**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

** **

----

** **

**FORM 10-Q**

 

**(MarkOne)**

 

**x****     ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended January 31, 2008**

 

**or**

 

**o****        ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from              to**

 

**Commissionfile number:  001-12531**

 

**ISONICS CORPORATION**

**(Exactname of registrant as specified in its charter)**

** **

| **California**                                                    | ** ** | **77-0338561**                      |
|-------------------------------------------------------------------|------------|-------------------------------------|
| (State or other  jurisdiction of

incorporation or  organization) |       | (IRS Employer

Identification  No.) |

 

**5906McIntyre Street**

**Golden,Colorado 80403**

(Address ofprincipal executive offices with zip code)

 

**(303)279-7900**

(Registrant’s telephone number, includingarea code)

 

**N/A**

(Former name,former address and former

fiscal year, ifchanged since last report)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes x     No o

 

Indicate by check mark whether the Registrantis a large accelerated filer, an accelerated filer, a non-accelerated filer, ora smaller reporting company. See definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company”in Rule 12b-2 of the Exchange Act.

 

| Large accelerated filer o                 |   | Accelerated filer o         |
|------------------------------------------------|--------|-----------------------------|
|                                           |   |                        |
| Non-accelerated filer o                        |   | Smaller reporting company x |
| (Do  not check if a smaller reporting company) |   |                        |

 

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

 

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

 

| **Class**                        | ** ** | **Outstanding at March 12, 2007** |
|----------------------------------|------------|----------------------------------------|
| Common Stock — no par value |       | 13,422,904 shares                      |

 

 

 

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**IsonicsCorporation and Subsidiaries**

** **

**TABLE OFCONTENTS**

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

 

 

2

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**Part I:  Financial Information**

** **

**Item 1: Financial Statements**

** **

**Isonics Corporation andSubsidiaries**

** **

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except shareamounts)**

 
| ** **                                                                                                                                                                  | ** ** | **January 31, 2008** | ** ** | **April 30, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **(Unaudited)**           | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                  |       |                      |       |                    |       |
| CURRENT ASSETS:                                                                                                                                                             |       |                      |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                  |       | $                         | 1,547      |                    | $          | 1,556 |   |
| Accounts  receivable (net of allowances of $44 and $146,respectively)                                                                                                       |       | 2,300                     |       | 3,678                   |       |
| Inventories                                                                                                                                                                 |       | 791                       |       | 1,259                   |       |
| Prepaid expenses  and other current assets                                                                                                                                  |       | 303                       |       | 1,388                   |       |
| Assets of  discontinued operations                                                                                                                                          |       | —                    |       | 491                     |       |
| Total current  assets                                                                                                                                                       |       | 4,941                     |       | 8,372                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| LONG-TERM ASSETS:                                                                                                                                                           |       |                      |       |                    |       |
| Property and  equipment, net                                                                                                                                                |       | 5,201                     |       | 5,666                   |       |
| Goodwill                                                                                                                                                                    |       | 3,631                     |       | 3,631                   |       |
| Intangible  assets, net                                                                                                                                                     |       | 42                        |       | 303                     |       |
| Equity in net  assets of investee                                                                                                                                           |       | —                    |       | 382                     |       |
| Other assets                                                                                                                                                                |       | 478                       |       | 606                     |       |
| Total long-term  assets                                                                                                                                                     |       | 9,352                     |       | 10,588                  |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| TOTAL ASSETS                                                                                                                                                                |       | $                         | 14,293     |                    | $          | 18,960 |   |
|                                                                                                                                                                        |       |                      |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                    |       |                      |       |                    |       |
| CURRENT LIABILITIES:                                                                                                                                                        |       |                      |       |                    |       |
| Accounts payable                                                                                                                                                            |       | $                         | 878        |                    | $          | 973 |   |
| Accrued  liabilities                                                                                                                                                        |       | 2,285                     |       | 2,522                   |       |
| Derivative  liabilities                                                                                                                                                     |       | 106                       |       | 1,021                   |       |
| Current portion  of accrued interest                                                                                                                                        |       | 2,652                     |       | —                  |       |
| Current portion  of obligations under capital lease                                                                                                                         |       | 571                       |       | 340                     |       |
| Current portion  of notes payable                                                                                                                                           |       | 59                        |       | 134                     |       |
| Current portion  of convertible debentures, net of discount                                                                                                                 |       | 11,124                    |       | —                  |       |
| Liabilities of discontinued  operations                                                                                                                                     |       | —                    |       | 72                      |       |
| Total current  liabilities                                                                                                                                                  |       | 17,675                    |       | 5,062                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| Obligations under capital lease, net of current  portion                                                                                                                    |       | 749                       |       | 710                     |       |
| Accrued interest, net of current portion                                                                                                                                    |       | —                    |       | 851                     |       |
| Other long-term liabilities                                                                                                                                                 |       | 43                        |       | 37                      |       |
| Convertible debentures, net of discount and current  portion                                                                                                                |       | —                    |       | 8,634                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| TOTAL LIABILITIES                                                                                                                                                           |       | 18,467                    |       | 15,294                  |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| Minority interest in consolidated subsidiary                                                                                                                                |       | —                    |       | 111                     |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| STOCKHOLDERS’ EQUITY (DEFICIT):                                                                                                                                        |       |                      |       |                    |       |
| Common stock -  no par value; 175,000,000 shares authorized; shares issued and outstanding:  January 31, 2008 — 12,658,150; April 30, 2007 — 12,639,400 |       | 64,348                    |       | 64,319                  |       |
| Additional paid  in capital                                                                                                                                                 |       | 20,982                    |       | 20,705                  |       |
| Accumulated  deficit                                                                                                                                                        |       | (89,504                   | )          | (81,469                 | )          |
| Total  stockholders’ equity (deficit)                                                                                                                                  |       | (4,174                    | )          | 3,555                   |       |
|                                                                                                                                                                        |       |                      |       |                    |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                  |       | $                         | 14,293     |                    | $          | 18,960 |   |

 

See notes to condensedconsolidated 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,**  | ** ** |
| ** **                                                                 | ** ** | **2008**               | ** ** | **2007**              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                  |       |                   |       |                  |       |   |   |   | ** ** |
| Products                                                                   |       | $                      | 903        |                  | $          | 1,543 |   | $ | 2,919 |   | $ | 4,864 | ** ** |
| Services                                                                   |       | 4,239                  |       | 4,992                 |       | 14,147 |   | 15,712 | ** ** |
| Total revenues                                                             |       | 5,142                  |       | 6,535                 |       | 17,066 |   | 20,576 | ** ** |
|                                                                       |       |                   |       |                  |       |   |   |   | ** ** |
| Cost of revenues:                                                          |       |                   |       |                  |       |   |   |   | ** ** |
| Products                                                                   |       | 1,073                  |       | 1,288                 |       | 3,424 |   | 4,116 | ** ** |
| Services                                                                   |       | 3,590                  |       | 3,851                 |       | 11,809 |   | 12,048 | ** ** |
| Total cost of  revenues                                                    |       | 4,663                  |       | 5,139                 |       | 15,233 |   | 16,164 | ** ** |
|                                                                       |       |                   |       |                  |       |   |   |   | ** ** |
| Gross margin                                                               |       | 479                    |       | 1,396                 |       | 1,833 |   | 4,412 | ** ** |
|                                                                       |       |                   |       |                  |       |   |   |   | ** ** |
| Operating expenses:                                                        |       |                   |       |                  |       |   |   |   | ** ** |
| Selling, general  and administrative                                       |       | 1,743                  |       | 3,150                 |       | 5,697 |   | 11,015 | ** ** |
| Impairment loss  on intangible assets                                      |       | —                 |       | —                |       | 145 |   | — | ** ** |
| Research and  development                                                  |       | 42                     |       | 1,442                 |       | 1,224 |   | 3,630 | ** ** |
| Total operating  expenses                                                  |       | 1,785                  |       | 4,592                 |       | 7,066 |   | 14,645 | ** ** |
|                                                                       |       |                   |       |                  |       |   |   |   | ** ** |
| Operating loss                                                             |       | (1,306                 | )          | (3,196                | )          | (5,233 | ) | (10,233 | ) |
|                                                                       |       |                   |       |                  |       |   |   |   |   |
| Other income (expense):                                                    |       |                   |       |                  |       |   |   |   |   |
| Amortization of  debt issuance costs                                       |       | (51                    | )          | (38                   | )          | (138 | ) | (197 | ) |
| Interest and  other income                                                 |       | 1                      |       | —                |       | 100 |   | 54 |   |
| Interest expense                                                           |       | (1,570                 | )          | (928                  | )          | (4,496 | ) | (2,347 | ) |
| Foreign exchange                                                           |       | 7                      |       | 3                     |       | 14 |   | 4 |   |
| Gain on  extinguishment of debt                                            |       | —                 |       | —                |       | — |   | 227 |   |
| Gain on  derivative instruments                                            |       | 411                    |       | 1,903                 |       | 915 |   | 4,223 |   |
| Equity in net  income (loss) of investee                                   |       | 11                     |       | 63                    |       | (69 | ) | 73 |   |
| Gain on sale of  equity methodinvestment                                   |       | 208                    |       | —                |       | 208 |   | — |   |
| Total other  income (expense), net                                         |       | (983                   | )          | 1,003                 |       | (3,466 | ) | 2,037 |   |
| Loss from  continuing operations before income taxes and minority interest |       | (2,289                 | )          | (2,193                | )          | (8,699 | ) | (8,196 | ) |
| Income tax expense                                                         |       | —                 |       | —                |       | — |   | — |   |
| Minority interest in operations of consolidated  subsidiary                |       | —                 |       | (97                   | )          | 111 |   | (55 | ) |
| Loss from continuing operations                                            |       | (2,289                 | )          | (2,290                | )          | (8,588 | ) | (8,251 | ) |
| Discontinued operations:                                                   |       |                   |       |                  |       |   |   |   |   |
| Gain (loss) on  operations of discontinued operations, net of income taxes |       | —                 |       | (87                   | )          | 37 |   | (99 | ) |
| Gain on disposal  of discontinued operations, net of income taxes          |       | —                 |       | —                |       | 516 |   | — |   |
| Gain (loss) on  discontinued operations, net of income taxes               |       | —                 |       | (87                   | )          | 553 |   | (99 | ) |
| NET LOSS                                                                   |       | $                      | (2,289     | )                     | $          | (2,377 | ) | $ | (8,035 | ) | $ | (8,350 | ) |
|                                                                       |       |                   |       |                  |       |   |   |   |   |
| **Net loss per share—basic and diluted**                              |       |                   |       |                  |       |   |   |   |   |
| Continuing  operations                                                     |       | $                      | (0.18      | )                     | $          | (0.19 | ) | $ | (0.68 | ) | $ | (0.71 | ) |
| Discontinued  operations                                                   |       | $                      | (0.00      | )                     | $          | (0.01 | ) | $ | 0.04 |   | $ | (0.01 | ) |
| Net loss                                                                   |       | $                      | (0.18      | )                     | $          | (0.20 | ) | $ | (0.64 | ) | $ | (0.72 | ) |
| Weighted average  common shares used in computing per share information    |       | 12,658                 |       | 11,962                |       | 12,657 |   | 11,666 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**Isonics Corporation andSubsidiaries**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands, except shareamounts)**

**(Unaudited)**

 
| ** **                                                                                            | ** ** | **Nine months Ended January 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                            | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| ** **                                                                                            | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net cash used in operating activities                                                                 |       | $                                      | (323       | ) | $ | (7,361 | ) |
|                                                                                                  |       |                                   |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                 |       |                                   |       |   |   |
| Purchases of  property and equipment                                                                  |       | (106                                   | )          | (1,615 | ) |
| Equity  investment in a business                                                                      |       | —                                 |       | (100 | ) |
| Proceeds from  assets held for sale                                                                   |       | 60                                     |       | — |   |
| Proceeds from  sale of equity method investment                                                       |       | 527                                    |       | — |   |
| Proceeds from  sale of discontinued operations, net of selling costs                                  |       | 805                                    |       | — |   |
| Cash provided by  (used in) investing activities                                                      |       | 1,286                                  |       | (1,715 | ) |
|                                                                                                  |       |                                   |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                 |       |                                   |       |   |   |
| Principal  payments under capital lease obligations                                                   |       | (359                                   | )          | (58 | ) |
| Principal  payments on borrowings                                                                     |       | (613                                   | )          | (5,718 | ) |
| Proceeds from  issuance of common stock                                                               |       | —                                 |       | 15 |   |
| Proceeds from  the issuance of convertible debentures and related warrants, net of offering  costs    |       | —                                 |       | 15,105 |   |
| Cash (used in)  provided by financing activities                                                      |       | (972                                   | )          | 9,344 |   |
|                                                                                                  |       |                                   |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                  |       | (9                                     | )          | 268 |   |
| Cash and cash  equivalents at beginning of period                                                     |       | 1,556                                  |       | 1,586 |   |
| Cash and cash  equivalents at end of period                                                           |       | $                                      | 1,547      |   | $ | 1,854 |   |
|                                                                                                  |       |                                   |       |   |   |
| Supplemental disclosure of cash flow information:                                                     |       |                                   |       |   |   |
| Cash paid during  the period for:                                                                     |       |                                   |       |   |   |
| Interest                                                                                              |       | $                                      | 199        |   | $ | 141 |   |
| Income taxes                                                                                          |       | $                                      | —     |   | $ | — |   |
|                                                                                                  |       |                                   |       |   |   |
| Supplemental disclosure of noncash investing and  financingactivities:                                |       |                                   |       |   |   |
| Capital lease  obligation for property and equipment                                                  |       | $                                      | 628        |   | $ | 1,138 |   |
| Accruals for  property and equipment                                                                  |       | $                                      | —     |   | $ | 32 |   |
| 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 |   |

 

See notes tocondensed consolidated financial statements.

 

5

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**IsonicsCorporation and Subsidiaries**

** **

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

 

**NOTE 1 - BASIS OF PRESENTATION**

 

Theaccompanying condensed consolidated balance sheet as of April 30, 2007,has been derived from audited financial statements.  The accompanying unaudited interim condensedconsolidated financial statements of Isonics Corporation and Subsidiaries havebeen prepared on the same basis as the annual audited financial statements andin accordance with accounting principles generally accepted in the UnitedStates (“US GAAP”) for interim financial information and the rules andregulations of the Securities and Exchange Commission (“SEC”) for interimfinancial statements.  In the opinion ofmanagement, such unaudited information includes all adjustments (consistingonly of normal recurring accruals) necessary for a fair presentation of thisinterim information.  Operating resultsand cash flows for interim periods are not necessarily indicative of resultsthat can be expected for the entire year. The information included in this report should be read in conjunctionwith our audited consolidated financial statements and notes thereto includedin our Annual Report on Form 10-K for the year ended April 30, 2007.

 

Duringthe three months ended January 31, 2007, we reclassified the operations ofour life sciences business 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.

 

OnFebruary 13, 2007, we effected a one-for-four reverse stock split of ourcommon shares upon the filing of a Certificate of Amendment to our Articles ofIncorporation with the California Secretary of State.  All impactedamounts included in the consolidated financial statements and notes theretohave been restated for the stock split.

 

***GoingConcern***

** **

Asof January 31, 2008, we had a working capital deficit of $(12,734,000), astockholders’ deficit of  ($4,174,000)and have incurred significant losses from operations and used significant cashflow to fund operations during the most recent several fiscal years and throughJanuary 31, 2008.  Historically, wehave relied upon outside investor funds to maintain our operations and developour business. We anticipate we will continue to require funding from investorsfor working capital as well as business expansion during the remaining monthsof this fiscal year and next fiscal year, and we can provide no assurance thatadditional investor funds will be available on terms acceptable to us.

 

Inaddition, we have convertible debentures and related accrued interestoutstanding in the cumulative amount of $20,634,000 (which is comprised of the$18,000,000 face amount of the debentures plus related accrued interest) as of January 31,2008, which, are due in May 2009 unless an Event of Default was to occurand the holder then declared an Event of Default.  We currently may be non-compliant with one ormore non-financial covenants of the convertible debentures as more fullydiscussed in Note 9.  The convertibledebentures and related accrued interest are classified as short-termliabilities as of January 31, 2008 because if the holder of theconvertible debentures were to successfully declare an Event of Default, thebalance of the convertible debentures and related accrued interest would be dueimmediately.  Although an Event ofDefault has not been declared, we cannot provide assurance that the holder ofthe convertible debentures will not attempt to declare an Event of Default atsome point in the future.

 

Theseconditions (being our working capital deficit, stockholders’ deficit andpotential default under the convertible debentures) and other factors raisesubstantial doubt about our ability to continue operations as a going concern.

 

6

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**Duringthe year ended April 30, 2007, and subsequently, we restructured ourmanagement team with the goal of refocusing our product lines, seeking jointventure partners and improving operating performance at the business segmentsthrough a focus on strategic products, increased efficiencies in businessprocesses and improvements to the cost structure of each segment.  Despite these changes, our ability tocontinue as a going concern is dependent upon raising capital through debt orequity financing, obtaining an appropriate waiver from the holders of ourconvertible debentures and/or satisfactorily curing any non-complianceprovisions of the debenture agreements and ultimately by increasing revenue andachieving profitable operations. We can offer no assurance that we will besuccessful in our efforts to raise additional proceeds or achieve profitableoperations.  The accompanying condensedconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the settlement of liabilitiesin the normal course of business.**

** **

**NOTE 2- SIGNIFICANT ACCOUNTING POLICIES**

** **

***Net Income (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 iscomputed using the weighted average number of common shares and potentiallydilutive securities outstanding during the period.  Potentially dilutive securities consist ofcontingently issuable shares, the incremental common shares issuable upon conversionof convertible debt (using the “if converted” method) and shares issuable uponthe exercise of stock options and warrants (using the “treasury stock”method).  Potentially dilutive securitiesare excluded from the computation if their effect is anti-dilutive.

 

Asof January 31, 2008, (a) a total of 4,989,375 outstanding stockoptions and common stock warrants and (b) the unissued shares underlyingour outstanding convertible debentures (with a cumulative outstanding faceamount of $18,000,000 at January 31, 2008) were excluded from the dilutednet loss per share calculation, as their inclusion would be anti-dilutive.  Asof January 31, 2007, (a) a total of 5,088,733 outstanding stockoptions and common stock warrants and (b) the unissued shares underlyingour outstanding convertible debentures (with a cumulative outstanding faceamount of $16,250,000 at January 31, 2007) were excluded from the dilutednet loss per share calculation, as their inclusion would be anti-dilutive.

 

Duringthe nine months ended January 31, 2008, we issued the following shares ofcommon stock:

** **

| **Description**                      | ** ** | **Number of Common Stock Shares** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|
| Balance as of  April 30, 2007   |       | 12,639,400                        |       |
| Shares issued for services           |       | 18,750                            |       |
| Balance as of  January 31, 2008 |       | 12,658,150                        |       |

 

The aforementioned equity transactionsincreased common stock in the accompanying condensed consolidated balancesheets by $29,000 for the nine months ended January 31, 2008.

 

***Recently Issued Accounting Standards***

 

In July 2006, the Financial AccountingStandards Board (“FASB”) issued Interpretation No. 48, *Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109*(“FIN 48”). This 

 

 

7

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

interpretationclarifies the application of SFAS 109 by defining a criterion that anindividual tax position must meet for any part of the benefit of that positionto be recognized in an enterprise’s financial statements and also providesguidance on measurement, derecognition, classification, interest and penalties,accounting in interim periods and disclosure. FIN 48 requires the recognition of penalties and interest on anyunrecognized tax benefits. Our policy is to reflect penalties and interest aspart of income tax expense as they become applicable.  We adopted FIN 48 effective May 1,2007.  No unrecognized tax benefits wererecorded as of the date of adoption.  Dueto certain “change in ownership” rules (as defined by the IRS),utilization of our federal net operating losses may be subject to certainannual limitations.  We have notcompleted a formal assessment as to the extent of such potential limitations.We file income tax returns in the U.S. federal and various state jurisdictions.We are no longer subject to U.S. federal and state and local examinations bytax authorities for fiscal years prior to 2004.

 

In September 2006,the FASB issued SFAS No. 157, *FairValue Measurements* (“SFAS 157”). SFAS 157 defines fair value,establishes a framework and gives guidance regarding the methods used formeasuring fair value, and expands disclosures about fair value measurements.SFAS 157 is effective for our fiscal year commencing May 1, 2008 forthose items that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually), including interim periodswithin that fiscal year.  The effectivedate of SFAS 157 for items not included in the aforementioned category has beendeferred.  We are currently evaluatingthe impact of adopting SFAS 157 on our results of operations and financial condition.

 

In February 2007,the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities* (“SFAS159”).  SFAS 159 provides the option toreport certain financial assets and liabilities at fair value, with the intentto mitigate volatility in financial reporting that can occur when relatedassets and liabilities are recorded on different bases.   SFAS 159also amends SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, by providingthe option to record unrealized gains and losses on held-for-sale andheld-to-maturity securities currently.  SFAS 159 is effective for ourfiscal year commencing May 1, 2008, including interim periods within thatfiscal year.  The implementation of FAS159 is not expected to have a material impact on our results of operations orfinancial position.

 

In December 2007,the FASB issued SFAS 141 (revised 2007), *BusinessCombinations*(“SFAS 141(R)”), which establishes principles andrequirements for how an acquirer recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in an acquiree, including the recognition andmeasurement of goodwill acquired in a business combination.  SFAS 141(R) is effective for our fiscalyear commencing May 1, 2009. Earlier adoption is prohibited.  We are currently evaluating the impact of adoptingSFAS 141(R) on our results of operations and financial condition.

 

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

 

 

8

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

onour results of operations and financial condition.

 

**NOTE 3 — FINANCIAL STATEMENT COMPONENTS**

** **

***Inventories***

 

Inventories consist of the following (in thousands):

 

| ** **             | ** ** | **January 31, 2008** | ** ** | **April 30, 2007** | ** ** |
|------------------------|------------|---------------------------|------------|-------------------------|------------|
| Finished goods         |       | $                         | 323        |                    | $          | 497 |   |
| Work in process        |       | 47                        |       | 47                      |       |
| Materials and supplies |       | 421                       |       | 715                     |       |
| Total inventories      |       | $                         | 791        |                    | $          | 1,259 |   |

 

***Property and equipment***

 

Property andequipment consist of the following (in thousands):

** **

| ** **                                 | ** ** | **January 31, 2008** | ** ** | **April 30, 2007** | ** ** |
|--------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| Office furniture and  equipment            |       | $                         | 349        |                    | $          | 331 |   |
| Production equipment                       |       | 8,782                     |       | 7,613                   |       |
| Vehicles                                   |       | 191                       |       | 191                     |       |
| Construction in process                    |       | 278                       |       | 854                     |       |
| Leasehold improvements                     |       | 1,215                     |       | 1,215                   |       |
|                                       |       | 10,815                    |       | 10,204                  |       |
| Accumulated depreciation  and amortization |       | (5,614                    | )          | (4,538                  | )          |
| Total property and equipment, net          |       | $                         | 5,201      |                    | $          | 5,666 |   |

 

**NOTE 4 —SEGMENT INFORMATION**

 

We currently have threereportable segments: homeland security products, security services and siliconproducts and services.  Our homelandsecurity products segment includes both the limited operations regarding our Ion Mobility Spectroscopy (“IMS”)technology (see Note 10) and the remaining operations of our 90%-ownedsubsidiary (SenseIt Corp, see Note 6). Our security services segment provides security and investigativeservices and is substantially comprised of the operations of Protection PlusSecurity Corporation (“PPSC”).  Oursilicon products and services segment provides 300-millimeter (and smaller diameter) test wafersand reclamation services, wafer thinning and custom wafer products and servicesfor the silicon industry.  Oursegments are strategic business units, each of which consists of similarproducts or services.  They are managedseparately because each segment requires different technology and marketingstrategy and because each segment sells to different customers.  Reconciling items consist primarily ofcorporate assets or expenses that have not been allocated to a specificreportable segment and the assets of our former life sciences business which werecategorized as discontinued operations prior to their sale in June 2007.  Prior period amounts have been reclassifiedto conform to current period presentation.

 

        Information by segment is set forth below (in thousands):

 

 

9

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 
| ** **                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **January 31,**   | ** ** | **January 31,**  | ** ** |
| ** **                    | ** ** | **2008**               | ** ** | **2007**              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Segment revenues:             |       |                   |       |                  |       |   |   |   | ** ** |
| Homeland security products    |       | $                      | —     |                  | $          | — |   | $ | 195 |   | $ | — | ** ** |
| Security services             |       | 3,332                  |       | 3,625                 |       | 10,954 |   | 11,241 | ** ** |
| Silicon products and services |       | 1,810                  |       | 2,910                 |       | 5,917 |   | 9,335 | ** ** |
| Total                         |       | $                      | 5,142      |                  | $          | 6,535 |   | $ | 17,066 |   | $ | 20,576 | ** ** |

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **January 31,**   | ** ** | **January 31,**  | ** ** |
| ** **                        | ** ** | **2008**               | ** ** | **2007**              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Segment operating (loss)  income: |       |                   |       |                  |       |   |   |   |   |
| Homeland security products        |       | $                      | (111       | )                     | $          | (1,983 | ) | $ | (2,147 | ) | $ | (6,054 | ) |
| Security services                 |       | 94                     |       | (83                   | )          | 417 |   | (377 | ) |
| Silicon products and services     |       | (635                   | )          | 88                    |       | (1,594 | ) | 40 |   |
| Reconciling amounts (1)           |       | (654                   | )          | (1,218                | )          | (1,909 | ) | (3,842 | ) |
| Total                             |       | $                      | (1,306     | )                     | $          | (3,196 | ) | $ | (5,233 | ) | $ | (10,233 | ) |

 

| ** **                    | ** ** | **January 31,** | ** ** | **April 30,** | ** ** |
|-------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                    | ** ** | **2008**             | ** ** | **2007**           | ** ** |
| Total assets:                 |       |                 |       |               |       |
| Homeland security products    |       | $                    | 7          |               | $          | 1,943 |   |
| Security services             |       | 6,181                |       | 6,127              |       |
| Silicon products and services |       | 6,883                |       | 9,068              |       |
| Reconciling amounts (2)       |       | 1,222                |       | 1,822              |       |
| Total                         |       | $                    | 14,293     |               | $          | 18,960 |   |

----

**(1) Reconcilingamounts for the operating (loss) income information includes corporate expensesconsisting primarily of corporate salaries and benefits, professional andconsulting fees, investor relations costs, insurance and directors’compensation.**

** **

**(2) Reconcilingamounts for the total asset information includes corporate assets consistingprimarily of cash and cash equivalents invested centrally, unamortized debtissuance costs and miscellaneous prepaid items as well as, for April 30,2007, the assets of our former life sciences business which were categorized asdiscontinued operations prior to their sale in June 2007.**

** **

**NOTE 5 —DISCONTINUED OPERATIONS**

 

During the three months ended January 31, 2007,we elected to discontinue the operation of our life sciences business and toput the assets and business up for sale. We decided to sell this business as it no longer fit our long-termstrategy and because of deteriorating business conditions in the historicalrevenue producing products in the segment.  Accountingrules required us to treat the operations of the life sciences business asdiscontinued operations whereby the net financial impact of the operations ofthe business (including revenue) were combined into a single line item andprior periods were reclassified for this presentation. On June 19,2007, we completed the sale of this business for total cash proceeds of$850,000, out of which we paid a selling fee of $45,000 and repaid a loanunderlying production equipment in the amount of $40,000.  As a result of this transaction, werecognized a gain on disposal of discontinued operations, net of income taxesof $516,000 for the nine months ended January 31, 2008.

 

Thebusiness’ revenue, which is reported as discontinued operations in theaccompanying condensed 

 

 

10

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

consolidatedstatements of operations, for the nine months ended January 31, 2008 and2007, was $101,000 and $1,659,000, respectively.  The business’ gain on operations ofdiscontinued operations, net of income taxes, for the nine months ended January 31,2008 was $37,000, while the loss on operations of discontinued operations, netof income taxes, for the nine months ended January 31, 2007, was$(99,000).

 

Followingis a summary of the net assets sold on the closing date of June 19, 2007,and included in the condensed consolidated balance sheet as discontinuedoperations on April 30, 2007 (in thousands):

 

| ** **                   | ** ** | **June 19,** | ** ** | **April 30,** | ** ** |
|------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                   | ** ** | **2007**          | ** ** | **2007**           | ** ** |
| Cash                         |       | $                 | —     |               | $          | 110 |   |
| Accounts receivable          |       | —            |       | 25                 |       |
| Inventory                    |       | 8                 |       | 66                 |       |
| Property and equipment,  net |       | 223               |       | 228                |       |
| Other assets                 |       | 58                |       | 62                 |       |
| Total assets                 |       | $                 | 289        |               | $          | 491 |   |

 

| ** **                                | ** ** | **June 19,** | ** ** | **April 30,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                | ** ** | **2007**          | ** ** | **2007**           | ** ** |
| Accounts payable and  accrued liabilities |       | $                 | —     |               | $          | 33 |   |
| Note payable                              |       | —            |       | 39                 |       |
| Total liabilities                         |       | $                 | —     |               | $          | 72 |   |

 

**NOTE 6 — INVESTMENT IN SENSEIT CORP**

 

On October 26, 2006, we enteredinto 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. (currently known as Alcatel-Lucent), (the “Lucent Agreement”and “Lucent,” respectively).  The jointventure was established through our acquisition of an initial 90% ownershipinterest in SenseIt in exchange for assigning to SenseIt all of our interestunder the Lucent Agreement. The assignment was approved by Lucent.  OurChairman of the Board and Chief Executive Officer, Christopher Toffales ownsthe remaining 10% interest in SenseIt, although we entered into that agreementwith Mr. Toffales before he became affiliated with IsonicsCorporation.  We invested an approximatecumulative $7,000,000 in SenseIt and the related Lucent Agreement.

 

We did not make the $1,000,000 payment that was due toLucent on or before July 16, 2007. As a result of not making this payment, effective October 13, 2007,Lucent terminated the Lucent Agreement and our investment in SenseIt has becomevalueless.

 

**NOTE 7 —DISPOSITION OF INVESTMENT IN IUT**

 

InJanuary 2008 we sold our 30% interest in Institut fur UmwelttechnologienGmbH (“IUT”) for cash consideration of $527,000 (EUR 360,000).  As a result of the transaction, we recorded again on the disposition of the investment of $208,000 during the nine monthsended January 31, 2008.  Asignificant portion of the investment that was sold (representing $414,000 ofthe cash proceeds received) was subject to the security interest held by ourdebenture holder.  In February 2008,at the request of our debenture holder (see Note 9) we forwarded $200,000 ofthese proceeds as a payment of outstanding 

 

 

11

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

interest.   We have retained the remaining $214,000 ofproceeds, pending further discussions with the debenture holder, for use forworking capital purposes.

** **

We had a research and development agreementwith IUT, which we funded as follows during the nine months endedJanuary 31, 2008 and 2007, and in total:

** **

| **Nine months ended January 31** | ** ** | **Cumulative amount** |
|---------------------------------------|------------|-----------------------|
| **2008**                              | ** ** | **2007**              | ** ** | **Since June 2004** |
| $80,000                               |       | $915,000              |   | $2,988,000 |

 

All funded payments havebeen included as research and development in the accompanying condensedconsolidated statements of operations. We intend to provide no further funds pursuant to this agreement.

 

**NOTE 8 — EQUITY**

 

###### ***2005Stock Option Plan***

###### *** ***

In May 2007, ourBoard of Directors approved a resolution increasing the shares available forissuance to 2,875,000, an increase of 2,000,000 shares.  Any options granted from this increasedallotment were not exercisable until approved by our shareholders within theperiod of one year.  Due to a lack ofworking capital, we decided to postpone our annual meeting of shareholders fromour earlier contemplated timing of November 2007 to a later period, ifever.  As a result, in January 2008,our Board of Directors terminated the amendment related to the increase inavailable shares as it was not likely that shareholder approval would beobtained by May 2008.  Consequently,the 150,000 stock options that were issued from the increased allotment wereimmediately terminated.  There arecurrently 427,500 stock options outstanding under the 2005 Stock Option Plan.

 

***2007Restructuring Equity Plan***

 

In February 2007,our Board of Directors approved a resolution authorizing the establishment ofthe 2007 Restructuring Equity Plan (the “2007 Plan”), which authorized thegrant of up to 3,500,000 shares of common stock to our key employees, officersand consultants. Any options granted under the 2007 Plan were not exercisableuntil approved by our shareholders within the period of one year. Due to a lackof working capital, we decided to postpone our annual meeting of shareholdersfrom our earlier contemplated timing of November 2007 to a later period,if ever.  As a result, in January 2008,our Board of Directors terminated the 2007 Plan, as it was not likely thatshareholder approval would be obtained by February 2008.  Consequently, the previously issued 3,250,000stock options from the 2007 Plan were immediately terminated.

 

***2008 StockOption Plan***

 

In February 2008,our Board of Directors approved a resolution authorizing the establishment ofthe 2008 Equity Plan (the “2008 Plan”), which authorized the grant of up to25,000,000 shares of common stock to our key employees, officers andconsultants.  The plan does not requireshareholder approval and therefore none of the options granted under the 2008Plan will qualify as incentive stock options. The exercise price of the options granted under the 2008 Plan must be atleast 100% of the fair market value of our common stock on the date of grantand the exercise period for options granted under the 2008 Plan cannot exceedten years from the date of grant.  The2008 Plan provides that an option may be exercised through the payment of cash,in accordance with the 2008 Plan’s cashless exercise provision or in shares ofour common stock subject to the approval of the compensation committee of theboard of directors.  No options or sharesof 

 

 

12

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

stock have been issuedunder the 2008 Plan.

 

***EquityInstruments Issued for Services***

 

In May 2007, weentered into a consulting agreement with CEOcast, Inc. to provide investorrelations services.  The compensationterms of the agreement included the issuance of 18,750 shares of our commonstock, which were valued at $29,000.  Thecommon stock was amortized ratably over the service period of six months.  For the nine months ended January 31,2008, we recognized $29,000 of selling, general and administrative expenserelated to the shares of common stock issued under the agreement.

 

In June 2007, wegranted options to purchase 200,000 shares of our common stock to SoundBusiness Solutions, Inc., an entity whose principal provided managementservices to our silicon products and services segment.  This option was granted pursuant to our 2005Stock Option Plan.  The stock optionsgranted to Sound Business Solutions Inc. were subject to the following vestingschedule: 66,667 shares vested immediately upon grant; 66,667 shares vested on September 7,2007; and 66,666 shares would have vested on January 31, 2008.  The stock options granted to Sound BusinessSolutions Inc. are exercisable through June 18, 2011, at $1.45 pershare.  Options to purchase 50,000 shares(valued at $53,000 using the Black-Scholes pricing model) are currentlyexercisable while options to purchase 150,000 shares were subject to ourshareholders approving the aforementioned increase to the cumulative sharesissuable under the 2005 Stock Option Plan. A charge in the amount of $53,000 was recognized as a selling, generaland administrative expense during the nine months ended January 31,2008.  This charge related to the portionof the fair value of the currently exercisable option to purchase 50,000 sharesthat is associated with work performed in the reporting period.  Under SFAS 123(R), a stock option is notconsidered granted for accounting purposes until stockholder approval isobtained (unless such approval is deemed a formality, which was not the casefor the proposed increase to the 2005 Stock Option Plan).  As such, no expense was recognized in thecondensed consolidated financial statements related to the option to purchase150,000 shares of common stock.

 

As discussed above, in January 2008our Board of Directors terminated the amendment related to the increase inavailable shares under the 2005 Stock Option Plan and as a result the 150,000shares issued to Sound Business Solutions, Inc. that were subject toshareholder approval have been terminated. We plan to reissue these 150,000 stock options under the 2008 Plan atsome point in the future.  The reissuancewill be at the same terms as the prior non-approved issuance.

 

**Common Stock Warrants**

 

On February 24,2008, 1,992,375 common stock warrants that were issued in conjunction with the2005 Convertible Debentures expired unexercised.

 

**NOTE 9 — BORROWINGS**

 

***Capital Lease***

 

In May 2007, weentered into a capital lease to finance equipment to be used in production byour silicon products and services segment. The lease was in the principal amount of $628,000, bears a nominalinterest rate of 16%, had a term of 36 months and includes a bargain purchaseoption whereby we have the right subsequent to the expiration of the lease termto purchase the asset under lease for no more than 5% of the original equipmentcost.  Additionally, we issued the lessora common stock warrant (valued at $39,000 using the Black-Scholes pricingmodel) to purchase 40,000 shares of common stock at $1.50 per share.  The common stock warrant vested immediately,expires on May 28, 2010, and is being amortized to interest 

 

 

13

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

expense over the termof the lease.

 

***April 2007Debenture***

 

In April 2007, weissued to YA Global Investments, L.P. (“YA Global”), formerly known as CornellCapital Partners, LP, a convertible debenture with a face amount of $2,000,000(the “April 2007 Debenture”) along with detachable common stockwarrants.  For the nine months ended January 31,2008, using the effective interest method we amortized $115,000 of the discounton the April 2007 Debenture to interest expense.  As of January 31, 2008, the April 2007Debenture has an outstanding face amount of $2,000,000 and is recorded in ourcondensed consolidated balance sheets at a carrying amount (net of discount) of$1,779,000.  We also recorded accruedinterest on the April 2007 Debenture in the amount of $197,000 for thenine months ended January 31, 2008. As of January 31, 2008, cumulative accrued interest is $211,000;such accrued interest is included in accrued interest in the condensedconsolidated balance sheet and is due upon maturity of the April 2007Debenture in May 2009.

 

We currently may benon-compliant with one or more non-financial covenants of the April 2007Debenture and its holder may be able to, in its discretion, declare an Event ofDefault.  Remedies for an Event ofDefault include the option to accelerate payment of the full principal amountof the April 2007 Debenture, together with interest and other amounts due(a cumulative amount of $2,211,000 at January 31, 2008), to the date ofacceleration and the holder will have the right to request such payment in cashor in shares of our common stock.  Anydefault declared under the April 2007 Debenture would create across-default under the 2006 Convertible Debentures discussed below.  If the holder of the April 2007Debenture declares an Event of Default, it is possible that we will not be ableto cure the default or contest any efforts that the holder may take toforeclose against its security interest in substantially all of our assets.

 

***2006Convertible Debentures***

 

In May, June and November 2006,we issued to YA Global convertible debentures with a cumulative face amount of$16,000,000 (the “2006 Debentures”) along with detachable common stockwarrants.  For the nine months ended January 31,2008, using the effective interest method we amortized $2,377,000 of the discounton the 2006 Debentures to interest expense. As of January 31, 2008, the 2006 Debentures have a cumulativeoutstanding face amount of $16,000,000 and are recorded in our condensedconsolidated balance sheet at a carrying amount (net of discount) of $9,345,000.  We also recorded accrued interest on the 2006Debentures in the amount of $1,572,000 for the nine months ended January 31,2008.  As of January 31, 2008,cumulative accrued interest is $2,423,000; such accrued interest is included inaccrued interest in the condensed consolidated balance sheets and is due uponmaturity of the 2006 Debentures in May 2009.

 

We currently may benon-compliant with one or more non-financial covenants of the 2006 Debentures and their holder may be able to, in its discretion,declare an Event of Default. Additionally, if the holder of the April 2007 Debenture were todeclare an Event of Default under that debenture (which they may currently beable to do as discussed previously within this footnote), the holder of the2006 Debentures could declare an Event of Default under the 2006Debentures.  Remedies for an Event ofDefault include the option to accelerate payment of the full principal amountof the 2006 Debentures, together with interest and other amounts due (a cumulativeamount of $18,423,000 at January 31, 2008), to the date of accelerationand the holder will have the right to request such payment in cash or in sharesof our common stock.  If the holder ofthe 2006 Debentures declares an Event of Default, it is possible that we willnot be able to cure the default or contest any efforts that the holder may taketo foreclose against its security interest in substantially all of our assets.

 

 

14

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**IsonicsCorporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

 

Subsequent to January 31, 2008, theholder of the 2006 Debentures converted $30,000 of face amount of the 2006Debentures into 614,754 shares of our common stock.

 

**NOTE 10 — IMS-BASED PRODUCTSSUSPENSION**

 

InAugust 2007, we elected to suspend the development, manufacture and saleof our IMS-based products.  Thesuspension was due primarily to a lack of working capital but we have also haddifficulty competing in the market space. We continue to seek alternatives towards finding a means of monetizingour investment in this product line, including an outright sale of thetechnology.  It is unclear as to when (ifat all) we will resume activity on our IMS-based products and we can offer no assurancethat we will be able to monetize any portion of our IMS technologyinvestment.  Due to our election tosuspend operations regarding our IMS-based products, we reviewed for impairmentthe trace and bulk detection technology intangible asset associated with theIMS technology.  We determined that thecarrying amount of the intangible asset was not recoverable and its carryingamount exceeded its fair value, as determined using the expected present valueof future cash flows.  As such, for thenine months ended January 31, 2008, we recognized an impairment loss inthe amount of $145,000, such impairment loss representing the full carryingvalue of the intangible asset prior to impairment.  The impaired intangible asset relates to thehomeland security products reportable segment.

 

**NOTE 11 — LICENSE AGREEMENT**

 

InSeptember 2007, we assigned our existing exclusive rights regardingsilicon-28 patents (secured under the 1997 License Agreement with YaleUniversity) to an independent entity, such assignment receiving the consent andagreement of Yale University.  Silicon-28is a naturally occurring stable isotope of silicon which, in a nearisotopically-pure form, may have performance benefits as compared tomulti-isotopic materials currently prevalent in the silicon marketplace.  In periods presented, our proceeds from thesale of silicon-28 based products have not been material and we have notinvested material resources in the program.

 

Inexchange for the assignment of our license, we received a cash payment in theamount of $60,000 and a Non-Recourse Promissory Note (the “Promissory Note”) inthe principal amount of $440,000.  Theoutstanding principal of the Promissory Note will be paid thirty days after theearlier of: (a) the date on which the counterparty first receives revenuesin consideration for the sale or licensing (or sublicensing) of the assignedpatents or (b) March 5, 2009. The Promissory Note is without recourse to any assets of thecounterparty except for the security interest held in the assigned patents andlicense.  Due to the non-recourse natureof the Promissory Note and the uncertainty surrounding receiving payment underit, the Promissory Note has not been recognized as an asset in our condensedconsolidated financial statements.  Rather,any potential payments will be being treated as a gain contingency and will berecognized in the financial statements upon realization, if ever.

 

**NOTE 12 — OFFICER EMPLOYMENT AGREEMENTS**

 

In February 2008,we entered into employment agreements with Christopher Toffales (our ChiefExecutive Officer), John Sakys (our President and Chief Operating Officer) andGregory A. Meadows (our Chief Financial Officer).  Each of the employment agreements has aninitial term of one year and thereafter will be renewed automatically forsuccessive one year terms unless either party provides sixty days notice priorto the expiration of the current term that the employment agreement is beingterminated.  The employment agreementsprovide that Mr. Toffales will receive an annual base salary of $250,000, Mr. Sakyswill receive an annual base salary of $240,000 and Mr. Meadows willreceive an annual base salary of $180,000. Under

 

15

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**Isonics Corporation andSubsidiaries**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

the employment agreements, each of Mr. Toffales, Mr. Sakysand Mr. Meadows are eligible for a discretionary cash bonus and areentitled to participate in all our equity-based compensation plans.  Discretionary cash bonuses and equity-basedcompensation will be based on the achievement of performance goals, and if noneare formally established, paid or granted in the discretion of the CompensationCommittee of the Board of Directors. Additionally we have agreed to pay each executive a one-timediscretionary bonus.  As a result, duringthe three months ended January 31, 2008, we recorded a selling, generaland administrative expense of $180,000, which is reflected as accruedliabilities in the accompanying condensed consolidated balance sheet as of January 31,2008.  The one-time discretionary bonusesare, in part, in recognition of the operational improvements accomplished sinceFebruary 2007.  The employmentagreements provide that these one-time discretionary bonuses will not be paiduntil we have sufficient working capital that is not committed for operationsto allow us to pay all or a portion of the bonus.

 

Under the employment agreements, we have theright to terminate the executive with or without cause (as defined in theemployment agreements).  If the executiveis terminated for cause, the executive will have no rights to any unvestedbenefits or any other compensation or payments after the termination date.  The employment agreements provide that if theexecutive is terminated without cause the executive is entitled to a severancepayment equal to twelve months of his current salary and is payable attermination in a lump sum.

 

The employmentagreements also provide that the executive may terminate the employmentagreement upon the occurrence of certain events (as defined in the employmentagreements) by providing us at least three- business days notice. If theemployment agreements are terminated by the executive for any of these reasons,the executive is due a severance payment equal to twelve months of his currentannual salary payable in a lump sum payment within three months of thetermination of the Employment Agreement.

 

Upon a change ofcontrol (as defined in the employment agreements), each executive may terminateits employment agreement and will be entitled to receive a severance paymentequal to twelve months of his current annual salary, and payable in a lump sumwithin three months of the Executive’s termination.

 

The employmentagreements contain non-competition and non-solicitation provisions.  However, each executive may engage in certainbusiness activities so long as such activities do not interfere with theexecutive’s duties and responsibilities at Isonics, and such activities are notwith persons or entities that directly compete with us.

 

**NOTE 13 — COMMITMENTS AND CONTINGENCIES**

 

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

 

**NOTE 14 —STOCK EXCHANGE LISTING**

 

OnDecember 6, 2007, we received notification from the Nasdaq Stock Market (“Nasdaq”)that it had determined to delist our securities from Nasdaq.  Trading of our shares on the Nasdaq CapitalMarket was suspended effective with the open of business on December 10,2007.  In January 2008 our commonstock was first traded on the OTC Bulletin Board.  Our common stock currently trades under thesymbol ISON.OB.

 

**NOTE 15 — SUBSEQUENT EVENTS**

 

Certain events occurring subsequent to January 31, 2008, arediscussed within other notes to the condensed consolidatedfinancial statements.

 

 

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

 

*Certainstatements in this report, other than purely historical information, includingestimates, projections, statements relating to our business plans, objectivesand expected operating results, and the assumptions upon which those statementsare based, are “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements generallyare identified by the words “expect”, “believe,” “intend,” “estimate,” “anticipate,”“project,” “will,” “plan,” “will continue,” “will likely result” and similarexpressions.  Forward-looking statementsare based on current expectations and assumptions that are subject to risks anduncertainties which may cause actual results to differ materially from theforward-looking statements.  A detaileddiscussion of these and other risks and uncertainties that could cause actualresults and events to differ materially from such forward-looking statements isincluded in the section entitled “Risk Factors” (refer to Item 1A of Part II).  We undertake no obligation to update orrevise publicly any forward-looking statements, whether as a result of newinformation, future events or otherwise.*

 

***General Discussion***

 

We are focused onthe provision of homeland security services and 300-millimeter (and smallerdiameter) test wafers and reclamation services, wafer thinning and custom waferproducts and services for the silicon industry. During the past several years, our operations have been characterized byworking capital and cash flow shortfalls, and the need for a significant amountof third party investment to enable us to meet our financial obligations.  Although we have met our core obligations todate, we have frequently been required to allocate our available cash amongvarious obligations.  During the ninemonths ended January 31, 2008 and subsequently, we have refocused ouroperations and are in the process of reducing significantly our expenses, includingthe cash flow necessary to pay our corporate and divisional overhead.

 

During the year ended April 30, 2007, and the nine months ended January 31,2008, we generated sales from stable and radioactive isotopes, silicon waferreclaim services and test products, wafer thinning and custom wafer productsand services for the silicon industry, although sales from stable andradioactive isotopes were reported as discontinued operations in theaccompanying condensed consolidated statements of operations as describedbelow, and during the quarter ended October 31, 2007 we suspendedsubstantially all of our operations in our homeland security productssegment.  During the year ended April 30,2007 and the nine months ended January 31, 2008, we also generated revenuesfrom providing security services forleading businesses and institutions in healthcare, education, retail,manufacturing, banking and the art world. For information about segment revenue, refer to Note 4 (SegmentInformation) to the condensed consolidated financial statements located in Item1: Financial Statements.

 

In June 2007, we sold our life sciencesbusiness (which supplied isotopes for life sciences and health-careapplications) as it no longer fit our long-term strategy for building a sustainableand profitable homeland security and silicon company and because ofdeteriorating business conditions in the historical revenue producing productsin this business.  Accounting rules requiredus to treat the operations of the life sciences business as discontinuedoperations whereby the net financial impact of the operations of the business(including revenue) is combined into a single line item and prior periods arereclassified for this presentation. Revenue for the life sciences business, reported in the single line itemof gain on operations of discontinued operations, net of income taxes, was$101,000 and $1,659,000 for the nine months ended January 31, 2008 and2007, respectively.

 

In August 2007, we elected to suspendthe development, manufacture and sale of our IMS-based products.  The suspension was due primarily to a lack ofworking capital but we have also had difficulty competing in the marketspace.  We will continue to seekalternatives towards finding a means of monetizing our investment in thisproduct line, including an outright sale of the technology.  It is unclear as to when (if at all) we willresume activity on our IMS-based 

 

 

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products and we can offer no assurance thatwe will be able to monetize any portion of our IMS technology investment.

 

In September 2007, we assigned ourexisting exclusive rights regarding silicon-28 patents (secured under the 1997License Agreement with Yale University) to an independent entity, such assignmentreceiving the consent and agreement of Yale University.  Silicon-28 is a naturally occurring stableisotope of silicon which, in a near isotopically-pure form, may haveperformance benefits as compared to multi-isotopic materials currently prevalentin the silicon marketplace.  In periodspresented, proceeds from the sale of silicon-28 based products have beenimmaterial and we have not invested material resources in the program.

 

In October 2007, Lucent terminated our development project regardinga next-generation infrared imaging and night vision surveillance technology dueto our inability to make a required development payment which was due in July 2007.  As a result, our investment in SenseIt hasbecome valueless.

 

On December 6, 2007,we received notification from the Nasdaq stating that it had determined todelist our securities from Nasdaq. Trading in our shares on the Nasdaq Capital Market was suspendedeffective with the open of business on December 10, 2007.  InJanuary 2008 our common stock was first traded on the OTC BulletinBoard.  Our common stock currently tradesunder the symbol ISON.OB.  Althoughdelisting from Nasdaq makes it more difficult for us to use our equity forfinancing activities, the delisting had no significant direct financial impact.

 

InJanuary 2008 we sold our 30% interest in IUT for cash consideration of$527,000 (EUR 360,000).  As a result ofthe transaction, we recorded a gain on the disposition of the investment of$208,000 during the nine months ended January 31, 2008.  A significant portion of the investment thatwas sold (representing $414,000 of the cash proceeds received) was subject tothe security interest held by our debenture holder.  In February 2008, at the request of ourdebenture holder we forwarded $200,000 of these proceeds as a payment ofoutstanding interest.   We have retainedthe remaining $214,000 of proceeds, pending further discussions with thedebenture holder, for use for working capital purposes.

 

Consistent with management focus during the nine months ended January 31,2008 and prior, we continue to evaluate our portfolio of operating businessesand technology with the goal of operating our business more efficiently andmonetizing non-core assets. Additionally, we have considered and will continue to consider businessexpansion through merger, acquisition, joint venture or other means, althoughwe can offer no assurance as to our ultimate success in increasing the scope ofour business through such means.

 

Liquidityand Capital Resources

 

We have had workingcapital shortages in the past and, although we raised capital totaling morethan $45,800,000 (net of expenses and $4,100,000 of payments related to our 8%Debentures) since May 1, 2004, we have generated significant losses, whichhave impacted working capital.  As of January 31,2008, our condensed consolidated balance sheet reflects a working capitaldeficit of $(12,734,000).  Thissignificant working capital deficit is due mainly to the classification of ouroutstanding convertible debentures, net of discount and related accruedinterest, as a current liability in the accompanying condensed consolidatedbalance sheet (see second paragraph below, Note 1 Basis of Presentation andNote 9 Borrowings for additional discussion). In addition, as a result of our continued operating losses and projecteddeclining working capital balances during the year ending April 30, 2008,the auditors report included with our financial statements for the year ended April 30,2007, included an explanatory paragraph indicating substantial doubt about ourability to continue as a going concern.

 

Based on the amountof capital we have remaining and our expected negative cash flow fromoperations and investing activities, we anticipate that we will not be able to positivelyimpact our working capital unless we are able to substantially increase ourrevenues or reduce our expenses thereby generating positive cash flow fromoperations and (ultimately) operating income. 

 

 

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We believe wehave sufficient working capital to finance our anticipated operations andprojected negative cash flow only into (but not through) our year ending April 30,2009, unless we are able to obtain additional financing or achieve positive operatingcash flow.  Because of the potentialdilution associated with the outstanding debentures and the holder’s securityinterest in substantially all of our assets, we believe that it is unlikelythat we will be able to obtain additional financing unless we are able to reachan accommodation with our existing debenture holder.

 

We currently may benon-compliant with one or more non-financial covenants of the 2006 Debenturesand the April 2007 Debenture (together referred to as the “13% Debentures”)and their holder may be able to, in its discretion, declare an Event ofDefault.  Additionally, an Event ofDefault under any one of the 13% Debentures would allow the holder to declarean Event of Default under all of the 13% Debentures.  Remedies for an Event of Default include theoption to accelerate payment of the full principal amount of the 13%Debentures, together with interest and other amounts due (a cumulative amountof $20,634,000 at January 31, 2008), to the date of acceleration and theholder will have the right to request such payment in cash or in shares of ourcommon stock.  If the holder of the 13%Debentures declares an Event of Default, it is possible that we will not beable to cure the default or contest any efforts that the holder may take toforeclose against its security interest in substantially all of our assets.

 

See additionaldiscussion of liquidity and capitalresources in the Liquidity and Capital Resources section included further belowin this Item 2: Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

 

HomelandSecurity

 

Isonics HomelandSecurity and Defense Corporation (“HSDC”) has historically focused the majorityof our efforts in the homeland security sector. These efforts have included entry into the security services marketthrough our acquisition of PPSC in May 2005, acquisition and (prior to August 2007)development of our IMS detection technology and our entry into a project todevelop innovative infrared imaging and night vision surveillance technologythrough an agreement with Lucent which has been terminated.

 

**SecurityServices** - Since the effective date of our acquisition ofPPSC in May 2005, PPSC has delivered significant revenue to our condensedconsolidated financial statements and has provided gross margins ofapproximately 22.8% of revenues for the nine months ended January 31,2008.

 

During the fourthquarter of the year ended April 30, 2007, and the nine months ended January 31,2008, we implemented cost cutting initiatives that have positively impacted theresults of PPSC’s operations. Additionally we initiated plans to improve operating margins at PPSC byfocusing on customers that are willing to pay for premium security services, amarket in which we believe that PPSC is able to differentiate itself from itspeers.  As a result of the impact of ourongoing cost cutting initiatives, the segment generated operating income of$417,000 for the nine months ended January 31, 2008, as compared to anoperating loss of $(377,000) for the nine months ended January 31,2007.  For the nine months ended January 31,2008 and 2007, the operating loss includes non-cash amortization ofacquisition-related customer intangibles and stock-based compensation expensein the aggregate amount of $129,000 and $183,000, respectively.

 

While we believethat these cost cutting initiatives and focused sales and marketing effortswill enable PPSC to report positive operating income for the year ending April 30,2008 and into our next fiscal year, the industry is cost competitive andcustomers switch security service providers on short notice and, therefore, wecan offer no assurance that this will actually occur.

 

**Detection Technology —**Duringour year ended April 30, 2007 and through August 2007, we offered ourIMS-based products (the panel-mounted IMS and 

 

 

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EnviroSecureTM), although we didnot engage in any significant marketing efforts for these products subsequentto late in calendar year 2006.  Althoughwe continued to offer EnviroSecureTM, a system that can monitor andidentify chemical weapons and toxic substances in the air in a variety ofvenues including airports, mass transit facilities, sports venues and publicand private sector office buildings, we did not make any sales of this productor engage in any significant marketing activities.  Our sales of the panel-mounted IMS productwere extremely limited and historically resulted in deferred revenue, althoughwe recognized the deferred revenue during the three months ended October 31,2008, as a result of reaching an accord with our sole customer for thatproduct.  We do not intend to recommenceany marketing efforts until (if ever) we are adequately capitalized, have acommercial product and have identified a market.

 

In August 2007, we elected to suspendthe development, manufacture and sale of our IMS-based products.  The suspension was due primarily to a lack ofworking capital but we have also had difficulty competing in the market space.  We will continue to seek alternatives towardsfinding a means of monetizing our investment in this product line, including anoutright sale of the technology.  It isunclear as to when (if at all) we will resume activity on our IMS-basedproducts and we can offer no assurance that we will be able to monetize anyportion of our investment in this technology.

 

**Infrared Imaging Technology —**In December, 2005, we approved a development plan that resulted in usbecoming obligated under the Lucent Agreement we entered into with Lucent in September 2005which, in October 2006, we assigned to our 90% owned subsidiary,SenseIt.  Under the Lucent Agreement, wewere attempting to develop a next-generation infrared imaging and night visionsurveillance technology based on Lucent’s micro electro-mechanical systems (“MEMS”)technology under development at its nanotechnology fabrication facility.

 

We did not make the $1,000,000 payment that was due to Lucent on orbefore July 16, 2007.  As a resultof not making this payment, effective October 13, 2007, Lucent terminatedthe Lucent Agreement.  Therefore, ourinvestment in SenseIt and the related Lucent Agreement (in the cumulativeamount of approximately $7,000,000) has become valueless.

 

SiliconProducts and Services

 

Our silicon operations,based in Vancouver, Washington, showed continued operational and financialimprovement during the years ended April 30, 2007 and 2006, although weexperienced a softening of demand for our products and services during the ninemonths ended January 31, 2008.  Thesegment generated operating income for the year ended April 30, 2007, inthe amount of $326,000 (which includes a non-cash charge of $122,000 forstock-based compensation expense) as compared to an operating loss for the yearended April 30, 2006, in the amount of $(5,151,000).  The positive operating income resultedprimarily from our ongoing effort to reduce our reliance on low margin smalldiameter products and diversify into higher margin 300-millimeter products andservices, wafer thinning and custom wafer products.

 

The large-diameterwafer segment has become one of the fastest growing segments of the siliconwafer market and the revenues and gross margins associated with the servicesare greater than those associated with the small diameter market.   As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 43% of segmentrevenue for the nine months ended January 31, 2008 ($2,528,000 of revenue)and 54% of segment revenue for the year ended April 30, 2007 ($7,049,000of revenue), as compared to approximately 36% of segment revenue for the yearended April 30, 2006 ($2,053,000 of revenue).  At the same time, there has also been a focuson operational efficiency and effectiveness, which has resulted in increasedproductivity and processing yields. Further, we continue to gain new customers (both large and smallerdiameter) and are also in the process of attempting to qualify our products atothers.

 

 

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While we reported significant revenue and operating income growth in oursilicon operations for the year ended April 30, 2007, many of our topsilicon customers experienced weakened business results in recentquarters.  In addition, some customersreported inventory buildup in reclaim and/or test products.  As a result of these two factors, during thenine months ended January 31, 2008, we have seen a slowdown in orders ofreclaim and test materials, which has had a negative impact on our operations.

 

The slowdown significantly impacted our revenues, results of operationsand cash flows for the nine months ended January 31, 2008, in which wegenerated an operating loss of $(1,594,000) as compared to operating income of$40,000 for the nine months ended January 31, 2007.  The impact of the slowdown in orders on ourbusiness is magnified when the results are compared to the three months ended April 30,2007, whereby we generated operating income of $286,000.

 

In order to minimize the effect of the slowdown, we implemented many costcutting measures and are continuing to do so. It is unclear as to when our customers’ demand will rebound but we arehopeful that we will begin to see a recovery during the three months ending April 30,2008.  While we continue to aggressivelypursue and add new customers to mitigate the underlying uncertainties with ourexisting customer base, we expect to reflect continued decreased revenue forthe three months ending April 30, 2008 (as compared to the three monthsended April 30, 2007) and the reporting of an operating loss for thesegment.  Wecontinue to monitor the situation closely and while we believe that we will seeimproving financial results in this operating segment (over the long-term), wecannot offer any assurance that we will be able to regain or sustain operatingprofitability in future periods.

 

***Results of Operations***

 

Our results of operations to date have notbeen profitable and, in fact, have resulted in significant losses.  Ourconsolidated revenues in the future will depend primarily on our success inselling products and services in the homeland security and siliconmarkets.  Our profitability will be dependent uponour ability to manage our costs and to increase our revenues in all of ourbusiness segments.  However, we can offerno assurance that we will be able to increase our revenues or ourprofitability.

 

The following table sets forth, for theperiods indicated, condensed consolidated statements of operations dataexpressed as a percentage of revenues. The table and the discussion below should be read in conjunction withthe condensed consolidated financial statements and the notes thereto appearingelsewhere in this report.  In January 2007,we elected to discontinue the operation of our life sciences business and toput the assets and business up for sale (which was sold in June 2007).  As a result, we reclassified the operationsof our life sciences business as discontinued operations.  Prior year information has been reclassifiedto conform to the current year presentation.

 
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** | **Nine months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                 | ** ** | **January 31,**   | ** ** | **January 31,**  | ** ** |
| ** **                                                                                 | ** ** | **2008**               | ** ** | **2007**              | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                 | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                                   |       | 100.0                  | %          | 100.0                 | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                                                                           |       | 90.7                   |       | 78.6                  |       | 89.3 |   | 78.6 |   |
| Gross margin                                                                               |       | 9.3                    |       | 21.4                  |       | 10.7 |   | 21.4 |   |
|                                                                                       |       |                   |       |                  |       |   |   |   |   |
| Operating expenses:                                                                        |       |                   |       |                  |       |   |   |   |   |
| Selling, general  and administrative                                                       |       | 33.9                   |       | 48.2                  |       | 33.4 |   | 53.5 |   |
| Impairment loss  on intangible assets                                                      |       | —                 |       | —                |       | .8 |   | — |   |
| Research and  development                                                                  |       | 0.8                    |       | 22.1                  |       | 7.2 |   | 17.6 |   |
| Total operating  expenses                                                                  |       | 34.7                   |       | 70.3                  |       | 41.4 |   | 71.1 |   |
| Operating loss                                                                             |       | (25.4                  | )          | (48.9                 | )          | (30.7 | ) | (49.7 | ) |
|                                                                                       |       |                   |       |                  |       |   |   |   |   |
| Other income (expense), net                                                                |       | (19.1                  | )          | 15.3                  |       | (20.3 | ) | 9.9 |   |
| Loss from  continuing operations before income taxes and elimination of minority  interest |       | (44.5                  | )          | (33.6                 | )          | (51.0 | ) | (39.8 | ) |
| Income tax expense                                                                         |       | —                 |       | —                |       | — |   | — |   |
| Minority interest in operations of consolidated  subsidiary                                |       |                   |       | (1.5                  | )          | 0.7 |   | (0.3 | ) |
| Loss from continuing operations                                                            |       |                   |       | (35.1                 | )          | (50.3 | ) | (40.1 | ) |
| Gain (loss) on discontinued operations, net of  income taxes                               |       | —                 |       | (1.3                  | )          | 3.2 |   | (0.5 | ) |
| NET LOSS                                                                                   |       | (44.5                  | )%         | (36.4                 | )%         | (47.1 | )% | (40.6 | )% |

 

 

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***Revenues***

 

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

** **
| ** **                    | ** ** | **Three Months Ended** | ** ** | **Nine months Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **January 31,**   | ** ** | **January 31,**  | ** ** |
| ** **                    | ** ** | **2008**               | ** ** | **2007**              | ** ** | **2008** | ** ** | **2007** | ** ** |
| Homeland security products    |       | —                 |       | —                |       | 195,000 |   | — |   |
| Security services             |       | 3,332,000              |       | 3,625,000             |       | 10,954,000 |   | 11,241,000 |   |
| Silicon products and services |       | 1,810,000              |       | 2,910,000             |       | 5,917,000 |   | 9,335,000 |   |
| Total                         |       | $                      | 5,142,000  |                  | $          | 6,535,000 |   | $ | 17,066,000 |   | $ | 20,576,000 |   |
|                               |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

The decrease inrevenue from the security services segment for the three and nine months ended January 31,2008, is due to the effect of the loss of several security services contractsduring the current period partially offset by the addition of new customers aswell as by increases in work performed at certain existing customers.  We continue to market our servicesaggressively by seeking premium accounts that prefer higher quality ofservice.  Whilewe are hopeful that in the long-term we will be able to grow revenue in thissegment by securing additional new security contracts in our PPSC subsidiaryand retaining existing customers under contract currently with PPSC, we cannotprovide any assurance that we will be able to do so and we may in theshort-term fail to retain certain of our customers.

 

While we reported significant revenue and operating income growth in oursilicon operations for the year ended April 30, 2007, many of our topsilicon customers experienced weakened business results in recentquarters.  In addition, some customersreported inventory buildup in reclaim and/or test products.  As a result of these two factors, during thenine months ended January 31, 2008, we saw a slowdown in orders of reclaimand test materials, which has had a negative impact on our operations.

 

The slowdown in the silicon products and services segment significantlyimpacted our revenues, which decreased by approximately 37% to $5,917,000 forthe nine months ended January 31, 2008, as compared to $9,335,000 for thenine months ended January 31, 2007. The impact of the slowdown in orders on our business is magnified whenthe results are compared to the three months ended April 30, 2007, wherebywe recorded revenues of $3,686,000.

 

In order to minimize the effect of the slowdown, we have implemented manycost cutting measures and are continuing to do so.  It is unclear as to when our customers’demand will rebound but we are hopeful that we will begin to see a recoveryduring the three

 

 

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months ending April 30, 2008. While we continue to aggressivelypursue and add new customers to mitigate the underlying uncertainties with ourexisting customer base, we expect to reflect continued decreased revenue forthe three months ending April 30, 2008 (as compared to the three monthsended April 30, 2007) and the reporting of an operating loss for thesegment.  We continue to monitor thesituation closely and while we believe that we will see improving financialresults in this operating segment (over the long-term), we cannot offer anyassurance that we will be able to regain or sustain operating profitability infuture periods.

 

Our homelandsecurity products segment recorded $195,000 of revenue for the nine monthsended January 31, 2008, as compared to no revenue during the same periodof our prior fiscal year.  The revenuerelates to the installation of fifteen commercial units of our panel-mountedIMS-based product in the AirChx systemmanufactured by DualDraw LLC, eight of which were installed during the ninemonths ended January 31, 2008, and seven of which were installed duringthe year ended April 30, 2007.  Theproceeds from the sale of the unitshad been classified as deferred revenue pending completion of certaintasks.  Based upon an agreement signedwith DualDraw LLC during the three months ended October 31, 2007, ourobligations to DualDraw LLC were materially fulfilled and we recognized therevenue related to the sale of the IMS-based products.

 

In August 2007, we elected to suspendthe development, manufacture and sale of our IMS-based products and, as aresult, we do not anticipate any additional revenues from the sale of homelandsecurity products during our fiscal year ending April 30, 2008, orsubsequently.  The suspension was due primarilyto a lack of working capital but we have also had difficulty competing in themarket space.  We will continue to seekalternatives towards finding a means of monetizing our investment in thisproduct line, including the development of a strategic partnership or anoutright sale of the technology.  It isunclear as to when (if at all) we will resume activity on our IMS-basedproducts and we can offer no assurance that we will be able to monetize anyportion of our IMS technology investment.

 

Although we have diversified our sources of revenue, we continue to haveconcentrations of revenue with certain customers.  For the nine months ended January 31,2008, two security services customers accounted for 20% and 13% of revenues,respectively, and one silicon products and services customer accounted for 12%of revenues as compared to the nine months ended January 31, 2007, inwhich two security services customers accounted for 15% and 11% of revenues,respectively, and one silicon products and services customer accounted for 22%of revenues.  Significant reductions insales to any of these large customers have had, and may in the future have, anadverse effect 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 products or services ordered from us.

 

***Gross Margin***

 

Our gross margindecreased for the three and nine months ended January 31, 2008, ascompared to the same periods of our prior fiscal year, both on a dollar amountand as a percentage of revenues, as reflected in the following table:

** **
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | 479,000    |                                   | $          | 1,396,000 |   | $ | 1,833,000 |   | $ | 4,412,000 |   |
| Percent of revenues |       | 9.3                                     | %          | 21.4                                   | %          | 10.7 | % | 21.4 | % |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

The decrease ingross margin on a percentage basis is due primarily to the downturn in oursilicon products and services segment whereby the downturn has lead to asignificant decrease in revenue, which has forced us to allocate our fixedfacility costs over a lower base, correspondingly decreasing gross margins on apercentage basis.  To a lesser extent,the decrease on a percentage basis is also due to the provision of lower pricesin order to obtain new or keep existing 

 

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business.  The decrease in gross margin on a dollarbasis is due mainly to the decrease in revenue for our silicon products andservices segment.

 

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

 

On a percentage ofrevenues basis, in general we anticipate that the gross margin percentage inour security services segment (within 1-2 percentage points) will remainrelatively stable.  As a result of thecurrent downturn which has and may lead to more increased competition and lowerprices, our silicon products and services segment will most likely experience adecrease in gross margins as a percentage of revenues during the year ending April 30,2008, as compared to the year ended April 30, 2007.  Due to fixed facility costs included in costof revenues in the silicon products and services segment, the gross marginpercentage is particularly sensitive to volume and revenue changes.

 

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

 

Our selling,general and administrative expenses decreased both as a dollar amount and as apercentage of revenues for the three and nine months ended January 31,2008, as compared to the same respective periods of our prior fiscal year, asreflected in the following table:

** **
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | 1,743,000  |                                   | $          | 3,150,000 |   | $ | 5,697,000 |   | $ | 11,015,000 |   |
| Percent of revenues |       | 33.9                                    | %          | 48.2                                   | %          | 33.4 | % | 53.5 | % |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

The $5,318,000 decrease in selling, general and administrative expensesfor the nine months ended January 31, 2008, compared to the same period inthe prior year is attributable to a combination of factors, including:

 

·                  approximately$1,250,000 due to a decrease in staffing and expenditures at the corporateoffice;

·                  approximately$900,000 due to a decrease in staffing and expenditures in the securityservices segment;

·                  approximately$1,770,000 due to a decrease in staffing and operations in the homelandsecurity products segment;

·                  approximately$430,000 due to a decrease in staffing and operations in the silicon productsand services segment;

·                  inclusion inthe nine months ended January 31, 2007, of a noncash charge in the amountof $357,000 related to the amendment to the number of shares issuable andexercise price of certain warrants with ratchet provisions;

·                  an approximate$610,000 decrease in noncash stock-based compensation expense.

 

We continue to be actively focused onreducing selling, general and administrative expenses and are hopeful that wewill be able to further reduce these expenses for the three months ending April 30,2008 as compared to the three months ended January 31, 2008.  However, there can be no assurance thatanticipated selling, general and administrative expenses will result inincreased revenues.

 

***Impairment Loss on Intangible Assets***

 

Our impairment loss on intangible assetsincreased on both a dollar and a percentage of revenues basis for the ninemonths ended January 31, 2008, as 

 

 

24

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compared to the same period of our priorfiscal year, as reflected in the following table:

** **
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | —     |                                   | —     |   | $ | 145,000 |   | — |   |
| Percent of revenues |       | 0                                       | %          | 0                                      | %          | 0.8 | % | 0 | % |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |

 

The impairment loss relates to a write off ofthe unamortized balance of the trace and bulk detection technology intangibleasset.  Due to suspension of development,manufacture and sale of our IMS-based products, we determined that the traceand bulk detection technology intangible asset was fully impaired.

 

***Research and Development Expenses***

 

Our research and development expensesdecreased on both a dollar and a percentage of revenues basis for the three andnine months ended January 31, 2008, as compared to the same period of ourprior fiscal year, as reflected in the following table:

** **
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | 42,000     |                                   | $          | 1,442,000 |   | $ | 1,224,000 |   | $ | 3,630,000 |   |
| Percent of revenues |       | 0.8                                     | %          | 22.1                                   | %          | 7.2 | % | 17.6 | % |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

The majority of research and developmentexpenses for the nine months ended January 31, 2008 and 2007 relateprimarily to (1) the development of next-generation infrared imaging andnight vision surveillance technology through our Lucent relationship and (2) ourIMS technology.  However, due to thetermination of the Lucent Agreement and the suspension of development of ourIMS technology, we did not incur material research and development expenseduring the three months ended January 31, 2008 for these projects and wedo not expect to incur material additional research and development expenserelated to these projects throughout the remainder of fiscal year 2008 andbeyond.

 

Historically a significant amount of theresearch and development on the IMS technology was performed by IUT.  We funded $80,000 and $915,000 under ouragreement with IUT for the nine months ended January 31, 2008 and 2007,respectively.  As a result of thesuspension of the development, manufacture and sale of our IMS-based productsas described above, we intend to provide no further funds pursuant to thisagreement.

 

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

 

***Operating(Loss) Income***

 

For the nine monthsended January 31, 2008 and 2007, our operating segments incurred operating(loss) income as follows:

 
| ** **                    | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|-------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Homeland security products    |       | $                                       | (111,000   | )                                      | $          | (1,983,000 | ) | $ | (2,147,000 | ) | $ | (6,054,000 | ) |
| Security services             |       | 94,000                                  |       | (83,000                                | )          | 417,000 |   | (377,000 | ) |
| Silicon products and services |       | (635,000                                | )          | 88,000                                 |       | (1,594,000 | ) | 40,000 |   |
| Reconciling amounts (1)       |       | (654,000                                | )          | (1,218,000                             | )          | (1,909,000 | ) | (3,842,000 | ) |
| Total                         |       | $                                       | (1,306,000 | )                                      | $          | (3,196,000 | ) | $ | (5,233,000 | ) | $ | (10,233,000 | ) |

 

 

25

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(1) Reconciling amounts for theoperating (loss) income information includes corporate expenses consistingprimarily of corporate salaries and benefits, professional and consulting fees,investor relations costs, insurance and directors’ compensation. In January 2007, we elected to discontinue the operation of our lifesciences business and put the assets and business up for sale (which was soldin June 2007).  As a result, wereclassified the operations of our life sciences business as discontinuedoperations.  Prior year information hasbeen reclassified to conform to the current year presentation.

 

Our homeland security products segmentgenerated significant operating losses during the nine months ended January 31,2008 as our effort to develop and commercialize our IMS technology and oureffort to develop next generation infrared imaging and night vision surveillancetechnology has not been successful.  As a result ofthe suspension of the development, manufacture and sale of our IMS-basedproducts and the cancellation of the Lucent Agreement (both described above),the operating loss was significantly decreased for the three months ended January 31,2008 and we expect that future operating losses will continue to decrease as weseek alternatives towards finding a means ofmonetizing our investment in this product line, including the development of astrategic partnership or an outright sale of the technology.  It is unclear as to when (if at all) we willresume activity on our IMS-based products and we can offer no assurance that wewill be able to monetize any portion of our IMS technology investment.

 

For the nine monthsended January 31, 2008 and 2007, our security services segment deliveredrevenue of $10,954,000 and $11,241,000, respectively.  The operating income for the nine monthsended January 31, 2008, is due primarily to the benefits received from thecost cutting initiatives we implemented at PPSC during the nine months ended January 31,2008 (see below for additional discussion). The operating loss for the nine months ended January 31, 2007 isinclusive of a write-off of a single customer’s accounts receivable balance inthe amount of $114,000 (of which the majority was subsequently collected duringthe nine months ended January 31, 2008). Although we continue to pursue selected domestic government contracts,we have taken steps to reduce our spending on sales and marketing in this area.

 

During the fourth quarter of the fiscal year ended April 30, 2007,and the nine months ended January 31, 2008, we implemented significantcost cutting initiatives that have positively impacted the results of PPSC’soperations.  Additionally we initiatedplans to improve operating margins at PPSC by focusing on customers that arewilling to pay for premium security services, a market in which we believe thatPPSC is able to differentiate itself from its peers.  While we believe that these cost cuttinginitiatives and refocused sales and marketing efforts will enable PPSC toreport positive operating income for the year ending April 30, 2008 andinto our next fiscal year, the industry is cost competitive and customersswitch security service providers on short notice and, therefore, we can offerno assurance that this will actually occur.

 

Our siliconoperations, based in Vancouver, Washington, showed continued operational andfinancial improvement during the years ended April 30, 2007 and 2006,although we experienced a softening of demand for our products and servicesduring the nine months ended January 31, 2008. The segment generatedoperating income for the year ended April 30, 2007, in the amount of$326,000 (which includes a non-cash charge of $122,000 for stock-basedcompensation expense) as compared to an operating loss for the year ended April 30,2006, in the amount of $(5,151,000).  Thepositive operating income resulted primarily from our ongoing effort to reduceour reliance on low margin small diameter products and diversify into highermargin 300-millimeter products and services, wafer thinning and custom waferproducts.

 

The large-diameterwafer segment has become one of the fastest growing segments of the siliconwafer market and the revenues and gross margins associated with the servicesare greater than those associated with the small diameter market.   As a result of our strategic realignment,revenue from 300-millimeter services comprised approximately 43% of segment 

 

 

26

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revenue for thenine months ended January 31, 2008 ($2,528,000 of revenue) and 54% ofsegment revenue for the year ended April 30, 2007 ($7,049,000 of revenue),as compared to approximately 36% of segment revenue for the year ended April 30,2006 ($2,053,000 of revenue).  At thesame time, there has also been a focus on operational efficiency andeffectiveness, which has resulted in increased productivity and processingyields.  Further, we continue to gain newcustomers (both large and small diameter) and are also in the process ofattempting to qualify our products for other customers.

 

While we reported significant revenue and operating income growth in oursilicon operations for the year ended April 30, 2007, many of our topsilicon customers experienced weakened business results in recentquarters.  In addition, some customersreported inventory buildup in reclaim and/or test products.  As a result of these two factors, during thenine months ended January 31, 2008, we have seen a slowdown in orders ofreclaim and test materials, which has had a negative impact on our operations.

 

The slowdown significantly impacted our revenues, results of operationsand cash flows for the nine months ended January 31, 2008 in which wegenerated an operating loss of $(1,594,000) as compared to operating income of$40,000 for the nine months ended January 31, 2007.  The impact of the slowdown in orders on ourbusiness is magnified when the results are compared to the three months ended April 30,2007 whereby we generated operating income of $286,000.

 

In order to minimize the effect of the slowdown, we implemented many costcutting measures and are continuing to do so. It is unclear as to when our customers’ demand will rebound but we arehopeful that we will begin to see a recovery during the three months ending April 30,2008.  While we continue to aggressivelypursue and add new customers to mitigate the underlying uncertainties with ourexisting customer base, we expect to reflect continued decreased revenue forthe three months ending April 30, 2008 (as compared to the three monthsended April 30, 2007) and the reporting of an operating loss for thesegment.  Wecontinue to monitor the situation closely and while we believe that we will seeimproving financial results in this operating segment (over the long-term), wecannot offer any assurance that we will be able to regain or sustain operatingprofitability in future periods.

 

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

 

Other income (expense), net decreased both asa dollar amount and as a percentage of revenues for the three and nine monthsended January 31, 2008 as compared to the same respective periods of ourprior fiscal year, as reflected in the following table:

** **
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | (983,000   | )                                      | $          | 1,003,000 |   | $ | (3,466,000 | ) | $ | 2,037,000 |   |
| Percent of revenues |       | (19.1                                   | )%         | 15.3                                   | %          | (20.3 | )% | 9.9 | % |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

For the ninemonths ended January 31, 2008, other income (expense), net includesinterest expense of $(4,496,000), the amortization of debt issuance costs of$(138,000) and equity in the net loss of an investee of $(69,000) partiallyoffset by a gain on sale of an equity method investment of $208,000, interestand other income of $100,000 and a gain on derivative instruments of$915,000.  Included in interest expensefor the nine months ended January 31, 2008 are non-cash charges of$4,261,000 related to the amortization of the discount and the accrual ofinterest on our outstanding convertible debentures.

 

For the ninemonths ended January 31, 2007, other income (expense), net includes therecording of a gain on derivative instruments in the amount of $4,223,000related to the change in fair value of the two derivative liabilities which werecorded in our condensed consolidated balance sheet, equity in the net incomeof an investee of $73,000, interest and other income of $54,000 and therecording of a gain on extinguishment of debt in the amount of $227,000, whichresulted from the retirement of $3,880,000 in 

 

 

27

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principal amountof 8% Debentures partially offset by $(2,347,000) of interest expense and$(197,000) of amortization of debt issuance costs.

 

We expect that ourother expenses will be volatile based on the future timing of repayment , ifever, of the remaining 13% Debentures (see the Liquidity and Capital Resourcesdiscussion below) and the fluctuations in fair value of and classification ofthe instruments underlying our derivative liabilities.

 

***Income Taxes***

 

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

 

***Minority Interest in Operationsof Consolidated Subsidiary***

 

Minority interest in operations ofconsolidated subsidiary for the three and nine months ended January 31,2008 and 2007 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | —     |                                   | $          | (97,000 | ) | $ | 111,000 |   | $ | (55,000 | ) |
| Percent of revenues |       | —                                  | %          | (1.5                                   | )%         | 0.7 | % | (0.3 | )% |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

The amount of minority interest in operationsof consolidated subsidiary recorded for the nine months ended January 31,2008, relates to our purchase of a 90% interest in SenseIt in October 2006and the subsequent operation of the business. Due to the cancellation of the Lucent Agreement, we do not expectminority interest in operations of SenseIt to be material in future periods.

 

***Gain on Discontinued Operations,net of Income Taxes***

 

Gain on discontinued operations, net ofincome taxes increased on both a dollar and a percentage of revenues basis forthe three and nine months ended January 31, 2008, as compared to the sameperiod of our prior fiscal year as reflected in the following table:

 
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | —     |                                   | $          | (87,000 | ) | $ | 37,000 |   | $ | (99,000 | ) |
| Percent of revenues |       | —                                  | %          | (1.3                                   | )%         | 3.2 | % | (0.5 | )% |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

In January 2007, we decided todiscontinue the operation of our life sciences business and to put the assetsand business up for sale (which was sold in June 2007).  We decided to sell this business as it nolonger fit our long-term strategy and because of deteriorating businessconditions in the historical revenue producing products in the segment.  Accounting rules required us to treatthe operations of the life sciences business as discontinued operations wherebythe net financial impact of the operations of the business is combined into asingle line item and prior periods are reclassified for this presentation.  The gain, net of income taxes, resulting fromoperations of the life sciences business was $37,000 for the nine months ended January 31,2008 as compared to a loss, net of income taxes, in the amount of $(99,000) forthe nine months ended January 31, 2007. The gain on sale of the life 

 

 

28

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sciences business was recorded in the ninemonths ended January 31, 2008, in the amount of $516,000.  Revenue for the life sciences business,reported in the single line item of gain on operations of discontinuedoperations, net of income taxes, was $101,000 and $1,659,000 for the ninemonths ended January 31, 2008 and 2007, respectively.

 

***Net Loss***

 

Net loss for the three and nine months ended January 31,2008 and 2007 is reflected in the following table:

 
| ** **          | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **          | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Dollar amount       |       | $                                       | (2,289,000 | )                                      | $          | (2,377,000 | ) | $ | (8,035,000 | ) | $ | (8,350,000 | ) |
| Percent of revenues |       | (44.5                                   | )%         | (36.4                                  | )%         | (47.1 | )% | (40.6 | )% |
|                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

We anticipate that consolidated losses willcontinue until (if ever) revenues from our current operations substantiallyincrease or we increase the scope of our operations through merger, acquisitionor other means.  Further, the revenueincreases must increase faster than any increases in operating and research anddevelopment expenses.  Additionally, weexpect that our consolidated net loss will continue as we continue to workthrough the downturn in the silicon market. As noted above, we suspended development and marketing of our IMS-basedproducts and we suspended operations at our SenseIt subsidiary due to thecancellation of the Lucent Agreement. Therefore, we can offer no assurance that we will be able to proceedwith either of these projects or that the development and commercialization ofthese technologies will ever occur.

 

We anticipate thatour operations during the remainder of fiscal year 2008 will result in a netloss since we are not likely to increase our revenues from our existingproducts or generate additional sales from the new products we may develop in asufficient amount (if at all) to offset our operating expenses.

 

**Liquidity and Capital Resources**

 

During the past several years, we have attimes had significant liquidity and working capital shortages, although we havebeen able to pay our core obligations as they have become due.  Included in the following table are condensedconsolidated balance sheet items as of January 31, 2008 and April 30,2007 and condensed consolidated cash flow items for the nine months ended January 31,2008 and 2007:

** **

| ** **                                                   | ** ** | **As of**                | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|
| **(in  thousands)**                                          | ** ** | **January 31,2008** | ** ** | **Change** | ** ** | **April 30,2007** | ** ** |
| Cash and cash equivalents                                    | ** ** | $                        | 1,547      |   | $ | (9 | ) | $ | 1,556 | ** ** |
|                                                         | ** ** |                     |       |   |   |   | ** ** |
| Working capital (deficit)                                    | ** ** | $                        | (12,734    | ) | (16,044 | ) | 3,310 | ** ** |
|                                                         | ** ** |                     |       |   |   |   | ** ** |
| Current portion of convertible  debentures, net of discount  | ** ** | $                        | 11,124     |   | 11,124 |   | — | ** ** |
| Convertible debentures, net of  discount and current portion | ** ** | —                   |       | (8,634 | ) | 8,634 | ** ** |
| Total convertible debentures, net of discount                | ** ** | $                        | 11,124     |   | $ | 2,490 |   | $ | 8,634 | ** ** |
|                                                         | ** ** |                     |       |   |   |   | ** ** |
| Total convertible debentures, face value outstanding         | ** ** | $                        | 18,000     |   | $ | — |   | $ | 18,000 | ** ** |

 

29

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| ** **                                           | ** ** | **Nine months ended**    | ** ** |
|------------------------------------------------------|------------|--------------------------|------------|
| ** **                                           | ** ** | **January 31,2008** | ** ** | **Change** | ** ** | **January  31,2007** | ** ** |
|                                                 |       |                     |       |   |   |   |   |
| Net cash used in operating activities                |       | $                        | (323       | ) | $ | 7,038 |   | $ | (7,361 | ) |
| Net cash provided by (used in) investing activities  |       | 1,286                    |       | 3,001 |   | (1,715 | ) |
| Net cash provided by (used in) financing activities  |       | (972                     | )          | (10,316 | ) | 9,344 |   |
| Net increase (decrease) in cash and cash equivalents |       | $                        | (9         | ) | $ | (277 | ) | $ | 268 |   |

 

Working Capital

 

We had a working capital deficit of$(12,734,000) as of January 31, 2008, as compared to working capital of$3,310,000 as of April 30, 2007. This $16,044,000 decrease in workingcapital for the nine months ended January 31, 2008, is due to acombination of factors, of which the significant factors are set out below:

 

        Factors which increasedworking capital

·                  net cash of$805,000 received from the sale of our life sciences business in June 2007;

·                  cash of$527,000 received from the sale of our 30% interest in IUT (although wesubsequently remitted $200,000 of these proceeds as a payment of outstandinginterest);

·                  net cash of$60,000 received from the assignment of our silicon-28 license (see Note 11 tothe accompanying condensed consolidated financial statements).

 

Factorswhich decreased working capital

·                  Classification of $13,758,000 of our outstanding convertible debentures,net of discount and related accrued interest as a current liability in theaccompanying condensed consolidated balance sheet (see Note 1 Basis ofPresentation for additional discussion).

·                  $3,019,000 ofcash consumed directly in operating activities (calculated as $323,000 of cashused in operating activities, increased by $2,696,000 of the cash impact of netchanges in other current assets or liabilities included therein);

·                  $106,000 relatedto purchases of fixed assets;

·                  $187,000representing the current portion of capital lease entered into during the ninemonths ended January 31, 2008;

·                  $44,000 inreclassification of capital leases from long-term to current;

·                  $322,000  in payments on notes payable entered into forinsurance during the nine months ended January 31, 2008, in excess of therelated unamortized prepaid insurance balance.

 

Based on the amountof capital we have remaining and our expected negative cash flow fromoperations and investing activities, we anticipate that we will not be able topositively impact our working capital unless we are able to substantiallyincrease our revenues or reduce our expenses thereby generating positive cashflow from operations and (ultimately) operating income.  We believe we have sufficientworking capital to finance our anticipated operations and projected negativecash flow only into (but not through) our year ending April 30, 2009,unless we are able to obtain additional financing or achieve positive operatingcash flow.  Because of the potentialdilution associated with the outstanding debentures and the holder’s securityinterest in substantially all of our assets, we believe that it is unlikelythat we will be able to obtain additional financing unless we are able to reachan accommodation with our existing debenture holder.

 

 

30

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Convertible Debentures

 

Selected information regarding the 13%Debentures follows (dollars in thousands):

 
| ** **                                        | ** ** | **2006 Debentures**                    | ** ** | **April 2007Debenture** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|------------------------------|------------|-----------|------------|
| Debenture agreement date(s)                       |       | May, June and  November 2006 |       | April 2007              |       | —    |       |
|                                              |       |                                   |       |                         |       |      |       |
| Due date - principal and interest                 |       | May 2009                          |       | May 2009                |       | —    |       |
|                                              |       |                                   |       |                         |       |      |       |
| Interest rate                                     |       | 13                                     | %          | 13                           | %          | —    |       |
|                                              |       |                                   |       |                         |       |      |       |
| Outstanding balances as of January 31, 2008: |       |                                   |       |                         |       |      |       |
| Face value                                        |       | $                                      | 16,000     |                         | $          | 2,000     |       | $ | 18,000 |   |
| Accrued interest                                  |       | 2,423                                  |       | 211                          |       | 2,634     |       |
| Total liability                                   |       | $                                      | 18,423     |                         | $          | 2,211     |       | $ | 20,634 |   |

 

We may benon-compliant with one or more non-financial covenants of the 13% Debenturesand their holder may be able to, in its discretion, declare an Event ofDefault.  Additionally, an Event ofDefault under any one of the 13% Debentures would allow the holder to declarean Event of Default under all of the 13% Debentures.  Remedies for an Event of Default include theoption to accelerate payment of the full principal amount of the 13%Debentures, together with interest and other amounts due (a cumulative amountof $20,634,000 at January 31, 2008), to the date of acceleration and theholder will have the right to request such payment in cash or in shares of ourcommon stock.  If the holder of the 13%Debentures declares an Event of Default, it is possible that we will not beable to cure the default or contest any efforts that the holder may take to forecloseagainst its security interest in substantially all of our assets.

 

Cash Flows

 

As of January 31, 2008, we had $1,547,000 of cash and cashequivalents, a decrease of $9,000 as compared to $1,556,000 at April 30,2007. Our principal source of funding for the nine months ended January 31,2008 was from the existing working capital as of April 30, 2007, alongwith the $805,000 (net of selling costs of $45,000) received for the sale ofour life sciences business in June 2007 and $527,000 received from thesale of our 30% interest in IUT.   Ourprincipal source of funding for the nine months ended January 31, 2007 wasfrom the issuance of the 2006 Debentures (with a face amount of $16,000,000)for which we received net proceeds of $15,105,000.

 

Cash used in operating activities of$(323,000) and $(7,361,000) for the nine months ended January 31, 2008 and2007, respectively, was primarily the result of a net loss of $(8,035,000)(which included noncash expenses and gains in the net amount of approximately a$3,100,000 expense) and of $(8,350,000) (which included noncash expenses andgains in the net amount of approximately a $700,000 expense), respectively.

 

Investing activities provided cash of$1,286,000 and used cash of $(1,715,000) for the nine months ended January 31,2008 and 2007, respectively. Cash provided by investing activities for the ninemonths ended January 31, 2008, consisted of $805,000 (net of selling costsof $45,000) received for the sale of our life sciences business in June 2007,$527,000 from the sale of our 30% interest in IUT and $60,000 from theassignment of our silicon-28 licenses partially offset by $106,000 expended onadditions of property and equipment. Cash used in investing activities for the nine months ended January 31,2007, consisted of $1,615,000 expended on additions of property and equipmentand $100,000 expended on a 9% equity investment in a business (which investmentwas subsequently written off in its entirety).

 

 

31

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Financing activities used cash of $(972,000)and provided cash of $9,344,000 for the nine months ended January 31, 2008and 2007, respectively. Cash used in financing activities for the nine monthsended January 31, 2008, consisted of payments of principal on capitalleases and notes payable in the amounts of $359,000 and $613,000,respectively.  Cash provided by financingactivities for the nine months ended January 31, 2007, resulted primarilyfrom the issuance of the 2006 Debentures, which yielded net proceeds of$15,105,000 offset primarily by principal payments on borrowings of $5,718,000.

 

Additional LiquidityConsiderations

 

As of January 31, 2008, we had 1,992,377common stock warrants exercisable at $5.00 related to the 8% Debenturetransaction.  In May 2006, 1,139,251of these common stock warrants were modified to reduce their anti-dilutionprovisions to a price-protection provision only. If we were to enter into afinancing agreement in the future with an effective price less then $5.00 (orif the holder of our 13% Debentures was to convert a portion of any outstandingdebenture at a conversion rate less than $5.00), the remaining 853,126 commonstock warrants that have a full anti-dilution provision, would ratchet into agreater number of common stock warrants at a lower exercise price.   These warrants expired on February 24,2008.  There was no direct financialimpact related to the expiration of these warrants.

 

As of January 31, 2008, we had nocommitments outstanding for capital expenditures.  Further, due to the cancellation of theLucent Agreement, we have no furthercommitments under that contract.

 

On December 6, 2007,we received notification from the Nasdaq stating that it had determined todelist our securities from Nasdaq. Trading in our shares on the Nasdaq Capital Market was suspendedeffective with the open of business on December 10, 2007.  InJanuary 2008 our common stock was first traded on the OTC BulletinBoard.  Our common stock currently tradesunder the symbol ISON.OB.  Because of thereduced liquidity associated with OTC Bulletin Board securities, we may not beable to use our equity for fundraising as easily as in the past.  Although delisting from Nasdaq makes it moredifficult for us to use our equity for financing activities, the delisting hadno significant direct financial impact.

 

The assumptions underlying the abovestatements include, among other things, that there will be no material adversedevelopments in the business or market in general. There can be no assuranceshowever that those assumed events will occur. If our plans are not achieved,there may be further negative effects on the results of operations and cashflows, which could have a material adverse effect on our financial position.

 

***Off-Balance Sheet Arrangements***

 

We have no material changes to the disclosureon this matter made in our Annual Report on Form 10-K for the year ended April 30,2007.

 

***Critical Accounting Estimates***

 

We consider an accounting estimate to becritical if 1) the accounting estimate requires us to make assumptions aboutmatters that were highly uncertain at the time the accounting estimate wasmade, and 2) changes in the estimate that are reasonably likely to occur fromperiod to period, or use of different estimates that we reasonably could haveused in the current period, would have a material impact on our financialcondition or results of operations.

 

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

 

 

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*Goodwill and Intangible Assets*

 

Goodwill is recorded onour books for acquisitions where the purchase price is in excess of thecumulative fair values of the identified tangible and intangible assets.  The assignment of fair value to theidentified tangible and intangible assets requires significant judgment and mayrequire 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.

 

In accordance with SFAS No. 142*Goodwill and Other Intangible Assets*,goodwill is not amortized, but instead is tested for impairment on an annualbasis or more frequently if the presence of certain circumstances indicatesthat impairment may have occurred.  Theimpairment review process, which is subjective and requires significantjudgment at many points during the analysis, compares the fair value of thereporting unit in which goodwill resides to its carrying value.  If the carrying value of a reporting unitexceeds its fair value, then the amount of the impairment loss must bemeasured. The impairment loss is calculated by comparing the implied fair valueof reporting unit goodwill to its carrying amount. In calculating the impliedfair value of reporting unit goodwill, the fair value of the reporting unit isallocated to all of the other assets and liabilities of that unit based ontheir fair values. The excess of the fair value of a reporting unit over theamount assigned to its other assets and liabilities is the implied fair valueof goodwill. An impairment loss would be recognized when the carrying amount ofgoodwill exceeds its implied fair value. We have goodwill in the amount of$3,631,000 on our condensed consolidated balance sheet as of January 31,2008, related to the acquisition of PPSC in May 2005.  During the three months ended January 31,2008, we performed our annual impairment review on the aforementioned goodwilland concluded that the goodwill is not impaired.

 

For intangible assetsother than goodwill, SFAS No. 144 *Accountingfor the Impairment or Disposal of Long-Lived Assets* (“SFAS 144”) 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 toassess whether the future cash flows related to these assets will be greaterthan their carrying value at the time of the test. Accordingly, while our cashflow assumptions are consistent with the plans and estimates we are using tomanage the underlying businesses, there is significant judgment in determining thecash flows attributable to our other intangible assets over their respectiveestimated useful lives.  We haveremaining other net intangible assets in the amount of $42,000 on our condensedconsolidated balance sheet as of January 31, 2008, comprised of  the customer base acquired in our acquisitionof PPSC in May 2005.  We arerequired to periodically evaluate our other intangible assets balances forimpairments.  Dueto our election to suspend operations regarding our IMS-based products, duringthe three months ended October 31, 2007, we reviewed for impairment thetrace and bulk detection technology intangible asset associated with the IMStechnology.  We determined that thecarrying amount of the intangible asset was not recoverable and its carrying amountexceeded its fair value, as determined using the expected present value offuture cash flows.  As such, during thethree months ended October 31, 2007, we recognized an impairment loss inthe amount of $145,000, such impairment loss representing the full carryingvalue of the intangible asset prior to impairment.  If we were to incur additional impairments to ourother intangible assets, it could have an adverse impact on our futureearnings, if any.

 

*Valuationof Equity Transactions*

 

We value transactionsassociated with common or preferred stock that is convertible into common stockbased on the market value of the underlying common stock on the date of thesigning of the agreement (or, sometimes, at the date of conversion). We valuetransactions associated with common stock warrants at the appropriatemeasurement date utilizing at a minimum, the Black-Scholes pricing model, withassumptions as to volatility, risk-free interest rate and estimated life of thewarrants based on historical information related to the life of the underlyingwarrant. If the assumptions used, as they relate to volatility, risk-freeinterest rate and estimated life 

 

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of the warrants, werematerially different, the overall valuation of these transactions could changesignificantly.

 

*Valuationof Convertible Debenture Transactions*

 

We enter intotransactions that include debentures that are convertible into common stock atrates that may be fixed or variable and also include detachable common stockwarrants.  We allocate the proceeds fromthe debenture transactions based on the estimated fair values of the debenturesand the warrants.  If the assumptionsused, as they relate to volatility, risk-free interest rate and estimated lifeof the warrants (including any anti-dilution adjustment provisions) and thefair value of the debentures (included the specific conversion features) werematerially different, the overall allocation of proceeds for these transactionscould change significantly.  Further, attimes we have classified certain embedded conversion features or warrantsissued in convertible debenture transactions as derivative liabilities inaccordance with US GAAP.  The estimatesof fair value of these derivative liabilities involve complex assumptions inthe initial recording of the liabilities and in the mark-to-market required foreach reporting period.  If theassumptions used to determine the fair value of these liabilities were materiallydifferent, the valuation of the liabilities could change significantly.

 

*Stock-BasedCompensation Expense*

 

We account forstock-based compensation in accordance with SFAS 123(R).  Under the fair value recognition provisionsof SFAS 123(R), stock-based compensation cost is estimated at the grant datebased on the fair value of the award and is recognized as expense ratably overthe requisite service period of the award. Determining the appropriate fair value model and calculating the fairvalue of stock-based awards, which includes estimates of stock pricevolatility, forfeiture rates and expected lives, requires judgment that couldmaterially impact our operating results.

 

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

 

We are exposed to market risk related tochanges in interest rates, equity security market values, foreign currencyrates and the market price of our common stock.

 

Interest Rates

 

Our investment portfolio consists of cash andcash equivalents (in the amount of $1,547,000 as of January 31, 2008), allof which is exposed to interest rate fluctuations.  The primary objective of our investments isto earn a market rate of return while preserving principal and maximizingliquidity.  The interest earned on theseinvestments (with a blended yield of approximately 0.5% at January 31,2008) may vary based on fluctuations in the prevailing interest rate.

 

Equity Securities

 

We do not hold any investments in marketableequity securities.  However, we holdinterests in various wholly- and partially-owned subsidiaries.  These securities are non-marketable.  Our investment in these subsidiaries may beimpacted by the underlying economic conditions of the entity, including theability to raise additional capital and the likelihood of our being able torealize our investments through liquidity events such as initial publicofferings, mergers or private sales. These investments involve a great deal of market risk, and there can beno assurance that a specific company will grow or become successful.  Consequently, we could lose all or part ofour investment.

 

 

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DerivativeInstruments

 

We do not purchase derivative instruments onthe open market.  However, in accordancewith current US GAAP, we have classified certain warrants as derivativeinstruments (a $106,000 current liability at January 31, 2008).  Classification as derivative liabilities wasrequired because there is a possibility that the instruments could be requiredto be settled on a net cash basis.  Weare required to mark these instruments to market as of the end of eachreporting period and to recognize the change in fair value in our condensedconsolidated statements of operations. Our stock price has been historically volatile and the fair values ofthese instruments are 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 31,2008, we recorded a gain on derivative instruments in the aggregate amount of$915,000 such amount representing the change in fair value between April 30,2007, and January 31, 2008.  SeeNote 9 to the consolidated financial statements located in Item 8. “FinancialStatements and Supplementary Data” of our Form 10-K for the year ended April 30,2007, for a more detailed discussion of the derivative instruments.

 

**Item4T: Controls and Procedures**

 

Our management, with the participation of ourprincipal executive officer and our principal financial officer have evaluatedthe effectiveness of our disclosure controls and procedures as required byExchange Act Rule 13a-15(b) as of January 31, 2008 (the end ofthe period covered by this report). Based on that evaluation, our principalexecutive officer and our principal financial officer have concluded that thesedisclosure controls and procedures are effective as of such date.

 

Disclosure controls and procedures arecontrols and other procedures that are designed to ensure that informationrequired to be disclosed in our reports filed or submitted under the SecuritiesExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s (“SEC”) rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in our reports filed under theExchange Act is accumulated and communicated to our management, including ourprincipal executive officer and our principal financial officer, asappropriate, to allow timely decisions regarding required disclosure.

 

Our management isalso responsible for establishing and maintaining adequate internal controlover financial reporting (“ICFR”) as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act. ICFR is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.  ICFR includes those policiesand procedures that

 

(i)                                     pertain to themaintenance of records which in reasonable detail accurately and fairly reflectthe transactions and dispositions of our assets;

 

(ii)                                  providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that our receipts and expenditures are being made inaccordance with our established policies and procedures; and

 

(iii)                               providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of our assets that could have a material effecton the financial statements.

 

Because of costand personnel limitations, we are not likely to be able to completeimplementation of the system required under §404 of the Sarbanes Oxley Act of2002 to evaluate the effectiveness of our ICFR. Therefore, at year end when required to evaluate our ICFR, a materialweakness will likely to be found to exist.  The Public Company Accounting Oversight Board’sAuditing Standard No. 2 (“*An Audit of InternalControl Over Financial Reporting Performed in*

 

 

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*Conjunction with An Audit of Financial Statements*” (“AS 2”)),defines a material weakness as a significant deficiency, or combination ofsignificant deficiencies, that results in more than a remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected.  Our first periodin which we must make an assessment of our ICFR is the year ending April 30,2008, and such assessment will appear in our Form 10-K for the year thenended.  We have not yet completed ourassessment of our ICFR and, consequently, have not identified any materialweakness.

 

If we determine the existence of a material weakness in our ICFR or areunable to evaluate properly our ICFR, we will also be obligated to report amaterial weakness in disclosure controls and procedures as well.  Notwithstanding our inability to implementthe required framework for an evaluation of the effectiveness of our ICFR(which is planned to be based on the framework set forth in *Internal Control-Integrated Framework* issued by the Committeeof Sponsoring Organizations of the Treadway Commission), our managementbelieves that ICFR and disclosure controls and procedures are adequate toensure the accuracy and completeness of our financial statements anddisclosure, and will remain so.

 

There were nochanges in our internal control over financial reporting during the threemonths ended January 31, 2008, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**Part II: Other Information**

** **

**Item 1:  Legal Proceedings**

 

None.

 

**Item 1A:Risk Factors**

 

There are no material changes to the riskfactors set forth in Part II, “Item 1A: Risk Factors” in our QuarterlyReport on Form 10-Q for the period ended October 31, 2007 except asset forth below.  With the followingmodification, we incorporate those risk factors by reference into this report.

 

We are unlikely tobe able to complete the implementation of a framework by which we will be ableto adequately assess our internal controls over financial reporting and ourinternal controls over financial reporting may be found to be deficient.

 

Section 404of the Sarbanes-Oxley Act of 2002 requires management to assess our internalcontrols over financial reporting pursuant to a defined framework and requiresauditors to express an opinion with respect to that assessment.  Current regulations of the Securities andExchange Commission require us to include management’s assessment andattestation in our Annual Report on Form 10-K commencing with the annualreport for our fiscal year ending April 30, 2008.  We have incurred significant costs inimplementing and responding to these requirements but (as described in Item 4T,above), because of personnel and working capital shortages, we are unlikely tobe able to complete the implementation of the framework pursuant to which weplanned to complete our evaluation.  Evenwhen the framework is implemented, we will have to incur additional expenses tocomplete the implementation and to maintain those controls.  Because of our working capital and liquidityshortages, it is unlikely that we will be able to complete the implementationof all aspects of Section 404 regarding internal controls over financialreporting.  Although management does notbelieve that there are any material weaknesses in our internal controls overfinancial reporting or our disclosure controls and procedures, our failure tobe able to assess those controls pursuant to an approved framework will likelyresult in identification of a ‘material weakness’ which (if identified) will bedisclosed in our forthcoming Form 10-K. If we identify any material weakness, investors may lose confidence inthe reliability of our financial statements, and, if we fail to complete ourinternal control assessment as anticipated, actions by the SEC or otherregulatory and listing agencies, if any, are unknown.  These could include limiting our ability toregister and sell 

 

 

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securities,impacting the trading market for our common stock or other enforcement actions.

 

In addition to the amended risk factor set forth above and the otherrisk factors set forth in our Quarterly Report on Form 10-Q for the periodended October 31, 2007, there are other risk factors and other importantinformation set forth in this report on Form 10-Q.  You should carefully consider these factorsand other disclosure, which set forth information that could materially affectour business, financial condition or future results.  Additional risks and uncertainties notcurrently known to us or that we currently deem to be immaterial also maymaterially adversely affect our business, financial condition or futureresults.

 

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

 

**Shares Issued Under a Consulting Agreement**

 

In February 2008, we issued an aggregateof 150,000 shares of restricted common stock to a consultant in considerationof an agreement to perform services for us. Based on representations made to us by the consultant and certainpersons to whom the consultant assigned an interest in the shares, wedetermined that they were all accredited investors and the offering had notbeen accomplished as a result of any form of public advertising or generalsolicitation.  In issuing the shares, werelied on the exemptions from registration provided by §§4(2) and 4(6) ofthe federal Securities Act of 1933 and Rule 506 of Regulation D.  No commissions or other remuneration was paidin connection with this issuance.

 

**Conversion of 2006 Debentures toCommon Stock**

 

On February 29, 2008 the holder of the2006 Debentures converted $30,000 of face amount of the 2006 Debentures into614,754 shares of common stock.

 

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

 

(a)           Thetransactions were completed effective as stated above.

 

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

 

(c)           Theshares were not sold for cash.

 

(d)           Werelied on the exemption from registration provided by Sections 4(2) and 4(6) underthe Securities Act of 1933 for these transactions.  We did not engage in any public advertisingor general solicitation in connection with these transactions.  The holder of the 2006 Debentures had access toall of our reports filed with the Securities and Exchange Commission, our pressreleases and other financial, business and corporate information.  Based on our investigation, we believe thatthe holder of the 2006 Debentures obtained all information regarding Isonicsthat they requested, received answers to all questions they posed and otherwiseunderstood the risks of accepting our securities for investment purposes.

 

(e)           The common stock issued in these transactions is not convertible orexchangeable.  No warrants were issued inthese transactions.

 

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

 

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

 

None

 

 

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**Item 5:Other Information**

 

On February 28, 2008 our Board ofDirectors unanimously appointed George O’Leary to fill one of the vacancies onour Board of Directors.  Mr. O’Learyaccepted his appointment on March 10, 2008.  Upon acceptance of his appointment, Mr. O’Learywas not appointed to any committees of the Board of Directors, however in thefuture we may determine it is appropriate to do so.

 

There is no arrangement or understandingpursuant to which Mr. O’Leary was appointed to our Board ofDirectors.  Mr. O’Leary has not hada direct or indirect interest in any of our previous transactions.  Upon his appointment, Mr. O’Leary wasnot granted stock options or any other form of remuneration, however in thefuture we may determine it is appropriate to grant Mr. O’Leary stockoptions in consideration for his service as a Board member.

 

Mr. O’Leary currently serves as adirector of several other companies including NeoGenomics, Inc. (NGNM.OB),a publicly traded cancer genetic testing laboratory.  The holder of our 13% Debentures has abusiness relationship with, and has previously invested in NeoGenomics, Inc.  Our Board of Directors has considered thepotential conflict of interest of Mr. O’Leary concurrently serving on ourBoard of Directors and other companies that have or had a business relationshipwith the holder of our 13% Debentures, and has determined that any suchrelationships will not interfere with Mr. O’Leary being able to faithfullycarry out his duties as a member of our Board of Directors.

 

**Item 6:Exhibits**

 

Exhibits.

 
|   |   | 3.1  |   | Restated  articles of incorporation (incorporated by reference from our Current  Report on Form 8-K (File No. 001-12531), dated June 13, 2007  and filed on June 25, 2007, and incorporated herein by reference. |
|--------|--------|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | 3.2  |   | Restated bylaws  (incorporated by reference from our Current Report on Form 8-K (File  No. 001-12531), dated March 27, 2006, and filed on March 31,  2006, and incorporated herein by reference.                 |
|   |   | 31.1 |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act                                                                                                                                   |
|   |   | 31.2 |   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act                                                                                                                                   |
|   |   | 32.1 |   | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                    |
|   |   | 32.2 |   | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                    |

 

 

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SIGNATURES

 

Pursuant to 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 13th day of March 2008.

 
|   | Isonics Corporation |
|--------|---------------------|
|   | (Registrant)        |
|   |                |
|   | By                  | /s/ Christopher Toffales |   |
|   |                | Christopher Toffales |   |
|   |                | Chief Executive Officer |   |
|   |                |   |   |
|   |                |   |   |
|   | By                  | /s/ Gregory A. Meadows |   |
|   |                | Gregory A. Meadows |   |
|   |                | Chief Accounting Officer and Chief Financial Officer |   |

 

 

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