Iris International 10Q 2006 Q2 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

June 30, 2006

¨	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. 1-11181

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 a large accelerated filer, an accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).


Large accelerated filer ¨		Accelerated filer x		Non accelerated filer ¨

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

The registrant had 17,902,770 shares of common stock issued and outstanding as of August 7, 2006.

IRIS INTERNATIONAL, INC.

INDEX TO FORM 10-Q


		Page
PART I	FINANCIAL INFORMATION

Item 1.	Financial Statements	3

	Consolidated Balance Sheets as of June 30, 2006 (unaudited) and December 31, 2005	3

	Consolidated Statements of Operations for the three months ended June 30, 2006 and 2005 (unaudited)	4

	Consolidated Statements of Operations for the six months ended June 30, 2006 and 2005 (unaudited)	5

	Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005 (unaudited)	6

	Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2006 and 2005 (unaudited)	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34

Item 4.	Controls and Procedures	35

PART II	OTHER INFORMATION

Item 1A.	Risk Factors	36

Item 6.	Exhibits	36

Signature		37

PART I

FINANCIAL INFORMATION

Item 1.

Financial Statements

IRIS INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)


	June 30, 2006			December 31, 2005
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	16,461		$	19,145
Accounts receivable, net of allowance for doubtful accounts and sales returns of $515 and $288		10,937			11,874
Inventories, net		9,834			7,590
Prepaid expenses and other current assets		944			1,132
Investment in sales-type leases		1,829			1,455
Deferred tax asset		2,792			2,792

Total current assets		42,797			43,988
Property and equipment, at cost, net		5,224			4,076
Goodwill		2,420			189
Core technology, net		1,768			—
Software development costs, net		1,296			1,570
Deferred tax asset		5,916			7,237
Inventories – long term portion		556			632
Investment in sales-type leases		6,500			5,841
Other assets		394			396

Total assets	$	66,871		$	63,929


Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	2,948		$	4,464
Accrued expenses		4,159			4,188
Deferred service contract revenue		1,304			1,457

Total current liabilities		8,411			10,109
Deferred service contract revenue, long term		25			51

Total liabilities		8,436			10,160
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par value – authorized: 50 million shares; issued and outstanding: 17,892 shares and 17,222 shares		179			172
Additional paid-in capital		77,781			70,310
Accumulated deficit		(19,525	)		(16,713	)

Total shareholders’ equity		58,435			53,769

Total liabilities and shareholders’ equity	$	68,871		$	63,929

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited – in thousands)


	For the three months ended June 30,
	2006			2005
Sales of IVD instruments	$	6,038		$	7,479
Sales of IVD consumables and service		7,745			5,887
Sales of sample processing and supplies		2,815			2,211

Net revenues		16,598			15,577

Cost of goods - IVD instruments		3,245			4,280
Cost of goods - IVD consumables and service		3,502			2,600
Cost of goods - sample processing and supplies		1,441			1,101

Cost of goods sold		8,188			7,981

Gross margin		8,410			7,596

Marketing and selling expenses		2,634			2,476
General and administrative expenses		2,830			1,649
Research and development, net		2,091			958
In-process research and development		5,180			—

Total operating expenses		12,735			5,083

Operating income (loss)		(4,325	)		2,513
Other income (expense):
Interest income		242			123
Interest expense		(11	)		(7	)
Other income		30			—

Income (loss) before income taxes		(4,064	)		2,629
Provision for income taxes		413			1,052

Net income (loss)	$	(4,477	)	$	1,577

Basic net income (loss) per share	$	(0.25	)	$	0.09

Diluted net income (loss) per share	$	(0.25	)	$	0.09

Basic - average shares outstanding		17,868			16,636

Diluted - average shares outstanding		17,868			18,471

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited – in thousands)


	For the six months ended June 30,
	2006			2005
Sales of IVD instruments	$	11,953		$	13,418
Sales of IVD consumables and service		15,004			11,586
Sales of sample processing and supplies		5,756			4,537

Net revenues		32,713			29,541

Cost of goods - IVD instruments		6,407			7,873
Cost of goods - IVD consumables and service		6,625			4,915
Cost of goods - sample processing and supplies		2,981			2,263

Cost of goods sold		16,013			15,051

Gross margin		16,700			14,490

Marketing and selling expenses		4,956			4,867
General and administrative expenses		4,945			3,043
Research and development, net		3,579			2,041
In-process research and development		5,180			—

Total operating expenses		18,660			9,951

Operating income (loss)		(1,960	)		4,539
Other income (expense):
Interest income		505			176
Interest expense		(12	)		(12	)
Other (expense) income		33			44

Income (loss) before income taxes		(1,434	)		4,747
Provision for income taxes		1,386			1,899

Net income (loss)	$	(2,820	)	$	2,848

Basic net income (loss) per share		(0.16	)		0.17

Diluted net income (loss) per share	$	(0.16	)	$	0.16

Basic - average shares outstanding		17,558			16,424

Diluted - average shares outstanding		17,558			17,968

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited – in thousands)


	For the six months ended June, 30
	2006			2005
Cash flows from operating activities:
Net income (loss)	$	(2,820	)	$	2,848
Adjustments to reconcile net income (loss) to net cash provided by operations:
Non-cash in-process research and development charge		5,180			—
Deferred taxes, net		1,385			1,873
Depreciation and amortization		1,064			1,077
Common stock and stock option compensation		672			(311	)
Gain on sale of investment		(30	)		(17	)
Changes in operating assets and liabilities:
Accounts receivable		937			(1,918	)
Deferred service contract revenue		(153	)		63
Inventories, net		(2,168	)		416
Prepaid expenses and other current assets		188			(257	)
Sales-type lease and other assets		(1,031	)		(1,977	)
Accounts payable & accrued expenses		(1,571	)		(9	)

Net cash provided by operating activities		1,653			1788

Cash flows from investing activities:
Acquisition of business, net of cash acquired		(3,561	)		—
Acquisition of property and equipment		(1,886	)		(414	)
Software development costs		—			(171	)
Sale of investments held for sale		30			102

Net cash used in investing activities		(5,417	)		(483	)

Cash flows from financing activities:
Issuance of common stock for cash		1,080			2,868
Borrowings under line of credit		3,000			—
Repayments of line of credit		(3,000	)		—
Payments of capital lease obligations		—			(20	)

Net cash provided by financing activities		1,080			2,848

Net increase (decrease) in cash and cash equivalents		(2,684	)		4,153
Cash and cash equivalents at beginning of period		19,145			12,839

Cash and cash equivalents at end of period	$	16,461		$	16,992

Supplemental schedule of non-cash financing activities:
Issuance of common stock and common stock warrants for services	$	1,061		$	311
Issuance of common stock and deferred compensation units to acquire subsidiary	$	5,000		$	—
Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	34		$	—
Cash paid for interest	$	12		$	12

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited – in thousands)


	For the three months ended June 30,
	2006			2005
Net income (loss)	$	(4,477	)	$	1.577
Unrealized loss on investments, net of taxes		—			(28	)

Comprehensive income (loss)	$	(4,477	)	$	1,549


	For the six months ended June 30,
	2006			2005
Net income (loss)	$	(2,820	)	$	2,848
Unrealized gain (loss) on investments, net of taxes		—			(39	)

Comprehensive income (loss)	$	(2,820	)	$	2,809

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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

1.	Company History

IRIS International, Inc. was incorporated in California in 1979 and reincorporated during 1987 in Delaware under the name of International Remote Imaging Systems, Inc. We changed our name to IRIS International, Inc. in December 2003. We design, develop, manufacture and market in vitro diagnostic (“IVD”) equipment and related consumables, 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.

2.	Summary of Significant Accounting Policies

Basis of Presentation of Unaudited Interim Financial Statements

The financial statements have been prepared in accordance with the instructions to Form 10-Q under the Securities Exchange Act of 1934, as amended, and do not include all of the information and note disclosures required by accounting principles generally accepted in the United States (“GAAP”). These financial statements should be read in conjunction with the Consolidated Financial Statements and accompanying notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 (the “2005 Form 10-K”).

The Consolidated Financial Statements included herein are unaudited, but in the opinion of management, such financial statements include all adjustments, consisting only of normal recurring adjustments, necessary to summarize fairly the Company’s financial position and results of operations for the interim period. The results reported in these Consolidated Financial Statements should not be taken as indicative of results that may be expected for the entire year.

Use of Estimates

The preparation of 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

Our 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 and debt instruments of the United States Government with maturities greater than three months and less than one year. For purposes of the statement of cash flows, we consider all highly liquid debt instruments purchased with a remaining maturity of three months or less when purchased to be cash equivalents. We place our cash and investments with high credit quality financial institutions. At times, these deposits may be in excess of the federally insured limit.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

Accounts Receivable

We sell predominantly to entities in the healthcare industry. We grant uncollateralized credit to customers, primarily hospitals, clinical and research laboratories, and distributors. We perform ongoing credit evaluations of customers before granting uncollateralized credit. No single customer accounts for 10% or more of our consolidated revenues or 10% or more of our accounts receivable at the balance sheet date.

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.

Management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. We include accounts receivable balances that are determined to be uncollectible, along with a general reserve, in our 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 June 30, 2006 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. We currently have approximately $556 of non-current inventory relating to spare parts for our legacy instruments which we no longer produce but continue to support and provide maintenance repairs for our customers. Other inventory that is considered excess inventory is fully reserved.

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 seven 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 and Core Technology

Our intangible assets consist of goodwill, which is not being amortized and core technology, which is being amortized over its useful life of 20 years. All intangible assets are subject to impairment tests on an annual or periodic basis. Goodwill is evaluated in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142 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. Core Technology is evaluated for impairment using the methodology set forth in SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144). Recoverability of these assets is assessed only when events have occurred that may give rise to an impairment. When a potential impairment has been identified, forecasted undiscounted net cash flows of the operations to which the asset relates are compared to the current carrying value of the long-lived assets present in that operation. If such cash flows are less than such carrying amounts, long-lived assets, including such intangibles, are written down to their respective fair values.

At December 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.”

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

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 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. We had no capitalized software development costs during the six months ended June 30, 2006 and recorded amortization of software development costs of $274 and $250 during the six months ended June 30, 2006 and 2005.

Long-Lived Assets

We will identify and record impairment losses 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. There were no impairments during the six months ended June 30, 2006 and 2005.

Revenue recognition

Revenues are primarily derived from the sale of IVD instruments, sales of consumable supplies and service contracts for IVD systems, as well as sales of sample processing instruments 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 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.

A portion of our revenues are derived from sale-type leases when we provide lease financing to certain customers that purchase our diagnostic instruments. Leases under these arrangements are classified as sales-type leases. These leases typically have terms of five years. Revenue from sales-type leases are recognized when collectibility of the minimum lease payments is reasonably predictable and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by us as lessor under the lease. The minimum lease payments that accrue to our benefit as lessor are recorded as the gross investment in the lease. The difference between the gross investment in the lease and the

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

sum of the present value of the minimum lease payments and unguaranteed residual value, accruing to our benefit as lessor, are recorded as unearned income.

We recognize revenues from service contracts ratably over the term of the service period, which typically ranges from twelve to twenty-four months. Currently, substantially all service contracts are for twelve 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.

IRIS recognizes revenues from the sale of diagnostics instruments, consumables and sample processing instruments 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

We recognize 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.

From time to time we receive grants from agencies of the US 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, we retain ownership of any intellectual property that results from the research and development and the US Government receives a right to use the results of the research for government projects.

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.

Marketing Costs

All costs related to marketing our products are expensed at the time the marketing takes place.

Fair Value of Financial Instruments

The carrying amounts of financial instruments including cash and cash equivalents, restricted cash, accounts receivable and payable, accrued and other current liabilities and current maturities of long-term

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

debt approximate fair value due to their short maturity. The carrying amount of our long-term liabilities also approximates fair value based on interest rates currently available to us for debt of similar terms and remaining maturities.

Earnings Per Share

Basic net income (loss) per share represents net income (loss) divided by the weighted average common stock outstanding during the period. Diluted net income (loss) per share represents net income (loss) divided by the weighted average common stock and non-antidilutive common stock equivalents outstanding during the period. Weighted average shares used in diluted net income (loss) per share include common stock equivalents, arising from stock options and warrants, under the treasury stock method. The weighted average amount of outstanding antidilutive common stock options and warrants excluded from the computation of diluted net income (loss) per common share for the three and six month periods ended June 30, 2006 was 694 and 823, respectively.

Stock Based Compensation

Effective January 1 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R,“Share-Based Payment,” which requires compensation costs related to share-based transactions, including employee stock options, to be recognized in the financial statements based on fair value. SFAS No. 123R revises SFAS No. 123, as amended,“Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees.” The Company adopted SFAS No. 123R using the modified prospective application transition method. Under this method, compensation cost is recognized for the unvested portion of share-based payments granted prior to January 1, 2006 and all share-based payments granted subsequent to December 31, 2005 over the related vesting period. However, as of December 31, 2005, existing employee stock options were fully vested; accordingly there was no SFAS No. 123R based compensation expense for such options that would be recognized in years subsequent to 2005.

Prior to the first quarter of 2006, the Company applied the intrinsic value based method prescribed in APB Opinion No. 25 and FIN 44, “Accounting for Certain Transactions involving Stock Compensation” in accounting for employee stock based compensation. Prior period results have not been restated.

Due to the adoption of SFAS No. 123R, the Company’s results for the three and six months ended June 30, 2006 include incremental share-based compensation expense totaling $296 and $345, respectively. As such, basic and diluted net income (loss) per share were impacted by $0.01 for the three and six months ended June 30, 2006, respectively. The Company’s results include total share based compensation expense of $435 and $672 for the three and six months ended June 30, 2006 and $108 and $187 for the three and six months ended June 30, 2005.

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 10 — “Segment and Geographic Information”.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

Certain Risks and Uncertainties

We derive most of our 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 our revenues and profits.

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 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 939UDx 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.

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 until 2009. The failure to successfully and timely complete the phase out of their strips and readers with the introduction of our iQ200 analyzers would have a material adverse affect on our instrument sales and the revenue growth for system consumables and service.

New Accounting Pronouncement

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of Accounting Research Bulletin No. 43, Chapter 4.” SFAS No. 151 requires that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recorded as current period charges and that the allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. SFAS No. 151 was effective for us on January 1, 2006. The adoption of SFAS No. 151 did not have a material impact on our consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (FIN 48) an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not (i.e. a likelihood of more than fifty percent) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Upon adoption, the cumulative effect of applying the recognition and measurement provisions of FIN 48, if any, shall be reflected as an adjustment to the opening balance of retained earnings.

FIN 48 requires that subsequent to initial adoption a change in judgment that results in subsequent recognition, derecognition or change in a measurement of a tax position taken in a prior annual period (including any related interest and penalties) be recognized as a discrete item in the period in which the change occurs. Currently, we record such changes in judgment, including audit settlements, as a component of our income tax provision. Thus, our reported quarterly income tax rate may become more volatile upon adoption of FIN 48. This change will not impact the manner in which we record income tax expense on an annual basis.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

FIN 48 also requires expanded disclosures including identification of tax positions for which it is reasonably possible that total amounts of unrecognized tax benefits will significantly change in the next twelve months, a description of tax years that remain subject to examination by major tax jurisdiction, a tabular reconciliation of the total amount of unrecognized tax benefits at the beginning and end of each annual reporting period, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate and the total amounts of interest and penalties recognized in the statements of operations and financial position. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of this standard on our Consolidated Financial Statements.

3.	Stock Option Plans

Summary of Stock Based Compensation Plans

As of June 30, 2006, the Company has three stock option plans under which we may grant non-qualified stock options, incentive stock options and stock appreciation rights. No stock appreciation rights have been granted under these plans. The source of share unit conversions is from authorized newly issued shares. In addition to the above, as of June 30, 2006 there were stock options outstanding to purchase 75,000 shares of common stock that were issued under special inducement grants (“SIG”).

During the six months ended June 30, 2006, we incurred approximately $672 of stock based compensation relating to employee stock options and stock purchases.

The following schedule sets forth options authorized, exercised, outstanding and available for grant under our three stock option plans and SIG as of June 30, 2006:


(In thousands)	Number of Option Shares
Plan	Authorized	Exercised/ Canceled	Outstanding	Available for Grant
1994 Plan	700	665	35	—
1997 Plan	600	547	53	—
1998 Plan	4,100	1,732	1,673	695
SIG	130	55	75	—

	5,530	2,999	1,836	695

The Compensation Committee of the Board of Directors determines the exercise price of options. Payment of the exercise price may be made either in cash or with shares of common stock that have been held at least six months. The options generally vest over either three or four years and expire either five or ten years from the date of grant. The exercise price for such options ranges from $0.88 to $26.02 per share.

Assumptions

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:


	Six Months Ended June 30, 2006		For the Year Ended December 31,
	Six Months Ended June 30, 2006		2005		2004		2003
Risk free interest rate	4.6	%	4.3	%	3.6	%	3.2	%
Expected lives (years)	3		3		5		5
Expected volatility	44	%	40	%	39	%	44	%
Expected dividend yield	—		—		—		—

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

The expected volatilities are based on the historical volatility of the Company’s stock. The observation is made on a weekly basis. The expected terms of the stock options are based on the average vesting period on a basis consistent with the historical experience for similar option grants. The risk-free rate is consistent with the expected terms of the stock options and based on the U.S. Treasury yield curve in effect at the time of grant.

Stock Option Activity

As summary of option activities under the stock option plans during the six months ended June 30, 2006 is presented as follows:

(In thousands, except for per share)


Stock Options	Shares		Weighted- Average Exercise Price		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value
Outstanding at January 1, 2006	1,717		$	6.89	4.18 yrs.	$	25,718
Granted	352		$	18.77
Exercised	(232	)	$	4.51
Canceled or Expired	(1	)	$	8.58

Outstanding at June 30, 2006	1,836		$	9.47	3.87 yrs.	$	6,786

Exercisable at June 30, 2006	1,494		$	7.35	3.64 yrs.	$	8,686

Cash received from options exercised during the six months ended June 30, 2006 amounted to $1,048. There were options to purchase 352 share of common stock granted during the six months ended June 30, 2006 under the 1998 Stock Option Plan.

A summary of the status of the Company’s non-vested stock options during the six months ended June 30, 2006 is presented below:


Non-vested Options	Shares	Weighted- Average Grant- Date Fair Value
Non-vested at January 1, 2006	—
Granted	352	$	6.27
Exercised	—		—
Forfeited or expired	—		—

Non-vested at June 30, 2006	352	$	6.27

As of June 30, 2006, there was approximately $1,788 of accumulated unrecognized stock compensation based on fair value on the grant date related to non-vested options granted under the stock option plans. That cost is expected to be recognized during the weighted average service period of 4.0 years. The share-based compensation will be amortized based on the straight line method over the vesting period and the expense includes an estimate of the awards that will be forfeited.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

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


	For the period ended June 30, 2005
(in thousands)	Three Months			Six Months
Net income as reported	$	1,577		$	2,848
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		109			187
Deduct: Total stock-based Employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(256	)		(469	)

Net income pro forma	$	1,430		$	2,566

Income per diluted share as reported	$	0.09		$	0.16

Income per diluted share pro forma	$	0.08		$	0.14

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.

4.	Acquisitions

On April 3, 2006 we acquired the stock of Leucadia Technologies, Inc., a development stage molecular diagnostics company. With this acquisition we acquired significant core technology for an ultra-sensitive immunoassay process and novel in-vitro separation and concentration process as well as in-process research and development for bacteria and cancer detection applications.

Pursuant to the acquisition agreement we paid $3,332 of cash, 272,375 shares of IRIS common stock, valued at $4,200, deferred stock units for 51,879 shares of IRIS common stock valued at $800 and $230 of transaction fees. The IRIS common stock and deferred stock units were valued based on the average closing price market price of IRIS common stock a few days before and a few days following the acquisition. In addition, we will pay up to 108,950 shares of IRIS common stock and deferred stock units for 20,752 shares of IRIS common stock as earn-out consideration if certain regulatory and sales milestones are achieved. The acquisition was accounted for as a purchase with the preliminary allocation, based on fair value, as follows:


Cash and cash equivalents	$	2
Fixed assets		21
Intangible assets
Core technology		1,790
Goodwill		2,231

Total assets acquired	$	4,044

Total liabilities – deferred tax liability	$	662

In-process Research and development expense	$	5,180

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

Goodwill from this transaction is not expected to be deductible for tax purposes. Final allocation of the purchase price is expected to be completed in the third quarter of 2006 upon review of the final independent valuation report.

On June 2, 2005, we completed the acquisition of the urinalysis business of Quidel Corporation. With this acquisition we acquired significant core technology and know-how in urine chemistry strips, patents and trademarks, product designs, a strip manufacturing facility in Germany and a semi-automated urine chemistry analyzer that will enable us to offer a more complete product line internationally.

Pursuant to the acquisition agreement, we paid $500 in cash and assumed approximately $34 in accrued liabilities. We also incurred approximately $243 in professional and other fees, the total acquisition cost amounting to $777. The acquisition was accounted for as a purchase with the purchase price allocated to the fair value of the assets acquired. The allocation of the acquisition price resulted in an excess of the fair value of the assets acquired over the purchase price and resulted in negative goodwill. The negative goodwill reduced the non-current assets to zero with the acquisition cost of $777 allocated to the fair value of the inventory acquired.

The following unaudited condensed consolidated pro forma statement of operations data shows the results of our operations for the three and six months ended June 30, 2006 and 2005 as if recently completed business combinations had occurred at the beginning of each period presented:


	Three months ended June 30,
(in thousands, except per share data)	2006			2005
Revenues	$	16,598		$	16,149
Net income (loss)		(4,477	)		956
Net income (loss) per share	$	(0.25	)	$	0.06

	Six months ended June 30,
(in thousands, except per share data)	2006			2005
Revenues	$	32,713		$	30,113
Net income (loss)		(2,945	)		(2,704	)
Net income (loss) per share	$	(0.17	)	$	(0.16	)

These unaudited condensed consolidated pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the actual results of operations had the acquisitions taken place as of the beginning of the respective periods or the results of our future operations. Furthermore, the pro forma results do not give effect to all cost savings or incremental costs that may occur as a result of the integration and consolidation of the acquisitions.

5.	Inventories

Inventories consist of the following:


(in thousands)	June 30, 2006			December 31, 2005
Finished goods	$	4,218		$	2,800
Work-in-process		304			337
Raw materials, parts and sub-assemblies		5,868			5,085

		10,390			8,222
Less non-current portion		(556	)		(632	)

Inventories – current portion	$	9,834		$	7,590

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

6.	Bank Loan Agreement

In May 2004, we signed a credit facility with a commercial 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 June 30, 2006, there were no borrowings under the credit facility. We are subject to certain financial covenants under the credit facility with the bank and as of June 30, 2006, we were in compliance with such covenants. On March 31, 2006, the Bank granted us a waiver to complete the acquisition of Leucadia described in Note 4.

7.	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.

8.	Capital Stock—Warrants

At June 30, 2006, there were outstanding and exercisable warrants to purchase 74,300 shares at a price of $7.80 per share.

9.	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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

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 June 30, 2006.

10.

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 supplies and (2) sample processing instruments 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 and chemistry procedures for urinalysis and conducts research and development for in vitro molecular diagnostics applications as well as imaging and pattern recognition. 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.

Revenue is also generated from sales of sample processing instruments and related supplies, which primarily consist of centrifuge systems, DNA processing workstations and blood analysis products. These products are sold worldwide through distributors.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

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


(in thousands)	IVD Instruments			Sample Devices		Unallocated Corporate Expenses			Total
For the three months ended June 30, 2006
Revenues	$	13,783		$	2,815	$	—		$	16,598
Interest income	$	239		$	3	$	—		$	242
Interest expense	$	11		$	—	$	—		$	11
Depreciation and amortization*	$	683		$	182	$	183		$	1,048
Segment pre tax profit (loss)	$	(3,468	)	$	676	$	(1,272	)	$	(4,064	)
Segment assets	$	53,808		$	14,866	$			$	68,674
Investment in long-lived assets	$	17,743		$	491	$	—		$	18,234

For the three months ended June 30, 2005
Revenues	$	13,366		$	2,211	$	—		$	15,577
Interest income	$	121		$	2	$	—		$	123
Interest expense	$	4		$	—	$	3		$	7
Depreciation and amortization*	$	450		$	34	$	22		$	506
Segment pre tax profit	$	3,074		$	419	$	(864	)	$	2,629
Segment assets	$	44,286		$	12,294	$	—		$	56,580
Investment in long-lived assets	$	9,839		$	216	$	—		$	10,055

For the six months ended June 30, 2006
Revenues	$	26,957		$	5,756	$			$	32,713
Interest income	$	500		$	5	$			$	505
Interest expense	$	11		$	—	$			$	11
Depreciation and amortization*	$	1,247		$	235	$	246		$	1,728
Segment pre tax profit (loss)	$	(417	)	$	1,326	$	(2,343	)	$	(1,434	)
Segment assets	$	53,808		$	14,866	$			$	68,674
Investment in long-lived assets	$	17,743		$	491	$			$	18,234

For the six months ended June 30, 2005
Revenues	$	25,004		$	4,537	$	—		$	29,541
Interest income	$	172		$	4	$	—		$	176
Interest expense	$	6		$	—	$	6		$	12
Depreciation and amortization*	$	940		$	93	$	44		$	1,077
Segment profit	$	5,445		$	928	$	(1,626	)	$	4,747
Segment assets	$	44,286		$	12,294	$	—		$	56,580
Investment in long-lived assets	$	9,839		$	216	$	—		$	10,055

*	Included in depreciation and amortization above is amortization of stock based compensation in the amounts $435 and $108 for the three months ended June 30, 2006 and 2005; and $672 and $187 for the six months ended June 30, 2006 and 2005.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

The Company ships products from two locations in the United States. Substantially all long-lived assets were located in the United States. Sales to international customers amounted to approximately $10.9 million and $8.1 million during the six months ended June 30, 2006 and 2005. 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.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

IRIS International, Inc. consists of two segments. Our largest segment, IVD instruments and supplies, (1) designs, manufactures and markets in vitro diagnostics (IVD) systems, consumables and supplies for urinalysis under the Iris Diagnostics name, (2) conducts research and development for in vitro molecular diagnostics applications through our Iris Molecular Diagnostics subsidiary, and (3) conducts government-sponsored research and contract development in imaging and pattern recognition through our Advanced Digital Imaging and Research LLC (ADIR) subsidiary. Our other segment, Sample Processing, markets small centrifuges and accessories for rapid specimen processing and DNA processing workstations.

We generate revenues primarily from: sales of IVD instruments, IVD consumables and service and sample processing instruments and supplies. Revenues from IVD instruments include sales of urine microscopy and chemistry analyzers manufactured by us and urine chemistry analyzers purchased from a Japanese manufacturer. We sell our IVD urine microscopy analyzers and the iChem 100, our new semi-automated chemistry analyzer introduced in the third quarter of 2006 on a global basis. The fully automated urine chemistry analyzers is domestically. 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 the analyzers 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 increases. Revenue is also generated from sales of sample processing instruments and related supplies, which primarily consists of centrifuge systems, DNA processing workstations and blood analysis products.

Domestic sales are direct to the customer through our sales force, whereas international IVD sales, with the exception of France, are through independent distributors. Sales in France are direct to end use customers. International IVD sales represented 31% of consolidated revenues during the six months ended June 30, 2006 as compared to 28% during fiscal 2005 and 18% in fiscal 2004. Since the launch of our iQ200 product line, we have increased our sales efforts in the international marketplace, with the ultimate goal of balancing our urinalysis business between domestic and international markets. Since international IVD sales are made through independent distributors, gross profit margin is lower than domestic sales of the same products, but we do not incur sales and marketing costs for such sales. Our Sample Processing products are sold worldwide through distributors.

Effective January 1, 2006 we implemented the provisions of SFAS No. 123R, “Share-Based Payment,” that establishes standards for accounting for transactions in which a company exchanges its equity instruments for goods and services or incurs a liability in exchange for goods and services that is based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The primary focus of this pronouncement is on issuing share-based payments for services provided by employees. This pronouncement also requires recognition of compensation expense for new equity instruments awarded or for modifications, cancellations or repurchases of existing awards starting January 1, 2006. Compensation expense for new equity awards, in most cases, will be based on the fair value of the stock on the date of grant and will be recognized over the vesting service period. An award of a liability instrument, as defined by this pronouncement, will initially be recorded at fair value and will be adjusted each reporting period to the new fair value through the date of settlement. Under the terms of this pronouncement, we began to expense equity awards using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the fair value of those awards on their respective grant dates.

On April 3, 2006 we acquired Leucadia Technologies, Inc., a development stage molecular diagnostics company. With this acquisition we acquired significant core technology for an ultra-sensitive immunoassay process and novel in-vitro separation and concentration process as well as in-process research and development for bacteria and cancer detection applications.

Pursuant to the acquisition agreement we paid $3,332 in cash, 272,375 shares of IRIS common stock, valued at $4,200, deferred stock units for 51,879 shares of IRIS common stock valued at $800 and $231 of transaction fees. In addition, we will pay up to 108,950 shares of IRIS common stock and deferred stock units for 20,752 shares of IRIS common stock as earn-out consideration if certain regulatory and sales milestones are achieved.

On June 2, 2005, we completed the acquisition of the assets (primarily technology and inventory) of the urinalysis business of Quidel Corporation. Our total acquisition cost amounted to $777. With this acquisition, we acquired significant core technology and know-how in urine chemistry strips, patents and trademarks, product designs, a strip manufacturing facility in Germany and a semi-automated urine chemistry analyzer that will enable us to offer a more complete product line internationally.

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

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


(in thousands)	For the three months ended June 30,						For the six months ended June 30,
	2006			2005			2006			2005
Total product technology expenditures	$	2,531		$	1,553		$	4,523		$	3,041
Less: amounts capitalized during year to software development costs as reported in the consolidated statements of cash flow		—			(171	)		—			(171	)
Less: amounts reimbursed through grants for government sponsored research and development		(440	)		(424	)		(944	)		(829	)

Research and development expense as reported in the consolidated statements of operations	$	2,091		$	958		$	3,579		$	2,041

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and our discussion and analysis of our financial condition and results of operations require us to make judgments, assumptions, and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Note 2 of the Notes to Consolidated Financial Statements included in this Form 10-Q describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We regularly discuss with our audit committee the basis of our estimates. Actual results may differ from these estimates and such differences may be material.

We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue recognition – Revenues are primarily derived from the sale of IVD instruments, sales of consumable supplies and services for IVD systems as well as sales of sample processing instruments 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 include installation and training to be performed.

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.

A portion of our revenues are derived from sale-type leases as we provide lease financing to certain customers that purchase our diagnostic instruments. Leases under these arrangements are classified as sales-type leases. These leases typically have terms of five years. Revenue from sales-type leases are recognized when collectibility of the minimum lease payments is reasonably predictable and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by us as lessor under the lease. The minimum lease payments that accrue to our benefit as lessor are recorded as the gross investment in the lease. The difference between the gross investment in the lease and the sum of the present value of the minimum lease payments and unguaranteed residual value, accruing to our benefit as lessor, are recorded as unearned income.

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.

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 line of analyzers, an installed based of our legacy products still exist. 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.

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 June 30,									Six months ended June 30,
	2006					2005				2006					2005
Revenues
IVD instruments	$	6,038		36	%	$	7,479	48	%	$	11,953		37	%	$	13,418	46	%
IVD consumables and service		7,745		47	%		5,887	38	%		15,004		46	%		11,586	39	%
Sample processing and supplies		2,815		17	%		2,211	14	%		5,756		18	%		4,537	15	%

Total revenues		16,598		100	%		15,577	100	%		32,713		100	%		29,541	100	%

Cost of Goods Sold
IVD instruments		3,245		54	%		4,280	57	%		6,407		54	%		7,873	59	%
IVD consumable and supplies		3,502		45	%		2,600	44	%		6,625		44	%		4,915	42	%
Sample processing and supplies		1,441		51	%		1,101	50	%		2,981		52	%		2,263	50	%

Total costs		8,188		49	%		7,981	51	%		16,013		49	%		15,051	51	%

Gross margin		8,410		51	%		7,596	49	%		16,700		51	%		14,490	49	%

Operating expenses
Marketing and selling		2,634		16	%		2,476	16	%		4,956		15	%		4,867	16	%
General and administrative		2,830		17	%		1,649	11	%		4,945		15	%		3,043	10	%
Research and development, net		2,091		13	%		958	6	%		3,579		11	%		2,041	7	%
In-process research and development		5,180		31	%		—				5,180		16	%		—

Total operating expenses		12,735		77	%		5,083	33	%		18,660		57	%		9,951	34	%

Operating income (loss)		(4,325	)	-26	%		2,513	16	%		(1,434	)	-4	%		4,539	15	%

Net income	$	(4,477	)	-27	%	$	1,577	10	%		(2,820	)	-9	%		2,848	10	%

Comparison of the three months ended June 30, 2006 to 2005

Net revenues for the three months ended June 30, 2006 increased 7% from the prior year quarter. Revenues from the IVD urinalysis segment totaled $13.8 million in the current quarter, up from $13.4 million in the prior year quarter. Sales of IVD instruments decreased to $6.0 million from $7.5 million, a 19% decrease from the prior year quarter. The decrease in instrument sales is due primarily to a reduction in unit sales to 102 iQ200 analyzers and systems during the current quarter as compared to unit sales of 117 iQ200 analyzers and systems during the prior year quarter. Sales of IVD consumables and service increased to $7.7 million from $5.9 million, an increase of $1.8 million or 32%, primarily due to the larger installed base of instruments. Revenues from the sample processing segment increased to $2.8 million from $2.2 million, or 27%. This increase is primarily due to increased unit sales of centrifuges, and DNA processing workstations within this segment.

Consolidated gross profit margins improved to 51% of revenues as compared to 49% during the prior year quarter. For the IVD instruments, margins improved to 46% of related revenues as compared to 43% for the prior year quarter. The improvement was attributable to reduced material costs through change in vendors for improved quality at lower costs and negotiated lower prices with existing vendors. Margins on IVD consumables and service during the current quarter were 55% compared to 56% during the prior year quarter. The decline is primarily attributable to the result of the chemistry strip manufacturing operation in Germany acquired last year which is currently operating below capacity and generated a negative gross profit margin of $272 for the current quarter. Margins on our sample processing instruments and supplies were 1% lower during the current quarter due to an increase in OEM customer mix.

Marketing and selling expenses totaled $2.6 million for the three months ended June 30, 2006 as compared to $2.5 million in the prior year quarter, a 6% increase. As a percentage of sales such expenses during the current quarter and prior year quarter were 16% of revenues. During the current quarter we incurred additional stock based compensation expense of approximately $0.1 million resulting from the adoption of SFAS No. 123R.

General and administrative expenses increased in the quarter to $2.8 million from $1.6 million in the prior year quarter. The increase includes approximately $0.5 million of expenses associated with the transition to a new Chief Financial Officer (consisting of severance for the retiring CFO and recruiting and relocation expense to retain the new CFO), $0.3 million of bad debt expense, $0.2 million of incremental stock based compensation resulting for the adoption of SFAS No. 123R in 2006, and $0.1 million of additional personnel costs during the quarter. As a percentage of sales, general and administrative expenses were 15% during the current quarter as compared to 14% for the prior year quarter.

Net research and development amounted to $2.1 million during the current quarter as compared to $1.0 million in the prior year quarter. Research and development expenses were net of reimbursed costs received from governmental research and development grants, which amounted to $454 and $608 during the three months ended June 30, 2006 and 2005. Approximately $0.4 million of the increase in research and development expense included relates to molecular diagnostics bacteria and cancer detection programs initiated with our acquisition of Leucadia Technologies on April 3, 2006.

As a result of our acquisition of Leucadia Technologies, on April 3, 2006 we acquired significant In-process research and development expense for bacteria and cancer detection applications which we have preliminarily valued at $5.2 million in the second quarter of 2006.

Interest income during the quarter amounted to $242, an increase from $119 in the prior year quarter and relates primarily to our investment of excess funds during the quarter plus interest received on sales-type equipment leases. Interest expense during the current quarter increased to $11, primarily relating to short-term borrowing to fund the Leucadia acquisition, as compared to $7 in the prior year quarter.

During the second quarter of 2006 the income tax provision of $0.4 million was 10% of pre tax loss versus 40% in the prior year quarter primarily as a result of the exclusion of the $5.2 million of In-process research and development expense from taxable income in 2006 partially offset by increased R&D credits realized during the quarter. The tax provision continues to be a non-cash item, since we have significant deferred tax assets relating to tax loss carryforwards.

Comparison of the six months ended June 30, 2006 to 2005

Net revenues for the six months ended June 30, 2006 decreased 11% from the prior year period. Revenues from the IVD urinalysis segment totaled $27.0 million during the current year six month period, up from $25.0 million in the prior year period. Sales of IVD instruments decreased to $12.0 million from $13.4 million, an 11% decrease from the prior year period. The decrease in instrument sales is due a reduction in domestic unit sales of iQ200 analyzers and systems during the current year six month period of 203 as compared to 217 in the prior year period. Sales of IVD consumables and service increased to $15.0 million up from $11.6 million, an increase of $3.4 million or 29%, primarily due to the larger installed base of instruments. Revenues from the sample processing segment increased to $5.7 million from $4.5 million, or 27%. This increase is primarily due to increased sales of centrifuges and DNA processing workstations within this segment.

Consolidated gross profit margins improved to 51% of revenues as compared to 49% during the prior year first half. For the IVD instruments, margins improved to 46% of related revenues as compared to 41% for the prior year first half. The improvement was attributable to reduced material costs through change in vendors for improved quality at lower costs and negotiated lower prices with existing vendors. Margins on IVD consumables and service during the of 56% compared to 58% during the prior year first half. The decline is primarily attributable to the result of the chemistry strip manufacturing operation in Germany acquired last year which is currently operating below capacity and generated a negative gross profit margin of $457 for the current first half. Margins on our sample processing instruments and supplies were 2% lower during the current quarter due to an increase in OEM customer mix.

Marketing and selling expenses totaled $5.0 million for the six months ended June 30, 2006 as compared to $4.9 million in the prior year six month period and as a percentage of sales such expenses were 15% in 2006 as compared to 16% in 2005. During the current half we incurred additional sales and marketing personnel costs of approximately $0.2 million and additional stock based compensation expense of $0.1 million which was partially offset by a reduction of trade shows and advertising expense of $0.1 million and a reduction in professional fees of $0.1 million.

General and administrative expenses increased to $4.9 million from $3.0 million during the prior year period. The increase includes approximately $0.5 million of expenses associated with the transition to a new Chief Financial Officer (consisting of severance for the retiring CFO and recruiting and relocation expense to retain the new CFO), $0.3 million of incremental stock based compensation resulting for the adoption of SFAS No. 123R in 2006, $0.3 million of bad debt expense, $0.5 million of additional personnel costs, and $0.1 million of additional professional fees.

Net research and development expense as shown in the accompanying statements of operations amounted to $3.6 million during the current six month period as compared to $2.0 million in the prior year six month period. Research and Development expenses were net of reimbursed costs received from governmental research and development grants, which amounted to $959 and $1,026 during the six months ended June 30, 2006 and 2005. Approximately $0.4 million of the increase in Research and Development expense included approximately $0.4 million relates to molecular diagnostics bacteria and cancer detection projects.

Interest income during the six months ended June 30, 2006 amounted to $505, an increase from $176 in the prior year and relates primarily to our investment of excess funds during the year plus interest received on sales-type equipment leases. Interest expense was $12 for the first six months of 2006 and 2005.

During the first half of 2006 the income tax provision of $1.4 million was -97% of pretax income (loss) versus 40% in the prior year first half primarily as a result of the exclusion of the $5.2 million of In-process research and development expense from taxable income in 2006 partially offset by increased R&D credits realized during the quarter. The tax provision continues to be a non-cash item, since we have significant deferred tax assets relating to tax loss carryforwards.

Off-Balance Sheet Arrangements

At June 30, 2006 and 2005, 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 sample processing instruments and related supplies. During the first six months of 2006, our cash and cash equivalents decreased $2.6 million to $16.5 million.

Operating Cash Flows.Cash provided by operations for the current year six month period amounted to $1,706 compared to cash provided by operations of $1,788 in the prior year. Cash provided by operations for the six months resulted primarily from the net loss adjusted for non-cash items ($5.8 million) partially offset by an increase in inventory ($2.2 million) due to anticipated demand for our products, an increase in sales-type leases ($1.0 million) financed internally and an increase in accounts payable and accrued liabilities ($1.5 million).

The relationship of receivables to revenues has improved to 60 days sales in accounts receivable as compared to 69 days sales in accounts receivable at the beginning of the year. The number of days of sales in inventory has increased to 109 days as compared to 86 days at the beginning of the year due to anticipated demand.

Investing Activities.Cash used in investing activities totaled $5.4 million during the six months ended June 30, 2006 ($0.5 million in 2005) primarily as a result of cash paid to acquire Leucadia Technologies ($3.3 million) and additions to property and equipment of $1.9 million ($0.5 million in 2005). Capital expenditures in 2006 included $1.3 million for facility expansion and upgrading in our California and Massachusetts locations.

Financing Activities.For the six months ended June 30, 2006, financing activities provided $1.1 million of cash, compared to $2.8 million provided during the prior year. During the current year, we received $1.1 million from issuances of shares of common stock compared to $2.9 million in the prior year.

We currently have a credit facility with a commercial bank consisting 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 June 30, 2006, 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 June 30, 2006, 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.

New Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of Accounting Research Bulletin No. 43, Chapter 4.” SFAS No. 151 requires that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recorded as current period charges and that the allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. SFAS No. 151 is effective for us on January 1, 2006. The adoption of SFAS No. 151 did not have a material impact on our consolidated financial statements.

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 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 first-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

Cautionary Statements and Risk Factors

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:

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

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

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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,

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increasing competition from imaging and non-imaging based in-vitro diagnostic products.

Set forth below are additional significant uncertainties and other factors affecting forward-looking statements. The readers should understand that the 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.

Risks Related to Our Business

Our success depends largely on the acceptance of our iQ200 product line.

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 product line in order to increase its market penetration, expand sales into new geographic areas and enhance and expand its system features. 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 sale of our future products and systems will grow at the rates expected by our management.

Any failure to successfully develop new products could adversely affect our business.

Our commercial success depends on the timely development of new products that are needed for future growth. These new products depend on our success in demonstrating technical feasibility and achieving cost targets and functionality demanded by the market. Significant delays in product releases will result in budget over-runs and lower revenues.

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 our technologies. 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 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 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 June 30, 2006, we have deferred tax assets of approximately $8.7 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. Management believes 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. Although the Company believes that the deferred tax asset is recoverable, there is no assurance that we will be able to generate taxable income in the years that the differences reverse. Also, if we 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.

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.

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 until 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 consumables 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 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 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 Sample Processing are manufactured in a single facility for each division, except for our IVD consumables. Our manufacturing facilities 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 US and internationally. In particular, if our growth continues, it 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 the management of our expenses. Our inability to scale our business appropriately or otherwise adapt 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:

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variation in demand for our products, including seasonality;

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

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

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our ability to control costs;

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

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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 international markets is subject to risks including:

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

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

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unexpected changes in regulatory requirements; and

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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:

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political instability;

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changes in diplomatic and trade relationships;

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general economic fluctuations in specific countries or markets; and

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changes in regulatory schemes.

Any of the above mentioned 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 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 US 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 profitability. Similarly, we are also exposed to currency fluctuations with respect to the exportation of our products. All of our sales are denominated in US Dollars. Accordingly, any fluctuation in the exchange rate between the US 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. We had no debt at June 30, 2006.

Interest Rates

At June 30, 2006, 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 purchases of products from a Japanese manufacturer. Our purchases of products from our Japanese supplier are negotiated annually and may be affected by changing foreign currency rates.

Item 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined by paragraph (e) of Exchange Act Rules 13a-15 or 15d-15, 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. Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2006, the end of the period covered by this report, and based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

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.

PART II

OTHER INFORMATION

Item 1A.

Risk Factors

A restated description of the risk factors associated with our business is included under “Cautionary Statements and Risk Factors” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in Item 2 of Part I of this report. This description includes any material changes to and supersedes the description of the risk factors associated with our business previously disclosed in our 2005 Annual Report on Form 10-K and is incorporated herein by reference.

Item 6.

Exhibits


Exhibit Number	Description	Reference Document
2.1	Merger Agreement, dated April 3, 2006, by and among Iris International, Inc., IRIS Molecular Diagnostics, Inc., Leucadia Technologies, Inc., and, Dr. Thomas H. Adams.	(1)

4.1	Registration Rights Agreement, dated April 3, 2006, by and between Iris International, Inc. and Dr. Thomas H. Adams.	(1)

10.1	Employment Agreement by and between Dr. Thomas H. Adams and Iris International, Inc., dated April 3, 2006.	(1)

10.2	Separation Agreement by and between Martin G. Paravato and IRIS International, Inc., dated May 11, 2006.	(2)

10.3	Key Employee Agreement by and between Donald Mueller and IRIS International, Inc., dated May 1, 2006.	(2)

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

(1)	Incorporated by reference to our Current Report on Form 8-K dated May 9, 2006, filed May 16, 2006.

(2)	Incorporated by reference to our Current Report on Form 8-K dated April 3, 2006, filed April 7, 2006.

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: August 9, 2006


IRIS INTERNATIONAL, INC.

By:		/s/ DONALD C. MUELLER
		Donald C. Mueller Chief Financial Officer

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Iris International (IRIS) Inactive 10-Q2006 Q2 Quarterly report

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