**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM10-QSB**

 
| **(****Mark One)** |
|--------------------|
|               |   |   |
| **ý**         | **Quarterly report under Section 13 or 15(d) of  the Securities Exchange Act of 1934.** | ** ** |
|               |   |   |
|               | **For the quarterly period ended January 31, 2006** | ** ** |
|               |   |   |
| **o**              | **Transition report under Section 13 or 15(d) of  the Exchange Act.** | ** ** |
|               |   |   |
|               | **For the transition period from           to         ** | ** ** |

 

**Commission file number: 001-12531**

 

**ISONICSCORPORATION**

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

 

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

 

**5906 McIntyre Street**

**Golden, Colorado 80403**

(Address of principal executive offices)

 

**(303) 279-7900**

(Issuer’s telephone number)

 

**N/A**

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

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý    No**  **o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act.)  Yes  o    No**  **ý

 

The number of sharesoutstanding of the registrant’s Common Stock, no par value, was 40,164,849 atMarch 15, 2006.

 

Transitional Small BusinessDisclosure Format (check one):

Yes  o    No**  **ý

 

 

----

 

**Isonics Corporation and Subsidiaries**

 

**TABLE OF CONTENTS**

 

**FORM 10-QSB**

 
| Part I:    | Financial Information |                                                                                                                   |
|------------|-----------------------|------------------------------------------------------------------------------------------------------------------------|
|       |                  |                                                                                                                   |
|       | Item 1:               | Financial Statements                                                                                                   |   |
|       |                  |                                                                                                                   |   |
|       |                  | Condensed  Consolidated Balance Sheets as of January 31, 2006 and April 30, 2005                                       |   |
|       |                  | Condensed  Consolidated Statements of Operations for the Three and Nine Month Periods  Ended January 31, 2006 and 2005 |   |
|       |                  | Condensed  Consolidated Statements of Cash Flows for the Nine Month Periods Ended  January 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:               | Controls  and Procedures                                                                                               |   |
|       |                  |                                                                                                                   |   |
| Part II:   | Other Information     |                                                                                                                   |
|       |                  |                                                                                                                   |   |
|       | Item 1:               | Legal  Proceedings                                                                                                     |   |
|       |                  |                                                                                                                   |   |
|       | Item 2:               | Unregistered  Sales of Equity Securities and Use of Proceeds                                                           |   |
|       |                  |                                                                                                                   |   |
|       | Item 6:               | Exhibits                                                                                                               |   |
|       |                  |                                                                                                                   |   |
| Signatures |                  |

 

2

----

 

**Part I:  FinancialInformation**

 

**Item 1: Financial Statements**

 

**Isonics Corporation and Subsidiaries**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 

**ASSETS**

 
| ** **                                                            | ** ** | **(Unaudited)**      | ** ** | ** **             | ** ** |
|-----------------------------------------------------------------------|------------|----------------------|------------|------------------------|------------|
| ** **                                                            | ** ** | **January 31, 2006** | ** ** | **April 30, 2005 (1)** | ** ** |
| CURRENT ASSETS:                                                       |       |                 |       |                   |       |
| Cash and cash equivalents                                             |       | $                    | 5,342      |                   | $          | 21,206 |   |
| Accounts receivable (net of allowances of  $59 and $59, respectively) |       | 3,058                |       | 935                    |       |
| Inventories                                                           |       | 1,222                |       | 1,550                  |       |
| Prepaid expenses and other current assets                             |       | 909                  |       | 153                    |       |
| Assets held for sale                                                  |       | 628                  |       | —                 |       |
| Total current assets                                                  |       | 11,159               |       | 23,844                 |       |
|                                                                  |       |                 |       |                   |       |
| LONG-TERM ASSETS:                                                     |       |                 |       |                   |       |
| Property and equipment, net                                           |       | 4,920                |       | 5,589                  |       |
| Goodwill                                                              |       | 3,631                |       | —                 |       |
| Intangible assets, net                                                |       | 538                  |       | 241                    |       |
| Equity in net assets of investee                                      |       | 384                  |       | —                 |       |
| Other assets                                                          |       | 713                  |       | 1,507                  |       |
| Total long-term assets                                                |       | 10,186               |       | 7,337                  |       |
|                                                                  |       |                 |       |                   |       |
| TOTAL ASSETS                                                          |       | $                    | 21,345     |                   | $          | 31,181 |   |

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**

 
| ** **                                                                                                                                                                                                                                                 | ** ** | **(Unaudited)**      | ** ** | ** **              | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                                                                 | ** ** | **January 31, 2006** | ** ** | **April  30, 2005 (1)** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                                                                                                                       |       |                 |       |                    |       |
| Accounts payable                                                                                                                                                                                                                                           |       | $                    | 1,063      |                    | $          | 1,079 |   |
| Accrued liabilities                                                                                                                                                                                                                                        |       | 1,699                |       | 1,033                   |       |
| Current portion of obligation under capital  lease                                                                                                                                                                                                         |       | 13                   |       | 44                      |       |
| Current portion of notes payable                                                                                                                                                                                                                           |       | 826                  |       | 672                     |       |
| Current portion of convertible debentures,  net of discount                                                                                                                                                                                                |       | 19,995               |       | 3,025                   |       |
| Total current liabilities                                                                                                                                                                                                                                  |       | 23,596               |       | 5,853                   |       |
|                                                                                                                                                                                                                                                       |       |                 |       |                    |       |
| Obligations under capital lease, net of  current portion                                                                                                                                                                                                   |       | 37                   |       | 47                      |       |
| Notes payable, net of current portion                                                                                                                                                                                                                      |       | 288                  |       | 653                     |       |
| Convertible debentures, net of current  portion and of discount                                                                                                                                                                                            |       | 1,597                |       | 15,040                  |       |
|                                                                                                                                                                                                                                                       |       |                 |       |                    |       |
| TOTAL LIABILITIES                                                                                                                                                                                                                                          |       | 25,518               |       | 21,593                  |       |
|                                                                                                                                                                                                                                                       |       |                 |       |                    |       |
| STOCKHOLDERS’ EQUITY (DEFICIT):                                                                                                                                                                                                                       |       |                 |       |                    |       |
| Preferred Stock; shares authorized: January  31, 2006-7,650,000; April 30, 2005-7,656,666                                                                                                                                                                  |       |                 |       |                    |       |
| Series A Convertible Preferred Stock—no par  value; zero and 6,666 shares issued and outstanding on January 31, 2006 and  April 30, 2005, respectively; zero and $10 liquidation preference on January  31, 2006 and April 30, 2005, respectively     |       | —               |       | 5                       |       |
| Series D Convertible Preferred Stock—no par  value; zero and 800 shares issued and outstanding on January 31, 2006 and  April 30, 2005, respectively; zero and $80 liquidation preference on January  31, 2006 and April 30, 2005, respectively       |       | —               |       | 90                      |       |
| Series E Convertible Preferred Stock—no par  value; zero and 33,000 shares issued and outstanding on January 31, 2006 and  April 30, 2005, respectively; zero and $3,300 liquidation preference on  January 31, 2006 and April 30, 2005, respectively |       | —               |       | 3,938                   |       |
| Common stock—no par value; shares  authorized: January 31, 2006- 75,000,000; April 30, 2005-40,000,000;  32,598,555 and 27,696,800 shares issued and outstanding on January 31, 2006  and April 30, 2005, respectively                                |       | 36,000               |       | 28,401                  |       |
| Additional paid in capital                                                                                                                                                                                                                                 |       | 13,909               |       | 13,080                  |       |
| Deferred compensation                                                                                                                                                                                                                                      |       | (34                  | )          | (64                     | )          |
| Accumulated deficit                                                                                                                                                                                                                                        |       | (54,048              | )          | (35,862                 | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                                                                                  |       | (4,173               | )          | 9,588                   |       |
|                                                                                                                                                                                                                                                       |       |                 |       |                    |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)                                                                                                                                                                                                 |       | $                    | 21,345     |                    | $          | 31,181 |   |

 

----

(1) Derived from auditedfinancial statements

 

See notes to condensed consolidated financial statements.

 

3

----

 

**Isonics Corporation and Subsidiaries**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(Unaudited)**

 
| ** **                                                              | ** ** | **Three Months Ended  January 31,** | ** ** | **Nine Months Ended  January 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                            | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                                |       | $                                   | 6,480      |                               | $          | 2,348 |   | $ | 17,386 |   | $ | 7,698 |   |
| Cost of revenues                                                        |       | 6,104                               |       | 3,002                              |       | 17,085 |   | 9,496 |   |
| Gross margin                                                            |       | 376                                 |       | (654                               | )          | 301 |   | (1,798 | ) |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| Operating expenses:                                                     |       |                                |       |                               |       |   |   |   |   |
| Selling, general and administrative                                     |       | 2,943                               |       | 2,550                              |       | 8,662 |   | 5,371 |   |
| Impairment loss on assets held for sale                                 |       | —                              |       | —                             |       | 398 |   | — |   |
| Impairment of goodwill and intangible  assets                           |       | —                              |       | 875                                |       | — |   | 875 |   |
| Research and development                                                |       | 2,606                               |       | 245                                |       | 3,817 |   | 613 |   |
| Total operating expenses                                                |       | 5,549                               |       | 3,670                              |       | 12,877 |   | 6,859 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| Operating loss                                                          |       | (5,173                              | )          | (4,324                             | )          | (12,576 | ) | (8,657 | ) |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| Other income (expense):                                                 |       |                                |       |                               |       |   |   |   |   |
| Amortization of debt issuance costs                                     |       | (272                                | )          | —                             |       | (773 | ) | — |   |
| Interest and other income                                               |       | 64                                  |       | 6                                  |       | 275 |   | 31 |   |
| Interest expense                                                        |       | (2,308                              | )          | (29                                | )          | (5,033 | ) | (78 | ) |
| Foreign exchange                                                        |       | —                              |       | 46                                 |       | (6 | ) | 63 |   |
| Equity in net income of investee                                        |       | 28                                  |       | —                             |       | 28 |   | — |   |
| Total other income (expense), net                                       |       | (2,488                              | )          | 23                                 |       | (5,509 | ) | 16 |   |
| Loss before income taxes                                                |       | (7,661                              | )          | (4,301                             | )          | (18,085 | ) | (8,641 | ) |
| Income tax expense                                                      |       | —                              |       | —                             |       | — |   | — |   |
| NET LOSS                                                                |       | $                                   | (7,661     | )                                  | $          | (4,301 | ) | $ | (18,085 | ) | $ | (8,641 | ) |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| DEEMED DIVIDEND ON SERIES E CONVERTIBLE  PREFERRED STOCK                |       | $                                   | —     |                               | $          | — |   | $ | — |   | $ | (1,206 | ) |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| DIVIDEND ON SERIES E CONVERTIBLE PREFERRED  STOCK                       |       | $                                   | —     |                               | $          | (66 | ) | $ | (101 | ) | $ | (66 | ) |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| NET LOSS ATTRIBUTABLE TO COMMON  STOCKHOLDERS                           |       | $                                   | (7,661     | )                                  | $          | (4,367 | ) | $ | (18,186 | ) | $ | (9,913 | ) |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| **Net loss per share—basic and diluted**                           |       |                                |       |                               |       |   |   |   |   |
| Net loss per share attributable to common  stockholders                 |       | $                                   | (.24       | )                                  | $          | (.17 | ) | $ | (.59 | ) | $ | (.48 | ) |
| Weighted average common shares used in  computing per share information |       | 32,420                              |       | 26,311                             |       | 30,585 |   | 20,636 |   |

 

See notes to condensed consolidated financial statements.

 

4

----

 

**Isonics Corporation and Subsidiaries**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

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

**(Unaudited)**

 
| ** **                                                                                                     | ** ** | **Nine Months Ended January 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                     | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                                                                           |       |                              |       |   |   |
| Net cash used in operating activities                                                                          |       | $                                 | (12,633    | ) | $ | (7,317 | ) |
|                                                                                                           |       |                              |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                          |       |                              |       |   |   |
| Purchases of property and equipment                                                                            |       | (1,488                            | )          | (2,008 | ) |
| Equity investment in a business                                                                                |       | (336                              | )          | — |   |
| Acquisition of business, net of cash  acquired                                                                 |       | (2,440                            | )          | (49 | ) |
| Cash used in investing activities                                                                              |       | (4,264                            | )          | (2,057 | ) |
|                                                                                                           |       |                              |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                          |       |                              |       |   |   |
| Principal payments under capital lease  obligations                                                            |       | (41                               | )          | (47 | ) |
| Principal payments on borrowings                                                                               |       | (583                              | )          | (212 | ) |
| Proceeds from issuance of common stock                                                                         |       | 1,758                             |       | 6,817 |   |
| Proceeds from issuance of preferred stock  and related warrants                                                |       | —                            |       | 3,069 |   |
| Preferred stock dividends                                                                                      |       | (101                              | )          | — |   |
| Cash provided by financing activities                                                                          |       | 1,033                             |       | 9,627 |   |
|                                                                                                           |       |                              |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                                          |       | (15,864                           | )          | 253 |   |
| Cash and cash equivalents at beginning of  period                                                              |       | 21,206                            |       | 3,691 |   |
| Cash and cash equivalents at end of period                                                                     |       | $                                 | 5,342      |   | $ | 3,944 |   |
|                                                                                                           |       |                              |       |   |   |
| Supplemental disclosure of cash flow  information:                                                             |       |                              |       |   |   |
| Cash paid during the period for:                                                                               |       |                              |       |   |   |
| Interest                                                                                                       |       | $                                 | 988        |   | $ | 66 |   |
| Income taxes                                                                                                   |       | $                                 | —     |   | $ | — |   |
|                                                                                                           |       |                              |       |   |   |
| Supplemental disclosure of noncash  investing and financing activities:                                        |       |                              |       |   |   |
| Capital lease obligation for property and  equipment                                                           |       | $                                 | —     |   | $ | 69 |   |
| Accruals for property and equipment                                                                            |       | $                                 | 31         |   | $ | 525 |   |
| Deemed dividend associated with beneficial  conversion on Series E Convertible Preferred Stock                 |       | $                                 | —     |   | $ | 1,206 |   |
| Value of warrants for 614,000 shares of  common stock issued to Series E Convertible Preferred Stock investors |       | $                                 | —     |   | $ | 337 |   |
| Stock issued in connection with an  acquisition                                                                |       | $                                 | 1,292      |   | $ | — |   |

 

During the nine months endedJanuary 31, 2006, we also issued 10,000 shares of common stock in a cashlessexercise of a common stock warrant and issued 2,734,017 shares of common stockupon conversion of convertible preferred stock.

 

See notes to condensed consolidated financial statements.

 

5

----

 

**Isonics Corporation and Subsidiaries**

** **

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

**NOTE 1 -BASIS OF PRESENTATION**

 

The accompanying unauditedcondensed consolidated financial statements of Isonics Corporation andSubsidiaries as of January 31, 2006, and for the three and nine months endedJanuary 31, 2006 and 2005, have been prepared on the same basis as the annualaudited financial statements. In the opinion of management, such unauditedinformation includes all adjustments (consisting only of normal recurringaccruals) necessary for a fair presentation of this interim information. Operatingresults and cash flows for interim periods are not necessarily indicative ofresults that can be expected for the entire year. The information included inthis report should be read in conjunction with our audited financial statementsand notes thereto included in our Annual Report on Form 10-KSB for the yearended April 30, 2005.

 

***Realization of Assets and Liquidity***

 

The accompanying condensedconsolidated financial statements assume our continuation as a going concern,which contemplates the realization of assets and satisfaction of liabilities inthe normal course of business. However, we have sustained substantial lossesfrom operations in recent years, and such losses have continued throughFebruary 28, 2006. As of January 31, 2006, we had cash and cash equivalents of$5,342,000 and a working capital deficit of $12,437,000. The working capitaldeficit includes the current portion of our 8% Convertible Debentures (the“Debentures”), an amount of $19,995,000. However, if we continue to meet theconditions to do so, we have the option of repaying the principal on the 8%Convertible Debentures in shares of our common stock in lieu of cash and, asdescribed in Note 14 – Subsequent Events, in March 2006 we converted$10,897,000 of the face value of the Debentures into common stock. Cash used inoperations for the nine months ended January 31, 2006 and 2005, was $12,633,000and $7,317,000, respectively.

 

In view of this matter,recoverability of a major portion of the recorded asset amounts shown in theaccompanying condensed consolidated balance sheet is dependent upon ourcontinued operations, which in turn is dependent upon our ability to meet ourfinancing requirements on a continuing basis, to maintain present financing andto ultimately develop profitable operations. We continue to pursue funding thatwill help us meet our future cash needs. We are currently working with severaldifferent sources, including both strategic and financial investors, in orderto raise sufficient capital to finance both our continuing operations and ourresearch and development activities. Although there is no assurance thatadditional funding will be available, we believe that our current businessplan, if successfully funded, will significantly improve our operating resultsand cash flow in the future.

 

If we do issue additionalsecurities, these securities may have rights, preferences or privileges seniorto those of our common stock, and our common stockholders may experiencedilution. The condensed consolidated financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classification of liabilities that might be necessaryshould we be unable to continue in existence.

 

**NOTE 2 -SIGNIFICANT ACCOUNTING POLICIES**

 

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

 

We account for stock-basedcompensation to employees and directors using the intrinsic value method inaccordance with Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*andrelated interpretations, as permitted by SFAS No. 123 *Accounting for Stock-Based Compensation*,as amended by SFAS No. 148 *Accounting forStock-based Compensation – Transition and Disclosure*.

 

6

----

 

Compensation expense forstock options is measured as the excess, if any, of the quoted market price ofour stock at the date of grant over the amount an employee must pay to acquirethe stock. No stock-based employee compensation costs relating to options isreflected within our net loss as all options granted had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant (though we have recognized expense for warrants granted toexternal parties for services). We record compensation expense for restrictedstock awards based on the quoted market price of our stock at the date of thegrant and the vesting period.

 

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  January 31,** | ** ** | **Nine Months Ended  January 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2006**                            | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss attributable to common  stockholders, as reported                                                                           |       | $                                   | (7,661     | )                                  | $          | (4,367 | ) | $ | (18,186 | ) | $ | (9,913 | ) |
| Add: stock-based compensation costs  included in reported net loss, net of related tax effects                                       |       | 10                                  |       | 10                                 |       | 30 |   | 30 |   |
| Deduct: total stock-based compensation  expense determined under fair value based method for all awards, net of related  tax effects |       | (227                                | )          | (170                               | )          | (818 | ) | (328 | ) |
| Adjusted net loss attributable to common  stockholders                                                                               |       | $                                   | (7,878     | )                                  | $          | (4,527 | ) | $ | (18,974 | ) | $ | (10,211 | ) |

** **
| ** **                                              | ** ** | **Three Months Ended  January 31,** | ** ** | **Nine Months Ended  January 31,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                              | ** ** | **2006**                            | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss per share attributable to common  stockholders | ** ** | ** **                          | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic and diluted – as reported                    |       | $                                   | (.24       | )                                  | $          | (.17 | ) | $ | (.59 | ) | $ | (.48 | ) |
| Basic and diluted – adjusted                       |       | $                                   | (.24       | )                                  | $          | (.17 | ) | $ | (.62 | ) | $ | (.49 | ) |

 

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

 

Basic net loss per share iscomputed using the weighted average number of common shares outstanding duringthe period. Contingently issuable shares are included in the computation ofbasic net income (loss) per share when the related conditions are satisfied. Dilutednet income (loss) per share is computed using the weighted average number ofcommon shares and potentially dilutive securities outstanding during the period.Potentially dilutive securities consist of contingently issuable shares, theincremental common shares issuable upon conversion of preferred stock orconvertible debt (using the “if converted” method) and shares issuable upon theexercise of stock options and warrants (using the “treasury stock” method). Potentiallydilutive securities are excluded from the computation if their effect isanti-dilutive.

 

As of January 31, 2006, (a)a total of 7,615,942 outstanding stock options and common stock warrants and(b) the unissued shares underlying our outstanding convertible debentures wereexcluded from the diluted net loss per share calculations, as their inclusionwould be anti-dilutive. As of January 31, 2005, (a) a total

 

7

----

 

of 6,023,257 outstandingstock options and common stock warrants and (b) 6,666, 1,900 and 33,000outstanding shares of Series A, D and E Convertible Preferred Stock,respectively, were excluded from the diluted net loss per share calculation, astheir inclusion would be anti-dilutive.

 

During the nine month periodended January 31, 2006, we issued the following shares of common stock:

 
| **Description**                                         | ** ** | **Number  of Common Stock Shares** | ** ** |
|---------------------------------------------------------|------------|------------------------------------|------------|
| Balance as of April 30,  2005                           |       | 27,696,800                         |       |
| Conversion of preferred  stock                          |       | 2,734,017                          |       |
| Exercise of common stock  warrants and options          |       | 1,439,626                          |       |
| Shares issued from  employee stock purchase plan        |       | 20,985                             |       |
| Shares issued in payment  of interest on the Debentures |       | 200,600                            |       |
| Shares issued for  acquisition of business              |       | 506,527                            |       |
| Balance as of January 31,  2006                         |       | 32,598,555                         |       |

 

The aforementioned equitytransactions increased common stock in the accompanying condensed consolidatedbalance sheets by $7,599,000 for the nine months ended January 31, 2006.

 

***Equity Method Investments***

 

Investee companies that arenot consolidated, but over which we exercise significant influence, areaccounted for under the equity method of accounting. Whether or not we exercisesignificant influence with respect to an investee depends on an evaluation ofseveral factors including, among others, representation on the investeecompany’s board of directors and ownership level, which is generally a 20% to50% interest in the voting securities of the investee company. Under the equitymethod of accounting, our share of the earnings or losses of the investeecompany is recognized and  is reflectedin the condensed consolidated statements of operation in the caption “Equity inearnings of investee.”  The carryingvalue of the investment is reflected in the condensed consolidated balancesheet in the caption “Equity in net assets of investee.”

 

***New Accounting Standards***

 

In June 2005, the FinancialAccounting Standards Board (“FASB”) ratified the consensus reached by theEmerging Issues Task Force (“EITF”) on EITF Issue No. 05-02 *The Meaning of “Conventional Convertible DebtInstrument” in Issue No. 00-19* (“EITF 05-02”). The abstract clarifiedthe meaning of “conventional convertible debt instruments” and confirmed thatinstruments which meet its definition should continue to receive an exceptionto certain provisions of EITF Issue No. 00-19 *Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock* (“EITF 00-19”). The guidance should be appliedto new instruments entered into and instruments modified in periods beginningafter June 29, 2005. The adoption of EITF 05-02 has not had a material impacton our consolidated financial statements.

 

In September 2005, theFASB ratified the consensus reached by the EITF on EITF Issue No. 05-08, *Income Tax Consequences of Issuing Convertible Debtwith a Beneficial Conversion Feature* (“EITF 05-08”). The EITFconsensus noted that for the purpose of applying SFAS No. 109, *Accounting for Income Taxes*, (1) theissuance of convertible debt with a beneficial conversion feature results in abasis difference, (2) the basis difference is a temporary difference and (3)the recognition of deferred taxes for the temporary difference of theconvertible debt with a beneficial conversion feature should be recorded as anadjustment to additional paid-in capital. The EITF also reached a consensusthat the guidance in

 

8

----

 

EITF 05-08 should be appliedto financial statements beginning in the first interim or annual reportingperiod beginning after December 15, 2005. The guidance should be applied byretrospective application pursuant to SFAS No. 154, *Accounting Changes and Error Corrections*, to all instrumentswith a beneficial conversion feature accounted for under EITF Issue No. 00-27, *Application of Issue No. 98-5 to Certain ConvertibleInstruments*. We will adopt the guidance in EITF 05-08 for ourquarter ending April 30, 2006. We are currently assessing the impact thatadoption of EITF 05-08 will have on our consolidated financial statements.

 

In September 2005, the FASBstaff reported that the EITF postponed further deliberations on IssueNo. 05-04 *The Effect of a LiquidatedDamages Clause on a Freestanding Financial Instrument Subject to Issue No.00-19* (“EITF 05-04”) pending the FASB reaching a conclusion as towhether a registration rights agreement meets the definition of a derivativeinstrument. The legal agreements related to our 8% Convertible Debenturesinclude a freestanding registration rights agreement. Once the FASB ratifiesthe then-completed consensus of the EITF on EITF 05-04, we will assess theimpact on our consolidated financial statements of adopting the standard and,if an impact exists, follow the transition guidance for implementation.

 

**NOTE 3 –FINANCIAL STATEMENT COMPONENTS**

 

***Inventories***

 

Inventories consist of thefollowing (in thousands):

** **
| ** **              | ** ** | **January 31, 2006** | ** ** | **April 30, 2005** | ** ** |
|-------------------------|------------|----------------------|------------|--------------------|------------|
| Finished  goods         |       | $                    | 672        |               | $          | 565 |   |
| Work in  process        |       | 178                  |       | 701                |       |
| Materials  and supplies |       | 372                  |       | 284                |       |
| Total inventories       |       | $                    | 1,222      |               | $          | 1,550 |   |

 

***Property and equipment***

 

Property and equipmentconsist of the following (in thousands):

 
| ** **                                 | ** ** | **January 31, 2006** | ** ** | **April 30, 2005** | ** ** |
|--------------------------------------------|------------|----------------------|------------|--------------------|------------|
| Office  furniture and equipment            |       | $                    | 320        |               | $          | 264 |   |
| Vehicles                                   |       | 175                  |       | —             |       |
| Production  equipment                      |       | 5,424                |       | 5,579              |       |
| Leasehold  improvements                    |       | 652                  |       | 396                |       |
| Construction  in process                   |       | 804                  |       | 814                |       |
|                                       |       | 7,375                |       | 7,053              |       |
| Accumulated  depreciation and amortization |       | (2,455               | )          | (1,464             | )          |
| Total property and equipment, net          |       | $                    | 4,920      |               | $          | 5,589 |   |

 

**NOTE 4–SEGMENT INFORMATION**

 

We currently have fourreportable segments: homeland security products, security services,semiconductor products and services and life sciences. Our homeland securityproducts segment is currently marketing and developing certain trace and bulkdetection technologies. Our security services segment provides advancedsecurity and investigative services. Our semiconductor products and services

 

9

----

 

segment (formerly called the“semiconductor materials and products” segment) manufactures and reclaimssilicon wafers, sells SOI wafers and is involved in several research anddevelopment projects including silicon-28. Our life sciences segment sellsstable and radioisotopes in elemental and simple compound forms for use in lifesciences applications. Our segments are strategic business units, each of whichconsists of similar products or services. They are managed separately becauseeach segment requires different technology and marketing strategy and becauseeach segment sells to different customers. The homeland security productssegment and the security services segment were previously combined in thehomeland security segment, but have been individually identified commencingwith the three months ended January 31, 2006, due to management focus now beingdevoted to each segment individually . Reconciling items consist primarily ofcorporate assets or expenses that have not been allocated to a specificreportable segment. Prior period amounts have been reclassified to conform tocurrent period presentation.

 

Information by segment isset forth below (in thousands):

 
| ** **                          | ** ** | **Three Months Ended  January 31,** | ** ** | **Nine Months Ended  January 31,** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                          | ** ** | **2006**                            | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Segment  revenues:                  |       |                                |       |                               |       |   |   |   |   |
| Homeland security products          |       | $                                   | —     |                               | $          | — |   | $ | 35 |   | $ | — |   |
| Security services                   |       | 3,457                               |       | —                             |       | 9,090 |   | — |   |
| Semiconductor products and services |       | 1,803                               |       | 739                                |       | 3,825 |   | 1,982 |   |
| Life sciences                       |       | 1,220                               |       | 1,609                              |       | 4,436 |   | 5,716 |   |
| Total                               |       | $                                   | 6,480      |                               | $          | 2,348 |   | $ | 17,386 |   | $ | 7,698 |   |

** **
| ** **                          | ** ** | **Three Months Ended  January 31,** | ** ** | **Nine Months Ended  January 31,** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                          | ** ** | **2006**                            | ** ** | **2005**                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Segment  operating loss:            |       |                                |       |                               |       |   |   |   |   |
| Homeland security products          |       | $                                   | (1,183     | )                                  | $          | (1,049 | ) | $ | (2,587 | ) | $ | (1,063 | ) |
| Security services                   |       | (117                                | )          | —                             |       | (79 | ) | — |   |
| Semiconductor products and services |       | (900                                | )          | (2,450                             | )          | (4,374 | ) | (5,058 | ) |
| Life sciences                       |       | (293                                | )          | 45                                 |       | (502 | ) | 10 |   |
| Reconciling amounts                 |       | (2,680                              | )          | (870                               | )          | (5,034 | ) | (2,546 | ) |
| Total                               |       | $                                   | (5,173     | )                                  | $          | (4,324 | ) | $ | (12,576 | ) | $ | (8,657 | ) |

** **
| ** **                          | ** ** | **January 31,  2006** | ** ** | **April 30,  2005** | ** ** |
|-------------------------------------|------------|-----------------------|------------|---------------------|------------|
| Total assets:                       |       |                  |       |                |       |
| Homeland security products          |       | $                     | 938        |                | $          | 206 |   |
| Security services                   |       | 6,017                 |       | —              |       |
| Semiconductor products and services |       | 6,862                 |       | 6,356               |       |
| Life sciences                       |       | 2,204                 |       | 2,432               |       |
| Reconciling amounts                 |       | 5,324                 |       | 22,187              |       |
| Total                               |       | $                     | 21,345     |                | $          | 31,181 |   |

 

10

----

 

**NOTE 5–EQUITY METHOD INVESTMENT**

 

On December 1, 2005, weincreased our equity ownership interest in Institut fur Umwelttechnologien GmbH(“IUT”), an entity located in Germany, from approximately 8% to 30% in exchangefor cash consideration of approximately $336,000 (EUR 284,400). The ShareTransfer Agreement also contemplates a potential further capital increase forIUT in the cumulative amount of approximately $230,000, of which approximately$70,000 would be required to be contributed by us in order to retain our 30%ownership interest. If the IUT shareholders approve the potential capitalincrease, we would have the right to fulfill our obligation by contribution ofour common stock in lieu of cash. The other IUT shareholders would have theright to fulfill their respective obligations by contribution of theirrespective outstanding shareholder loans in lieu of cash. As of January 31,2006, no additional capital contributions have occurred.

 

We are now able to exertsignificant influence, but not control, over the operations of IUT and,accordingly, we are applying the equity method of accounting for the investment.Prior to the December 2005 equity purchase, the investment was accounted forunder the cost method. An adjustment to prior period financial statements torestate our then-held investment from the cost method to the equity methodwould not be material. As of January 31, 2006, the difference between thecarrying value of the IUT investment and the amount of underlying equity in thenet assets of IUT is $126,000. We will monitor our investment in IUT andrecognize, if ever existing, a loss in value which is other than temporary.

 

In June 2004, we enteredinto a research and development agreement with IUT, which contemplated thefunding of certain projects of up to $4,000,000 over several years. The work isbeing funded in steps and is based upon the completion of various milestones,as defined. We have no obligation to fund any work under this agreement unlesswe have approved such effort. We funded approximately $535,000 and $1,192,000under this agreement during the three and nine months ended January 31, 2006,respectively (and a total of $1,689,000 since entering into the agreement inJune 2004). All funded amounts have been included as research and developmentin the condensed consolidated statement of operations. Additionally, IUTproduces carbon-14 precursors for us that we resell in the market place. Totalpurchases from IUT for this product during the three and nine months endedJanuary 31, 2006 were $15,000 and $327,000, respectively and during the threeand nine months ended January 31, 2005 were $100,000 and $406,000,respectively.

 

**NOTE 6 –DEVELOPMENT AND LICENSING AGREEMENT**

 

On December 5, 2005, weapproved a development plan that resulted in us becoming obligated under aDevelopment & Licensing Agreement (the “Agreement”) entered into with LucentTechnologies, Inc. (“Lucent”) in September 2005. Under that Agreement, the twocompanies will endeavor to develop a next-generation infrared imaging and nightvision surveillance technology at Lucent’s micro electro-mechanical systems andnanotechnology fabrication facility. The Agreement provides for us to receivean exclusive right, except for certain rights reserved by Lucent, to make, useand sell licensed products arising from technology developed under theAgreement. In exchange 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 underthis agreement during the nine months ended January 31, 2006 (of which1,666,667 was charged to research and development expense during the threemonths ended January 31, 2006). The balance will be paid in $1,000,000increments approximately every three months thereafter. These developmentpayments will continue to be expensed to research and development expense asthe expenses are incurred. We have the right to terminate the developmentproject for any reason from time-to-time, so long as termination is prior tothe

 

11

----

 

first commercial sale of alicensed product. When, if ever, commercial sales of developed productscommence, a royalty payment based on revenue will be due Lucent (subject to aminimum semi-annual cumulative royalty payment amount). Additionally, if Lucentexpends substantial sales effort to accomplish a sale, we will also pay them asales referral fee based on revenue. Lastly, in order to retain the exclusivityof our license for the developed technology, we have agreed to pay an annualexclusivity payment commencing the October 1 next following the firstcommercial sale or the end of the development project.

 

**NOTE 7 –ACQUISITION OF PROTECTION PLUS SECURITY CORPORATION**

 

On May 16, 2005, we signedand completed an agreement to acquire Protection Plus Security Corporation(“PPSC”), a New York City based corporation that primarily provides armed andunarmed security personnel.  It also provides electronic security systems,armed escort couriers, executive bodyguards, video/electronic surveillance, mobilevehicle patrols, special event security and VIP escorts. PPSC’s investigativesolutions include communications security, eavesdropping/espionagecountermeasures, industrial sabotage investigations, employment investigationsand a range of forensic services such as voice and handwriting analysis, DNAtesting and drug screening. Some of the services are provided on an outsourcedbasis.

 

We acquired all of theoutstanding equity securities of PPSC for a total price of $3,792,000.  Ofthe purchase price, we paid $2,500,000 in cash and issued 506,527 shares of ourrestricted stock to the sellers.  The number of shares issued was based on$1,125,000 (per the stock purchase agreement) divided by the average closingbid price on the Nasdaq Small Cap Market on each of the ten consecutive tradingdays ending four business days prior to the closing ($2.22 per share). Theissued shares were then valued under purchase accounting using a measurementdate of May 16, 2005, the day the acquisition was contractually agreed to andalso consummated. The closing bid price for our common stock on the NasdaqSmall Cap Market on the measurement date was $2.55 per share, yielding avaluation of the shares issued for the acquisition of $1,292,000. We paid thepurchase price to the two owners of PPSC, each of whom represented to us thathe was an accredited investor and was acquiring the shares for investmentpurposes only and without a view toward further distribution.  Inaddition, we paid $98,000 in legal and accounting fees and we have a remainingreceivable from the seller for $21,000. These payments, net of the sellerreimbursement, increased the effective purchase price that was allocated to theacquired tangible and intangible assets.

 

The stock is price protectedfor the benefit of the former owners of PPSC.  The price protectionprovision will provide a cash benefit to them if the as-defined market price ofour common stock is less than $2.22 per share at the time they can first sellthe shares (as defined, either due to their inclusion in an effectiveregistration statement or pursuant to SEC Rule 144).  If the as-definedmarket price is less than $2.22 per share, we will be required to pay theformer owners of PPSC the difference in cash.  There are no registrationrights associated with the shares issued in the PPSC acquisition, although atour discretion we may include the shares in a future registration statement.

 

The following tablesummarizes (in thousands) the estimated fair values of the assets acquired andliabilities assumed at the date of acquisition. Included in the table below isa net increase to goodwill of $38,000 relating mainly to the adjustment ofpreacquisition contingencies that have been recently settled. While we believethe purchase accounting associated with this transaction to essentially becomplete, there is always the possibility that it may be subject to refinement.

 

12

----

 
| Current assets                     |   | $      | 1,473  |   |
|------------------------------------|--------|--------|--------|--------|
| Property and  equipment            |   | 11     |   |
| Intangible  assets - customer base |   | 431    |   |
| Goodwill                           |   | 3,631  |   |
| Total assets acquired              |   | 5,546  |   |
| Current  liabilities               |   | (1,445 | )      |
| Long-term  liabilities             |   | (259   | )      |
| Net assets acquired                |   | $      | 3,842  |   |

 

The $3,631,000 of goodwillwas assigned to the security services segment and is expected to be deductiblefor tax purposes. The $431,000 of intangible assets relates to the acquiredcustomer base and is being amortized ratably over its estimated life of threeyears. As of January 31, 2006, the unamortized balance of the intangible assetis $329,000. There was no in-process research and development acquired in thistransaction.

 

The following tablesummarizes our results of operations for the three and nine months endedJanuary 31, 2006 and 2005, as if the acquisition of PPSC had occurred on May 1,2005 and 2004, respectively. There have been no adjustments made to thehistorical results of PPSC.

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                       | ** ** | **January 31,**        | ** ** | **January 31,**       | ** ** |
| ** **                                                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues                                                                         |       | $                      | 6,480      |                  | $          | 6,634 |   | $ | 17,900 |   | $ | 18,721 |   |
| Net loss attributable  to common stockholders                                    |       | $                      | (7,661     | )                     | $          | (4,099 | ) | $ | (18,170 | ) | $ | (9,538 | ) |
| Net loss per share attributable to common  stockholders – basic and diluted |       | $                      | (.24       | )                     | $          | (.15 | ) | $ | (.59 | ) | $ | (.45 | ) |

 

**NOTE 8–ASSETS HELD FOR SALE**

 

During the first quarter offiscal year 2006, management committed to a plan to sell specific productionequipment in our semiconductor products and services segment. Based on ongoinganalysis of the semiconductor operations, these assets were deemed to be excessequipment or incompatible with the future direction of the segment’soperations. We have listed these assets for sale and are actively attempting tosell them. Immediately prior to the decision to sell the assets, the equipmenthad a cumulative net book value of approximately $1,026,000. Certain assetshave been written down to their fair value, less selling costs, yielding animpairment loss on assets held for sale in the amount of $398,000. The assetsheld for sale are now classified in current assets at the lower of their bookvalue or fair value, less selling costs, in the cumulative amount of $628,000.During the nine months ended January 31, 2006, none of the assets held for salewere sold.

 

**NOTE 9 –EQUITY**

 

***Common Shares Authorized***

 

On May 9, 2005, our Articlesof Incorporation were amended to increase the authorized number of commonshares issuable from 40,000,000 to 75,000,000. Prior to filing the Certificateof Amendment

 

13

----

 

with the Secretary of Stateof the State of California, the change to the authorized shares of common stockwas first approved by a vote of the shareholders and by a vote of the Board ofDirectors.

 

***Convertible Preferred Stock***

 

As of January 31, 2006,there are no outstanding shares of any series of our preferred stock, but thereremain 2,500,000 shares designated as Series B Preferred Stock, 22,000 sharesdesignated as Series C Preferred Stock, 32,950 shares designated as Series DPreferred Stock and 33,000 shares designated as Series E Preferred Stock.Subject to the approval of the board of directors, the designation of rights,preferences, privileges and restrictions of the Series C Preferred Stock,Series D Preferred Stock, and Series E Preferred Stock will be cancelled byfiling an amendment to our articles of incorporation with the CaliforniaSecretary of State and thereby be returned to undesignated “blank check”preferred stock. Our authorized preferred stock balance as of April 30, 2005,has been amended from 7,622,516 previously reported to 7,656,666 in order torecognize the impact of California state law (our state of incorporation) onour authorized preferred stock balance.

 

On August 9, 2005, weredeemed the remaining 6,666 outstanding shares of the Series A ConvertiblePreferred Stock (“Series A Stock”). The Series A Stock originally consisted of1,850,000 shares issued with a liquidation preference of $1.50 per share. As aresult, the holder no longer is able to convert the shares and the rights andpreferences associated with the Series A Stock have been terminated. The holderis entitled to receive $1.50 for each share of the Series A Stock, an amount ofapproximately $10,000.

 

On May 19, 2005, theremaining 800 shares of Series D Convertible Preferred Stock (“Series D Stock”)were converted into 72,727 shares of common stock. As a result, as of January31, 2006, there were zero shares of Series D Stock outstanding.

 

On July 27, 2005, 23,000shares of Series E Convertible Preferred Stock (“Series E Stock”) wereconverted into 1,854,838 shares of common stock. On October 19, 2005, theremaining 10,000 shares of Series E Stock were converted into 806,452 shares ofcommon stock. As a result, as of January 31, 2006, there were zero shares ofSeries E Stock outstanding.

 

***Warrant Amendments***

 

On June 17, 2005, weextended the expiration date of the Class B and C Warrants from December 31,2005, to December 29, 2006, via an amendment to the warrant agreements. Therewere no other changes made to the terms and conditions of the warrantagreements. The holders of these warrants were unable to exchange the warrantsfor registered shares of our common stock between October 2004 (at which timethe underlying registration statement was no longer current) and August 24,2005 (at which time a post-effective amendment to the registration statementgained effectiveness). In October 2004, we originally attempted to file apost-effective amendment to the respective registration statement, but we wereunable to do so because our former auditor, Grant Thornton LLP, was unwillingto consent to the inclusion of its report on our April 30, 2004 and 2003,financial statements in the post-effective amendment. During the three monthsended July 31, 2005, we recorded a non-cash operating expense in the condensedconsolidated statement of operations in the amount of approximately $297,000,such charge representing the excess of the fair value of the amended warrantover the fair value of the original warrant immediately prior to amendment.

 

During the nine months endedJanuary 31, 2006, 362,011 Class B Warrants were exercised which yieldedproceeds of $543,000. Upon exercise of a Class B Warrant, a holder is providedone share of common stock and one Class C Warrant. No Class C Warrants wereexercised during the nine months ended January 31, 2006.

 

14

----

 

On December 29, 2005, weextended the expiration date of certain warrants to purchase 232,500 shares ofcommon stock at an exercise price of $1.25. The warrants were initially issuedin a financing transaction and the holder of the warrants had, for a period oftime as described in the Class B and C Warrant disclosure above, an inabilityto exercise the warrants for registered shares of our common stock. Theexpiration date of the warrants was extended from December 31, 2005, toDecember 29, 2006. There were no other changes made to the terms and conditionsof the warrant agreements. During the quarter ended January 31, 2006, werecorded a non-cash operating expense in the statement of operations in theamount of approximately $213,000, such charge representing the excess of thefair value of the amended warrant over the fair value of the original warrantimmediately prior to amendment.

 

**NOTE 10 –EQUITY INSTRUMENTS ISSUED FOR SERVICES**

 

In September 2005, weentered into a financial advisory services agreement with Clayton DunningCapital Partners, Inc., whereby we issued a common stock warrant (valued at$152,000 using the Black-Scholes pricing model) to purchase 100,000 shares ofcommon stock at $2.81 per share. The common stock warrant vested immediately,expires on September 8, 2007, and was recorded as prepaid consulting expense,to be amortized ratably over the expected service period of one year. As ofJanuary 31, 2006, $63,000 has been expensed to selling, general andadministrative expenses.

 

In September 2005, weentered into a consulting agreement with an individual to provide managementservices in our semiconductor products and services segment, whereby we issueda common stock warrant (valued at $75,000 using the Black-Scholes pricingmodel) to purchase 50,000 shares of common stock at $2.84 per share. The commonstock warrant vested immediately, expires on August 16, 2007, and was recordedas prepaid consulting expense, to be amortized ratably over the expectedservice period of eight months. As of January 31, 2006, $47,000 has beenexpensed to selling, general and administrative expenses.

 

**NOTE 11 –CONVERTIBLE DEBENTURES**

 

On February 24, 2005, wecompleted a private placement pursuant to which we issued to accreditedinvestors 8% convertible debentures in the aggregate principal amount of$22,000,000 and common stock warrants (collectively, the “Warrants”) grantingthe right to purchase a total of 1,540,000 common shares. The Debentures areconvertible by the holders into shares of our common stock at any time and at aconversion price of $5.00 per share (the “Conversion Price”). This ConversionPrice will be adjusted upon the occurrence of any stock dividends, stocksplits, pro rata distributions, or fundamental transactions as described in theDebenture agreement. The Warrants are exercisable for a period of three yearsand at an exercise price of $6.25 per share. Under specified conditions,including the lack of an effective registration statement for the underlyingshares, and after a period of one year from issuance, the Warrants may beexercised by means of a cashless exercise. This provision permits the warrantholder to cancel a portion of the warrants at the then current share price toreceive the balance of the warrants in common stock without payment to us.Further, the Warrants contain a ratchet provision triggered by a subsequentequity sale. Under this provision, the warrant exercise price would be reducedto the effective price per share (or effective exercise price per share) of thesubsequent equity sale. Concurrently, the number of warrants would be adjustedsuch that the aggregate exercise price would be equal to the aggregate exerciseprice prior to adjustment.

 

Interest on the Debentureswas payable quarterly at the end of each calendar quarter until March 1, 2006,at which time all accrued and unpaid interest is now payable the 1st day ofeach calendar month thereafter.

 

15

----

 

The Debentures are requiredto be reduced by 1/12th per month beginning March 1, 2006. The Debentures willmature on February 28, 2007. We may not prepay the principal amount of theDebentures without the consent of the holders.

 

Both the principal andinterest are payable, at our option, in common stock or cash, subject tovarious requirements. If we choose to make a scheduled principal payment byissuing common stock, and all requirements to do so are met, the conversionprice will be the lesser of the then Conversion Price or 88% of the average ofthe ten final bid prices ending on the trading day immediately prior to themonthly redemption date. If we choose to make a scheduled interest payment byissuing common stock, and all requirements to do so are met, the conversionprice will be the lesser of the then Conversion Price or the lesser of (i) 90%of the average of the twenty final bid prices ending on the trading dayimmediately prior to the applicable interest payment date or (ii) 90% of theaverage of the twenty final bid prices ending on the trading day immediatelyprior to the date the applicable interest payment shares are issued anddelivered if after the interest payment date.

 

Having met all requirementsto allow us to do so, we elected to make the quarterly interest payment due onSeptember 30, 2005, in shares of our common stock. Accordingly, we issued200,600 shares of common stock in settlement of our interest obligation for thequarter ended September 30, 2005. A charge in the amount of $506,000 wasrecorded as interest expense related to the share issuance, an amount thatrepresents the fixed monetary amount of the interest obligation when settled instock (as opposed to a fixed monetary amount of $455,000 if the interest paymenthad been made in cash). The December 31, 2005, interest payment was made incash. See Note 14 – Subsequent Events for additional information about paymentsmade in shares of our common stock.

 

The Debentures are nowredeemable at our option, in whole or in part, if the closing prices for anytwenty days in a thirty consecutive trading day period (such period commencingafter February 25, 2006) exceeds 150% of the then Conversion Price.

 

The Debentures and theWarrants have certain limitations on our ability to issue shares to the holdersof the Debentures and Warrants (the Holders). Under the terms of the Debenturesand the Warrants, we are prohibited from issuing shares of our common stock tothe holders of the Debentures (upon conversion, in payment of interest, or inredemption or payment of the Debentures) and the Warrants (upon exercise)if:  (a) the issuance would result in anyHolder owning more than 4.99% of our outstanding common stock (although theholders can waive this provision upon more than 60 days’ notice to us) or(b) the issuance would result in more than 5,514,601 shares having been issuedpursuant to the Debentures and the Warrants (19.999% of the total number ofshares outstanding on February 24, 2005) unless our shareholders haveapproved the transaction as required by the Nasdaq rules. As our shareholdersapproved the transaction on October 25, 2005, the 19.999% contractuallimitation as to the number of shares that can be issued is no longer beapplicable, although the 4.99% limitation will continue to be applicable until(if ever) waived by a the respective Holder. Waiver by one Holder does noteliminate the provision as to all Holders.

 

As a result of afreestanding registration rights agreement, we had an obligation to registerthe shares underlying the Debentures and Warrants (the registration statementbecame effective on July 26, 2005) and have a continuing obligation to keep theregistration statement continuously effective. Failure to meet this obligation,as defined, will result in our incurring liquidated damages in the amount of1.0% of the principal amount of the purchase price per month for any sharesderived from the Debentures or Warrants and then held by each of the holders ofthe Debentures at the time liquidated damages are payable.

 

Additionally, other events,as defined in the Debenture agreement, may also allow the Debenture holders todeclare us in default. Remedies for an event of default, include the option toaccelerate payment of the full

 

16

----

 

principal amount of theDebentures, together with interest and other amounts due, to the date ofacceleration. The principal amount of the Debentures shall be equal to 130% ofthe then-principal amount of the Debentures plus all interest and other amountsdue or a conversion calculation, whichever is higher.

 

We evaluated the embeddedconversion feature in the Debentures and concluded that the feature does notrequire classification as a derivative instrument because the feature would beclassified in equity if it were a freestanding instrument and, therefore, meetsthe scope exception found in SFAS 133 *Accountingfor Derivative Instruments and Hedging Activities* (“SFAS 133”).Included in this evaluation is the conclusion that the Debentures meet thedefinition of “conventional convertible debt instrument” and, therefore, theembedded conversion feature is not subject to the more onerous provisions ofEITF 00-19. Further, we evaluated the detachable Warrants and concluded that thewarrants also meet the scope exception found in SFAS 133 and, therefore, areappropriately classified in equity. Lastly, we evaluated the freestandingregistration rights agreement (discussed above) and concluded that it meets thedefinition of a derivative instrument under SFAS 133. The fair value of thisderivative liability is immaterial based on a probability-weighted, discountedcashflow evaluation of its terms.

 

We allocated the proceedsreceived between the Debentures and the Warrants based on the relative fairvalue of each instrument. The $3,525,000 allocated to the Warrants was recordedas additional paid-in capital and as a corresponding reduction to the carryingvalue of the Debentures. In addition, in accordance with EITF 00-27“Application of Issue No. 98-5 to Certain Convertible Instruments” wecalculated the intrinsic value of the conversion option by using the effectiveconversion price based on the proceeds allocated to the Debentures. As aresult, we determined that the value of the beneficial conversion feature(based upon a $5.00 conversion price) contained in the Debentures to be$1,720,000. This amount was recorded as additional paid-in capital and as acorresponding reduction to the carrying value of the Debentures. The cumulativediscount on the Debentures as originally booked is being amortized to interestexpense over the term of the Debentures using the effective interest method atan effective interest rate of 19%. During the three and nine months endedJanuary 31, 2006, $925,400 and $2,633,000, respectively, of this discount onthe Debentures were amortized to interest expense. At January 31, 2006, theunamortized original discount on the Debentures is $2,071,000.

 

We believe it is probablethat we will repay the principal portion of the Debentures in common stockinstead of cash. As such, we are accreting the aggregate Debentures balance inour condensed consolidated balance sheet to the fixed monetary amount of theobligation when settled in common stock. When paid in common stock, the fixedmonetary amount of principal repayment is $25,875,000, as opposed to$22,770,000 if paid in cash, the difference being due to the aforementionedfixed discount applied to the price of our common stock in the calculation ofthe number of common shares due for each principal payment, as defined. As aresult, for the three months ended January 31, 2006, we recorded additionalinterest expense of $893,000, representing the increased accretion resultingfrom the probable repayment of the Debentures principal in common stock.

 

In connection withcompleting the financing arrangement, we paid a placement agent (i) a 6.5% feeconsisting of $660,000 and a $770,000 convertible debenture and (ii) a CommonStock Purchase Warrant granting the right to purchase 53,900 shares of commonstock (valued at $142,000 using the Black-Scholes pricing model). Theconvertible debenture and related debt issuance cost was measured at the fairvalue of the convertible debenture, $745,000. The total debt issuance costs of$1,547,000 were capitalized and are being amortized to amortization of debtissuance costs over the life of the convertible debenture using the effectiveinterest method. During the three and nine months ended January 31, 2006,$272,000 and $773,000, respectively, of the capitalized debt issuance costswere amortized to expense. At January 31, 2006, the unamortized debt issuancecost is $608,000. The terms of both the convertible debenture and the warrantare the same as those for the accredited investors, as described above. Thediscount on the

 

17

----

 

convertible debenture isbeing amortized to interest expense over the term of the convertible debentureusing the effective interest method.

 

**NOTE 12 –COMMITMENTS AND CONTINGENCIES**

 

As of January 31, 2006, wehad commitments outstanding for capital expenditures of approximately $474,000.

 

On March 25, 2005, PrimeInternational Equities, LLC (“the Plaintiff”) filed a complaint against us inthe United States District Court for the District of Colorado (Civil Case No.05-F-562 (BNB). On October 31, 2006, a settlement agreement was signed in whichno liability or wrongdoing was admitted. In return for dismissal of thecomplaint, we paid the Plaintiff $50,000 and issued a common stock warrant(valued $109,000 using the Black-Scholes pricing model) to purchase 120,000shares of common stock at $2.40 per share. The common stock warrant vestedimmediately, expires on December 29, 2006, and was recorded as a selling,general and administrative expense in the three months ended October 31, 2005.Further, the common stock warrant includes a registration rights clause wherebywe have agreed to use our best efforts to include the common stock underlyingthe warrant in a registration statement by not later than May 31, 2006.

 

**NOTE 13 -RELATED PARTY TRANSACTIONS**

 

In conjunction with theacquisition of PPSC, we retained the services of both the former owners in anemployment relationship. PPSC continues to lease premises partially owned byone of these individuals. The lease term is for the four-year period ended May15, 2009. Annual rent payments are $48,000 in each of the four years of thelease term. Additionally, we reimburse the landlord 80% of the costs incurredby the landlord for taxes, maintenance of common areas and fire and hazardinsurance as well as the entire amount of the premium incurred for rental lossinsurance.

 

**NOTE 14 -SUBSEQUENT EVENTS**

 

Having met all requirementsto allow us to do so, we elected to make the principal and interest payment duefor our Debentures on March 1, 2006, in shares of our common stock.Accordingly, we issued a total of 1,347,361 shares of common stock insettlement of (1) our repayment of 1/12 of the original principal balance (anamount of $2,156,000 which represents the fixed monetary amount of the paymentwhen made in stock, as opposed to a fixed monetary amount of $1,897,000 if thepayment had been made in cash) and (2) our interest obligation for the twomonths ended March 1, 2006. In our condensed consolidated statement ofoperations for the three months ended January 31, 2006, a charge in the amountof $169,000 was recorded as interest expense related to the share issuance, anamount that represents the fixed monetary amount of the January 2006 interestobligation when settled in stock (as opposed to a fixed monetary amount of$151,800 if the interest payment had been made in cash). We have notified theholders of the Debentures that we intend to make the April 1, 2006, principaland interest payment in shares of our common stock.

 

On March 9, 2006, holders ofour Debentures converted outstanding principal in the amount of $9,000,000 into6,206,899 shares of our common stock. We gave the holders of all Debentures theright to convert a portion or their entire principal amount into shares of ourcommon stock at a temporary conversion price of $1.45 per share (a reductionfrom the prior conversion price of $5.00 per share). At the close of businesson March 8, 2006, the closing price for our common stock was $1.64 per share.Additionally, we issued 10,034 shares of our common stock in payment ofinterest then due on the converted principal amount. As a result of theconversion, there remain outstanding convertible debentures with a principal amountof $11,872,500.

 

18

----

 

The conversion will resultin a charge to our statement of operations in the fourth quarter of our fiscalyear 2006. However, determination of the amount of the charge has not yet beenconcluded.

 

19

----

 

**Item 2:  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*Thestatements contained in this Report on Form 10-QSB that are not purelyhistorical are forward looking statements within the meaning of Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934, including statements regarding our expectations, hopes, intentions orstrategies regarding the future. Forward-looking statements include: statementsregarding future products or product development, including our ability toleverage existing research and development efforts into commercially viableproducts; statements regarding future selling, general and administrative costsand research and development spending and our product development strategy; andstatements regarding future capital expenditures, commitments and financingrequirements. All forward-looking statements included in this document arebased on information available to us on the date hereof, and we undertake noobligation to update any such forward-looking statements. It is important tonote that our actual results could differ materially from those in suchforward-looking statements.*

 

***General Discussion***

 

Founded in 1992, we are anadvanced materials and technology company focused on the development andprovision of homeland security products and services, the manufacturing andreclamation of silicon wafers and the manufacturing of silicon-on-insulator (“SOI”)wafers to the semiconductor industry and the supply of isotopes for lifesciences and health-care applications.

 

Liquidity and CapitalResources

 

As a result of our ongoingoperating losses and financial commitments, including both borrowings andresearch and development funding, see our discussion of liquidity and capitalresources in the Liquidity and Capital Resources section included further belowin this Item 2: Management’s Discussion and Analysis of Financial Condition andResults of Operations.

 

Homeland Security

 

In October 2004, we formed anew subsidiary, Isonics Homeland Security and Defense Corporation (“HSDC”), tofocus and consolidate our efforts in the homeland security sector. Theseefforts include entry into the security service market, acquisition anddevelopment of certain trace and bulk detection technology that can be used todetect various types of explosives and/or chemical agents, the launch of apartnership to provide intelligent digital video solutions and the enteringinto an agreement with an established partner to develop innovative infraredimaging technology. Each of these efforts are discussed below:

 

•                  Security Services - In May 2005, we acquiredPPSC, a provider of a wide range of security-related services, including armedescort personnel, electronic security systems, mobile vehicle controls,forensic analysis, communications security and other security expertise. Sincethe effective date of the acquisition, PPSC has delivered significant revenue($9,090,000, although the pro forma amount would have been approximately$9,604,000 if the acquisition had occurred on May 1, 2005) and gross margin ofapproximately 23%. Although the segment has generated an operating loss throughthe nine months ended January 31, 2006, of $79,000, this amount is inclusive ofamortization of acquisition-related customer intangibles in the amount of$102,000 and also includes incremental investment in personnel specificallyfocused on selling to the government sector 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.

 

20

----

 

InAugust 2005, PPSC secured over approximately $4,800,000 in cumulative newcontracts for six private sector customers for security services to beperformed throughout the United States. The contract terms range from one tothree years in length and expected incremental revenue for fiscal year 2006 isapproximately $1,200,000. In January 2006, PPSC secured Forbes, Inc. and theNational Basketball Association as customers in the metropolitan New York area.Further, though currently PPSC does not have government service contracts, inJuly 2005 PPSC was awarded a GSA federal supply schedule under which PPSC canand has begun to pursue government service contracts. While we believe that wewill be successful in acquiring government service contracts in fiscal year2006, we can offer no assurance that we will be able to do so. Current PPSCactivities in business integration, customer retention, customer solicitationand customer expansion are on pace with our integration plan.

 

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

 

IonMobility Spectroscopy (“IMS”) – IMS is a “sniffer” technology originallydeveloped by IUT, the German entity in which we recently increased our minorityownership position to 30%. During the three months ended January 31, 2006, weramped up our marketing and sales efforts of EnviroSecureTM, a new system thatcan monitor and identify chemical weapons and toxic substances in the air in avariety of venues including airports, mass transit facilities, sports venuesand public and private sector office buildings. Available for immediate saleand installation, our system is designed to continuously monitor the air andimmediately detect and identify harmful substances at the parts per billion(ppb) level, providing warning of a possible attack in a matter of minutes. Earliergenerations of this product have been in continuous use at the Germanparliament building since 1999, effectively monitoring the air for toxicsubstances and chemical weapons. This turnkey solution would include systemdesign, engineering, hardware, software, installation, training and maintenance.It is anticipated that the EnviroSecureTM system could be installed and becomefully operational within three to nine months, though the time frame will varydepending on the size and complexity of each installation. While we have notyet made any sales of this product, the product is available for sale, and wecontinue to focus our efforts on marketing and customer engagement.

 

Throughour ongoing funding of research and development efforts at IUT, we continue toexplore other commercial applications for our IMS technology, including effortsto decrease the size and weight of the IMS units to a form factor that wouldallow portability. Additionally, in November 2005 we signed a developmentagreement with DualDraw LLC (“DualDraw”), a manufacturer of air qualityequipment. We have jointly agreed to create and test a prototype that combinesour IMS based technology with DualDraw’s Mailroom Inspection Workstations, adowndraft workstation that keeps toxic substances away from the breathing zoneof mailroom workers who are sorting or opening mail and captures suchsubstances with a HEPA filtration system. The incorporation of our IMScapability would provide an alarm if toxic or explosive substances are detected.A prototype of the product has been completed and is expected to be introducedto the industry and exhibited at the 2006 National Postal Forum, April 2-5 inOrlando, Florida. Though our intention is to introduce additional commercialIMS products in calendar 2006, we can offer no assurances that we will be ableto do so.

 

Neutronbased detection - We have developed a hand-held explosive detection devicenamed “NeutroTestTM.”  We hadearlier projected that we expected to have a NeutroTestTM product available for international sales in late second calendarquarter and for United States sales in the third calendar quarter of 2005,respectively. As expected, we completed the sale of two, first-generation unitsto a German entity in June 2005, although we have not completed any subsequentsales in Europe or the United States. Feedback on the performance of these twounits has been positive and has also included product enhancementrecommendations. We have

 

21

----

 

takenthe feedback from our initial international sales of the first-generationNeutroTestTM and have implemented them into oursecond-generation units, one of which is now available in the United States forcustomer demonstrations. Our marketing plan for the second-generationNeutroTestTM product includes targeting potential UnitedStates based customers to which we will demonstrate the value of NeutroTestTM. To facilitate this plan, we have reached an agreement with a thirdparty to establish a fully licensed customer demonstration and trainingfacility in the United States. One issue that has impeded the sales process isthe regulatory and licensing requirements regarding the neutron-generationsource, generally a radioisotope, whereby both our company and the customer mustmeet certain criteria in order to possess and use the radioisotope for itsintended purpose. Though we believe the regulatory and licensing requirementscan be met by both, these requirements will likely limit the customer based forour NeutroTestTM product to government and military entities and ,possibly, large organizations with the resources to meet the licensingrequirements. We can make no assurances that we will be able to successfullymitigate the requirements to the extent required for broad-based marketacceptance of the NeutroTestTM product. The development ofsecond-generation functionality, implementation of the domestic marketing planand addressing the existing aforementioned regulatory requirements have beenthe focus of activities in the third and fourth quarters of calendar year 2005,and we expect to continue these efforts in the first and second quarters ofcalendar year 2006. Although we have continued research and development fundingof both the IMS and neutron-based detection technologies, we expect that futurefunding decisions will place a higher emphasis on IMS-based applications.

 

•                  Intelligent Digital Video Solutions – InFebruary 2006, we entered into an agreement with Intelligent Security Systems,Inc. (“ISS”), a developer of innovative video security technology, to offer arange of intelligent video security solutions for the homeland security market.These solutions integrate proprietary technology to provide advanced securityapplications in addition to standard digital video monitoring, including facialrecognition, iris recognition, object tracking, body tracking and behaviorrecognition and license plate recognition. ISS-based video surveillancesolutions have been previously successfully deployed globally in the homeland securitymarket. Available for immediate order, our initial efforts have been focused onmarketing and customer engagement.

 

•                  Infrared Imaging Technology – On December 5,2005, we approved a development plan that resulted in us becoming obligatedunder a Development & Licensing Agreement entered into with Lucent inSeptember 2005. Under this Agreement, the two companies will endeavor todevelop a next-generation infrared imaging and night vision surveillancetechnology based on research by Lucent’s Bell Labs micro electro-mechanicalsystems (“MEMS”) and nanotechnology fabrication facility. Infrared technology,which converts infrared radiation in the non-visible spectrum, such as bodyheat, into a visible image, is commonly found in both commercial and military/homelandsecurity applications including night vision goggles and cameras, rifle scopes,and threat detection devices used to identify concealed weapons or explosives. TheMEMS approach to infrared imaging, if successful, may lead to products whichare higher performance at a lower power consumption than products currentlyavailable in the marketplace today. Additionally, a MEMS-based product may alsoprovide for cost efficiencies in the manufacturing process. The developmentplan contemplates a proof-of-concept within 12 months, followed by stepstowards commercialization, though we can provide no assurances that acommercially attractive product will ultimately be available.

 

The Agreement provides forus to receive an exclusive right, except for certain rights reserved by Lucent,to make, use and sell licensed products arising from technology developed underthe Agreement. In exchange for 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

 

22

----

 

totaling $12,000,000. Wepaid $2,000,000 under this agreement in the nine months ended January 31, 2006.The balance will be paid in $1,000,000 increments approximately every threemonths thereafter. We have the right to terminate the development project forany reason (including if the development work is not proceeding up to ourexpectations) from time-to-time, so long as termination is prior to the firstcommercial sale of a licensed product. Additionally, upon the commencement ofcommercial sales, if ever, we would be obligated to pay royalties based onrevenue, potentially a sales referral fee based on revenue and also an annualexclusivity payment to maintain our exclusive rights to the developedtechnology.

 

Semiconductor products andservices

 

Our semiconductoroperations, based in Vancouver, Washington, showed continued substantialoperational and financial improvement for the three months ended January 31,2006, though still generating an operating loss and negative cash flow. In aneffort to reduce historical negative financial results, in April 2005 we beganthe process to realign our business whereby we planned to significantly reduceour reliance on low margin small diameter products and focus mainly on highermargin 300-millimeter large-diameter and SOI products. The large-diameter wafersegment has become one of the fastest growing segments of the silicon wafermarket and the revenues and gross margins associated with the services aresubstantially greater than those associated with the small diameter market. Asa result of our strategic realignment, revenue from 300-millimeter servicescomprised approximately 48% of segment revenue for the three months endedJanuary 31, 2006 ($859,000 in revenue), an increase from approximately 1% ofsegment revenue for the three months ended July 31, 2005, and approximately 31%for the three months ended October 31, 2005. Also, revenue from SOI productshas increased to approximately $108,000 for the three months ended January 31,2006, from approximately $66,000 for the three months ended July 31, 2005. Additionally,there has been a focus on processing efficiency and effectiveness, which hasresulted in increased processing yields. Further, we have continued to gain newcustomers and are also in the process of attempting to qualify our product atothers. We have successfully completed the first phase of qualification for thesupply of 300mm wafers to two leading global semiconductor industryparticipants. If the second phase of either or both qualifications issuccessfully completed, we expect to begin recognizing additional revenue fromthese customers in quarters subsequent to successful qualification. However, wecan offer no assurances that we will ultimately successfully qualify for eitheror both of the aforementioned customers, as well as any others.

 

As a result, while thesegment generated an operating loss of $900,000 for the three months endedJanuary 31, 2006, this operating loss is approximately 37% less than thatexperienced for the three months ended October 31, 2005 ($1,420,000), andapproximately 63% less than that experienced in the comparative quarter of ourfiscal year 2005 ($2,450,000). The operating loss of $4,374,000 for the ninemonths ended January 31, 2006, is approximately 14% less than the comparableperiod in fiscal year 2005 ($5,058,000), and includes an impairment charge of$398,000 related to certain production equipment that was no longer necessaryunder the new business plan. We continue to monitor the situation closely and,while we believe that our realignment of the business has enhanced our chancesto reach profitability in the future and that we will continue to see improvingfinancial results in the segment, the overall process will take time and thereare no assurances that profitability will be reached.

 

Life Sciences

 

Our life sciences divisionhas historically been primarily a distribution business. We acquire isotopesfrom several manufacturers who are located primarily in republics that werepart of the former Soviet Union. We buy these isotopes from the manufacturersand resell them in the form of common chemical compounds. For example,oxygen-18 is sold as water, and zinc-68 is sold as zinc oxide. We sell theseisotopes for use in basic scientific research, medical diagnostics/therapy andindustrial applications. An isotope is one of two or more species (or nuclides)of the same chemical element that differ from one another only in the number ofneutrons in the atom’s nucleus. The different number of neutrons can createsignificantly different

 

23

----

 

nuclear properties. The mostwell known of these properties is radioactivity. Radioactive isotopes (orradioisotopes) can be found in nature. Most of our radioisotopes, however, areman-made. Stable isotopes, as distinguished from radioisotopes, are notradioactive. We continue to evaluate possible applications for stable isotopes,radioisotopes and non-isotopic materials.

 

At the present time, ourlife sciences division is being adversely affected by increased domestic andinternational competition. The oxygen-18 market continues to be dynamic andvolatile. Established suppliers have increased capacity and reputable suppliershave entered the market with a comparable high quality product. The market iscurrently in a surplus state and we expect it to be so for several years tocome. Prices have declined over 50% from highs of approximately three years ago.Our average selling price for oxygen-18 during our third quarter of fiscal year2006 has decreased approximately 9% from that received during our previousquarter and approximately 36% from that received in the comparable period inthe prior year. Additionally, this average selling price is likely in excess ofthe spot rate in the market due to the advanced pricing agreements we have withcertain customers. As such, additional price erosion may be expected. In anattempt to offset the degradation of the oxygen-18 market, we are expandinginto other areas, such as actinium-225 and indium-111. While we don’t expectthese isotopes to contribute materially to our revenues in fiscal year 2006,this expansion is indicative of our business goal to broaden revenue beyond theconcentration found in a few, core products (mainly oxygen-18).

 

In addition, ourinternational radioisotope business experienced rising supplier prices in amarket that is highly price-sensitive. In an effort to reduce costs, in theprior quarter we took the steps necessary to close our European trading officeby the close of our fiscal year ending April 30, 2006. During the three monthsended January 31, 2006, our ability to pass on these increasing supply pricesto our customers has proven to be problematic as our customers have access toradioisotope supply from other entities. In response, we concluded thatcontinuing the sales operations formerly of our European trading office was notan economically viable business and thus we terminated sales activity with theexisting customer base. Revenue from our international isotope trading businesswas $348,000 for the three months ended January 31, 2006, reduced from ahistorical run rate of approximately $600,000 per quarter. We do not anticipatematerial, if any, revenue from this business in future quarters. For our lifesciences business in the aggregate, as with all our reportable segments, wecontinually monitor business conditions and marketplace changes and evaluateall investment, divestiture and other strategic options.

 

Our consolidated revenues inthe future will depend on our success in developing and selling products in thehomeland security, semiconductor and stable and radioactive isotope markets. Ourprofitability will be dependent upon our ability to manage our costs and toincrease our revenues in all of our business segments. However, we can offer noassurance that we will be able to increase our revenue or our profitability.

 

We have not received anyrequests for additional information from either the SEC or NASDAQ during thelast thirteen months and to the best of our knowledge, these issues are behindus and we are moving forward.

 

***Results of Operations***

 

The following table setsforth, for the periods indicated, condensed consolidated statements ofoperations data expressed as a percentage of revenues. The table and thediscussion below should be read in conjunction with the condensed consolidatedfinancial statements and the notes thereto appearing elsewhere in this report.

 

24

----

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **January 31,**        | ** ** | **January 31,**       | ** ** |
| ** **                                    | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                          |       |                   |       |                  |       |   |   |   |   |
| Revenues                                      |       | 100.0                  | %          | 100.0                 | %          | 100.0 | % | 100.0 | % |
| Cost of  revenues                             |       | 94.2                   |       | 127.9                 |       | 98.3 |   | 123.4 |   |
| Gross margin                                  |       | 5.8                    |       | (27.9                 | )          | 1.7 |   | (23.4 | ) |
|                                          |       |                   |       |                  |       |   |   |   |   |
| Operating  expenses:                          |       |                   |       |                  |       |   |   |   |   |
| Selling, general and administrative           |       | 45.4                   |       | 108.6                 |       | 49.8 |   | 69.8 |   |
| Impairment loss on assets held for sale       |       | —                 |       | —                |       | 2.3 |   | — |   |
| Impairment of goodwill and intangible  assets |       | —                 |       | 37.3                  |       | — |   | 11.3 |   |
| Research and development                      |       | 40.2                   |       | 10.4                  |       | 21.9 |   | 8.0 |   |
| Total operating expenses                      |       | 85.6                   |       | 156.3                 |       | 74.0 |   | 89.1 |   |
| Operating  loss                               |       | (79.8                  | )          | (184.2                | )          | (72.3 | ) | (112.5 | ) |
|                                          |       |                   |       |                  |       |   |   |   |   |
| Other income  (expense), net                  |       | (38.4                  | )          | 1.0                   |       | (31.7 | ) | 0.3 |   |
| Loss before  income taxes                     |       | (118.2                 | )          | (183.2                | )          | (104.0 | ) | (112.2 | ) |
| Income tax  expense                           |       | —                 |       | —                |       | — |   | — |   |
| NET LOSS                                      |       | (118.2                 | )%         | (183.2                | )%         | (104.0 | )% | (112.2 | )% |

 

***Revenues***

 

Revenues increased duringboth the three and nine months ended January 31, 2006, as compared to the sameperiods 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 segment whichreflected a decrease, as described in the following table:

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **January 31,**        | ** ** | **January 31,**       | ** ** |
| ** **                           | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                 |       | $                      |       | $                     |       | $ |   | $ |   |
| Life  sciences:                      |       |                   |       |                  |       |   |   |   |   |
| Domestic                             |       | 872,000                |       | 981,000               |       | 2,905,000 |   | 3,690,000 |   |
| International                        |       | 348,000                |       | 628,000               |       | 1,531,000 |   | 2,026,000 |   |
| Total life  sciences                 |       | 1,220,000              |       | 1,609,000             |       | 4,436,000 |   | 5,716,000 |   |
| Homeland  security products          |       | —                 |       | —                |       | 35,000 |   | — |   |
| Security  services                   |       | 3,457,000              |       | —                |       | 9,090,000 |   | — |   |
| Semiconductor  products and services |       | 1,803,000              |       | 739,000               |       | 3,825,000 |   | 1,982,000 |   |
| Total                                |       | $                      | 6,480,000  |                  | $          | 2,348,000 |   | $ | 17,386,000 |   | $ | 7,698,000 |   |
|                                      |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

As a result of theacquisition of PPSC, we have significantly increased our revenues during thethree and nine months ended January 31, 2006, and thus we significantlydecreased our reliance on a few life sciences customers for a significantportion of our revenues.

 

•                  During the three months ended January 31,2006, one security services customer comprised approximately 17% of revenuesand one semiconductor products and services customer comprised approximately12% of revenues as compared to the three months ended January 31, 2005, inwhich one life sciences customer accounted for 16% of revenues.

 

•                  During the nine months ended January 31,2006, one security services customer comprised approximately 18% of revenues ascompared to the nine months ended January 31, 2005, in which one life sciencescustomer accounted for 19% of revenues.

 

Significant reductions insales to any of these large customers have had, and may in the future have, anadverse effect on us by reducing our revenues and our gross margins. Present orfuture customers could

 

25

----

 

terminate their purchasingpatterns with us or significantly change, reduce or delay the amount ofproducts or services ordered from us.

 

The increase in revenue fromthe security services segment for the three and nine months ended January 31,2006, was almost entirely due to the purchase of PPSC in May 2005. On a proforma basis, assuming the acquisition of PPSC had occurred on May 1, 2005,homeland security revenue for the nine months ended January 31, 2006, wouldhave been $9,604,000. While we anticipate that we will continue to grow revenuein this segment through new contracts signed by PPSC in the three months endedJanuary 31, 2006 and subsequently, securing additional new security contractsin our PPSC subsidiary, retaining existing customers under contract currentlywith PPSC and by increasing our sales of detection technology, we cannotprovide any assurance that we will be able to do so.

 

Our semiconductor productsand services segment has experienced a rapid increase in revenue during fiscalyear 2006. Revenues for the three months ended January 31, 2006, were 48%higher than revenues for the three months ended October 31, 2005, that were, inturn, 51% higher than revenues for the three months ended July 31, 2005. Theincrease is predominately due to the expansion of sales of higher-margin300-millimeter products and services as well as, to a lesser degree, sales ofSOI products. Our 300-millimeter business provided revenue of $859,000 and$1,240,000 for the three and nine months ended January 31, 2006, respectively. Thenine months ended January 31, 2005, includes revenues and operating resultsfrom the EMG acquisition for only 226 days during the nine-month period ascompared to a full nine months for the related period in fiscal year 2006. On apro forma basis, assuming acquisition of the business and assets of EMG on May1, 2004, the revenue for the first nine months of fiscal year 2005 would havebeen approximately $376,000 higher. While we believe that continued expandedfocus on the 300-millimeter and SOI markets will allow us to continue toincrease revenues in the future, we can provide no assurances that we will beable to do so.

 

While we continue to moveforward with our development program and to pursue the establishment of a lowcost supply of silicon-28, we did not receive a material amount of revenue inour 2004 or 2005 fiscal years or in the nine months ended January 31, 2006, andwe are not aware of any plans by any company for the introduction of productsbased on silicon-28 wafers. Therefore we do not anticipate any material amountof proceeds from silicon-28 product sales during fiscal year 2006, although wecould respond to customer demand in a relatively short time frame. Our goalultimately is to profitably (1) license our proprietary technology to otherentities and/or (2) sell chemicals required for the production of epitaxial orbulk silicon-28 wafers and/or (3) produce epitaxial or bulk silicon-28 wafersfor resale. The costs associated with maintaining this program are notsignificant.

 

The decrease in revenue fromdomestic isotope product sales for the three and nine months ended January 31,2006, was primarily the result of a significant decrease in the unit price ofour main isotope sold domestically, oxygen-18, which was partially offset by anincrease in volume. Our average sales price for oxygen-18 for the three monthsended January 31, 2006 was approximately 9% less than the prior sequentialquarter and was 36% less than the comparable period in the prior fiscal year. Ouraverage sales price for oxygen-18 for the nine months ended January 31, 2006was approximately 35% less than the comparable nine-month period in the priorfiscal year. As a result, in order to increase our revenues from the sale ofoxygen-18, we will need to increase our volume at a rate greater than anycontinuing decreases that may occur in the future market price for that product.The market for oxygen-18 in the United States is continuing to expand and wecontinue to actively bid to become the supplier for additional customers.However, we can offer no assurance that we will be able to increase oxygen-18revenue in the face of the domestic and international competition in thismarket.

 

In January 2005 we commencedsupplying limited quantities of actinium-225 for testing purposes. Actinium-225is a radioisotope that is believed to be valuable in the treatment of certaincancers. Assuming our Russian business partners reach target production levelsduring fiscal year 2006, we believe that we will be able to nearly double theworld’s supply of actinium-225 by the end of calendar 2006 to the extent

 

26

----

 

required by the market. Thenine months ended January 31, 2006, included minimal sales of actinium-225. InJune 2005, we entered into an agreement with Central RadiopharmaceuticalServices, Inc. of Buffalo, New York (“CRS”) for the joint production andmarketing of certain radioisotopes with the first expected to be indium-111. Whilethe projected revenues for these two radioisotopes are expected to be minimal(less than $100,000) for fiscal year 2006, we believe these to be importantfirst steps in our effort to extend our distribution operations to provide morevalue-added products and to increase our share of the domestic radioisotopemarket to a meaningful number. We can, however, offer no assurance that we willbe able to do so.

 

Our internationalradioisotope business experienced rising supplier prices in a market that ishighly price-sensitive. In an effort to reduce costs, in the prior quarter wetook the steps necessary to close our European trading office by the close ofour fiscal year ending April 30, 2006. During the three months ended January31, 2006, our ability to pass on these increasing supply prices to ourcustomers has proven to be problematic as our customers have access toradioisotope supply from other entities. In response, we concluded thatcontinuing the sales operations formerly of our European trading office was notan economically viable business and thus we terminated sales activity with theexisting customer base. Revenue from our international isotope trading businesswas $348,000 for the three months ended January 31, 2006, reduced from ahistorical run rate of approximately $600,000 per quarter. We do not anticipatematerial, if any, revenue from this business in future quarters.

 

***Gross Margin***

 

Our gross margin increasedduring the three and nine months ended January 31, 2006, as compared to thesame periods of our prior fiscal year, both on a dollar amount and on a percentageof revenues as reflected in the following table:

 
| ** **           | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount       |       | $                                  | 376,000    |                              | $          | (654,000 | ) | $ | 301,000 |   | $ | (1,798,000 | ) |
| Percent of  revenues |       | 5.8                                | %          | (27.9                             | )%         | 1.7 | % | (23.4 | )% |
|                      |            |                                    |            |                                   |            |  |  |  |  |  |  |  |  |

 

For the three months endedJanuary 31, 2006, we realized our second consecutive quarter of positive grossmargin, which is also the second quarter of positive gross margin since ouracquisition of the assets and business of EMG in June 2004. The increase ingross margin is due mainly to two factors: (1) the impact of PPSC’s operations, which were acquired in May 2005 and(2) continued improvement in operations in our semiconductor products andservices segment where there were improvements to gross margin on a dollaramount and on a percentage of revenues basis, though both metrics remainnegative. In addition, the life sciences segment also contributed positivegross margin, though such gross margin as a percentage of revenue was reducedseven absolute percentage points from that experienced for the nine monthsended January 31, 2005.

 

On a dollar basis, grossmargin is expected to increase correspondingly with increases in revenue, ifany, with dependencies on customer and supplier pricing. Our ability topositively impact consolidated gross margin will in a large part be dependentupon our ability to grow sales in our homeland security segments throughincreased sales of security services and detection products and in oursemiconductor products and services segment through increased sales of300-millimeter large diameter and SOI products. With the realignment of ourbusiness to focus on the higher margin 300-millimeter large diameter and SOIproducts, we believe that we have greatly enhanced our ability to increase oursales and related gross margin in these areas. As such, we anticipate that thegross margin from sales of semiconductor products and services (both in dollarvalue and as a percentage of revenues) will increase over time, though we canoffer no assurance that the gross margin increase will occur.

 

27

----

 

On a percentage of revenuebasis, in general we anticipate that the gross margin percentage in oursecurity services segment will remain relatively stable. The gross marginpercentage in our semiconductor products and services segment may be volatilebased upon revenue growth achieved, if any. The gross margin percentage in thelife sciences segment is expected to decrease due to the continued pricingpressure on oxygen-18 and on the substantial cessation of sales in theinternational isotope business. Lastly, the gross margin percentage on ourhomeland security products segment is likely also to be volatile as we attemptto increase revenue in that segment, though we can offer no assurances that wewill be able to do so.

 

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

 

Our selling, general andadministrative expenses increased as a dollar amount for the three and ninemonths ended January 31, 2006, as compared to the same respective periods ofour prior fiscal year. On a percentage of revenues basis, selling, general andadministrative expenses decreased for the three and nine months ended January31, 2006, as compared to the same respective periods of our prior fiscal year,as reflected in the following table:

 
| ** **           | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount       |       | $                                  | 2,943,000  |                              | $          | 2,550,000 |   | $ | 8,662,000 |   | $ | 5,371,000 |   |
| Percent of  revenues |       | 45.4                               | %          | 108.6                             | %          | 49.8 | % | 69.8 | % |
|                      |            |                                    |            |                                   |            |  |  |  |  |  |  |  |  |

 

The approximate $3,300,000dollar increase in selling, general and administrative expenses for the ninemonths ended January 31, 2006, compared to the same period in the prior year isattributable to a combination of factors, including:

 

•                  approximately $2,200,000 directly related tothe addition of PPSC’s operations in May 2005;

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

•                  a noncash charge in the amount of $510,000related to the extension of the expiration dates of certain warrants;

•                  approximately $900,000 due to the increase instaffing and operations in the homeland security products segment;

•                  approximately $100,000 due to increased legaland accounting fees related to the filing of two registration statements duringthe nine months ended January 31, 2006, and to the reaudit of the fiscal year2004 financial statements (the work was performed in fiscal year 2006) requireddue to Grant Thornton’s unwillingness to consent to the inclusion of its reportfor that fiscal year;

•                  approximately $100,000 due to the increase inother corporate headquarters expenses;

•                  offset by $669,000 in expense recognized inthe prior year relating to warrants granted to homeland security advisory boardmembers and other advisors.

 

We anticipate that we willincrease our selling, general and administrative expenses during the remainderof fiscal year 2006 through anticipated increased marketing efforts for andoperations in our homeland security products operations and semiconductorproducts and services segment. There can be no assurance that our anticipatedincreased selling, general and administrative expenses will result in increasedrevenues from product sales.

 

***Impairment Loss on Assets Held for Sale***

 

Our impairment loss ongoodwill and intangible assets increased during the nine months ended January31, 2006, as compared to the same period of our prior fiscal year, both on adollar amount and on a percentage of revenues basis as reflected in thefollowing table (while there was no such charge in the three months endedJanuary 31, 2006 and 2005, respectively):

 

28

----

 
| ** **           | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount       |       | —                             |       | —                            |       | $ | 398,000 |   | — |   |
| Percent of  revenues |       | —                             |       | —                            |       | 2.3 | % | — |   |
|                      |            |                                    |            |                                   |            |  |  |  |  |  |

 

The increase for the ninemonths ended January 31, 2006, resulted from operational decisions made relatedto the ongoing review and improvements underway in our semiconductor productsand services segment. As part of this ongoing review and resulting operationalchanges, certain equipment was identified as excessive for our planned futureoperations. As a result, certain of the identified equipment whose book valueexceeded estimated net realizable were individually written down to estimatednet realizable value, resulting in a cumulative impairment charge of $398,000. Theequipment has not yet been sold, but we expect that the equipment will be soldwithin the upcoming year.

 

***Impairment of Goodwill and Intangible Assets***

 

Our impairment loss ongoodwill and intangible assets decreased during the three and nine months endedJanuary 31, 2006, as compared to the same period of our prior fiscal year, bothon a dollar amount and on a percentage of revenues basis as reflected in thefollowing:

 
| ** **           | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount       |       | —                             |       | $                                 | 875,000    |   | — |   | $ | 875,000 |   |
| Percent of  revenues |       | —                             |       | 37.3                              | %          | — |   | 11.3 | % |
|                      |            |                                    |            |                                   |            |  |  |  |  |  |  |

 

The prior year impairment ofgoodwill and intangible assets relates to the write off of $447,000 associatedwith the acquisition of the assets of EMG and $428,000 associated with theacquisition of technology from Silicon Evolution, Inc. No similar impairmentcharges have been recorded for the nine months ended January 31, 2006.

 

***Research and Development Expenses***

 

Our research and developmentexpenses increased on both a dollar and a percentage of revenues basis duringthe three and nine months ended January 31, 2006, as compared to the sameperiods of our prior fiscal year, as reflected in the following table:

 
| ** **           | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount       |       | $                                  | 2,606,000  |                              | $          | 245,000 |   | $ | 3,817,000 |   | $ | 613,000 |   |
| Percent of  revenues |       | 40.2                               | %          | 10.4                              | %          | 21.9 | % | 8.0 | % |
|                      |            |                                    |            |                                   |            |  |  |  |  |  |  |  |  |

 

The dollar increase for thethree and nine months ended January 31, 2006, is primarily related to anincrease in research and development expenses associated with payments made toLucent under our infrared imaging and night vision surveillance technologyDevelopment & Licensing Agreement as well as, to a lesser extent, our traceand bulk detection technology and semiconductor research and development workrelated mainly to various SOI processes. 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, to a production-readystate. The majority of this research and development on trace and bulkdetection technology is being performed by IUT and is related to IMS andneutron-based detection. In June 2004, we entered into a research anddevelopment agreement with IUT, which contemplated the funding of certainprojects of up to $4,000,000 over several years. The work is being funded insteps and is based upon the completion of various milestones, as defined. Wehave no obligation to fund any work under this agreement unless we haveapproved such effort. We funded

 

29

----

 

approximately $1,192,000under this agreement during the nine months ended January 31, 2006 (as comparedto $247,000 during the nine months ended January 31, 2005, and a total of$1,689,000 since entering into the agreement in June 2004).

 

In December 2005, weapproved a development plan with Lucent that obligated us under a Development& Licensing Agreement. Under that Agreement, we will endeavor to develop anext-generation imaging and night vision surveillance technology. Thedevelopment plan contemplates a proof-of-concept within 12 months followed bysteps towards commercialization, although we can provide no assurances that acommercially attractive product will ultimately be available. For the threemonths ended January 31, 2006, we recorded research and development expense of$1,667,000 (relating to payments made in the nine months ended January 31,2006) and we may be obligated to pay an additional $1,000,000 per quarter indevelopment funding for the next ten quarters. We have the right to terminatethe development project for any reason from time-to-time, so long astermination is prior to the first commercial sale of a licensed product. As such,assuming we continue with the development program, we expect our quarterlyresearch and development expense for this purpose to remain elevated.

 

We believe that thedevelopment and introduction of new product applications is critical to ourfuture success. We expect that research and development expenses may increaseassuming sufficient cash remains available and we are able to procure necessarymaterials 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 allother research and development work is performed by outside entities, none ofwhich we control (although we have increased our minority ownership position inIUT to 30%). Although we expend significant resources on research and development,we cannot offer any assurance that our current or future lines of business orproducts resulting from our research and development efforts will be profitableor generate significant revenues.

 

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

 

Other Income (Expense), netdecreased during the three and nine months ended January 31, 2006, as comparedto the same periods of our prior fiscal year as reflected in the followingtable:

 
| ** **     | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **     | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount |       | $                                  | (2,488,000 | )                                 | $          | 23,000 |   | $ | (5,509,000 | ) | $ | 16,000 |   |
|                |            |                                    |            |                                   |            |  |  |  |  |  |  |  |  |

 

The decrease for the threeand nine months ended January 31, 2006, resulted primarily from interestcharges and amortization of debt issuance costs related to our convertibledebentures issued in February 2005. Included in the amount for the nine monthsended January 31, 2006, is a noncash interest charge of approximately $3,526,000related to the amortization of the debt discount on the convertible debenturesand a noncash charge for amortization of debt issuance costs of $773,000. Theamortization of debt discount increased for the three months ended January 31,2006, as compared to the previous two sequential quarters, due to theadditional amortization in the amount of approximately $900,000 related to thenow probable repayment of the convertible debentures in discounted shares ofour common stock. Also included in other expense for the nine months endedJanuary 31, 2006, is the nominal 8% interest expense on the convertibledebentures, of which $506,000 was paid in common stock and $910,000 was paid incash. Lastly, interest income in the amount of $275,000 was earned thatpartially offset the cash and noncash interest expense.

 

We expect that our otherexpenses will be volatile based on the future timing of repayment , if ever, ofthe remaining convertible debentures (see the Liquidity and Capital Resourcesdiscussion below).

 

30

----

 

***Income Taxes***

 

We currently operate at aloss and expect to operate at a loss until the products currently underdevelopment begin to generate sufficient revenue. The losses we anticipateincurring during the remaining portion of the current fiscal year are notexpected to generate an income tax benefit because of the uncertainty of therealization of the deferred tax asset. As such, we have also provided avaluation allowance against our net deferred tax asset as realization isuncertain.

 

***Net Loss***

 

Our net loss increasedduring the three and nine months ended January 31, 2006, as compared to thesame periods of our prior fiscal year, as reflected in the following table:

 
| ** **     | ** ** | **Three months ended January 31,** | ** ** | **Nine months ended January 31,** | ** ** |
|----------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **     | ** ** | **2006**                           | ** ** | **2005**                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dollar  amount |       | $                                  | (7,661,000 | )                                 | $          | (4,301,000 | ) | $ | (18,085,000 | ) | $ | (8,641,000 | ) |
|                |            |                                    |            |                                   |            |  |  |  |  |  |  |  |  |

 

We anticipate that losseswill continue until (if ever): (i) revenues from our current operationssubstantially increase or (ii) we generate substantial revenues from productsintroduced as a result of our research and development projects. Further, therevenue increases must increase faster than any increases in operating andresearch 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 business and as we continue ourmarketing and research efforts to expand sales and develop new products in thehomeland security business, including the commercialization of the IMS andNeutroTestTM technology and, eventually, the infrared imagingtechnology based on our Development & Licensing Agreement with Lucent. However,we can offer no assurances that the development and commercialization of thesetechnologies will occur.

 

We anticipate that ouroperations during the remainder of fiscal year 2006 will result in a loss sincewe are not likely to increase our revenues from our existing products orgenerate additional sales from the new products we may develop in a sufficientamount (if at all) to offset our operating and research and developmentexpenses.

 

***Liquidity and Capital Resources***

 

Working Capital

 

Our working capitaldecreased by approximately $30,428,000 during the nine months ended January 31,2006, from a working capital surplus of $17,991,000 at April 30, 2005, to aworking capital deficit of $(12,437,000) at January 31, 2006. The decrease inworking capital is due to a combination of factors, of which the significantfactors are set out below:

 

•                  approximately $17,000,000 due to an increasein the current portion of the convertible debentures (which are payable at ouroption in cash or common stock, assuming all contractual requirements forpayment in common stock are met – see discussion of convertible debenturerepayment below);

•                  approximately $10,900,000 of cash consumeddirectly in operating activities (calculated as approximately $12,600,000 ofcash used in operating activities, netted down by approximately $1,700,000 ofthe cash impact of changes in other current assets or liabilities included therein);

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

•                  approximately $300,000 of cash paid topurchase additional equity in IUT;

•                  approximately $1,500,000 expended onpurchases of fixed assets;

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

 

31

----

 

•                  an offsetting amount of approximately$1,000,000 related to the net impact of proceeds from common stock exceedingprincipal repayments on debt and preferred stock dividends paid.

 

Convertible Debentures

 

As noted above,approximately $17,000,000 of our change in working capital between April 30,2005, and January 31, 2006, is due to a substantial portion of the convertibledebentures being reclassified from long-term liabilities to currentliabilities.

 

The first of twelve monthlyprincipal payments (each monthly payment in the amount of approximately$1,900,000) on our 8% Convertible Debentures (the “Debentures”) become due inMarch 2006. However, both the principal and interest are payable, at ouroption, in common stock , subject to various requirements (which we currentlymeet). If we choose to make a scheduled principal payment by issuing commonstock, and all requirements to do so are met, the conversion price will be thelesser of the then Conversion Price (currently $5.00 per share) or 88% of theaverage of the ten closing prices ending on the trading day immediately priorto the monthly redemption date. The Debentures and the related warrants havecertain limitations on our ability to issue shares to the holders of theDebentures and warrants (the “Holders”). Under the terms of the Debentures andthe warrants, we are prohibited from issuing shares of our common stock to theholders of the Debentures (upon conversion, in payment of interest, or inredemption or payment of the Debentures) and the related warrants (uponexercise) if:  (a) the issuance wouldresult in any Holder owning more than 4.99% of our outstanding common stock(although the holders can waive this provision upon more than 60 days’notice to us) or (b) the issuance would result in more than 5,514,601 shareshaving been issued pursuant to the Debentures and the Warrants (19.999% of thetotal number of shares outstanding on February 24, 2005) unless ourshareholders approved the transaction as required by the Nasdaq rules. In ourshareholder meeting on October 25, 2005, the shareholders voted to approve theremoval of share issuance limitations associated with the Debentures andrelated warrants. As such, the 19.999% share issuance limitation is no longerapplicable, although the 4.99% limitation will continue to be applicable until(if ever) waived by the respective Holder.

 

Having met all requirementsto do so, on March 1, 2006, we made the first principal payment on theDebentures by issuing common stock, as allowed in the Debenture agreement. Thereduction in the face amount of the debentures was approximately $1,900,000. Weissued 1,347,361 shares in satisfaction of the principal payment and accruedinterest then due.

 

On March 9, 2006, holders ofour Debentures converted outstanding principal in the amount of $9,000,000 into6,206,899 shares of our common stock. We gave the holders of all Debentures theright to convert a portion or their entire principal amount into shares of ourcommon stock at a temporary conversion price of $1.45 per share (a reductionfrom the prior conversion price of $5.00 per share). At the close of businesson March 8, 2006, the closing price for our common stock was $1.64 per share. Additionally,we issued 10,034 shares of our common stock in payment of interest then due onthe converted principal amount.

 

As a result of the scheduledprincipal payment and acceptance of our conversion offer, there remainoutstanding convertible debentures with a principal amount of $11,872,500. Theconversion of a portion of the Debentures into our common stock did not provideus with any cash and, although it reduced our working capital deficit, wecontinue to have a working capital deficit. We currently do not have sufficientcash and cash equivalents on hand to make the remaining principal payments incash. It is likely that, if the Debentures are not modified and if we continueto meet all requirements to allow us to do so, we will issue shares of ourcommon stock in payment of a portion of or all of our Debenture obligation.

 

Cash Flows

 

At January 31, 2006, we had$5,342,000 of cash and cash equivalents, a decrease of $15,864,000 as comparedto $21,206,000 at April 30, 2005. Our principal source of funding for the ninemonths ended

 

32

----

 

January 31, 2006, was fromthe existing cash balance at April 30, 2005, which was derived from ourconvertible debenture offering completed in February 2005. Our principal sourceof funding for the nine months ended January 31, 2005, was from the issuance ofpreferred stock ($3,049,000 net of due diligence fees and related expenses ascompared to $0 during the comparable period of fiscal year 2006) and theexercise of common stock options and warrants ($6,708,000 as compared to$1,720,000 during the comparable period of fiscal year 2006).

 

We used cash in operatingactivities of $12,633,000 and $7,317,000 during the nine months ended January31, 2006 and 2005, respectively. Cash used in operating activities for the ninemonths ended January 31, 2006 and 2005 was principally the result of ourongoing business activities that resulted in a net loss of $18,085,000 and$8,641,000, respectively. Activity during the nine months ended January 31,2006, also included $2,000,000 of payments to Lucent in relation to thedevelopment plan signed in December 2005.

 

Our investing activitiesused cash of $4,264,000 and $2,057,000 for the nine months ended January 31,2006 and 2005, respectively. Cash used in investing activities for the ninemonths ended January 31, 2006, consisted primarily of the purchase of PPSC inMay 2005 (for which we paid approximately $2,500,000 in cash and issued 506,527shares of our restricted stock at an agreed valuation of $1,125,000 ($2.22 pershare), and paid $98,000 in legal and accounting fees), along with $1,488,000expended on additions of property and equipment and $336,000 expended onincreasing our ownership share of IUT to 30%. Our investing expenditures duringthe first nine months of our 2005 fiscal year are comprised primarily ofpurchases of property and equipment.

 

Financing activitiesprovided cash of $1,033,000 and $9,627,000 for the nine months ended January31, 2006 and 2005, respectively. Cash provided by financing activities for thenine months ended January 31, 2006, resulted primarily from the exercise ofcommon stock options and warrants ($1,720,000) which was offset primarily bydebt repayments and dividend payments on our then outstanding Series E Stock. Cashprovided by financing activities for the nine months ended January 31, 2005,resulted primarily from the exercise of common stock warrants ($6,708,000)along with the issuance of preferred stock ($3,049,000 net of due diligencefees and related expenses) during that period.

 

Effective June 17, 2005 theexpiration date of our Class B and C warrants was extended from December 31,2005, to December 29, 2006. Effective December 29, 2005, the expiration date of232,500 warrants granted to an investor was extended from December 31, 2005, toDecember 29, 2006. There were no other changes in the terms or conditions ofthe warrants.

 

Additional Liquidity Considerations

 

As of January 31, 2006, wehad commitments outstanding for capital expenditures of approximately $474,000in addition to our obligations under our agreement with Lucent described below.

 

Our future commitments haveincreased due to the agreement and development plan with Lucent, under which weendeavor to develop a next-generation imaging and night vision surveillancetechnology (although we can provide no assurances that a commerciallyattractive product will ultimately be available). We have paid Lucent$2,000,000 during the nine months ended January 31, 2006, and to maintain ourrights under the agreement we are obligated to make an additional ten paymentsin the amount of $1,000,000 approximately every three months thereafter. Thisamount provides development funding required under the agreement. We have theright to terminate the development project for any reason from time-to-time, solong as termination is prior to the first commercial sale of a licensed product.As such, assuming we continue the development program, we expect our quarterlyresearch and development funding for this purpose to remain elevated.

 

We anticipate that withoutentering into another financing transaction, our cash and cash equivalents willcontinue to decrease as we continue to use cash in operations and investingactivities, and until (if ever) we

 

33

----

 

achieve positive cash flowfrom our operations – dependent on our ability to increase our revenuessignificantly and to maintain control over our expenses. As of January 31,2006, we believe we have sufficient working capital to finance our anticipatedoperations and projected negative cash flow through our 2006 fiscal year, butwe will need a significant amount of additional financing to meet ourobligations during our 2007 fiscal year. We continue to explore economicallyviable financing arrangement options, which, if available, will likely beimplemented.

 

The warrants that wereissued with the Debentures (“Debenture Warrants”), which grant the right topurchase a total of 1,540,000 common shares at an exercise price of $6.25 pershare, include a provision which would decrease the exercise price of theDebenture Warrants to that of any subsequent equity sale and increase thenumber of common shares issuable such that the aggregate exercise price remainsequal to that in existence currently ($9,625,000). Upon entering a futurefinancing arrangement, it is highly likely (given the current price of ourcommon stock) that this warrant provision would be activated which would resultin a greater number of outstanding Debenture Warrants at a lower exerciseprice.

 

The assumptions underlyingthe above statements include, among other things, that there will be nomaterial adverse developments in the business or market in general. There canbe no assurances however that those assumed events will occur. If our plans arenot achieved, there may be further negative effects on the results ofoperations and cash flows, which could have a material adverse effect on ourfinancial position.

 

***Contractual Cash Obligations***

 

We have no material changesto the disclosure on this matter made in our Annual Report on Form 10-KSB forthe year ended April 30, 2005, except for the agreement with Lucent under whichwe became obligated upon approval of the development plan on December 5, 2005,and for the commitments for capital expenditures of approximately $474,000outstanding at January 31, 2006. As discussed in Note 6 to the financialstatements in Part I, in exchange for an exclusive right, except for certainrights reserved by Lucent, to make, use and sell licensed products arising fromtechnology developed under the agreement, we have agreed to fund Lucent’sdevelopment efforts for the project through the periodic payment over a two andone-half year period of a development fee totaling $12,000,000. Of this amount,$2,000,000 was paid during the nine months ended January 31, 2006, and thebalance will be paid in $1,000,000 increments approximately every three monthsthereafter. However, we have the right to terminate the development project forconvenience from time-to-time, so long as termination is prior to the firstcommercial sale of a licensed product. As such, the contractual cash obligationis contingent on our decision to continue with each funding payment throughoutthe development timeline.

 

***Off-Balance Sheet Arrangements***

 

We have no material changesto the disclosure on this matter made in our Annual Report on Form 10-KSB forthe year ended April 30, 2005.

 

***Critical Accounting Estimates***

 

We consider an accountingestimate to be critical if 1) the accounting estimate requires us to makeassumptions about matters that were highly uncertain at the time the accountingestimate was made, and 2) changes in the estimate that are reasonably likely tooccur from period to period, or use of different estimates that we reasonablycould have used in the current period, would have a material impact on ourfinancial condition or results of operations.

 

Management has discussed thedevelopment and selection of these critical accounting estimates with the AuditCommittee of our Board of Directors and the Audit Committee has reviewed theforegoing disclosure. In addition, there are other items within our financialstatements that require estimation, but are not deemed

 

34

----

 

critical as defined above. Changesin estimates used in these and other items could have a material impact on ourfinancial statements.

 

*Goodwilland Intangible Assets*

 

Goodwill is recorded on ourbooks for acquisitions where the purchase price is in excess of the cumulativefair values of the identified tangible and intangible assets. The assignment offair value to the identified tangible and intangible assets requiressignificant judgment and may require independent valuations of certainidentified assets. Once goodwill and other intangible assets are established onour balance sheet, we evaluate the assets for impairment as described in thefollowing paragraphs.

 

In accordance with SFAS No. 142 *Goodwilland Other Intangible Assets*, goodwill is not amortized, but insteadis tested for impairment on an annual basis or more frequently if the presenceof certain circumstances indicates that impairment may have occurred. 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 carryingvalue of a reporting unit exceeds its fair value, then the amount of theimpairment loss must be measured. The impairment loss is calculated bycomparing the implied fair value of reporting unit goodwill to its carryingamount. In calculating the implied fair value of reporting unit goodwill, thefair value of the reporting unit is allocated to all of the other assets andliabilities of that unit based on their fair values. The excess of the fairvalue of a reporting unit over the amount assigned to its other assets andliabilities is the implied fair value of goodwill. An impairment loss would berecognized when the carrying amount of goodwill exceeds its implied fair value.We have goodwill in the amount of $3,631,000 on our condensed consolidatedbalance sheet as of January 31, 2006, related to the acquisition of PPSC in May2005. In association with the three months ended January 31, 2006, we performedour annual impairment review on the aforementioned goodwill and concluded thatthe goodwill is not impaired.

 

For intangible assets other than goodwill, SFAS No. 144 *Accounting for the Impairment or Disposal ofLong-Lived Assets* is the authoritative standard on the accountingfor the impairment of such intangible assets. As required, we perform tests forimpairment of intangible assets other than goodwill whenever events orcircumstances suggest that such assets may be impaired. To evaluate potentialimpairment, SFAS No. 144 requires us to assess whether the future cash flowsrelated to these assets will be greater than their carrying value at the timeof the test. Accordingly, while our cash flow assumptions are consistent withthe plans and estimates we are using to manage the underlying businesses, thereis significant judgment in determining the cash flows attributable to our otherintangible assets over their respective estimated useful lives. We haveremaining other net intangible assets in the amount of $538,000 on ourcondensed consolidated balance sheet as of January 31, 2006, comprised of ourtrace and bulk detection technology acquired in December 2002, customer listsacquired in our acquisition of the business and assets of EMG in June 2004 andthe customer base acquired in our acquisition of PPSC in May 2005. We arerequired to periodically evaluate our other intangible assets balances forimpairments. If we were to incur additional impairments to our other intangibleassets, it could have an adverse impact on our future earnings, if any.

 

*Valuationof Equity Transactions*

 

We value transactions associatedwith common or preferred stock that is convertible into common stock based onthe market value of the underlying common stock on the date of the signing ofthe agreement. We value transactions associated with common stock warrants atthe appropriate measurement date utilizing the Black-Scholes pricing model,with assumptions as to volatility (100% for fiscal years 2005 and 2006),risk-free interest rate (4.0%) and estimated life of the warrants based onhistorical information. During the nine months ended January 31, 2006, weissued common stock warrants for services and in settlement of a lawsuit in thecumulative amount of $336,000. If the assumptions used, as

 

35

----

 

they relate to volatility,risk-free interest rate and estimated life of the warrants, were materiallydifferent, the overall valuation of these and any future equity basedtransactions could change significantly.

 

**Item 3: Controls and Procedures**

 

With the participation ofour management, including the Chief Executive Officer and Chief FinancialOfficer, we have evaluated the effectiveness of our disclosure controls andprocedures as required by Exchange Act Rule 13a-15(b) as of the end of theperiod covered by this report. Based on that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer have concluded that these disclosurecontrols and procedures are effective. There were no changes in our internalcontrol over financial reporting during the quarter ended January 31, 2006,that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

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

 

**Part II:Other Information**

 

**Item1:  Legal Proceedings**

 

See Note 12 to the financialstatements in Part I for the description of the litigation brought by PrimeInternational Equities, LLC in March 2005 and settled in October 2005.

 

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

 

**Conversionof Convertible Debenture**

 

On March 9, 2006, we issued6,206,899 shares of our common stock to holders of our 8% convertibledebentures upon conversion of a portion of the debentures at a price of $1.45per share. Concurrently, we issued 10,034 shares of our common stock in paymentof interest then due on the converted principal amount. The following setsforth the information required by Item 701 in connection with that transaction:

 

(a)           The transaction was completed effective March9, 2006.

 

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

 

(c)           The shares were not sold for cash.

 

(d)           We relied on the exemption from registrationprovided by Section 3(a)(9) under the Securities Act of 1933 for thistransaction. In addition, each of the debenture holders was an accreditedinvestor. We did not engage in any public advertising or general solicitationin connection with this transaction. The investors had access to all of ourreports filed with the Securities and Exchange Commission, our press releasesand other financial, business and corporate information. Based on ourinvestigation, we believe

 

36

----

 

that the investors obtainedall information regarding Isonics that they requested, received answers to allquestions they posed and otherwise understood the risks of accepting oursecurities for investment purposes.

 

(e)           The common stock issued in this transactionis not convertible or exchangeable. No warrants were issued in thistransaction.

 

(f)            We received no cash proceeds from theissuance of the shares. We did receive a relief from indebtedness as describedabove.

 

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

 

On March 1, 2006, we issued1,347,361 shares of our common stock to holders of our 8% convertibledebentures in payment of our principal obligation and of our interestobligation for the two months ended February 28, 2006. The following sets forththe information required by Item 701 in connection with that transaction:

 

(a)           The transaction was completed effective March1, 2006.

 

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

 

(c)           The shares were not sold for cash.

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction. We did not engage in any public advertising or generalsolicitation in connection with this transaction. The investors had access toall of our reports filed with the Securities and Exchange Commission, our pressreleases and other financial, business and corporate information. Based on 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 stock issued in this transactionis not convertible or exchangeable. No warrants were issued in thistransaction.

 

**(f)**            We received no cash proceeds from theissuance of the shares. We did receive a relief from indebtedness as describedabove.

 

**Acquisitionof PPSC**

 

On May 16, 2005, we issued506,527 shares of our restricted common stock to the former shareholders ofPPSC as partial consideration for the completion of the transaction describedabove. The shareholders represented that they were accredited investors. Thefollowing sets forth the information required by Item 701 in connection withthat transaction:

 

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

 

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

 

(c)           The shares were not sold for cash. The shareswere issued in partial consideration for the purchase by our wholly-ownedsubsidiary of the business described above. At the time the number of shareswas calculated, the market price of our stock was approximately $2.22 per share.

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction. We did not engage in any public advertising or general

 

37

----

 

solicitation in connectionwith this transaction. We provided the accredited investor with disclosure ofall aspects of our business, including providing the accredited investor withour reports filed with the Securities and Exchange Commission, our press releases,access to our auditors, and other financial, business, and corporateinformation. Based on our investigation, we believe that the accreditedinvestor obtained all information regarding Isonics it requested, receivedanswers to all questions it posed, and otherwise understood the risks ofaccepting our securities for investment purposes.

 

(e)           The common stock issued in this transactionis not convertible or exchangeable. No warrants were issued in thistransaction.

 

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

 

**Payment ofConvertible Debenture Interest in Common Stock**

 

On September 30, 2005, weissued 200,600 shares of our restricted common stock to holders of ourConvertible Debentures in payment of our interest obligation for the quarterended September 30, 2005. The following sets forth the information required byItem 701 in connection with that transaction:

 

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

 

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

 

(c)           The shares were not sold for cash.

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction. We did not engage in any public advertising or general solicitationin connection with this transaction. The investors had access to all of ourreports filed with the Securities and Exchange Commission, our press releasesand other financial, business and corporate information. Based on 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 stock issued in this transactionis not convertible or exchangeable. No warrants were issued in thistransaction.

 

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

 

**WarrantIssuances**

 

During the nine months endedJanuary 31, 2006, we issued warrants (other than registered issuances) topurchase a cumulative 271,000 shares of our common stock, including:  (1) an August 2005 grant to a formeremployee, exercisable through July 31, 2006, to purchase 1,000 shares of ourrestricted common stock for $3.25 per share, (2) a September 2005 grant to afinancial advisor, exercisable through September 8, 2007, to purchase 100,000shares of our restricted common stock for $2.81 per share, (3) a September 2005grant to a management consultant, exercisable through August 16, 2007, topurchase 50,000 shares of our restricted common stock for $2.84 per share and(4) an October 2005 grant, in settlement of a lawsuit, exercisable throughDecember 29, 2006, to purchase 120,000 shares of our restricted common stockfor $2.40 per share. The following sets forth the information required by Item701 in connection with that transaction:

 

(a)           The transactions were completed during thenine months ended January 31, 2006.

 

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

 

38

----

 

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

 

(d)           We relied on the exemption from registrationprovided by Sections 4(2) and 4(6) under the Securities Act of 1933 for thistransaction. We did not engage in any public advertising or generalsolicitation in connection with this transaction. The investors had access toall of our reports filed with the Securities and Exchange Commission, our pressreleases and other financial, business and corporate information. Based on ourinvestigation, we believe that the investors obtained all information regardingIsonics it requested, received answers to all questions it posed, and otherwiseunderstood the risks of accepting our securities for investment purposes.

 

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

 

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

 

**Exercise ofCommon Stock Warrants**

 

During the nine months endedJanuary 31, 2006, we issued 1,022,511 shares of common stock as a result of theexercise of common stock warrants. The following sets forth the informationrequired by Item 701 in connection with these transactions:

 

(a)           The transactions were completed during thenine months ended January 31, 2006.

 

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

 

(c)           The total amount we received from the cashexercises during the nine months ended January 31, 2006, was $1,366,864. Certainwarrant holders completed cashless exercises.

 

(d)           We relied on the exemption from registrationprovided by Sections 3(a)(9), 4(2) and 4(6) under the Securities Act of 1933for these transactions and Regulation D. We did not engage in any publicadvertising or general solicitation in connection with the transactions. 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 our investigation, we believe that theinvestors obtained all information regarding Isonics that they requested,received answers to all questions they posed and otherwise understood the risksof accepting our securities for investment purposes.

 

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

 

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

 

**Conversionof Preferred Stock**

 

During the nine months endedJanuary 31, 2006, (1) a holder of our Series D Stock (an accredited investor)converted 800 shares of Series D Stock into 72,727 shares of common stock and(2) a holder of our Series E Stock (an accredited investor) converted 33,000shares of Series D Stock into 2,661,290 shares of common stock. The followingsets forth the information required by Item 701 in connection with thattransaction:

 

(a)                                  The transactions were completed during thenine months ended January 31, 2006.

 

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

 

39

----

 

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

 

(d)           We relied on the exemption from registrationprovided by Sections 3(a)(9) under the Securities Act of 1933 for thesetransactions and Regulation D. We did not engage in any public advertising orgeneral solicitation in connection with the transactions. The accreditedinvestors had access to all of our reports filed with the Securities andExchange Commission, our press releases and other financial, business andcorporate information. Based on our investigation, we believe that theaccredited investors obtained all information regarding Isonics that theyrequested, received answers to all questions they posed and otherwiseunderstood the risks of accepting our securities for investment purposes.

 

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

 

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

 

**Item 6:Exhibits**

 

Exhibits.

 

31.1Certification of Chief Executive Officer pursuant to Sarbanes-Oxley Section 302

31.2Certification of Chief Financial Officer pursuant to Sarbanes-Oxley Section 302

32.1Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350

32.2Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350

 

40

----

 

**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized, in the City of Golden, County of Jefferson, State of Colorado, onthe 17th day of March 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 |

 

41

----