ISON Isonics Corporation New (CE)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 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 October 31, 2008

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:  001-12531

ISONICS CORPORATION

(Exact name of registrant as specified in its charter)

535 8 ^th Avenue, 3 ^rd Floor

New York, NY 10018-2491

(Address of principal executive offices with zip code)

(212) 356-7400

(Registrant’s telephone number, including area code)

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.   Yes x     No o

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

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

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

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Isonics Corporation and Subsidiaries

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Part I:  Financial Information

Item 1: Financial Statements

Isonics Corporation and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

ASSETS

LIABILITIES AND STOCKHOLDERS’ DEFICIT

See notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

See notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, except share amounts)

(Unaudited)

See notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - BASIS OF PRESENTATION

The accompanying condensed consolidated balance sheet as of April 30, 2008, has been derived from audited financial statements. The accompanying unaudited interim condensed consolidated financial statements of Isonics Corporation and Subsidiaries have been prepared on the same basis as the annual audited financial statements and in accordance with accounting principles generally accepted in the United States (“US GAAP”) for interim financial information and the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial statements. In the opinion of management, such unaudited information includes all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of this interim information. Operating results and cash flows for interim periods are not necessarily indicative of results that can be expected for the entire year. The information included in this report should be read in conjunction with our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended April 30, 2008.

Going Concern

As of October 31, 2008, we had a working capital deficit of $(20,162,000) and a stockholders’ deficit of $(14,976,000).  Furthermore, included in current liabilities are $15,833,000 of convertible debentures and term notes (both net of related discounts) for which we may not be in compliance with certain covenants. As a result and as described in Note 6, the holder may have the right to call such debentures and term notes for the full-face amount of $19,003,900 plus accrued interest. In addition, we incurred significant losses from operations and used significant cash flow to fund operations for the periods presented. Historically, we have relied upon outside investor funds to maintain our operations and develop our business. Although we raised an additional $1,352,500 (net of expenses) through the issuance of $1,550,000 of term notes in June and November 2008 (see Note 6), we anticipate we will continue to require funding from investors to finance our negative cash flow as well as business expansion during this fiscal year and we can provide no assurance that additional investor funds will be available on terms acceptable to us. These conditions raise substantial doubt about our ability to continue operations as a going concern.

In December 2008, as a result of a garnishment of our bank account, approximately $200,000 in funds are not available to us, resulting in our inability to be able to meet certain corporate obligations. This garnishment has exacerbated our liquidity shortage. We anticipate that YA Global will take action to enforce its security interest in those funds.

Our ability to continue as a going concern is dependent upon raising capital through debt or equity financing and by increasing revenue and ultimately achieving positive cash flow and profitable operations. We have substantial limitations on our ability to raise additional financing, and we can offer no assurance that we will be successful in our efforts to raise additional funds or achieve positive cash flow or profitable operations. The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.

NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES

Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Contingently issuable shares are included in the computation of basic net income (loss) per share when the related conditions are satisfied. Diluted net income (loss) per share is

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

computed using the weighted average number of common shares and potentially dilutive securities outstanding during the period.  Potentially dilutive securities consist of contingently issuable shares, the incremental common shares issuable upon conversion of convertible debt (using the “if converted” method) and shares issuable upon the exercise of stock options and warrants (using the “treasury stock” method).  Potentially dilutive securities are excluded from the computation if their effect is anti-dilutive.

As of October 31, 2008, (a) a total of 31,481,500 outstanding stock options and common stock warrants and (b) the unissued shares underlying our outstanding convertible debentures (with a cumulative outstanding face amount of $11,858,900 at October 31, 2008) were excluded from the diluted net loss per share calculation, as their inclusion would be anti-dilutive.  As of October 31, 2007, (a) a total of 5,112,125 outstanding stock options (excluding 3,550,000 stock options not deemed granted under US GAAP because the underlying plan or increase to the underlying plan had not been approved by our shareholders) and common stock warrants and (b) the unissued shares underlying our outstanding convertible debentures (with a cumulative outstanding face amount of $18,0000,000 at October 31, 2007) were excluded from the diluted net loss per share calculation, as their inclusion would be anti-dilutive.

During the six months ended October 31, 2008, we issued the following shares of common stock:

The aforementioned equity transactions increased common stock in the accompanying condensed consolidated balance sheets by $65,000 for the six months ended October 31, 2008.

Recently Issued Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities.  The FASB believes the standard also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value and the effect of fair value measurements on earnings.  The provisions of SFAS 157 are to be applied prospectively as of the beginning of the fiscal year in which SFAS No. 157 is initially applied.  SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value to any new circumstances.  SFAS 157 for financial assets and liabilities was effective for us on May 1, 2008.  On May 1, 2009 SFAS 157 will also apply to non-financial assets and liabilities.  The adoption of SFAS 157 for financial assets and liabilities did not have a material impact on our financial position or results of operations.  FASB Staff Position SFAS 157-2 Effective Date FASB Statement No. 157 (“FSP FAS 157-2”) delays the effective date of SFAS 157 for non-financial assets and liabilities, except for items recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).  We do not expect the application of FSP FAS 157-2 will have a material impact on our financial position or results of operations.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”).  SFAS 159 provides the option to report certain financial assets and liabilities at fair value, with the intent to mitigate volatility in financial reporting that can occur when related assets and liabilities are recorded on different bases.   SFAS 159 also amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities , by providing the option to record unrealized gains

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and losses on held-for-sale and held-to-maturity securities currently.  SFAS 159 was effective for us on May 1, 2008, including interim periods within this fiscal year.  The implementation of FAS 159 did not have a material impact on our financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141(R)”), which establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in an acquiree, including the recognition and measurement of goodwill acquired in a business combination.  SFAS 141(R) is effective for our fiscal year commencing May 1, 2009.  Earlier adoption is prohibited.  We are currently evaluating the impact of adopting SFAS 141(R) on our results of operations and financial condition.

In December 2007, the FASB issued SFAS No. 160 , Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51( “SFAS 160”).  SFAS 160 amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.  It clarifies that a noncontrolling interest in a subsidiary, which is sometimes referred to as minority interest, is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements.  Among other requirements, this statement requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest.  It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest.   SFAS 160 is effective for our fiscal year commencing May 1, 2009, including interim periods within that fiscal year. Earlier adoption is prohibited.  We are currently evaluating the impact of adopting SFAS 160 on our results of operations and financial condition.

NOTE 3 – FINANCIAL STATEMENT COMPONENTS

Inventories

Inventories consist of the following (in thousands):

Property and equipment

Property and equipment consist of the following (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4 –SEGMENT INFORMATION

We currently have two reportable segments: security services and silicon products and services.  Our security services segment provides security and investigative services and is substantially comprised of the operations of Protection Plus Security Corporation (“PPSC”).  Our silicon products and services segment provides 300-millimeter (and smaller diameter) test wafers and reclamation services, wafer thinning and custom wafer products and services for the silicon industry.  Our segments are strategic business units, each of which consists of similar products or services.  They are managed separately because each segment requires different technology and marketing strategy and because each segment sells to different customers from different locations.  Reconciling items consist primarily of corporate assets or expenses that have not been allocated to a specific reportable segment and the assets and results of operations of our former homeland security products segment.  Our former homeland security products segment included both the operations of our Ion Mobility Spectroscopy (“IMS”) technology and, through our 90%-owned subsidiary SenseIt Corp, the development of next-generation infrared imaging and night vision technology through our Development and Licensing Agreement with Lucent Technologies, Inc. (“Lucent”).  We no longer consider homeland security products to be a reportable segment due to the suspension of these segment operations during our year ended April 30, 2008.  Prior period amounts have been reclassified to conform to the current period presentation.

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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 –IMPAIRMENT OF GOODWILL

Goodwill related to our security services segment resulted from the acquisition of PPSC in May 2005.  Due to the loss of a significant customer during the six months ended October 31, 2008, we determined that there had been a significant adverse change to that business.  We determined that the $3,631,000 of goodwill associated with our security services segment had been impaired and as a result,  $2,346,000 of the goodwill was written off to reflect impairment of goodwill during the six months ended October 31, 2008.  The fair value of the reporting unit was estimated using the present value of expected future cash flows.

NOTE 6 – BORROWINGS

June 2008 Term Note

On June 13, 2008, we completed a private placement pursuant to which we issued to one accredited investor, YA Global Investments, L.P. (“YA Global”), a 13% term promissory note in the principal amount of $1,175,000 (the “June 2008 Term Note”), of which the entire amount remains outstanding as of October 31, 2008, but offset by a discount of $306,000 for financial statement presentation.  In addition we issued to YA Global 13,000,0000 common stock warrants which are exercisable at $.03 per share and expire on June 13, 2015.

The June 2008 Term Note bears an interest rate of 13% per annum, is secured by individual security agreements with Isonics Corporation, Isonics Vancouver, Inc. (“IVI”), Isonics Homeland Security and Defense Corporation (“HSDC”) and PPSC and both interest and principal are due in cash on October 31, 2009.  At October 31, 2008, accrued interest payable on the June 2008 Term Note was $59,000 and is included in the caption “accrued interest” in the accompanying condensed consolidated balance sheets.

In accordance with the transaction, we paid Yorkville Advisors, LLC, an affiliate of YA Global, a structuring and monitoring fee in the total amount of $175,000.

Under the terms of the June 2008 Term Note, we agreed not to issue or sell any common stock or preferred stock, or any derivative security exercisable or convertible into shares of common stock, at a price that is less than the current bid price of our common stock without the prior consent of YA Global.  However this covenant does not apply to certain excluded securities, as defined.  In addition, we agreed to several covenants including that we will not permit our revenues to fall more than 10% below the projections provided to YA Global for our three months ended July 31, 2008 or for any monthly period thereafter.  As discussed below, we failed to meet this covenant during the six months ended October 31, 2008 and as a result YA Global can declare an event of default.  Remedies for an event of default, include the option to accelerate payment of the full principal amount of the June 2008 Term Note, together with interest to the date of acceleration.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

While the June 2008 Term Note is outstanding, YA Global has a first right of refusal to participate in any future financings to raise capital.  We also agreed to not grant any security interests in any or all of our assets or file a Form S-8 registration statements without the consent of YA Global as long as the June 2008 Term Note is outstanding.

We have the right to prepay the principal amount of the June 2008 Term Note at any time upon not less than ten trading days notice.  If we prepay the June 2008 Term Note, we are obligated to pay 120% of the outstanding principal amount.

The warrant issued to YA Global is exercisable for cash only unless there in no effective underlying registration statement or an event of default exists under the transaction documents, at which point the holder can elect a cashless exercise.  Under certain circumstances, the warrant’s exercise price may be adjusted to correspond to common stockholders’ rights to any stock dividend, stock split, stock combination or reclassification of shares.  Additionally if we issue common stock or options or other derivative securities that are exercisable or convertible at a price less than the then current warrant exercise price, both the warrant’s exercise price and the number of shares the warrant may be exercisable into will be proportionately adjusted.  This adjustment does not apply to certain excluded securities, as defined in the warrant agreement.

We have an obligation to register the common stock underlying the warrant upon receiving a request from YA Global.  We are required to file the related registration statement within 30 days of receiving the request and having it be declared effective within 120 days of the filing date.  Our obligation to file and obtain effectiveness of a registration statement is contingent on us being eligible to file a registration statement under the rules and regulations of the Securities and Exchange Commission.

We allocated the net proceeds received between the June 2008 Term Note and the related warrant based on the relative fair value of each instrument.  The $227,000 allocated to the warrant was recorded as additional paid-in capital and as a corresponding reduction to the carrying value of the June 2008 Term Note.  The cumulative discount in the amount of $402,000 (arising from the allocation of a portion of the proceeds to the related warrants and the cash fees paid to YA Global) is being amortized to interest expense over the term of the June 2008 Term Note using the effective interest method at an effective interest rate of 44%.  During the six months ended October 31, 2008, $96,000 of discount was amortized to interest expense.

2006 Convertible Debentures

In May, June and November 2006, we issued to YA Global convertible debentures with a cumulative face amount of $16,000,000 (the “2006 Debentures”) along with detachable common stock warrants.  During the six months ended October 31, 2008, we issued 10,685,226 shares of common stock as repayment of $73,300 of principal amount of the 2006 Debentures.  In connection with the issuance of the June 2008 Term Notes, $5,970,000 of the 2006 Debentures were converted to term notes (the “Converted Term Notes”) with the same terms and maturity date as the June 2008 Term Notes.  As a result, as of October 31, 2008 we had outstanding 2006 Debentures with a face amount of $9,858,900 and Converted Term Notes with a face value of $5,970,000.  The 2006 Debentures and the Converted Term Notes are recorded in our condensed consolidated balance sheets at carrying amounts (net of discount) of $7,113,000 and $5,970,000, respectively.  Subsequent to October 31, 2008 we issued an additional 2,604,167 shares of common stock as repayment of $2,400 of 2006 Debentures principal.

In connection with the conversion of the 2006 Debentures to Converted Term Notes, the remaining 2006 Debentures were amended so that the maturity date was extended from May 31, 2009 to October 31, 2009.  Furthermore, the conversion price was modified to be the lower of $0.03 or eighty percent of the lowest

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volume weighted average price (as defined) in the ten trading days prior to the conversion date along with the interest rate being increased to 13%.

As a result of the modification of the fixed conversion price on the remaining 2006 Debentures, we recorded a beneficial conversion feature of $110,000.  This amount was recorded as additional paid-in capital and as a corresponding reduction to the carrying value of the 2006 Debentures.  The discount related to this beneficial conversion feature is being amortized to interest expense over the remaining term of the 2006 Debentures using the effective interest method which resulted in amortization of $30,000 for the six months ended October 31, 2008.  In addition, the original discount is being amortized to interest expense through October 31, 2009 using the effective interest method, which resulted in amortization of $1,413,000 for the six months ended October 31, 2008.  The combined discounts on the 2006 Debentures are being amortized to interest expense using the effective interest method at an effective interest rate of 44%.

For the six months ended October 31, 2008, we recorded accrued interest associated with the 2006 Debentures of $623,000.  As a result, as of October 31, 2008, cumulative accrued interest associated with the 2006 Debentures is $2,302,000 and is included in accrued interest in the accompanying condensed consolidated balance sheet.

Converted Term Notes

At the time of the conversion of $5,970,000 of 2006 Debentures to Converted Term Notes, the original conversion option was eliminated and as a result, the remaining original discount associated with the Converted Term Notes of $1,546,000 was immediately charged to interest expense.  For the six months ended October 31, 2008, we recorded accrued interest associated with the Converted Term Notes of $377,000.  As a result, as of October 31, 2008, cumulative accrued interest associated with the Converted Term Notes is $1,421,000 and is included in accrued interest in the accompanying condensed consolidated balance sheet.

April 2007 Debenture

In April 2007, we issued to YA Global a convertible debenture with a face amount of $2,000,000 (the “April 2007 Debenture”) along with detachable common stock warrants.  For the six months ended October 31, 2008, using the effective interest method we amortized $63,000 of the discount on the April 2007 Debenture to interest expense.  As of October 31, 2008, the April 2007 Debenture is recorded in our condensed consolidated balance sheet at a carrying amount (net of discount) of $1,881,000.  We also recorded accrued interest on the April 2007 Debenture in the amount of $131,000 for the six months ended October 31, 2008.  As of October 31, 2008, cumulative accrued interest is $406,000 and is included in accrued interest in the accompanying condensed consolidated balance sheet.

In connection with the conversion of the 2006 Debentures to Converted Term Notes, the April 2007 Debentures were amended so that the maturity date was extended from May 31, 2009 to October 31, 2009.  Furthermore, the conversion price was modified to be the lower of $0.03 or eighty percent of the lowest volume weighted average price (as defined) in the ten trading days prior to the conversion date along with the interest rate being increased to 13%.  We did not record an additional beneficial conversion feature resulting from the modifications as it was not deemed to be material.  As a result of the modification of the fixed conversion feature, the discount associated with the beneficial conversion feature of $1,381,000 was written off as a loss on extinguishment of debt.  As a result, we are now amortizing the remaining discount  ($119,000 as of October 31, 2008) through October 31, 2009 using the effective interest method at an effective interest rate of 19%.

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Summary

As of October 31, 2008, we had $8,994,000, net of discount of remaining convertible debentures (the 2006 Debentures and the April 2007 Debenture, collectively the “13% Debentures”) and $6,839,000 in outstanding non-convertible term debt (the June 2008 Term Note and the Converted Term Notes, collectively the “Term Notes”).

Currently, we may not be in compliance with certain covenants of the remaining 13% Debentures and, in the June financing, YA Global refused to waive any non-compliance with the earlier financing documents.  In addition, we have not been able to comply with certain financial covenants of the Term Notes during the six months ended October 31, 2008 and as a result YA Global may, in its discretion, declare an event of default on those notes.  If YA Global were to declare an event of default under the 13% Debentures or the Term Notes it would likely have the legal right to foreclose against its security interest and take control of, and/or dispose of, the assets subject to its security interest.  Although YA Global has not yet declared an event of default, and although we are continuing to have discussions with YA Global with the aim to further our business operations, we can offer no assurance that YA Global will not declare an event of default under the 13% Debentures or the Term Notes and seek to collect the amounts due by foreclosure on our assets.

November 2008 Term Note

In November 2008, we completed a private placement pursuant to which we issued to YA Global, a 13% term promissory note in the principal amount of $375,000 (the “November 2008 Term Note”).  The November 2008 Term Note bears interest at 13% per annum, is secured by individual security agreements with Isonics Corporation, IVI, HSDC and PPSC and both interest and principal are due on October 31, 2009.  We had been using these funds for day-to-day corporate expenses, including salaries and other corporate expenses.  The funds were subject to the global security interest of the lender, YA Global.  Nevertheless, a judgment creditor garnished the remaining portion of these funds in December 2008, and these funds are no longer available to us for use (see Note 8).  We anticipate that YA Global will take action to enforce its security interest in those funds.

NOTE 7 – ASSETS HELD FOR SALE

During the fourth quarter of our year ended April 30, 2008, we committed to a plan to sell one specific piece of production equipment in our silicon products and services segment.  Based on ongoing analysis of the silicon operations, this asset was deemed to be unnecessary to support our current operations.  This asset, with a net book value of $212,000 as of April 30, 2008 was sold by our silicon products and services subsidiary, IVI in May 2008 for net proceeds of $221,000, resulting in a net gain of $9,000.  In addition, we are exploring the possibility of the sale of other corporate assets, in all cases subject to compliance with YA Global’s security interest in our assets.

NOTE 8 – LEGAL CONTINGENCIES

In February 2007, we entered into a Settlement Agreement and Mutual Release with James E. Alexander, our former Chief Executive Officer, President and Chairman of the Board of Directors (our “Former CEO”) whereby he resigned his positions, terminated his employment agreement with us and accepted specified cash-based and stock-based remuneration for the ensuing twelve months.  During August 2007, due to a lack of sufficient liquidity and a working capital deficit, we stopped making the contractually required payments to our Former CEO.  As a result, as of April 30, 2008 we had an accrued liability in the amount of $118,000, which represented the remainder of the contractual amounts due.

On July 22, 2008 our former CEO filed a complaint against us in the Jefferson County, Colorado, District Court.  The complaint alleged that we breached the Settlement Agreement and Mutual General Release

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entered into by Mr. Alexander and the Company in February 2007.  We did not contest the complaint.  As a result, Mr. Alexander obtained a judgment of approximately $190,000 (including attorneys fees, statutory interest and statutory penalties).  As a result of the judgment, we increased our accrued liability to $190,000, which resulted in a charge to selling, general and administrative expenses of  $72,000 during the six months ended October 31, 2008.

In an effort to collect on his judgment, in December 2008 our Former CEO garnished one of our bank accounts and has prevented our access to approximately $200,000 of the funds we were using for our day-to-day operations, including salaries for our operating personnel.  We believe that the garnishment, which attempts to take possession of assets in which YA Global has a security interest, is improper, and we anticipate that YA Global will seek to enforce its security interest.

In February through April 2007, we also entered into Settlement Agreements and Mutual Releases with other officers.  In order to conserve liquidity and with their consent, in August 2007 we reduced the amount payable to them.  Commencing in August 2008, because of our liquidity limitations, we were unable to continue payments for their benefit.  It is currently unclear as to when, if ever we will be able to resume payments.  They have not commenced or threatened litigation, but may do so in the future.

On September 12, 2008 we received notification from a former customer claiming approximately $1,000,000 in damages it had suffered from several alleged breaches of contract.  We have only begun to review the underlying facts and have not had a chance to discuss them with our legal counsel or the former customer and therefore we are unable to determine the probability of an unfavorable outcome at this time.

NOTE 9– COMMITMENTS AND CONTINGENCIES

As of October 31, 2008, we had no commitments outstanding for capital expenditures.

NOTE 10- SUBSEQUENT EVENTS

Certain events occurring subsequent to October 31, 2008, are discussed within other notes to the condensed consolidated financial statements.

Effective October 31, 2008 (and as reported in a Form 8-K as of that date), we terminated various employment agreements with persons who were then our senior officers, and we entered into a new employment agreement with Christopher Toffales, then our Chairman of the Board and Chief Executive Officer, who became our President.  At the same time, George O’Leary, a member of the board of directors became our Chief Financial Officer.

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

Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements generally are identified by the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” “plan,” “will continue,” “will likely result” and similar expressions.  Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements.  A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” (refer to Item 1A of our Form 10-K for the year ended April 30, 2008 and the risks identified elsewhere herein).  A significant risk of which all reading this report should be aware is that we have significant cash shortages as a result of a garnishment, which blocked our access to our principal bank account and has resulted in our inability to meet certain corporate obligations.   We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

General Discussion

We are focused on the provision of security services and 300-millimeter (and smaller diameter) test wafers and reclamation services, wafer thinning and custom wafer products and services for the silicon industry.  As a result of working capital shortages previously reported in our quarterly and annual reports and the garnishment resulting from a judgment, we have limited to no ability to finance our day-to-day operations and we cannot offer any assurance that we will be able to continue operations into calendar year 2009 without the infusion of capital and/or the sale of assets approved by YA Global.

During the year ended April 30, 2008, and the six months ended October 31, 2008, we generated sales from 300-millimeter (and smaller diameter) test wafers and reclamation services, wafer thinning and custom wafer products and services for the silicon industry and the provision of security services for leading businesses and institutions in healthcare, education, retail, manufacturing, banking and art industries.  In addition, during the six months ended October 31, 2007 we also generated sales from stable and radioactive isotopes, although these sales were reported as discontinued operations in the accompanying condensed consolidated statements of operations as described below.

In June 2007, we sold our life sciences business (which supplied isotopes for life sciences and health-care applications) as it no longer fit our long-term strategy for building a sustainable and profitable security and silicon company and because of deteriorating business conditions in the historical revenue producing products in this business.  Accounting rules required us to treat the operations of the life sciences business as discontinued operations whereby the net financial impact of the operations of the business (including revenue) was combined into a single line item and prior periods are reclassified for this presentation.  Revenue for the life sciences business, reported in the single line item of gain on operations of discontinued operations, net of income taxes, was $101,000 for the six months ended October 31, 2007.

In August 2007, we elected to suspend the development, manufacture and sale of our IMS based products.  The suspension was due primarily to our limited success in completing any sales of our IMS based products and a lack of working capital to sustain our efforts in the market space.  We continue to seek alternatives to finding a means of monetizing our investment in this product line, including an outright sale of the technology.  It is unclear as to when (if at all) we will resume activity on our IMS-based products and we can offer no assurance that we will be able to monetize any portion of our IMS technology investment.  In October 2007, as a result of our inability to meet our financial commitments, Lucent terminated our

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agreement for the development of next-generation infrared imaging and night vision surveillance technology.

Consistent with management focus during the year ended April 30, 2008 and the six months ended October 31, 2008, we continue to evaluate our operating businesses and technology portfolio with the goal of operating our business more efficiently and monetizing assets as we deem to be appropriate and as our senior secured creditor may consent.  Additionally, we have considered and will continue to consider business expansion through merger, acquisition, joint venture or other means, although we can offer no assurance as to our ultimate success in increasing the scope of our business through such means.  Because substantially all of our assets are subject to a perfected security interest, we have in the past, and will likely continue to engage in discussions on these issues with YA Global as our primary debt holder.

Liquidity and Capital Resources

We have had liquidity shortages in the past and, although we raised $1,000,000 (net of expenses) through the issuance of $1,175,000 of Term Notes to YA Global in June 2008 and an additional $352,500 (net of expenses) through the issuance of $375,000 of Term Notes to YA Global in November 2008, we have generated significant losses, which have exacerbated our working capital deficit.  As of October 31, 2008, our condensed consolidated balance sheet reflects a working capital deficit of $(20,162,000).  In addition, as a result of our continued operating losses, working capital deficit and negative cash flow during the year ending April 30, 2008, the auditors report included with our financial statements for the year ended April 30, 2008 includes an explanatory paragraph indicating substantial doubt about our ability to continue as a going concern.  This condition has continued since the date of those financial statements, and we expect that these conditions will continue for the foreseeable future unless we are able to raise a substantial amount of additional financing (of which there can be no assurance and which would be subject to the approval of YA Global).

Currently, we may not be in compliance with certain covenants of the remaining 13% Debentures and, in the June financing, YA Global refused to waive any non-compliance with the earlier financing documents.  In addition, we have not been able to comply with certain financial covenants of the Term Notes during the six months ended October 31, 2008 and as a result YA Global may, in its discretion, declare an event of default on those notes.  If YA Global were to declare an event of default under the 13% Debentures or the Term Notes it would likely have the legal right to foreclose against its security interest and take control of, and/or dispose of, the assets subject to its security interest.  Although YA Global has not yet declared an event of default, and although we are continuing to have discussions with YA Global with the aim to further our business operations, we can offer no assurance that YA Global will not declare an event of default under the 13% Debentures or the Term Notes and seek to collect the amounts due by foreclosure on our assets.  In addition, a judgment creditor, our Former CEO, has sought to garnish approximately $200,000, which has resulted in our inability to meet certain corporate obligations and consequently, we may not be able to continue operations into calendar year 2009 without the infusion of capital and/or sale of assets approved by YA Global.

As a result of our significant working capital deficit and lack of operating funds resulting from the garnishment, we are financing our operations and negative cash flow from our liquid assets, which we allocate to pay our most urgent obligations.  During the six months ended October 31, 2008, we used $1,211,000 in operating activities.  At our current burn rate, it is unclear if our remaining liquidity is sufficient to finance our anticipated operations and projected negative cash flow into calendar year 2009.  In addition, it is unlikely that we will be able to continue the operations of the parent corporation beyond the near future without immediate additional financing from the sale of assets or a further investment by our principal creditor, YA Global, neither of which can be assured.  If we are able to secure an offer for asset based financing from a third party, YA Global has agreed to review that proposed financing and, in its sole discretion, consider releasing its security interest in certain of our assets to secure that financing.  Because

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of the terms of the existing YA Global financing, we are unable to collateralize any additional financing without YA Global’s consent and approval.

See additional discussion of liquidity and capital resources in the Liquidity and Capital Resources section included further below in this Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Security Services

Since the effective date of our acquisition of PPSC in May 2005, PPSC has delivered significant revenue to our condensed consolidated financial statements and has provided gross margins of approximately 22% and 23% of revenues for the six months ended October 31, 2008 and 2007, respectively.

During the fourth quarter of our year ended April 30, 2007, and subsequently, we implemented cost cutting initiatives that have positively impacted the results of PPSC’s operations.  Additionally we initiated plans (with limited success) to improve operating margins at PPSC by focusing on customers that are willing to pay for premium security services, a market in which we believe that PPSC is able to differentiate itself from its peers.  The segment generated an operating loss of $(2,203,000) for the six months ended October 31, 2008 as compared to operating income of $323,000 for the six months ended October 31, 2007 primarily due to the inclusion of a $2,346,000 non-cash writedown of goodwill during the six months ended October 31, 2008 (see additional discussion below).

While these cost cutting initiatives and focused sales and marketing efforts have enabled PPSC to positively impact its results for the six months ended October 31, 2008, the industry is cost competitive and customers switch security service providers on short notice.  In addition, effective August 1, 2008, one of our significant customers (who accounted for $802,000 of revenue for the three months ended July 31, 2008) is no longer using our services.  This customer accounted for $1,459,000 of revenue for the six months ended October 31, 2007.  As a result of these factors and the $2,346,000 impairment of goodwill, it is unlikely that we will be able to generate positive operating income in this segment for the year ending April 30, 2009 even assuming that we are able to continue operations through that period notwithstanding our cash and working capital deficits.  In addition, we can offer no assurance that PPSC will be able to contribute positive cash flow as well.

Silicon Products and Services

Our silicon operations, based in Vancouver, Washington, continue to focus on the provision of 300-millimeter (and smaller diameter) test wafers and reclamation services, wafer thinning and custom wafer products and services for the silicon industry.  We are particularly focused on the 300-millimeter segment of the market.  This large-diameter wafer segment has become one of the fastest growing segments of the silicon wafer market and the revenues and gross margins associated with the services are greater than those associated with the small diameter market.   At the same time, we have also been focused on operational efficiency and effectiveness, which has resulted in increased productivity and processing yields.  Further, we continue to gain new customers (both large and smaller diameter) and are also in the process of attempting to qualify our products at others.

While we reported significant revenue and operating income growth in our silicon operations for the year ended April 30, 2007, many of our top silicon customers experienced weakened business results during our year ended April 30, 2008.  In addition, some customers reported inventory buildup in reclaim and/or test products while one other top customer ceased doing business with us as we could no longer meet the required specifications for their product.  As a result of these factors, during the year ended April 30, 2008, we experienced a slowdown in orders and a reduction in average selling prices of reclaim and test materials, which had a negative impact on our results.  This trend has continued through the six months ended October 31, 2008.

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The slowdown significantly impacted our revenues, results of operations and cash flows from our silicon products and services segment for the six months ended October 31, 2008 and 2007, in which we generated operating losses of $(1,094,000) and $(959,000), respectively.

In order to minimize the effect of the continuing slowdown, during our year ended April 30, 2008 we implemented many cost cutting measures in our silicon operations and are continuing to do so.  We have also increased our marketing efforts and are hopeful that we will see a recovery during the year ending April 30, 2009 if our cash resources allow us to continue operations through that period (which cannot be assured).  During the latter portion of our year ended April 30, 2008 and into our six months ended October 31, 2008 we have started to obtain new customers (both large and smaller diameters) and are in the process of attempting to qualify our products at others.  In an effort to control our marketing expenses, in August 2008 we entered into a distribution agreement with Silicon Quest International, Inc. (“SQI”), by which SQI agreed to act as an exclusive independent contractor to market, sell and distribute our silicon products and services to customers who are not previously our customers.  We continue to monitor our silicon operation closely and while we are hopeful that we will see improving financial results in this operating segment over the long-term, we cannot offer any assurance that we will be able to regain or sustain operating profitability in future periods.

Results of Operations

The following table sets forth, for the periods indicated, condensed consolidated statements of operations data expressed as a percentage of revenues.  The table and the discussion below should be read in conjunction with the condensed consolidated financial statements and the notes thereto appearing elsewhere in this report.  This should also be read with an understanding of the significant cash shortages that we currently have, which are discussed more completely above in Liquidity and Capital Resources .

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Revenues

Revenues from our security services and silicon products and services segments decreased for the three and six months ended October 31, 2008, as compared to the same periods of our prior fiscal year, as described in the following table:

(1) Reconciling amounts for revenues information consists of revenue from our former homeland security products segment.

The decrease in revenue from the security services segment for the three and six months ended October 31, 2008, is due to the effect of the loss of several security services contracts during the year ended April 30, 2008 and the six months ended October 31, 2008 partially offset by the addition of new customers as well as by increases in work performed at certain existing customers.  Effective August 1, 2008, one of our significant customers (who accounted for $802,000 of revenue for the three months ended July 31, 2008) ceased using our services.  This customer accounted for $1,459,000 of revenue for the six months ended October 31, 2007.   As a result, our revenue for the three months ended October 31, 2008 was lower than the revenue for both the three months ended October 31, 2007 and the three months ended July 31, 2008.  In an effort to increase our revenue, we continue to market our services aggressively by seeking premium accounts that prefer higher quality of service.  W hile we are hopeful that in the long-term we will be able to grow revenue in this segment by securing new security contracts in our PPSC subsidiary and retaining existing customers under contract currently with PPSC, we cannot provide any assurance that we will be able to do so and we may in the short-term fail to retain certain of our customers.

While we reported significant revenue and operating income growth in our silicon operations for the year ended April 30, 2007, many of our top silicon customers experienced weakened business results during our year ended April 30, 2008.  In addition, some customers reported inventory buildup in reclaim and/or test products while one other top customer ceased doing business with us as we could no longer meet the required specifications for their product.  As a result of these factors, during the year ended April 30, 2008, we experienced a slowdown in orders and a reduction in average selling prices of reclaim and test materials, which had a negative impact on our results.  This trend has also continued through the six months ended October 31, 2008.

Although we have diversified our sources of revenue, we continue to have concentrations of revenue with certain customers.  For the six months ended October 31, 2008, two security services customers accounted for 26% and 9% of revenues, respectively, and one silicon products and services customer accounted for 13% of revenues as compared to the six months ended October 31, 2007, in which two security services customers accounted for 19% and 12% of revenues, respectively, and one silicon products and services customer accounted for 12% of revenues.  Significant reductions in sales to any of our large customers have had, and may in the future have, a material adverse effect on us by reducing our revenues and our gross margins.  Present or future customers could terminate their purchasing patterns with us or significantly reduce or delay the amount of products or services ordered from us.

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For the six months ended October 31, 2008, the silicon products and services customer mentioned above accounted for 38% of silicon products and services revenue as compared to 34% for the six months ended October 31, 2007.  Due to the relationship of revenues to the absorption of fixed facility costs, the elimination or even a significant reduction in sales to this customer would have a material adverse effect on our silicon products and services operations.

Gross Margin

Our gross margin decreased for the three and six months ended October 31, 2008, as compared to the same periods of our prior fiscal year, both on a dollar amount and on a percentage of revenues, as reflected in the following table:

The decrease in gross margin on a percentage basis is due primarily to the downturn in our silicon products and services segment resulting in a significant decrease in revenue, which has forced us to allocate our fixed facility costs over a lower revenue base, correspondingly decreasing gross margins on a percentage basis.  To a lesser extent, the decrease on a percentage basis is also due to the provision of lower prices in order to obtain new or keep existing business.  The decrease in gross margin on a dollar basis is due to the decrease in revenue for both our silicon products and services and security services segments.

On a dollar basis, gross margin is expected to increase correspondingly with increases in revenue, if any, with dependencies on customer and supplier pricing.  Our ability to positively impact consolidated gross margin will in a large part be dependent upon our ability to grow sales in our security service segment through increased sales of security services and in our silicon products and services segment through increased sales of 300-millimeter products and services and wafer thinning services.

On a percentage of revenues basis, in general we anticipate that the gross margin percentage in our security services segment (within 1-2 percentage points) will remain relatively stable.  However, as a result of the ongoing downturn in our silicon products and services segment, we have experienced and expect to continue to experience increased competition and lower prices.  As a result, there has been a focus on operational efficiency and effectiveness, which has resulted in increased productivity and processing yields in order to reduce our costs.  In addition, due to fixed facility costs included in cost of revenues in the silicon products and services segment, the gross margin percentage is particularly sensitive to volume and revenue changes.

We have increased our marketing efforts and are hopeful that we will see a rebound in our customers demand and we have (and are hopeful to continue to) added several new silicon products and services customers during the year ending April 30, 2009.   Effective August 1, 2008, one of our significant security services customers (who accounted for $802,000 of revenue for the three months ended July 31, 2008) ceased using our services.  As a result, our revenues and gross margin for the three months ending October 31, 2008 was lower than the revenues and gross margin for both the three months ended October 31, 2007 and July 31, 2008. While we are hopeful that revenues (and corresponding gross margins) will increase (as compared to the year ended April 30, 2008) for the year ending April 30, 2009, we can offer no assurance that this will actually occur.

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Selling, General and Administrative Expenses

Our selling, general and administrative expenses decreased both as a dollar amount and as a percentage of revenue for the three and six months ended October 31, 2008, as compared to the same respective periods of our prior fiscal year, as reflected in the following table:

The $1,537,000 decrease in selling, general and administrative expenses for the six months ended October 31, 2008, compared to the six months ended October 31, 2007 is attributable to a combination of factors, including:

·                   approximately $300,000 due to a decrease in staffing and expenditures at the corporate office,

·                   approximately $300,000 due to a decrease in staffing and expenditures in the security services segment,

·                   approximately $650,000 due to a decrease in staffing and expenditures in our former homeland security products segment, and

·                   an approximate $270,000 decrease in staffing and expenditures at our silicon products and services segment.

We continue to be actively focused on reducing selling, general and administrative expenses and are hopeful that we will be able to further reduce these expenses for the three months ending January 31, 2009 as compared to the three months ended October 31, 2008.  However, any reduction in selling, general and administrative expenses most likely would be less significant as compared to the reductions realized for the three months ended October 31, 2008 as compared to the three months ended October 31, 2007.

Impairment of Goodwill

Our impairment of goodwill increased on both a dollar and a percentage of revenues basis for the six months ended October 31, 2008, as compared to the same periods of our prior fiscal year, as reflected in the following table:

Due to the loss of a significant security services customer during the six months ended October 31, 2008, we determined that there had been a significant adverse change to the security services business.  We determined that the $3,631,000 of goodwill associated with our security services segment had been impaired and as a result, $2,346,000 of the goodwill was written off to reflect impairment of goodwill during the six months ended October 31, 2008.

Impairment Loss on Intangible Assets

Our impairment loss on intangible assets decreased on both a dollar and a percentage of revenues basis for the three and six months ended October 31, 2008, as compared to the same periods of our prior fiscal year, as reflected in the following table:

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The impairment loss for the three and six months ended October 31, 2007 relates to a write off of the unamortized balance of the trace and bulk detection technology intangible asset.  Due to suspension of development, manufacture and sale of our IMS-based products, we determined that the trace and bulk detection technology intangible asset was fully impaired.

Research and Development Expenses

Our research and development expenses decreased on both a dollar and a percentage of revenues basis for the three and six months ended October 31, 2008, as compared to the same periods of our prior fiscal year, as reflected in the following table: