Iris International (IRIS) 10-Q 2005 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2005

OR

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

For the transition period from                    to                    .

Commission File No. 1-9767

IRIS INTERNATIONAL, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware	94-2579751
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

9172 Eton Avenue, Chatsworth, CA.	91311
(Address of principal executive offices)	(Zip Code)

(818) 709-1244

(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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

The registrant had 16,416,391 shares of common stock issued and outstanding as of April 26, 2005.

IRIS INTERNATIONAL, INC.

INDEX TO FORM 10-Q

		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Consolidated Balance Sheet as of March 31, 2005 (unaudited) and December 31, 2004	3
	Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004 (unaudited)	4
	Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004 (unaudited)	5
	Consolidated Statements of Comprehensive Income for the three months ended March 31, 2005 and 2004 (unaudited)	6
	Notes to Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	26
Item 4.	Controls and Procedures	26
PART II	OTHER INFORMATION
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	28
Item 6.	Exhibits	28
Signature		29

2

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

IRIS INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

	March 31, 2005			December 31, 2004
Assets
Current assets:
Cash and cash equivalents	$	13,428		$	12,839
Accounts receivable, net of allowance for doubtful accounts and sales returns of $326 and $336		10,290			8,847
Inventories, net		7,012			7,834
Prepaid expenses and other current assets		447			381
Investment available for sale		121			198
Deferred tax asset		3,650			3,650
Total current assets		34,948			33,749
Property and equipment, at cost, net		3,896			3,880
Goodwill		189			189
Software development costs, net		1,760			1,930
Deferred tax asset		4,824			5,665
Inventories – long term portion		489			290
Other assets		3,111			2,433
Total assets	$	49,217		$	48,136
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	3,287		$	4,258
Accrued expenses		2,661			3,398
Deferred service contract revenue		1,269			1,134
Total current liabilities		7,217			8,790
Deferred service contract revenue, long term		139			173
Total liabilities		7,356			8,963
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par value – authorized: 50 million shares; issued and outstanding: 16,322 shares and 15,962 shares		163			159
Additional paid-in capital		63,545			61,972
Unearned compensation		(274	)		(125	)
Accumulated other comprehensive income		—			11
Accumulated deficit		(21,573	)		(22,844	)
Total shareholders’ equity		41,861			39,173
Total liabilities and shareholders’ equity	$	49,217		$	48,136

The accompanying notes are an integral part of these consolidated financial statements.

3

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited – in thousands)

	For the three months ended March 31,
	2005			2004
Sales of IVD instruments	$	5,939		$	2,543
Sales of IVD consumables and service		5,699			4,672
Sales of small laboratory devices and supplies		2,326			1,974
Royalty and license revenues		—			186
Net revenues		13,964			9,375
Cost of goods - IVD instruments		3,593			1,864
Cost of goods - IVD consumables and service		2,315			1,800
Cost of goods - small laboratory devices and supplies		1,162			1,007
Cost of goods sold		7,070			4,671
Gross margin		6,894			4,704
Marketing and selling expenses		2,391			1,490
General and administrative expenses		1,394			1,193
Research and development, net		1,083			1,053
Total operating expenses		4,868			3,736
Operating income		2,026			968
Other income (expense):
Interest income		53			11
Interest expense		(5	)		(90	)
Other (expense) income		44			(7	)
Income before income taxes		2,118			882
Provision for income taxes		847			353
Net income	$	1,271		$	529
Basic net income per share		0.08			0.04
Diluted net income per share	$	0.07		$	0.04
Basic - average shares outstanding		16,218			12,051
Diluted - average shares outstanding		17,294			13,846

The accompanying notes are an integral part of these consolidated financial statements.

4

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited – in thousands)

	For the three months ended March 31,
	2005			2004
Cash flows from operating activities:
Net income	$	1,271		$	529
Adjustments to reconcile net income to net cash provided by (used in) operations:
Deferred taxes, net		847			353
Depreciation and amortization		492			395
Common stock and stock option compensation		79			22
Loss (gain) on sale of investment		(43	)		7
Changes in operating assets and liabilities:
Accounts receivable		(1,443	)		195
Deferred service contract revenue		102			39
Inventories, net		623			77
Prepaid expenses and other current assets		(66	)		(108	)
Other assets		(702	)		(28	)
Accounts payable		(970	)		(1,315	)
Accrued expenses		(728	)		(19	)
Net cash provided by (used in) operating activities		(538	)		147
Cash flows from investing activities:
Acquisition of property and equipment		(314	)		(339	)
Software development costs		—			(13	)
Sale of investments held for sale		102			197
Net cash used in investing activities		(212	)		(155	)
Cash flows from financing activities:
Issuance of common stock for cash		1,349			381
Borrowings under line of credit		—			2,900
Repayments of line of credit		—			(2,400	)
Repayments of term loan		—			(87	)
Payments of capital lease obligations		(10	)		(14	)
Net cash provided by financing activities		1,339			780
Net increase in cash and cash equivalents		589			772
Cash and cash equivalents at beginning of period		12,839			2,444
Cash and cash equivalents at end of period	$	13,428		$	3,216
Supplemental schedule of non-cash financing activities:
Issuance of common stock and common stock warrants for services	$	228		$	46
Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	17		$	21
Cash paid for interest	$	—		$	36

The accompanying notes are an integral part of these consolidated financial statements.

5

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited – in thousands)

	For the three months ended March 31,
	2005			2004
Net income	$	1,271		$	529
Unrealized gain on investments, net of taxes		(11	)		30
Comprehensive income	$	1,260		$	559

The accompanying notes are an integral part of these consolidated financial statements.

6

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Company History

IRIS International, Inc., (“IRIS” or the “Company”) was incorporated in California in 1979 and reincorporated during 1987 in Delaware under the name of International Remote Imaging Systems, Inc. The Company changed its name to IRIS International, Inc. in December 2003. The Company designs, develops, manufactures and marketsin vitro diagnostic (“IVD”) equipment, including IVD imaging systems based on patented and proprietary automated intelligent microscopy (“AIM”) technology, as well as special purpose centrifuges and other small instruments for automating microscopic procedures performed in clinical laboratories. On April 27, 2005 the Company signed an agreement to acquire the assets of the urinalysis business segment of Quidel Corporation. We expect to consummate the transaction on or before May 31, 2005.

2. Summary of Significant Accounting Policies

Basis of Presentation of Unaudited Interim Financial Statements:

In the opinion of management, the accompanying unaudited consolidated financial statements contain all normal recurring adjustments necessary to present fairly the financial position of the Company as of March 31, 2005 and the results of its operations for the three-month periods then ended. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s latest annual report on Form 10-K. Interim results are not necessarily indicative of results for a full year.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The significant estimates in the preparation of the consolidated financial statements relate to the assessment of the carrying value of accounts receivables, inventories, purchased intangibles, estimated provisions for warranty costs and deferred tax assets. Actual results could differ materially from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of IRIS International, Inc. and its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated in the consolidated financial statements.

Cash Equivalents and Short-Term Investments

Short-term investments principally include certificates of deposit with maturities greater than three months and less than one year. For purposes of the statement of cash flows, IRIS considers all highly liquid debt instruments purchased with a remaining maturity of three months or less when purchased to be cash equivalents. IRIS places its cash and investments with high credit quality financial institutions. At times, these deposits may be in excess of the federally insured limit.

Accounts Receivable

IRIS sells predominantly to entities in the healthcare industry. IRIS grants uncollateralized credit to its customers, primarily hospitals, clinical and research laboratories, and distributors. IRIS performs ongoing credit evaluations of its customers before granting uncollateralized credit. The Company does not have any single customer that accounts for 10% or more of its consolidated revenues or 10% or more of its accounts receivable at the balance sheet date.

7

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Accounts receivable are customer obligations due under normal trade terms. We sell our products to distributors and customers in the health care industry. We perform credit evaluations of our customers’ financial condition and although we generally do not require collateral, letters of credit may be required from our customers in certain circumstances.

Senior management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. We include any accounts receivable balances that are determined to be uncollectible, along with a general reserve, in our overall allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. Based on the information available to us, we believe our allowance for doubtful accounts as of March 31, 2005 is adequate.

Inventories

Inventories are carried at the lower of cost or market on a first in, first out basis. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. The Company currently has approximately $489,000 of non-current inventory relating to spare parts for its legacy instruments which are no longer produced but which the Company will continue to support and provide maintenance repairs for our customers. Other inventory that is considered excess inventory is fully reserved by the Company.

Investment available for sale

Management classifies the investment in the common shares of Applied Imaging Corporation (NASDAQ: AICX), as available for sale. Investments in available for sale securities are reported at fair value with unrealized holding gains and losses, net of tax, reported as a separate component of shareholders’ equity until realized, or until management believes a permanent decline in value has occurred. Realized gains and losses are included in earnings.

Property and Equipment and Depreciation

Property and equipment are recorded at cost, less accumulated depreciation and amortization. Depreciation is generally computed using the straight-line method over three to five years, the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of their useful life or the remaining term of the lease.

Goodwill

Goodwill is recorded at cost. The realizability of the goodwill is evaluated at least annually, or as events or circumstances indicate a possible inability to recover the carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections. The analysis necessarily involves significant management judgment to evaluate the capacity of an acquired business to perform within projections. At March 31, 2005, the Company evaluated its goodwill and determined that fair value had not decreased below carrying value and no adjustment to impair goodwill was necessary in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”

Software Development Costs

The Company capitalizes certain software development costs for new products and product enhancements once all planning, designing, coding and testing activities necessary to establish that the product can be produced to meet its design specifications are completed, and concludes capitalization when the product is ready for general release. Research and development costs relating to software development are expensed as incurred. Amortization of capitalized software development costs is

8

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

provided on a product-by-product basis at the greater of the amount computed using (a) the ratio of current revenues for a product to the total of current and anticipated future revenues or (b) the straight-line method over the remaining estimated economic life of the product up to five years. The Company capitalized $-0- and $13,000 of software development costs and recorded amortization of software development costs of $170,000 and $123,000 during the three months ended March 31, 2005 and 2004.

Long-Lived Assets

The Company identifies and records an impairment loss for long-lived assets whenever events or changes in circumstances result in the carrying amount of the assets exceeding the sum of the expected future undiscounted cash flows associated with such assets. The measurement of the impairment losses recognized is based on the difference between the fair values and the carrying amounts of the assets.

Stock-Based Compensation

The Company has adopted the disclosure-only provisions of Statement on Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148. SFAS No. 123 defines a fair value based method of accounting for an employee stock option. Fair value of the stock option is determined considering factors such as the exercise price, the expected life of the option, the current price of the underlying stock and its volatility, expected dividends on the stock, and the risk-free interest rate for the expected term of the option. Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period. Pro forma disclosures for entities that elect to continue to measure compensation cost under the intrinsic method provided by Accounting Principles Board Opinion No. 25 must include the effects of all awards granted. The Company accounts for stock-based awards to non-employees in accordance with SFAS No. 123 and EITF 96-18. An expense is recognized for common stock, warrants or options issued or re-priced, for services rendered by non-employees based on the estimated fair value of the security exchanged.

If compensation expense for the stock options had been determined using “fair value” at the grant date for awards during 2005 and 2004, consistent with the provisions of SFAS No. 123, the Company’s net income (loss) and income (loss) per share would have been reduced to the pro forma amounts indicated below:

	For the three months ended March 31,
(in thousands)	2005		2004
Net income as reported	$	1,271	$	529
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		47		14
Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects		213		306
Net income pro forma	$	1,105	$	237
Income per diluted share as reported	$	0.07	$	0.04
Income per diluted share pro forma	$	0.06	$	0.02

9

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The pro forma calculations above are for informational purposes only. Future calculations of the pro forma effects of stock options may vary significantly due to changes in the assumptions described above as well as future grants, and for forfeitures of stock options.

Revenue Recognition

Revenues are derived from the sale of IVD instruments, sales of consumable supplies and services for its IVD systems as well as sales of small laboratory devices and related supplies. Revenue is recognized once all of the following conditions have been met: a) an authorized purchase order has been received in writing with a fixed and determinable sales price, b) customer credit worthiness has been established, and c) delivery of the product based on shipping terms. The majority of domestic IVD instrument sales generally require installation and training to be performed.

Revenue is recorded in accordance with the provisions of Emerging Issues Task Force (EITF) Statement No. 00-21 “Revenue Arrangements with Multiple Deliverables” and Staff Accounting Bulletin (SAB) No. 104 “Revenue Recognition in Financial Statements” which generally requires revenue earned on product sales involving multiple-elements to be allocated to each element based on the relative fair values of those elements. Multiple elements of the Company’s domestic product sales and typically include IVD instruments and training. Training elements are valued based on hourly rates, which the Company charges for these services when sold apart from hardware sales. Accordingly, IRIS allocates revenue to each element in a multiple-element arrangement based on the element’s respective fair value, with the fair value determined by the price charged when that element is sold and specifically defined in a quotation or contract.

IRIS recognizes revenues from the sale of instruments, consumables and small laboratory devices when title and risk of loss passes to the customers and revenues from service contracts are recognized ratably over the term of the service period, which typically ranges from twelve to sixty months. Payments for service contracts are generally received in advance. Deferred revenue represents the revenues to be recognized over the remaining term of the service contracts.

Warranties

IRIS records warranty expense, based on management’s estimate of expected cost, as an accrued liability at the time of sale.

Research and Development Expenditures

Except for certain software development costs capitalized as described above (see Software Development Costs), research and development expenditures are charged to operations as incurred. Net research and development expense includes total research and development costs incurred, including costs incurred under research and development grants and contracts, less costs reimbursed under research and development contracts.

The Company, from time to time receives grants from agencies of the U.S. Government. We do not recognize any revenue from such grants since they are cost reimbursement grants whereby the Company submits requests for reimbursement for certain costs incurred. There are no ongoing obligations or requirements with respect to the grants received, the Company retains ownership of any intellectual property that results from the research and development and the U.S. Government receives a right to use the results of the research for government projects. The Company received cost reimbursements (government grants) of $405,000 and $104,000 during the three months ended March 31, 2005 and 2004.

10

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Income Taxes

IRIS accounts for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes,” which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense represents the tax payable for the period and the change during the period in deferred tax assets and liabilities.

Marketing Costs

All costs related to marketing and advertising are expensed at the time the advertising takes place.

Fair Value of Financial Instruments

The amount recorded for financial instruments in the Company’s consolidated financial statements approximates fair value as defined in SFAS No. 107, “Disclosures about Fair Value of Financial Instruments”. The fair value of short-term borrowings and notes payable described in Note 4 approximate their carrying value due to the variable nature of the interest rates in these instruments.

Earnings Per Share

Basic earnings per share are computed by dividing net income or loss by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares and common stock equivalents outstanding, calculated on the treasury stock method for options and warrants. Common stock equivalents for the three months ended March 31, 2005 and 2004 include 1,076,000 and 1,795,000 from stock options and warrants.

Segment Reporting

The Company determines and discloses its segments in accordance with SFAS No. 131; “Disclosures about Segments of an Enterprise and Related Information,” which uses a “management” approach for determining business segments. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the Company’s reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas, and major customers. See Note 9 — “Segment and Geographic Information”.

Certain Risks and Uncertainties

Dependence on Instrument Sales: The Company derives most of its revenues from the sale of the urinalysis analyzers, and related supplies and services. Relatively modest declines in unit sales or gross margins could have a material adverse effect on the Company’s revenues and profits.

Reliance on Single Source Suppliers: Certain key components of our instruments are manufactured according to our specifications or are available only from single suppliers.

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IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. Inventories

Inventories consist of the following (in thousands):

	March 31, 2005			December 31, 2004
Finished goods	$	2,027		$	2,642
Work-in-process		779			664
Raw materials, parts and sub-assemblies		4,695			4,818
		7,501			8,124
Less non-current portion		(489	)		(290	)
Inventories – current portion	$	7,012		$	7,834

4. Bank Loan Agreement

In April 2004, the Company used a portion of the proceeds it received from a private placement of common stock to retire all outstanding indebtedness to its former bank and subordinated note holder. See Note 6.

In May 2004, the Company signed a new credit facility with a major bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of March 31, 2005, there were no borrowings under the new credit facility. The Company is subject to certain financial covenants under the credit facility with the bank and as of March 31, 2005, the Company was in compliance with such covenants.

5. Income Taxes

The income tax provision differs from the federal statutory rate due primarily to state income taxes and permanent differences between income reported for financial statement and income tax purposes.

Realization of deferred tax assets associated with net operating losses (“NOL”) and tax credit carry forward is dependent upon our being able to generate sufficient taxable income prior to their expiration. The Company believes that it is more likely than not that the deferred tax assets will be realized through future taxable income or alternative tax strategies. However, the net deferred tax assets could be reduced in the near term if management’s estimates of taxable income during the carryforward period are not realized or are significantly reduced or alternative tax strategies are not available. The Company will continue to review the estimates of taxable income and will make adjustments to the valuation allowance, when necessary.

Also, should the Company undergo an ownership change as defined in Section 382 of the Internal Revenue Code, NOLs generated prior to the ownership change would be subject to an annual limitation. If this occurs, a valuation allowance may be necessary.

6. Capital Stock

Private Placement of Stock

On April 16, 2004, the Company signed an agreement with an investment bank for the private placement of 2,130,000 shares of the Company’s common stock at a price of $5.85 per share (a 10% discount to market). In addition, each of the investors received a 5-year warrant to purchase 3 additional shares of common stock for each 20 shares of common stock purchased in the offering. The agreement

12

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

requires the Company to file a registration statement within 30 days of closing and to have the registration statement declared effective within 90 days of closing. In May 2004, the Company filed a registration statement, which was declared effective on May 21, 2004. The Company realized net proceeds (after deducting offering expense of $1.0 million) of approximately $11.5 million. The Company used approximately $5.5 million of the net proceeds to retire all of its outstanding indebtedness to its former bank and subordinated note holder.

Stock and Stock Option Issuances

During the three months ended March 31, 2005, the Company (i) issued 372,000 shares of common stock from the exercise of options, warrants and shares issued under our Employee Stock Purchase Plan, (ii) issued options to purchase – 0—shares of common stock and (iii) cancelled and forfeited options to purchase 11,000 shares of common stock. At March 31, 2005, options to purchase 2,143,000 shares of common stock were issued and still outstanding. Outstanding options will expire at various dates through the end of 2012. The exercise price for such options ranges from $0.69 to $8.58 per share. At March 31, 2005, there were 164,000 shares of common stock available for the granting of future options under the Company’s stock option plans.

Warrants

At March 31, 2005, there were outstanding and exercisable warrants to purchase 247,000 shares at a price of $7.80 per share.

7. Contingencies

Litigation

From time to time, the Company is party to certain litigation arising in the normal course of business. Management believes that the resolution of such matters will not have a material adverse effect on our financial position, results of operations or cash flows.

Guarantees

The Company enters into indemnification provisions under (i) agreements with other companies in the ordinary course of business, typically with business partners, contractors, customers and landlords, and (ii) agreements with investors. Under such provisions the Company generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of the Company’s activities or, in some cases, as a result of the indemnified party’s activities under the agreement. Indemnification provisions often include indemnifications relating to representations made by the Company with regard to intellectual property rights. Such indemnification provisions generally survive termination of the underlying agreement. In addition, in some cases, the Company agrees to reimburse employees for certain expenses and to provide salary continuation. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is unlimited. To date, the Company has not incurred any material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no recorded liabilities for these agreements as of March 31, 2005.

8. Royalty Income

A competitor previously developed several urine sediment analyzers under license agreements using the Company’s technology. The Company received royalties under the license of $0 and $186,000 for the three months ended March 31, 2005 and 2004.

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IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9. Segment and Geographic Information

The Company’s continuing operations are organized on the basis of products and related services, and under SFAS No. 131, the Company operates in two segments: (1) IVD instruments and (2) small laboratory devices and related supplies.

The IVD instrument segment designs, develops, manufactures, markets and distributes IVD systems based on patented and proprietary AIM technology for automating microscopic procedures for urinalysis. The segment also provides ongoing sales of supplies and services necessary for the operation of installed urinalysis workstations. In the United States, these products are sold through a direct sales force. Internationally, products are sold through distributors.

The small laboratory devices segment designs, develops, manufactures and markets a variety of benchtop centrifuges, small instruments and supplies. These products are used primarily for manual specimen preparation and dedicated applications in coagulation, cytology, hematology and urinalysis. These products are sold worldwide through distributors.

The tables below present information about reported segments (in thousands):

(in thousands)	IVD Instruments		Small Laboratory Devices		Unallocated Corporate Expenses			Total
For the three months ended March 31, 2005
Revenues	$	11,638	$	2,326	$	—		$	13,964
Interest income	$	51	$	2	$	—		$	53
Interest expense	$	2	$	—	$	3		$	5
Depreciation and amortization*	$	490	$	59	$	22		$	571
Segment profit	$	2,371	$	509	$	(762	)	$	2,118
Segment assets	$	37,624	$	3,119	$	8,474		$	49,217
Investment in long-lived assets	$	241	$	73	$	—		$	314
For the three months ended March 31, 2004
Revenues	$	7,401	$	1,974	$	—		$	9,375
Interest income	$	10	$	1	$	—		$	11
Interest expense	$	2	$	—	$	88		$	90
Depreciation and amortization*	$	367	$	38	$	12		$	417
Other non-cash items	$	7		—		—		$	7
Segment profit	$	1,178	$	416	$	(712	)	$	882
Segment assets	$	21,450	$	2,566	$	8,421		$	32,437
Investment in long-lived assets	$	330	$	22	$	—		$	352

* Included in depreciation and amortization above is amortization of deferred compensation in the amounts $79,000 and $22,000 for the three months ended March 31, 2005 and 2004.

The Company ships products from two locations in the United States. Substantially all long-lived assets were located in the United States and totaled $9.4 million at March 31, 2005. Sales to international customers amounted to approximately $3.9 million and $1.7 million during the three months ended March 31, 2005 and 2004. Long-lived assets include property and equipment, goodwill, software development costs, long-term portion of inventory and other long-term assets. Deferred income tax is excluded from long-lived assets.

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements, which reflect our current views about future events and financial results. We have made these statements in reliance on the safe harbor created by the Private Securities Litigation Reform Act of 1995. Forward-looking statements include our views on future financial results, financing sources, product development, capital requirements, market growth and the like, and are generally identified by phrases such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans” and similar words. Forward-looking statements are merely predictions and therefore inherently subject to uncertainties and other factors which could cause the actual results to differ materially from the forward-looking statement. These uncertainties and other factors include, among other things:

• unexpected technical and marketing difficulties inherent in major product development efforts such as the new platform for our urinalysis workstation,

• the potential need for changes in our long-term strategy in response to future developments,

• future advances in diagnostic testing methods and procedures, as well as potential changes in government regulations and healthcare policies, both of which could adversely affect the economics of the diagnostic testing procedures automated by our products,

• rapid technological change in the microelectronics and software industries, and

• increasing competition from imaging and non-imaging basedin vitrodiagnostic products.

Set forth below are other significant uncertainties and factors affecting forward-looking statements. The readers should understand that uncertainties and other factors identified in this Quarterly Report are not a comprehensive list of all the uncertainties and other factors that may affect forward-looking statements. We do not undertake any obligation to update or revise any forward-looking statements or the list of uncertainties and other factors that could affect those statements.

Overview

IRIS International, Inc. was incorporated in 1979. Our company consists of three operating units. Our largest unit, Iris Diagnostics Division, designs, manufactures and markets in vitro diagnostics (IVD) systems, consumables and supplies for urinalysis. Our StatSpin subsidiary markets small centrifuges and other processing equipment and accessories for rapid specimen processing, and our Advanced Digital Imaging and Research LLC (ADIR) subsidiary assists in the advancement of proprietary imaging technology while conducting government-sponsored research and contract development in imaging and pattern recognition.

We generate revenues primarily from three sources: Sales of; IVD instruments, IVD consumables and service, and small laboratory device instruments and supplies. Sales of IVD consumables supplies and services currently represent approximately 40% of our revenues and contribute higher gross margins than other sources of revenues. Consumables include products such as chemical reagents and urine test strips. Service revenues are derived primarily from annual service contracts purchased by our domestic customers after the initial year of sale, which is covered by product warranties. Once our analyzers and systems are installed, we generate recurring revenue from sales of consumables. Consumable and service revenue will continue to expand as the installed base of related instruments expand. Sales of small laboratory devices and supplies primarily consist of centrifuge systems and related supplies sold by StatSpin. Sales of StatSpin’s products are made worldwide through distributors.

Sales of IVD analyzers, consumables and services are made both domestically and internationally. Domestic sales are made directly by our own sales staff to the customer, whereas international sales are made to independent distributors. International sales represent 28% of consolidated net revenues in the first quarter of 2005, compared to 18% during the comparable quarter in 2004. With the launch of the iQ200 analyzer, we have increased our focus on the international marketplace, with the ultimate goal of balancing our urinalysis business between domestic and international markets. Since international sales are made through independent

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distributors, gross profit margins are lower than domestic sales of the same products but without sales and marketing costs.

We make significant investments in research and development for new products and enhancements to existing products. We internally fund our research and development programs, and through our subsidiary ADIR; we also receive government grants to fund various research activities.

The following table summarizes product technology expenditures for the periods indicated:

	For the three months ended March 31,
(in thousands)	2005			2004
Total product technology expenditures during year		1,488			1,170
Less: amounts capitalized during year to software development costs as reported in the consolidated statements of cash flow		-0-			(13	)
Less: amounts reimbursed through grants for government sponsored research and development		(405	)		(104	)
Research and development expense as reported in the consolidated statements of operations	$	1,083		$	1,053

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are described in Note 2 of the notes to our consolidated financial statements, and of those policies, we believe that the following accounting policies involve the greatest degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations.

Revenue recognition –We derive our revenues from the sale of IVD instruments, consumable supplies and services for IVD systems, sales of small laboratory devices and related supplies. Revenue is recognized once all of the following conditions have been met: i) an authorized purchase order has been received in writing with a fixed and determinable sales price, ii) customer credit worthiness has been established, and iii) delivery of the product based on shipping terms. The majority of domestic IVD instrument sales generally require that we install the instrument at our customer’s facility and train personnel in the instrument’s use.

Revenue is recorded in accordance with the provisions of Emerging Issues Task Force (EITF) Statement 00-21 “Revenue Arrangements with Multiple Deliverables” and Staff Accounting Bulletin (SAB) 104 “Revenue Recognition in Financial Statements which generally requires revenue earned on product sales involving multiple-elements to be allocated to each element based on the relative fair values of those elements. Multiple elements of our domestic product sales include IVD instruments and training. Training elements are valued based on hourly rates, which we charge for these services when sold apart from hardware sales.

Accordingly, we allocate revenue to each element in a multiple- element arrangement based on the element’s respective fair value, with the fair value determined by the price charged when that element is sold and specifically defined in a quotation or contract.

We recognize revenues from service contracts ratably over the term of the service period, which typically ranges from twelve to sixty months. Payments for service contracts are generally received in advance. Deferred revenue represents the revenues to be recognized over the remaining term of the service contracts.

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Inventory valuation –We value inventories at the lower of cost or market value on a first-in, first-out basis. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. We recognize that although we have introduced our new iQ200 product family of analyzers, an installed based of our legacy products still exists. We maintain a base supply of service parts for these products, a portion of which is classified as a long-term asset on our balance sheet. Management will periodically review the carrying value of such parts to ensure that they continue to have net realizable value.

Capitalized Software –We capitalize software development costs in connection with our development of our urine analyzers in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Cost of Capitalized Software to Be Sold, Leased or Otherwise Marketed.” We capitalize software development costs once technological feasibility is established and such costs are determined to be recoverable against future revenues.

Capitalized software development costs are expensed to cost of sales over periods up to five years. When, in management’s estimate, future revenues will not be sufficient to recover previously capitalized software development costs, we will expense such items as additional software development amortization in the period the impairment is identified. Such adjustments are normally attributable to changes in market conditions or product quality considerations.

Income taxes – We account for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes,” which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense represents the tax payable for the period and the change during the period in deferred tax assets and liabilities.

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Results of Operations

The following table summarizes results of operations data for the periods indicated. The percentages in the table are based on total revenues with the exception of percentages for cost of goods sold that are computed on related revenue.

	Three months ended March 31,
	2005				2004
	(in thousands)
Revenues
IVD instruments	$	5,939	42	%	$	2,543	27	%
IVD consumables and service		5,699	41	%		4,672	50	%
Small laboratory devices and supplies		2,326	17	%		1,974	21	%
Royalty and license revenues		—				186	2	%
Total revenues		13,964	100	%		9,375	100	%
Cost of Goods Sold
IVD instruments		3,593	60	%		1,864	73	%
IVD consumable and supplies		2,315	41	%		1,800	39	%
Small laboratory devices and supplies		1,162	50	%		1,007	51	%
Total costs		7,070	51	%		4,671	50	%
Gross margin		6,894	49	%		4,704	50	%
Operating expenses
Marketing and selling		2,391	17	%		1,490	16	%
General and administrative		1,394	10	%		1,193	13	%
Research and development, net		1,083	8	%		1,053	11	%
Total operating expenses		4,868	35	%		3,736	40	%
Operating income		2,026	14	%		968	10	%
Net income		1,271	9	%	$	529	6	%

Comparison of the three months ended March 31, 2005 to 2004

Net revenues for the three months ended March 31, 2005 increased 49% over the prior year quarter. Revenues from the IVD urinalysis segment totaled $11.6 million in the current quarter, up from $7.4 million in the prior year quarter. Sales of IVD instruments increased to $5.9 million from $2.5 million, a 134% increase ($3.4 million) over the prior year quarter. The increase in instrument sales is due to the strong sales of 100 iQ200 analyzers and systems during the current quarter as compared to 47 iQ200 analyzers and systems during the prior year quarter. Sales of IVD consumables and service increased to $5.7 million from $4.7 million, an increase of $1.0 million or 22%, primarily due to the larger installed base of instruments. Revenues from the small laboratory devices segment increased to $2.3 million from $2.0 million, or 18%. This increase is primarily due to increased sales of centrifuges, parts and service within this segment.

Gross profit margins were slightly lower during the current quarter as compared to the prior year quarter. For the IVD instruments, margins improved to 40% of related revenues as compared to 27% for the prior year quarter. The improvement was attributable to the economies of scale that resulted from greater overhead absorption and other efficiencies from higher production levels during the quarter. Gross margin on IVD consumables and service was lower during the current quarter, primarily as a result of higher sales to international independent distributors at lower margins as well as the fact that our instruments include a one-year warranty during which period we don’t realize service revenue but incur warranty cost. Margins on our small laboratory devices and supplies were 1% lower during the current quarter due to slightly higher raw material costs and increased overhead.

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Marketing and selling expenses totaled $2.4 million for the three months ended March 31, 2005 as compared to $1.5 million in the prior year quarter, a 60% increase. As a percentage of sales such expenses during the current quarter were 17% of revenues compared to 16% the prior year. During the current quarter we incurred additional sales and marketing personnel costs of approximately $330,000 and additional travel costs to support the increased sales revenues during the quarter of approximately $100,000.

General and administrative expenses increased in the first quarter to $1.4 million from $1.2 million in the prior year quarter. The increase includes approximately $100,000 of increased professional fees associated with compliance with Section 404 of the Sarbanes Oxley Act of 2002, and the remainder relates to various costs resulting from the increase revenues for the period.

Net research and development expense as shown in the accompanying statements of operations amounted to $1.1 million during both periods. Research and Development expenses were net of reimbursed costs received from governmental research and development grants, which amounted to $405,000 and $104,000 during the three months ended March 31, 2005 and 2004. We expect to continue investing in research and development activities during the remainder of 2005 but at a slightly higher rate than the current quarter.

Interest expense during the current quarter decreased to $5,000 from $90,000 in the prior year quarter as a result of the repayment of outstanding indebtedness in the second quarter of 2004. Interest income during the quarter amounted to $53,000, an increase from $42,000 over the prior year quarter and relates primarily to our investment of excess funds during the year plus interest received on sales-type equipment leases that the company entered into during the second half of 2004.

During the first three months of 2005 we incurred an income tax provision of approximately $847,000 as compared to $353,000 in the prior year quarter. The tax provision continues to be a non-cash item, since we have significant deferred tax assets, primarily relating to tax loss carryforwards.

Off-Balance Sheet Arrangements

At March 31, 2005 and 2004, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Liquidity and Capital Resources

Our primary source of liquidity is cash from operations, which depends heavily on sales of our IVD urinalysis systems and the sales of consumables and service for these systems as well as the sale of small laboratory devices and supplies. During the first three months of 2005, our cash and cash equivalents increased to $13.4 million.

Operating Cash Flows.Cash used in operations for the current quarter amounted to $538,000 compared to cash provided by operations of $147,000 in the prior year quarter. Cash used in operations for the three months ended March 31, 2005 resulted primarily from increases in receivables ($1.4 million) due to increased sales during the period, increases in other assets ($702,000) and decreases in accounts payable and accrued expenses ($1.7 million). These uses of cash were partially offset by net income in the current quarter ($1.3 million), a reduction in inventory ($623,000) due to greater than anticipated sales in the period, and non-cash expenses consisting primarily of deferred taxes ($847,000) and depreciation and amortization ($492,000).

The relationship of receivables to revenues has remained at 67 days sales in accounts receivable as compared to the prior year quarter. Inventories during the current quarter have decreased $623,000 over the prior year end with the number of days sales in inventory decreasing to 90 days at the end of the first quarter as compared to 128 days at the end of 2004 and 109 days at the end of the prior year quarter. The lower inventory levels resulted from the higher than anticipated sales during the quarter.

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Investing Activities.Cash used in investing activities totaled $212,000 during the three months ended March 31, 2005 and 2004 primarily for additions to property and equipment of $314,000 and $339,000 and partially offset by proceeds from the sales of investments held for sale in the amounts of $102,000 and $197,000.

Financing Activities.For the three months ended March 31, 2005, financing activities provided $1.3 million of cash, compared to $.8 million provided during the prior year period. During the current year quarter, we received $1.3 million from issuances of shares of common stock whereas in the prior year quarter we received $381,000 million for issuances of shares and $500,000 borrowing on our bank credit line.

In May 2004, we signed a new credit facility with a major bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of March 31, 2005, there were no borrowings under the new credit facility. We are subject to certain financial covenants under the credit facility with the bank and as of March 31, 2005, we were in compliance with such covenants.

We believe that our current cash on hand, together with cash generated from operations and cash available under the credit facility with the bank will be sufficient to fund normal operations. However additional funding may be required to fund expansion of our business. There is no assurance that such funding will be available, on terms acceptable to us.

We recently entered into an agreement to acquire the assets of the urinalysis business segment of Quidel Corporation, which acquisition, if consummated, will be funded from cash on hand. We expect to consummate the transaction on or before May 31, 2005.

New Accounting Pronouncements

In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs, an amendment of APB Opinion No. 43, Chapter 4.SFAS No. 151 clarifies the language used in Accounting Principles Board (“APB”) Opinion No. 43 with respect to accounting for abnormal amounts of idle facility expenses, freight, handling costs and spoilage. The guidance does not result in a substantive change in accounting for these costs but eliminates inconsistencies in wording between U.S. and international accounting standards. As such, this pronouncement is not expected to have any material impact on our consolidated statements of operations or financial position.

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (Revised 2004),Share-Based Payment,or SFAS No. 123R, which is a revision of SFAS No. 123. SFAS No. 123R supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and amends SFAS No. 95,Statement of Cash Flows. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. SFAS No. 123R is effective for us beginning January 1, 2006 and will require us to expense share-based payments under the “modified prospective” method. Under this method, compensation expense is recognized for all share-based payments granted after January 1, 2006 and also for all awards granted prior to January 1, 2006 that remain unvested on the effective date. We will adopt SFAS No. 123R effective January 1, 2006 using the modified prospective method. Consequently, compensation expense for awards that we granted prior to January 1, 2006 that are not fully vested on January 1, 2006 will be subject to expense beginning January 1, 2006 under SFAS No. 123R. We are currently evaluating the effects of adopting this standard on our results of operations or financial position.

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Inflation

We do not foresee any material impact on our operations from inflation.

Healthcare Reform Policies

In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the healthcare system, nationally, at the state level or both. Future legislation, regulation or payment policies of Medicare, Medicaid, private health insurance plans, health maintenance organizations and other third-party payors could adversely affect the demand for our current or future products and our ability to sell our products on a profitable basis. Moreover, healthcare legislation is an area of extensive and dynamic change, and we cannot predict future legislative changes in the healthcare field or their impact on our business.

RISK FACTORS

Risks Related to Our Business

Our success depends largely on the acceptance of our new iQ200 operating platform.

Our current strategy assumes that our iQ200 operating platform will be adopted by a large number of end-users. We have invested and continue to invest, a substantial amount of our resources in promotion and marketing of the iQ200 operating platform in order to increase its market penetration, expand its sales into new geographic areas and enhance and expand its system features. A failure of our iQ200 operating platform to achieve and maintain a significant market presence, or the failure to successfully implement our promotion and marketing strategy, will have a material adverse effect on our financial condition and results of operations.

Any failure to successfully introduce our future products and systems into the market could adversely affect our business.

The commercial success of our future products and systems depends upon their acceptance by the medical community. Our future product plans include capital-intensive laboratory instruments. We believe that these products can significantly reduce labor costs, improve precision and offer other distinctive benefits to the medical research community. However, there is often market resistance to products that require significant capital expenditures or which eliminate jobs through automation. We have no assurance that the market will accept our future products and systems, or that sales of our future products and systems will grow at the rates expected by our management.

If we fail to meet changing demands of technology, we may not continue to be able to compete successfully with our competitors.

The market for our products and systems is characterized by rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements. Our future success depends upon our ability to introduce new products that keep pace with technological developments, enhance current product lines and respond to evolving customer requirements. Our failure to meet these demands could result in a loss of our market share and competitiveness and could harm our revenues and results of operations.

Any failure or inability to protect our technology and confidential information could adversely affect our business.

Patents.Our commercial success depends in part on our ability to protect and maintain our Automated Intelligent Microscopy (or AIM) and other proprietary technology. We have received patents with respect to portions of the technologies of AIM. However, ownership of technology patents may not insulate us from potentially damaging competition. Patent litigation relating to clinical laboratory instrumentation patents (like the ones we own) often involves complex legal and factual questions. Therefore, we can make no assurance that claims under patents currently held by us, or our pending or future patent applications, will be sufficiently broad to adequately protect what we believe to be our proprietary rights. Additionally, one or more of our patents could be circumvented by a competitor. We believe that our proprietary rights do not infringe upon the proprietary

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rights of third parties. However, third parties may assert infringement claims against us in the future. If we are unsuccessful in our defense against any infringement claim our patents, or patents in which we have licensed rights, may be held invalid and unenforceable.

Trade Secrets.We have trade secrets, unpatented technology and proprietary knowledge related to the sale, promotion, operation, development and manufacturing of our products. We generally enter into confidentiality agreements with our employees, suppliers and consultants. However, we cannot guarantee that our trade secrets, unpatented technology or proprietary knowledge will not become known or be independently developed by competitors. If any of this proprietary information becomes known to third parties, we may have no practical recourse against these parties.

Copyrights and Trademarks.We claim copyrights in our software and the ways in which it assembles and displays images. We also claim trademark rights in the United States and other foreign countries. However, we can make no assurance that we will be able to obtain enforceable copyright and trademark protection, nor that this protection will provide us a significant commercial advantage.

Potential Litigation Expenses.Offensive or defensive litigation regarding patent and other intellectual property rights could be time-consuming and expensive. Additionally, litigation could demand significant attention from our technical and management personnel. Any change in our ability to protect and maintain our proprietary rights could materially and adversely affect our financial condition and results of operations.

Our products could infringe on the intellectual property rights of others.

Given the complete factual and legal issues associated with intellectual property rights, there can be no assurance that our current and future products do not or will not infringe the intellectual property rights of others. A determination that such infringement exists or even a claim that it exists could involve us in costly litigation and have an adverse effect on our business and financial condition.

We operate in a consolidating industry that creates barriers to our market penetration.

The healthcare industry in recent years has been characterized by consolidation. Large hospital chains and groups of affiliated hospitals prefer to negotiate comprehensive supply contracts for all of their supply needs at once. Large suppliers can often equip an entire laboratory and offer hospital chains and groups one-stop shopping for laboratory instruments, supplies and service. Larger suppliers also typically offer annual rebates to their customers based on the customer’s total volume of business with the supplier. The convenience and rebates offered by these large suppliers are administrative and financial incentives that we do not offer our customers. Our plans for further market penetration in the urinalysis market will depend in part on our ability to overcome these and any new barriers resulting from continued consolidation in the healthcare industry. The failure to overcome such barriers could have a material adverse effect on our financial condition or results of operation.

Since we operate in the medical technology industry, our products are subject to government regulation that could impair our operations.

Most of our products are subject to stringent government regulation in the United States and other countries. These regulatory processes can be lengthy, expensive and uncertain. Additionally, securing necessary clearances or approvals may require the submission of extensive official data and other supporting information. Our failure to comply with applicable requirements could result in fines, recall or seizure of products, total or partial suspension of production, withdrawal of existing product approvals or clearances, refusal to approve or clear new applications or notices, or criminal prosecution. If any of these events were to occur, they could harm our business. Changes in existing federal, state or foreign laws or regulations, or in the interpretation or enforcement of these laws, could also materially and adversely affect our business.

Changes in government regulation of the healthcare industry could adversely affect our business.

Federal and state legislative proposals are periodically introduced or proposed that would affect major changes in the healthcare system, nationally, at the state level or both. Future legislation, regulation or payment policies of Medicare, Medicaid, private health insurance plans, health maintenance organizations and other

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third-party payors could adversely affect the demand for our current or future products and our ability to sell our products on a profitable basis. Moreover, healthcare legislation is an area of extensive and dynamic change, and we cannot predict future legislative changes in the healthcare field or their impact on our industry or our business. Any impairment in our ability to market our products could have a material adverse effect on our financial condition and results of operation.

We may not be able to realize the deferred tax asset relating to our tax net operating loss carry forward.

As of December 31, 2004, IRIS has deferred tax assets of approximately $9.3 million resulting from the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. There is no assurance that we will be able to generate taxable income in the years that the differences reverse. Also, should the Company undergo an ownership change as defined in Section 382 of the Internal Revenue Code, the Company’s NOL generated prior to the ownership change would be subject to an annual limitation. If this occurs, a valuation allowance may be necessary.

Our success depends largely on sales of laboratory instruments and related sales of consumables and service contracts.

Historically, we derived most of our revenues from the sale of urinalysis instruments. Relatively modest declines in unit sales or gross margins for this product line could diminish our revenues and profits. In addition, because our installed instruments utilize a large volume of consumables and produce service revenue, any decline in our installed base will diminish our revenues and profits even further.

We rely on independent and some single-source suppliers for key components of our instruments. Any delay or disruption in the supply of components may prevent us from selling our products and negatively impact our operations.

Certain of our components are obtained from outside vendors, and the loss or breakdown of our relationships with these outside vendors could subject us to substantial delays in the delivery of our products to our customers. Furthermore certain key components of our instruments are manufactured by only one supplier. For example, ARKRAY is the single source supplier for our new line of urine chemistry analyzers and related consumable products and spare parts. Roche Diagnostics is the sole source for our proprietary CHEMSTRIP/IRIStrip urine test strips and related urine test strip readers, both used in our legacy instruments, the Model 500 and 939 UDx urinalysis workstations. Because these suppliers are the only vendors with which we have a relationship for a particular component, we may be unable to sell products if one of these suppliers becomes unwilling or unable to deliver components meeting our specifications. Our inability to sell products to meet delivery schedules could have a material adverse effect on our reputation in the industry as well as our financial condition and results of operation.

One of our single-source suppliers has terminated its agreement with us.

Roche Diagnostics has exercised its right to terminate its agreements with us relating to the supply of test strips and related urine test strip readers. Roche will continue to supply test strips and replacement readers to our installed base of legacy workstations for six years after termination of these contracts or 2009. The failure to successfully and timely complete the phase out of their strips and readers with the introduction of our new iQ200 analyzers would have a material adverse affect on our instrument sales and the revenue growth for system supplies and service.

We face intense competition and our failure to compete effectively, particularly against larger, more established companies will cause our business to suffer.

The healthcare industry is highly competitive. We compete in this industry based primarily on product performance, service and price. Many of our competitors have substantially greater financial, technical and human resources than we do, and may also have substantially greater experience in developing products, obtaining regulatory approvals and manufacturing and marketing and distribution. As a result, they may be better able to compete for market share, even in areas in which our products may be superior. Further, our

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competitive position could be harmed by the establishment of patent protection by our competitors or other companies. The existing competitors or other companies may succeed in developing technologies and products that are more effective or affordable than those being developed by us or that would render our technology and products less competitive or obsolete. If we are unable to effectively compete in our market, our financial condition and results of operation will materially suffer.

Our success depends on our ability to attract, retain and motivate management and other skilled employees.

Our success depends in significant part upon the continued services of key management and skilled personnel. Competition for qualified personnel is intense and there are a limited number of people with knowledge of, and experience in, our industry. We do not have employment agreements with most of our key employees nor maintain life insurance polices on them. The loss of key personnel, especially without advance notice, or our inability to hire or retain qualified personnel, could have a material adverse effect on our instrument sales and our ability to maintain our technological edge. We cannot guarantee that we will continue to retain our key management and skilled personnel, or that we will be able to attract, assimilate and retain other highly qualified personnel in the future.

Defective products may subject us to liability.

Our products are used to gather information for medical decisions and diagnosis. Accordingly, a defect in the design or manufacture of our products, or a failure of our products to perform for the use that we specify, could have a material adverse effect on our reputation in the industry and subject us to claims of liability arising from inaccurate or allegedly inaccurate test results. Misuse of our products by a technician that results in inaccurate or allegedly inaccurate test results could similarly subject us to claims of liability. We currently maintain product liability insurance coverage for up to $1.0 million per incident and up to an aggregate of $2.0 million per year. We also currently maintain a product liability umbrella policy for coverage of claims aggregating to $10.0 million. Although management believes this liability coverage is sufficient protection against future claims, there can be no assurance of the sufficiency of these policies. Any substantial underinsured loss would have a material adverse effect on our financial condition and results of operation. Furthermore, any impairment of our reputation could have a material adverse effect on our sales, revenues and prospects for future business. We have not received any indication that our insurance carrier will not renew our product liability insurance at or near current premiums; however, we cannot guarantee that this will continue to be the case. In addition, any failure to comply with Federal Drug Administration regulations governing manufacturing practices could hamper our ability to defend against product liability lawsuits.

Business interruptions could adversely affect our business.

Products for Iris Diagnostics and StatSpin are manufactured in a single facility for each division and are vulnerable to interruption in the event of war, terrorism, fire, earthquake, power loss, floods, telecommunications failure and other events beyond our control. If our facilities were significantly damaged or destroyed by any cause, we would experience delays in locating a new facility and equipment and qualifying the new facility with the FDA. Our results would suffer. In addition, we may not carry adequate business interruption insurance to compensate us for losses that may occur and any losses or damages incurred by us could be substantial.

If we are unable to manage our growth, our results could suffer.

We have been experiencing significant growth in the scope of our operations. This growth has placed significant demands on our management as well as operational resources. In order to achieve our business objectives, we anticipate that we will need to continue to grow. If this growth occurs, it will continue to place additional significant demands on our management and our operational resources, and will require that we continue to develop and improve our operational, financial and other internal controls both in the U.S. and internationally. In particular, our growth rate has increased, if it continues, will increase the challenges in implementing appropriate control systems, expanding our sales and marketing infrastructure capabilities, providing adequate training and supervision to maintain high quality standards, and preserving our cultural values. The main challenge associated with our growth has been cash flow management. Our inability to scale

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our business appropriately or otherwise adopt to growth, could cause our business, financial condition and results of operations to suffer.

Our quarterly sales and operating results may fluctuate in future periods, and if we fail to meet expectations the price of our common stock may decline.

Our quarterly sales and operating results have fluctuated significantly in the past and are likely to do so in the future due to a number of factors, many of which are not within our control. If our quarterly sales or operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Factors that might cause quarterly fluctuations in our sales and operating results include the following:

• variation in demand for our products, including seasonality;

• our ability to develop, introduce, market and gain market acceptance of new products and product enhancements in a timely manner;

• our ability to manage inventories, accounts receivable and cash flows;

• our ability to control costs;

• the size, timing, rescheduling or cancellation of orders from consumers and distributors; AND

• our ability to forecast future sales and operating results and subsequently attain them.

The amount of expenses we incur depends, in part, on our expectations regarding future sales. In particular, we expect to continue incurring substantial expenses relating to the marketing and promotion of our products. Since many of our costs are fixed in the short term, if we have a shortfall in sales, we may be unable to reduce expenses quickly enough to avoid losses. If this occurs, we will not be profitable. Accordingly, you should not rely on quarter-to-quarter comparisons of our operating results as an indication of our future performance.

We depend on independent distributors to sell our products in international markets.

We sell our products in international markets through independent distributors. These distributors may not command the necessary resources to effectively market and sell our products. If a distributor fails to meet annual sales goals, it may be difficult and costly to locate an acceptable substitute distributor. If a change in our distributors becomes necessary, we may experience increased costs, as well as substantial disruption and a resulting loss of sales.

Our sales in international markets are subject to a variety of laws and political and economic risks that may adversely impact our sales and results of operations in certain regions.

Our ability to capitalize on growth in new international markets and to maintain the current level of operations in our existing international markets is subject to risks associated with international sales operations. These include:

• changes in currency exchange rates which impact the price to international consumers;

• the burdens of complying with a variety of foreign laws and regulations;

• unexpected changes in regulatory requirements; and

• the difficulties associated with promoting products in unfamiliar cultures.

We are also subject to general, political, economic and regulatory risks in connection with our international sales operations, including:

• political instability;

• changes in diplomatic and trade relationships;

• general economic fluctuations in specific countries or markets; and

• changes in regulatory schemes.

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Any of the abovementioned factors could adversely affect our sales and results of operations in international markets.

We are subject to currency fluctuations.

We are exposed to certain foreign currency risks in the importation of goods from Japan The new line of urine chemistry analyzers, two assemblies for our iQ200 platform and related consumables strips and spare parts are sourced from ARKRAY, a supplier located in Kyoto, Japan. Our purchases from this supplier are denominated in Japanese Yen. These components represent a significant portion of our material costs. Fluctuations in the U.S. Dollar/ Japanese Yen exchange rate could result in increased costs for our key components. Any increases would reduce our gross margins and would be likely to result in a material adverse effect on our revenues and financial condition. Similarly, we are also exposed to currency fluctuations with respect to the exportation of our products. All of our sales are denominated in U.S. Dollars. Accordingly, any fluctuation in the exchange rate between the U.S. Dollar and the currency of the country with which we are exporting products could also affect our ability to sell internationally.

Risks Related to Ownership of Our Common Stock

Anti-takeover provisions of Delaware law could delay or prevent an acquisition of our Company.

We are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which regulates corporate acquisitions. These provisions could discourage potential acquisition proposals and could delay or prevent a change in control transaction. They could also have the effect of discouraging others from making tender offers for our common stock or preventing changes in our management.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our business is exposed to various market risks relating to fluctuations in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. We do not invest in derivatives or other financial instruments for trading or speculative purposes.

Interest Rates

At March 31, 2005, we did not have any outstanding indebtedness subject to interest rate fluctuations. All of our cash equivalents are held in United States bank accounts and we do not believe we have significant market risk exposure with regard to our investments.

Foreign Currencies

We are subject to some currency risk on a portion of our licensing revenues for product sales in Japan, as well as from purchases of products from our Japanese manufacturer of the AX-4280. The licensing portion of our revenues is calculated quarterly based on sales results in Japanese Yen and subsequently converted into United States dollars at the then current exchange rate. Our purchases of products from our Japanese supplier are negotiated annually and may be affected by changing foreign currency rates. Additionally, currency fluctuations can increase the price of our products to foreign customers which can adversely impact the level of our export sales from time to time.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the SEC and to approve, summarize and disclose this information within the time periods specified in the rules of the SEC. Our Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining these procedures, and, as required by the rules of the SEC, evaluate their effectiveness. Based on their evaluation of our disclosure controls and procedures as of the end of the period covered by this quarterly report, the Chief Executive and Chief Financial Officers believe that these

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procedures are adequate and effective to ensure that we are able to collect, process and disclose the information we are required to disclose in the reports we file with the SEC within the required time periods.

Changes in Internal Controls over Financial Reporting

We maintain a system of internal controls designed to provide reasonable assurance that transactions are executed in accordance with management’s general or specific authorization; transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles, (2) to maintain accountability for assets, and (3) to ensure that access to assets is permitted only in accordance with management’s general or specific authorization; and the recorded accountability for access is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

Since the date of the most recent evaluation of our internal controls over financing reporting by the Chief Executive Officer and Chief Financial Officer, there have been no significant changes in such controls or in other factors that could have significantly affected those controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

Limitations on the Effectiveness of Controls

The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that transactions are executed in accordance with management’s authorization and recorded properly to permit the preparation of financial statements in accordance with accounting principles generally accepted in the United States. However, the Company’s management, including the CEO and CFO, does not expect that the Company’s disclosure controls or internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no absolute assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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PART II

OTHER INFORMATION

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

From January 1, 2005 through March 31, 2005, the Registrant has issued and sold the following securities:

1. In January 2005, we issued to Wall Street Consultants, Inc., 129,767 shares of common stock upon the exercise of a warrant to purchase 129,767 shares of common stock at an exercise price of $7.80 per share and received proceeds of $272,916.

2. In February 2005, we issued to Sherleigh Associates, 62,250 shares of common stock upon the exercise of a warrant to purchase 62,250 shares of common stock at an exercise price of $7.80 per share and received proceeds of $485,550.

3. In March 2005, we issued to Westpark Capital, LP, 2,351 shares of common stock upon the cashless exercise of a warrant to purchase 10,500 shares of common stock at an exercise price of $7.80 per share.

The issuance and sales of these securities was made in reliance on Section 4(2) and/or Section 3(a)(9) of the Securities Act and/or Regulation D promulgated under the Securities Act. These sales were made without general solicitation or advertising. Each purchaser was a sophisticated investor with access to all relevant information necessary to evaluate the investment and represented to the Registrant that the shares were being acquired for investment.

Item 6. Exhibits

Exhibit Number	Description	Reference Document
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer	*
31.2	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Principal Financial Officer	*
32.1	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer	*
32.2	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Principal Financial Officer	*

* filed herewith

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SIGNATURE

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.

Date: May 6, 2005

IRIS INTERNATIONAL, INC.
By:	/s/ Martin G. Paravato
	Martin G. Paravato
	Chief Financial Officer

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