**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**FORM
      10-Q**


(Mark
      One)





**x**
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**





For
                the quarterly period ended
            September
                30, 2006





or





**o**
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**





For
                the transition period from
            
            to





Commission
      File Number: 0-21214





ORTHOLOGIC
      CORP. 
 (Exact
      name of registrant as specified in its charter)





Delaware
            86-0585310(State
                of other jurisdiction of incorporation or organization)
            (IRS
                Employer Identification No.)1275
                W. Washington Street, Tempe, Arizona
            85281(Address
                of principal executive offices)
            (Zip
                Code)





(602)
      286-5520


(Registrant's
      telephone number, including area code)












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





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





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.




Large
                accelerated filero
            Accelerated
                filerx
            Non-accelerated
                filero




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





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





41,564,291
      shares of common stock outstanding as of October 31, 2006










1





ORTHOLOGIC
      CORP.


(A
      Development Stage Company)


INDEX





Page
                No.Part
                I
            Financial
                InformationItem
                1. Financial Statements
                (Unaudited)Condensed
                Balance Sheets as of September 30, 2006 and
                December 31, 2005
            3Condensed
                Statements of Operations for the three and
                nine months ended September 30, 2006 and 2005
            4Condensed
                Statements of Cash Flows for the nine months ended
                September 30, 2006 and 2005
            5Notes
                to Unaudited Condensed Financial
                Statements
            6Item
                2. Management’s Discussion and Analysis of Financial Condition andResults
                of Operations
            15Item
                3. Quantitative and Qualitative Disclosures about Market
                Risk
            21Item
                4. Controls and Procedures
            21Part
                II
            Other
                InformationItem
                1A. Risk Factors
            21Item
                6. Exhibits
            24




EXHIBIT
      31.1


EXHIBIT
      31.2


EXHIBIT
      32





2
 *Index*





**PART
      I - Financial Information**


**Item
      1. Financial Statements**





ORTHOLOGIC
      CORP.


(A
      Development Stage Company)


CONDENSED
      BALANCE SHEETS


*(in
      thousands, except per share data)*


(Unaudited)





September
                30,
              2006
            
            December
                31,
              2005ASSETSCurrent
                assetsCash
                and cash equivalents
            
            $
            36,890
            
            $
            35,111Short-term
                investments
            
            
            27,318
            
            
            46,437Prepaids
                and other current assets
            
            
            480
            
            
            857Total
                current assets
            
            
            64,688
            
            
            82,405Furniture
                and equipment, net
            
            
            403
            
            
            525Long-term
                investments
            
            
            9,930
            
            
            2,084Deferred
                income taxes
            
            
            -
            
            
            1,106Patents,
                net
            
            
            -
            
            
            2,223Total
                assets
            
            $
            75,021
            
            $
            88,343LIABILITIES
                AND STOCKHOLDERS' EQUITYCurrent
                liabilitiesAccounts
                payable
            
            $
            852
            
            $
            1,036Accrued
                compensation
            
            
            642
            
            
            711Accrued
                clinical
            
            
            472
            
            
            544Accrued
                severance and restructuring costs
            
            
            178
            
            
            602Other
                accrued liabilities
            
            
            813
            
            
            1,089Total
                current liabilities
            
            
            2,957
            
            
            3,982Deferred
                rent and other non-current liabilities
            
            
            372
            
            
            183Total
                liabilities
            
            
            3,329
            
            
            4,165Stockholders'
                EquityCommon
                Stock $.0005 par value; 100,000,000 shares authorized; 41,564,291
                and
                38,124,742 shares issued and outstanding at 2006 and 2005,
                respectively
            
            
            21
            
            
            19Additional
                paid-in capital
            
            
            187,708
            
            
            171,355Accumulated
                deficit
            
            
            (116,037
            )
            
            (87,196
            )Total
                stockholders' equity
            
            
            71,692
            
            
            84,178Total
                liabilities and stockholders' equity
            
            $
            75,021
            
            $
            88,343





*See
      notes to unaudited condensed financial statements*





3
 *Index*





ORTHOLOGIC
      CORP.


(A
      Development Stage Company)


CONDENSED
      STATEMENTS OF OPERATIONS


*(in
      thousands, except per share data)*


** (Unaudited)


Three
                  months endedSeptember
                  30,
              
              Nine
                  months endedSeptember
                  30.
              
              As
                  a Development
                Stage
                  Company2006
              
              2005
              
              2006
              
              2005
              
              8/5/2004
                  - 9/30/2006OPERATING
                  EXPENSESGeneral
                  and administrative
              
              $
              1,414
              
              $
              1,027
              
              $
              5,567
              
              $
              3,210
              
              $
              12,355Research
                  and development
              
              
              5,651
              
              
              7,266
              
              
              16,575
              
              
              18,660
              
              
              50,099Other
                  divestiture and related gains
              
              
              -
              
              
              -
              
              
              -
              
              
              (250
              )
              
              (375
              )Purchased
                  in-process research and development
              
              
              2
              
              
              -
              
              
              8,471
              
              
              -
              
              
              34,311Total
                  operating expenses
              
              
              7,067
              
              
              8,293
              
              
              30,613
              
              
              21,620
              
              
              96,390Interest
                  and other income, net
              
              
              (1,250
              )
              
              (700
              )
              
              (2.879
              )
              
              (1,906
              )
              
              (6,270
              )Loss
                  from continuing operations before taxes
              
              
              5,817
              
              
              7,593
              
              
              27,734
              
              
              19,714
              
              
              90,120Income
                  tax expense (benefit)
              
              
              -
              
              
              -
              
              
              1,106
              
              
              (12
              )
              
              356Loss
                  from continuing operations
              
              
              5,817
              
              
              7,593
              
              
              28,840
              
              
              19,702
              
              
              90,476Discontinued
                  operations - net gain on the saleof
                  the bone device business, net of taxes ($267)
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (2,202
              )NET
                  LOSS
              
              $
              5,817
              
              $
              7,593
              
              $
              28,840
              
              $
              19.702
              
              $
              88,274Per
                  Share Information:Net
                  loss, basic and diluted
              
              $
              0.14
              
              $
              0.20
              
              $
              0.71
              
              $
              0.52Basic
                  and diluted shares outstanding
              
              
              41,545
              
              
              38,025
              
              
              40,496
              
              
              38,019




*See
      notes to unaudited condensed financial statements*





4
 *Index*





ORTHOLOGICCORP.


(A
      Development Stage Company)


CONDENSED
      STATEMENTS OF CASH FLOW


*(in
      thousands)*


(Unaudited)


For
                  nine months ended September 30,
              
              As
                  a Development
                Stage
                  Company2006
              
              2005
              
              8/5/2004
                  - 9/30/2006OPERATING
                  ACTIVITIESNet
                  loss
              
              $
              (28,840
              )
              $
              (19,702
              )
              $
              (88,274
              )Non-cash
                  items:Deprecation
                  and amortization
              
              
              2,790
              
              
              296
              
              
              3,222Deferred
                  tax expense
              
              
              1,106
              
              
              -
              
              
              770Non-cash
                  stock compensation
              
              
              2,252
              
              
              -
              
              
              2,414Gain
                  on sale of bone device business
              
              
              -
              
              
              -
              
              
              (2,298
              )In-process
                  research and development
              
              
              8,471
              
              
              -
              
              
              34,311Change
                  in other operating items:Prepaids
                  and other current assets
              
              
              374
              
              
              (15
              )
              
              1,227Accounts
                  payable
              
              
              (184
              )
              
              482
              
              
              132Accrued
                  liabilities
              
              
              (1,225
              )
              
              (512
              )
              
              (736
              )Cash
                  flows used in operating activities
              
              
              (15,256
              )
              
              (19,451
              )
              
              (49,232
              )INVESTING
                  ACTIVITIESExpenditures
                  for equipment and furniture
              
              
              (86
              )
              
              (229
              )
              
              (405
              )Proceeds
                  from sale of assets
              
              
              -
              
              
              -
              
              
              7,000Cash
                  Paid for assets of AzERx/CBI
              
              
              (390
              )
              
              -
              
              
              (4,058
              )Cash
                  paid for patent assignment rights
              
              
              (100
              )
              
              (400
              )
              
              (500
              )Purchases
                  of investments
              
              
              (34,432
              )
              
              (35,514
              )
              
              (123,817
              )Maturities
                  of investments
              
              
              45,705
              
              
              46,917
              
              
              144,507Cash
                  flows provided by investing activities
              
              
              10,697
              
              
              10,774
              
              
              22,727FINANCING
                  ACTIVITIESNet
                  proceeds from stock option exercises
              
              
              2,962
              
              
              44
              
              
              4,612Net
                  proceeds from sale of stock
              
              
              3,376
              
              
              -
              
              
              3,376Cash
                  flows provided by financing activities
              
              
              6,338
              
              
              44
              
              
              7,988NET
                  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
              
              
              1,779
              
              
              (8,633
              )
              
              (18,517
              )CASH
                  AND CASH EQUIVALENTS, BEGINNING OF PERIOD
              
              
              35,111
              
              
              38,377
              
              
              55,407CASH
                  AND CASH EQUIVALENTS, END OF PERIOD
              
              $
              36,890
              
              $
              29,744
              
              $
              36,890AzERx
              
              
              
              
              **AzERx
                  and CBI****Supplement
                  Disclosure of Non-Cash Investing Activities**AzERx/CBI
                  AcquisitionsCurrent
                  assets acquired
              
              $
              -
              
              
              
              
              $
              29Patents
                  acquired
              
              
              -
              
              
              
              
              
              2,142Liabilities
                  acquired, and accrued acquisition costs
              
              
              (317
              )
              
              
              
              
              (457
              )Original
                  investment reversal
              
              
              -
              
              
              
              
              
              (750
              )In-process
                  research and development accquired
              
              
              8,471
              
              
              
              
              
              34,311Common
                  Stock issued for acquisition
              
              
              (7,764
              )
              
              
              
              
              (31,217
              )Cash
                  paid for accuistion
              
              $
              390
              
              
              
              
              $
              4,058




*See
      notes to unaudited condensed financial statements*




5
 *Index*




**ORTHOLOGIC
      CORP.**


**(A
      Development Stage Company)**


**NOTES
      TO UNAUDITED CONDENSED FINANCIAL STATEMENTS**


**SEPTEMBER
      30, 2006**





**OVERVIEW
      OF BUSINESS**





**Description
      of the business** ****





OrthoLogic
      is a biotechnology company committed to developing a pipeline of novel peptides
      and other molecules aimed at helping patients with under-served conditions.
      We
      are focused on the development and commercialization of two product platforms:
      Chrysalin® (TP508) and AZX100.





Chrysalin,
      the Company’s first novel synthetic peptide, is being studied in two lead
      indications, both of which represent areas of significant unmet medical need
      -
      fracture repair and diabetic foot ulcer healing. Based on the Company’s
      pioneering scientific research of the natural healing cascade, OrthoLogic has
      become a leading company focused on bone and tissue repair. The Company owns
      exclusive worldwide rights to Chrysalin.





AZX100,
      the Company’s second peptide, is a novel synthetic pre-clinical 24-amino acid
      peptide, one of a new class of compounds in the field of smooth muscle
      relaxation called Intracellular Actin Relaxing Molecules, or ICARMsTM. AZX100 is
      currently being evaluated for medically and commercially significant
      applications, such as the treatment of vasospasm associated with subarachnoid
      hemorrhage, the prevention of keloid scarring, pulmonary fibrosis, and the
      treatment of asthma. OrthoLogic has an exclusive worldwide license to AZX100.





We
      continue to explore other biopharmaceutical compounds that can complement our
      research activity internally and broaden our potential pipeline for successful
      products.





**Company
      History**





Prior
      to
      November 26, 2003, we developed, manufactured and marketed proprietary,
      technologically advanced orthopedic products designed to promote the healing
      of
      musculoskeletal bone and tissue, with particular emphasis on fracture healing
      and spine repair. Our product lines included bone growth stimulation and
      fracture fixation devices including the OL1000 product line, SpinaLogic® and
      OrthoFrame/Mayo, which we sometimes refer to as our “Bone Device Business.”





On
      November 26, 2003, we sold our Bone Device Business. Our principal business
      remains focused on tissue repair, although through biopharmaceutical approaches
      rather than through the use of medical devices.





On
      August
      5, 2004, we purchased substantially all of the assets and intellectual property
      of Chrysalis Biotechnology, Inc. (“CBI”), including its exclusive worldwide
      license for Chrysalin for all medical indications, for $2.5 million in cash
      and
      $25.0 million in OrthoLogic common stock plus an additional $7.0 million in
      OrthoLogic common stock upon the occurrence of certain triggering events. We
      became a development stage entity commensurate with the acquisition.
      Subsequently, all of our collective efforts were focused on research and
      development of our Chrysalin Product Platform, with the goal of commercializing
      our products.





6
 *Index*





On
      February 23, 2006 the Company entered into an agreement to purchase certain
      assets and assume certain liabilities of AzERx, Inc. The transaction was
      completed (closed) on February 27, 2006. Under the terms of the transaction,
      OrthoLogic acquired an exclusive license for the core intellectual property
      relating to AZX100, and will continue to develop the new class of compounds
      in
      the field of smooth muscle relaxation called Intracellular Actin Relaxing
      Molecules, or ICARMsTM, based on the unique technology developed by AzERx. The
      acquisition provides the Company with a new technology platform
      that diversifies the portfolio, and may provide more than one potential
      product.  AzERx’s lead compound is AZX100, a 24-amino acid synthetic
      peptide.  AZX100 is currently being evaluated for medically important and
      commercially significant applications such as the treatment of vasospasm
      associated with subarachnoid hemorrhage (SAH), prevention of keloid scarring,
      pulmonary fibrosis and the treatment of asthma.  Preclinical and human *in
      vitro* studies
      have shown that this novel compound has the ability to relax smooth muscle
      in
      multiple tissue types. The Company will continue AZX100 pre-clinical development
      activities in 2006.





Our
      development activities for the Chrysalin Product Platform and AZX100 represent
      a
      single operating segment as they share the same product development path and
      utilize the same Company resources. As a result, we have determined that it
      is
      appropriate to reflect our operations as one reportable segment. Through
      September 30, 2006, we have incurred $88 million in net losses as a development
      stage company.




In
      these
      notes, references to “we”, “our” and the “Company” refer to OrthoLogic Corp.
      References to our Bone Device Business refer to our former business line of
      bone
      growth stimulation and fracture fixation devices, including the OL1000 product
      line, SpinaLogic®, OrthoFrame® and OrthoFrame/Mayo.




Financial
      Statement Presentation





In
      the
      opinion of management, the unaudited condensed interim financial statements
      include all adjustments necessary for the fair presentation of our financial
      position, results of operations, and cash flows. The results of operations
      for
      the interim periods are not necessarily indicative of the results to be expected
      for the complete fiscal year.





Use
      of
      estimates: The preparation of financial statements in accordance with accounting
      principles generally accepted in the United States of America requires that
      management make a number of assumptions and estimates that affect the reported
      amounts of assets, liabilities, and expenses in our financial statements and
      accompanying notes. Management bases its estimates on historical experience
      and
      various other assumptions believed to be reasonable. Although these estimates
      are based on management’s assumptions regarding current events and actions that
      may impact the Company in the future, actual results may differ from these
      estimates and assumptions. Our critical accounting policies are those that
      affect, or could affect, our financial statements materially and involve a
      significant level of judgment by management. The accounting policies and related
      risks described in our Annual Report for the year ended December 31, 2005 are
      those that depend most heavily on these judgments and estimates. As of September
      30, 2006, there have been no material changes to any of the critical accounting
      policies contained therein, except for the adoption of SFAS No. 123(R) as
      disclosed in Note A.





As
      discussed in the following section of this report, Item 2. “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations”, the
      results of the Company’s Phase 3 Chrysalin fracture repair human clinical trial
      resulted in a change in our planned clinical pathway and timeline for our
      Chrysalin fracture repair indication. This potential change, when factored
      with
      our current significant net operating loss carryovers and current period net
      loss, resulted in a revision of our estimate of the need for a valuation
      allowance for the previously recorded deferred tax asset related to a
      Alternative Minimum Tax credit carryover. Due to the uncertainty that the
      deferred tax asset will be realized, we recorded a valuation allowance for
      the
      full amount of the deferred tax asset ($1,106,000) in the nine month period
      ended September 30, 2006.





7
 *Index*





The
      interim analysis of data from the Company’s Phase 2b fracture repair dose
      ranging clinical trial, as discussed in the following section of this report,
      Item 2 “Management’s Discussion and Analysis of Financial Condition and Results
      of Operations”, confirmed the above discussed potential changed timeline to
      market for Chrysalin-based products. On
      November 2, 2006, the Company announced that it has no immediate plans to
      re-enter clinical trials for Chrysalin-based product candidates and a strategic
      shift in its development approach to its Chrysalin product platform. The Company
      currently intends to pursue development partnering or licensing opportunities
      for its Chrysalin-based product candidates, a change from its previous
      development history of independently conducting human clinical trials necessary
      to advance its Chrysalin-based product candidates to market. SFAS
      No.
      142 requires an impairment loss be recognized for an amortizable intangible
      asset whenever the net cash in-flow to be generated from an asset is less that
      its carrying cost. Currently, the Company is unable to determine the timing
      or
      amount of net cash in-flow to be generated from Chrysalin-based product
      candidates. Accordingly, due to this uncertainty, the Company has elected to
      recognize an impairment loss for the amount of unamortized Chrysalin product
      platform patent costs of $2,100,000 at September 30, 2006. The impairment loss
      is included in research and development expenses in the Condensed Statements
      of
      Operations at September 30, 2006.





Certain
      information and footnote disclosures normally included in financial statements
      prepared in accordance with generally accepted accounting principles have been
      condensed or omitted pursuant to Securities and Exchange Commission rules and
      regulations, although the Company believes that the disclosures herein are
      adequate to make the information presented not misleading. These unaudited
      condensed financial statements should be read in conjunction with the financial
      statements and the notes thereto included in the Company’s Annual Report on Form
      10-K for the year ended December 31, 2005.




New
      Accounting Pronouncements. In June 2006, the FASB issued Interpretation
      No. 48, Accounting for Uncertainty in Income Taxes (an interpretation of
      FASB Statement No. 109), (“FIN 48”), which clarifies the relevant
      criteria and approach for the recognition, de-recognition and measurement of
      uncertain tax positions. FIN 48 will be effective for the Company beginning
      January 1, 2007. We are currently in the process of assessing the
      provisions of FIN 48, but do not expect the adoption of FIN 48 to have
      a material impact on our financial statements.




**A.
      STOCK BASED COMPENSATION** .
      SFAS
      No. 123(R) supersedes APB No. 25 and revises guidance in SFAS No. 123. Effective
      January 1, 2006 we adopted SFAS No. 123 (revised 2004), Share-Based Payment,
      (SFAS 123(R)). SFAS 123(R) requires all share-based payments, including grants
      of stock options, restricted stock units and employee stock purchase rights,
      to
      be recognized in our financial statements based on their respective grant date
      fair values. Under this standard, the fair value of each employee stock option
      and employee stock purchase right is estimated on the date of grant using an
      option pricing model that meets certain requirements. We currently use the
      Black-Scholes option pricing model to estimate the fair value of our share-based
      payments. The determination of the fair value of share-based payment awards
      utilizing the Black-Scholes model is affected by our stock price and a number
      of
      assumptions, including expected volatility, expected life, risk-free interest
      rate and expected dividends. We use the historical volatility adjusted for
      future expectations. The expected life of the stock options is based on
      historical data and future expectations. The risk-free interest rate assumption
      is based on observed interest rates appropriate for the terms of our stock
      options and stock purchase rights. The dividend yield assumption is based on
      our
      history and expectation of dividend payouts. The fair value of our restricted
      stock units is based on the fair market value of our common stock on the date
      of
      grant. Stock-based compensation expense recognized in our financial statements
      in 2006 and thereafter is based on awards that are ultimately expected to vest.
      The amount of stock-based compensation expense in 2006 and thereafter will
      be
      reduced for estimated forfeitures. Forfeitures are required to be estimated
      at
      the time of grant and revised, if necessary, in subsequent periods if actual
      forfeitures differ from those estimates. We will evaluate the assumptions used
      to value stock awards on a quarterly basis. If factors change and we employ
      different assumptions, stock-based compensation expense may differ significantly
      from what we have recorded in the past. To the extent that we grant additional
      equity securities to employees, our stock-based compensation expense will be
      increased by the additional compensation resulting from those additional grants.
      The Company chose the modified-prospective transition alternatives in adopting
      SFAS 123(R). Under the modified-prospective transition method, compensation
      cost
      is recognized in financial statements issued subsequent to the date of adoption
      for all stock-based payments granted, modified or settled after the date of
      adoption, as well as for any unvested awards that were granted prior to the
      date
      of adoption. Because the Company previously adopted only the pro forma
      disclosure provisions of SFAS 123, we will recognize compensation cost relating
      to the unvested portion of awards granted prior to the date of adoption using
      the same estimate of the grant-date fair value and the same attribution method
      used to determine the pro forma disclosure under SFAS 123, except that a
      forfeiture rate will be estimated for all options, as required by SFAS 123(R).





8
 *Index*





Unrecognized
      non-cash stock compensation expense related to unvested options outstanding
      as
      of December 31, 2005 was approximately $1 million (includes 328,124 shares
      valued at $500,000 unvested and cancelled on April 5, 2006 upon the resignation
      of James M. Pusey, MD). Because of the significant expected forfeiture rate
      caused by the options cancelled at the time of Dr. Pusey’s resignation, the
      expected compensation cost for unvested options at December 31, 2005, was
      approximately $250,000. Compensation cost recorded for the nine months ended
      September 30, 2006 for the options outstanding and unvested at December 31,
      2005
      was $154,000. At September 30, 2006 the remaining compensation cost related
      to
      unvested options outstanding at December 31, 2005, is approximately $100,000,
      which will be recognized over the remaining vesting period of approximately
      three years, with an estimated weighted average period of one year.





We
      have
      provided the required additional disclosures below which illustrates the effect
      on net loss and loss per share if the Company had applied the fair value
      recognition provisions of SFAS No. 123(R), “Accounting for Stock-based
      Compensation,” to stock-based employee compensation (in thousands except per
      share data) prior to the actual date of adoption of SFAS No. 123 (R), January
      1,
      2006.


9
 *Index*




Three
                months ended
              September
                30, 2005
            
            Nine
                months ended
              September
                30, 2005Estimated
                weighted-average fair value of options granted during the
                period
            
            None
            
            $
            3.36Net
                loss attributable to common stockholders:As
                reported
            
            $
            7,593
            
            $
            19,702Stock
                based compensation expense (included in net loss)
            
            
            -
            
            
            -Stock
                based compensation expense, net of tax
            
            
            392
            
            
            1,044Pro
                forma
            
            $
            7,985
            
            $
            20,746Basic
                and diluted net loss per share:As
                reported
            
            $
            0.20
            
            $
            0.52Pro
                forma
            
            $
            0.21
            
            $
            0.55Black-Scholes
                model assumptions:Risk
                free interest rate
            
            
            4.2
            %
            
            4.2
            %Expected
                volatility
            
            
            30
            %
            
            55
            %Expected
                term
            
            
            2.4
                Years
            
            
            2.4
                YearsDividend
                yield
            
            
            0
            %
            
            0
            %




**2006
      Stock Options**





On
      June
      2, 2006, the Board of Directors granted options to purchase 800,000 shares
      of
      the Company’s common stock, at an exercise price of $1.70 per share, to certain
      Company employees. These options vest pro rata over a two-year
      period.





On
      May
      12, 2006, The Board of Directors of the Company granted each Director a fully
      vested option to purchase 25,000 shares of the Company’s common stock at an
      exercise price of $1.75.





As
      part
      of their service agreements, on May 12, 2006, the Board granted options to
      John
      M. Holliman, III, Executive Chairman, and Randolph C. Steer, MD, Ph.D.,
      President, to each purchase 200,000 shares of the Company’s common stock, at an
      exercise price of $1.75 per share. The options vest pro rata over a two-year
      period.





During
      the three months ended March 31, 2006, the Board granted employees options
      to
      purchase 584,000 shares of the Company’s common stock at exercise prices ranging
      from $4.73 to $5.39 per share. These options vest over a four-year period.
      On
      January 1, 2006, the Board also granted each Director a fully vested option
      to
      purchase 10,000 shares of the Company’s common stock at an exercise price of
      $4.90 per share.





**** The
      Company used the Black-Scholes model with the following assumptions, to
      determine the total fair market value of $3,555,000 for options to purchase
      1,994,000 shares of the Company’s common stock issued during the nine months
      ended September 30, 2006:





10
 *Index*




Three
                months ended
              March
                31, 2006
            
            Three
                months ended
              June
                30, 2006Risk
                free interest rate
            
            4.8%
            
            5.2%Volatility
            
            73%
            
            70%Expected
                term from vesting
            
            2.9
                years
            
            2.9
                yearsDividend
                yield
            
            0%
            
            0%




Using
      an
      estimated forfeiture rate of 5%, compensation cost recorded for the nine months
      ended September 30, 2006, for options issued in that period, was $1,673,000.
      The
      options granted generally vest over a two to four-year period from the date
      of
      grant and, accordingly, the remaining unamortized cost at September 30, 2006
      of
      approximately $1,622,000 will be amortized ratably over the period ending
      December 31, 2009, with an estimated weighted average period of 1.2
      years.





**2006
      Restricted Stock**





On
      May
      12, 2006, the Shareholders of the Company approved the 2005 Equity Incentive
      Plan, which reserves an additional 2,000,000 shares of the Company’s common
      stock for equity incentive awards. In conjunction with the approval, on May
      12,
      2006, the Board of Directors of the Company awarded 117,750 shares of restricted
      stock, of which 87,550 shares were fully vested at September 30, 2006, and
      30,200 shares will vest December 31, 2006. All of the restricted stock awards
      had been conditionally awarded in 2005, subject to shareholder approval of
      the
      2005 Equity Incentive Plan. Of the restricted shares awarded, 62,750 shares
      related to annual awards to the Board of Directors, and 55,000 shares were
      performance based awards to officers of the Company. The total fair market
      value
      of the grants, determined using the closing price of the Company’s common stock
      on the date of grant, was $206,000, of which $181,000 has been recognized as
      compensation cost in the nine months ended September 30, 2006.





In
      connection with the employment of James M. Pusey, MD, President and CEO, in
      March 2005, the Company granted Dr. Pusey 200,000 shares of restricted stock,
      which vested if certain milestones were reached. In March 2006, 100,000 shares
      of restricted stock vested resulting in total compensation expense of $588,000,
      of which $426,000 was recorded in the quarter ended March 31, 2006 and $162,000
      in fiscal year 2005, as general and administrative expenses. The compensation
      cost was determined using the closing price of the Company’s common stock on
      March 3, 2005, the date of grant. The remaining unvested 100,000 shares of
      restricted stock were cancelled upon Dr. Pusey’s resignation on April 5, 2006 of
      his employment with the Company.




Summary





Non-cash
      stock compensation cost for the nine months ended September 30, 2006 totaled
      $2,252,000 of which $607,000 related to restricted stock, as described above.
      In
      the condensed Statements of Operations for the nine months ended September
      30,
      2006, non-cash stock compensation expense of $1,649,000 was recorded as a
      general and administrative expense and $603,000 was recorded as a research
      and
      development expense.





During
      the nine months ended September 30, 3006, options to purchase 670,400 shares
      of
      the Company’s common stock were exercised resulting in the receipt by the
      Company of net cash proceeds of $2,962,000.


11
 *Index*




A
      summary
      of option activity under our stock option plans for the nine months ended
      September 30, 2006, is as follows:




Number
              of options
            
            Weighted
              average
                exercise
              price
            
            Weighted
              average
              remaining
              contractual
                term
              (years)Options
                outstanding at December 31, 2005
            
            
            3,040,785
            
            $
            5.23Plus:
                Options granted
            
            
            1,994,000
            
            $
            2.85Less:Options
                exercised
            
            
            (670,400
            )
            $
            4.42Options
                expired/forfeited
            
            
            (794,666
            )
            $
            7.22Options
                outstanding at September 30, 2006
            
            
            3,569,719
            
            $
            3.67
            
            
            7.64Options
                exercisable at September 30, 2006
            
            
            1,965,342
            
            $
            4.37
            
            
            6.13Options
                vested and expected to vest at September 30, 2006
            
            
            3,487,113
            
            $
            3.68





A
      summary
      of the status of the Company’s unvested shares as of September 30, 2006, and
      changes during the nine months ended September 30, 2006, is presented
      below:





Unvested
                Shares
            
            Number
                of
              Options
            
            Weighted
              average
                Grant date
              Fair
                ValueUnvested
                shares at December 31, 2005
            
            
            200,000
            
            $
            5.88Granted
            
            
            117,750
            
            $
            1.75Vested
            
            
            (187,550
            )
            $
            3.95Canceled/forfeited
            
            
            (100,000
            )
            $
            5.88Unvested
                shares at September 30, 2006
            
            
            30,200
            
            $
            1.75





It
      is the
      Company’s policy to issue options from shareholder approved incentive plans.
      However, if the options are issued as an inducement for an individual to join
      the Company, the Company may issue stock options outside of shareholder approved
      plans. The options granted under shareholder approved incentive plans have
      a
      ten-year term and vest over a two to four-year period of service. All options
      and stock purchase rights are granted with an exercise price equal to the
      current market value on the date of grant and, accordingly, options or stock
      purchase rights have no intrinsic value.





**B.**
            **Acquisition
                of New Class of Molecules,
                ICARMsTM**





On
      February 23, 2006, the Company entered into an agreement to purchase certain
      assets and assume certain liabilities of AzERx, Inc. for $390,000 in cash and
      the issuance of 1,355,000 shares of the Company’s common stock. The transaction
      was completed (closed) on February 27, 2006.  Under the terms of the
      transaction, OrthoLogic acquired an exclusive license for the core intellectual
      property relating to AZX100, and will continue to develop the new class of
      compounds in the field of smooth muscle relaxation called Intracellular Actin
      Relaxing Molecules, or ICARMsTM, based on the unique technology developed by
      AzERx.





12
 *Index*





The
      acquisition provides the Company with a new technology platform that diversifies
      the portfolio, and may provide more than one potential product.  AzERx’s
      lead compound is AZX100, a 24-amino
      acid synthetic peptide.  AZX100 is currently being evaluated for medically
      important and commercially significant applications such as the treatment of
      vasospasm associated with subarachnoid hemorrhage, prevention of keloid
      scarring, pulmonary fibrosis and the treatment of asthma.  Preclinical and
      human in vitro studies have shown that this novel compound has the ability
      to
      relax smooth muscle in multiple tissue types.





The
      Company deemed the cost of the acquisition to be in-process research and
      development costs and, accordingly, charged the acquisition costs to research
      and development expense in the nine month period ended September 30, 2006.





The
      costs
      associated with the acquisition were as follows:





Cash
            
            $
            390,000Fair
                Market Value of the Company's common stock issued (1)
            
            
            7,764,000Transaction
                costs
            
            
            242,000Liabilities
                assumed
            
            
            75,000In-process
                research and development costs
            
            $
            8,471,000








(1)
      The
      fair market value of the Company’s common stock ($5.73) was determined by
      reference to the closing market price of the Company’s common stock for a
      reasonable period before and after February 24, 2006.





Valley
      Ventures III, L.P., an investment fund affiliated with the Executive Chairman
      of
      OrthoLogic, John M. Holliman, III, is a minority stockholder of AzERx.  Mr.
      Holliman did not participate in the evaluation or approval of this transaction
      on behalf of OrthoLogic.





**C.**
            **Sale
                of Shares of Company Stock, Issuance of Warrants and Entry into****Master
                Services Agreement**





On
      February 24, 2006 the Company entered into agreements with PharmaBio Development
      Inc., (dba NovaQuest), an affiliate of Quintiles, Inc., and Quintiles, Inc.
      (collectively “Quintiles”), which provided for the purchase of $2,000,000 of the
      Company’s common stock, with the number of shares (359,279) determined by the
      15-day average closing stock price prior to February 24, 2006 ($5.56). The
      transaction was completed (closed) on February 27, 2006. Additionally, under
      the
      terms of the agreements, at the election of the Company, Quintiles would have
      been required to purchase $1,500,000 of the Company’s common stock on June 30,
      2006, (Second Closing) with the number of shares determined by the 15-day
      average closing stock price prior to June 30, 2006, and would have been required
      to purchase $1,500,000 of the Company’s common stock on September 29, 2006, with
      the number of shares determined by the 15-day average closing stock price prior
      to September 29, 2006 (Third Closing). Each stock purchase would include the
      issuance of fully vested warrants, exercisable for a ten-year period from the
      date of issuance, for an amount of shares equal to 13% of the shares purchased
      and with the exercise price set at 115% of the share price of each respective
      share purchase. (For the February 27, 2006 investment, warrants to purchase
      46,706 shares at $6.39 were issued).





13
 *Index*





On
      July
      3, 2006, the Company closed the transaction contemplated by the agreements
      on
      the Second Closing Date. Pursuant to the agreements, on July 3, 2006, the
      Company issued a total of 903,252 shares of its common stock to Quintiles for
      a
      purchase price of $1,500,000 and issued a fully vested warrant to purchase
      117,423 shares of the Company’s common stock at $1.91 a share.





On
      September 14, 2006, the Company notified Quintiles that the Company would not
      offer for sale or issue to Quintiles the shares contemplated in the Third
      Closing. Accordingly, the Company has no further right to request Quintiles
      purchase shares of its common stock and Quintiles has no further obligation
      to
      purchase such shares under the agreements.





Summary
      of the stock sale transactions:


February
                27, 2006
            
            July
                3, 2006Capital
                stock and additional paid-in capital
            
            $
            1,913,000
            
            $
            1,463,000Accrued
                transaction costs
            
            
            87,000
            
            
            37,000Cash
                proceeds
            
            $
            2,000,000
            
            $
            1,500,000








Accrued
      transaction costs represent direct costs of the transaction (legal and
      accounting fees) and are treated as reduction of additional paid-in
      capital.





As
      part
      of the transaction, the Company and Quintiles also entered into a Master
      Services Agreement whereby Quintiles agreed to become the Company’s exclusive
      contract research organization service provider for the Company’s Chrysalin
      Product Platform and to provide certain other technical assistance. The Company
      may enter into a variety of contracts over the five-year term of the agreement
      as determined by the development and clinical progress of its Chrysalin
      products. In return for this agreement, the Company has granted Quintiles the
      right of first negotiation to promote Chrysalin with a specialty sales force
      under a fee-for-service or risk-based structure. Additionally, the Company
      has
      granted Quintiles warrants to purchase up to 240,000 shares of the Company’s
      common stock, with the exercise price set at 115% of the Second Closing stock
      price ($1.91). The shares will be exercisable for a ten-year period from
      February 27, 2006 and the warrants will vest based on the achievement of certain
      milestones (milestone warrants).





The
      total
      cost of the milestone warrants will be charged to expense over the period of
      performance. The costs will be determined based on the fair market value of
      the
      milestone warrants determined by using the Black-Scholes model, revalued at
      each
      Company reporting date until fully vested. The fair market value of the
      milestone warrants using the Black-Scholes model, 67% volatility, 0% dividend
      yield, expected term of 9.4 years, and 4.7% interest rate was $221,000 at
      September 30, 2006. No costs were charged to expense at September 30, 2006
      as it
      is not yet probable that any milestone warrants will vest.





**D.**
            **Property
                Tax Dispute**





The
      Company, along with similar affected property owners or Lessees, contested
      certain property taxes levied by Maricopa County on Salt River Project leasehold
      improvements. In September 2006, the Superior Court of Arizona ruled in favor
      of
      the Company. However, the court ruling is subject to appeal by Maricopa County.
      Given the uncertainty of the appeal process, at September 30, 2006 the Company
      could not determine that recovery of the amounts involved is probable, and,
      accordingly, expected recoveries have not been recorded at September 30, 2006.
      The property tax bills subject to the court’s decision, totaled $466,000 and
      covered tax years 2004 and 2005. The Company has also been billed $240,000
      for
      tax year 2006 for the same taxes, of which $180,000 has been charged to expense
      at September 30, 2006. If the Company is successful in the recovery of the
      amounts for tax years 2004 and 2005, it is expected to also recover the amounts
      for tax year 2006. During 2006 the Arizona State Legislature repealed the
      property tax which is the subject of the dispute.





14
 *Index*





**Item
              2.**
            **Management’s
                Discussion and Analysis of Financial Condition and****Results
                of Operations.**





The
      following is management’s discussion of significant events in the three and nine
      month periods ended September 30, 2006 and factors that affected OrthoLogic’s
      interim financial condition and results of operations. This should be read
      in
      conjunction with our “Management’s Discussion and Analysis of Financial
      Condition and Results of Operations” included in our Annual Report on Form 10-K
      for the year ended December 31, 2005 and Item 1A. Risk Factors included in
      Part
      II of this quarterly report.





**Overview
      of the Business**





OrthoLogic
      is currently a development stage biotechnology company focused on the
      development and commercialization of the novel synthetic peptides Chrysalin®
(TP508) and AZX100. However, we continue to evaluate other biopharmaceutical
      compounds that can complement our research activity internally and broaden
      our
      potential pipeline for successful products.







**Chrysalin
      Product Platform**





Chrysalin,
      or TP508, is a 23-amino acid synthetic peptide representing a receptor-binding
      domain of the human thrombin molecule, a naturally occurring molecule in the
      body responsible for both blood clotting and initiating many of the cellular
      events responsible for tissue repair. Chrysalin mimics specific attributes
      of
      the thrombin molecule, stimulating the body’s natural healing processes. Drugs
      based on the Chrysalin peptide can be used to mimic part of the thrombin
      response without stimulating the events associated with blood clotting and
      therefore has the potential to accelerate the natural cascade of healing events.
      The Chrysalin molecule serves as the basis for a group of potential therapeutic
      products we refer to collectively as the “Chrysalin Product Platform.” We have
      conducted clinical trials for two potential Chrysalin products, acceleration
      of
      fracture repair, and diabetic foot ulcer. We previously conducted a pilot study
      for spine fusion. We have conducted pre-clinical testing for cartilage defect
      repair, cardiovascular repair, dental bone repair, and tendon repair (see the
      Company’s Annual Report on Form 10-K for the year ended December 31, 2005 for
      additional comments on the Chrysalin Product Platform).





The
      development of each of our potential product candidates in the Chrysalin Product
      Platform is based on our collective knowledge and understanding of how the
      human
      thrombin molecule contributes to the repair of bone and soft tissue. While
      there
      are important differences in each of the product candidates in terms of purpose
      (fracture repair, diabetic foot ulcer healing, etc.) each product candidate
      is
      focused on accelerating and enhancing tissue repair and is based on the ability
      of Chrysalin to mimic specific attributes of the human thrombin molecule to
      stimulate the body’s natural healing process.





15
 *Index*





Through
      September 30, 2006, the Company has focused most of its efforts on the
      development and commercialization of fracture repair and diabetic foot ulcer
      healing indications.




**Acceleration
      of Fracture Repair**





Every
      broken bone is called a fracture and approximately 30 million fractures are
      treated every year throughout the developed world, as reported by medical
      reimbursement records in countries with national healthcare systems. The
      treatment of a fracture depends on the severity of the break. Simple fractures
      often heal themselves, with more complex closed fractures potentially amenable
      to treatment by manipulation (also called “reduction”) without requiring
      surgery. Fractures that break the skin (or “open fractures”) or where the
      fragments cannot be lined up correctly usually require surgery. Sometimes
      plates, screws or pins are used for mechanical stabilization, occasionally
      with
      the use of bone grafts, all of which are invasive, expensive and time consuming
      procedures.





Chrysalin
      is a substance that, when injected through the skin into the fracture site
      at
      the time of fracture reduction, was shown in a preliminary clinical trial to
      accelerate the healing of the fracture. Chrysalin does this by mimicking certain
      stimulatory aspects of the thrombin molecule. Fractures that heal faster lead
      to
      earlier return of function for the patient and potentially improved clinical
      outcomes.





In
      pre-clinical animal studies, a single injection of Chrysalin into the fracture
      gap accelerated fracture healing by up to 50% as measured by mechanical testing.
      In late 1999, we initiated a combined Phase 1/2 human clinical trial to evaluate
      the safety of Chrysalin and its effect on the rate of healing in adult subjects
      with unstable distal radius fractures (fractures around and in the wrist joint).
      We presented the results of this Phase 1/2 human clinical trial for fracture
      repair at the 57th Annual Meeting of the American Society for Surgery of the
      Hand in October 2002. The data from x-ray evaluations revealed that a single
      injection of Chrysalin into the fracture gap resulted in a trend toward
      accelerated fracture healing compared with the saline placebo control. There
      were no reportable adverse events attributable to Chrysalin in the study.





We
      completed subject enrollment in our pivotal Phase 3 human clinical trial
      evaluating the efficacy of Chrysalin in subjects with unstable and/or displaced
      distal radius (wrist) fractures in May 2005. We enrolled a total of 503 study
      subjects in 27 health centers throughout the United States. The primary efficacy
      endpoint in the trial was to measure how quickly wrist fractures in subjects
      injected with Chrysalin heal, as measured by the removal of immobilization.
      Accelerated removal of immobilization allows patients to initiate hand therapy
      and regain full function of their wrists and hands sooner. The clinical trial’s
      secondary efficacy endpoints include radiographic analysis of healing, as well
      as clinical, functional, and subject outcome parameters. On March 15, 2006,
      the
      Company reported results of an analysis of data from its Phase 3 clinical trial
      of the novel synthetic peptide Chrysalin ® (TP508)
      in unstable, displaced distal radius (wrist) fractures. Treatmen t
      with
      10μg Chrysalin did not demonstrate a statistically significant benefit compared
      to placebo in the primary efficacy endpoint of time to removal of
      immobilization. Within
      the secondary endpoints, radiographic evidence of time to radial cortical
      bridging, showed a statistically significant benefit for Chrysalin-treated
      subjects (p = 0.046). This benefit mirrored findings from the Phase 1/2 clinical
      trial that provided part of the foundation for the Phase 3 study. A
      statistically significant difference between Chrysalin treatment and placebo
      in
      the functional secondary endpoints was not observed. From a safety perspective,
      there were no adverse events related to Chrysalin reported in this Phase 3
      trial, nor were there any differences in adverse event rates observed between
      the Chrysalin and placebo treated subjects.





16
 *Index*





The
      Company was assessing Chrysalin in a Phase 2b human clinical trial in distal
      radius fractures, which is a double-blind, randomized placebo controlled trial
      that explored a wider dose range of Chrysalin, including 1μg, 3 μg, 10 μg, or 30
μg doses. Our enrollment goal was 500 evaluable subjects in approximately 60
      sites. On March 15, 2006, the Company temporarily interrupted enrollment in
      its
      Phase 2b fracture repair dosing human clinical trial to perform an interim
      analysis of the subjects enrolled up to that date.





On
      August
      29, 2006, the Company reported the results of interim analysis of data from
      our
      Phase 2b dose ranging clinical trial of the novel synthetic peptide Chrysalin
      (TP508) in unstable, displaced distal radius (wrist) fractures and termination
      of the Phase 2b study. In the dataset of 240 subjects as a group that were
      evaluable in the Phase 2b interim analysis, treatment with Chrysalin did not
      demonstrate benefit compared to placebo in the primary efficacy endpoint of
      time
      to removal of immobilization. Individual findings of efficacy in secondary
      endpoints, including radiographic healing, were not seen in this interim
      analysis and no dose response relationship was observed. The trial met the
      pre-specified safety endpoint by demonstrating no significant difference in
      the
      incidence of adverse events between the Chrysalin and placebo
      groups.




**Dermal
      Wound Healing**





Our
      dermal wound healing studies are focused on healing diabetic foot ulcers, a
      common problem for diabetic patients. Diabetic patients suffer from open wound
      foot ulcers because diabetes related nerve damage causes the patient to lose
      sensation. Patients thus may not notice an injury to the foot and neglect the
      injury. This fact and the diminished blood flow to extremities caused by
      diabetes cause a diabetic patient’s wounds to heal more slowly or not at all.





Current
      standard treatment for diabetic foot ulcer wounds focuses on sanitation of
      the
      wound and non-use of the foot (off loading) to allow for the body’s natural
      healing processes to occur. These treatments require high patient compliance
      and
      effectively heal only approximately 33% of these ulcers. Wounds that do not
      respond to treatment can sometimes result in amputation of the affected limb.





We
      believe topical treatment of the wound with Chrysalin will promote new tissue
      growth necessary for healing of a diabetic foot ulcer. CBI conducted a
      multicenter Phase 1/2 double blind human trial with 60 subjects, the results
      of
      which were presented at the Wound Healing Society in May 2002. We found no
      drug
      related adverse events due to Chrysalin in this trial and complete wound closure
      occurred in 70% of Chrysalin-treated ulcers versus 33% in placebo controls,
      a
      statistically significant difference.






On
        November 2, 2006, the Company announced that it has no immediate plans to
        re-enter clinical trials for Chrysalin-based product candidates and a strategic
        shift in its development approach to its Chrysalin Product Platform. The
        Company
        currently intends to pursue development partnering or licensing opportunities
        for its Chrysalin-based product candidates, a change from its previous
        development history of independently conducting human clinical trials necessary
        to advance its Chrysalin-based product candidates to market.





17
 *Index*





**AZX100
      - ICARMsTM**





On
      February 23, 2006, the Company entered into an agreement to purchase certain
      assets and assume certain liabilities of AzERx, Inc. The transaction was
      completed (closed) on February 27, 2006. Under the terms of the transaction,
      OrthoLogic acquired an exclusive license for the core intellectual property
      relating to AZX100, and will continue to develop the new class of compounds
      in
      the field of smooth muscle relaxation called Intracellular Actin Relaxing
      Molecules, or ICARMsTM, based on the unique technology developed by AzERx. The
      acquisition provides the Company with a new technology platform that diversifies
      the portfolio, and may provide more than one potential product.  AzERx’s
      lead compound is AZX100, a 24-amino acid synthetic peptide.




AZX100
      relaxes smooth muscle, which modulates the function of blood vessels,
      sphincters, the gastrointestinal tract, the genitourinary tract, and the
      airways. Sustained abnormal contraction of any of these muscles is called spasm.
      Any disorders known to be associated with excessive constriction or inadequate
      dilation of smooth muscle represent potential applications for
      AZX100.





AZX100
      may also reverse the fibrotic phenotype of fibroblasts and smooth muscle cells
      in a mechanism similar to that which causes vasorelaxation. Through phenotypic
      modulation of fibroblasts and smooth muscle cells, AZX100 may inhibit the
      scarring that results from wound healing and disease states in the dermis,
      blood
      vessels, lungs, liver and other organs.





AZX100
      is
      currently being evaluated by the Company for applications such as the treatment
      of vasospasm associated with subarachnoid hemorrhage, prevention of keloid
      scarring, pulmonary fibrosis and the treatment of asthma.  Preclinical and
      human *in
      vitro* studies
      have shown that this novel compound has the ability to relax smooth muscle
      in
      multiple tissue types. The Company will continue pre-clinical development
      activities on AZX100 in 2006, and intends to also explore development partnering
      or licensing opportunities for certain AZX100 potential applications, such
      as
      asthma.




**Results
      of Operations Comparing Three-Month Period Ended September 30, 2006 to the
      Corresponding Period in 2005.**


*General
        and Administrative (“G&A”) Expenses:* G&A
        expenses related to our ongoing development operations increased by $387,000
        from $1,027,000 in the third quarter of 2005 to $1,414,000 in the third quarter
        of 2006. Our administrative expenses during the third quarter of 2006 were
        higher than the same period of 2005 primarily as a result of stock compensation,
        as disclosed in Note A to the unaudited condensed financial statements, and
        a
        reduction in the allocation of general and administration expenses to research
        and development due to the decline in clinical activity, partically offset
        by
        decreased employee related costs associated with a decrease in the number
        of
        full time employees.




*Research
        and Development Expenses:* Research
        and development expenses were $5,651,000 for the three months ended September
        30, 2006 compared to $7,266,000 for the same period in 2005. Our research
        and
        development expenses decreased $1,615,000 in the third quarter of 2006 over
        the
        same period in 2005 primarily due to the substantial completion of our Phase
        3
        human clinical trial for fracture repair and the temporary interruption and
        later termination of our Phase 2b dose-ranging human clinical trial for fracture
        repair. This decrease in clinical trial costs was partially offset by
        recognition of a $2,100,000 Chrysalin product platform patent impairment
        loss.
        The primary focus of our research and development work was our Chrysalin-based
        fracture repair indication. On November 2, 2006, the Company announced that
        it
        has no immediate plans to re-enter clinical trials for Chrysalin-based product
        candidates and a strategic shift in its development approach to its Chrysalin
        Product Platform. The Company currently intends to pursue development partnering
        or licensing opportunities for its Chrysalin-based product candidates, a
        change
        from its previous development history of independently conducting human clinical
        trials necessary to advance its Chrysalin-based product candidates to market. We
        will
        continue expenditures related to ongoing regulatory requirements for the
        Phase
        2b clinical trial for Chrysalin in fracture repair and, as
        disclosed in Note B to the unaudited condensed financial statements, the
        Company
        acquired and will continue pre-clinical and other development work on AZX100
        in
        2006.





18
 *Index*





*Interest
      and Other Income, Net* :
      Interest and other income, net, increased from $700,000 in the third quarter
      of
      2005 to $1,250,000 in the third quarter of 2006 due to the increase in interest
      rates between the two periods and the receipt of STTR grant income of $341,000
      in 2006





*Net
      Loss* :
      We
      incurred a net loss in the three months ended September 30, 2006 of $5.8 million
      compared to a net loss of $7.6 million in the same period in 2005. The net
      loss
      in the three months ended September 30, 2006 includes stock compensation expense
      of $600,000 and recognition of a $2,100,000 Chrysalin product platform patent
      impairment loss. These items were offset by the decrease in fracture repair
      human clinical trial activity compared to the same period in 2005.




**Results
      of Operations Comparing Nine-Month Period Ended September 30, 2006 to the
      Corresponding Period in 2005.**


*General
        and Administrative (“G&A”) Expenses:* G&A
        expenses related to our ongoing development operations increased by $2,357,000
        from $3,210,000 in the nine month period of 2005 to $5,567,000 in the nine
        month
        period of 2006. Our administrative expenses during the nine month period
        of 2006
        were higher than the same period of 2005 primarily as a result of stock
        compensation expense of $1,649,000, as disclosed in Note A to the unaudited
        condensed financial statements, and a reduction in the allocation of general
        and
        administrative expenses to research and development due to the decline in
        clinical activity.


*Research
      and Development Expenses:* Research
      and development expenses were $16,575,000 for the first nine months in 2006
      and
      compared to the $18,660,000 of expenses incurred in the first nine months in
      2005. This decrease is primarily due to the decrease in clinical trial activity
      in 2006 when compared to 2005 but was partially offset by recognition of a
      $2,100,000 Chrysalin product platform patent impairment loss. The primary focus
      of our research and development work in 2005 and 2006 was our Chrysalin-based
      fracture repair indication.





*Interest
      and Other Income, Net* :
      Interest and other income, net increased from $1,906,000 in the nine month
      period of 2005 to $2,879,000 in the nine month period of 2006 due to the
      increase in interest rates between the two periods and the receipt of STTR
      grant
      income of $341,000.


*Net
        Loss* :
        We
        incurred a net loss in the first nine months of 2006 of $28.8 million compared
        to a net loss of $19.7 million in the first nine months of 2005. The $9.1
        million increase in the net loss in the nine months ended September 30, 2006
        compared to the same period in 2005, results primarily from $2.2 million
        of
        stock compensation expense, recognition of a $2.1 million Chrysalin product
        platform patent impairment loss, $8.4 million of in-process research and
        development costs related to the acquisition of the AZX100 technology platform,
        as disclosed in Note B to the unaudited condensed financial statements, and
        recognition of income tax expense related to the recording of a valuation
        allowance of $1.1 million for a deferred tax asset related to a Alternative
        Minimum Tax credit carryover. These items were offset by the decrease in
        fracture repair human clinical trial activity compared to the same period
        in
        2005.





19
 *Index*


With
        the
        adoption of SFAS 123 (R), as disclosed in Note A to the unaudited condensed
        financial statements, we recorded a non-cash compensation expense related
        to
        restricted stock and stock options granted to our employees and members of
        our
        Board of Directors of $2.2 million for the nine months ended September 30,
        2006
        and currently estimate the expense for the year ended December 31, 2006 will
        be
        approximately $2.8 million.




**Liquidity
      and Capital Resources**


We
        have
        historically financed our operations through operating cash flows and the
        public
        and private sales of equity securities. However, with the sale of our Bone
        Device Business in November 2003, we sold all of our revenue producing
        operations. Since that time, we have relied on our cash and investments to
        finance all our operations, the focus of which was research and development
        of
        our Chrysalin Product Platform. We received approximately $93.0 million in
        cash
        from the sale of our Bone Device Business. On December 1, 2005, we received
        the
        additional $7.2 million, including interest, from the escrow balance related
        to
        the sale of the Bone Device Business. On February 27, 2006, the Company entered
        into an agreement with Quintiles (see Note C to the unaudited condensed
        financial statements), which provided an investment by Quintiles in the
        Company’s common stock, of which $2,000,000 was received on February 27, 2006
        and $1,500,000 was received on July 3, 2006. The Company also received net
        proceeds of $2,962,000 from the exercise of stock options during the nine
        months
        ended September 30, 2006. At September 30, 2006, we had cash and cash
        equivalents of $36.9 million, short-term investments of $27.3 million and
        long-term investments of $9.9 million.




We
      do not
      expect to make significant capital investments in 2006. On November 2, 2006
      the Company
      announced that it has no immediate plans to re-enter clinical trials for
      Chrysalin-based product candidates and a strategic shift in its development
      approach to its Chrysalin Product Platform. The Company currently intends to
      pursue development partnering or licensing opportunities for its Chrysalin-based
      product candidates, a change from its previous development history of
      independently conducting human clinical trials necessary to advance its
      Chrysalin-based product candidates to market. We
      will
      continue expenditures related to ongoing regulatory requirements for the Phase
      2b clinical trial for Chrysalin in fracture repair, and we will also continue
      research and development expenditures for further pre-clinical studies for
      AZX100.





Our
      future research and development expenses may vary significantly from prior
      periods depending on the Company’s decisions on its future Chrysalin and AZX100
      development plans.





We
      anticipate that our cash and short-term investments will be sufficient to meet
      our presently projected cash and working capital requirements for the next
      two
      years. Within two years, we may need to identify other sources of capital to
      continue our research programs. However, the timing and amounts of cash used
      will depend on many factors, including our ability to continue to control our
      expenditures related to our current research and development programs. If we
      decide to expand our clinical trials or if we consider other opportunities
      in
      the market, our expense levels may change, which could require us to seek other
      sources of capital. If additional funding is required, we would be required
      to
      seek new sources of funds, including raising capital through the sales of
      securities or licensing agreements. These sources of funds may not be available
      or could only be available at terms that would have a material adverse impact
      on
      our existing stockholders’ interests.





20
 *Index*





**Item3.**
            **Quantitative
                and Qualitative Disclosures about Market
                Risk**





We
      had no
      debt outstanding and no derivative instruments at September 30,
      2006.





Our
      investment portfolio is used to preserve our capital until it is required to
      fund our operations. All of these investment instruments are classified as
      held-to-maturity. We do not own derivative financial instruments in our
      investment portfolio.  Our investment portfolio contains instruments that
      are subject to the risk of a decline in interest rates. We maintain a
      non-trading investment portfolio of investment grade, liquid debt securities
      that limits the amount of credit exposure of any one issue, issuer or type
      of
      instrument. Due to the short duration and conservative nature of these
      instruments, we do not believe that we have a material exposure to interest
      rate
      risk.


We
        have
        deposited our cash with a national banking institution, which we believe
        is
        stable. Even though our accounts in this bank have balances in excess of
        the
        $100,000 limit that is insured by the Federal Deposit Insurance Corporation,
        we
        believe these accounts are not subject to significant market risk due to
        bank
        failure.




**Item
              4.**
            **Controls
                and Procedures**





Disclosure
      Controls and Procedures





Our
      principal executive officer and chief financial officer have reviewed and
      evaluated the effectiveness of our disclosure controls and procedures as of
      the
      end of the period covered by this Form 10-Q. Based on their evaluation, the
      principal executive officer and chief financial officer have each concluded
      that, as of the end of such period, our disclosure controls and procedures
      are
      effective and provide reasonable assurance that we record, process, summarize,
      and report information required to be disclosed in the reports we file under
      the
      Securities Exchange Act of 1934 within the time periods specified by the
      Securities and Exchange Commission’s rules and forms.








Internal
      Control Over Financial Reporting





There
      have not been any changes in our internal control over financial reporting
      during the fiscal quarter to which this report relates that have materially
      affected, or are reasonably likely to materially affect, our internal control
      over financial reporting.




**Part
      II - Other Information**





**Item1A.**
            **Risk
                Factors**





Forward
      looking statements





21
 *Index*





OrthoLogic
      may from time to time make written or oral forward-looking statements, including
      statements contained in our filings with the Securities and Exchange Commission
      and our reports to stockholders. The safe harbor for forward-looking statements
      contained in the Private Securities Litigation Reform Act of 1995 protects
      companies from liability for their forward looking statements if they comply
      with the requirements of that Act. This Quarterly Report on Form 10-Q should
      be
      read in conjunction with the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2005, and contains forward-looking statements made pursuant
      to that safe harbor. These forward-looking statements relate to future events
      or
      to our future financial performance, and involve known and unknown risks,
      uncertainties and other factors that may cause our actual results, levels of
      activity, performance, or achievements to be materially different from any
      future results, levels of activity, performance or achievements expressed or
      implied by these forward-looking statements. In some cases, you can identify
      forward-looking statements by the use of words such as “may,” “could,” “expect,”
“intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,”
“potential,” “continue,” or the negative of these terms or other comparable
      terminology. You should not place undue reliance on forward-looking statements
      since they involve known and unknown risks, uncertainties and other factors
      which are, in some cases, beyond our control and which could materially affect
      actual results, levels of activity, performance or achievements. Factors that
      may cause actual results to differ materially from current expectations include,
      but are not limited to:





·
            unfavorable
                results of our product candidate development
                efforts;


·
            unfavorable
                results of our pre-clinical or clinical
                testing;


·
            delays
                in obtaining, or failure to obtain FDA
                approvals;


·
            increased
                regulation by the FDA and other
                agencies;


·
            the
                introduction of competitive
                products;


·
            impairment
                of license, patent or other proprietary
                rights;


·
            failure
                to achieve market acceptance of our
                products;


·
            the
                impact of present and future collaborative agreements;
                and


·
            failure
                to successfully implement our drug development
                strategy.





If
      one or
      more of these or other risks or uncertainties materialize, or if our underlying
      assumptions prove to be incorrect, actual results may vary significantly from
      what we projected. Any forward-looking statement you read in this Quarterly
      Report on Form 10-Q reflects our current views with respect to future events
      and
      is subject to these and other risks, uncertainties and assumptions relating
      to
      our operations, results of operations, business strategy and liquidity. We
      assume no obligation to publicly update or revise these forward-looking
      statements for any reason, or to update the reasons actual results could differ
      materially from those anticipated in these forward-looking statements, even
      if
      new information becomes available in the future.





Except
      as
      set forth below, there were no material changes from the risk factors disclosed
      in our Annual Report on Form 10-K for the year ended December 31,
      2005.





***Certain
      results from our Phase 3 and Phase 2b clinical trials showed that the
      differences in the primary endpoint analyses between our lead compound,
      Chrysalin, and the placebo were not statistically significant, which will make
      it more difficult to obtain FDA approval and result in a substantial delay
      in
      our ability to generate revenue.***





On
      March
      15, 2006, we reported results of our Phase 3 fracture repair human clinical
      trial. For the primary endpoint, time to removal of immobilization , no
      statistically significant difference was observed between placebo and a single
      injection of Chrysalin. Consistent with the Phase 1/2 human clinical trial
      results, a statistically significant difference for a secondary endpoint,
      radiographic evidence of radial cortical bridging, was achieved. However, no
      statistically significant difference was noted in the study’s other secondary
      endpoints. On March 15, 2006, we temporarily halted our Phase 2b fracture repair
      dosing clinical trial to perform an interim analysis of the data of the subjects
      enrolled to that date.





22
 *Index*





On
      August
      29, 2006, we reported the results of interim analysis of data from our Phase
      2b
      dose-ranging clinical trial of the novel synthetic peptide Chrysalin ® (TP508)
      in unstable, displaced distal radius (wrist) fractures and termination of
      the Phase 2b study. In the dataset of 240 subjects as a group that were
      evaluable in the Phase 2b interim analysis, treatment with Chrysalin did not
      demonstrate benefit compared to placebo in the primary efficacy endpoint of
      time
      to removal of immobilization. Individual findings of efficacy in secondary
      endpoints, including radiographic healing, were not seen in this interim
      analysis and no dose response relationship was observed. The trial met the
      pre-specified safety endpoint by demonstrating no significant difference in
      the
      incidence of adverse events between the Chrysalin and placebo groups.





On
      November 2, 2006, the Company announced a strategic shift in its development
      approach to its Chrysalin Product Platform. The Company currently intends to
      pursue development partnering or licensing opportunities for its Chrysalin-based
      product candidates, a change from its previous development history of
      independently conducting human clinical trials necessary to advance its
      Chrysalin-based product candidates to market.


This
        increases the risk that we will not be successful and there will be a
        substantial delay in obtaining FDA approval and may lead to the termination
        of
        development efforts for the Chrysalin fracture repair or other Chrysalin-based
        product candidates, will result in a delay in our ability to generate revenue,
        will change the amount of revenue we may generate and could have a material
        adverse effect on our business going forward.


***Our
      stock price is volatile and fluctuates due to a variety of
      factors.*** ****





Our
      stock
      price has varied significantly in the past (from a high of $8.96 to a low of
      $1.25 from January 1, 2003 to August 31, 2006) and may vary in the future
      due to a number of factors, including:





·
            announcement
                of the results of, or delays in, preclinical or studies of clinical
                trials;


·
            fluctuations
                in our operating results;


·
            developments
                in litigation to which we or a competitor is
                subject;


·
            announcements
                and timing of potential acquisitions, divestitures or issuance of
                preferred stock;


·
            announcements
                of technological innovations or new products by us or our
                competitors;


·
            FDA
                and other regulatory actions;


·
            developments
                with respect to our or our competitors’ patents or proprietary
                rights;


·
            public
                concern as to the safety of products developed by us or others;
                and


·
            changes
                in stock market analyst recommendations regarding us, other drug
                development companies or the pharmaceutical industry generally.





In
      addition, the stock market has from time to time experienced significant price
      and volume fluctuations that are unrelated to the operating performance of
      particular companies. These broad market fluctuations may adversely affect
      the
      market price of our stock.





23
 *Index*





**Item
              6**
            Exhibits





See
      Exhibit List following this report





24
 *Index*




**SIGNATURES**








Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





**ORTHOLOGIC
                CORP.**(Registrant)Signature
            
            Title
            
            Date/s/
                John M. Holliman, III
            
            Executive
                Chairman
            
            November
                8, 2006John
              Mn, Holliman, III
            
            (Principal
              Executive Officer)/s/
                Les M. Taeger
            
            Senior
                Vice-President and Chief
            
            November
                8, 2006Les
              M. Taeger
            
            Financial
              Officer(Principal
              Financial and Accounting Officer)




25
 *Index*





**OrthoLogic
      Corp.**


**(the
      “Company”)**


**Exhibit
      Index to Quarterly Report on Form 10-Q**


**For
      the Quarterly Period Ended September 30, 2006**





**Exhibit********No.**
            
            **Description**
            
            **Incorporated
                by Reference To****:**
            
            **Filed
                Herewith**31.1
            
            Certification
                  of Principal Executive Officer Pursuant to Section 302 of the
                  Sarbanes-Oxley Act of 2002
            
            
            
            X31.2
            
            Certification
                  of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002
            
            
            
            X32
            
            Certification
                  of Principal Executive Officer and Chief Financial Officer Pursuant
                  to 18
                  U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                  Sarbanes-Oxley Act of 2002
            
            
            
            X






26