due to the expansion of sales ofhigher-margin 300-millimeter products and services.  Our 300-millimeter business provided revenueof  $1,121,000 and $5,021,000 for thethree and nine months ended January 31, 2007, as compared to $859,000 and$1,241,000 for the three and nine months ended January 31, 2006, respectively.While we believe that continued expanded focus on the 300-millimeter, waferthinning and other semiconductor services markets will allow us to continue toincrease revenue in the future, we can provide no assurance that we will beable to do so.

Our homeland security products segment has recordedminimal or no revenue for the three and nine months ended January 31, 2007 and2006.  The proceeds related to theinstallation of the first seven commercial units in November and December 2006are being classified as deferred revenue pending completion of certain tasks.  See the update provided for this segment inthe General Discussion section of this Item 2: Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

Althoughwe have diversified our sources of revenue, we continue to have concentrationsof revenue with certain customers.  Forthe nine months ended January 31, 2007, two security services customersaccounted for 15% and 11% of revenues, respectively, and one semiconductorproducts and services customer accounted for 22% of revenues as compared to thenine months ended January 31, 2006, in which one security services customeraccounted for 24% of revenues. Significant reductions in sales to any of these large customers havehad, and may in the future have, an adverse effect by reducing our revenues andour

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grossmargins.  Present or future customerscould terminate their purchasing patterns with us or significantly change,reduce or delay the amount of products or services ordered from us.

***GrossMargin***

Our gross margin increased for the three and ninemonths ended January 31, 2007, 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 January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | 1,396,000  |                                                  | $          | 334,000 |   | $ | 4,412,000 |   | $ | (232,000 | ) |
| Percent of revenues |       | 21.4                                                   | %          | 6.3                                                   | %          | 21.4 | % | (1.8 | )% |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |  |  |

 

The increase in gross margin is due mainly tocontinued improvement in operations in our semiconductor products and servicessegment where there were significant improvements to gross margin on a dollaramount and on a percentage of revenues basis.

On a dollar basis, gross margin is expected toincrease correspondingly with increases in revenue, if any, with dependencieson customer and supplier pricing.  Ourability to positively impact consolidated gross margin will in a large part bedependent upon our ability to grow sales in our homeland security segmentsthrough increased sales of security services and detection products and in oursemiconductor products and services segment through increased sales of300-millimeter products and services and wafer thinning services.  With the realignment of our semiconductorproducts and services business to focus on the higher margin products andservices, we believe that we have greatly enhanced our ability to increase oursales and related gross margin in these areas. As such, we anticipate that the gross margin from sales of semiconductorproducts and services (both in dollar value and as a percentage of revenues)will increase over time, though we can offer no assurance that the gross marginincrease will occur.

On a percentage of revenue basis, in general weanticipate that the gross margin percentage in our security services segmentwill remain relatively stable.  The grossmargin percentage in our semiconductor products and services segment may varygreatly based upon revenue growth achieved, if any.  Due to fixed facility costs included in costof revenues in the semiconductor products and services segment, the grossmargin percentage is particularly sensitive to changes in revenue.  Lastly, the gross margin percentage on ourhomeland security products segment is likely to be volatile as well as weattempt to increase revenue in that segment, though we can offer no assurancesthat we will be able to do so.

*Selling, General andAdministrative Expenses*

Our selling, general and administrative expensesincreased as a dollar amount but decreased as a percentage of revenue for thethree and nine months ended January 31, 2007, as compared to the samerespective periods of our prior fiscal year, as reflected in the followingtable:
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | 3,150,000  |                                                  | $          | 2,651,000 |   | $ | 11,015,000 |   | $ | 7,771,000 |   |
| Percent of revenues |       | 48.2                                                   | %          | 50.4                                                  | %          | 53.5 | % | 60.0 | % |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |  |  |

 

Theapproximate $3,250,000 increase in selling, general and administrative expensesfor the nine months ended January 31, 2007, compared to the same period in theprior year is attributable to a combination of factors, including:

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·                  approximately $800,000 directly related toPPSC, such increase resulting primarily from an impact of approximately$100,000 due to the inclusion of less than a full two quarters of expense beingincluded in the nine months ended January 31, 2006 (due to the acquisitionoccurring on May 16, 2005), a write-off of a specific customer receivable of$114,000, increased rent of approximately $90,000 due to relocation andincreased staffing and commissions due to the pursuit of new contracts for thenine months ended January 31, 2007;

·                  approximately $510,000 due to increasedoperations in the homeland security products segment;

·                  a noncash charge of approximately $320,000incurred due to a registration rights penalty on the 6% Debentures;

·                  approximately $150,000 due primarily toincreased selling costs associated with higher revenue in the semiconductorproducts and services segment;

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

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

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

·                  approximately $115,000 of operating expensesincurred by SenseIt;

·                  cumulative noncash charges of $800,000related to stock-based compensation expense associated with our adoption ofSFAS 123(R) in the nine months ended January 31, 2007;

·                  offset by approximately $200,000 in cash and noncash expense incurred insettlement of a lawsuit in the nine months ended January 31, 2006, and byapproximately $300,000 due to the inclusion in the nine months ended January31, 2006, of a charge related to the extension of the expiration date ofcertain warrants and reduced general corporate expenditures of approximately$70,000.

Althoughwe are actively focused on reducing selling, general and administrative expenditures,we anticipate that our reported selling, general and administrative expenseswill increase during the remainder of fiscal year 2007 due primarily tostock-based incentive compensation issued as part of a series of managementchanges made in February 2007.  There canbe no assurance that anticipated selling, general and administrative expenseswill result in increased revenues from product sales.

***ImpairmentLoss on Assets Held for Sale***

Ourimpairment loss on assets held for sale decreased for the nine months endedJanuary 31, 2007, as compared to the same period of our prior fiscal year, bothon a dollar amount and on a percentage of revenues basis as reflected in thefollowing table:
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | —                                                 |       | —                                                |       | — |   | $ | 398,000 |   |
| Percent of revenues |       | —                                                 |       | —                                                |       | — |   | 3.1 | % |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |

 

During the nine months ended January 31, 2006, aspart of a review of our semiconductor products and services segment thatresulted in operational changes, certain equipment was identified asunnecessary 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.  We have $225,000 of thisequipment recorded on the accompanying condensed consolidated balance sheets asof January 31, 2007, which was subsequently sold in February 2007 for $340,000.

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***Researchand Development Expenses***

Ourresearch and development expenses decreased on both a dollar and a percentageof revenues basis for the three and nine months ended January 31, 2007, ascompared to the same periods of our prior fiscal year, as reflected in thefollowing table:

 
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | 1,442,000  |                                                  | $          | 2,563,000 |   | $ | 3,630,000 |   | $ | 3,673,000 |   |
| Percent of revenues |       | 22.1                                                   | %          | 48.7                                                  | %          | 17.6 | % | 28.3 | % |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |  |  |

 

Thedollar decrease for the three and nine months ended January 31, 2007 relatedprimarily to a decrease in research and development expenses associated withthe development of our IMS technology.  Consistent with our product developmentstrategy, we are seeking to identify and evaluate new products in the homelandsecurity operations (including next-generation infrared technology through ourLucent relationship and SenseIt subsidiary) as well as to bring existingtechnologies (including IMS-basedtechnology) to a production-ready state.  A significant amount of this research anddevelopment on IMS technology is being performed by IUT.  We funded $194,000 and $915,000 under the IUTagreement during the three and nine months ended January 31, 2007, as comparedto funding of $535,000 and $1,192,000 during the three and nine months endedJanuary 31, 2006, respectively (and a total of $2,724,000 since entering intoour first research and development agreement in June 2004).  We expect to significantly reduce ourresearch and development expenses performed by IUT through the remainder of ourcurrent fiscal year.

InDecember 2005, we approved a development plan with Lucent that obligated usunder the Lucent Agreement.  Under theLucent Agreement, we will endeavor to develop a next-generation imaging andnight vision surveillance technology.  In October 2006, weacquired a 90% interest in SenseIt in exchange for assigning to SenseIt all ofour interest under the Lucent Agreement (such assignment was approved byLucent) and we also entered into a new statement of work with Lucent (which wasalso transferred to SenseIt).  SenseItwill coordinate the development of the next-generation infrared imagingtechnology and work towards commercialization of any resultant products.  Thedevelopment plan contemplates for prototype products to be available withinnine to twelve months, although we can provide no assurance that a commerciallyattractive product will ultimately be available.  For the nine months ended January 31, 2007,we recorded research and development expense of $2,000,000 (as compared to expense of $1,666,667 recognized in thecomparable period of the prior year) and we have the option to invest anadditional $1,000,000 in April 2007 in SenseIt in order for SenseIt to make theLucent payment then due.  Under theLucent agreement, SenseIt must provide funding of $1,000,000 per quarter indevelopment funding for the next seven quarters or lose its rights under theLucent Agreement; to the extent we have the funding available to make thesepayments, we have a right of first refusal to do so by purchasing additionalshares of SenseIt Series A Common Stock at $10 per share.  Also under the Lucent Agreement, SenseIthas the right to terminate the development project for any reason from time-to-time,so long as termination is prior to the first commercial sale of a licensedproduct.  As such, assuming SenseIt continues with the development program, weexpect our quarterly research and development expense for this purpose toremain elevated.  If we are unableprovide SenseIt with the funds necessary to make the quarterly Lucent paymentsdue to Lucent, SenseIt will be required to seek funding from outside sources,which would dilute our current 90% ownership of the entity.

Webelieve that the development and introduction of new product applications iscritical to our future success.  While weexpect to continue to incur significant research and development expenses overtime  (assuming sufficient cash remainsavailable and we are able to procure necessary materials and outside services),we anticipate that expenditures on research and development with IUT willdecrease.  However, research anddevelopment expenses are expected to increase at SenseIt as work continuesunder the Lucent Agreement and in ancillary efforts to produce a marketableinfrared imaging product.  It is likelythat research and development expenditures will continue to vary as apercentage of revenues because of the 

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timingand amount of future revenues and the timing of research and developmentexpenses. Except for work being performed on our semiconductor products at ourfacilities in Vancouver, Washington, we operate no other facilities of our ownfor research and development.  Significantlyall other research and development work is performed by outside entities, noneof which we control (although we have an ownership position in IUT of30%).  Although we expend significantresources on research and development, we cannot offer any assurance that ourcurrent or future lines of business or products resulting from our research anddevelopment efforts will be profitable or generate significant revenues.

***Operating Income (Loss)***

Our operating losses (in total) decreased for thethree and nine months ended January 31, 2007, as compared to the same periodsof our prior fiscal year, as reflected in the following table:

 
| ** **                           | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Homeland  security products          |       | $                                                      | (1,983,000 | )                                                     | $          | (2,183,000 | ) | $ | (6,054,000 | ) | $ | (4,254,000 | ) |
| Security  services                   |       | (83,000                                                | )          | (117,000                                              | )          | (377,000 | ) | (79,000 | ) |
| Semiconductor  products and services |       | 88,000                                                 |       | (900,000                                              | )          | 40,000 |   | (4,374,000 | ) |
| Reconciling  amounts                 |       | (1,218,000                                             | )          | (1,680,000                                            | )          | (3,842,000 | ) | (3,367,000 | ) |
| Total                                |       | $                                                      | (3,196,000 | )                                                     | $          | (4,880,000 | ) | $ | (10,233,000 | ) | $ | (12,074,000 | ) |

 

Our homeland security products segment generated asignificant operating loss in an effort to develop and commercialize our IMStechnology into products that can be used to detect various types of explosivesand/or chemical agents and innovative infrared imaging technology.  While we generated no revenue in this segmentfor the nine months ended January 31, 2007, we have completed our initialcommercial installations of IMS product (the proceeds of which are beingclassified as deferred revenue pending completion of certain tasks) and arehopeful that we will generate revenue in this segment during the remainder ofour fiscal year ending April 30, 2007. The increase in operating loss for the nine months ended January 31,2007, as compared to the same period in the prior year is due substantially to(1) approximately $780,000 in non-Lucent expenditures at SenseIt, including a$667,000 noncash charge incurred related to the 10% equity interest in SenseItretained by it chief executive officer, (2) $275,000 in stock-basedcompensation charges recorded due to a change in accounting rules, (3) the$100,000 write-off of our investment in ISCON and (4) increased research anddevelopment expense related to the Lucent agreement of $333,000.

Our security services segment consists of PPSC,which was acquired in May 2005.  For thenine months ended January 31, 2007, the segment delivered significant revenuetotaling $11,241,000 and gross margin of approximately 23.7%, as compared to$9,090,000 and 23.0% for the nine months ended January 31, 2006.  The operating loss for the nine months endedJanuary 31, 2007, is due primarily to an increase in selling, general andadministrative expenses as compared to the comparable period in the prioryear.  This increase is due to increasedmarketing spending, a write-off of a single customer’s accounts receivablebalance in the amount of $114,000, the inclusion of a $75,000 noncash chargerelated to stock-based compensation expense (due to our adoption of SFAS 123(R)in the nine months ended January 31, 2007), $90,000 in increased rent due to arelocation and incremental investment in personnel to support future revenuegrowth in both the governmental and commercial markets.  Although we continue to pursue selecteddomestic government contracts, we have taken steps to reduce our spending onsales and marketing in this area.

Our semiconductor products and services segmentshowed continued operational and financial improvement (due mainly to therealignment of our business to significantly reduce our reliance on low marginsmall diameter products and focus mainly on higher margin 300-millimeterproducts and services, wafer thinning 

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and SOI products) for the nine months ended January31, 2007, recording our second consecutive quarterly operating income for thethree months ended January 31, 2007. Additionally, the operating (loss) income has generally increased eachsequential quarter during fiscal year 2006 and in the nine months ended January31, 2007, as reflected in the following table:
|                                      | ** ** | **Semiconductor products**       | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **and services**                 | ** ** |
| ** **                           | ** ** | **operating income (loss)** | ** ** |
|                                 |       |                                  |       |
| Three months  ended July 31, 2005    |       | $                                     | (2,054,000 | )(1) |
| Three months  ended October 31, 2005 |       | $                                     | (1,420,000 | ) |
| Three months  ended January 31, 2006 |       | $                                     | (900,000   | ) |
| Three months  ended April 30, 2006   |       | $                                     | (777,000   | ) |
| Three months  ended July 31, 2006``  |       | $                                     | (199,000   | ) |
| Three months  ended October 31, 2006 |       | $                                     | 151,000    |   |
| Three months ended  January 31, 2007 |       | $                                     | 88,000     |   |

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

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

Reconcilingamounts for the operating loss information includes corporate expensesconsisting primarily of corporate salaries and benefits, professional andconsulting fees, investor relations costs, warrant amendment expense, insuranceand directors’ compensation.

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

Otherincome (expense), net increased on both a dollar and a percentage of revenuesbasis for the three and nine months ended January 31, 2007, as compared to thesame periods of our prior fiscal year as reflected in the following table:

 
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | 1,003,000  |                                                  | $          | (2,491,000 | ) | $ | 2,037,000 |   | $ | (5,517,000 | ) |
| Percent of revenues |       | 15.3                                                   | %          | (47.3                                                 | )%         | 9.9 | % | (42.6 | )% |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |  |  |

 

The increase for the three months ended January 31,2007, as compared to the same period in the prior fiscal year resultedprimarily from two items:  (1) a decreasein interest expense and amortization of debt issuance costs in the combined amountof $1,613,000, which is reflective of a lower outstanding convertible debenturebalance through the duration of the respective periods and (2) the recording ofa gain on derivative instruments in the amount of $1,903,000 related to thechange in the fair value of the derivative liabilities which we have recordedin our condensed consolidated balance sheets (as discussed in the Liquidity andCapital Resources section below). Lastly, interest and other income decreased $60,000 due to a lower cashand cash equivalent balance carried for the three months ended January 31,2007, as compared to such balance carried in the comparable period in the priorfiscal year.

The increase for the nine months ended January 31,2007, as compared to the same period in the prior fiscal year resultedprimarily from two items:  (1) a decreasein interest expense and amortization of debt issuance costs in the combinedamount of $3,255,000, which is reflective of a lower outstanding convertibledebenture balance through the duration of the respective periods and (2) therecording of a gain on derivative instruments in the amount of $4,223,000related to the change in the fair value of the derivative 

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liabilities which we have recorded in our condensedconsolidated balance sheets.  Lastly,interest income decreased $206,000 due to a lower cash and cash equivalentbalance carried for the nine months ended January 31, 2007, as compared to suchbalance carried in the comparable period in the prior fiscal year.

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

***Income Taxes***

We currently operate at a loss and expect tooperate at a loss until the products currently under development begin togenerate sufficient revenue. The losses incurred in the current year are notexpected to generate an income tax benefit because of the uncertainty of therealization of the deferred tax asset. As a result, we have provided avaluation allowance against our net deferred tax asset because, based onavailable evidence including our continued operating losses, it is more likelythan not, that all of the deferred tax assets will not be realized.Additionally, due to certain “change in ownership” rules (as defined bythe IRS), utilization of our federal net operating losses may be subject tocertain annual limitations.

***Minority Interestin Operations of Consolidated Subsidiary***

Minorityinterest in operations of consolidated subsidiary increased on both a dollarand a percentage of revenues basis for the three and nine months ended January31, 2007, as compared to the same periods of our prior fiscal year as reflectedin the following table:

 
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | (97,000    | )                                                     | —     |   | $ | (55,000 | ) | — |   |
| Percent of revenues |       | (1.5                                                   | )%         | —                                                |       | (0.3 | )% | — |   |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |

 

Theamount of minority interest in operations of consolidated subsidiary recordedfor the three and nine months ended January 31, 2007, relates to our purchaseof a 90% interest in SenseIt in October 2006 and the subsequent operation ofthe business.  The amount is expected tofluctuate in future periods dependent upon the development and, potentially,financing activities of SenseIt in future reporting periods.

***Loss FromDiscontinued Operations, net of Income Taxes***

Lossfrom discontinued operations, net of income taxes decreased on both a dollarand a percentage of revenues basis for the three and nine months ended January31, 2007, as compared to the same periods of our prior fiscal year as reflectedin the following table:
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | (87,000    | )                                                     | $          | (290,000 | ) | $ | (99,000 | ) | $ | (494,000 | ) |
| Percent of revenues |       | (1.3                                                   | )%         | (5.5                                                  | )%         | (0.5 | )% | (3.9 | )% |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |  |  |

 

Duringthe three months ended January 31, 2007, we decided to discontinue operationsof our life sciences business and to put the assets and business up forsale.  We decided to sell this businessas it no longer fits our long-term strategy and because of deterioratingbusiness conditions in the historical revenue producing products in the segment.  We expect to dispose of the business by July31, 2007.   Accounting rules require usto treat the operations of the life sciences business as discontinuedoperations whereby the net financial impact of the operations of the businessis combined into a single line item and prior periods are restated for thispresentation.  Revenue for the lifesciences business, reported in discontinued operations, was $466,000 

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and$1,659,000 for the three and nine months ended January 31, 2007, respectively,as compared to $1,220,000 and $4,436,000 for the three and nine months endedJanuary 31, 2006, respectively.

***Net Loss***

Ournet loss decreased on both a dollar and a percentage of revenues basis for thethree and nine months ended January 31, 2007, as compared to the same period ofour prior fiscal year, as reflected in the following table:
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                               | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Dollar amount       |       | $                                                      | (2,377,000 | )                                                     | $          | (7,661,000 | ) | $ | (8,350,000 | ) | $ | (18,085,000 | ) |
| Percent of revenues |       | (36.4                                                  | )%         | (145.6                                                | )%         | (40.6 | )% | (139.7 | )% |
|                     |            |                                                        |            |                                                       |            |  |  |  |  |  |  |  |  |

 

Weanticipate that consolidated losses will continue until (if ever): (i) revenuesfrom our current operations substantially increase or (ii) we generatesubstantial revenues from products introduced as a result of our research anddevelopment projects.  Further, therevenue increases must increase faster than any increases in operating andresearch and development expenses.  Althoughour semiconductor products and services segment has now recorded two consecutivequarters of operating income, we expect that our consolidated net loss willcontinue during at least the short term as we continue to improve oursemiconductor products and services segment and as we continue our marketingand research efforts to expand sales and develop new products in the homelandsecurity business, including the commercialization of the IMS technology and,eventually, the infrared imaging technology based on the Lucent Agreement andthe operations of our 90% owned subsidiary, SenseIt.  However, we can offer no assurances that thedevelopment and commercialization of these technologies will occur.

We anticipate that our operations during theremainder of fiscal year 2007 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 and Capital Resources**

WorkingCapital

Ourworking capital was $3,915,000 at January 31, 2007, as compared to a workingcapital deficit of $(6,445,000) at April 30, 2006. This $10,360,000improvement in working capital for the nine months ended January 31, 2007, isdue to a combination of factors, of which the significant factors are set outbelow:

Factorswhich increased working capital

·                  approximately $15,105,000 due to the issuanceof the 6% Debentures, which are classified as long-term liabilities;

·                  approximately $5,363,000 due to a decrease in the current portion of the8% Debentures related to principal payments made in shares of our common stock(see discussion of 8% Debenture repayment below).

Factorswhich decreased working capital

·                  approximately $7,666,000 of cash consumeddirectly in operating activities (calculated as approximately $7,361,000 ofcash used in operating activities, increase by approximately $305,000 of thecash impact of changes in other current assets or liabilities includedtherein);

·                  approximately $ 287,000 due to a cumulativeincrease in the current portion of convertible debentures related to thecumulative amortization of the debt discount on the 8% Debentures;

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·                  $1,615,000 related to purchases of fixedassets;

·                  approximately $312,000 representing thecurrent portion of capital lease entered into in the nine months ended January31, 2007;

·                  $100,000 related to an investment into abusiness (subsequently written off in its entirety);

·                  approximately $100,000 in reclassification of notes payable from longterm to current.

Asa result of the recent financing, with Cornell in May, June and November 2006,we believe we have enough cash to finance our anticipated operations andprojected negative cash flow into our 2008 fiscal year.

Wehave satisfied our working capital requirements primarily through financingactivities in the past, including the issuance of the 8% Debentures inFebruary 2005 and the 6% Debentures in May, June and November 2006.As described above, we have recently cured a listing deficiency with Nasdaq.   We may receive additional deficiencynotifications, which, if not cured timely, may result in our delisting from theNasdaq Capital Market. Any such delisting, if it should occur, will make futurefinancing activities significantly more difficult.

8%Convertible Debentures 

Thefirst of twelve monthly principal payments on our 8% Debentures became due inMarch 2006.  Both the principal andinterest were payable, at our option, in common stock, subject to variousrequirements (which we believe we met at the time of payment). During the ninemonths ended January 31, 2007 and subsequently, we repaid the 8% Debentures infull, with the last payment being made on February 1, 2007.  Through February 1, 2007, we repaid $4,970,000in nominal principal and $112,250 in interest by issuing 1,502,532 shares ofcommon stock and also repaid nominal principal in the amount of $5,005,000 incash

Twoformer holders of the 8% Debentures have at various times asserted that theissuance of the 6% Debentures constituted a default (due to a potentialvariable conversion provision contained within the 6% Debentures) under the 8%Debentures.  We have contested thatallegation on several bases and will defend against any further allegation of defaultas necessary.   Remedies for an event ofdefault include the option to accelerate payment of the full principal amountof the debentures, together with interest and other amounts due, to the date ofacceleration.  The principal amount ofthe debentures shall be equal to 130% of the then-principal amount of thedebentures plus all interest and other amounts due or a conversion calculation,whichever is higher.  If they prove adefault, we could be liable for an amount of approximately $1,150,000, includingaccrued interest.

6%Convertible Debentures

OnMay 31, 2006, we completed a private placement by which we issued to anaccredited investor 6% Debentures in the aggregate principal amount of$16,000,000 (including debentures of $3,000,000 each purchased in June andNovember 2006) and warrants to purchase a total of 2,000,000 shares of ourcommon stock at exercise prices of $5.00 per share (500,000 warrants), $7.00per share (750,000 warrants) and $8.00 per share (750,000 warrants) for aperiod of three years.  The 6% Debenturesmature on May 31, 2009.  The accreditedinvestor and an unaffiliated third party provided us services in connectionwith completing the transaction (which were valued at $825,000) and as aresult, we issued 165,000 shares of restricted common stock as compensation. Theaccredited investor may convert the 6% Debenture into shares of our commonstock at any time at a conversion price of $5.00 per share.  The holder may convert the 6% Debentures intocommon stock at the lesser of $5.00 or 80% of the average of the two lowestdaily volume weighted average prices of our stock during the five trading daysimmediately preceding the conversion date (the “Market Conversion Price”),subject to certain conversion limitations (see Note 9 to the accompanyingcondensed consolidated financial statements). If the holder converts using the Market Conversion Price, the holder is 

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limitedto converting no more than $400,000 of the principal or accrued interest on the6% Debentures into shares of our common stock in any seven calendar day period.

Interestaccrues on the outstanding principal balance at the annual rate of 6%.  Interest is payable on May 31, 2009, in cashor shares of our common stock, at our option. If we choose to pay accrued interest in shares of our common stock, thenumber of shares to be issued will be calculated as the amount of interest duedivided by 88% of the volume weighted average price of our common stock for thefive trading days preceding the Maturity Date.

Ifwe have insufficient shares authorized but unissued and unreserved to convertprincipal and pay interest in common stock, our stock is not listed or quotedon a market, we have not timely satisfied any conversion obligations or theissuance of shares would violate certain other defined sections of the agreement,the holder has a right to request net cash settlement of the conversion basedupon a defined calculation.

Wewere contractually required to seek shareholder approval of this transaction byno later than October 31, 2006, (exclusive of any shares acquired in thistransaction or related transactions), including the ability to issue a maximumof 16 million shares upon conversion of the 6% Debentures and to approve anincrease in authorized shares of common stock to at least 175 million shares.  On October 30, 2006, we held our annualmeeting of shareholders.  The proposal toapprove the transaction was approved. Although more shareholders voted in favor of the proposal for amendingour articles of incorporation to increase our authorized common stock, we didnot receive the number of votes for the proposal required by California law tocomplete the amendment as required.  Wecalled a special meeting of shareholders which was held on January 2, 2007, toreconsider a proposal for an increase in our authorized capitalization and theproposal was approved.   In the WaiverAgreement discussed below, Cornell waived the initial compliance period.

**OnFebruary 19, 2007, we entered into the Waiver Agreement with Cornell that,among other terms, waived certain deficiencies in compliance with and amendedcertain clauses of the 6% Debenture transaction documents.  In return for the waivers granted and otheramendments to the transaction documents, we agreed to provide a one-timeratchet to the $7.00 warrant and the $8.00 warrant, each exercisable for750,000 shares.  The one-time ratchetwill occur upon the first conversion by a holder of a 6% Debenture and theexercise price of the aforementioned warrants will be automatically adjusted tothe average of the two lowest daily VWAP’s of our common stock during the fivetrading days prior to such conversion (to the extent that the new exerciseprice is lower than the then existing exercise price).**

Additionally,other events, as defined in the 6% Debenture agreement, may also allow the 6%Debenture holders to declare us in default. Remedies for an event of default, include the option to acceleratepayment of the full principal amount of the Debentures, together with interestand other amounts due, to the date of acceleration and Cornell will have theright to request such payment in cash or in shares of our common stock.  We are not obligated to pay liquidateddamages for more than a total of 365 calendar days.  We may elect to pay any liquidated damages incash or shares of our common stock if registered.   Failure to comply with our registrationobligations may, subsequent to any grace periods and opportunities to cure, bedeemed an event of default.

CashFlows

Asof January 31, 2007, we had $1,854,000 of cash and cash equivalents, anincrease of $268,000 as compared to $1,586,000 at April 30, 2006. Ourprincipal source of funding for the nine months ended January 31, 2007 was fromthe issuance of the 6% Debentures for which we received net proceeds of$15,105,000. Our principal source of funding for the nine months ended January31, 2006 was from cash and cash equivalents on hand at the start of the periodrelated to the issuance of 8% Debentures completed in February 2005whereby we received $22,000,000 ($21,340,000 net of placement fees).

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Cashused in operating activities of $7,361,000 and $12,635,000 for the nine monthsJanuary 31, 2007 and 2006, respectively, was primarily the result of a net lossattributable to common stockholders of $8,350,000 (which included noncashexpenses and gains in the net amount of approximately a $700,000 expense) and$18,186,000 (which included noncash expenses and gains in the aggregate amountof approximately a $7,200,000 expense), respectively.

Investingactivities used cash of $1,715,000 and $4,264,000 for the nine months endedJanuary 31, 2007 and 2006, respectively. Cash used in investing activities forthe nine months ended January 31, 2007, consisted of $1,615,000 expended onadditions of property and equipment and $100,000 expended on a 9% equityinvestment in a business (which was subsequently written off in itsentirety).  Cash used in investingactivities for the nine months ended January 31, 2006 resulted primarily fromthe purchase of PPSC in May 2005 (which purchase price included a net cashoutflow of $2,440,000) as well as purchases of property and equipment of$1,488,000.

Financingactivities provided cash of $9,344,000 and $1,033,000 for the nine months endedJanuary 31, 2007 and 2006, respectively. Cash provided by financing activitiesfor the nine months ended January 31, 2007 resulted primarily from the issuanceof the 6% Debentures which yielded net proceeds of $15,105,000 offset primarilyby principal payments on borrowings of $5,718,000. Cash provided by financingactivities for the nine months ended January 31, 2006 resulted primarily theexercise of common stock warrants offset primarily by debt repayments anddividend payments on our outstanding Series E Convertible Preferred Stock.

AdditionalLiquidity Considerations

Asa result of the 6% Debenture transaction, anti-dilution provisions associatedwith the 398,475 common stock warrants issued in the 8% Debenture transactionwere triggered whereby we issued an additional 1,593,902 common stock warrantsto these holders and reduced the exercise price on all related warrants to$5.00. As a result, as of March 12, 2007, we have 1,992,377 common stockwarrants exercisable at $5.00 related to the 8% Debenture transaction.  As a result of the May 18, 2006agreement (as discussed above), 1,139,251 of these common stock warrants havebeen modified to reduce their anti-dilution provisions to a price-protectionprovision only. If we were to enter into a financing agreement in the futurewith an effective price less then $5.00 (or of the holder of our 6% Debentureswas to convert a portion of the outstanding debenture at a conversion rate lessthan $5.00), the remaining 853,126 common stock warrants that have a fullanti-dilution provision, would ratchet into a great number of common stockwarrants at a lower exercise price. There were no other changes in the terms or conditions of the warrants.

Asof January 31, 2007, we had commitments outstanding for capital expenditures of$2,470,000.  We are attempting to securelease financing for a portion of the assets included in the commitment atJanuary 31, 2007.  Lease financing, ifavailable, will reduce our short term obligation to use our limited cashresources for these capital expenditures.

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

We are currently engaged in fundraising activitiesto allow us fund SenseIt in order to make its contractual development paymentsto Lucent and to ensure we have sufficient working capital to continue fundingrequired operations.  We cannot offer anyassurance that we will be able to raise the funds required.

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

***Off-Balance Sheet Arrangements***

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

***Critical Accounting Estimates***

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

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

*Goodwill and Intangible Assets*

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

Inaccordance with SFAS No. 142 *Goodwilland Other Intangible Assets*, goodwill is not amortized, but insteadis tested for impairment on an annual basis or more frequently if the presenceof certain circumstances indicates that impairment may have occurred.  The impairment review process, which issubjective and requires significant judgment at many points during theanalysis, compares the fair value of the reporting unit in which goodwillresides to its carrying value.  If thecarrying value of a reporting unit exceeds its fair value, then the amount ofthe impairment loss must be measured. The impairment loss is calculated bycomparing the implied fair value of reporting unit goodwill to its carryingamount. In calculating the implied fair value of reporting unit goodwill, thefair value of the reporting unit is allocated to all of the other assets andliabilities of that unit based on their fair values. The excess of the fairvalue of a reporting unit over the amount assigned to its other assets andliabilities is the implied fair value of goodwill. An impairment loss would berecognized when the carrying amount of goodwill exceeds its implied fairvalue.  We have goodwill in the amount of$3,631,000 on our condensed consolidated balance sheet as of January 31, 2007,related to the acquisition of PPSC in May 2005. During the three months ended January 31, 2007, we performed our annualimpairment review on the aforementioned goodwill and concluded that thegoodwill was not impaired.For intangible assets other than goodwill, SFAS No. 144 *Accounting for the Impairment or Disposal ofLong-Lived Assets* is the authoritative standard on theaccounting for the impairment of such intangible assets.  As required, we perform tests for impairmentof intangible assets other than goodwill whenever events or circumstancessuggest that such assets may be impaired. To evaluate potential impairment, SFAS No. 144 requires us to assesswhether the future cash flows related to these assets will be greater thantheir 

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carryingvalue at the time of the test. Accordingly, while our cash flow assumptions areconsistent with the plans and estimates we are using to manage the underlyingbusinesses, there is significant judgment in determining the cash flowsattributable to our other intangible assets over their respective estimateduseful lives.  We have remaining othernet intangible assets in the amount of $350,000 on our condensed consolidatedbalance sheet as of January 31, 2007, comprised of our IMS technology, acquiredin December 2002, customer lists acquired in our acquisition of the businessand assets of EMG in June 2004 and the customer base acquired in ouracquisition of PPSC in May 2005.  We arerequired to periodically evaluate our other intangible assets balances forimpairments. If we were to incur additional impairments to our other intangibleassets, it could have an adverse impact on our future earnings, if any.

*Stock-based Compensation*

Forour employees, our stock-option program is a broad-based, long-term retentionprogram that is intended to attract and retain talented employees and alignstockholder and employee interests.  OnMay 1, 2006, we adopted the provisions of SFAS 123(R), requiring us torecognize expense related to the fair value of our stock-based compensationawards.  We elected the modifiedprospective transition method as permitted by SFAS 123(R).  Under this transition method, stock-basedcompensation expense for the nine months ended January 31, 2007, includescompensation expense for all stock-based compensation awards granted prior to,but not yet vested as of May 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of SFAS 123 andcompensation expense for all stock-based compensation awards granted subsequentto May 1, 2006, based on the grant date fair value estimated in accordance withthe provisions of SFAS 123(R).  See Note7 to our condensed consolidated financial statements for further detail,including the impact of the adoption to our condensed consolidated statementsof operations.  We assess the fair valueof option awards using the Black-Scholes option pricing model, a model whichrequires several estimates including stock price volatility, risk-free interestrate and expected term of the option. Additionally, we must estimate the number of options we expect to beforfeited prior to vesting in future periods. As of January 31, 2007, $1,514,000 of total unrecognized compensationcost related to stock options is expected to be recognized over aweighted-average period of 0.9 years.  Ifthe assumptions used, as they relate to volatility, risk-free interest rate,estimated term of the options and forfeiture rate, were materially different,the overall valuation of these and any future stock-based awards and the timingof recognition of related expense could change significantly.

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

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

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

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otherestimates associated with estimating the end-of-period fair value of thederivative instrument could have a material impact on our financial statements.

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

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

InterestRates

Ourinvestment portfolio consists of cash and cash equivalents (in the amount of$1,854,000 at January 31, 2007), all of which is exposed to interest ratefluctuations.  The primary objective ofour investments is to earn a market rate of return while preserving principaland maximizing liquidity.  The interestearned on these investments (with a blended yield of 0.5% at January 31, 2007)may vary based on fluctuations in the prevailing interest rate.

EquitySecurities

Wedo not hold any investments in marketable equity securities.  However, we hold a 30% interest in IUT, whichis a non-marketable equity security.  Ourstrategic investment in this entity may be impacted by the underlying economicconditions of the entity, including the ability to raise additional capital andthe likelihood of our being able to realize our investments through liquidityevents such as initial public offerings, mergers or private sales.  This investment involves a great deal ofmarket risk, and there can be no assurances that a specific company will growor become successful.  Consequently, wecould lose all or part of our investment. Additionally, because IUT is located in Germany, our investment in theentity (and our share of their earnings or losses) may be impacted by changesin foreign currency rates.  The carryingamount of this investment was $460,000 as of January 31, 2007.

Derivative Instruments

Wedo not purchase derivative instruments on the open market.  However, in accordance with current US GAAP,we have classified certain warrants and the embedded conversion feature in our6% Debentures as derivative instruments (a combined $5,583,000 noncurrentliability at January 31, 2007). Classification as derivative liabilities was required because, for eachinstrument, there is a possibility that the instrument could be required to besettled on a net cash basis.  We arerequired to mark these instruments to market as of the end of each reportingperiod and to recognize the change in fair value in our condensed consolidatedstatements of operations.  Our stockprice has been historically volatile and the fair values of these instrumentsare sensitive to changes in our underlying stock price.  As such, the carrying amount of theseinstruments may be volatile from period to period.  For the nine months ended January 31, 2007,we recorded a gain on derivative instruments in the aggregate amount of $4,223,000,such amount representing the change in fair value between the respectiveinitial recording of the derivatives and either their reclassification backequity or January 31, 2007, as applicable.

**Item 4: Controls and Procedures**

**With the participation of our management, including ourPresident (who is serving as our interim Chief Executive Officer) and ChiefFinancial Officer, we have evaluated the effectiveness of our disclosurecontrols and procedures as required by Exchange Act Rule 13a-15(b) as of theend of the period covered by this report. Based on that evaluation, the interimChief Executive Officer and Chief Financial Officer have concluded that thesedisclosure controls and procedures are effective. There were no changes in ourinternal control over financial reporting during the three months ended January31, 2007, that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.**

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**Disclosure controls and procedures are controls and otherprocedures that are designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed inour reports filed under the Exchange Act is accumulated and communicated tomanagement, including our principal executive officer and our principalfinancial officer, as appropriate, to allow timely decisions regarding requireddisclosure.**

**Part II: Other Information**

**Item1:  Legal Proceedings**

None.

**Item 1A:Risk Factors**

*An investment in and ownership of our common stockor any other of our convertible securities is one of high risk.  You should carefully consider the risksdescribed below before deciding whether to exercise your warrants, or to investin or continue to hold our common stock. If any of the contingencies discussed in the following paragraphs orother materially adverse events actually occur, the business, financialcondition and results of operations could be materially and adverselyaffected.  In such case, the tradingprice of our common stock could decline, and you could lose all or part of yourinvestment.*

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

We have had working capital shortages in the pastand, although we raised capital totaling more than $43,800,000 (net of expensesand $4,100,000 of payments related to our 8% Debentures) since May 1, 2004, wehave generated significant losses which have impacted working capital.  As of January 31, 2007, our condensedconsolidated balance sheet reflects working capital of $3,915,000.

Based on the amount of capital we have remaining,our current negative cash flow from operations and investing activities, weanticipate that we may incur a working capital deficit unless we are able tosubstantially increase our revenue or reduce our expenses thereby generatingpositive cash flow from operations and (ultimately) operating income.  Nevertheless, as a result of theNovember 2006 investment, other anticipated cash flows, and certain cost-savingmeasures we have instituted, we believe we have sufficient working capital to finance our anticipatedoperations and projected negative cash flow into our 2008 fiscal year.

**Our ability to obtain further financing when necessary is limited.**

We have historically financed our operating lossesand cash flow deficits through private placements of our equity and debtsecurities.  Our outstanding 6%Debentures contain significant restrictions on our ability to raise anyadditional capital for so long as the convertible debentures are outstandingand ultimately, our ability to finance our operations will depend on ourability to generate revenues that exceed our expenses.  Although we believe we are on a path to thatend, we cannot offer any assurance that we will be able to succeed in reachingthat goal.

**We may be delisted from the Nasdaq Capital Market and delisting mayadversely impact our ability to raise capital.**

During fiscal year 2007, we received threenotifications from Nasdaq identifying listing deficiencies, which, if not curedtimely, could have resulted in our delisting from the Nasdaq CapitalMarket.  While we cured thesedeficiencies, we continue to besubject to other continued listing requirements, including a 

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requirementfor either a minimum level of stockholders’ equity or market value of listedsecurities.  With stockholders equityless than $2,500,000 at January 31, 2007 and our current market capitalizationof listed securities, we believe we may not be in compliance with therequirement and as a result we may receive another notification from Nasdaqidentifying a listing deficiency.  Ifsuch notification is received and is not cured timely, it could result in ourdelisting from the Nasdaq Capital Market.  We can offer no assurance that we will be able to cure any futurelisting deficiencies or sustain compliance with all continued listingrequirements.

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

**We havethree business segments and, for the nine months ended January 31, 2007, two ofour three  segments operated at a loss,in some cases significant losses.**

For the nine months ended January 31, 2007, and asreflected in the following table, our condensed consolidated financialstatements show that two of our three operating segments have been operating ata loss and the one segment’s operating income is not material when compared toour total operating loss (amounts in thousands):

|                                     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **January 31,**            | ** ** |
| ** **                          | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| Segment  operating (loss) income:   |       |                            |       |   |   |
| Homeland security products          |       | $                               | (6,054     | ) | $ | (4,254 | ) |
| Security services                   |       | (377                            | )          | (79 | ) |
| Semiconductor products and services |       | 40                              |       | (4,374 | ) |
| Reconciling amounts                 |       | (3,842                          | )          | (3,367 | ) |
| Total                               |       | $                               | (10,233    | ) | $ | (12,074 | ) |

 

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

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

We have not operated profitably since our 1996fiscal year, and as discussed in the preceding risk factor, two of our threesegments were not operating profitably for the nine months ended January 31,2007.  We recognized net income for theyear ended April 30, 2000, only because of the gain recognized on the sale ofour depleted zinc assets to Eagle-Picher Technologies, LLC.

Our ability to generate additional revenues (andultimately net income) is dependent upon the success of our homeland securityproducts, security services and semiconductor operations and our ability todevelop new products, while marketing and selling those productsprofitably.  Historically, oursemiconductor operations have been a significant cash drain and, although thesegment has recorded positive quarterly operating income for the nine monthsended January 31, 2007 as a result of successful steps taken to reduce costsand increase revenue, we cannot offer any assurance that the measures we havetaken will continue to be successful.

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We have had limited success in marketing ourhomeland security products, having sold our first units of our IMS technologyfor the detection of chemical weapons and other toxic substances in Novemberand December 2006 but none thereafter.  Although we continue to market products based on our IMS technology, wecannot offer any assurance that our marketing efforts will result in anyadditional sales or that additional sales would result in significant revenuesto us.

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

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

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

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

·                  technological and market developments; or

·                  a corporate decision to expand our productioncapacity through capital investment or acquisition.

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

**We have raised capital and issued securities during the years endedApril 30, 2006 and 2005, and subsequently which has resulted (and will in thefuture when warrant exercises or conversions occur result) in dilution to ourexisting shareholders.  This wasaccomplished to provide necessary working capital or obtain assets andservices.  We will likely issue moresecurities to raise additional capital or to obtain other services or assets,any of which may result in substantial additional dilution.**

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

The6% Debentures issued during fiscal year 2007, and the securities we may issuein connection with our current capital raising activities, have significantrestrictions on our ability to raise any additional capital.  If we raise additional working capital, wewill likely have to issue additional shares of our common stock and commonstock warrants at prices that may dilute the interests of our existingshareholders.

** **

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**Twoformer holders of a portion of the then outstanding  8% Debentures have asserted that a defaultexisted.**

Twoentities who held 8% Debentures (which have been paid in full as of February 1,2007) have previously asserted that the issuance of the 6% Debenturesconstituted a default (due to a potential variable conversion provisioncontained within the 6% Debentures which gives the 6% Debenture holder theright to convert the 6% Debentures into common stock at the lower of $5.00 orat a discount to market, subject to certain limitations and as defined) underthe 8% Debentures.  We have contestedthat allegation (based on such clause not surviving the final agreement and adefense of *in pari delicto*), and will defend it incourt if necessary.  Although we have nothad any further communication from the former holders regarding this issueother than the allegation of default, any litigation, if enacted would be timeconsuming and expensive and, although we believe that we have significantgrounds to contest the existence of any default, we cannot be assured ofsuccess.  If they were to prove adefault, we could be liable for 130% of the principal amount of their 8%Debentures on the closing date of the 6% Debenture transaction (an amount ofapproximately $1,150,000, including accrued interest).

**Accounting charges resulting fromour issuance of the 6% Debentures may lead to significant non-cash chargeswhich would adversely impact future interest expense, net income and earningsper share and may also lead to future volatility in our financial statementcomponents.**

Theissuance of the 6% Debentures during fiscal year 2007 has resulted in theclassification of certain warrants and the conversion feature embedded in the6% Debentures as derivative liability instruments (a combined $5,583,000noncurrent liability at January 31, 2007). We are required to mark these instruments to market as of the end ofeach reporting period and to recognize the change in fair value in our consolidatedstatements of operations.  Additionally,we will be required to record significant non-cash interest charges over thelife of the 6% Debentures (in addition to interest expense relating to the 6%interest rate borne by the 6% Debentures which will be paid in cash or sharesof our common stock, at our option).  The combination of these two factorswill likely result in a significant adverse impact to future net income andearnings per share and will likely introduce additional volatility to ourfuture operating results.

**Operations in Russia may be disrupted because of a volatile politicaland economic climate beyond our control, which could adversely affect oursupply of raw materials.**

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

**We are dependent on suppliers from Russia forsubstantially all of our stable isotopes and our radioisotopes.  Accordingly, our operations or our ability tosuccessfully divest the life sciences business could be materially adverselyaffected if hostilities in Russia should occur, if trade between Russia and theUnited States were interrupted or ceased, if political conditions in Russiadisrupt transportation or processing of our goods, if laws or governmentpolicies concerning foreign business operations in Russia change substantially,or if tariffs are introduced.**

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**Historically we depended upon few customers for a significant portionof our revenues and our business could have been materially and adverselyaffected if we lost any one of those customers.**

As a result of the acquisition of PPSC and thegrowth of our semiconductor products and services segment, we rely on a fewcustomers for a significant portion of our revenues.  For the nine months ended January 31, 2007,two security services customers accounted for 15% and 11% of revenues,respectively, and one semiconductor materials and products customer accountedfor 22% of revenues, while one security services customer accounted for 24% ofrevenues for the nine months ended January 31, 2006.  Significant reductions in sales to any ofthese large customers have had, and may in the future have, an adverse effecton us by reducing our revenues and our gross margins.  Present or future customers could terminatetheir purchasing patterns with us or significantly change, reduce or delay theamount of isotopes or other products ordered from us.

**We realized increased expenses, reduced revenues, and longer thananticipated delays in integrating past business acquisitions into ouroperations, and we may face similar difficulties with future acquisitions aswell.**

We experienced increased costs and delays inintegrating the operations of the business and assets we acquired from EMG, inJune 2004, and we also realized revenues that were significantly reduced fromthat which we had anticipated. Regardless of the extent of our planning, we may recognize increasedcosts and delays, and reduced revenues, when integrating future businessacquisitions into our business operations and strategy.  While we believe that we have and willcontinue to plan for integration of business operations to the best of ourability, we cannot offer any assurance that any or all such efforts willproceed as anticipated.  While theintegration of PPSC (acquired in May 2005) has been more successful than thatof EMG, if efforts at integrating other businesses and assets that we mayacquire in the future achieve similar difficulties as we realized in theintegration of the EMG business and assets, we may have unanticipated expenses,delays and revenue reductions.

**If demand for any of our products grows suddenly, we may lack theresources to meet demand or we may be required to increase our capital spendingsignificantly.**

If we are able to develop and market our productssuccessfully, we may experience periods of rapid growth that place asignificant strain on our financial and managerial resources.  Through our research and development effortswe are also attempting to develop additional products and lines of business.  Our ability to manage growth effectively,particularly given our increasing scope of operations, will require us tocontinue to implement and improve our management, operational and financialinformation systems, and will require us to develop the management skills ofour personnel and to train, motivate and manage our employees.  Our failure to effectively manage growthcould increase our costs of operations and reduce our margins and liquidity,which could have a material adverse effect on our business, financial conditionand results of operations.

**Because we are dependent upon ourkey personnel for our future success, if we fail to retain or attract keypersonnel, our business will be adversely affected.**

Our future success will depend in significant partupon the continued service of our key technical, sales and senior managementpersonnel and consultants, including Christopher Toffales, our Chairman of theBoard. Currently Mr. Toffales is covered by two year employment agreement thatis renewable on an annual basis.

We believe that our future success will also dependupon our ability to attract and retain other qualified personnel for ouroperations.  The failure to attract orretain such persons could materially adversely affect our business, financialcondition and results of operations.

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**The reorganization of our Company and the changesin our senior management may result in a disruption of operations or haveadverse impacts on our business.**

Aspart of the our management reorganization in February 2007, James E. Alexanderand Boris Rubizhevsky, resigned from their positions as officers and directors;Lindsay A Gardner, a vice president, resigned from her position as adirector.  Both Mr. Alexander and Mr.Rubizhevsky were founding members of Isonics and actively managed ouroperations since formation.  Thedeparture of Mr. Alexander and Mr. Rubizhevsky, and the introduction of our newofficers and directors may disrupt our operations and adversely effect ourbusiness operations.

**We may not be able to protect our intellectual property, which wouldreduce our competitive advantage.**

We rely primarily on a combination of patents andpatent applications, trade secrets, confidentiality procedures, and contractualprovisions to protect our technology. Despite our efforts to protect our technology, unauthorized parties mayattempt to copy aspects of our products or to obtain and use information thatwe regard as proprietary.  Policingunauthorized use of our technology and products is difficult.  In addition, the laws of many countries donot protect our rights to information, materials and intellectual property thatwe regard as proprietary and that are protected under the laws of the UnitedStates.  We may not be able to protectour proprietary interests, or our competitors may independently develop similartechnology or intellectual property.  Ifeither one of these situations occurs, we may lose existing customers and ourbusiness may suffer.

Thevalidity of any of the patents licensed to us, or that may in the future beowned by us, may not be upheld if challenged by others in litigation.  Further, our products or technologies, evenif covered by our patents, may infringe upon patents owned by others.  We could incur substantial costs in defendingsuits brought against us, or any of our licensors, for infringement, in suitsby us against others for infringement, or in suits contesting the validity of apatent.  Any such proceeding may beprotracted.  In any suit contesting thevalidity of a patent, the patent being contested would be entitled to apresumption of validity and the contesting party would be required todemonstrate invalidity of such patent by clear and convincing evidence.  If the outcome of any such litigation wereadverse to our interests, our liquidity and business operations would bematerially and adversely affected.

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

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

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

**We could be subject to environmental regulation by federal, state andlocal agencies, including laws that********imposeliability without fault, which could produce working capital shortages andlessen shareholders’ equity.**

We could become subject to a variety of federal,state, and local environmental regulations relating to the use, storage,discharge and disposal of hazardous chemicals used during manufacturingprocesses, although

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we do not believe that there is any such regulationdirectly applicable to our current operations. Regulations that become applicable to our operations in the future couldrestrict our ability to expand our facilities or could require us to acquire costlyequipment or to incur other significant expenses to comply with governmentalregulations.  Historically, our costs ofcompliance with environmental regulations have not been significant.

**We are controlled by only a few officers and directors and,consequently, purchasers of our shares will have little ability to elect orcontrol our management.**

Our shares are widely-held.  Even though our management beneficially owns(as of March 12, 2007) our securities equivalent to approximately 12% of theoutstanding votes at any shareholders’ meeting (assuming no exercises of commonstock warrants or options by any person other than management or conversions ofthe 6% Debentures), it is likely that they will be able to continue tosubstantially influence all matters submitted to stockholders for approval,including the election and removal of directors and any merger, consolidationor sale of substantially all of our assets, and to control our management andaffairs.  Such concentration of ownershipmay have the effect of delaying, deferring or preventing a change in control,impeding a merger, consolidation or takeover or other business combinationinvolving us or discouraging a potential acquirer from making a tender offer orotherwise attempting to obtain control of our business, even if such a transactionwould be beneficial to other stockholders.

**We risk exposing ourselves to an above-policy limit product liabilityclaim, which could adversely affect our working capital, shareholders’ equityand profitability.**

The use of our radioisotopes in radiopharmaceuticalsand in clinical trials may expose us to potential product liability risks thatare inherent in the testing, manufacture, marketing, and sale of humandiagnostic and therapeutic products. Additionally, the sale and use of explosive and chemical detectionproducts may expose us to potential liability risks that are inherent with theoperation of these types of products (including, but not limited to faileddetection).  We currently have productliability insurance; however, there is a risk that our insurance would notcover completely or would fail to cover a claim, in which case we may not havethe financial resources to satisfy such claims, and the payment of claims wouldrequire us to use funds that are otherwise needed to conduct our business andmake our products.

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

The trading price of our securities has beensubject to wide fluctuations in response to quarter-to-quarter variations inour operating results, our announcements of technological innovations or newproducts by us or our competitors, and other events and factors. The securitiesmarkets themselves have from time to time and recently experienced significantprice and volume fluctuations that may be unrelated to the operatingperformance of particular companies. Announcements of delays in our testing anddevelopment schedules, technological innovations or new products by us or ourcompetitors and developments or disputes concerning patents or proprietaryrights could have a significant and adverse impact on such market prices.Regulatory developments in the United States and foreign countries, publicconcern as to the safety of products containing radioactive compounds, economicand other external factors, all affect the market price of our securities. *In addition, the realization of any of the risks describedin these “Risk Factors” could have a significant and adverse impact on suchmarket prices*.

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**SECpenny stock regulations may limit the ability to trade our securities on theNasdaq Capital Market.**

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

Under this rule, broker-dealers who recommend suchsecurities to persons other than established customers and accredited investorsmust make a special written disclosure to, and suitability determination for,the purchaser and receive the purchaser’s written agreement to a transactionprior to sale.  The regulations on pennystocks limit the ability of broker-dealers to sell our common stock and thusthe ability of purchasers of our common stock to sell their securities in thesecondary market.  To the extent we areable to maintain our listing on the Nasdaq Capital Stock Market, we will not besubject to these penny stock rules.  Reasonsfor being unable to maintain our listing on the Nasdaq Capital Market include:

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

·      the inability to maintain either the minimumstockholders’ equity, market capitalization or net income along with therequired number of market makers and shareholders necessary for listing.

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

If our shares are removed from the Nasdaq CapitalMarket because of our failure to meet any of the requirements, the ability ofholders of our common stock to sell the shares they hold will likely beadversely affected because the lower tier markets (such as the OTC BulletinBoard and the Pink Sheets) do not provide shareholder liquidity as do thehigher tier markets (such as the Nasdaq Capital Market).  In addition, unless traded on Nasdaq CapitalMarket or other higher tier markets (such as the American Stock Exchange), ourcommon stock will be subject to the penny stock rules, and many stock brokerswill not make a market in those shares, further reducing the marketability ofour shares.

**Future sales of our common stockmay cause our stock price to decline.**

Ourstock price has declined from a price of approximately $24.00 (adjusted for thereverse split) per share at the beginning of 2005 to prices of less than $2.00(adjusted for the reverse split) at various times since May 2006. Our stockprice may decline further as a result of future sales of our shares, theperception that such sales may occur or other reasons.  As of March 12, 2007, approximately 1,700,000shares of common stock held by existing stockholders constitute “restrictedshares” as defined in Rule 144 under the Securities Act.  The restricted shares may only be sold ifthey are registered under the Securities Act, or sold under Rule 144, oranother exemption from registration under the Securities Act.

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

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

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

**Outstandingdebentures, options and warrants may make it difficult for us to obtainadditional capital on reasonable terms.**

The aggregate $16,000,000 (as of March 12, 2007) inprincipal of the 6% Debentures outstanding is convertible (at the election ofthe 6% Debenture holder, subject to certain weekly limitations) into 11,851,852shares of common stock, assuming a conversion price of $1.35 (based upon a 20%discount to the closing price of $1.69 on March 12, 2007 which is lower thanthe fixed conversion price of $5.00). The holders’ rights to convert the 6% Debentures and associated warrantsare, however, subject to certain share issuance limitations.  Additionally, we are currently working toraise additional capital through the issuance of securities containing similarconversion features to the 6% Debentures. As of March 12, 2007, we had outstanding options and common stockwarrants for the purchase of up to 7,936,339 shares of common stock at anaverage exercise price of approximately $4.50 per share.  If all of the outstanding options, debenturesand common stock warrants were to be converted, they would represent approximately61% of our outstanding common shares on a fully diluted basis.  Future investors will likely recognize thatthe holders of the options and warrants will only exercise their rights toacquire our common stock when it is to their economic advantage to do so.  Therefore, even with lower current marketprices for our common stock, the market overhang of such a large number sharesunderlying warrants, options and convertible debentures may adversely impactour ability to obtain additional capital because any new investors willperceive that the securities offer a risk of substantial potential futuredilution.

****The continuously adjustable conversion price feature of our 6%Debentures, and any similar features of any debentures we may subsequentlyissue, could require us to issue a large number of shares, which would causedilution to our existing stockholders and may encourage investors to make shortsales of our common stock, which could depress the price of our common stock.****

We may be obligated to issue an extremely largenumber of shares upon the conversion of the 6% Debentures we have issued (orhave agreed to issue) to Cornell because the conversion price is to be thelower of (a) $5.00 per share or (b) 80% of the average of the two lowest daily volume weightedaverage price (“VWAP”) of our commonstock during the five trading days immediately preceding the conversiondate.  Hence, the number of shares of our commonstock issuable upon conversion of the 6% Debentures will increase if the marketprice of our stock declines, which may cause dilution to our existingstockholders.  Furthermore, thesignificant downward pressure on the price of the common stock as Cornellconverts and sells material amounts of common stock could encourage short salesby investors. This could place further downward pressure on the price of thecommon stock, which in turn would lead to further dilution. In addition, notonly the sale of shares issued upon conversion or exercise of debentures orwarrants, but also the mere perception that these sales could occur, may adverselyaffect the market price of the common stock.

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

Wehave various obligations to file and obtain the effectiveness of certainregistration statements which include certain outstanding common stock andcommon stock underlying outstanding convertible debentures and common stockwarrants.  Once effective, the prospectuscontained within a registration statement can only be used for a period of timeas specified by statute without there being a post-effective amendment filedthat has become effective under the Securities Act of 1933.  For example, we are required to file aregistration statement for the shares underlying the 6% Debentures by April 22,2007 and then to use our best efforts to obtain effectiveness of thatregistration statement.  If we are unableto meet these obligations, we may be obligated to pay liquidated damages of 1%of the principal amount of the 6% Debentures outstanding per month (up to$160,000 per month).  We cannot offer anyassurance that we will be able to maintain the currency of the informationcontained in a prospectus or to obtain the effectiveness of any registrationstatement or post-effective amendments that we may file.

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

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

**Provisions in our charter documents could preventor delay a change in control, which could delay or prevent a takeover.**

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

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

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

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

Section 404of the Sarbanes-Oxley Act of 2002 requires management to assess our internalcontrols over financial reporting and requires auditors to attest to thatassessment. Current regulations of the Securities and Exchange Commission, orSEC, will require us to include this assessment and attestation in our AnnualReport on Form 10-K commencing with the annual report for our fiscal yearending April 30, 2008.   We will incursignificant increased costs in implementing and responding to theserequirements. In particular, the rules governing the standards that must be metfor management to assess its internal controls over financial reporting underSection 404 are complex, and require significant documentation, testingand possible remediation. Our process of reviewing, documenting and testing ourinternal controls over financial reporting may cause a significant strain onour management, information systems and resources. We may have to invest inadditional accounting and software systems. We may be required to hireadditional personnel and to use outside legal, accounting and advisoryservices. In addition, we will incur additional fees from our auditors as theyperform the additional services necessary for them to provide theirattestation. If we are unable to favorably assess the effectiveness of ourinternal control over financial reporting when we are required to, or if ourindependent auditors are unable to provide an unqualified attestation report onsuch assessment (if applicable for the fiscal year ending April 30, 2008), wemay be required to change our internal control over financial reporting toremediate deficiencies. In addition, investors may lose confidence in thereliability of our financial statements causing our stock price to decline.

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

**Payment of 8% Convertible DebenturePrincipal and Interest in Common Stock**

From May 1, 2006 through February 1, 2007 wehave issued various shares of common stock to holders of our 8% Debentures inpayment of our monthly principal and interest obligations.  The following table summarizes such paymentsthrough March 12, 2007:
| **For Month  Ended** | ** ** | **Effective Date of Transaction** | ** ** | **Number of Shares Issued** |
|----------------------|------------|-----------------------------------|------------|-----------------------------|
| April 30, 2006       |       | May 1, 2006                       |       | 404,110                     |
| May 31, 2006         |       | June 1, 2006                      |       | 499,318                     |
| August 31, 2006      |       | September 1,  2006                |       | 74,215                      |
| September 30,  2006  |       | October 1, 2006                   |       | 88,481                      |
| October 31, 2006     |       | November 1, 2006                  |       | 109,329                     |
| November 30,  2006   |       | December 1, 2006                  |       | 89,085                      |
| December 31,  2006   |       | January 1, 2007                   |       | 120,262                     |
| January 31, 2007     |       | February 1, 2007                  |       | 117,732                     |

 

The following sets forth the informationrequired by Item 701 in connection with the above stated transactions:

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

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

(c)           Theshares were not sold for cash.

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

(e)           The common stockissued in these transactions is not convertible or exchangeable.  No warrants were issued in thesetransactions.

(f)            We received no cashproceeds from the issuance of the shares. We did receive a relief from indebtedness as described above.

**Warrant Issuances**

From May 1, 2006 through December 1, 2006 wehave issued variouswarrants (other than registered issuances) for services provided to us.  The following table summarizes such warrantissuances through March 12, 2007
| **Effective  Date of Issuance** | ** ** | **Number of shares purchasable** | ** ** | **Exercise price** | ** ** | **Expiration Date** |
|---------------------------------|------------|----------------------------------|------------|--------------------|------------|---------------------|
| May 18, 2006                    | ** ** | 12,500                           |       | $4.20              |       | May 17, 2008        |
| August 1, 2006                  | ** ** | 12,500                           |       | $2.68              |       | July 31, 2008       |
| November 29, 2006               | ** ** | 31,250                           |       | $3.36              |       | November 28,  2009  |

 

The following sets forth the informationrequired by Item 701 in connection with the above stated transactions:

(a)           The transactions werecompleted effective as stated in the above table.

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

(c)           The warrants were notissued for cash, but for services provided to us.

(d)           We relied on theexemption from registration provided by Sections 4(2) and 4(6) under theSecurities Act of 1933 for these transactions. We did not engage in any public advertising or general solicitation inconnection with this transaction.  Theinvestors 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 investors obtained all information regardingIsonics it requested, received answers to all questions it posed, and otherwiseunderstood the risks of accepting our securities for investment purposes.

(e)           The warrants areexercisable to purchase shares of our common stock at the respective prices andwith the respective expiration dates as stated in the above table.

(f)            We received no cashproceeds from the warrant grants.

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

Asreported in our Form 8-K reporting an event of January 2, 2007 (filed January4, 2007), on January 2, 2007, we held a special meeting of shareholdersin Denver, Colorado.  Two proposals were submitted to the shareholders forapproval as set forth in our proxy statement dated December 5, 2006:

1.                                       An amendment to our Articles of Incorporationto increase our authorized common stock to 175,000,000 shares.

2.                                       An amendment to our Articles of Incorporationto effect a reverse stock split of 1:1.5, 1:2, 1:3, or 1:4 as finally selectedby the Board of Directors at any time selected by the Board of Directors priorto December 31, 2007.

Therewas no solicitation contrary to Isonics’ proxy statement.

**There were 11,950,619 shares of common stock outstanding asof the record date (December 4, 2006) and no shares of preferred stock. 9,569,163 shares of common stock were present at the meeting and constituted aquorum.**

Atthe meeting, the shareholders approved both proposals, as follows:
|                                            | ** ** | **For**          | ** ** | **Against**    | ** ** | **Abstain**    |
|--------------------------------------------|------------|------------------|------------|----------------|------------|----------------|
| Amendment to Increase Authorized Capital   |       | 8,882,427 shares |       | 534,785 shares |       | 151,951 shares |
| Amendment to effect a  reverse stock split |       | 9,019,225 shares |       | 390,181 shares |       | 159,757 shares |

 

**Item 6:Exhibits**
| Exhibits. |   |
|-----------|--------|
|      |   |   |
|      | 3.01   | Registrant’s Amended and Restated Articles of  Incorporation (dated May 5, 1997) (1) |
|      | 3.02   | Registrant’s Amended and Restated Bylaws (2) |
|      | 3.03   | Certificate of Amendment to Articles of  Incorporation (dated November 15, 2001) (3) |
|      | 3.04   | Certificate of Amendment to Articles of  Incorporation (dated April 29, 2005) (4) |
|      | 3.05   | Certificate of Amendment to Articles of  Incorporation (dated January 2, 2007) (8) |
|      | 3.06   | Certificate of Amendment to Articles of  Incorporation (dated January 30, 2007) (7) |
|      | 10.01  | 6% Secured Convertible Debenture no. CCP-5:  $3,000,000 principal (5) |
|      | 10.02  | Class A Common Stock Purchase Agreement, dated as of  October 26, 2006 (6) |
|      | 10.03  | Employment Agreement with Christopher Toffales,  dated as of October 27, 2006 (6) |
|      | 10.04  | Stockholders’ Agreement between Isonics, SenseIt,  and Mr. Toffales, dated as of October 27, 2006 (6) |
|      | 10.05  | Waiver Agreement with Cornell Capital Partners, L.P.  (7) |
|      | 10.06  | Settlement Agreement and Mutual Releases between  Isonics and Mr. Alexander (7) |
|      | 10.07  | Settlement Agreement and Mutual Releases between  Isonics and Mr. Rubizhevsky (7) |
|      | 10.08  | Employment Agreement with Christopher Toffales (7) |
|      | 10.09  | 2007 Restructuring Equity Plan (7) |
|      |   |   |
|      | 31.1   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of the Exchange Act |
|      | 31.2   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) of the Exchange Act |
|      | 32.1   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350 |
|      | 32.2   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350 |

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(1)          Incorporated herein by reference to exhibit 3.03 filed with Isonics’Registration Statement on Form SB-2 (“Registration Statement”) (Commission fileNo. 333-13289).

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(2)          Filed with Isonics’ Current Report on Form 8-K (File No. 001-12531)dated March 27, 2006, and filed March 31, 2006, and incorporated herein byreference.

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

(4)          Incorporated byreference from Isonics’ annual report on Form 10-KSB for the year ended April30, 2005.

(5)          Incorporated herein by reference to exhibit 10.1 to the Form 8-Kreporting an event of November 14, 2006, filed on November 17, 2006.

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

(7)          Incorporated herein by reference to exhibit 3.1 and exhibits 10.1through 10.5 to the Form 8-K reporting an event of February 13, 2007, filed onFebruary 20, 2007.

(8)          Incorporated herein by reference to exhibit 3.1 to the Form 8-Kreporting an event of January 2, 2007, filed on January 4, 2007.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Golden, County of Jefferson, State of Colorado,on the 19th day of March 2007.
|   | Isonics Corporation |
|--------|---------------------|
|   | (Registrant)        |   |
|   |                |
|   | By                  | /s/ John Sakys |   |
|   |                | John Sakys |
|   |                | President, interim Chief Executive Officer |
|   |                |   |
|   | By                  | /s/ Kenneth J. Deane |   |
|   |                | Kenneth J. Deane |
|   |                | Chief Accounting Officer and Chief Financial Officer |
|        |                     |  |  |  |

** **

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