**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-Q**

(**Mark One)**

**x****                             ****Quarterly report pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934**

**For the quarterly period ended July 31, 2006**

**or**

o**                                 ****Transitionreport pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

**For the transition period from               to               **

**Commissionfile number:  001-12531**

**ISONICS CORPORATION**

(Exact name of registrantas specified in its charter)

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

 

**5906 McIntyre StreetGolden, Colorado 80403**

(Address of principal executive offices with zip code)

**(303)279-7900**

(Registrant’s telephone number, including area code)

**N/A**

(Former name, former address and formerfiscal year, if changed since last report)

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

Indicate by check mark whether the Registrant is a large acceleratedfiler, an accelerated filer or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.
| Large accelerated  filer o | Accelerated  filer o | Non-accelerated  filer x |
|---------------------------------|---------------------------|--------------------------|

 

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

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

| Class                             | ** ** | **Outstanding at September 12, 2006** |
|-----------------------------------|------------|---------------------------------------|
| Common Stock —  no par value |       | 46,654,899  shares                    |

 

 

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**IsonicsCorporation and Subsidiaries**

**TABLE OF CONTENTS**
| Part I:    | Financial  Information |   |                                                                                                |
|------------|------------------------|--------|-----------------------------------------------------------------------------------------------------|
|       | Item 1:                |   | Financial  Statements                                                                               |   |   |
|       |                   |   | Condensed  Consolidated Balance Sheets as of July 31, 2006 and April 30, 2006                       |   |   |
|       |                   |   | Condensed  Consolidated Statements of Operations for the Three Months Ended July 31,  2006 and 2005 |   |   |
|       |                   |   | Condensed  Consolidated Statements of Cash Flows for the Three Months Ended July 31,  2006 and 2005 |   |   |
|       |                   |   | Notes  to Condensed Consolidated Financial Statements                                               |   |   |
|       | Item 2:                |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations         |   |   |
|       | Item 3:                |   | Quantitative  and Qualitative Disclosures About Market Risk                                         |   |   |
|       | Item 4:                |   | Controls and  Procedures                                                                            |   |   |
| Part II:   | Other Information      |   |                                                                                                |
|       | Item 1:                |   | Legal Proceedings                                                                                   |   |   |
|       | Item 1A:               |   | Risk  Factors                                                                                       |   |   |
|       | Item 2:                |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                        |   |   |
|       | Item 6:                |   | Exhibits                                                                                            |   |   |
| Signatures |                   |   |

2

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**PartI: Financial Information**

**Item 1: FinancialStatements**

**IsonicsCorporation and Subsidiaries**

**CONDENSEDCONSOLIDATED BALANCE SHEETS(in thousands, except share amounts)**

**ASSETS**
| ** **                                                             | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **July 31, 2006** | ** ** | **April 30, 2006** | ** ** |
| CURRENT ASSETS:                                                        |       |                        |       |                         |       |
| Cash and cash equivalents                                              |       | $                           | 5,977      |                         | $          | 2,117 |   |
| Accounts receivable (net of allowances of $173 and  $67, respectively) |       | 3,821                       |       | 3,410                        |       |
| Inventories                                                            |       | 1,196                       |       | 1,077                        |       |
| Prepaid expenses and other current assets                              |       | 960                         |       | 1,142                        |       |
| Assets held for sale                                                   |       | 225                         |       | 560                          |       |
| Total current assets                                                   |       | 12,179                      |       | 8,306                        |       |
|                                                                   |       |                        |       |                         |       |
| LONG-TERM  ASSETS:                                                     |       |                        |       |                         |       |
| Property and equipment, net                                            |       | 5,042                       |       | 4,854                        |       |
| Goodwill                                                               |       | 3,631                       |       | 3,631                        |       |
| Intangible assets, net                                                 |       | 444                         |       | 491                          |       |
| Equity in net assets of investee                                       |       | 298                         |       | 386                          |       |
| Other assets                                                           |       | 811                         |       | 195                          |       |
| Total long-term assets                                                 |       | 10,226                      |       | 9,557                        |       |
|                                                                   |       |                        |       |                         |       |
| TOTAL ASSETS                                                           |       | $                           | 22,405     |                         | $          | 17,863 |   |

 

**LIABILITIES ANDSTOCKHOLDERS’ EQUITY**
| ** **                                                                                                                                                              | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                              | ** ** | **July 31, 2006** | ** ** | **April 30, 2006** | ** ** |
| CURRENT  LIABILITIES:                                                                                                                                                   |       |                        |       |                         |       |
| Accounts payable                                                                                                                                                        |       | $                           | 1,584      |                         | $          | 2,175 |   |
| Accrued liabilities                                                                                                                                                     |       | 2,030                       |       | 1,606                        |       |
| Derivative liabilities                                                                                                                                                  |       | 5,984                       |       | —                       |       |
| Current portion of obligation under capital lease                                                                                                                       |       | 14                          |       | 14                           |       |
| Current portion of notes payable                                                                                                                                        |       | 749                         |       | 786                          |       |
| Current portion of convertible debentures, net of  discount                                                                                                             |       | 5,603                       |       | 10,432                       |       |
| Total current liabilities                                                                                                                                               |       | 15,964                      |       | 15,013                       |       |
|                                                                                                                                                                    |       |                        |       |                         |       |
| Obligation under  capital lease, net of current portion                                                                                                                 |       | 30                          |       | 34                           |       |
| Notes payable,  net of current portion                                                                                                                                  |       | 139                         |       | 173                          |       |
|                                                                                                                                                                    |       |                        |       |                         |       |
| TOTAL  LIABILITIES                                                                                                                                                      |       | 16,133                      |       | 15,220                       |       |
|                                                                                                                                                                    |       |                        |       |                         |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                             |       |                        |       |                         |       |
| Common stock - no par value; shares authorized:  75,000,000; 46,358,044 and 42,071,119 shares issued and outstanding on July  31, 2006 and April 30, 2006, respectively |       | 61,717                      |       | 57,061                       |       |
| Additional paid in capital                                                                                                                                              |       | 15,244                      |       | 13,910                       |       |
| Deferred compensation                                                                                                                                                   |       | (13                         | )          | (24                          | )          |
| Accumulated deficit                                                                                                                                                     |       | (70,676                     | )          | (68,304                      | )          |
| Total stockholders’ equity                                                                                                                                         |       | 6,272                       |       | 2,643                        |       |
|                                                                                                                                                                    |       |                        |       |                         |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                        |       | $                           | 22,405     |                         | $          | 17,863 |   |

 

See notes to condensedconsolidated financial statements.

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**IsonicsCorporation and Subsidiaries**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(in thousands, except per share data)(Unaudited)**
| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **July 31,**                | ** ** |
| ** **                                                              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Revenues                                                                |       | $                                | 7,402      |   | $ | 5,074 |   |
| Cost of revenues                                                        |       | 6,011                            |       | 5,218 |   |
| Gross margin                                                            |       | 1,391                            |       | (144 | ) |
|                                                                    |       |                             |       |   |   |
| Operating  expenses:                                                    |       |                             |       |   |   |
| Selling, general and administrative                                     |       | 3,877                            |       | 2,732 |   |
| Impairment loss on assets held for sale                                 |       | —                           |       | 398 |   |
| Research and development                                                |       | 1,436                            |       | 454 |   |
| Total operating expenses                                                |       | 5,313                            |       | 3,584 |   |
|                                                                    |       |                             |       |   |   |
| Operating loss                                                          |       | (3,922                           | )          | (3,728 | ) |
|                                                                    |       |                             |       |   |   |
| Other income  (expense):                                                |       |                             |       |   |   |
| Amortization of debt issuance costs                                     |       | (115                             | )          | (245 | ) |
| Interest and other income                                               |       | 41                               |       | 118 |   |
| Interest expense                                                        |       | (651                             | )          | (1,317 | ) |
| Foreign exchange                                                        |       | 5                                |       | — |   |
| Gain on extinguishment of debt                                          |       | 227                              |       | — |   |
| Gain on derivative instruments                                          |       | 2,131                            |       | — |   |
| Equity in net loss of investee                                          |       | (88                              | )          | — |   |
| Total other income (expense), net                                       |       | 1,550                            |       | (1,444 | ) |
| Loss before  income taxes                                               |       | (2,372                           | )          | (5,172 | ) |
| Income tax  expense                                                     |       | —                           |       | — |   |
| NET LOSS                                                                |       | $                                | (2,372     | ) | $ | (5,172 | ) |
|                                                                    |       |                             |       |   |   |
| DIVIDEND ON  SERIES E CONVERTIBLE PREFERRED STOCK                       |       | $                                | —     |   | $ | (66 | ) |
|                                                                    |       |                             |       |   |   |
| NET LOSS  ATTRIBUTABLE TO COMMON STOCKHOLDERS                           |       | $                                | (2,372     | ) | $ | (5,238 | ) |
|                                                                    |       |                             |       |   |   |
| **Net  loss per share—basic and diluted**                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net loss per  share attributable to common stockholders                 |       | $                                | (.05       | ) | $ | (.18 | ) |
| Weighted average common  shares used in computing per share information |       | 45,470                           |       | 28,468 |   |

 

See notes to condensedconsolidated financial statements.

4

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**IsonicsCorporation and Subsidiaries**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands, except share amounts)(Unaudited)**
| ** **                                                                                                     | ** ** | **Three Months Ended  July 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| ** **                                                                                                     | ** ** | ** **                                      | ** ** | ** ** | ** ** |
| Net cash used in  operating activities                                                                         |       | $                                               | (3,411     | ) | $ | (5,240 | ) |
|                                                                                                           |       |                                            |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                         |       |                                            |       |   |   |
| Purchases of property and equipment                                                                            |       | (360                                            | )          | (725 | ) |
| Equity investment in a business                                                                                |       | (100                                            | )          | — |   |
| Acquisition of business, net of cash acquired                                                                  |       | —                                          |       | (2,495 | ) |
| Cash used in investing activities                                                                              |       | (460                                            | )          | (3,220 | ) |
|                                                                                                           |       |                                            |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                         |       |                                            |       |   |   |
| Principal payments under capital lease obligations                                                             |       | (3                                              | )          | (17 | ) |
| Principal payments on borrowings                                                                               |       | (4,551                                          | )          | (193 | ) |
| Proceeds from issuance of common stock                                                                         |       | 15                                              |       | 296 |   |
| Proceeds from the issuance of convertible debentures  and related warrants, net of certain offering costs |       | 12,270                                          |       | — |   |
| Preferred stock dividends                                                                                      |       | —                                          |       | (66 | ) |
| Cash provided by financing activities                                                                          |       | 7,731                                           |       | 20 |   |
|                                                                                                           |       |                                            |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                          |       | 3,860                                           |       | (8,440 | ) |
| Cash and cash equivalents at beginning of period                                                               |       | 2,117                                           |       | 21,206 |   |
| Cash and cash equivalents at end of period                                                                     |       | $                                               | 5,977      |   | $ | 12,766 |   |
|                                                                                                           |       |                                            |       |   |   |
|                                                                                                           |       |                                            |       |   |   |
| Supplemental  disclosure of cash flow information:                                                             |       |                                            |       |   |   |
| Cash paid during the period for:                                                                               |       |                                            |       |   |   |
| Interest                                                                                                       |       | $                                               | 70         |   | $ | 486 |   |
| Income taxes                                                                                                   |       | $                                               | —     |   | $ | — |   |
|                                                                                                           |       |                                            |       |   |   |
| Supplemental  disclosure of noncash investing and financing Activities:                                        |       |                                            |       |   |   |
| Accruals for property and equipment                                                                            |       | $                                               | 245        |   | $ | 92 |   |
| Capitalized debt issuance costs associated with  issuance of common stock in a financing transaction           |       | $                                               | 601        |   | $ | — |   |
| Payment in common stock of principal due on  convertible debentures                                            |       | 3,943                                           |       | — |   |
| Stock issued in  connection with an acquisition                                                                |       | $                                               | —     |   | $ | 1,292 |   |

 

During the three monthsended July 31, 2005, we issued 10,000 shares of common stock in a cashlessexercise of a common stock warrant and issued 1,927,565 shares of common stockupon conversion of convertible preferred stock.

See notes to condensedconsolidated financial statements.

5

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**IsonicsCorporation and Subsidiaries**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 - BASIS OFPRESENTATION**

The accompanying unaudited condensed consolidatedfinancial statements of Isonics Corporation and Subsidiaries have been preparedon the same basis as the annual audited financial statements and in accordancewith accounting principles generally accepted in the United States (“US GAAP”)for interim financial information and the rules and regulations of theSecurities and Exchange Commission (“SEC”) for interim financialstatements.  In the opinion ofmanagement, such unaudited information includes all adjustments (consistingonly of normal recurring accruals) necessary for a fair presentation of thisinterim information.  Operating resultsand cash flows for interim periods are not necessarily indicative of resultsthat can be expected for the entire year. The information included in this report should be read in conjunctionwith our audited financial statements and notes thereto included in our AnnualReport on Form 10-KSB for the year ended April 30, 2006.

We incurred significant losses from operations for thefiscal periods presented and, as of July 31, 2006, have a working capitaldeficit of $(3,785,000).  Additionally,barring a restructuring of our company, it is likely that we will continue toincur operating losses throughout the remainder of fiscal year 2007 as wecontinue to fund research and development of new and existing products andcover operating costs.  Should losses begreater than anticipated, we may encounter liquidity problems which couldrequire us to curtail development projects, seek joint venture partners, sellassets and/or obtain additional financing with terms that may not be asfavorable as might otherwise be available. However, we raised additional financing (see Note 8), through long-termconvertible debentures with a single investor, in the amount of$13,000,000.  That investor has committedan additional $3,000,000 pending the successful registration with the SEC ofthe securities underlying the convertible debentures issued.  We believe that based on our financialposition at July 31, 2006, the subsequent financing (including the additional$3 million commitment by the investor) and our projections of futureoperations, we will be able to continue operations into fiscal year 2008.

**NOTE 2 -SIGNIFICANT ACCOUNTING POLICIES**

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

Basic net income (loss) per share is computed usingthe weighted average number of common shares outstanding during theperiod.  Contingently issuable shares areincluded in the computation of basic net income (loss) per share when therelated conditions are satisfied.  Dilutednet income (loss) per share is computed using the weighted average number ofcommon shares and potentially dilutive securities outstanding during theperiod.  Potentially dilutive securitiesconsist of contingently issuable shares, the incremental common shares issuableupon conversion of convertible debt (using the “if converted” method) andshares issuable upon the exercise of stock options and warrants (using the “treasurystock” method).  Potentially dilutivesecurities are excluded from the computation if their effect is anti-dilutive.

As of July 31, 2006, (a) a total of 23,161,042outstanding stock options and common stock warrants and (b) the unissued sharesunderlying our outstanding 6% and 8% convertible debentures were excluded fromthe diluted net loss per share calculation, as their inclusion would beanti-dilutive.  As of July 31, 2005, (a) a total of 7,968,157outstanding stock options and commonstock warrants, (b) 6,666 and 10,000 outstanding shares of Series A and E Convertible Preferred Stock,respectively, and (c) the unissued shares underlying our outstanding 8%convertible debentures were excluded from the diluted net loss per sharecalculation, as their inclusion would be anti-dilutive.

During the three month period ended July 31, 2006, weissued the following shares of common stock:

6

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| Description                                                                          | ** ** | **Number of Common Stock Shares** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Balance as of April 30,  2006                                                        |       | 42,071,119                                            |       |
| Shares issued from  employee stock purchase plan                                     |       | 13,227                                                |       |
| Shares issued in  payment of principal and interest on the 8% convertible debentures |       | 3,613,698                                             |       |
| Shares issued related  to the 6% convertible debenture financing                     |       | 660,000                                               |       |
| Balance as of July 31, 2006                                                          |       | 46,358,044                                            |       |

 

The aforementioned equity transactionsincreased common stock in the accompanying condensed consolidated balancesheets by $4,656,000 for thethree months ended July 31, 2006.

***RecentlyIssued Accounting Standards***

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004) *Share-Based Payments*(“SFAS123(R)”).  This statement requires thatwe record all share-based payment expense in our financial statements based ona fair value methodology.   Additionally,in March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107),which summarizes the staff’s views regarding share-based payment arrangementsfor public companies.  We selected theBlack-Scholes option-pricing model as the most appropriate fair-value methodfor our awards and will recognize compensation cost on a straight-line basis overour awards’ vesting periods. We adopted SFAS 123(R) commencing May 1, 2006. SeeNote 6 for further detail.

In September 2005, theFASB staff reported that the Emerging Issues Task Force (“EITF”) postponedfurther deliberations on Issue No. 05-04 *TheEffect of a Liquidated Damages Clause on a Freestanding Financial InstrumentSubject to Issue No. 00-19* (“EITF 05-04”) pending the FASB reachinga conclusion as to whether a registration rights agreement meets the definitionof a derivative instrument.  The legalagreements related to both our 8% convertible debentures and 6% convertibledebentures include a freestanding registration rights agreement.  Once the FASB concludes the standard settingprocess regarding this issue, we will assess the impact on our consolidatedfinancial statements of adopting the standard and, if an impact exists, followthe transition guidance for implementation.

In July 2006, the FASBissued Interpretation No.48, **Accountingfor Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109****(“FIN48”).  This interpretation clarifies theapplication of SFAS 109 by defining a criterion than an individual tax positionmust meet for any part of the benefit of that position to be recognized in anenterprise’s financial statements and also provides guidance on measurement,derecognition, classification, interest and penalties, accounting in interimperiods and disclosure.  FIN 48 iseffective for our fiscal year commencing May 1, 2007. **At this time,we have not completed our review and assessment of the impact of adoption ofFIN 48.

**NOTE 3 — FINANCIALSTATEMENT COMPONENTS**

***Inventories***

Inventories consist of the following (in thousands):
| ** **             | ** ** | **July 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Finished goods         |       | $                           | 656        |                         | $          | 604 |   |
| Work in process        |       | 51                          |       | 40                           |       |
| Materials and supplies |       | 489                         |       | 433                          |       |
| Total inventories      |       | $                           | 1,196      |                         | $          | 1,077 |   |

 

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***Property and equipment***

Property andequipment consist of the following (in thousands):
|                                            | ** ** | **July 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Office furniture and  equipment            |       | $                           | 361        |                         | $          | 322 |   |
| Production equipment                       |       | 6,092                       |       | 5,941                        |       |
| Vehicles                                   |       | 191                         |       | 175                          |       |
| Construction in process                    |       | 956                         |       | 608                          |       |
| Leasehold improvements                     |       | 653                         |       | 653                          |       |
|                                       |       | 8,253                       |       | 7,699                        |       |
| Accumulated  depreciation and amortization |       | (3,211                      | )          | (2,845                       | )          |
| Total property and  equipment, net         |       | $                           | 5,042      |                         | $          | 4,854 |   |

 

**NOTE 4 —SEGMENTINFORMATION**

We currently have fourreportable segments: homeland security products, security services,semiconductor products and services and life sciences.  Our homeland security products segment iscurrently marketing and developing certain trace and bulk detectiontechnologies.  Our security servicessegment provides advanced security and investigative services and issubstantially comprised of the operations of Protection Plus SecurityCorporation (“PPSC”) which was acquired in May 2005.  Our semiconductor products and servicessegment manufactures and reclaims silicon wafers, sells silicon-on-insulator (“SOI”)wafers and is involved in several research and development projects includingsilicon-28.  Our life sciences segmentsells stable and radioisotopes in elemental and simple compound forms for usein life sciences applications.  Oursegments are strategic business units, each of which consists of similarproducts or services.  They are managedseparately because each segment requires different technology and marketingstrategy and because each segment sells to different customers.  Reconciling items consist primarily ofcorporate assets or expenses that have not been allocated to a specificreportable segment.  Prior period amountshave been reclassified to conform to current period presentation.

Information by segment is set forth below (in thousands):
|                                          | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **July 31,**                | ** ** |
| ** **                               | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Segment revenues from  external sources: |       |                             |       |   |   |
| Homeland  security products              |       | $                                | —     |   | $ | 35 |   |
| Security  services                       |       | 3,877                            |       | 2,637 |   |
| Semiconductor  products and services     |       | 2,909                            |       | 805 |   |
| Life sciences                            |       | 616                              |       | 1,597 |   |
| Total                                    |       | $                                | 7,402      |   | $ | 5,074 |   |
|                                     |       |                             |       |   |   |
| Segment operating  (loss) income         |       |                             |       |   |   |
| Homeland  security products              |       | $                                | (1,114     | ) | $ | (502 | ) |
| Security  services                       |       | (274                             | )          | 110 |   |
| Semiconductor  products and services     |       | (199                             | )          | (2,054 | ) |
| Life sciences                            |       | 31                               |       | (149 | ) |
| Reconciling  amounts (1)                 |       | (2,366                           | )          | (1,133 | ) |
| Total                                    |       | $                                | (3,922     | ) | $ | (3,728 | ) |

 
|                                      | ** ** | **July 31,** | ** ** | **April 30,** | ** ** |
|--------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                           | ** ** | **2006**          | ** ** | **2006**           | ** ** |
| Total assets:                        |       |              |       |               |       |
| Homeland  security products          |       | $                 | 706        |               | $          | 800 |   |
| Security  services                   |       | 6,050             |       | 5,992              |       |
| Semiconductor  products and services |       | 7,761             |       | 7,027              |       |
| Life sciences                        |       | 1,669             |       | 1,713              |       |
| Reconciling  amounts (2)             |       | 6,219             |       | 2,331              |       |
| Total                                |       | $                 | 22,405     |               | $          | 17,863 |   |

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(1)Reconcilingamounts for the operating (loss) income information includes corporate expensesconsisting primarily of payments to Lucent under our development agreement,corporate salaries and benefits, professional and consulting fees, investorrelations costs, warrant amendment expense, insurance and directors’compensation.

(2)Reconcilingamounts for the total asset information includes corporate assets consistingprimarily of cash and cash equivalents invested centrally, unamortized debtissuance costs and miscellaneous prepaid items.

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**NOTE 5—INVESTMENT IN ISCON VIDEO IMAGING, INC.**

ISCONVideo Imaging, Inc. (“ISCON”) is a company that is attempting to developpatent-pending infrared imaging-based technologies for the non-invasivedetection of objects hidden under clothing as well as technology for thedetermination of the chemical composition of such objects to identifyexplosives and narcotics.  On May 12,2006, we signed a stock purchase agreement with ISCON that provides us theoption, but not the obligation, to purchase authorized but unissued shares ofSeries B common stock from ISCON at five intervals based on successfulcompletion of developmental and commercial milestones.  If ISCON succeeds in meeting all fivemilestones and if we choose to exercise our option to purchase shares for eachcompleted milestone, we would own 51% of ISCON for a cumulative investment of$1,750,000.  On June 9, 2006, we made ourfirst investment in the amount of $100,000, which is being accounted for usingthe cost method.  We have not made anysubsequent investment in ISCON.  As aresult, we currently own approximately 9% of ISCON.

**NOTE 6 —STOCK-BASED COMPENSATION**

On May 1, 2006, weadopted the provisions of SFAS 123(R), requiring us to recognize expenserelated to the fair value of our stock-based compensation awards.  We elected to use the modified prospectivetransition method as permitted by SFAS 123(R) and therefore have not restatedour financial results for prior periods. Under this transition method, stock-based compensation expense for thethree months ended July 31, 2006, includes compensation expense for allstock-based compensation awards granted prior to, but not yet vested as of May1, 2006, based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS 123. Stock-based compensation expense for all stock-based compensation awardsgranted subsequent to May 1, 2006, was based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123(R).  We recognize compensation expense for stock optionawards on a straight-line basis over the requisite service period of the award.

Options currently grantedto employees generally expire ten years from the grant date and vest over athree year period, with 25% of the stock option vesting immediately and 25%vesting on the anniversary

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date of the grant datefor each of the subsequent three years. Options currently granted to external members of our board of directorsgenerally expire five years from the grant date and vest immediately.  As of July 31, 2006, we have 1,986,000 sharesissuable under the 2005 Stock Option Plan. The Directors’ Stock Option Plan does not have an explicit cap as to thenumber of shares issuable under the plan. It is our current policy to issue new shares out of our authorized butunissued shares upon exercise of a stock option by a holder.

The following table setsforth the total stock-based compensation expense resulting from stock optionsincluded in our condensed consolidated statements of operations (in thousands):
|                                                           | ** ** | **Three Months**       | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                | ** ** | **Ended**                   | ** ** |
| ** **                                                | ** ** | **July 31, 2006** | ** ** |
| Cost of revenues                                          |       | $                           | 33         |   |
| Selling, general and  administrative                      |       | 324                         |       |
| Research and  development                                 |       | 3                           |       |
| Stock-based  compensation expense before income taxes     |       | 360                         |       |
| Income tax benefit                                        |       | —                      |       |
| Total stock-based compensation expense after income taxes |       | $                           | 360        |   |

 

Net cash proceeds fromthe exercise of stock options were $0 and $93,000 for the three months endedJuly 31, 2006 and 2005, respectively.  Inaccordance with SFAS 123(R), we present excess tax benefits from the exerciseof stock options, if any, as financing cash flows rather than operating cashflows.  We have not realized excess taxbenefits in any period presented.  Therewas no share-based compensation cost capitalized as part of an asset as of July31, 2006.

We previously accountedfor awards granted under our equity incentive plans under the intrinsic valuemethod prescribed by Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*and related interpretations, as permitted bySFAS No. 123 *Accounting for Stock-BasedCompensation* (“SFAS 123”),as amended by SFAS No. 148 *Accounting for Stock-basedCompensation — Transition and Disclosure,*and provided pro forma disclosure required by those statements, as ifthe fair value based method defined in SFAS 123 had been applied.* *The exercise price of stock options grantedwas equal to the market price of our common stock on date of grant.  Accordingly, no share-based compensation,other than for instruments issued to outside parties for services, wasrecognized in our condensed consolidated financial statements in priorperiods.  The following tableillustrates the effect on net loss attributable to common stockholders and netloss per share attributable to common stockholders if we had applied the fairvalue recognition provisions of SFAS No. 123 to stock-based compensation (inthousands, except per share data):
|                                                                                                                                      | ** ** | **Three Months**       | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                           | ** ** | **Ended**                   | ** ** |
| ** **                                                                                                                           | ** ** | **July 31, 2005** | ** ** |
| Net loss attributable  to common stockholders, as reported                                                                           |       | $                           | (5,238     | ) |
| Add: stock-based compensation costs included in reported net  loss, net of related tax effects                                  |       | 10                          |       |
| Deduct: total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (229                        | )          |
| Adjusted net loss  attributable to common stockholders                                                                               |       | $                           | (5,457     | ) |
| Net loss per share  attributable to common stockholders                                                                              |       |                        |       |
| Basic and  diluted — as reported                                                                                                |       | $                           | (.18       | ) |
| Basic and diluted —  adjusted                                                                                                   |       | $                           | (.19       | ) |

 

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Share-based compensationrecognized in the three months ended July 31, 2006, as a result of the adoptionof SFAS 123(R) as well as pro forma disclosures according to the originalprovisions of SFAS 123 for periods prior to the adoption of SFAS 123(R) use theBlack-Scholes option pricing model for estimating fair value of options grantedunder our equity incentive plans.  Thefollowing table sets out the weighted-average assumptions used for calculatingthe fair value of our options for the three months ended July 31, 2006 and2005, respectively:
|                           | ** ** | **Three Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **July 31,**                | ** ** |
| ** **                | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Expected life  (in years) |       | 5.75                             |       | 3.0 |   |
| Interest rate             |       | 5.01                             | %          | 4.0 | % |
| Volatility                |       | 85                               | %          | 100 | % |
| Dividend yield            |       | —                           |       | — |   |

 

Expected volatility isbased on historical volatility for a period at least equal to the expected lifeof the option under evaluation.  Theexpected life of an option is calculated using the simplified calculation ofexpected life, described in the SAB No. 107. The interest rate is based on the U.S. Treasury yield curve in effect atthe time of grant.

Stock option activity forthe three months ended July 31, 2006, is as follows:
|                                 | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|---------------------------------|------------|--------------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **                      | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** **         | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares**         | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
| Outstanding, April 30,  2006    |       | 2,933,932          |       | $            | 2.12       |            |       |          |       |   |
| Granted                         |       | 849,000            |       | $            | 1.15       |            |       |          |       |   |
| Exercised                       |       | —             |       | $            | —     |            |       |          |       |   |
| Forfeitures or  expirations     |       | (21,000            | )          | $            | 2.46       |            |       |          |       |   |
|                            |       |               |       |         |       |            |       |          |       |
| Outstanding, July 31,  2006     |       | 3,761,932          |       | $            | 1.90       |            | 6.8        |          | $          | — |   |
|                            |       |               |       |         |       |            |       |          |       |
| Exercisable, July 31,  2006     |       | 2,200,932          |       | $            | 1.82       |            | 5.1        |          | $          | — |   |
|                            |       |               |       |         |       |            |       |          |       |
| Expected to vest, July 31, 2006 |       | 1,316,775          |       | $            | 2.12       |            | 9.2        |          | $          | — |   |

 

The aggregate intrinsicvalue in the table above represents the total pretax intrinsic value (i.e. thedifference between our closing stock price on July 31, 2006, and the exerciseprice, times the number of shares) that would have been received by the optionholders had all option holders exercised their options on July 31, 2006.  This amount changes based on the fair marketvalue of our common stock.  Total

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intrinsic value ofoptions exercised is $0 and $194,000 for the three months ended July 31, 2006and 2005, respectively.

The weighted averagegrant-date fair value of options granted in the three months ended July 31,2006 and 2005, were $.84 and $1.99, respectively.  As of July 31, 2006, $1,928,000 of totalunrecognized compensation cost related to stock options is expected to berecognized over a weighted-average period of 1.6 years.

**NOTE 7 — EQUITYINSTRUMENTS ISSUED FOR SERVICES**

In May 2006, we entered into a financialadvisory services agreement with Clayton Dunning Capital Partners, Inc.,whereby we issued a common stock warrant (valued at $28,000 using the Black-Scholes pricing model) to purchase50,000 shares of common stock at $1.05 per share.  The common stock warrant vested immediately,expires on May 17, 2008, and was recorded as prepaid consulting expense, to beamortized ratably over the expected service period of four months.  During the three months ended July 31, 2006,$21,000 was expensed to selling, general and administrative expenses.

**NOTE 8 — BORROWINGS**

***8% Convertible Debentures***

On May 18, 2006, we made an offer to the holders ofour outstanding 8% convertible debentures (the “8% Debentures”) to pay in cashthe principal balance remaining immediately subsequent to making the monthlypayment scheduled June 1, 2006, plus a 5% premium and accrued interest, bothitems to also be paid in cash.  On May 19, 2006, approximately $5.0 millionout of the then-outstanding $8.2 million 8% Debentures accepted our offer.  The offer was made and accepted contingentupon the cash payment being made to the accepting holders on or before June 1,2006, from the proceeds of a financing that we were then working to completeand which is discussed below.   Inaccepting our offer, the holders agreed to limit the anti-dilution provision ontheir warrants originally issued with their debentures such that the warrants wouldfully ratchet based upon the financing completed on May 31, 2006, and then theratchet would be converted to a price-only ratchet whereby the exercise pricewould still be reduced to the effective price per share (or effective exerciseprice per share) of the subsequent equity sale but where the number of sharespurchasable under the warrant would be fixed. The holders also agreed to waive certain provisions of the SecuritiesPurchase Agreement entered into concurrently with the 8% Debentures which relateto entering into a future financing with variable conversion terms (suchcontractual terms we do not believe to be in force).  In accordance with this offer andsubsequently to closing the financing on May 31, 2006, we paid approximately$4.1 million from the proceeds of the financing to the holders accepting ouroffer (such payment was calculated after including the impact on theiroutstanding principal balance of the normal monthly amortization payment madeto them on June 1, 2006).   This paymentresulted in a reduction in the principal balance of the 8% Debentures of$3,880,000.

In accounting for the offer and subsequent payment,we allocated between three components the $4.1 million paid to certain holdersof the 8% Debentures:  the interest dueat the time of payment, the amendment to the terms of certain outstandingwarrants and the principal reduction of the 8% Debentures.  We recorded an expense in the amount of$357,000 (included in selling, general and administrative expenses) related tothe amendment to the terms of certain outstanding warrants originally issuedwith the 8% Debentures, such charge representing the decrease in the fair valueof the amended warrants as compared to the fair value of the warrantsimmediately prior to amendment.  Werecorded a gain in the amount of $227,000 on the extinguishment of debt(included as a line item in other income (expense)), such amount calculated asthe difference between the reacquisition price and the net carrying amount ofthe

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extinguished debt, which bore a nominal principalamount of $3,880,000.  Additionally, wewrote off capitalized debt issuance cost related to the extinguished debt inthe amount of $44,000 (included in amortization of debt issuance costs).

As a result of entering the financing transactiondiscussed below, which includes a fixed conversion price of $1.25, the warrantsassociated with the 8% Debentures were amended per the warrant such that thewarrant exercise price was reduced from $6.25 per share of common stock to$1.25 per share of common stock. Simultaneously, the number of shares purchasable under the warrantsincreased from 1,593,900 to 7,969,500. Due to our offer made on May 18, 2006, to the holders of the 8%Debentures and the acceptance of the offer by certain holders, of the currentlyoutstanding warrants associated with the 8% Debentures, warrants to purchase4,557,000 shares of common stock have a price ratchet only whereby no change tothe number of shares purchasable will occur and warrants to purchase 3,412,500shares of common stock continue to retain the original ratchet provisions.

Upon issuance of the financing transaction discussedbelow, which has a variable pricing component, we reevaluated theclassification of the aforementioned 3,412,500 warrants originally issued withthe 8% Debentures and which still contain a full ratchet provision.  We evaluated the warrants in accordance withthe provisions of SFAS No. 133 *Accountingfor Derivative Instruments and Hedging Activities*(“SFAS 133”) andEITF Issue No. 00-19 *Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock* (“EITF 00-19”) which provide guidance, amongother topics, as to whether equity or derivative liability classification isappropriate for freestanding warrants. Because of the issuance of the variable rate financing, we no longerhave control over the ratchet of the fully ratcheting warrants.  Therefore, there is a possibility (and perEITF 00-19, we are not allowed to consider in our evaluation the likelihood ofsuch an event occurring) that the number of shares issuable related to thewarrant could exceed our authorized but unissued shares if the warrant were toratchet to a sufficiently low exercise price. If we did not have sufficient authorized but unissued shares to satisfythe number of shares issuable under the warrant if exercised, we may have tonet cash settle a portion or all of the warrant.  Accordingly, we have reclassified theaforementioned warrants from equity to derivative liabilities in the amount of$1,773,000, which represents the estimated fair value of the warrants at thedate of reclassification.  Further, weare required to recognize in earnings at each reporting date the gain or losson our derivative instruments.  Werecorded a gain on derivatives for the three months ended July 31, 2006, in theamount of $486,000, such amount representing the estimated change in fair valueof the warrants between the date the warrants were classified as liabilitiesand July 31, 2006.

Having met all requirements to allow us to do so, weelected to make the monthly principal and interest payments due for our 8%Debentures on May 1, 2006, and June 1, 2006, in shares of our commonstock.  Accordingly, we issued a total of1,616,433 and 1,997,265 shares of common stock, respectively, in settlement of(1) principal amounts owed on the 8% Debentures in the nominal amounts of$1,822,500 and $1,647,500, respectively and (2) interest obligations for themonths of April 2006 and May 2006 in the nominal amounts of $66,500 and$21,250, respectively.  As the paymentswere made in stock in lieu of cash, the fixed monetary amounts of the principaland interest payments will have a larger impact on the condensed consolidatedfinancial statements as compared to the nominal amounts disclosed.  This difference is due to application of thefixed discount applied to the price of our common stock in the calculation ofthe number of common shares due for each principal payment and interest paymentwhen made in shares of our common stock, as defined.  We elected to make our monthly principal andinterest payment due on July 1, 2006 in cash. This payment included a reduction to outstanding principal of $562,000and interest in the amount of  $17,500.

We elected to make our monthly principal andinterest payment due on August 1, 2006 in cash. This payment included a reduction to outstanding principal of $562,000and interest in the amount of  $13,750.

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Having met all requirements to allow us to do so, weelected to make the monthly principal and interest payment due for our 8%Debentures on September 1, 2006, in shares of our common stock.  Accordingly, we issued a total of 296,855shares of common stock in settlement of (1) the principal amount owed on the 8%Debentures in the nominal amount of $250,000 and (2) the interest obligationfor the month of August 2006 in the nominal amount of $10,000.  Subsequent to this payment, the outstandingprincipal balance on the 8% Debentures is $1,250,000.

In June 2006, one of the two remaining holders ofour 8% Debentures, with remaining principal outstanding in the amount of $0 onSeptember 12, 2006, asserted that the issuance of the 6% convertible debentures(see discussion below) constituted a default (due to a potential variableconversion provision contained within the 6% convertible debenture agreement)under the 8% Debentures.  We havecontested that allegation on several bases and will defend against any furtherallegation of default as necessary.  Remedies for an event of default include the option to acceleratepayment of the full principal amount of the debentures, together with interestand other amounts due, to the date of acceleration.  The principal amount of the debentures shallbe equal to 130% of the then-principal amount of the debentures plus all interestand other amounts due or a conversion calculation, whichever is higher.  The holder had approximately $937,000 (andthe other remaining holder had $2,250,000) due on its 8% Debenture at the timewe entered into the 6% convertible debentures.

***6% Convertible Debentures***

On May 31, 2006, we completed a privateplacement pursuant to which we issued to one accredited investor, CornellCapital, L.P. (“Cornell”) a 6% secured convertible debenture with a principalamount of $10,000,000, which is the first of three 6% secured convertibledebentures (cumulatively, the “6% Debentures”), for which the aggregateprincipal amount will be $16,000,000.  OnJune 5, 2006 (two trading days prior to the filing of a registrationstatement contemplated in the transaction documents correlated with the 6%Debentures), we issued the second of the three 6% Debentures. This 6% Debenturehas a principal amount of $3,000,000. The final 6% Debenture with a principal amount of $3,000,000 is scheduledto be issued and funding received two trading days prior to a registrationstatement being declared effective by the SEC. The 6% Debentures are convertible into shares of our common stock at thelesser of $1.25 (the “Fixed Conversion Price”) or 80% of the average of the twolowest daily volume weighted average prices of our stock during the fivetrading days immediately preceding the conversion date (the “Market ConversionPrice”).  The 6% Debentures mature on May31, 2009 (the “Maturity Date”).  Inaddition to the 6% Debentures, we issued three warrants (the “6% DebentureWarrants”) to purchase a total of 8,000,000 shares of our common stock atexercise prices of $1.25 per share (2,000,000 warrants), $1.75 per share(3,000,000 warrants) and $2.00 per share (3,000,000 warrants). Each of thewarrants can be exercised for a period of three years.

The then-effective conversion price will be adjustedupon the occurrence of any stock dividends, stock splits, pro ratadistributions, or fundamental transactions as described in the 6% Debenture agreement.  Additionally, the Fixed Conversion Price willbe reduced if we issue shares of stock or other instruments that areexchangeable into or convertible into common stock at an effective price lessthan the Fixed Conversion Price.  TheFixed Conversion Price will be adjusted to mirror the conversion, exchange orpurchase price at issue.  Our issuanceand exercise of options which are compensatory and pursuant to our stock optionor stock purchase plans will not cause an adjustment under this provision.

Interest accrues on the outstanding principalbalance at the annual rate of 6%. Interest is payable on the Maturity Date in cash or shares of our commonstock, at our option.  If we choose topay accrued interest in shares of our common stock, the number of shares to beissued will be calculated as the amount of interest

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due divided by 88% of the volume weighted averageprice of our common stock for the five trading days preceding the MaturityDate.

The investor and an unaffiliated party provided usservices in connection with completing the transaction. To compensate theseentities for those services, we issued them 660,000 shares of our common stock(the “Buyers Shares”).  We also paidCornell or its affiliates fees in the amount of $735,000 and will pay fromproceeds of the unissued $3 million 6% Debenture an additional $165,000 whenissued.

We have agreed to seek shareholder approval of thistransaction by no later than October 31, 2006, (exclusive of any sharesacquired in this transaction or related transactions), including the ability toissue a maximum of 64 million shares upon conversion of the 6% Debentures andto approve an increase in authorized shares of common stock to at least 175million shares.

The 6% Debentures, the 6% Debenture Warrants and theBuyers Shares have certain limitations on our ability to issue shares to theholders of the instruments and impose certain limitations on Cornell’s abilityto sell shares.

·                  We are prohibited fromissuing shares of our common stock to the holders of the 6% Debentures (uponconversion or payment of interest) and the 6% Debenture Warrants (uponexercise) if the issuance would result in Cornell beneficially owning more than4.99% of our outstanding common stock (although Cornell can waive this provisionupon more than 65 days’ notice to us).

·                  Until (and if) theshareholders approve the transaction as required by Nasdaq rules, the number ofshares issuable upon conversion of the 6% Debentures shall not be greater than6,075,785, which along with the Buyers Shares and the 2,000,000 warrant sharesexercisable at $1.25 represent less than 19.99% of the total number of sharesoutstanding on May 31, 2006.

·                  Cornellis prohibited from selling shares related to the 6% Debentures until the laterof the related registration statement achieving effectiveness or September 28,2006 (120 days subsequent to the issuance of the first 6% Debenture).

·                  BetweenSeptember 29, 2006, and January 26, 2007, if converting using the MarketConversion Price, Cornell is limited to converting no more than $200,000 of theprincipal or accrued interest on the 6% Debentures into shares of our commonstock in any seven calendar day period.  Subsequent to January 26, 2007, if converting using the MarketConversion Price, Cornell is limited to converting no more than $400,000 of theprincipal or accrued interest on the 6% Debentures into shares of our commonstock in any seven calendar day period.

·                  Themaximum number of shares that may be issued upon conversion of the principalamount of the 6% Debentures is contractually limited to 64 million shares.

·                  The6% Debenture Warrants with an exercise price of $1.75 per share (3,000,000 warrants) and$2.00 per share (3,000,000 warrants) are not exercisable until after ourshareholders approve the issuance of these two warrants (as part of the totaltransaction shares, as defined) in a shareholders’ meeting.

If after December 31, 2006, we have insufficientshares authorized but unissued and unreserved to convert principal and payinterest in common stock, our stock is not listed or quoted on a market, wehave not timely satisfied any conversion obligations or the issuance of shareswould violate certain other defined sections of the agreement, the holder has aright to request net cash settlement of the conversion based upon a definedcalculation.

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If there is an effective underlying registrationstatement and if the volume weighted average price of our common stock is equalto or greater than $2.50 for twenty consecutive trading days, we may force Cornellto convert the outstanding principal and any accrued interest, subject to theshare issuance limitations discussed above.

We have the right, after providing ten trading daysadvance written notice, to redeem a portion or all amounts outstanding underthe 6% Debentures prior to the Maturity Date provided the closing bid price ofour common stock is less than $2.50 at the time the redemption notice isprovided.  If we exercise this redemptionright, a redemption premium in the amount of 20% of the principal amount beingredeemed will be due.  During the ten daynotification period, Cornell may elect to convert any portion or all of theoutstanding 6% Debenture amount.

For a period of one year subsequent to entering intothe 6% Debenture agreements on May 31, 2006, we have granted Cornell the rightto participate in any allowed capital raise up to 50% of the raise.  After that one year period expires and untilsuch time no portion of the principal and interest due on the 6% Debentures isoutstanding, we have granted Cornell the right to participate in any allowedcapital raise up to 25% of the raise.

As a result of a freestanding registration rightsagreement, we have an obligation to register the shares underlying the 6%Debentures, Buyers Shares and 6% Debenture Warrants.  We were required to file an initialregistration statement to register 8,735,785 shares of common stock (related tothe Buyers Shares, the 6% Debenture Warrant exercisable for 2,000,000 shares at$1.25 per share and 6,075,785 shares to be issued upon conversion of the 6%Debentures) no later than August 7, 2006 (a registration statement was filed onJune 7, 2006) and to have the initial registration statement declared effectiveby September 28, 2006.  If we fail tomeet our effectiveness deadline, we will incur liquidated damages of onepercent of the outstanding balance of the 6% Debentures for each thirty-dayperiod, prorated by day, subsequent to the date of the deadline missed untilsuch time as the registration statement is declared effective.  Within thirty days of obtaining shareholderapproval to issue in excess of 19.99% of the outstanding shares of ours as ofMay 31, 2006, we must file an amended registration statement to register thefull number of shares required under the 6% Debenture transaction documents(representing the Buyers Shares, shares underlying the 6% Debenture Warrantsand shares upon the conversion of the 6% Debentures based on a defined formulabut in an amount not to exceed 64 million shares).  Additionally, once effectiveness of both theinitial and the amended registration statement is achieved and until such timethat all eligible shares have been sold under the registration statements, ifsales are not able to be made under the registration statement (due to failureto keep the registration statement effective or failure to register sufficientshares or otherwise), Cornell will have recourse to the aforementioned onepercent per thirty day liquidated damages penalty.  We are contractually not obligated to pay liquidateddamages for more than a total of 365 calendar days.  Failure to comply with our registrationobligations may, subsequent to any grace periods and opportunities to cure, bedeemed an event of default.

Additionally, other events, as defined in the 6%Debenture agreement, may also allow the 6% Debenture holders to declare us indefault.  Remedies for an event ofdefault, include the option to accelerate payment of the full principal amountof the Debentures, together with interest and other amounts due, to the date ofacceleration and Cornell will have the right to request such payment in cash orin shares of our common stock.

So long as principal amounts are outstanding underthe 6% Debentures, we have agreed to not sell capital stock or grant securityinterests which meet certain defined characteristics without the prior consentof Cornell.  However, certaintransactions defined as Excluded Securities are exempted from this priorconsent provision.  Excluded Securitiesinclude (1) securities issued in connection with a strategic partnership or

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joint venture, (2) securities issued asconsideration for a merger or consolidation or the acquisition of a business,product, license or other asset of another person or entity, (3) options(priced not less than at the market) provided to employees within the firstthirty days of employment, (4) securities issued pursuant to an approved stockplan, (5) up to 1 million shares (priced not less than market) which may beissued as long as no registration rights are included and as long as notpursuant to a Form S-8 and (6) any other issuances to holders of otherpre-existing securities if such issuances are provided for in the terms of suchinstrument.

The 6% Debenture Warrants are exercisable for cashonly, unless after January 15, 2007, there is no effective underlyingregistration statement, at which point a cashless exercise can be elected bythe holder.  The then-effective warrantexercise price will be adjusted upon the occurrence of any stock dividends,stock splits, pro rata distributions, or fundamental transactions as describedin the 6% Debenture Warrant agreements. Additionally, the exercise price and number of shares upon issuance ofcommon stock are subject to adjustment in cases where we issue shares of commonstock (other than Excluded Securities or issuances in connection with othercomponents of the 6% Debenture documents) for consideration per share less thanthe then-existing warrant exercise price. If an adjustment is triggered, the warrant exercise price for thewarrant for 2,000,000 shares at an exercise price of $1.25 per share and thewarrant for 3,000,000 shares at an exercise price of $1.75 per share will beadjusted to a price determined by multiplying such exercise price by a fractionof which (a) the numerator shall be the number of shares of common stockoutstanding immediately before such issuance plus the number of shares ofcommon stock that the aggregate consideration received by us for such issuancewould purchase at the warrant exercise price then in effect and (b) thedenominator shall be the number of shares of common stock outstandingimmediately prior to such issuance plus the number of new shares to be issuedin the triggering event.  Concurrently,the number of shares issuable upon exercise of the warrant will be adjustedsuch that the aggregate exercise price would be equal to the aggregate exerciseprice prior to adjustment.  The warrantfor 3,000,000 shares exercisable at $2.00 per share has a different adjustmentcalculation whereby a subsequent triggering equity issuance would lead to areduction in the warrant exercise price per share equal to the price per share(of effective exercise price per share) of the subsequent equity issuance.  There would be no change to the number ofshares issuable under the warrant.

The 6% Debentures are secured by individual securityagreements with Isonics Vancouver, Inc. (“IVI”), Isonics Homeland Security and DefenseCorporation (“HSDC”) and PPSC.

We allocated the net proceeds received between the6% Debentures and the related warrants based on the relative fair value of eachinstrument.  The $2,718,000 allocated tothe warrants was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the 6% Debentures.  We evaluated the embedded conversion featurein the 6% Debentures in accordance with the provisions of SFAS 133 and EITF00-19 and concluded that, due to certain provisions which could result in netcash settlement, the feature should be classified as a derivative instrumentand should be recorded as a liability in our condensed consolidated financialstatements.  Accordingly, we recorded theaforementioned embedded conversion feature as a derivative liability in theamount of $6,342,000 (which represents the estimated fair value of the featureat the date the financing was consummated) and as a corresponding reduction inthe carrying value of the 6% Debentures. Further, we are required to recognize in earnings at each reporting datethe gain or loss on our derivative instruments. We recorded a gain on derivatives for the three months ended July 31,2006, in the amount of $1,645,000, such amount representing the estimatedchange in fair value of the embedded conversion feature between the date the financingtransaction was consummated and July 31, 2006.

The cumulative discount on the 6% Debentures(arising from the allocation of a portion of the proceeds to the relatedwarrants and the classification of the embedded conversion feature as aderivative liability) is being amortized to interest expense over the term ofthe 6% Debentures using the effective interest method

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at an effective interest rate of 49%.  During the three months ended July 31, 2006,$264,000 of this discount was amortized to interest expense.

We capitalized as debt issuance costs the fair valueof the 660,000 Buyers shares (an amount of $601,000) and $28,000 of costsdirectly incurred in consummating the financing and these capitalized costs arebeing amortized to amortization of debt issuance costs over the life of the 6%Debenture using the effective interest method. For the three months ended July 31, 2006, $17,000 of the capitalizeddebt issuance costs was amortized to expense.

**NOTE 9 — COMMITMENTS AND CONTINGENCIES**

As of July 31, 2006, we had commitmentsoutstanding for capital expenditures of approximately $1,600,000.

**NOTE 10 - RELATED PARTYTRANSACTIONS**

In conjunction with theacquisition of PPSC, we retained the services of both the former owners in anemployment relationship.  Subsequent tothe acquisition, PPSC continued to lease premises partially owned by one ofthese individuals.   However, this leasewas terminated effective August 31, 2006.

Wehave a research and development agreement with Institut fur UmwelttechnologienGmbH (“IUT”), an equity method investee of which we own 30%.  We funded $460,000 and $333,000 under thisagreement during the three months ended July 31, 2006 and 2005, respectively(and a total of $2,270,000 since entering into our first research and developmentagreement in June 2004).  All fundedpayments have been included as research and development in the condensedconsolidated statements of operations.

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** **

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

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

***General Discussion***

We are an advanced materials and technology companyfocused on the development and provision of homeland security products and services,the manufacture and reclamation of silicon wafers and the manufacture of SOIwafers to the semiconductor industry, and the supply of isotopes for lifesciences and health-care applications.

On July 10, 2006, we received a letter from Nasdaqthat advised us that the minimum bid price of our common stock had closed atless than $1.00 per share over the previous 30 consecutive business days, and,as a result, did not comply with Marketplace Rule 4310(c)(4). Therefore, inaccordance with Marketplace Rule 4310(c)(8)(D), we were provided 180 calendardays, or until January 8, 2007, to regain compliance with the Rule (whichconsists of the bid price of our common stock closing at $1.00 per share ormore or a minimum of 10 consecutive business days).  If we fail to obtain compliance, as long aswe meet the Nasdaq Capital Market initial listing criteria as set forth inMarketplace Rule 4310(c), except for the bid price requirement, we will begranted an additional 180 calendar days to obtain compliance.  We cannot give any assurance that we will beable to meet the Nasdaq requirements to maintain our Nasdaq Capital Marketlisting, or that if we do, a stable trading market will develop for our stockor our warrants.

As a result of the low market price for our commonstock, our outstanding Class B Warrants and Class C Warrants (both of whichexpire on December 29, 2006) are no longer exercisable pursuant to the existingregistration statement (SEC file no. 333-110032).  We intend to file a post-effective amendmentto that registration statement in the future, but we cannot provide anyassurance that such registration statement will be effective in time for theexercise of the Class B Warrants or the Class C Warrants prior to theirexpiration date, assuming (without assurance) that market conditions recover sothat the warrants are economically exercisable.

Liquidity and Capital Resources

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

Overview

During fiscal year 2006 andthe three months ended July 31, 2006, our revenues were generated from sales ofstable and radioactive isotopes, small and large diameter test and reclaimsilicon wafers, SOI wafers and other semiconductor services.  Additionally, as a result of the acquisitionof PPSC in May 2005, we also generated revenues from providing advanced securityservices for leading businesses and institutions in

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healthcare, education, retail, manufacturing and theart world.  We expect that sales from our semiconductor operations will continue toincrease during the remainder of our 2007 fiscal year due mainly to the growthof our 300-millimeter large-diameter silicon wafer and thinning productlines.  We do not however anticipate anysignificant increases (if at all) in small diameter wafer manufacturing orreclamation services as we are moving capacity away from these products andtowards our other higher-margin products. PPSC has successfully obtained its Government Contract Schedule (“GSASchedule”) for security services.  As aresult, PPSC is actively attempting to acquire federal security contracts, amarket they do not currently serve.  Weare hopeful that PPSC will be successful in acquiring such federal securitycontracts but we can offer no assurances that it will be able to do so.  In addition, we are hopeful that we willbegin to generate revenue from our trace and bulk detection and intelligentdigital video technologies during the remainder of fiscal year 2007.

As evidenced by our homelandsecurity operations and the introduction of new products into our semiconductorproducts and services and life sciences segments, we are attempting to bringour recently developed product lines to market, which we expect to add to ourrevenue stream in the future.  The followingis a more specific discussion of our current operations.

Homeland Security

**In October 2004, we formed a new subsidiary, HSDC,to focus and consolidate our efforts in the homeland security sector and toprovide better visibility to our activities in this area.  These efforts include entry into the securityservices market, acquisition and development of certain trace and bulkdetection technology that can be used to detect various types of explosivesand/or chemical agents, the launch of a collaboration to provide intelligentdigital video solutions and the entry into an agreement with an establishedpartner to develop innovative infrared imaging technology.   HSDC’s ownership includes our 100% interestsin**IUTDetection Technologies, Inc. (“IUTDT”) and PPSC along with our 30% minorityinterest in IUT and 9% minority interest in ISCON.  We previously held an 85% interest in IUTDTuntil April 2006 at which time we acquired the remaining 15% ownership from IUT(along with contractual clarification of ownership of certain trace and bulkdetection technology) in exchange for a royalty in an amount equal to 2% of thenet selling price of existing developed products (based upon the trace and bulkdetection technology previously acquired from IUT in December 2002) that aresold, leased or otherwise put into use by HSDC or any of its affiliatedentities anywhere in the world.  Wepreviously held an 8% interest in IUT until December 1, 2005, at which time weincreased our ownership to 30%.  Thefollowing is a detail of each of our product lines within our homeland securityoperations:

**SecurityServices** - In May 2005, we acquired PPSC, a provider of awide range of security-related services. Since the effective date of the acquisition, PPSC has delivered significantrevenue and gross margin (which was approximately 23% of revenues for the threemonths ended July 31, 2006).   Althoughthe segment generated an operating loss for the three months ended July 31,2006, of $(274,000), this amount is inclusive of amortization ofacquisition-related customer intangibles in the amount of $36,000, stock-basedcompensation expense of $54,000, a write-off of a single customer’s accountsreceivable balance in the amount of $114,000 and also includes incrementalinvestment in personnel specifically focused on selling to the governmentsector of the Unites States.  Further, webelieve that the acquisition of PPSC provides us with a deep source ofknowledge and contacts within the homeland security space and that it iscapable of providing key insight for the development of our next-generationproducts along with successful marketing and sales processes. 

During our fiscal yearended April 30, 2006, PPSC secured over approximately $5,000,000 in cumulativenew contracts for seven private sector customers for security services to beperformed throughout the United States. The contract terms range from one to three years in length.  We expect these new contracts to generateincremental revenue for the remainder of fiscal year 2007 of approximately$1,500,000.  Among the new clients areForbes, Inc. and the National Basketball Association.

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Further, althoughcurrently PPSC does not have any government service contracts, in July 2005PPSC was awarded a GSA Schedule under which PPSC can and has begun to pursuegovernment service contracts.  While webelieve that we will be successful in acquiring government service contractsduring the remainder of fiscal year 2007, we can offer no assurance that wewill be able to do so.

**Detection Technology**– Our efforts are currently focused on twodetection technologies, as follows:

*Ion Mobility Spectroscopy (“IMS”)***–** IMS is a “sniffer” technology originallydeveloped by IUT. During the last three quarters, we ramped up our marketingand sales efforts of EnviroSecureTM, a new system that can monitor and identifychemical weapons and toxic substances in the air in a variety of venuesincluding airports, mass transit facilities, sports venues and public andprivate sector office buildings.  Oursystem is designed to continuously monitor the air and immediately detect andidentify harmful substances at the parts per billion (ppb) level, providingwarning of a possible attack in a matter of minutes.  Earlier generations of this product have beenin continuous use at the German parliament building since 1999, effectivelymonitoring the air for toxic substances and chemical weapons.  This turnkey solution includes system design,engineering, hardware, software, installation, training and maintenance.  It is anticipated that the EnviroSecureTMsystem could be installed in any facility and become fully operational withinthree to nine months, though the time frame will vary depending on the size andcomplexity of each installation.  Whilewe have not yet made any sales of this product, the product is available forsale, and we continue to focus our efforts on marketing and customerengagement.

Throughour ongoing funding of research and development efforts at IUT, we continue toexplore other commercial applications for our IMS technology.  We are currently in the process of taking ourIMS technology and miniaturizing and re-designing it for low-cost, high-volumemanufacturing in the United States and pursuing all regulatory licensesrequired for sales of such products in the United States.

InNovember 2005 we signed a development agreement with DualDraw LLC (“Dual Draw”),a manufacturer of air quality equipment. Under that agreement, we have developed and are testing a prototype thatcombines our IMS based technology with DualDraw’s mailroom inspectionworkstations, a downdraft workstation that keeps toxic substances away from thebreathing zone of mailroom workers who are sorting or opening mail and capturessuch substances with a HEPA filtration system. The incorporation of our IMS capability would provide an alarm if toxicor explosive substances are detected.  Wecompleted a prototype of the product and exhibited that prototype at varioustrade shoes including the 2006 National Postal Forum and ISC West Expo 2006.

Weare also seeking to package our IMS technology in a hand-held “sniffer”designed for military and first responder use.

Althoughwe have not yet made any sales of products incorporating the smaller version ofthe IMS technology, we have received favorable feedback from potentialcustomers.  We have, therefore, placed aninitial order of 100 units with our contract manufacturer for use in themailroom workstation and with the hand-held sniffers.  We expect the first delivery of units fromour manufacturer will be available for commercial sale in the second or thirdquarter of fiscal 2007 (after the completion of certain testing and the receiptof certain regulatory approvals) and while we are confident that we will beginto generate revenue from these IMS based products during the remainder offiscal year 2007, we can offer no assurances that we will be able to do so.

*Neutron based detection* - We have developed a hand-held explosivedetection device named NeutroTestTM.   We had earlier projected thatwe expected to have a NeutroTestä productavailable for international sales in late second calendar quarter and forUnited States sales in the third calendar quarter of 2005, respectively.  As expected, we completed the sale of two,first-generation units to a German entity in June 2005, although we have notcompleted any subsequent sales in Europe or the United States.  Feedback on the performance 

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ofthese two units has been positive and has also included product enhancementrecommendations.  We have taken thefeedback from our initial international sales of the first-generationNeutroTestä and have implemented them into oursecond-generation units, one of which is now available in the United States forcustomer demonstrations and several are available in Germany.  Our marketing plan for the second-generationNeutroTestä product includes targeting potential UnitedStates based customers to which we will demonstrate the value of NeutroTestä.  To facilitate this plan, we have reached anagreement with a third party to establish a fully licensed customerdemonstration and training facility in the United States.

Oneissue that has impeded the sales process is the regulatory and licensingrequirements regarding the neutron-generation source, generally a radioisotope,whereby both our company and the customer must meet certain criteria in orderto possess and use the radioisotope for its intended purpose.  Though we believe the regulatory andlicensing requirements can be met by both, these requirements will likely limitthe customer base for our NeutroTestTM product to government and military entitiesand, possibly, large organizations with the resources to meet the licensingrequirements.  In order to meet the needsof this customer group, the second generation of NeutroTestTM isbeing repackaged into a one piece, more rugged form factor that can bemanufactured in the United States.  Wecan make no assurances that we will be able to successfully mitigate therequirements to the extent required for broad-based market acceptance of theNeutroTestTM product. The development of second-generation functionality, implementation ofthe domestic marketing plan and addressing the existing aforementionedregulatory requirements were the focus of activities to date, and we expect tocontinue these efforts during the second and third quarters of fiscal year2007.

Althoughwe have continued research and development funding of both the IMS andneutron-based detection technologies, we expect that future funding decisionswill place a higher emphasis on IMS-based applications.  We have not made any sales of our NeutroTestTM product after the initial sales made in June2005.

**Intelligent Digital VideoSolutions****–** In February 2006, we entered into anagreement with Intelligent Security Systems, Inc. (“ISS”), a developer ofinnovative video security technology, to offer a range of intelligent videosecurity solutions for the homeland security market.  These solutions integrate proprietarytechnology to provide advanced security applications in addition to standarddigital video monitoring, including facial recognition, iris recognition,object tracking, body tracking, behavior recognition and license platerecognition.  ISS-based videosurveillance solutions have been previously successfully deployed globally inthe homeland security market.  Ourinitial efforts have been focused on marketing and customer engagement.  We have not yet made any sales of thisproduct line.

**InfraredImaging Technology****–**On December 5, 2005, we approved a development planthat resulted in us becoming obligated under a development & licensingagreement (“the Agreement”) entered into with Lucent Technologies, Inc. (“Lucent”)in September 2005.  Under this Agreement,the two companies are attempting to develop a next-generation infrared imagingand night vision surveillance technology based on research by Lucent’s BellLabs micro electro-mechanical systems (“MEMS”) and nanotechnology fabricationfacility.  Infrared technology, whichconverts infrared radiation in the non-visible spectrum, such as body heat,into a visible image, is commonly found in both commercial andmilitary/homeland security applications including night vision goggles andcameras, rifle scopes, and threat detection devices used to identify concealed weaponsor explosives.  The MEMS approach toinfrared imaging, if successful, may lead to products, which are at least equalin performance with a lower power consumption and price than products currentlyavailable in the marketplace today. Additionally, a MEMS-based product may also provide for costefficiencies in the manufacturing process. The development plan contemplates a proof-of-concept within 9-12 months,followed by steps towards commercialization, though we can provide noassurances that a commercially attractive product will ultimately be available.

The Agreement provides for us to receive anexclusive right, except for certain rights reserved by Lucent, to make, use andsell licensed products arising from technology developed under the Agreement.  In exchange 

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for this license, we will fund Lucent’s developmentefforts for the project through the periodic payment over a two and one-halfyear period of a development fee totaling $12,000,000.  We paid $2,000,000 under this agreementduring the year ended April 30, 2006 and paid an additional $1,000,000 in June2006 and an additional $1,333,000 in August 2006. The remaining balance will bepaid in $1,000,000 increments approximately every three months thereafter.  We do not currently have sufficient fundingto meet our payment obligations to Lucent. If we fail to make payments when due, Lucent may cancel the agreement orcease working on the project and then assess us a “start-up” fee if funding wasto resume.  We cannot offer any assurancethat we will be able to make all of the required payments to Lucent, or thatthe technology will be developed to a point where we want to continue to makesuch payments when due.

We have the right to terminate the developmentproject for any reason (including if the development work is not proceeding upto our expectations) from time-to-time, so long as termination is prior to thefirst commercial sale of a licensed product. Additionally, upon the commencement of commercial sales, if ever, wewould be obligated to pay royalties based on revenue, potentially a salesreferral fee based on revenue and also an annual exclusivity payment tomaintain our exclusive rights to the developed technology.  In order to focus the Lucent developmenteffort to best achieve an effective and marketable product, we have commenceddiscussions on a new statement of work to govern the development effort.  Unless we accept a statement of work fromLucent for the infrared project by September 29, 2006, the contract with Lucentwill likely be terminated, and Lucent will be required to reimburse us $900,000of the amount we paid them in August 2006. We continue to work with Lucent to develop an appropriate statement ofwork.

On May 12, 2006, we entered into an agreement withISCON, (a company that is attempting to develop patent-pending infraredimaging-based technologies for the non-invasive detection of objects hiddenunder clothing as well as technology for the determination of the chemicalcomposition of such objects to identify explosives and narcotics) that providesus the option to purchase shares of ISCON common stock based upon thesuccessful completion of developmental and commercial milestones.  If ISCON succeeds in meeting all five milestonesand if we choose to exercise our option to purchase shares for each completedmilestone, we would then own 51% of ISCON for a cumulative investment of$1,750,000.  On June 9, 2006, we made ourfirst investment in the amount of $100,000 for an ownership interest ofapproximately 9%.  We continue toevaluate the technology and the market for such technology and have made nofurther investments in ISCON as of September 12, 2006.

Semiconductor Products and Services

Our semiconductor operations, based in Vancouver,Washington, showed continued operational and financial improvement for the yearended April 30, 2006 and through the three months ended July 31, 2006, thoughstill generating an operating loss and negative cash flow in thoseperiods.   In an effort to reducehistorical negative financial results, in April 2005 we began the process torealign our business to significantly reduce our reliance on low margin smalldiameter products and focus mainly on higher margin 300-millimeter products andservices, wafer thinning and SOI products. The large-diameter wafer segment has become one of the fastest growingsegments of the silicon wafer market and the revenues and gross marginsassociated with the services are greater than those associated with the smalldiameter market.   As a result of our strategicrealignment, revenue from 300-millimeter services comprised approximately 62%of segment revenue for the three months ended July 31, 2006 ($1,780,000 inrevenue), as compared to approximately 36% of segment revenue for the yearended April 30, 2006 ($2,053,000 in revenue) and 1% of segment revenue for thethree months ended July 31, 2005 ($8,000 in revenue).  There has also been a focus on operationalefficiency and effectiveness, which has resulted in increased productivity andprocessing yields.  Further, we continueto gain new customers and are also in the process of attempting to qualify ourproduct at others.

As a result, while the segment generated anoperating loss of $(199,000), which includes stock-based compensation of$55,000, for the three months ended July 31, 2006, this operating loss isapproximately 90% less than the operating loss of $(2,054,000) experienced forthe three months ended July 31, 2005.

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Additionally, the operating loss was reduced eachsequential quarter during fiscal year 2006 and through the three months endedJuly 31, 2006, and it has continued to improve in the second quarter of ourfiscal 2007 year.  We continue to monitorthe situation closely and, while we believe that our realignment of thebusiness has enhanced our chances to reach profitability in the future and thatwe will continue to see improving financial results in the segment, the overallprocess will take time and there are no assurances that if profitability isreached it can be sustained in every period, if at all.

Life Sciences

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

At the present time, our life sciences division isbeing adversely affected by increased domestic and international competition.  The oxygen-18 market continues to be dynamicand volatile.  Established suppliers haveincreased capacity and reputable suppliers have entered the market with acomparable high quality product.  Themarket is currently in a surplus state and we expect it to be so for severalyears to come.  Prices have declined over60% from highs of approximately three years ago.  Our average selling price for oxygen-18 forthe three months ended July 31, 2006, decreased approximately 24% from thatreceived during the same period one year earlier, although the average sellingprice remained consistent as compared to the fourth quarter of our fiscal year2006.  This average selling price islikely in excess of the spot rate in the market due to the advanced pricing agreementswe have with certain customers.  As such,additional price erosion may be expected. In an attempt to offset the degradation of the oxygen-18 market, we havesuccessfully lowered our acquisition price of oxygen-18 and we are expandinginto other areas, such as actinium-225 and indium-111 (through our June 2005joint production and marketing agreement with Central RadiopharmaceuticalServices, Inc. (“CRS”)).  While we don’texpect these isotopes to contribute significantly to our revenues until thethird quarter of our fiscal year ending April 30, 2007, this expansion isindicative of our business goal to broaden revenue beyond the concentrationfound in a few, core products (mainly oxygen-18).

In the prior year, our international radioisotopebusiness also experienced rising supplier prices in a market that is highlyprice-sensitive.  In an effort to reducecosts, we closed our European trading office (Chemotrade) during the secondhalf of fiscal year 2006.  We do notanticipate material, if any, revenue from this business during fiscal year2007.  For our life sciences business inthe aggregate, as with all our reportable segments, we continually monitorbusiness conditions and marketplace changes and evaluate all investment,divestiture and other strategic options.

Our consolidatedrevenues in the future will depend on our success in developing and sellingproducts in the homeland security, semiconductor and stable and radioactiveisotope markets.  Our profitability willbe dependent upon our ability tomanage our costs and to increase our revenues in all of our businesssegments.  However, we can offer noassurance that we will be able to increase our revenue or our profitability.

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

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* *

***Results ofOperations***

The following table sets forth, for the periods indicated, condensedconsolidated statements of operations data expressed as a percentage ofrevenues.  The table and the discussionbelow should be read in conjunction with the condensed consolidated financialstatements and the notes thereto appearing elsewhere in this report.
|                                         | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **July 31,**                | ** ** |
| ** **                              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
|                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenues                                | ** ** | 100.0                            | %          | 100.0 | % |
| Cost of revenues                        | ** ** | 81.2                             |       | 102.8 |   |
| Gross margin                            | ** ** | 18.8                             |       | (2.8 | ) |
|                                    | ** ** |                             |       |   |   |
| Operating  expenses:                    | ** ** |                             |       |   |   |
| Selling, general and administrative     | ** ** | 52.4                             |       | 53.8 |   |
| Impairment loss on assets held for sale | ** ** | —                           |       | 7.8 |   |
| Research and development                | ** ** | 19.4                             |       | 9.0 |   |
| Total operating expenses                | ** ** | 71.8                             |       | 70.6 |   |
| Operating loss                          | ** ** | (53.0                            | )          | (73.4 | ) |
|                                    | ** ** |                             |       |   |   |
| Other income  (expense), net            | ** ** | 21.0                             |       | (28.5 | ) |
| Loss before income  taxes               | ** ** | (32.0                            | )          | (101.9 | ) |
| Income tax  expense                     | ** ** | —                           |       | — |   |
| NET LOSS                                | ** ** | (32.0                            | )%         | (101.9 | )% |

 

***Revenues***

Revenues increased for the three months endedJuly 31, 2006, as compared to the same period of our prior fiscal year.  Revenues from both our security services andsemiconductor products and services segments did reflect an increase duringthese periods as compared to revenues from our life sciences and homelandsecurity products segments which reflected a decrease, as described in thefollowing table:
|                                      | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **July 31,**                | ** ** |
| ** **                           | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Life sciences:                       |       |                             |       |   |   |
| Domestic                             |       | $                                | 616,000    |   | $ | 1,048,000 |   |
| International                        |       | —                           |       | 549,000 |   |
| Total life  sciences                 |       | 616,000                          |       | 1,597,0000 |   |
| Homeland  security products          |       | —                           |       | 35,000 |   |
| Security  services                   |       | 3,877,000                        |       | 2,637,000 |   |
| Semiconductor  products and services |       | 2,909,000                        |       | 805,000 |   |
| Total                                |       | $                                | 7,402,000  |   | $ | 5,074,000 |   |

 

Therevenue for our security services segment is generated by PPSC, a business thatwe acquired in May 2005.  Pro formarevenue for the three months ended July 31, 2005 would have been approximately$3,150,000 if the PPSC acquisition had occurred on the first day of thatquarter.  The increase in revenue from the security services segment for thethree months ended July 31, 2006, was due to the net addition of additionalsecurity services contracts since the acquisition of PPSC.  While we anticipate that we will continue togrow revenue in this segment by securing additional new security contracts inour PPSC

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subsidiary and retaining existing customers undercontract currently with PPSC, we cannot provide any assurance that we will beable to do so.

Our semiconductor products and services segment hasexperienced a rapid increase in revenue during the prior five fiscalquarters.  Revenue for the three monthsended July 31, 2006, was 261% higher than revenue for the three months endedJuly 31, 2005, and 53% higher than revenues for the three months ended April30, 2006.  The increase is predominatelydue to the expansion of sales of higher-margin 300-millimeter products andservices.  Our 300-millimeter businessprovided revenue of $1,780,000 for the three months ended July 31, 2006, ascompared to $813,000 and $8,000 for the three months ended April 30, 2006 and July31, 2005, respectively.  While we believethat continued expanded focus on the 300-millimeter and SOI markets will allowus to continue to increase revenues in the future, we can provide no assurancesthat we will be able to do so.

While we continue to move forward with ourdevelopment program and to pursue the establishment of a low cost supply ofsilicon-28, we did not receive a material amount of revenue in our 2005 or 2006fiscal years or for the three months ended July 31, 2006, and we are not awareof any plans by any company for the introduction of products based onsilicon-28 wafers.  Therefore we do notanticipate any material amount of proceeds from silicon-28 product sales duringthe remainder of fiscal year 2007, although we could respond to customer demandin a relatively short time frame.  Ourgoal ultimately is to profitably (1) license our proprietary technology toother entities and/or (2) sell chemicals required for the production ofepitaxial or bulk silicon-28 wafers and/or (3) produce epitaxial or bulksilicon-28 wafers for resale.  The costsassociated with maintaining this program are not significant.

The decrease in revenue from domestic isotopeproduct sales for the three months ended July 31, 2006, was the result of asignificant decrease in the unit price of our main isotope sold domestically,oxygen-18, combined with a decrease in sales volume of that product.  Our average sales price for oxygen-18 for thethree months ended July 31, 2006 was approximately 24% less than the sameperiod in the prior fiscal year, though relatively consistent with the priorsequential quarter.  This averageselling price is likely in excess of the spot rate in the market due to theadvanced pricing agreements we have with certain customers.  As such, additional price erosion may beexpected.  The supply of oxygen-18 in the market hascontinued to expand, both in the prior fiscal years as well as into the threemonths ended July 31, 2006, which has led to a price-driven market.  Although we have successfullylowered our acquisition price of oxygen-18, we can offer no assurances that we will be ableto expand or maintain our current volume of sales.

In an attempt to offset the degradation of theoxygen-18 market, we have successfully lowered our acquisition price ofoxygen-18 and we are expanding into other areas, such as actinium-225 andindium-111 (through our June 2005 joint production and marketing agreement withCRS).  While we do not expect theseisotopes to contribute significantly to our revenues until the third quarter ofour fiscal year ending April 30, 2007, this expansion is indicative of ourbusiness goal to broaden revenue beyond the concentration found in a few, coreproducts (mainly oxygen-18).  However, wecan offer no assurance that we will be able to increase oxygen-18 revenue orsell additional products in the face of the domestic and internationalcompetition in this market.

Our international radioisotope business has alsoexperienced rising supplier prices in a market that is highlyprice-sensitive.  In an effort to reduce costs,we closed our European trading office (Chemotrade) during the second half offiscal year 2006.  Revenue from ourinternational isotope trading business was $0 for the three months ended July31, 2006, as compared to $549,000 for the three months ended July 31,2005.  We do not anticipate material, ifany, revenue from this business during the remainder of fiscal year 2007.  For our life sciences business in theaggregate, as with all our reportable segments, we continually monitor businessconditions and marketplace changes and evaluate all investment, divestiture andother strategic options.

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Our homeland security products segment has recordedminimal or no revenue for the three months ended July 31, 2006 and 2005.  See the update provided for this segment inthe General Discussion section of this Item 2: Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

Althoughwe have diversified our sources of revenue, we continue to have concentrationsof revenue with certain customers.  Forthe three months ended July 31, 2006, two security services customers accountedfor 15% and 10% of revenues, respectively, and one semiconductor products andservices customer accounted for 23% of revenues as compared to the three monthsended July 31, 2005, in which one security services customer accounted for 19%of revenues.  Significant reductions insales to any of these large customers have had, and may in the future have, anadverse effect by reducing our revenues and our gross margins.  Present or future customers could terminatetheir purchasing patterns with us or significantly change, reduce or delay theamount of products or services ordered from us.

***GrossMargin***

Our gross margin increased for the threemonths ended July 31, 2006, as compared to the same period of our prior fiscalyear, both on a dollar amount and on a percentage of revenues as reflected inthe following table:
|                     | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                   | 1,391,000  |   | $ | (144,000 | ) |
| Percent of revenues |       | 18.8                                                | %          | (2.8 | )% |
|                     |            |                                                     |            |  |  |  |  |

 

The increase in gross margin is due mainly to twofactors:  (1) continued improvement inoperations in our semiconductor products and services segment where there weresignificant improvements to gross margin on a dollar amount and on a percentageof revenues basis and (2) to a lesser extent, improvements in life sciencesmargins on a percentage basis.  Theseincreases were offset by a slight reduction in gross margin percentage in oursecurity services segment.

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

On a percentage of revenue basis, in general weanticipate that the gross margin percentage in our security services segmentwill remain relatively stable.  The grossmargin percentage in our semiconductor products and services segment may be volatilebased upon revenue growth achieved, if any. The gross margin percentage in the life sciences segment is expected toalso be somewhat volatile due to the continued pricing pressure on oxygen-18and on the substantial cessation of sales in the international isotopebusiness.  Lastly, the gross marginpercentage on our homeland security products segment is likely also to bevolatile as well as we attempt to increase revenue in that segment, though wecan offer no assurances that we will be able to do so.

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

Our selling, general and administrative expensesincreased as a dollar amount for the three months ended July 31, 2006, ascompared to the same respective periods of our prior fiscal year.  On a percentage of

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revenues basis, selling, general and administrativeexpenses remained relatively stable, as reflected in the following table:
|                     | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                   | 3,877,000  |   | $ | 2,732,000 |   |
| Percent of revenues |       | 52.4                                                | %          | 53.8 | % |
|                     |            |                                                     |            |  |  |  |  |

 

**The approximate $1,150,000increase in selling, general and administrative expenses for the three monthsended July 31, 2006, compared to the same period in the prior year isattributable to a combination of factors, including:**

·                  approximately $540,000 directly related to PPSC, such increase resultingprimarily from an impact of approximately $100,000 due to the inclusion of lessthan a full quarter of expense being included in the three months ended July31, 2005 (due to the acquisition occurring on May 16, 2005), a write-off of aspecific customer receivable of $114,000 and increased staffing due to thepursuit of government and other commercial contracts for the three months endedJuly 31, 2006;

·                  approximately $300,000 due to increase in staffing and operations in thehomeland security products segment;

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

·                  cumulative noncash charges of $324,000 related to stock-basedcompensation expense associated with our adoption of SFAS 123(R) in the threemonths ended July 31, 2006;

·                  offset by approximately $200,000 in reduced life sciences expense due toscaled back operations in the segment and by approximately $300,000 due to theinclusion in the three months ended July 31, 2005, of a charge related to theextension of the expiration date of certain warrants.

Weanticipate that we will increase our core selling, general and administrativeexpenses during the remainder of fiscal year 2007 through anticipated increasedmarketing efforts for and operations in our homeland security productsoperations and semiconductor products and services segment.  There can be no assurance that ouranticipated increased selling, general and administrative expenses will resultin increased revenues from product sales.

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

Ourimpairment loss on assets held for sale decreased for the three months endedJuly 31, 2006, as compared to the same period of our prior fiscal year, both ona dollar amount and on a percentage of revenues basis as reflected in thefollowing table:

|                     | ** ** | **Three Months Ended July 31,**                              | ** ** |
|---------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **          | ** ** | **      2006      ** | ** ** | **      2005      ** | ** ** |
| Dollar amount       |       | —                                                                           |       | $ | 398,000 |   |
| Percent of revenues |       | —                                                                           |       | 7.8 | % |
|                     |            |                                                                                  |            |  |  |  |

 

During the three months ended July 31, 2005, aspart of a review of our semiconductor products and services segment thatresulted in operational changes, certain equipment was identified as excessivefor our planned future operations.  As aresult, certain of the identified equipment whose book value exceeded estimatednet realizable were individually written down to estimated net realizablevalue, resulting in a cumulative impairment charge of $398,000.  As of July 31, 2006, equipment with a bookvalue of $225,000 remains unsold, but we expect that the equipment will be soldwithin the upcoming year.

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***Researchand Development Expenses***

Our research anddevelopment expenses increased on both a dollar and a percentage of revenuesbasis for the three months ended July 31, 2006, as compared to the same periodof our prior fiscal year, as reflected in the following table:
|                     | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                   | 1,436,000  |   | $ | 454,000 |   |
| Percent of revenues |       | 19.4                                                | %          | 9.0 | % |
|                     |            |                                                     |            |  |  |  |  |

 

The dollar increase for the three months ended July31, 2006, is primarily related to an increase in research and developmentexpenses associated with payments made to Lucent under our infrared imaging andnight vision surveillance technology development & licensing agreement aswell as, to a lesser extent, our trace and bulk detection technology andsemiconductor research and development work related mainly to various SOIprocesses.  Consistent with our productdevelopment strategy, we are seeking to identify and evaluate new products inthe homeland security operations as well as to bring existing technologies,including IMS-based products and NeutroTestTM, toa production-ready state.  A significantamount of this research and development on trace and bulk detection technologyis being performed by IUT and is related to IMS and neutron-based detection.  We funded $460,000 and $333,000 under thisagreement during the three months ended July 31, 2006 and 2005, respectively(and a total of $2,270,000 since entering into our first research anddevelopment agreement in June 2004).

In December 2005, we approved a development plan withLucent that obligated us under a development & licensing agreement.  Under that Agreement, we will endeavor todevelop a next-generation imaging and night vision surveillance technology.  The development plan contemplates a proof-of-conceptwithin 9-12 months followed by steps towards commercialization, although we canprovide no assurances that a commercially attractive product will ultimately beavailable.  For the three months ended July31, 2006, we recorded research and development expense of  $833,000 and we may be obligated to pay anadditional $1,000,000 per quarter in development funding for the next eightquarters.  We have the right to terminatethe development project for any reason from time-to-time, so long as terminationis prior to the first commercial sale of a licensed product.  As such, assuming we continue with thedevelopment program, we expect our quarterly research and development expensefor this purpose to remain elevated. Subsequent to the close of the quarter ending July 31, 2006, we made aquarterly payment to Lucent in the amount of $1,333,000 in August 2006.  In order to focus the Lucent developmenteffort to best achieve an effective and marketable product, we have commenceddiscussions on a new statement of work to govern the development effort.  Unless we accept a statement of work fromLucent for the infrared project by September 29, 2006, the contract with Lucentwill likely be terminated, and Lucent will be required to reimburse us $900,000of the amount we paid them in August 2006. We continue to work with Lucent to develop an appropriate statement ofwork.

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

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***OperatingLoss***

 

Our operatinglosses (in total) increased for the three months ended July 31, 2006, ascompared to the same period of our prior fiscal year as reflected in thefollowing table:
|                                      | ** ** | **Three Months Ended July 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Homeland  security products          |       | $                                                   | (1,114,000 | ) | $ | (502,000 | ) |
| Security  services                   |       | (274,000                                            | )          | 110,000 |   |
| Semiconductor  products and services |       | (199,000                                            | )          | (2,054,000 | ) |
| Life Sciences                        |       | 31,000                                              |       | (149,000 | ) |
| Reconciling  amounts                 |       | (2,366,000                                          | )          | (1,133,000 | ) |
| Total                                |       | $                                                   | (3,922,000 | ) | $ | (3,728,000 | ) |

 

Our homeland security products segment generated asignificant operating loss in an effort to develop and commercialize our traceand bulk detection technology into products that can be used to detect varioustypes of explosives and/or chemical agents and innovative infrared imagingtechnology.  While we generated no revenuein this segment for the three months ended July 31, 2006, we are hopeful thatwe will be able to begin to generate revenue in this segment during our yearending April 30, 2007.

Our security services segment consists of PPSC, whichwas acquired in May 2005.  For the threemonths ended July 31, 2006, the segment delivered significant revenue totaling$3,877,000 and gross margin of approximately 23.4%, as compared to $2,637,000and 26.3% for the three months ended July 31, 2005.  The operating loss for the three months endedJuly 31, 2006, is due primarily to an increase in selling, general andadministrative expenses as compared to the comparable period in the prioryear.  This increase is due to increasedmarketing spending, a write-off of a single customer’s accounts receivablebalance in the amount of $114,000, the inclusion of a $54,000 noncash chargerelated to stock-based compensation expense (due to our adoption of SFAS 123(R)in the three months ended July 31, 2006) and incremental investment in personnel specifically focused on selling tothe government sector of the United States.

Our semiconductor products and services segment showedcontinued operational and financial improvement (due mainly to the realignmentof our business to significantly reduce our reliance on low margin smalldiameter products and focus mainly on higher margin 300-millimeter products andservices, wafer thinning and SOI products) for the three months ended July 31,2006, though still generating an operating loss.  Additionally, the operating loss was reducedeach sequential quarter during fiscal year 2006 and in the three months endedJuly 31, 2006, as reflected in the following table:
|                                      | ** ** | **Semiconductor products  and services  operating loss** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                           | ** ** | ** **                                                              | ** ** |
| Three months  ended July 31, 2005    |       | $                                                                       | (2,054,000 | )(1) |
| Three months  ended October 31, 2005 |       | $                                                                       | (1,420,000 | ) |
| Three months  ended January 31, 2006 |       | $                                                                       | (900,000   | ) |
| Three months  ended April 30, 2006   |       | $                                                                       | (777,000   | ) |
| Three months ended July  31, 2006    |       | $                                                                       | (199,000   | ) |

 

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

Weexpect continued improvement to the operating results of our semiconductorproducts and services segment during the second quarter of our year endingApril 30, 2007.

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Our life sciences segment generated operating incomeof $31,000 for the three months ended July 31, 2006 as compared to an operatingloss of $(149,000) for the comparable period in the prior year.  This segment has undergone significantchanges in the past year and earlier. Due to a large increase in the supply available to the market, werealized a substantial decrease in the average selling price of our mainproduct, oxygen-18, over the last three years. Additionally, during the second half of fiscal year 2006, we closed ourEuropean trading office (Chemotrade) as it was no longer economically viableand we terminated sales activity with the existing customer base.  In anattempt to offset the degradation of the oxygen-18 market, we have successfullylowered our acquisition price of oxygen-18 and we are expanding into otherareas, such as actinium-225 and indium-111 (through our June 2005 jointproduction and marketing agreement with CRS). While we don’t expect these isotopes to contribute significantly to ourrevenues until the third quarter of our fiscal year ending April 30, 2007, thisexpansion is indicative of our business goal to broaden revenue beyond theconcentration found in a few, core products (mainly oxygen-18).

Reconciling amounts for the operating loss informationincludes corporate expenses consisting primarily of payments to Lucent underour development agreement, corporate salaries and benefits, professional andconsulting fees, investor relations costs, warrant amendment expense, insuranceand directors’ compensation.  Theincrease in the reconciling amounts for the three months ended July 31, 2006,as compared to the comparable period in the prior year is due mainly toresearch and development expense related to the Lucent agreement and in theamount of $833,000, along with other various items.

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

Other Income (Expense), net increased on both a dollarand a percentage of revenues basis for the three months ended July 31, 2006, ascompared to the same period of our prior fiscal year as reflected in thefollowing table:
|                     | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                   | 1,550,000  |   | $ | (1,444,000 | ) |
| Percent of revenues |       | 21.0                                                | %          | (28.5 | )% |
|                     |            |                                                     |            |  |  |  |  |

 

The increase for the three months ended July 31, 2006,as compared to the same period in the prior fiscal year resulted primarily fromthree items:  (1) a decrease in interestexpense and amortization of debt issuance costs in the combined amount ofapproximately $800,000, which is reflective of a lower outstanding convertibledebenture balance through the duration of the respective periods, (2) therecording of a gain on extinguishment of debt in the amount of $227,000, whichresulted from the retirement of $3,880,000 in principal amount of  8% Debentures in May 2006 (as discussed inthe Liquidity and Capital Resources section below) and (3) the recording of again on derivative instruments in the amount of $2,131,000 related to thechange in the fair value of the two derivative liabilities which we have recordedin our condensed consolidated balance sheets (as discussed in the Liquidity andCapital Resources section below). Lastly, interest income decreased $77,000 due to a lower cash and cashequivalent balance carried for the three months ended July 31, 2006, ascompared to such balance carried in the comparable period in the prior fiscalyear.

We expect that our other expenses will be volatilebased on the future timing of repayment, if ever, of the remaining convertibledebentures (see the Liquidity and Capital Resources discussion below).

***Income Taxes***

Wecurrently operate at a loss and expect to operate at a loss until the productscurrently under development begin to generate sufficient revenue. The lossesincurred in the current year are not expected to generate an 

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income tax benefit because of the uncertainty of therealization of the deferred tax asset. As a result, we have provided avaluation allowance against our net deferred tax asset because, based onavailable evidence including our continued operating losses, it is more likelythan not, that all of the deferred tax assets will not be realized.Additionally, due to certain “change in ownership” rules (as defined bythe IRS), utilization of our federal net operating losses may be subject to certainannual limitations.

***Net Loss***

Our net loss decreased on both a dollar and apercentage of revenues basis for the three months ended July 31, 2006, ascompared to the same period of our prior fiscal year, as reflected in thefollowing table:
|                     | ** ** | **Three Months Ended July 31,** | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Dollar amount       |       | $                                                   | (2,372,000 | ) | $ | (5,172,000 | ) |
| Percent of revenues |       | (32.0                                               | )%         | (101.9 | )% |
|                     |            |                                                     |            |  |  |  |  |

 

We anticipate that losses will continue until (ifever): (i) revenues from our current operations substantially increase or (ii)we generate substantial revenues from products introduced as a result of ourresearch and development projects. Further, the revenue increases must increase faster than any increasesin operating and research and development expenses.  We expect that our net loss will continueduring at least the short term as we continue to pursue new revenue streams inour semiconductor products and services segment and as we continue ourmarketing and research efforts to expand sales and develop new products in thehomeland security business, including the commercialization of the IMStechnology and, eventually, the infrared imaging technology based on ourdevelopment & licensing agreement with Lucent.   However, we can offer no assurances that thedevelopment and commercialization of these technologies will occur.

We anticipate that our operations during the remainderof fiscal year 2007 will result in a loss since we are not likely to increaseour revenues from our existing products or generate additional sales from thenew products we may develop in a sufficient amount (if at all) to offset ouroperating and research and development expenses.

**Liquidity andCapital Resources**

**Working Capital**

Our working capital deficit decreased by $2,922,000during the three months ended July 31, 2006, from a working capitaldeficit of $(6,707,000) at April 30, 2006, to a working capital deficit of$(3,785,000) at July 31, 2006. The decrease in working capital deficit forthe three months ended July 31, 2006, is due to a combination of factors,of which the significant factors are set out below:

**Factorswhich increased working capital**

·                    approximately $2,718,000 due to the issuanceof the 6% Debentures (calculated as net proceeds of $12,270,000 less (a)$3,210,000, the amount of the 6% Debentures initially included in currentliabilities and (b) $6,342,000, the initial amount of the conversion featureassociated with the 6% Debentures recorded as a current derivative liability);

·                    approximately $4,000,000 due to a decrease inthe current portion of the 8% Debentures related to principal payments made inshares of our common stock (see discussion of 8% Debenture repayment below);

·                    $2,131,000 decrease to the initial recordingof derivative liabilities due to the change in fair value of such derivativeliabilities during the three months ended July 31, 2006;

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**Factorswhich decreased working capital**

·                    approximately $3,100,000 of cash consumeddirectly in operating activities (calculated as approximately $3,400,000 ofcash used in operating activities, netted down by approximately $300,000 of thecash impact of changes in other current assets or liabilities includedtherein);

·                    $1,772,000 due to initial reclassification ofcertain warrants from equity to current derivative liabilities (see discussionof warrant classification below);

·                    approximately $400,000 due to a cumulativeincrease in the current portion of convertible debentures related toamortization of the debt discounts on each related series of debenture;

·                    $360,000 related to purchases of fixedassets;

·                    approximately $270,000 in repayments ofprincipal on notes payable;

·                    $100,000 related to an investment in a business.

As a result of the recent financing and the commitmentfor the purchase of an additional $3,000,000 6% Debenture, we believe we haveenough cash to finance our anticipated operations and projected negative cashflow into our 2008 fiscal year.

We have satisfied our working capital requirementsprimarily through financing activities in the past, including the issuance ofthe 8% Debentures in February 2005 and the 6% Debentures in May andJune 2006. As described above, we have recently received a notificationfrom Nasdaq identifying a listing deficiency, which, if not cured timely, may resultin our delisting from the Nasdaq Capital Market. Any such delisting, if itshould occur, will make future financing activities significantly moredifficult.

8% Convertible Debentures 

Thefirst of twelve monthly principal payments on our 8% Debentures became due in March 2006.However, both the principal and interest are payable, at our option, in commonstock, subject to various requirements (which we believe we currently meet). Ifwe choose to make a scheduled principal payment by issuing common stock, and allrequirements to do so are met, the conversion price will be the lesser of thethen conversion price (currently $5.00 per share) or 88% of the average of theten closing prices ending on the trading day immediately prior to the monthlyredemption date.  During the three monthsended July 31, 2006 and subsequently, there has been substantial activity inreducing the outstanding principal balance on the 8% Debentures.  Having met all requirements to do so, we madeseveral interest and principal payments on the 8% Debentures in shares of ourcommon stock and we also made a temporary conversion offer to the Holders, asfollows:

·                    On May 1, 2006, we made our monthlypayment on the 8% Debentures by issuing 1,616,433 shares of our common stock insatisfaction of the principal payment and accrued interest then due. We reducedthe principal balance of the 8% Debentures by the nominal amount ofapproximately $1,820,000 and settled our interest obligation in the nominalamount of approximately $65,000.

·                    On June 1, 2006, we made our monthlypayment on the 8% Debentures by issuing 1,997,265 shares of our common stock insatisfaction of the principal payment and accrued interest then due. We reducedthe principal balance of the 8% Debentures by the nominal amount of approximately$1,650,000 and settled our interest obligation in the nominal amount ofapproximately $20,000.

·                    In connection with the financing transactiondiscussed in “Additional Liquidity Considerations” below, on May 19, 2006we entered into an agreement with certain of the 8% Debenture holders to paytheir remaining principal balance after June 1, 2006, along with a 5%premium in cash. In accepting our offer, these Holders also agreed to limit theanti-dilution provision on their warrants originally issued with the 8%Debentures and to waive certain provisions of the 8% Debentures as they relatedto the completion of our 6% Debentures (although we believe such contractualterms not to be in force). Approximately $5,000,000 of the then outstanding$8,200,000 8% Debentures accepted our offer. As a result, we paid these holders$4,107,102 (which resulted in a reduction of principal outstanding of$3,880,000).

·                    On July, 1 2006, we made our monthly paymenton the 8% Debentures in cash, reducing the principal balance outstanding by$562,500.

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·                    On August 1, 2006, we made our monthlypayment on the 8% Debentures in cash, reducing the principal balanceoutstanding by $562,500.

·                    On September 1, 2006, we made our monthly payment on the 8% Debentures byissuing 296,855 shares of our common stock in satisfaction of the principalpayment and accrued interest then due. We reduced the principal balance of the8% Debentures by the nominal amount of approximately $250,000.

As of September, 12, 2006, there is one remainingholder of our 8% Debentures outstanding with a principal balance outstanding of$1,250,000, an amount which will be paid in either cash or stock in fivemonthly amortization payments of $250,000.

In June 2006, one of the holders of the 8%Debentures, with a remaining principal balance of $0 as of September 12, 2006,informed us of its belief that the issuance of the 6% Debentures (as discussedabove) constituted a default (due to a potential variable conversion provisioncontained within the 6% Debenture) under the 8% Debentures. Remedies of suchdefault (if actual) include the option to accelerate payment of the fullprincipal amount of the remaining 8% Debentures, together with interest andother amounts due, to the date of acceleration. The principal amount of the 8%Debentures shall be equal to 130% of the then-principal amount of the 8%Debentures at the time of default plus all interest and other amounts due or aconversion calculation, whichever is higher. The holder had approximately$937,000 due on its debenture at the time we entered into the 6% Debenture. Wehave contested that allegation (based among other things that such clause didnot survive the final agreement) and will defend it in court, if necessary.

6% Convertible Debentures

On May 31, 2006 and June 5, 2006 wecompleted a private placement by which we issued to an accredited investor 6%Debentures in the aggregate principal amount of $13,000,000 and warrants topurchase a total of 8,000,000 shares of our common stock at exercise prices of$1.25 per share (2,000,000 warrants), $1.75 per share (3,000,000 warrants) and$2.00 per share (3,000,000 warrants) for a period of three years. In addition,the purchaser of our 6% Debentures has an obligation to purchase an additional$3,000,000 6% Debenture two days before the registration statement underlyingthe 6% Debentures is declared effective. The 6% Debentures mature on May 31,2009.  The accredited investor andan unaffiliated third party provided us services in connection with completingthe transaction (which were valued at $825,000) and as a result, we issued660,000 shares of restricted common stock as compensation. The accreditedinvestor may convert the 6% Debenture into shares of our common stock at anytime at a conversion price of $1.25 per share. After September 27, 2006(and subject to an effective registration statement), the holder may convertthe 6% Debentures into common stock at thelesser of $1.25 or 80% of the average of the two lowest daily volume weightedaverage prices of our stock during the five trading days immediately precedingthe conversion date (the “Market Conversion Price”), subject to certainconversion limitations (see Note 8 to the accompanying condensed consolidatedfinancial statements).  One substantialpotential limitation is that between September 29, 2006, and January 26, 2007,if converting using the Market Conversion Price, the holder is limited toconverting no more than $200,000 of the principal or accrued interest on the 6%Debentures into shares of our common stock in any seven calendar dayperiod.   Subsequent to January 26, 2007,if converting using the Market Conversion Price, the holder is limited toconverting no more than $400,000 of the principal or accrued interest on the 6%Debentures into shares of our common stock in any seven calendar day period.

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

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If after December 31, 2006, we have insufficientshares authorized but unissued and unreserved to convert principal and payinterest in common stock, our stock is not listed or quoted on a market, wehave not timely satisfied any conversion obligations or the issuance of shareswould violate certain other defined sections of the agreement, the holder has aright to request net cash settlement of the conversion based upon a definedcalculation.

We allocated the net proceeds received between the 6%Debentures and the related warrants based on the relative fair value of eachinstrument.  The $2,718,000 allocated tothe warrants was recorded as additional paid-in capital and as a correspondingreduction to the carrying value of the 6% Debentures.  Additionally, under currently existing USGAAP, we were required to classify the embedded conversion feature as aderivative liability in the amount of $6,342,000 (which represents theestimated fair value of the feature at the date the financing was consummated)and as a corresponding reduction in the carrying value of the 6%Debentures.  Further, we are required torecognize in earnings at each reporting date the gain or loss on our derivativeinstruments.  We recorded a gain onderivatives for the three months ended July 31, 2006, in the amount of$1,645,000, such amount representing the estimated change in fair value of theembedded conversion feature between the date the financing transaction wasconsummated and July 31, 2006.  Thecumulative discount on the 6% Debentures (arising from the allocation of aportion of the proceeds to the related warrants and the classification of theembedded conversion feature as a derivative liability) is being amortized tointerest expense over the term of the 6% Debentures using the effective interestmethod.

Cash Flows

As of July 31, 2006, we had $5,977,000 of cashand cash equivalents, an increase of $3,860,000 as compared to $2,117,000 atApril 30, 2006. Our principal source of funding for the three months endedJuly 31, 2006 was from the issuance of the 6% Debentures for which wereceived net proceeds of $12,270,000. Our principal source of funding for thethree months ended July 31, 2005 was from cash and cash equivalentsrelated to the issuance of 8% Debentures completed in February 2005 wherebywe received $22,000,000 ($21,340,000 net of placement fees).

Cash used in operating activities of $3,411,000 and$5,240,000 for the three months July 31, 2006 and 2005, respectively, wasprimarily the result of a net loss attributable to common stockholders of$2,372,000 (which included noncash expenses and gains in the net amount of a$725,000 gain) and $5,238,000 (which included noncash expenses in the aggregateamount of  $2,204,000), respectively.

Investing activities used cash of $460,000 and $3,220,000for the three months ended July 31, 2006 and 2005, respectively. Cash usedin investing activities for the three months ended July 31, 2006,consisted of $360,000 expended on additions of property and equipment and$100,000 expended on a 9% equity investment in a business.  Cash used in investing activities for thethree months ended July 31, 2005 resulted primarily from the purchase ofPPSC in May 2005 (which purchase price included a net cash outflow of $2,495,000)as well as purchases of property and equipment of $725,000.

Financing activities provided cash of $7,731,000 and$20,000 for the three months ended July 31, 2006 and 2005, respectively. Cashprovided by financing activities for the three months ended July 31, 2006resulted primarily from the issuance of the 6% Debentures which yielded netproceeds of $12,270,000 offset by principal payments on borrowings of$4,551,000. Cash provided by financing activities for the three months endedJuly 31, 2005 resulted primarily the exercise of common stock warrantsoffset primarily by debt repayments and dividend payments on our outstandingSeries E Convertible Preferred Stock.

Additional Liquidity Considerations

Asa result of the 6% Debenture transaction, anti-dilution provisions associatedwith the 1,593,900 common stock warrants issued in the 8% Debenture transactionwere triggered whereby we issued an additional 6,375,600 common stock warrantsto these holders and reduced the exercise price on all related warrants to 

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$1.25. As a result, as of September 12, 2006 wehave 7,969,500 common stock warrants exercisable at $1.25 related to the 8%Debenture transaction. As a result of the May 18, 2006 agreement (asdiscussed above), 4,557,000 of these common stock warrants have been modifiedto reduce their anti-dilution provisions to a price-protection provision only.If we were to enter into a financing agreement in the future with an effectiveprice less then $1.25 (or of the holder of our 6% Debentures was to convert aportion of the outstanding debenture at a conversion rate less than $1.25), theremaining 3,412,500 common stock warrants that have a full anti-dilutionprovision, would ratchet into a great number of common stock warrants at alower exercise price.  There were noother changes in the terms or conditions of the warrants.

As of July 31, 2006, we had commitmentsoutstanding for capital expenditures of approximately $1,600,000.  Our other future commitments have increaseddue to the agreement and development plan with Lucent, under which we endeavorto develop a next-generation imaging and night vision surveillance technology(although we can provide no assurances that a commercially attractive productwill ultimately be available). We have paid Lucent $4,333,000 through September12, 2006, and to maintain our rights under the agreement we are obligated tomake an additional eight payments in the amount of $1,000,000 approximatelyevery three months thereafter. This amount provides development fundingrequired under the agreement. We have the right to terminate the developmentproject for any reason from time-to-time, so long as termination is prior tothe first commercial sale of a licensed product. As such, assuming we continuethe development program, we expect our quarterly research and developmentfunding for this purpose to remain elevated, although we may attempt to find apartner with which to divide the financial burden (and potential financialbenefits of any developed technology, if any) of the Lucent research anddevelopment payments or seek to finance the payments through the sale of equityor issuance of debt instruments.  In order to focus the Lucent developmenteffort to best achieve an effective and marketable product, we have commenceddiscussions on a new statement of work to govern the development effort.  Unless we accept a statement of work fromLucent for the infrared project by September 29, 2006, the contract with Lucentwill likely be terminated, and Lucent will be required to reimburse us $900,000of the amount we paid them in August 2006. We continue to work with Lucent to develop an appropriate statement ofwork.

Our agreement with ISCON provides us the option topurchase shares of ISCON common stock based upon the successful completion ofdevelopmental and commercial milestones. If ISCON succeeds in meeting all five milestones and if we choose toexercise our option to purchase shares for each completed milestone, we wouldthen own 51% of ISCON for a cumulative investment of $1,750,000.  On June 9, 2006, we made our first investmentin the amount of $100,000 for an ownership interest of approximately 9%.  We continue to evaluate the technology andthe market for such technology and have made no further investments in ISCON asof September 14, 2006.

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

***Off-Balance Sheet Arrangements***

We have no material changes to the disclosure on thismatter made in our Annual Report on Form 10-KSB for the year ended April 30,2006.

***Critical Accounting Estimates***

Weconsider an accounting estimate to be critical if 1) the accounting estimaterequires us to make assumptions about matters that were highly uncertain at thetime the accounting estimate was made, and 2) changes in the estimate that arereasonably likely to occur from period to period, or use of different 

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estimates that we reasonably could have used in thecurrent period, would have a material impact on our financial condition orresults of operations.

Management has discussed the development and selectionof these 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 and IntangibleAssets*

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

In accordance with SFAS No. 142 *Goodwill and Other Intangible Assets*,goodwill is not amortized, but instead is tested for impairment on an annualbasis or more frequently if the presence of certain circumstances indicatesthat impairment may have occurred.  Theimpairment review process, which is subjective and requires significantjudgment at many points during the analysis, compares the fair value of thereporting unit in which goodwill resides to its carrying value.  If the carrying value of a reporting unitexceeds its fair value, then the amount of the impairment loss must bemeasured. The impairment loss is calculated by comparing the implied fair valueof reporting unit goodwill to its carrying amount. In calculating the impliedfair value of reporting unit goodwill, the fair value of the reporting unit isallocated to all of the other assets and liabilities of that unit based ontheir fair values. The excess of the fair value of a reporting unit over theamount assigned to its other assets and liabilities is the implied fair valueof goodwill. An impairment loss would be recognized when the carrying amount ofgoodwill exceeds its implied fair value. We have goodwill in the amount of $3,631,000 on our condensedconsolidated balance sheet as of July 31, 2006, related to the acquisition ofPPSC in May 2005.  During the threemonths ended January 31, 2006, we performed our annual impairment review on theaforementioned goodwill and concluded that the goodwill was not impaired.

Forintangible assets other than goodwill, SFAS No. 144 *Accounting for theImpairment or Disposal of Long-Lived Assets* is theauthoritative standard on the accounting for the impairment of such intangibleassets.  As required, we perform testsfor impairment of intangible assets other than goodwill whenever events orcircumstances suggest that such assets may be impaired.  To evaluate potential impairment, SFAS No.144 requires us to assess whether the future cash flows related to these assetswill be greater than their carrying value at the time of the test. Accordingly,while our cash flow assumptions are consistent with the plans and estimates weare using to manage the underlying businesses, there is significant judgment indetermining the cash flows attributable to our other intangible assets overtheir respective estimated useful lives. We have remaining other net intangible assets in the amount of $444,000on our condensed consolidated balance sheet as of July 31, 2006, comprised ofour trace and bulk detection technology acquired in December 2002, customerlists acquired in our acquisition of the business and assets of EMG in June2004 and the customer base acquired in our acquisition of PPSC in May2005.  We are required to periodicallyevaluate our other intangible assets balances for impairments. If we were toincur additional impairments to our other intangible assets, it could have anadverse impact on our future earnings, if any.

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*Stock-basedCompensation*

For our employees, our stock-option program is abroad-based, long-term retention program that is intended to attract and retaintalented employees and align stockholder and employee interests.  On May 1, 2006, we adopted the provisions ofSFAS 123(R), requiring us to recognize expense related to the fair value of ourstock-based compensation awards.  Weelected the modified prospective transition method as permitted by SFAS123(R).  Under this transition method,stock-based compensation expense for the three months ended July 31, 2006,includes compensation expense for all stock-based compensation awards grantedprior to, but not yet vested as of May 1, 2006, based on the grant date fairvalue estimated in accordance with the original provisions of SFAS 123 andcompensation expense for all stock-based compensation awards granted subsequentto May 1, 2006, based on the grant date fair value estimated in accordance withthe provisions of SFAS 123(R).  See Note6 to our condensed consolidated financial statements for further detail,including the impact of the adoption to our condensed consolidated statementsof operations.  We assess the fair valueof option awards using the Black-Scholes option pricing model, a model whichrequires several estimates including stock price volatility, risk-free interestrate and expected term of the option. Additionally, we must estimate the number of options we expect to beforfeited prior to vesting in future periods. As of July 31, 2006, $1,928,000 of total unrecognized compensation costrelated to stock options is expected to be recognized over a weighted-averageperiod of 1.6 years.  If the assumptionsused, as they relate to volatility, risk-free interest rate, estimated term ofthe options and forfeiture rate, were materially different, the overallvaluation of these and any future stock-based awards and the timing ofrecognition of related expense could change significantly.

Additionally, we similarly evaluate the financialstatement impact of stock-based grants made to external parties for servicesand in settlement of litigation by using the Black-Scholes model, which alsorequires several estimates including stock price volatility, risk-free interestrate and expected term of the option.  Ifthe assumptions used, as they relate to volatility, risk-free interest rate andestimated term of the warrants, were materially different, the overallvaluation of these and any future stock-based awards could changesignificantly.

*Initial andContinuing Valuation of Financing Transactions*

We value transactions associated convertible debenturesor preferred stock that are convertible into common stock based on the marketconditions existing on the date of the signing of the agreement.  In allocating the 6% Debenture financingproceeds between the freestanding warrants, the convertible debenture and theembedded conversion feature within the convertible debenture, we were requiredto estimate the fair values of each of the components.  If the assumptions used, as they relate tovolatility, risk-free interest rate, estimated term of the warrants,probability-weighted exercise patterns of the debentures and fair value of theembedded conversion feature (accounted for as a derivative liability) werematerially different, there could be a material financial impact to ourcondensed consolidated financial statements. Additionally, all derivative liabilities must be marked to then-currentfair value at the end of each reporting period with the change in fair valuebeing included in our condensed consolidated statements of operations.  Due to the fair value of the derivativeliability being highly sensitive to the market price of our common stock,changes in other estimates associated with estimating the end-of-period fairvalue of the derivative instrument could have a material impact on ourfinancial statements.

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

We are exposed to market risk related to changes ininterest rates, equity security market values, foreign currency rates and themarket price of our common stock.

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Interest Rates

Our investment portfolio consists of cash and cashequivalents (in the amount of $5,977,000 at July 31, 2006), all of which isexposed to interest rate fluctuations. The primary objective of our investments is to earn a market rate ofreturn while preserving principal and maximizing liquidity.  The interest earned on these investments(with a blended yield of 5.05% at July 31, 2006) may vary based on fluctuationsin the prevailing interest rate.

Equity Securities

We do not hold any investments in marketable equitysecurities.  However, we hold a 30%interest in IUT and a 9% interest in ISCON, both of which are non-marketableequity securities.  Our strategic investmentsin these entities may be impacted by the underlying economic conditions of eachentity, including the ability to raise additional capital and the likelihood ofour being able to realize our investments through liquidity events such asinitial public offerings, mergers or private sales.  These investments involve a great deal ofmarket risk, and there can be no assurances that a specific company will growor become successful.  Consequently, wecould lose all or part of our investment. Additionally, because IUT is located in Germany, our investment in theentity (and our share of their earnings or losses) may be impacted by changesin foreign currency rates.  Theaggregated carrying amount of these investments was $398,000 as of July 31,2006.

Derivative Instruments

We do not purchase derivative instruments on the openmarket.  However, in accordance withcurrent US GAAP, we have classified certain warrants and the embeddedconversion feature in our 6% Debentures as derivative instruments (a combined$5,984,000 current liability at July 31, 2006). Classification as derivative liabilities was required because, for eachinstrument, there is a possibility that the instrument could be required to besettled on a net cash basis.  We arerequired to mark these instruments to market as of the end of each reportingperiod and to recognize the change in fair value in our condensed consolidatedstatements of operations.  Our stockprice has been historically volatile and the fair values of these instrumentsare sensitive to changes in our underlying stock price.  As such, the carrying amount of theseinstruments may be volatile from period to period.  For the three months ended July 31, 2006, werecorded a gain on derivative instruments in the aggregate amount of$2,131,000, such amount representing the change in fair value between the respectiveinitial recording of the derivatives within the quarter and July 31, 2006.

**Item 4: Controlsand Procedures**

With the participation of our management, includingthe Chief Executive Officer and Chief Financial Officer, we have evaluated theeffectiveness of our disclosure controls and procedures as required by ExchangeAct Rule 13a-15(b) as of the end of the period covered by this report. Based onthat evaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that these disclosure controls and procedures are effective. Therewere no changes in our internal control over financial reporting during thethree months ended July 31, 2006, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

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

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**Part II: Other Information**

**Item 1:  Legal Proceedings**

None.

**Item 1A: RiskFactors**

*Aninvestment in and ownership of our common stock, Class B or Class C Warrants,or any other of our convertible securities is one of high risk.  Youshould carefully consider the risks described below before deciding whether toexercise your warrants, or to invest in or continue to hold our common stock.  Ifany of the contingencies discussed in the following paragraphs or othermaterially adverse events actually occur, the business, financial condition andresults of operations could be materially and adversely affected.  In such case, the trading price of our commonstock could decline, and you could lose all or part of your investment.*

**We have historically had severeworking capital shortages, even following significant financing transactions.**

Althoughwe raised capital totaling more than $32,900,000 (net of expenses) during thelast two fiscal years and issued the 6% Debentures in the three months endedJuly 31, 2006, we have had working capital shortages in the past and ourconsolidated financial statements for the three months ended July 31, 2006,indicate that we have a working capital deficit of $(3,785, 000).

Weissued the 6% Debentures in May and June 2006. The total principal amount of these 6% Debentures issued was $13,000,000which netted approximately $8,170,000 in proceeds after expenses and $4,100,000of payments related to our 8% Debentures. The purchaser has an obligation topurchase an additional $3,000,000 6% Debenture two days before the registrationstatement underlying the 6% Debentures is declared effective.

Basedon the amount of capital we have remaining, our current negative cash flow fromoperations and investing activities, we anticipate that we may continue toincur a working capital deficit unless we are able to substantially increaseour revenue or reduce our expenses thereby generating positive cash flow fromoperations and (ultimately) operating income.

Asa result of the recent financing and the commitment to purchase an additional$3,000,000 6% Debenture immediately prior to the effectiveness of theregistration statement underlying the 6% Debentures, we believe we havesufficient working capital to finance our anticipated operations and projectednegative cash flow into our 2008 fiscal year.

**Our ability to obtain furtherfinancing when necessary is limited and we may be delisted from the NasdaqCapital Market.**

Wehave historically financed our operating losses and cash flow deficits throughprivate placements of our equity and debt securities.  Both of our outstanding 8% and 6% Debenturescontain significant restrictions on our ability to raise any additional capitalfor so long as the convertible debentures are outstanding and ultimately, ourability to finance our operations will depend on our ability to generaterevenues that exceed our expenses. Although we believe we are on a path to that end, we cannot offer anyassurance that we will be able to succeed in reaching that goal.

OnJuly 10, 2006, we received a letter from Nasdaq that advised us that theminimum bid price of our common stock had closed at less than $1.00 per shareover the previous 30 consecutive business days, and, as a result, did notcomply with Marketplace Rule 4310(c)(4). Therefore, in accordance withMarketplace Rule 4310(c)(8)(D), we were provided 180 calendar days, or untilJanuary 8, 2007, to regain compliance with the Rule (which consists of the bidprice of our common stock closing at $1.00 per share or more or a 

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minimumof 10 consecutive business days).  If wefail to obtain compliance, as long as we meet the Nasdaq Capital Market initiallisting criteria as set forth in Marketplace Rule 4310(c), except for the bidprice requirement, we will be granted an additional 180 calendar days to obtaincompliance.  If we fail to meet theseNasdaq requirements within the allotted time frame, we may be delisted from theNasdaq Capital Market.

Asof September 12, 2006, the price of our common stock was $.93 and as a result,if any of our convertible securities are converted or outstanding common stockwarrants or stock options are exercised, it may be more difficult to achievethe necessary $1.00 price per share requirements due to additional shares ofcommon stock being available in the market as well as the correspondingdilution to our investors caused by potentially issuing (based on existingvariable rate conversion rights) the conversion shares at a conversion pricebelow the then-current market price of our common stock.

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

**We have four business segmentsand, for the three months ended July 31, 2006, three of our four segmentsoperated at a loss, in some cases significant losses.**

For the three months ended July 31, 2006, and as reflected in thefollowing table, our condensed consolidated financial statements show thatthree of our four operating segments have been operating at a loss (amounts inthousands):
|                                     | ** ** | **Three Months Ended**                         | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                          | ** ** | **July 31,**                                        | ** ** |
| ** **                          | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** |
| Segment  operating (loss) income:   |       |                                                     |       |   |   |
| Homeland security products          |       | $                                                        | (1,114     | ) | $ | (502 | ) |
| Security services                   |       | (274                                                     | )          | 110 |   |
| Semiconductor products and services |       | (199                                                     | )          | (2,054 | ) |
| Life sciences                       |       | 31                                                       |       | (149 | ) |
| Reconciling amounts                 |       | (2,366                                                   | )          | (1,133 | ) |
| Total                               |       | $                                                        | (3,922     | ) | $ | (3,728 | ) |

 

Weexpect that these losses (on a consolidated basis) will continue through theremainder of our 2007 fiscal year (albeit at significantly lower levels).  As described in the next risk factor, unlesswe are able to develop and sell new products profitably, we may be unable toremain competitive and it is likely that our losses and negative cash flow willcontinue.  Reconciling amounts includecorporate expenses consisting primarily of payments to Lucent under ourdevelopment agreement, corporate salaries and benefits, professional andconsulting fees, investor relations costs, warrant amendment expense, insuranceand directors’ compensation.

**Unless we are able to develop andsell new products profitably, we may be unable to remain competitive,furthering the likelihood that our losses and negative cash flow will continue.**

We have not operated profitably since our 1996fiscal year, and as discussed in the preceding risk factor, three of our foursegments are not currently operating profitably.  We recognized net income for the year endedApril 30, 2000, only because of the gain recognized on the sale of our depletedzinc assets to Eagle-Picher Technologies, LLC.

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Ourability to generate additional revenues (and ultimately net income) isdependent upon the success of our homeland security products, security servicesand semiconductor operations and our ability to develop new products, includingthose that use stable and radioactive isotopes, while marketing and sellingthose products profitably.  Historically,our semiconductor operations have been a significant cash drain and, while wehave taken steps to reduce the costs of the operation and to increase therevenues (including the launch and growth of our 300-millimeter product line),we cannot offer any assurance that the measures we have taken will continue tobe successful. In addition, because of competitive conditions and, due to theloss of substantially all of our former Chemotrade radioisotope customers inJanuary 2006, it will be difficult for our life sciences operations to becomesignificantly profitable in the future.

Wehave had limited success in marketing our homeland security products, havingsold only two units of the first generation of our NeutroTestTM portable, neutron-based explosive detectiondevice and no units of our IMS technology for the detection of chemical weaponsand other toxic substances or the second generation of our NeutroTestTM device.  Although we have commenced marketing these products, we cannot offer anyassurance that our marketing efforts will result in any sales or that any saleswill result in significant revenues to us.

Weare currently dependent on our continuing revenues and increasing orders toimprove our operating results, and cash payments from our customers to provideworking capital.  To the extent ordersand deliveries are reduced because of changing customer needs or our inabilityto supply product, or to the extent payments from customers are reduced becauseof adverse financial conditions affecting our customers, our financial conditionwill be adversely affected.

Itis possible that the following circumstances may develop and may adverselyimpact our available working capital and materially impact our ability tocontinue our business operations:

·       unanticipated expenses indeveloping our new products or in producing or marketing our existing products;

·       the necessity of having toprotect and enforce our intellectual property rights;

·       technological and marketdevelopments; or

·       a corporate decision toexpand our production capacity through capital investment or acquisition.

We may not be able toobtain equity or debt financing on reasonable terms when we need suchfinancing.  The unavailability ofadditional financing, when needed, could have a material adverse effect on ourbusiness.

**We haveraised capital and issued securities during the years ended April 30, 2006 and2005, and subsequently which has resulted (and will in the future when warrantexercises or conversions occur result) in dilution to our existingshareholders.  This was accomplished toprovide necessary working capital or obtain assets and services.  We will likely issue more securities to raiseadditional capital or to obtain other services or assets, any of which mayresult in substantial additional dilution.**

Duringthe course of the last two fiscal years and the current 2007 fiscal year,we have raised in excess of $41,0000,000 (net of expenses and $4,100,000 ofpayments related to our 8% Debentures) to finance our business operations andacquisitions. We have raised this capital by issuing convertible debentures,shares of common stock, convertible preferred stock, common stock warrants toaccredited investors and as compensation to investment bankers makingintroductions to the accredited investors and the exercise of previously issuedcommon stock warrants and stock options. During this same period of time, weissued 

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commonstock warrants and shares of common stock to several persons in exchange fortheir promises to perform investment banking and financial advisory services tous. In many cases, these issuances were below the then-current market pricesand can be considered dilutive to our existing shareholders—both as a reductionof their percentage ownership in Isonics and because of issuances that will be,when warrants are exercised or debentures are converted, at prices below themarket.

The8% Debentures issued in February 2005 and the 6% Debentures issued in May andJune 2006, have significant restrictions on our ability to raise any additionalcapital.  If we raise additional workingcapital, we will likely have to issue additional shares of our common stock andcommon stock warrants at prices that may dilute the interests of our existingshareholders.

**A holder of a portion of theremaining 8% Debentures has asserted and another may assert that a defaultexists.**

Oneof the two holders of the 8% Debentures that did not accept our prior offer toall holders has asserted and another may assert that the issuance of the 6%Debentures constituted a default (due to a potential variable conversionprovision contained within the 6% Debentures which, beginning September 29,2006, gives the 6% holder the right to convert the 6% Debentures into commonstock at the lower of $1.25 or at a discount to market, as defined) under the8% Debentures.  We have contested thatallegation (based among other things that such clause did not survive the finalagreement), and will defend it in court if necessary.  Any such litigation will be time consumingand expensive and, although we believe that we have significant grounds tocontest the existence of any default, we cannot be assured of success.  If the two holders prove that a defaultexists, we could be liable to them for 130% of the principal amount of their 8%debentures on the closing date of the 6% Debenture transaction (a cost ofapproximately $950,000, plus accrued interest in addition to the currentoutstanding principal of $1,250,000).

**We havean insufficient number of shares of common stock authorized, and if ourshareholders do not increase our authorized capital at the next shareholders’meeting, we will be in default of our obligations to the holders of our 6%Debentures and the related warrants.**

Wecurrently have 75,000,000 shares of common stock authorized, but that number isinsufficient for us to meet our obligations to certain persons, including theholders of our 6% Debentures and related warrants.  We have agreed to seek shareholder approvalof an increase in our authorized capitalization to at least 175,000,000 byOctober 31, 2006, but we cannot provide any assurance that we will be able toobtain the necessary shareholder approval. If we fail to obtain shareholder approval for the increase in authorizedcapitalization, we may be in default under the terms of the 6% Debentures andrelated warrants as well as pursuant to certain other obligations.

**Accountingcharges resulting from our issuance of the 6% Debentures may lead tosignificant non-cash charges which would adversely impact future interestexpense, net income and earnings per share and may also lead to futurevolatility in our financial statement components.**

Theissuance of the 6% Debentures in May and June 2006 has resulted in theclassification of certain warrants and the conversion feature embedded in the6% Debentures as derivative liability instruments (a combined $5,984,000current liability at July 31, 2006).  Weare required to mark these instruments to market as of the end of eachreporting period and to recognize the change in fair value in our condensedconsolidated statements of operations. Additionally, we will be required to record significant non-cashinterest charges over the life of the 6% Debentures (in addition to interestexpense relating to the 6% interest rate borne by the 6% Debentures which willbe paid in cash or shares of our common stock, at our option).  Thecombination of these two factors will likely result in a significant adverseimpact to future net income and earnings per share and will likely introduceadditional volatility to our future operating results.

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

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

We are dependent on suppliers from Russia forsubstantially all of our stable isotopes and our radioisotopes.  Accordingly, our operations could bematerially adversely affected if hostilities in Russia should occur, if tradebetween Russia and the United States were interrupted or ceased, if politicalconditions in Russia disrupt transportation or processing of our goods, if lawsor government policies concerning foreign business operations in Russia changesubstantially, or if tariffs are introduced.

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

As a result of the acquisition of PPSC, we havesignificantly increased our revenues for the three months ended July 31, 2006as compared to the three months ended July 31, 2005. As a result, we decreasedour reliance on a few customers for a significant portion of our revenues.  For the three months ended July 31, 2006 twosecurity services customers accounted for 15% and 10% of revenues, respectivelyand one semiconductor materials and products customer accounted for 23% ofrevenues, while one security services customer accounted for 19% of revenuesfor the three months ended July 31, 2005. However, significant reductions in sales to any of these large customershave had, and may in the future have, an adverse effect on us by reducing ourrevenues and our gross margins.  Presentor future customers could terminate their purchasing patterns with us orsignificantly change, reduce or delay the amount of isotopes or other productsordered from us.

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

We experienced increased costs and delays inintegrating the operations of the business and assets we acquired from EMG, inJune 2004, and we also realized revenues that were significantly reduced fromthat which we had anticipated. Regardless of the extent of our planning, we may recognize increasedcosts and delays, and reduced revenues, when integrating future business acquisitionsinto our business operations and strategy. While we believe that we have and will continue to plan for integrationof business operations to the best of our ability, we cannot offer anyassurance that any or all such efforts will proceed as anticipated.  While the integration of PPSC (acquired inMay 2005) has been more successful than that of EMG, if efforts at integratingother businesses and assets that we may acquire in the future achieve similardifficulties as we realized in the integration of the EMG business and assets,we may have unanticipated expenses, delays and revenue reductions.

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

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

**Because we are dependent upon our key personnel for our future success,if we fail to retain or attract key personnel, our business will be adverselyaffected.**

Ourfuture success will depend in significant part upon the continued service ofour key technical, sales and senior management personnel, including James E.Alexander, our President and Chief Executive Officer and Boris Rubizhevsky, ourSenior Vice President and President of HSDC. Currently both Mr. Alexander and Mr. Rubizhevsky are coveredby employment agreements that are renewable on an annual basis.

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

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

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

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

**We face technological change and intense competition both domesticallyand internationally which may adversely affect our ability to sell our productsprofitably.**

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

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Further,it is possible that future technological developments may occur.  The market for our homeland security productsand our isotope products is characterized by rapidly evolving technology and acontinuing process of development. Our future success will depend upon ourability to develop and market our homeland security and isotope products thatmeet changing customer and technological needs on a cost effective and timelybasis.  If we fail to remain competitiveby anticipating the needs of our customers and our customers contract withother suppliers, our revenues and resulting cash flow could be materially andadversely affected.

**We could be subject to environmental regulation by federal, state andlocal agencies, including laws that impose liability without fault, which couldproduce working capital shortages and lessen shareholders’ equity.**

We could become subject to a variety of federal,state, and local environmental regulations relating to the use, storage,discharge and disposal of hazardous chemicals used during manufacturingprocesses, although we do not believe that there is any such regulationdirectly applicable to our current operations. Regulations that become applicable to our operations in the future couldrestrict our ability to expand our facilities or could require us to acquirecostly equipment or to incur other significant expenses to comply withgovernmental regulations.  Historically,our costs of compliance with environmental regulations have not beensignificant.

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

Ourshares are widely held.  Consequently,even though our management beneficially owns (as of September 12, 2006) oursecurities equivalent to approximately 12% of the outstanding votes at anyshareholders’ meeting (assuming zero conversions of common stock warrants,options or the 6% or 8% Debentures), it is likely that they will be able tocontinue to substantially influence all matters submitted to stockholders forapproval, including the election and removal of directors and any merger,consolidation or sale of substantially all of our assets, and to control ourmanagement and affairs.  Suchconcentration of ownership may have the effect of delaying, deferring or preventinga change in control, impeding a merger, consolidation or takeover or otherbusiness combination involving us or discouraging a potential acquirer frommaking a tender offer or otherwise attempting to obtain control of ourbusiness, even if such a transaction would be beneficial to other stockholders.

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

The use of our radioisotopes inradiopharmaceuticals and in clinical trials may expose us to potential productliability risks that are inherent in the testing, manufacture, marketing, andsale of human diagnostic and therapeutic products.  Additionally, the use of explosive andchemical detection products may expose us to potential liability risks that areinherent with the operation of these types of products (including, but notlimited to failed detection).  Wecurrently have product liability insurance; however, there is a risk that our insurancewould not cover completely or would fail to cover a claim, in which case we maynot have the financial resources to satisfy such claims, and the payment ofclaims would require us to use funds that are otherwise needed to conduct ourbusiness and make our products.

**Ourcommon stock is vulnerable to pricing and purchasing actions that are beyondour control and, therefore, persons acquiring or holding our shares or warrantsmay be unable to resell their shares at a profit as a result of thisvolatility.**

The trading price of our securities has been subject to wide fluctuationsin response to quarter-to-quarter variations in our operating results, ourannouncements of technological innovations or new products by us or ourcompetitors, and other events and factors. The securities markets themselveshave from time to time 

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and recently experienced significant price and volumefluctuations that may be unrelated to the operating performance of particularcompanies. Announcements of delays in our testing and development schedules,technological innovations or new products by us or our competitors anddevelopments or disputes concerning patents or proprietary rights could have asignificant and adverse impact on such market prices. Regulatory developmentsin the United States and foreign countries, public concern as to the safety ofproducts containing radioactive compounds, economic and other external factors,all affect the market price of our securities. *Inaddition, the realization of any of the risks described in these “Risk Factors”could have a significant and adverse impact on such market prices*

**SEC penny stock regulations may limit the abilityto trade our securities on the Nasdaq Capital Market.**

Although our common stock is currently quoted on theNasdaq Capital Market, our common stock has in the past been subject toadditional disclosure requirements for penny stocks mandated by the SecuritiesEnforcement Remedies and Penny Stock Reform Act of 1990.  The SEC Regulations generally define a pennystock to be an equity security that is not traded on the Nasdaq Stock Marketand has a market price of less than $5.00 per share. We have, at times in thepast, been included within the SEC Rule 3a-51 definition of a penny stock, andwe are currently subject to two notifications from Nasdaq which may place us inthat status again.  When our common stockis considered to be a “penny stock,” trading is covered by Rule 15g-9promulgated under the Securities Exchange Act of 1934, for non-Nasdaq andnon-national securities exchange listed securities.

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

·       the inability to maintain abid price for our common stock of $1.00 for the requisite period of time, and

·       the inability to maintaineither the minimum stockholders’ equity, market capitalization or net incomealong with the required number of market makers and shareholders necessary forlisting.

We cannot give any assurance that we will be able tomeet the Nasdaq requirements to maintain our Capital Market listing, or that ifwe do, a stable trading market will develop for our stock or our warrants. See “ourability to obtain further financing when necessary is limited and we may bedelisted from the Nasdaq Capital Market” for additional risk factors associatedwith our current Nasdaq listing deficiencies.

If our shares are removed from the Nasdaq CapitalMarket because of our failure to meet the minimum price requirement or forother reasons, the ability of holders of our common stock to sell the sharesthey hold will likely be adversely affected because the lower tier markets(such as the OTC Bulletin Board and the Pink Sheets) do not provide shareholderliquidity as do the higher tier markets (such as the Nasdaq CapitalMarket).  In addition, unless traded onNasdaq Capital Market or other higher tier markets (such as the American StockExchange), our common stock will be subject to the penny stock rules, and manystock brokers will not make a market in those shares, further reducing themarketability of our shares.

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

Ourstock price has declined from a price of approximately $6.00 per share at thebeginning of 2005 to prices of less than $1.00 at various times since May 2006.Our stock price may decline further as a result of future sales of our shares,the perception that such sales may occur or other reasons.  As of September 12, 

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2006,approximately 5,700,000 shares of common stock held by existing stockholdersconstitute “restricted shares” as defined in Rule 144 under the SecuritiesAct.  The restricted shares may only besold if they are registered under the Securities Act, or sold under Rule 144,or another exemption from registration under the Securities Act.

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

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

Wehave never declared or paid a cash dividend on our common stock.  We presently intend to retain our earnings,if any, to fund development and growth of our business and, therefore, we donot anticipate paying cash dividends in the foreseeable future.  Additionally, the terms of the 6% and 8%Debentures contain restrictions on our ability to pay dividends to holders ofour common stock.

**Outstanding 6% and 8% Debentures,options and warrants may make it difficult for us to obtain additional capitalon reasonable terms.**

As of September 12, 2006, we had 8% Debentures inthe principal amount convertible of $1,250,000 and 6% Debentures aggregating$13,000,000 in principal amount convertible (at our election for the 8%Debentures and at the election of the 6% Debenture holder, subject to certainweekly limitations) into 1,524,390 shares of common stock, assuming a conversion price of $.82 (based upona 12% discount to the closing price of $.93 on September 12, 2006, which islower than the fixed conversion price of $5.00) and into 17,567,568 shares ofcommon stock, assuming a conversion price of $.74 (based upon a 20% discount tothe closing price of $.93 on September 12, 2006, which is lower than the fixedconversion price of $1.25), respectively (although the holders’ rights toconvert the 8% and 6% Debentures and associated warrants are subject to certainshare issuance limitations).  In addition, we had outstanding options andcommon stock warrants for the purchase of up to 23,211,042 shares of commonstock at an average exercise price of approximately $1.62 per share.  If all of the outstanding options,debentures and common stock warrants were to be converted, they would representapproximately 48% of our outstanding common shares on a fully dilutedbasis.  Future investors will likelyrecognize that the holders of the options and warrants will only exercise theirrights to acquire our common stock when it is to their economic advantage to doso.  Therefore, even with lower currentmarket prices for our common stock, the market overhang of such a large numberof warrants, options, and convertible preferred stock may adversely impact ourability to obtain additional capital because any new investors will perceivethat the securities offer a risk of substantial potential future dilution.

Inaddition, if the remaining $3,000,000 6% Debenture commitment was to be fundedby Cornell, it would be convertible into an additional 4,054,054 shares ofcommon stock, assuming a conversion price of $.74 (based upon a 20% discount tothe closing price of $.93 on September 12, 2006, which is lower than the fixedconversion price of $1.25).

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

Wehave various obligations to file and obtain the effectiveness of certainregistration statements which include certain outstanding common stock andcommon stock underlying outstanding convertible debentures and common stockwarrants.  Once effective, the prospectuscontained within a registration 

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statementcan only be used for a period of time as specified by statute without therebeing a post-effective amendment filed that has become effective under theSecurities Act of 1933.

Ifwe fail to meet any obligations we have to have effective and currentregistration statements available (including the current registration statementrelated to the common stock underlying our Class B and C warrants), we maybecome obligated to pay damages to investors to the extent they may be entitledto damages.  We cannot offer anyassurances that we will be able to maintain the currency of the informationcontained in a prospectus or to obtain the effectiveness of any registrationstatement or post-effective amendments that we may file.

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

Regulatorsof public companies such as Isonics have the authority to commence inquiriesand investigations where the regulators have concerns.  The investigations, while involving thecompany, may not have anything to do with actions taken by the company or ourfailure to act.  Furthermore, theregulators may not inform us when the issues they were addressing are resolved.  From October 2004 through February 2005, bothNasdaq and the SEC requested documents from us with respect to inquiries theywere undertaking (related primarily to questions regarding our press releases,public relations advisors, certain other disclosures that were made publiclyand the termination of Grant Thornton LLP as our independent auditor).   We also met with representatives of Nasdaqto discuss issues related to market activity, press announcements, SEC filings,status of our business and other issues.  We provided information, which we believe to be responsive to all of thequestions posed in the Nasdaq inquiry and to the SEC.  We have not received any requests foradditional information from either the SEC or Nasdaq relating to those earlierinquiries since February 2005 and while we believe these issues are behind us,if any action resulted from these inquiries in the future, it may adverselyimpact us, and our ability to carry on our business.  As discussed above, we have received anotification from Nasdaq advising us that we are not in compliance with Nasdaq’slisting standards.

**Provisions in our charterdocuments could prevent or delay a change in control, which could delay orprevent a takeover.**

OurArticles of Incorporation authorize the issuance of “blank check” preferredstock with such designations, rights, and preferences, as may be determined byour Board of Directors.  Accordingly, theBoard of Directors may, without shareholder approval, issue shares of preferredstock with dividend, liquidation, conversion, voting, or other rights that couldadversely affect the voting power or other rights of the holders of our commonstock.  Preferred stock could also beissued to discourage, delay, or prevent a change in our control, although we donot currently intend to issue any additional series of our preferred stock.

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

Our Bylaws provide for indemnification of officersand directors to the full extent permitted by California law, our state ofincorporation.  We may be required to payjudgments, fines, and expenses incurred by an officer or director, includingreasonable attorneys’ fees, as a result of actions or proceedings in which suchofficers and directors are involved by reason of being or having been anofficer or director. Funds paid in satisfaction of judgments, fines andexpenses may be funds we need for the operation of our business and the developmentof our products, thereby affecting our ability to attain profitability.  This could cause our stock price to drop.

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

**Payment ofConvertible Debenture Principal and Interest in Common Stock**

On June 1, 2006, we issued 1,997,265 shares of our common stock toholders of our 8% convertible debentures in payment of our principal obligationand of our interest obligation for the month ended May 31, 2006.  The following sets forth the informationrequired by Item 701 in connection with that transaction:

(a)           The transaction wascompleted effective June 1, 2006.

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

(c)           The shares were notsold for cash.

(d)           We relied on the exemptionfrom registration provided by Sections 4(2) and 4(6) under the Securities Actof 1933 for this transaction.  We did notengage in any public advertising or general solicitation in connection withthis transaction.  The investors hadaccess to all of our reports filed with the Securities and Exchange Commission,our press releases and other financial, business and corporateinformation.  Based on our investigation,we believe that the investors obtained all information regarding Isonics thatthey requested, received answers to all questions they posed and otherwiseunderstood the risks of accepting our securities for investment purposes.

(e)           The common stockissued in this transaction is not convertible or exchangeable.  No warrants were issued in this transaction.

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

On September 1, 2006, we issued 295,855 shares of our common stock toholders of our 8% convertible debentures in payment of our principal obligationand of our interest obligation for the month ended September 30, 2006.  The following sets forth the informationrequired by Item 701 in connection with that transaction:

(a)           The transaction wascompleted effective September 1, 2006.

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

(c)           The shares were notsold for cash.

(d)           We relied on theexemption from registration provided by Sections 4(2) and 4(6) under theSecurities Act of 1933 for this transaction. We did not engage in any public advertising or general solicitation inconnection with this transaction.  Theinvestors had access to all of our reports filed with the Securities andExchange Commission, our press releases and other financial, business andcorporate information.  Based on ourinvestigation, we believe that the investors obtained all information regardingIsonics that they requested, received answers to all questions they posed andotherwise understood the risks of accepting our securities for investmentpurposes.

(e)           The common stockissued in this transaction is not convertible or exchangeable.  No warrants were issued in this transaction.

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

**WarrantIssuance**

On May 18, 2006, we issued a warrant (other than registered issuances)to a financial advisor to purchase 50,000 shares of our common stock for $1.05per share, exercisable through May 17, 2008.  The following sets forth theinformation required by Item 701 in connection with that transaction:

(a)           The transaction wascompleted on May 18, 2006.

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

(c)           The warrant was notissued for cash, but for services provided to us.

(d)           We relied on theexemption from registration provided by Sections 4(2) and 4(6) under theSecurities Act of 1933 for this transaction. We did not engage in any public advertising or general solicitation inconnection with this transaction.  Theinvestors had access to all of our reports filed with the Securities andExchange Commission, our press releases and other financial, business andcorporate information.  Based on ourinvestigation, we believe that the investors obtained all information regardingIsonics it requested, received answers to all questions it posed, and otherwiseunderstood the risks of accepting our securities for investment purposes.

(e)           The warrant isexercisable to purchase shares of our common stock at $1.05 per share with anexpiration dates of  May 17, 2008.

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

**Issuance of Buyers Sharesassociated with the 6% Debentures**

On May 31, 2006, we entered into a financingagreement with Cornell. The transaction documents provided for the issuance of660,000 shares of restricted common stock as follows:  560,000 shares to Cornell for services rendered in connection with thepurchase of the 6% Debentures and 100,000 shares to Roadrunner Capital Group, LLC (“Roadrunner”), as considerationfor assistance in the issuance of the 6% Debentures.  The following sets forth the informationrequired by Item 701 in connection with that transaction:

(a)           The transaction was effective May 31,2006. We issued an aggregate 660,000 shares of restricted common stock.

(b)           No underwriters were involved in thetransaction. The only entities who received securities from us in this transactionwere Cornell and Roadrunner.

(c)           The securities were not sold forcash. The securities were issued to Cornell and Roadrunner as consideration forservices rendered in issuing the 6% Debentures..

(d)           Theissuance of the restricted common stock was accomplished pursuant to theexemptions from registration contained in Sections 4(2) and 4(6) of theSecurities Act of 1933. We did not engage in any public advertising or generalsolicitation in connection with this transaction. We provided Cornell and Roadrunnerwith disclosure of all aspects of our business, including providing Cornell andRoadrunner and its management with our reports filed with the Securities andExchange Commission, our press releases, access to our auditors, and otherfinancial, business, and corporate information. Based on our investigation, webelieve that the management and the board of directors of Cornell andRoadrunner obtained all

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information regarding Isonics they requested,received answers to all questions they posed, and otherwise understood therisks of accepting our securities in exchange for services to be provided.

(e)           The common stockissued in this transaction is not convertible or exchangeable.

(f)            Wereceived no proceeds from the issuance of the restricted common stock and,therefore, we have no use of proceeds.

**Item 6: Exhibits**

Exhibits.

| 3.01  |   | Registrant’s Amended and Restated Articles of  Incorporation (dated May 5, 1997) (1)                                                                             |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.02  |   | Registrant’s Amended and Restated Bylaws (2)                                                                                                                     |
| 3.03  |   | Certificate of Amendment to Articles of  Incorporation (dated November 15, 2001) (3)                                                                                  |
| 3.04  |   | Certificate of Amendment to Articles of  Incorporation (dated April 29, 2005) (4)                                                                                     |
| 10.01 |   | Securities Purchase Agreement dated May 30, 2006,  between Isonics and Cornell Capital Partners, L.P. (5)                                                             |
| 10.02 |   | Investor Registration Rights Agreement dated May 30,  2006, between Isonics and Cornell Capital Partners, L.P. (5)                                                    |
| 10.03 |   | Irrevocable Transfer Agent Instructions dated May  30, 2006 (5)                                                                                                       |
| 10.04 |   | Voting Agreement dated May 30, 2006 (5)                                                                                                                               |
| 10.05 |   | Surrender and Reissuance Agreement (6)                                                                                                                                |
| 10.06 |   | Amended and Restated 6% Secured Convertible  Debenture no. CCP-3: $10,000,000 principal (6)                                                                           |
| 10.07 |   | Amended and Restated 6% Secured Convertible  Debenture no. CCP-4: $3,000,000 principal (6)                                                                            |
| 10.08 |   | Amended and Restated Warrant no. CCP-002 ($1.25  exercise price) (6)                                                                                                  |
| 10.09 |   | Amended and Restated Warrant no. CCP-003 ($1.75  exercise price) (6)                                                                                                  |
| 10.10 |   | Amended and Restated Warrant no. CCP-004 ($2.00  exercise price) (6)                                                                                                  |
| 10.11 |   | Security Agreement dated May 30, 2006, between  Isonics as grantor and Cornell Capital Partners, L.P as secured party (5)                                             |
| 10.12 |   | Security Agreement dated May 30, 2006, between  Isonics Homeland Security and Defense Corporation; as grantor and Cornell  Capital Partners, L.P as secured party (5) |
| 10.13 |   | Security Agreement dated May 30, 2006, between  Isonics Vancouver, Inc. as grantor and Cornell Capital Partners, L.P as  secured party (5)                            |
| 10.14 |   | Security Agreement dated May 30, 2006, between  Protection Plus Security Corporation as grantor and Cornell Capital Partners,  L.P as secured party (5)               |
| 31.1  |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of the Exchange Act                                                                              |
| 31.2  |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) of the Exchange Act                                                                              |
| 32.1  |   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350                                                                                          |
| 32.2  |   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350                                                                                          |

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(1)    Incorporatedherein by reference to exhibit filed with Isonics’ Registration Statement onForm SB-2 (“Registration Statement”) (Commission file No. 333-13289) in whichthis exhibit bears the same number except exhibit 3.01, which was numbered 3.03in that registration statement. 

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

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

(4)    Incorporatedby reference from Isonics’ annual report on Form 10-KSB for the year endedApril 30, 2005.

(5)    Filed withIsonics’ current report on Form 8-K (file no. 001-12531) dated May 31, 2006,filed on June 6, 2006.

(6)    Filed withIsonics’ current report on Form 8-K (file no. 001-12531) dated June 21, 2006,filed on June 21, 2006.

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized, in the City of Golden, County of Jefferson, State of Colorado,on the 14th day of September 2006.
| Isonics Corporation |
|---------------------|
| (Registrant)        |
|                |
|                |
|                |
| By                  | /s/ James E. Alexander |   |
|                | James E. Alexander |
|                | President, Chief Executive Officer and Director |
|                |
|                |
|                |
| By                  | /s/ John Sakys |   |
|                | John Sakys |
|                | Chief Accounting Officer and Chief Financial Officer |

 

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