**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-QSB**

(**Mark One)**

 
| **ý** | ** Quarterly report under  Section 13 or 15(d) of the Securities Exchange Act of 1934.**                                                                                       |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                |
|       | **For the quarterly period ended  October 31, 2004**                                                                                                                                |
|       |                                                                                                                                                                                |
| **o**      | **Transition report under Section  13 or 15(d) of the Exchange Act.**                                                                                                               |
|       |                                                                                                                                                                                |
|       | **For the transition period from             to               ** |
|       |                                                                                                                                                                                |
|       | **Commission file number:  001-12531**                                                                                                                                              |

 

**ISONICS CORPORATION**

(Exact name of small businessissuer as specified in its charter)

** **

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

 

**5906 McIntyre Street**

**Golden, Colorado  80403**

(Address of principal executiveoffices)

 

**(303) 279-7900**

(Issuer’s telephone number)

 

Check whether the issuer (1) filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during the past 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.

Yes ý   No o

 

The number of shares outstanding of the registrant’s CommonStock, no par value, was 26,183,496 at December 10, 2004.

 

Transitional Small Business Disclosure Format (check one):

Yes o   No ý

 

 

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**Isonics Corporation**

** **

**TABLE OF CONTENTS**

** **

**FORM 10-QSB**

** **
| Part I:    | Financial Information |                                                                                                                  |
|------------|-----------------------|-----------------------------------------------------------------------------------------------------------------------|
|       |                  |                                                                                                                  |
|       | Item 1:               | Financial Statements                                                                                                  |   |
|       |                  |                                                                                                                  |   |
|       |                  | Condensed Consolidated Balance Sheets as  of October 31, 2004 and April 30, 2004                                      |   |
|       |                  | Condensed Consolidated  Statements of Operations for the Three and Six Month Periods Ended October  31, 2004 and 2003 |   |
|       |                  | Condensed Consolidated  Statements of Cash Flows for the Six Month Periods Ended October 31, 2004 and  2003           |   |
|       |                  | Notes to  Condensed Consolidated Financial Statements                                                                 |   |
|       |                  |                                                                                                                  |   |
|       | Item 2:               | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                           |   |
|       |                  |                                                                                                                  |   |
|       | Item 3:               | Controls and Procedures                                                                                               |   |
|       |                  |                                                                                                                  |
| Part II:   | Other Information     |                                                                                                                  |
|       |                  |                                                                                                                  |
|       | Item 2:               | Unregistered  Sales of Equity Securities and Use of Proceeds                                                          |   |
|       |                  |                                                                                                                  |   |
|       | Item 6:               | Exhibits                                                                                                              |   |
|       |                  |                                                                                                                  |   |
| Signatures |                  |                                                                                                                  |

 

2

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**Part I:  FinancialInformation**

** **

**Item 1:   Condensed FinancialStatements**

 

**ISONICS CORPORATION ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except shareamounts)**

 

**ASSETS**

 
| ** **                                                            | ** ** | **(Unaudited)**      | ** ** | ** **         | ** ** |
|-----------------------------------------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                                                            | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
| CURRENT  ASSETS:                                                      |       |                 |       |               |       |
| Cash  and cash equivalents                                            |       | $                    | 6,624      |               | $          | 3,691 |   |
| Accounts  receivable (net of allowances of $75 and $16, respectively) |       | 966                  |       | 851                |       |
| Inventories                                                           |       | 1,879                |       | 985                |       |
| Prepaid  expenses and other current assets                            |       | 529                  |       | 143                |       |
| Total  current assets                                                 |       | 9,998                |       | 5,670              |       |
|                                                                  |       |                 |       |               |       |
| LONG-TERM  ASSETS:                                                    |       |                 |       |               |       |
| Property  and equipment, net                                          |       | 4,667                |       | 471                |       |
| Goodwill                                                              |       | 2,254                |       | 1,807              |       |
| Intangible  assets, net                                               |       | 707                  |       | 706                |       |
| Other  assets                                                         |       | 141                  |       | 27                 |       |
| Total  long-term assets                                               |       | 7,769                |       | 3,011              |       |
|                                                                  |       |                 |       |               |       |
| TOTAL  ASSETS                                                         |       | $                    | 17,767     |               | $          | 8,681 |   |

 

**LIABILITIES AND STOCKHOLDERS’EQUITY**

 
| ** **                                                                                                                                                                                                                                                           | ** ** | **(Unaudited)**      | ** ** | ** **         | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                                                                                           | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
| CURRENT  LIABILITIES:                                                                                                                                                                                                                                                |       |                 |       |               |       |
| Current  portion of obligation under capital leases                                                                                                                                                                                                                  |       | $                    | 68         |               | $          | 54 |   |
| Accounts  payable                                                                                                                                                                                                                                                    |       | 1,994                |       | 628                |       |
| Accrued  liabilities                                                                                                                                                                                                                                                 |       | 892                  |       | 256                |       |
| Current  portion of note payable                                                                                                                                                                                                                                     |       | 653                  |       | —             |       |
| Total  current liabilities                                                                                                                                                                                                                                           |       | 3,607                |       | 938                |       |
|                                                                                                                                                                                                                                                                 |       |                 |       |               |       |
| OBLIGATION  UNDER CAPITAL LEASES, net of current portion                                                                                                                                                                                                             |       | 56                   |       | 32                 |       |
|                                                                                                                                                                                                                                                                 |       |                 |       |               |       |
| NOTE  PAYABLE, net of current portion                                                                                                                                                                                                                                |       | 994                  |       | —             |       |
|                                                                                                                                                                                                                                                                 |       |                 |       |               |       |
| TOTAL  LIABILITIES                                                                                                                                                                                                                                                   |       | 4,657                |       | 970                |       |
|                                                                                                                                                                                                                                                                 |       |                 |       |               |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                                                                                          |       |                 |       |               |       |
| Preferred  Stock; 10,000,000 shares authorized                                                                                                                                                                                                                       |       |                 |       |               |       |
| Series  A Convertible Preferred Stock—no par value; 6,666 and 963,666 shares issued  and outstanding on October 31, 2004 and April 30, 2004, respectively; $9,999  and $1,445,499 liquidation preference on October 31, 2004 and April 30, 2004,  respectively  |       | 5                    |       | 745                |       |
| Series  C Convertible Preferred Stock—no par value; zero and 9,000 shares issued and  outstanding on October 31, 2004 and April 30, 2004, respectively; zero and  $900,000 liquidation preference on October 31, 2004 and April 30, 2004,  respectively         |       | —               |       | 1,141              |       |
| Series  D Convertible Preferred Stock—no par value; 5,000 and 32,950 shares issued  and outstanding on October 31, 2004 and April 30, 2004, respectively;  $500,000 and $3,295,000 liquidation preference on October 31, 2004 and April  30, 2004, respectively |       | 566                  |       | 3,727              |       |
| Series  E Convertible Preferred Stock—no par value; 33,000 and zero shares issued and  outstanding on October 31, 2004 and April 30, 2004, respectively; $3,300,000  and zero liquidation preference on October 31, 2004 and April 30, 2004,  respectively      |       | 3,938                |       | —             |       |
| Common  stock—no par value; 40,000,000 shares authorized; 25,856,678 and 15,344,913  shares issued and outstanding on October 31, 2004 and April 30, 2004,  respectively                                                                                        |       | 26,509               |       | 14,817             |       |
| Additional  paid in capital                                                                                                                                                                                                                                          |       | 7,069                |       | 6,732              |       |
| Deferred  compensation                                                                                                                                                                                                                                               |       | (84                  | )          | (104               | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                 |       | (24,893              | )          | (19,347            | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                     |       | 13,110               |       | 7,711              |       |
|                                                                                                                                                                                                                                                                 |       |                 |       |               |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                     |       | $                    | 17,767     |               | $          | 8,681 |   |

** **

See notes to condensed consolidatedfinancial statements.

 

3

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**ISONICS CORPORATION ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except pershare data)**

**(Unaudited)**

 
| ** **                                              | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** |       |
|---------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                              | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** |   |
| Revenues                                                |       | $                                   | 3,065      |                              | $          | 2,214 |   | $ | 5,350 |   | $ | 4,499 |   |
| Cost of revenues                                        |       | 3,907                               |       | 1,741                             |       | 6,494 |   | 3,471 |   |
| Gross margin                                            |       | (842                                | )          | 473                               |       | (1,144 | ) | 1,028 |   |
|                                                    |       |                                |       |                              |       |   |   |   |   |
| Operating  expenses:                                    |       |                                |       |                              |       |   |   |   |   |
| Selling, general  and administrative                    |       | 1,475                               |       | 986                               |       | 2,821 |   | 2,069 |   |
| Research and  development                               |       | 138                                 |       | 165                               |       | 368 |   | 230 |   |
| Total operating  expenses                               |       | 1,613                               |       | 1,151                             |       | 3,189 |   | 2,299 |   |
|                                                    |       |                                |       |                              |       |   |   |   |   |
| Operating loss                                          |       | (2,455                              | )          | (678                              | )          | (4,333 | ) | (1,271 | ) |
|                                                    |       |                                |       |                              |       |   |   |   |   |
| Other income  (expense):                                |       |                                |       |                              |       |   |   |   |   |
| Foreign exchange                                        |       | 5                                   |       | (10                               | )          | 17 |   | (25 | ) |
| Interest and  other income                              |       | 12                                  |       | 6                                 |       | 25 |   | 30 |   |
| Interest expense                                        |       | (30                                 | )          | (5                                | )          | (49 | ) | (12 | ) |
| Total other  income (expense), net                      |       | (13                                 | )          | (9                                | )          | (7 | ) | (7 | ) |
| loss before  income taxes                               |       | (2,468                              | )          | (687                              | )          | (4,340 | ) | (1,278 | ) |
| Income tax  expense                                     |       | —                              |       | —                            |       |   |   | — |   |
| NET LOSS                                                |       | $                                   | (2,468     | )                                 | $          | (687 | ) | $ | (4,340 | ) | $ | (1,278 | ) |
|                                                    |       |                                |       |                              |       |   |   |   |   |
| DEEMED DIVIDEND  ON PREFERRED STOCK                     |       | $                                   | (1,206     | )                                 | $          | — |   | $ | (1,206 | ) | $ | — |   |
|                                                    |       |                                |       |                              |       |   |   |   |   |
| NET LOSS  ATTRIBUTABLE TO COMMON STOCKHOLDERS           |       | $                                   | (3,674     | )                                 | $          | (687 | ) | $ | (5,546 | ) | $ | (1,278 | ) |
| ** **                                              | ** ** | ** **                          | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** |   |
| **Net  loss per share—basic and diluted**          | ** ** | ** **                          | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** |   |
| ** **                                              | ** ** | ** **                          | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** |   |
| Net loss per  share attributable to common stockholders |       | $                                   | (.20       | )                                 | $          | (.05 | ) | $ | (.31 | ) | $ | (.10 | ) |
| Shares used in  computing per share information         |       | 18,746                              |       | 12,651                            |       | 17,799 |   | 12,383 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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**ISONICS CORPORATION ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                              | ** ** | **Six Months Ended October 31,** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| ** **                                                              | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net cash used in  operating activities                                  |       | $                                | (4,965     | ) | $ | (1,320 | ) |
|                                                                    |       |                             |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                  |       |                             |       |   |   |
| Purchases of  property and equipment                                    |       | (517                             | )          | (4 | ) |
| Acquisition of  business, net of cash acquired                          |       | (49                              | )          | — |   |
|                                                                    |       |                             |       |   |   |
| Cash used in  investing activities                                      |       | (566                             | )          | (4 | ) |
|                                                                    |       |                             |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                  |       |                             |       |   |   |
| Payments on  notes payable                                              |       | (53                              | )          | (170 | ) |
| Proceeds from  issuance of notes payable                                |       | —                           |       | 170 |   |
| Proceeds from  issuance of common stock                                 |       | 5,479                            |       | 1,084 |   |
| Proceeds from  issuance of preferred stock                              |       | 3,069                            |       | — |   |
| Principal  payments under capital lease obligations                     |       | (31                              | )          | (24 | ) |
| Cash provided by  financing activities                                  |       | 8,464                            |       | 1,060 |   |
|                                                                    |       |                             |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS:                  |       | 2,933                            |       | (264 | ) |
| Cash and cash  equivalents at beginning of period                       |       | 3,691                            |       | 742 |   |
| Cash and cash  equivalents at end of period                             |       | $                                | 6,624      |   | $ | 478 |   |
|                                                                    |       |                             |       |   |   |
| Supplemental  disclosure of cash flow information:                      |       |                             |       |   |   |
| Cash paid during  the period for:                                       |       |                             |       |   |   |
| Interest                                                                |       | $                                | 41         |   | $ | 13 |   |
| Income taxes                                                            |       | $                                | —     |   | $ | — |   |
|                                                                    |       |                             |       |   |   |
| Supplemental  disclosure of noncash investing and financing activities: |       |                             |       |   |   |
|                                                                    |       |                             |       |   |   |
| Common stock  issued in legal settlement                                |       | $                                | —     |   | $ | 97 |   |
| Capital lease  obligation for property and equipment                    |       | 69                               |       | — |   |
| Accruals for  property and equipment                                    |       | 1,542                            |       | — |   |

 

See notes to condensedconsolidated financial statements.

 

5

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**ISONICS CORPORATION ANDSUBSIDIARIES**

**NOTES****TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

***Basis of Presentation***

 

The accompanying unaudited condensed consolidated financialstatements of Isonics Corporation and Subsidiaries as of October 31, 2004, andfor the three and six months ended October 31, 2004 and 2003 have been preparedon the same basis as the annual audited financial statements.  In the opinion of management, such unauditedinformation includes all adjustments (consisting only of normal recurringaccruals) necessary for a fair presentation of this interim information.  Operating results and cash flows for interimperiods are not necessarily indicative of results for the entire year.  The information included in this reportshould be read in conjunction with our audited financial statements and notesthereto included in our Annual Report on Form 10-KSB for the year ended April30, 2004.

 

***Realization of Assetsand Liquidit****y*

 

The accompanying condensedconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America, whichcontemplates our continuation as a going concern.  However, we have sustained substantial lossesfrom operations in recent years, and such losses have continued throughDecember 10, 2004.  In view of thismatter, recoverability of a major portion of the recorded asset amounts shownin the accompanying condensed consolidated balance sheet is dependent upon ourcontinued operations, which in turn is dependent upon our ability to meet ourfinancing requirements on a continuing basis, to maintain present financing andto succeed in our future operations.  Thecondensed consolidated financial statements do not include any adjustmentsrelating to the recoverability and classification of recorded asset amounts oramounts and classification of liabilities that might be necessary should we beunable to continue in existence.

 

As of October 31, 2004, we hadcash and cash equivalents of $6,624,000 and working capital of $6,391,000.  On June 11, 2004, we acquired the siliconwafer manufacturing and recycling assets of EnCompass Materials Group, Ltd. (“EMG”)(See *Acquisition of Business and Assets ofEncompass Materials Group, Ltd.*). Upon acquisition, we implemented an integration plan, which we believedif made, would result in significant productivity improvements and costreductions.  The integration plan howeverhas not achieved the results we anticipated and as a result our semiconductormaterials and products segment has generated significant negative gross marginsand an operating loss of $2,608,000 for the six months ended October 31, 2004(as compared to an overall company wide operating loss of $4,333,000 for thesix months ended October 31, 2004).  Asthe implementation of our integration plan has not achieved the results weanticipated, we are making several additional changes (above those contemplatedin our original integration plan) to the manufacturing processes associatedwith our manufacturing and reclamation of silicon wafer business in order toachieve the substantial reduction in costs that is required to allow thatbusiness to operate profitably.  At thesame time we are considering all additional available strategic optionsincluding scaling back the silicon wafer reclamation operations (which may alsolead to an impairment of goodwill and intangible assets). Concurrently we arealso working to redeploy resources to our other higher margin, strategicproduct lines, including the manufacturing of SOI wafers, which was theoriginal impetus for the acquisition of the EMG assets. While we anticipatethat the course we ultimately take will significantly reduce operating expenses(and correspondingly reduce the negative gross margin) at our semiconductormaterials and products segment, it is currently unclear as to the timing andamount of that reduction. We cannot however, provide any assurances that wewill be able to do so.

 

6

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As we continue to work towardsreducing the negative margins and operating losses in our semiconductormaterials and products segment, we did complete a private placement in October2004 whereby we received $3,300,000 ($3,049,000 net of due diligence fees andrelated expenses) and with the exercise of common stock warrants whereby wereceived $5,428,000 during the six months ended October 31, 2004, we havesufficient cash available to fund our working capital requirements into our2006 fiscal year.

 

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

 

***Accounting forStock-Based Compensation***

 

We account for stock-basedcompensation to employees and directors using the intrinsic value method inaccordance with Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*and related interpretations, as permitted bySFAS No. 123 *Accounting for Stock-BasedCompensation*, as amended.  Compensation expense for stock options ismeasured as the excess, if any, of the quoted market price of our stock at thedate of grant over the amount an employee must pay to acquire the stock.  No stock-based employee compensation costsrelating to options is reflected within our net loss as all options granted hadan exercise price equal to or greater than the market value of the underlyingcommon stock on the date of grant.  Werecord compensation expense for restricted stock awards based on the quotedmarket price of our stock at the date of the grant and the vesting period.

 

The following table illustratesthe effect on net loss and net loss per share if we had applied the fair valuerecognition provisions of SFAS No. 123 to stock-based compensation to employeesand directors (in thousands, except per share data):

 
| ** **                                                                                                                           | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss attributable  to common stockholders, as reported                                                                           |       | $                                   | (3,674     | )                                 | $          | (687 | ) | $ | (5,546 | ) | $ | (1,278 | ) |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (93                                 | )          | (60                               | )          | (138 | ) | (120 | ) |
| Adjusted net  loss                                                                                                                   |       | $                                   | (3,767     | )                                 | $          | (747 | ) | $ | (5,684 | ) | $ | (1,398 | ) |

 
| ** **                                              | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                              | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss per  share attributable to common stockholders |       |                                |       |                              |       |   |   |   |   |
| Basic and  diluted – as reported                   |       | $                                   | (.20       | )                                 | $          | (.05 | ) | $ | (.31 | ) | $ | (.10 | ) |
| Basic and  diluted – adjusted                      |       | $                                   | (.20       | )                                 | $          | (.06 | ) | $ | (.32 | ) | $ | (.11 | ) |

 

7

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

 

Basic net income (loss) per share is computed using theweighted average number of common shares outstanding during the period.  Contingently issued shares are included inthe computation of basic net income (loss) per share when the relatedconditions are satisfied.  Diluted netincome (loss) per share is computed using the weighted average number of commonshares and potentially dilutive securities outstanding during the period.  Potentially dilutive securities consist ofcontingently issued shares, the common shares issuable upon conversion ofpreferred stock or convertible debt (using the “if converted” method) andshares issuable upon the exercise of stock options and common stock warrants(using the “treasury stock” method). Potentially dilutive securities are excluded from the computation iftheir effect is anti-dilutive.

 

As of October 31, 2004, a total of 7,371,458 outstandingstock options and common stock warrants and 6,666, 5,000 and 33,000 outstandingshares of Series A, D and E Convertible Preferred Stock, respectively wereexcluded from the diluted net income (loss) per share calculation, as theinclusion would be anti-dilutive.  As of October 31, 2003, a total of 7,102,840outstanding stock options and common stock warrants and 963,666 outstandingshares of Class A Convertible Preferred Stock were excluded from the dilutednet income (loss) per share calculations, as the inclusion would beanti-dilutive.

 

During the six month period ended October 31, 2004, weissued the following shares of Common Stock:

** **
| **Description**                                  | ** ** | **Number of Common Stock Shares** | ** ** |
|--------------------------------------------------|------------|-----------------------------------|------------|
| Balance as of  April 30, 2004                    |       | 15,344,913                        |       |
| Conversion of  preferred stock                   |       | 5,402,276                         |       |
| Exercise of  common stock warrants               |       | 4,328,500                         |       |
| Shares issued  from employee stock purchase plan |       | 4,059                             |       |
| Exercise of  employee stock options              |       | 45,000                            |       |
| Shares issued  for acquisition of assets         |       | 731,930                           |       |
| Balance as of  October 31, 2004                  |       | 25,856,678                        |       |

 

The aforementioned equity transactions increased commonstock in the accompanying condensed consolidated balance sheet by $11,692,000for the six months ended October 31, 2004.

 

***Inventories***

 

Inventories consist of (in thousands):

 
| ** **              | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
|-------------------------|------------|----------------------|------------|--------------------|------------|
| Finished goods          |       | $                    | 840        |               | $          | 407 |   |
| Work in process         |       | 646                  |       | 508                |       |
| Materials and  supplies |       | 393                  |       | 70                 |       |
| Total  inventories      |       | $                    | 1,879      |               | $          | 985 |   |

 

8

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***Property and equipment***

 

Propertyand equipment consist of the following (in thousands):

** **
| ** **                                 | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
|--------------------------------------------|------------|----------------------|------------|--------------------|------------|
| Office furniture  and equipment            |       | $                    | 377        |               | $          | 304 |   |
| Production  equipment                      |       | 2,930                |       | 648                |       |
| Leasehold  improvements                    |       | 295                  |       | 30                 |       |
| Construction in  process                   |       | 2,008                |       | —             |       |
|                                       |       | 5,610                |       | 982                |       |
| Accumulated  depreciation and amortization |       | (943                 | )          | (511               | )          |
| Total property  and equipment              |       | $                    | 4,667      |               | $          | 471 |   |

 

***Accrued liabilities***

 

Accrued liabilities consist of the following (inthousands):

 
| ** **                      | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
|---------------------------------|------------|----------------------|------------|--------------------|------------|
| Compensation                    |       | $                    | 134        |               | $          | 103 |   |
| Customer  advances and deposits |       | 50                   |       | 67                 |       |
| Equipment                       |       | 425                  |       | —             |       |
| Other                           |       | 283                  |       | 86                 |       |
| Total accrued  liabilities      |       | $                    | 892        |               | $          | 256 |   |

 

***Significant Customers***

 

As of October 31, 2004, three customers accounted forapproximately 32% of total net accounts receivable.  Three customers accounted for approximately34% of total net accounts receivable at April 30, 2004.  One customer (Eastern Isotopes) accounted forapproximately 21% of revenues for the six months ended October 31, 2004.  One customer (Eastern Isotopes) accounted forapproximately 18% of revenues for the three months ended October 31, 2004.  One customer (Eastern Isotopes) accounted forapproximately 33% of revenues for the six months ended October 31, 2003.  One customer (Eastern Isotopes) accounted forapproximately 35% of revenues for the three months ended October 31, 2003.

 

Three customers (Perkin Elmer Life Sciences, InternationalIsotopes and IBT SA) accounted for approximately 48%, 18% and 15%, respectivelyof the German operation’s revenues for the six months ended October 31,2004.  Three customers (Perkin Elmer LifeSciences, International Isotopes and IBT SA) accounted for approximately 34%,26% and 19%, respectively of the German operation’s revenues for the threemonths ended October 31, 2004.  Threecustomers (Perkin Elmer Life Sciences, IBT SA and International Isotopes)accounted for approximately 36%, 25% and 21%, respectively of the German operation’srevenues for the six months ended October 31, 2003.  Three customers (Perkin Elmer Life Sciences,IBT SA and International Isotopes) accounted for approximately 27%, 26% and26%, respectively of the German operation’s revenues for the three months endedOctober 31, 2003.  Two customersaccounted for approximately 79% of the German operation’s accounts receivableat October 31, 2004.  Two customersaccounted for approximately 49% of the German operation’s accounts receivableat April 30, 2004.

 

9

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***Business Segments and Foreign Operations***

 

We currently have two reportablesegments: life sciences and semiconductor materials and products.  Our life sciences segment sells stable andradioisotopes in elemental and simple compound forms for use in life sciencesapplications.  Our semiconductormaterials and products segment manufactures and reclaims silicon wafers, sellsSOI wafers and is involved in several research and development projectsincluding silicon-28.  Reconciling itemsconsist primarily of corporate and homeland security expenses that have notbeen allocated to a specific reportable segment.

 

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

 
| ** **                            | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                            | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Segment  revenues:                    |       |                                |       |                              |       |   |   |   |   |
| Life sciences                         |       | $                                   | 2,156      |                              | $          | 2,082 |   | $ | 4,107 |   | $ | 4,104 |   |
| Semiconductor  materials and products |       | 909                                 |       | 132                               |       | 1,243 |   | 395 |   |
| Total                                 |       | $                                   | 3,065      |                              | $          | 2,214 |   | $ | 5,350 |   | $ | 4,499 |   |

 
| ** **                            | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                            | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Segment  operating (loss) income:     |       |                                |       |                              |       |   |   |   |   |
| Life sciences                         |       | $                                   | (199       | )                                 | $          | 303 |   | $ | (35 | ) | $ | 469 |   |
| Semiconductor  materials and products |       | (1,568                              | )          | (265                              | )          | (2,608 | ) | (397 | ) |
| Reconciling  amounts                  |       | (688                                | )          | (716                              | )          | (1,690 | ) | (1,343 | ) |
| Total                                 |       | $                                   | (2,455     | )                                 | $          | (678 | ) | $ | (4,333 | ) | $ | (1,271 | ) |

 
| ** **                            | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
|---------------------------------------|------------|----------------------|------------|--------------------|------------|
| Total Assets:                         |       |                 |       |               |       |
| Life sciences                         |       | $                    | 4,330      |               | $          | 4,066 |   |
| Semiconductor  materials and products |       | 6,896                |       | 1,037              |       |
| Reconciling  amounts                  |       | 6,541                |       | 3,578              |       |
| Total                                 |       | $                    | 17,767     |               | $          | 8,681 |   |

 

A summary of operations by geographic area is as follows:

 
| ** **    | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|---------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **    | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues: |       |                                |       |                              |       |   |   |   |   |
| United States |       | $                                   | 2,370      |                              | $          | 1,681 |   | $ | 3,952 |   | $ | 3,412 |   |
| Germany       |       | 695                                 |       | 533                               |       | 1,398 |   | 1,087 |   |
| Total         |       | $                                   | 3,065      |                              | $          | 2,214 |   | $ | 5,350 |   | $ | 4,499 |   |

 

10

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| ** **                | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Operating (loss)  income: |       |                                |       |                              |       |   |   |   |   |
| United States             |       | $                                   | (2,449     | )                                 | $          | (686 | ) | $ | (4,309 | ) | $ | (1,265 | ) |
| Germany                   |       | (6                                  | )          | 8                                 |       | (24 | ) | (6 | ) |
| Total                     |       | $                                   | (2,455     | )                                 | $          | (678 | ) | $ | (4,333 | ) | $ | (1,271 | ) |

 
| ** **    | ** ** | **October 31, 2004** | ** ** | **April 30, 2004** | ** ** |
|---------------|------------|----------------------|------------|--------------------|------------|
| Total Assets: |       |                 |       |               |       |
| United States |       | $                    | 15,042     |               | $          | 5,914 |   |
| Germany       |       | 2,725                |       | 2,767              |       |
| Total         |       | $                    | 17,767     |               | $          | 8,681 |   |

 

***Acquisition of Business and Assets ofEncompass Materials Group, Ltd.***

 

On June 11, 2004, we acquired the silicon wafermanufacturing and recycling assets of EMG. The results of the operations associated with the acquired assets havebeen included in the condensed consolidated financial statements since thatdate.  EMG was engaged in the business ofmanufacturing and reclamation of silicon wafers.  As a result of the acquisition, we not onlyhave entered into the business of manufacturing and reclamation of siliconwafers but we also expect to use the acquired assets as a platform to launchour full scale SOI operations.  Inconjunction with this acquisition, in May 2004 we established our wholly ownedsubsidiary Isonics Vancouver, Inc. (“Isonics Vancouver”).  Isonics Vancouver is a Washington basedentity that now conducts our SOI and manufacturing and reclamation of siliconwafer operations.

 

The aggregate purchase price was $2,920,000, whichconsisted of a $1,700,000 promissory note (secured by the assets acquired andcertain other assets owned by us relating to our SOI business) payable over 33months with an interest rate of 6%, 731,930 shares of our restricted commonstock (valued at $1,171,000 based upon the fair market value of the commonstock on June 11, 2004) and $49,000 of legal and accounting fees.  In addition, we assumed operating leases(that expire in various years through fiscal year 2011) with future commitmentsof approximately $1,200,000.

 

The following table summarizes the estimated fair values ofthe assets acquired and liabilities assumed at the date of acquisitionincluding property and equipment, which was based on an independent third partyvaluation.  While we believe the purchaseaccounting associated with this transaction to essentially be complete, thereis always the possibility that it may be subject to refinement.

** **
| Current assets          |   | $         | 604,000   |   |
|-------------------------|--------|-----------|-----------|--------|
| Property and  equipment |   | 2,497,000 |      |
| Other assets            |   | 16,000    |      |
| Intangible  assets      |   | 50,000    |      |
| Goodwill                |   | 447,000   |      |
| Total assets  acquired  |   | 3,614,000 |      |
| Current  liabilities    |   | (694,000  | )         |
| Net assets  acquired    |   | $         | 2,920,000 |   |

 

11

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The $447,000 of goodwill was assigned to the semiconductormaterials and products segment and is expected to be deductible for taxpurposes.  The $50,000 of intangibleassets relates to customer lists and is being amortized ratably over itsestimated life of 3 years.  There was noin-process research and development acquired in this transaction.

 

The $1,700,000 promissory note is payable by oursubsidiary, Isonics Vancouver.  Inaccordance with the terms of the acquisition of the business and assets of EMG,we have guaranteed all payments (totaling $1,854,000 including interest) ofsuch loan should Isonics Vancouver be in default at any point over the life ofthe loan.

 

The following table summarizes our results of operationsfor the three and six months ended October 31, 2004 and 2003 as if theacquisition of the business and assets of EMG had occurred on May 1, 2004 and2003, respectively.  There have been noadjustments made to the historical results of EMG.

** **
| ** **                                                                       | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                                                                         |       | $                                   | 3,065      |                              | $          | 3,101 |   | $ | 5,726 |   | $ | 6,248 |   |
| Net loss  attributable to common stockholders                                    |       | $                                   | (3,674     | )                                 | $          | (1,110 | ) | $ | (5,908 | ) | $ | (1,978 | ) |
| Net loss  attributable to common stockholders per share – basic and diluted |       | $                                   | (.20       | )                                 | $          | (.09 | ) | $ | (.33 | ) | $ | (.16 | ) |

 

***Private Placement***

 

On October 4, 2004 we completed afinancing arrangement whereby we issued 33,000 shares of our Series EConvertible Preferred Stock (“Series E Stock”) and 614,000 common stockwarrants to Asset Managers, Inc. (“AMI”) for $3,300,000. In addition, we paidAMI $251,000 in due diligence fees and related expenses. Each common stockwarrant is exercisable for one share of common stock through October 4,2007.  One-half (307,000) of the commonstock warrants have an exercise price of $1.24 per share while the remaininghalf (307,000) of the common stock warrants have an exercise price of $1.35 pershare.

 

The Series E Stock is convertibleinto common stock at a price equal to 85% of Market Price on the conversiondate, but at a price no higher than $1.24 per share (the “Ceiling Price”) andno lower than $1.00 per share (the “Floor Price”).  For purposes of determining the ConversionPrice, the “Market Price”**shall be the average of the lowestthree intra-day trading prices of Isonics’ common stock (which need not occuron consecutive trading days) during the 5 trading days immediately precedingthe conversion date.

 

We have an obligation to registerthe shares underlying the Series E Stock and the common stock warrants,including the obligation to file a registration statement by November 7, 2004and to obtain effectiveness of the registration statement within 70 days afterthe filing of the registration statement. We are currently in default of our obligation and as a result, we areincurring a penalty of $2,000 per day until the registration statement isfiled.  In addition, as a result of notmeeting the deadline to file the registration statement, the preferred stock isnow convertible into common stock at a price equal to 75% of the Market Priceon the conversion date (subject to the same Floor and Ceiling Prices) asdiscussed above.

 

12

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We have allocated the proceedsreceived between the Series E Stock and related warrants based on the relativefair value of each instrument.  Inaddition, in accordance with EITF 00-27 “Application of Issue No. 98-5 toCertain Convertible Instruments” we have calculated the intrinsic value of theconversion option by using the effective conversion price based on the proceedsallocated to the convertible instrument. As a result, we determined that the value of the beneficial conversionfeature contained in our Series E Stock (based upon a $1.24 conversion price)to be $1,206,000, which has been reported as a deemed dividend for the threeand six months ended October 31, 2004.

 

The Series E Stock is non-votingand has a liquidation preference equal to $100 per share.  In addition, the Series E Stock bears adividend of 8% per annum, payable in cash, in arrears, monthly, commencing onOctober 4, 2004.  The dividend obligationterminates after one year or earlier if the Series E Stock is converted tocommon stock.

 

***Convertible Preferred Stock***

 

There are provisions associatedwith the Series A Convertible Preferred Stock (“Series A Stock”) that if triggered,would reduce the current conversion price and effectively allow the preferredshares to convert to common stock at a more favorable ratio.  The Series A Stock is convertible at twoshares of common stock for each share of Series A Stock outstanding.  During the six months ended October 31, 2004,957,000 shares of Series A Stock were converted into 1,914,000 shares of commonstock.  As of December 10, 2004, therewere 6,666 shares of Series A Stock outstanding convertible into 13,332 sharesof common stock based upon the current conversion ratio.

 

During the six months endedOctober 31, 2004, 9,000 shares of Series C Convertible Preferred Stock (“SeriesC Stock”) were converted into 947,368 shares of common stock.  As a result of these conversions, there areno shares of Series C Stock outstanding.

 

During the six months endedOctober 31, 2004, 27,950 shares of Series D Convertible Preferred Stock (“SeriesD Stock”)  were converted into 2,540,908shares of common stock.  On November 1,2004, 2,000 additional shares of Series D Stock were converted into 181,818shares of common stock.  As of December10, 2004, there were 3,000 shares of Series D Stock outstanding convertibleinto 272,727 shares of common stock.

 

***Commitments andContingencies***

 

In June 2004, we entered into anagreement with Institut of Umwelttechnologien GmbH (“IUT”) whereby we agreed tofund $275,000 of research and development expenses on behalf of IUT DetectionTechnology, Inc. (“IUTDT”) during the year ending April 30, 2005.  The research and development work will becompleted by IUT and will be funded in steps based upon completion of variousmilestones.  We funded the first $100,000of this commitment in June 2004 (which was recorded as research and developmentexpense on the accompanying condensed consolidated statement of operations) andsubsequently funded a second $100,000 in November 2004.

 

We are currently responding torequests for information received from the Nasdaq Stock Market (“Nasdaq”) withrespect to the significant trading volume and volatility that occurred inOctober following announcements related to our homeland security and defensedivision.  While we have and willcontinue to provide all information and documents as requested by Nasdaq, it iscurrently unclear as to when Nasdaq will be completed with this process.

 

13

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As of October 31, 2004, we hadcommitments outstanding for capital expenditures of approximately $1,600,000.

 

***IsonicsHomeland Security and Defense Corporation***

 

On October 7, 2004, weestablished Isonics Homeland Security and Defense Corporation (“HSDC”), awholly owned Delaware corporation to consolidate our efforts in the homelandsecurity market.  In connection with theestablishment of HSDC, we created an advisory board, which provides guidanceand advice to HSDC in matters of technology, business and applications as wedevelop technologies and products for the homeland security marketplace.  In November 2004 we issued 300,000 commonstock warrants (valued at $669,000 using the Black-Scholes pricing model) tothree newly hired advisory board members. The common stock warrants vested immediately, are exercisable at $4.00per share, expire on November 1, 2007 and will be expensed to selling, generaland administrative expenses during our third fiscal quarter.

 

***Letter ofIntent to Acquire Protection Plus Security Consultants, Inc.***

 

On December 2, 2004, we enteredinto a non-binding letter of intent to acquire Protection Plus SecurityConsultants, Inc. (“Protection Plus”), an international provider of advancedsecurity and investigative services.  Theletter of intent contemplates a purchase price of 1,000,000 shares ofrestricted common stock and a contingent amount consisting of 500,000 commonstock warrants exercisable at $4.00 per share. The common stock warrants may be earned in the future by meetingpredetermined future earnings goals.  Theclosing of this proposed transaction is subject to standard due diligenceprocedures and closing conditions.

 

***New AccountingStandards***

 

In March 2004, the FASB issuedconsensus on EITF 03-6 *ParticipatingSecurities and the Two-Class Method Under FASB Statement No. 128, Earnings PerShare*related to calculating earnings per share with respect tousing the two-class method for participating securities.  This pronouncement was effective for allperiods after March 31, 2004 and required prior periods to be restated.  As we have incurred net losses in the currentand prior periods, and as our preferred stock does not have a contractualobligation to share in our losses, the adoption of EITF 03-6 had no impact onour financial condition or the results of our operations.

 

14

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** **

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

** **

*The statements contained in this Report on Form 10-QSB that are notpurely historical are forward looking statements within the meaning of Section27A of the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934, including statements regarding our expectations, hopes, intentionsor strategies regarding the future. Forward-looking statements include: statements regarding future productsor product development; statements regarding future selling, general andadministrative costs and research and development spending and our productdevelopment strategy; and statements regarding future capital expenditures andfinancing requirements.  All forward-lookingstatements included in this document are based on information available to uson the date hereof, and we undertake no obligation to update any suchforward-looking statements.  It isimportant to note that our actual results could differ materially from those insuch forward-looking statements.*

 

***General Discussion***

* *

Founded in 1992, we are anadvanced materials and technology company focusing on the supply of isotopesfor life sciences and health-care applications and silicon-on-insulator (“SOI”)wafers to the semiconductor industry. Most recently, in June 2004 we acquired the business and assets of EMG,which was engaged in the business of manufacturing and reclamation of siliconwafers.  In addition, we continue todevelop additional products created from materials whose natural isotopicratios have been modified as well as non-isotopic (natural) materials.  An isotope is one of two or more species (ornuclides) of the same chemical element that differ from one another only in thenumber of neutrons in the atom’s nucleus. The different number of neutrons can create significantly differentnuclear properties.  Radioactivity is themost well known of these properties. Radioactive isotopes (or radioisotopes) can be found in nature.  Most of our radioisotopes, however, areman-made.  Stable isotopes, asdistinguished from radioisotopes, are not radioactive.

** **

Several manufacturers, locatedprimarily in republics that once were part of the Soviet Union, produceradioactive and stable isotopes.  We buythese isotopes from the manufacturers and resell them in the form of commonchemical compounds.  For example,oxygen-18 is sold as water, and zinc-68 is sold as zinc oxide.  Today our business addresses the materialneeds of two primary markets:

** **

•                  Life sciences (involvingisotopic materials) and

•                  Semiconductor materialsand products (including both isotopic and non-isotopic materials).

** **

While we currently are focusingon these two markets, we continue to evaluate other applications for stableisotopes, radioisotopes and non-isotopic materials.  In December 2002, we acquired certainisotope-based trace detection technology that can be used to detect explosivesand chemical and biological weapons.  Weacquired this technology through our 85%-owned subsidiary, IUTDT from IUT, anentity in which we hold a 6% ownership interest.  (IUT owns the remaining 15% of IUTDT.)  If and when we begin sales of these detectionproducts, we expect these products to constitute a third market (the homelandsecurity market) for our products.  Weare continuing to pursue research and development opportunities with respect tothe technology we acquired from IUT under a research and development agreementwe entered into with IUT, as well as continuing research and development of oursilicon-28 semiconductor materials.  Wehave transferred our 85% interest in IUTDT to our new, wholly-owned subsidiary,HSDC.

 

15

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We also sell isotopes for use inbasic scientific research and industrial applications.  We believe our core competency is our abilityto identify, develop, source, and commercialize products and services based onisotopically engineered materials as well as non-isotopic semiconductormaterials.  At the present time (and asdescribed in more detail below), our life sciences segment is being adverselyaffected by increased domestic and international competition.  While we are developing strategies to addressthese issues and gain a competitive advantage, we cannot offer any assurancesthat we will succeed in doing so.

** **

Prior to our acquisition of thebusiness and assets of EMG, we developed an integration plan which waspredicated on making numerous changes to the related business that we believedif made, would result in significant productivity improvements and costreductions.  Our original plan required astructured three to five month implementation process, and was started withinthe first three weeks after the acquisition of the business and assets of EMGin June 2004.  While we didn’t anticipateto start seeing the benefits of our cost reduction program until the end of oursecond fiscal quarter, we did incur costs associated with the integration ofthe business, establishing processes and procedures (aimed at lowering theoverall future costs of the operation) within the plant and hiring the properpersonnel necessary to bring the assets to their full operating capacity.  In addition, our revenues during the sixmonths ended October 31, 2004 were at times significantly less than thehistorical run rates at EMG (due mainly to the unavailability of a keyproduction tool, which has since been corrected).  These integration expenses, reduced revenuesand the fact that we haven’t begun to see the results of our cost savings programhave generated significant negative gross margins and an operating loss of$2,608,000 in our semiconductor materials and products segment for the sixmonths ended October 31, 2004.

** **

As the implementation of ourintegration plan has not achieved the results we anticipated, we are makingseveral additional changes (above those contemplated in our originalintegration plan) to the manufacturing processes associated with ourmanufacturing and reclamation of silicon wafer business in order to achieve thesubstantial reduction in costs that is required to allow that business tooperate profitably.  At the same time weare considering all additional available strategic options including scalingback the silicon wafer reclamation operations (which may also lead to animpairment of goodwill and intangible assets). Concurrently we are also workingto redeploy resources to our other higher margin, strategic product lines,including the manufacturing of SOI wafers, which was the original impetus forthe acquisition of the EMG assets. While we anticipate that the course weultimately take will significantly reduce operating expenses (andcorrespondingly reduce the negative gross margin) at our semiconductormaterials and products segment, it is currently unclear as to the timing andamount of that reduction. We cannot however, provide any assurances that wewill be able to do so.

** **

We have been required to makesignificant cash investments in our SOI wafer manufacturing operations, ournewly-acquired wafer manufacturing and reclamation operations and for researchand development of our homeland security and silicon-28 semiconductortechnology.  We anticipate that we willbe required to make significant additional investments of cash, personnel, andmaterials in these operations in the future. During the quarter ended October31, 2004, we raised in excess of $8 million through the issuance of our SeriesE Stock and the exercise of common stock warrants and as a result, we believewe have enough cash to execute our business plan well into our 2006 fiscalyear.

** **

Our revenues in the future willdepend on our success in developing and selling products in the semiconductorand stable and radioactive isotope markets, and (ultimately, if and whenproduct development has been completed) in our homeland security division.  Our profitability will be dependent upon ourability to manage our costs and to increase our revenues in all of our businesssegments.  Consistent with our historicalexperience, our quarterly results have been materially affected by the size,timing, and quantity of orders and product shipments during a given quarter.

 

16

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***Results ofOperations***

* *

The following table sets forth,for the periods indicated, statement of operations data expressed as apercentage of net sales.  The table andthe discussion below should be read in conjunction with the condensedconsolidated financial statements and the notes thereto appearing elsewhere inthis report.

 
| ** **                           | ** ** | **Three Months Ended  October 31,** | ** ** | **Six Months Ended  October 31,** | ** ** |
|--------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| ** **                           | ** ** | **2004**                            | ** ** | **2003**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                 |       |                                |       |                              |       |   |   |   |   |
| Revenues                             |       | 100.0                               | %          | 100.0                             | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                     |       | 127.5                               |       | 78.6                              |       | 121.4 |   | 77.2 |   |
| Gross margin                         |       | (27.5                               | )          | 21.4                              |       | (21.4 | ) | 22.8 |   |
|                                 |       |                                |       |                              |       |   |   |   |   |
| Operating  expenses:                 |       |                                |       |                              |       |   |   |   |   |
| Selling, general  and Administrative |       | 48.1                                |       | 44.5                              |       | 52.7 |   | 46.0 |   |
| Research and  development            |       | 4.5                                 |       | 7.5                               |       | 6.9 |   | 5.1 |   |
| Total operating  expenses            |       | 52.6                                |       | 52.0                              |       | 59.6 |   | 51.1 |   |
| Operating loss                       |       | (80.1                               | )          | (30.6                             | )          | (81.0 | ) | (28.3 | ) |
|                                 |       |                                |       |                              |       |   |   |   |   |
| Other income  (expense), net         |       | (.4                                 | )          | (.4                               | )          | (.1 | ) | (.1 | ) |
| Loss before  income taxes            |       | (80.5                               | )          | (31.0                             | )          | (81.1 | ) | (28.4 | ) |
| Income tax  expense                  |       | —                              |       | —                            |       | — |   | — |   |
| NET LOSS                             |       | (80.5                               | )%         | (31.0                             | )%         | (81.1 | )% | (28.4 | )% |

 

17

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* *

***Revenues***

* *

Revenuesincreased during both the three and six months ended October 31, 2004 ascompared to the same periods of our prior fiscal year, as described in thefollowing table:

** **
| ** **                            | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Life sciences                         |       |                               |       |                             |       |   |   |   |   |
| Domestic                              |       | $                                  | 1,461,000  |                             | $          | 1,549,000 |   | $ | 2,709,000 |   | $ | 3,017,000 |   |
| International                         |       | $                                  | 695,000    |                             | $          | 533,000 |   | $ | 1,398,000 |   | $ | 1,087,000 |   |
|                                  |       |                               |       |                             |       |   |   |   |   |
| Semiconductor materials  and products |       | $                                  | 909,000    |                             | $          | 132,000 |   | $ | 1,243,000 |   | $ | 395,000 |   |
|                                  |       |                               |       |                             |       |   |   |   |   |
| Total                                 |       | $                                  | 3,065,000  |                             | $          | 2,214,000 |   | $ | 5,350,000 |   | $ | 4,499,000 |   |

 

As a significant portion of ourrevenues are derived from a small concentration of customers (see *Significant Customers*), if one or more ofthese customers were to discontinue or reduce their purchases of our isotopeproducts, the result could have a material effect on both our revenues andrelated cash flows.

** **

Thedecrease in revenues from domestic isotope product sales for the three and sixmonths ended October 31, 2004 was primarily the result of a decrease in theunit price of oxygen-18, which was partially offset by an increase in volume.

** **

Whilethe substantial majority of our revenues at our German subsidiary are derivedfrom the sale of radioisotopes, we have had difficulty in the United Stateswith our ability to enter the radioisotope market.  The difficulty arises from the fact that ourpotential customers have long established relationships with their suppliers(who are mostly foreign) and as a result they are hesitant to change.  While we continue to work towards increasingour share in the domestic radioisotope market to a meaningful number, we canoffer no assurances that we will be able to do so.

** **

Thesubstantial majority of our domestic isotope product sales result from the saleof oxygen-18.  Our sales volume continuesto increase, but because the per-unit price of oxygen-18 has been decreasing asa result of increasing competition, we have not been able to increase totalsales revenue in this market.  As aresult, in order to increase our revenues from the sale of oxygen-18, we willneed to increase our volume at a rate greater than the continuing decreases inthe anticipated future market price for that product.  While the market for oxygen-18 in the UnitedStates continues to expand, it appears that the supply for oxygen-18 may begrowing at an even faster rate, which will continue to depress the price ofoxygen-18.  We are actively bidding tobecome the supplier for additional customers and while we hope that we will besuccessful in increasing our gross revenues and margin in sales of oxygen-18 inthe future  (notwithstanding thedecreasing per-unit margins), we can offer no assurance that we will be able todo so in the face of the domestic and international competition in this market.

 

18

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Theincrease in revenues from international isotope product sales for the three andsix months ended October 31, 2004 was primarily the result of a significantincrease in sales of radioisotopes.

** **

Ingeneral, our German subsidiary has had difficulty entering the oxygen-18 marketin Europe as many of  its potentialcustomers are under long-term supply contracts with their current suppliers andthe market is relatively flat (unlike the United States where the volume ofsales (although not the per-unit price) is growing at a significant rate).  The quality of our product is high but wemust wait until our potential customers’ current supply agreements terminate beforewe will be able to bid on new supply contracts. Our ability to significantly increase the revenues in our Germansubsidiary (and ultimately its gross margin) is directly related to howsuccessful we can be in gaining market share in the European oxygen-18market.  While we anticipate that we willcontinue to obtain European oxygen-18 customers in fiscal year 2005 (we haveobtained two new customers as of December 10, 2004), the process is expected tobe slow and we cannot provide any assurance that we will be able to do so.

** **

Theincrease in revenues from semiconductor materials and products sales for thethree and six months ended October 31, 2004 was primarily due to the additionalrevenues generated from the business and assets acquired from EMG in June2004.  In addition, although revenuesincreased as a result of the acquisition of the EMG business and assets, theincrease was not as large as we had anticipated (due mainly to theunavailability of a key production tool, which has since been corrected).  Included in revenues for the six months endedOctober 31, 2003 was $200,000 related to the sale of silicon-28 as a bulkisotope; no comparable transaction in silicon-28 was included in revenues forthe six months ended October 31, 2004 and we do not anticipate any significantsales of silicon-28 during the remainder of fiscal 2005.

** **

As aresult of our acquisition of the business and assets of EMG in June 2004, webelieved we had the platform to not only continue and improve the EMG legacymanufacturing and reclamation of silicon wafers business but also to launch afull scale SOI operation.  While wecontinue to expand our SOI operations, the implementation of our integrationplan related to the manufacturing and reclamation of silicon wafer business hasnot achieved the anticipated results.  Asdiscussed above, we are considering all available strategic options and whileit is currently unclear as to what impact any of these decisions may have onfuture revenues from our semiconductor materials and products segment, if weelect to scale back our silicon wafer reclamation operations, it is probablethat revenues from this line of business will decrease.

** **

We donot anticipate significant revenues from sales of silicon-28 based productsduring the remainder of fiscal year 2005. We are collaborating with academia and industry to evaluate the benefitsof isotopically pure silicon-28.  Webelieve that if evaluations demonstrate the commercial feasibility of one ormore products, demand could emerge in the high-performance microprocessorsegment of the semiconductor market.  Wecan offer no assurance, however that these evaluations will demonstrate thecommercial feasibility of any products, that we will be able to commercializeany such products, or that a market will emerge for any such products.

** **

***Gross Margin***

* *

Ourgross margins decreased during the three and six months ended October 31, 2004as compared to the same periods of our prior fiscal year, both on a dollaramount and on a percentage of revenues as reflected in the following table:

 

19

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** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dollar amount        |       | $                                  | (842,000   | )                                | $          | 473,000 |   | $ | (1,144,000 | ) | $ | 1,028,000 |   |
| Percent of  revenues |       | (27.5                              | )%         | 21.4                             | %          | (21.4 | )% | 22.8 | % |
|                      |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

** **

Thedecrease in gross margin for the three and six months ended October 31, 2004 isdue mainly to the negative margins generated by the business and assetsacquired from EMG in June 2004 and partially by a continuing degradation of theprice of oxygen-18 which resulted in operating losses for our life sciencessegment of ($35,000) for the six months ended October 31, 2004 as compared tooperating income from that segment of $469,000 for the six months ended October31, 2003.

** **

Thedynamics of the oxygen-18 market are changing as customers are electing to moreoften than not forego recyling of used water (which leads to lower grossmarkings for suppliers) and as oxygen-18 prices continue to decrease, weanticipate our margins will continue to decline until we can generate apositive margin for the semiconductor materials and products segment.  As a result of the acquisition of thebusiness and assets of EMG in June 2004, we believed we had the platform to notonly continue and improve the EMG legacy manufacturing and reclamation ofsilicon wafers business but to launch a full scale SOI operation.   While we continue to expand our full-scaleSOI operations, the implementation of our integration plan related to the manufacturingand reclamation of silicon wafer business has not achieved the anticipatedresults.  As discussed above, we areconsidering all available strategic options and while we anticipate that thecourse we ultimately take will significantly reduce operating expenses (andcorrespondingly reduce the negative gross margin) at our semiconductormaterials and products segment, it is currently unclear as to the timing andamount of that reduction.  We cannot,however provide any assurances that we will be able to do so.

** **

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

* *

Ourselling, general and administrative expenses increased during the three and sixmonths ended October 31, 2004 as compared to the same periods of our priorfiscal year, both on a dollar amount and on a percentage of revenues basis asreflected in the following table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dollar amount        |       | $                                  | 1,475,000  |                             | $          | 986,000 |   | $ | 2,821,000 |   | $ | 2,069,000 |   |
| Percent of  revenues |       | 48.1                               | %          | 44.5                             | %          | 52.7 | % | 46.0 | % |
|                      |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

** **

Boththe dollar and percentage increase for the three and six months ended October31, 2004 is attributable primarily to an increase in consulting and otherprofessional services expenses and an increase in headcount and facility costsrelated to the expansion of our SOI operations (primarily due to theacquisition of the business and assets of EMG in June 2004).

** **

As a result of the proceedsgenerated from the financings and exercises of common stock warrants during thesix months ended October 31, 2004 and our acquisition of the business andassets of EMG in June 2004, we anticipate that we will increase our selling,general and administrative expenses during the remainder of fiscal year 2005through anticipated increased marketing efforts for our semiconductor materialsand products segment.  In addition, wewill increase our selling, general and administrative expenses during theremainder of fiscal year 2005 in an effort to market the isotope-based tracedetection technology that we acquired from IUT if products attractive to themarket can be developed and then successfully manufactured

 

20

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using that technology.  There can be no assurance that ouranticipated increased selling, general and administrative expenses will resultin increased revenues from product sales.

** **

***Research and Development Expenses***

** **

Our research and developmentexpenses decreased both on a dollar amount and on a percentage of revenuesbasis during the three months ended October 31, 2004 as compared to the sameperiod in our prior fiscal year.  Ourresearch and development expenses increased both on a dollar amount and on apercentage of revenues basis during the six months ended October 31, 2004 ascompared to the same period in our prior fiscal year as reflected in thefollowing table:

** **
| ** **           | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dollar amount        |       | $                                  | 138,000    |                             | $          | 165,000 |   | $ | 368,000 |   | $ | 230,000 |   |
| Percent of  revenues |       | 4.5                                | %          | 7.5                              | %          | 6.9 | % | 5.1 | % |
|                      |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

** **

Both the dollar and percentagedecrease for the three months ended October 31, 2004 is due to a decrease inresearch and development expenses associated with our thin-film SOI product(and an increase in revenues as it relates to the percentage decrease)partially offset by an increase in research and development expenses associatedwith our isotope-based detection technology. Both the dollar and percentage increase for the six months ended October31, 2004  is primarily related to anincrease in research and development expenses associated with our isotope-baseddetection technology partially offset by a decrease in research and developmentexpenses associated with our thin-film SOI product (and an increase in revenuesas it relates to the percentage decrease).

** **

Consistent with our product development strategy, we areseeking to identify and evaluate new stable and radioactive isotope products,SOI products and potential markets for economic and technical feasibility.  In June 2004, we entered into an agreementwith IUT to fund $275,000 of research and development expenses on behalf ofIUTDT in fiscal 2005 (of which $200,000 has been funded as of December 10,2004) and we anticipate that if we obtain additional financing, we may incuradditional research and development costs associated with the detectiontechnology that we acquired from IUT. We will, in addition, continue fundingresearch and development to improve technologies for isotope separation andmaterial processing technologies and our SOI processes.  Because of the uniqueness of our business,the unique chemicals and processes we deal with and the handling precautionsrequired, these expenses can be significant. We cannot offer any assurance that our current or future lines ofbusiness or products resulting from our research and development efforts willbe profitable or generate significant revenues.

** **

We believe that the development and introduction of newproduct applications is critical to our future success.  We expect that research and developmentexpenses may increase assuming sufficient cash remains available and we areable to procure necessary materials and outside services.  It is likely that research and developmentexpenditures will continue to vary as a percentage of revenues because of thetiming and amount of future revenues. Except for work being performed on ourSOI thin-film product at our facilities in Vancouver, Washington, we operate noother facilities of our own for research and development.  All other research and development work isperformed by outside entities, none of which we control.  None of the companies that currently performresearch and development work for us does so on an exclusive basis.

 

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

** **

Other income (expense), netdecreased during the three months ended October 31, 2004 as compared to thesame period of our prior fiscal year. Other income (expense), net remained flat during the six months endedOctober 31, 2004 as compared to the same period of our prior fiscal year, asreflected in the following table:

** **
| ** **    | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **    | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dollar amount |       | $                                  | (13,000    | )                                | $          | (9,000 | ) | $ | (7,000 | ) | $ | (7,000 | ) |
|               |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

** **

Forthe three and six months ended October 31, 2004 and 2003, other income(expense), net includes interest income and expense and foreign currency gainsand losses.

** **

***Income Taxes***

* *

We currently operate at a lossand expect to operate at a loss until the products currently under developmentbegin to generate sufficient revenue. The losses we anticipate incurring during the remaining portion of thecurrent year are not expected to generate an income tax benefit because of theuncertainty of the realization of the deferred tax asset.  As such, we have also provided a valuationallowance against our net deferred tax asset as realization is uncertain.

** **

***Net Loss***

* *

Our net losses increased duringthe three and six months ended October 31, 2004 as compared to the same periodsof our prior fiscal year, as reflected in the following table:

** **
| ** **    | ** ** | **Three months ended October 31,** | ** ** | **Six months ended October 31,** | ** ** |
|---------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **    | ** ** | **2004**                           | ** ** | **2003**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dollar amount |       | $                                  | (2,468,000 | )                                | $          | (687,000 | ) | $ | (4,340,000 | ) | $ | (1,278,000 | ) |
|               |            |                                    |            |                                  |            |  |  |  |  |  |  |  |  |

** **

We anticipate that losses willcontinue until (if ever): (i) revenues from our current operations (includingour newly acquired assets from EMG) substantially increase or (ii) we generatesubstantial revenues from products introduced as a result of our research anddevelopment projects.  We expect that ournet loss will continue during at least the short term as we continue toincorporate and integrate the business and assets acquired from EMG into ouroperations, as we continue our marketing and research efforts to expand salesand develop new products in our life sciences segment and as we continueresearch and development efforts to commercialize the NeutroTest technology forthe homeland security market.

** **

In accordance with the issuanceof our Series E Stock (see *PrivatePlacement)*, we determined that the value of the beneficialconversion feature (based upon a $1.24 conversion price) to be $1,206,000,which has been reported as a deemed dividend for the three and six months endedOctober 31, 2004.  As a result, the netloss attributable to common stockholders was $3,674,000 and $5,546,000 for thethree and six months ended October 31, 2004, respectively.

 

22

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Net income in future years willbe dependent upon our ability to increase net revenues (and related margins)faster than we increase our operating expenses. As a result of our acquisitionof the business and assets of EMG in June 2004, we believed we had the platformto not only continue and improve the EMG legacy manufacturing and reclamationof silicon wafers business but to launch a full scale SOI operation.  While we continue to expand our SOIoperations, the implementation of our integration plan related to themanufacturing and reclamation of silicon wafer business has not achieved theanticipated results.  As discussed above,we are considering all available strategic options and while we anticipate thatthe course we ultimately take will significantly reduce operating expenses (andcorrespondingly reduce the net loss) at our semiconductor materials andproducts segment, it is currently unclear as to the timing and amount of thatreduction. We anticipate that our operations during the remainder offiscal year 2005 will result in a loss since we are not likely to increase ourrevenues from our existing products or generate additional sales from the newproducts we may develop in a sufficient amount (if at all) to offset ouroperating expenses.

** **

***Liquidity andCapital Resources***

* *

Our working capital and liquidityincreased during the six months ended October 31, 2004 due to the privateplacement completed in October 2004 whereby we received $3,300,000 ($3,049,000net of due diligence fees and related expenses) and the exercise of commonstock warrants whereby we received $5,428,000 . Working capital increased$1,659,000, to $6,391,000 at October 31, 2004, from $4,732,000, at April 30,2004.

** **

Our principal source of fundingfor the six months ended October 31, 2004 was from the private placementcompleted in October 2004 and from the exercise of common stock warrants.  Our principal source of funding for the sixmonths ended October 31, 2003 was from a private placement completed inSeptember 2003.  We used cash inoperating activities of $4,965,000 and $1,320,000 during the six months endedOctober 31, 2004 and 2003, respectively. Cash used in operating activities for the six months ended October 31,2004 and 2003 was principally the result of a net loss during the quarters of$4,340,000 and $1,278,000, respectively.

** **

As a significant portion of ourrevenues and accounts receivable are derived from a small concentration ofcustomers (see *Significant Customers*),if one or more of these customers were to discontinue or reduce their purchasesof our isotope products or fail to pay our accounts receivable, the resultcould have a material effect on both our revenues and related cash flows.

** **

Our investing activities usedcash of $566,000 and $4,000 for the six months ended October 31, 2004 and 2003,respectively.  Cash used in investingactivities for the six months ended October 31, 2004 and 2003,  resulted primarily from purchases of propertyand equipment.

** **

Financing activities providedcash of $8,464,000 and $1,060,000 for the six months ended October 31, 2004 and2003, respectively.   Cash provided byfinancing activities for the six months ended October 31, 2004 resultedprimarily from the private placement completed in October 2004 whereby wereceived $3,300,000 ($3,049,000 net of due diligence fees and related expenses)and the exercise of common stock warrants whereby we received $5,428,000.  Cash provided by financing activities for thesix months ended October 31, 2003 resulted primarily from the private placementof $1,200,000 ($1,080,000 net of placement fees) completed in September 2003.

** **

At October 31, 2004, we had$6,624,000 of cash and cash equivalents, an increase of  $2,933,000, compared to $3,691,000, at April30, 2004.

 

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On June 11, 2004, we acquired thesilicon wafer manufacturing and recycling assets of EMG.  The aggregate purchase price was $2,920,000which consisted of a $1,700,000 promissory note (secured by the assets acquiredand certain other assets owned by us relating to our SOI business) payable over33 months with an interest rate of 6%, 731,930 shares of our restricted commonstock (valued at $1,171,000 based upon the fair market value of the commonstock on June 11, 2004) and $49,000 of legal and accounting fees.  In addition, we assumed operating leases(that expire in various years through fiscal year 2011) with future commitmentsof approximately $1,200,000.

** **

There are provisions associatedwith the Series A Convertible Preferred Stock (“Series A Stock”) that iftriggered, would reduce the current conversion price and effectively allow thepreferred shares to convert to common stock at a more favorable ratio.  The Series A Stock is convertible at twoshares of common stock for each share of Series A Stock outstanding.  During the six months ended October 31, 2004,957,000 shares of Series A Stock were converted into 1,914,000 shares of commonstock.  As of December 10, 2004, therewere 6,666 shares of Series A Stock outstanding convertible into 13,332 sharesof common stock based upon the current conversion ratio.

** **

As of October 31, 2004, we had commitments outstanding forcapital expenditures of approximately $1,600,000.

 

On October 7, 2004, weestablished HSDC, a wholly owned Delaware corporation to consolidate ourefforts in the homeland security market. In connection with the establishment of HSDC, we created an advisoryboard, which provides guidance and advice to HSDC in matters of technology,business and applications as we develop technologies and products for thehomeland security marketplace.  InNovember 2004 we issued 300,000 common stock warrants (valued at $669,000 usingthe Black-Scholes pricing model) to three newly hired advisory boardmembers.  The common stock warrantsvested immediately, are exercisable at $4.00 per share, expire on November 1,2007 and will be expensed to selling, general and administrative expensesduring our third fiscal quarter.

 

On December 2, 2004, we enteredinto a non-binding letter of intent to acquire Protection Plus, aninternational provider of advanced security and investigative services.  The letter of intent contemplates a purchaseprice of 1,000,000 shares of restricted common stock and a contingent amountconsisting of 500,000 common stock warrants exercisable at $4.00 pershare.  The common stock warrants may beearned in the future by meeting predetermined future earnings goals.  The closing of this proposed transaction issubject to standard due diligence procedures and closing conditions.

 

At the present time, our working capital is primarily dependenton financing received from accredited investors.  In general, we expect that our workingcapital will decrease over time as we continue to use our capital and cashflows from revenues for operations, research and development, and investingactivities. We do not expect working capital to increase from activities otherthan our financing activities until (if ever) we are able to increase ourrevenues to exceed our cash out-flows (assuming we are able to increase ourrevenues) or complete a financing arrangement. As a result of the privateplacement completed in October 2004 whereby we received $3,300,000 ($3,049,000net of due diligence fees and related expenses) and the exercise of commonstock warrants whereby we received $5,428,000 during the six months endedOctober 31, 2004, we have sufficient cash available to fund our working capitalrequirements into our 2006 fiscal year.

 

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***ContractualCash Obligations***

* *

We have no material changes tothe disclosure on this matter made in our Annual Report on Form 10-KSB for theyear ended April 30, 2004.

** **

***CriticalAccounting Estimates***

* *

We consider an accounting estimate to be critical if 1) theaccounting estimate requires us to make assumptions about matters that werehighly uncertain at the time the accounting estimate was made, and 2) changesin the estimate that are reasonably likely to occur from period to period, oruse of different estimates that we reasonably could have used in the currentperiod, would have a material impact on our financial condition or results ofoperations.

** **

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

** **

*Goodwill andIntangible Assets*

** **

Effective May 1, 2002 we adoptedSFAS No. 142 *Goodwill and Other IntangibleAssets.*  SFAS No. 142addresses the methods used to amortize intangible assets and to assessimpairment of those assets, including goodwill resulting from businesscombinations accounted for under the purchase method.  Although we adopted SFAS No. 142 effectiveMay 1, 2002, goodwill and intangible assets other than goodwill acquired afterJune 30, 2001 have been amortized or not amortized in accordance with SFAS142.  We acquired intangible assets fromSilicon Evolution, Inc. (“SEI”), IUT and EMG subsequent to June 30, 2001, andhave accounted for those assets in accordance with the requirements of SFAS No.142.  Included in our assets at October31, 2004, is goodwill related to the acquisition of Chemotrade in 1998 and thebusiness and assets of EMG in June 2004 with a net carrying value of $1,807,000and $447,000, respectively.

** **

In accordance with SFAS No. 142,we have completed our annual impairment test (as of April 30, 2004) on our lifesciences reporting unit, which has recorded goodwill.  In completing our analysis of the lifesciences reporting unit, we used the Discounted Cash Flow Method (“DCF Method”)in which the reporting unit was valued by discounting the projected cash flowsto its present value based upon a risk adjusted discount rate.  As a result of the testing, we determinedthat there is no impairment of goodwill. We are required to assess goodwill for impairment at least annually, orwhen circumstances indicate that impairment may have occurred.  We expect to complete our annual impairmenttest on our semiconductor materials and products reporting unit as of April 30,2005 (unless circumstances suggest the need for earlier testing).

** **

In performing the calculationunder SFAS No. 142, we made several assumptions, including the use of the DCFMethod, the number of years used in the projection, the discount rate andgrowth assumptions.  If we had elected touse different variables, the outcome of the calculation could have beendifferent.

** **

We utilized the DCF Method inorder to calculate the fair value of our life sciences reporting unit.  We had the option to utilize the marketcapitalization method but given the complexity of our business, we determinedthat we couldn’t reasonably bifurcate the market value of the life sciencesreporting unit from our other operations based upon our market value as awhole.  In utilizing the DCF method, webased our calculation over a conservative six-year life with no projectedgrowth over the final four years.  Thefinal four years were kept constant in order to ensure that we did notoverestimate the potential of the reporting unit.  The six-year life was utilized as a result ofthe fact that the life sciences reporting unit has been selling

 

25

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isotopes for over sixteen yearsand that demand for isotopes is projected to increase over the next tenyears.  Given the history of the reportingunit and the projected future of the industry, we determined that it wasreasonable to utilize a six-year life. Had we utilized a life of less than six years, the calculation may havesuggested that impairment was present. In addition, we discounted the projected cash flows at a rate of12%.  The 12% was deemed reasonable giventhe current low market interest rate and the extremely low risk of the lifesciences business offset by the higher cost of capital for a small company andthe related difficulties we have had in raising necessary capital over theyears.  Had we utilized a discount ratethat was substantially larger than 12%, the calculation may have suggested thatimpairment was present.

** **

Our intangible assets result fromthe perpetual, exclusive technology license agreement with SEI that we enteredinto on September 14, 2001, the isotope-based trace detection technology weacquired from IUT in December 2002 and customer lists associated with theacquisition of the business and assets of EMG in June 2004.  We initially determined that the intangibleassets acquired from SEI had an indefinite useful life as they were not boundby any legal time periods or otherwise limited due to competing technologiesand, therefore in accordance with SFAS No. 142 they were not amortized butrather tested annually for impairment. During the year ended April 30, 2003, upon further evaluation of theuses and applications of the acquired technology and the advancement of the developmentof our SOI business plan, we determined that the intangible assets no longerhad an indefinite life and as a result, the assets are now being amortized overtheir estimated useful life of ten years. The isotope-based trace detection technology is also being amortizedover its estimated useful life of ten years (which is based upon many factorsincluding the time it will take to develop the technology, the expected life ofthe finalized product(s) and the estimated lives of similar products) while thecustomer list is being amortized over its estimated useful life of three years..  We will continue to evaluate eachreporting period whether events and circumstances continue to support ourassessment of useful lives for these intangible assets.  Additionally, if indicators of impairment do arisein the future, the intangible assets will be tested for impairment and mayresult in an impairment charge in the future.

** **

*Valuation ofEquity Transactions*

** **

We value transactions associatedwith common or preferred stock that is convertible into common stock based onthe market value of the underlying common stock on the date of the signing ofthe agreement.  We value transactionsassociated with common stock warrants at the appropriate measurement dateutilizing the Black-Scholes pricing model, with assumptions as to volatility(100%), risk-free interest rate (4.0%) and estimated life of the warrants basedon historical information.  If theassumptions used, as they relate to volatility, risk-free interest rate andestimated life of the warrants, were materially different, the overallvaluation of these transactions could change significantly.

 

26

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**Item 3****: Controls and Procedures**

 

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

** **

Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatinformation required to be disclosed in our reports filed or submitted underthe Securities Exchange Act is recorded, processed, summarized and reported,within the time periods specified in the Securities and Exchange Commission’srules and forms.  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 management, including ourprincipal executive officer and our principal financial officer, as appropriate,to allow timely decisions regarding required disclosure.

 

PART II

OTHER INFORMATION

 

**Item 2: UnregisteredSales of Equity Securities and Use of Proceeds**

 

**Exercise of Common Stock Warrants**

** **

During the six months ended October 31, 2004, we issued 4,328,500shares of common stock as a result of the exercise of common stock warrants (atan average exercise price of approximately $1.25 per share).  All of the shares of common stock issued uponexercise of warrants were included in outstanding registration statements.

 

**Conversion of Preferred Stock**

 

During the six months endedOctober 31, 2004, we issued 1,914,000, 947,368 and 2,540,908 shares of commonstock as the result of the conversion of 957,000, 9,000 and 27,950 shares ofour Series A, C and D Convertible Preferred Stock, respectively.

 

**Acquisition of Business and Assets of EMG**

** **

On June11, 2004, we issued 731,930 shares of our restricted common stock to EMG aspartial consideration for the completion of the transaction describedabove.  EMG represented that it, and itstwo equity holders, were accredited investors. The following sets forth the information required by Item 701 inconnection with that transaction:

** **

(a)           The transaction was completed effective June 11, 2004.

** **

(b)           There was no placement agent or underwriter for thetransaction.

** **

(c)           The shares were not sold for cash.  The shares were issued in partialconsideration for the purchase by our wholly-owned subsidiary of assets asdescribed above.  At the time the numberof shares was calculated, the market price of our stock was approximately $1.06per share.

** **

(d)           We relied on the exemption from registration provided bySections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction.  We did not engage in anypublic advertising or general 

 

27

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solicitation in connection withthis transaction.  We provided theaccredited investor with disclosure of all aspects of our business, includingproviding the accredited investor with our reports filed with the Securitiesand Exchange Commission, our press releases, access to our auditors, and otherfinancial, business, and corporate information. Based on our investigation, we believe that the accredited investorobtained all information regarding Isonics it requested, received answers toall questions it posed, and otherwise understood the risks of accepting oursecurities for investment purposes.

** **

(e)           The common stock issued in this transaction are notconvertible or exchangeable.  No warrantswere issued in this transaction.  We didgrant the holder certain registration rights, including piggy-back registrationrights for the shares issued, and the right to demand registration if theshares have not been registered before December 11, 2004.

** **

(f)            We received no cash proceeds from the issuance of theshares.

** **

**Series E Convertible Preferred Stock**

** **

OnOctober 4, 2004, we issued 33,000 shares of our Series E Stock and 614,000common stock warrants to a single, offshore, accredited investor in exchangefor its investment of $3,300,000.  Inaddition, we paid a due diligence fee of $231,000 and reimbursement of $20,000in expenses, and (after our own expenses) received net proceeds of $3,049,000.  The accredited investor is AMI of Dublin,Ireland.  The following sets forth theinformation required by Item 701 in connection with that transaction:

** **

(a)           The transaction was completed effective October 4,2004.   We issued 33,000 shares of ourSeries E Stock and 614,000 common stock warrants to one offshore, accreditedinvestor.

** **

(b)           There was no placement agent or underwriter for thetransaction.

** **

(c)           The total offering price was $3,300,000.  No underwriting discounts or commissions werepaid.  We paid a fee of $231,000 to AMIas a due diligence fee and paid its legal expenses of $20,000.

** **

(d)           We relied on the exemption from registration provided bySections 4(2) and 4(6) under the Securities Act of 1933 for this transaction,as well as Regulation D and Regulation S. We did not engage in any public advertising or general solicitation inconnection with this transaction. We provided the accredited investor withdisclosure of all aspects of our business, including providing the accreditedinvestor with our reports filed with the Securities and Exchange Commission,our press releases, access to our auditors, and other financial, business, andcorporate information.  Based on ourinvestigation, we believe that the accredited investor obtained all informationregarding Isonics it requested, received answers to all questions it posed, andotherwise understood the risks of accepting our securities for investmentpurposes.

** **

(e)           The Series E Stock bears a dividend of 8% per annum ($8.00per share per year), payable in cash, in arrears, monthly, commencing October4, 2004 (and payable at each month end). The dividend obligation terminates after one year or earlier if theSeries E Stock is converted to common stock.

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The Series E Stock has aliquidation preference of $100 per share plus any accrued but unpaid dividends.

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The Series E Stock is convertibleinto common stock at a price equal to 75% of Market Price on the conversiondate, but at a price no higher than $1.24 per share (the “Ceiling Price”) andno lower than $1.00 per share (the “Floor Price”).  (The conversion price ratio was reduced from85% because we were unable to meet our obligation to register the underlyingshares of common stock) For purposes of determining the Conversion Price, the “Market Price”**shall be the average of the lowest three intra-daytrading prices of Isonics’ common stock (which need not occur on consecutivetrading days) during the 5 trading days immediately preceding the conversiondate.  The 5 trading day period shall beextended by the number of trading days during such period on which

 

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(i) tradingin Isonics’ common stock is suspended by, or not traded on, the OTC BulletinBoard or a subsequent market on which the common stock is then traded, or

** **

(ii) afterthe date of Registration Statement (the “Registration Statement”) for theunderlying shares of common stock of the Corporation into which the Series EPreferred Stock may be converted is declared effective by the SEC, theprospectus included in the Registration Statement may not be used by the holderfor resale of underlying shares of common stock, is suspended by, or not tradedon, the NASDAQ Small Cap or a subsequent market on which the common stock isthen listed, or

** **

(iii) afterthe date the Registration Statement is declared effective by the SEC, theprospectus included in the Registration Statement for the underlying shares maynot be used by the holder for the resale of underlying shares of common stock(provided such inability to use the prospectus is not (a) caused by the holderor (b) as a result of Isonics’ filing of post-effective amendments to theRegistration Statement.)

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Each common stock warrant isexercisable to purchase one share of common stock through October 4, 2007.  One-half (307,000) of the common stockwarrants have an exercise price of $1.24 per share; the remaining one-half ofthe common stock warrants have an exercise price of $1.35 per share.  (At the time we reached agreement for thetransaction on September 30, 2004, the market price for our stock was $1.31 pershare and the twenty-day average closing price of our common stock ending atthe close of market on September 30, 2004, was $1.27 per share.)

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We have an obligation to registerthe shares underlying the Series E Stock and the common stock warrants, includingthe obligation to file a registration statement by November 7, 2004 and toobtain effectiveness of the registration statement within 70 days after thefiling of the registration statement.  Weare currently in default of our obligation and as a result, we are incurring apenalty of $2,000 per day until the registration statement is filed.

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(f)            We will use the proceeds for continued development ofNeutroTest and other expenses related to our Homeland Security division, in oursemiconductor division, for new product development in our life sciencesdivision, and for general corporate purposes.

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**Item 6: Exhibits**

 

(a)                                  Exhibits.

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31.Certification pursuant to Sarbanes-Oxley Section 302

32.Certification pursuant to 18 U.S.C. Section 1350

 

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**SIGNATURES**

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Pursuant to the requirements of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized, in the City of Golden, County ofJefferson, State of Colorado, on the 15th day of December 2004.

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

 

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