Standard Diversified (SDI) 10-Q 2006 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the Quarterly Period Ended March 31, 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 Number 000-22400

STRATEGIC DIAGNOSTICS INC.

(Exact name of Registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)
56-1581761
(I.R.S. employer
identification no.)

111 Pencader Drive
Newark, Delaware
(Address of principal executive offices)

19702
(Zip Code)

Registrant’s telephone number, including area code: (302) 456-6789

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: No:

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

 Large Accelerated Filer Accelerated Filer          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:

As of March 31, 2006 there were 19,570,339 outstanding shares of the Registrant’s common stock, par value $.01 per share.

STRATEGIC DIAGNOSTICS INC.

INDEX

	Item	Page
PART I FINANCIAL INFORMATION
	ITEM 1. Financial Statements
	Consolidated Balance Sheets – March 31, 2006 and December 31, 2005	2
	Consolidated Statements of Operations – Three months ended March 31, 2006 and 2005	3
	Consolidated Statements of Cash Flows – Three months ended March 31, 2006 and 2005	4
	Notes to Consolidated Interim Financial Statements	5
	ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
	ITEM 3. Quantitative and Qualitative Disclosures About Market Risk	15
	ITEM 4. Controls and Procedures	15
PART II OTHER INFORMATION		16
	ITEM 6. Exhibits	16
SIGNATURES		16

1

PART I.– FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

STRATEGIC DIAGNOSTICS INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)
(unaudited)

	March 31, 2006			December 31, 2005
ASSETS
Current Assets :
Cash and cash equivalents	$	9,389		$	10,009
Receivables, net		3,464			3,242
Inventories		2,955			3,212
Deferred tax asset		1,002			1,048
Other current assets		962			362
Total current assets		17,772			17,873
Property and equipment, net		3,777			3,884
Other assets		3			3
Deferred tax asset		8,390			8,101
Intangible assets, net		6,442			6,800
Total assets	$	36,384		$	36,661
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities :
Accounts payable	$	455		$	464
Accrued expenses		1,053			1,439
Deferred revenue		186			207
Current portion of long term debt		211			211
Total current liabilities		1,905			2,321
Long-term debt		509			562
Stockholders’ Equity:
Preferred stock, $.01 par value, 20,920,648 shares authorized, no shares issued or outstanding		—			—
Common stock, $.01 par value, 35,000,000 shares authorized, 19,965,566 and 19,916,635 issued and outstanding at March 31, 2006 and December 31, 2005, respectively		200			200
Additional paid-in capital		38,026			37,936
Accumulated deficit		(4,282	)		(4,374	)
Cumulative translation adjustments		26			16
Total stockholders’ equity		33,970			33,778
Total liabilities and stockholders’ equity	$	36,384		$	36,661

The accompanying notes are an integral part of these statements.

2

STRATEGIC DIAGNOSTICS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

	Three Months Ended March 31,
		2006		2005
NET REVENUES:
Product related	$	6,268	$	6,677
Total net revenues		6,268		6,677
OPERATING EXPENSES:
Manufacturing		2,940		2,817
Research and development		697		807
Selling, general and administrative		2,563		2,475
Total operating expenses		6,200		6,099
Operating income		68		578
Interest income, net		83		27
Income before taxes		151		605
Income tax expense		59		186
Net income		92		419
Basic net income per share	$	0.005	$	0.022
Shares used in computing basic net income per share		19,960,000		19,458,000
Diluted net income per share	$	0.005	$	0.021
Shares used in computing diluted net income per share		20,113,000		19,614,000

The accompanying notes are an integral part of these statements.

3

STRATEGIC DIAGNOSTICS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Three Months Ended March 31,
	2006			2005
Cash Flows from Operating Activities :
Net income	$	92		$	419
Adjustments to reconcile net income to net cash provided by (used in) operating activities :
Depreciation and amortization		248			231
Stock-based compensation expense		66			31
Deferred income tax provision		59			186
(Increase) decrease in :
Receivables		(222	)		(223	)
Inventories		257			(69	)
Other current assets		(600	)		(696	)
Other assets		—			(3	)
Increase (decrease) in :
Accounts payable		(9	)		(416	)
Accrued expenses		(386	)		114
Deferred revenue		(21	)		—
Net cash used in operating activities		(516	)		(426	)
Cash Flows from Investing Activities :
Purchase of property and equipment		(80	)		(41	)
Purchase of intangible assets		—			(17	)
Net cash used in investing activities		(80	)		(58	)
Cash Flows from Financing Activities :
Proceeds from exercise of incentive stock options		12			406
Proceeds from employee stock purchase plan		7			2
Repayments on financing obligations		(53	)		(53	)
Net cash provided by (used in) financing activities		(34	)		355
Effect of exchange rate changes on cash		10			(20	)
Net decrease in cash and cash equivalents		(620	)		(149	)
Cash and cash equivalents, beginning of period		10,009			8,096
Cash and cash equivalents, end of period	$	9,389		$	7,947
Supplemental Cash Flow Disclosure :
Cash paid for taxes		7			8
Cash paid for interest		12			11

The accompanying notes are an integral part of these statements

4

STRATEGIC DIAGNOSTICS INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS

(in thousands, except share and per share data)

(unaudited)

1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES :

Business

Strategic Diagnostics Inc. and its subsidiaries (the “Company”) develops, manufactures and markets antibody products and analytical test kits to a diverse customer base, across multiple industrial and human health markets. By applying its core competency of creating custom antibodies to assay development, the Company produces unique, sophisticated diagnostic testing and reagent systems that are responsive to customer diagnostic and information needs. Customers benefit with quantifiable “return on investment” by reducing time, labor, and/or material costs. All this is accomplished while increasing accuracy, reliability and actionability of essential test results. The Company is focused on sustaining this competitive advantage by leveraging its expertise in immunology, proteomics, bio-luminescence and other bio-reactive technologies to continue its successful customer-focused research and development efforts.

Basis of Presentation and Interim Financial Statements

The accompanying unaudited consolidated interim financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. In the opinion of management, the accompanying consolidated financial statements include all adjustments (all of which are of a normal recurring nature) necessary for a fair presentation of the results of operations.

Certain amounts have been reclassified to conform to the current period’s presentation.

Revenue Recognition

Revenues composed of sales of immunoassay-based test kits and certain antibodies and immunochemical reagents are recognized upon the shipment of the product and transfer of title or, when related services are provided. Revenues associated with such products or services are recognized when persuasive evidence of an order exists, shipment of product has occurred or services have been provided, the price is fixed and determinable and collectibility is probable. Management is required to make judgments based on actual experience about whether or not collectibility is reasonably assured.

The Company enters into contracts related to the production of custom antibodies, which provide for the performance of defined tasks for a fixed price, with delivery of the product upon completion of production. The standard time to complete a project is typically longer than 30 days, but less than 12 months, and effort is expended over the life of the project. Revenues related to sales of custom antibody projects are recognized when a project’s specifications have been met and the related materials have been shipped.

Fees associated with products and services added on to a custom antibody project subsequent to delivery of the initial project are billed monthly and recognized as revenue as the services and other deliverables are provided.

Use of Estimates

The preparation of the consolidated interim financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated interim financial statements, and the reported amounts of revenues and expenses during the period. These estimates include those made in connection with assessing the valuation of accounts receivable, inventories and deferred tax assets. Actual results could differ from these estimates.

New Accounting Pronouncement

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) 123R, “Share-Based Payment,” using the modified prospective transition method and, accordingly, has not retroactively adjusted results from prior periods. SFAS 123R revises SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123R requires that compensation costs related to share-based payment transactions be recognized in the financial statements (with limited exceptions).

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In prior years, the Company applied the intrinsic-value-based method to account for its incentive plan stock options and had adopted only the disclosure requirements of SFAS No. 123. In recording stock-based compensation expense, the Company recognized in its consolidated financial statements the fair value of restricted stock, the intrinsic value of options wherein the current market price of the underlying stock, at the grant date, exceeded the exercise price and the discount from the market price of common stock acquired by employees under a stock purchase plan. Under SFAS 123R, the Company recognizes stock-based compensation expense based on the fair value of both restricted stock and stock options and the employee discount. Stock-based compensation expense is recognized on a straight-line basis ratably over the respective vesting periods for restricted stock and stock options, and in the period the employee discount is realized.

On December 27, 2005, the Board of Directors of the Company approved the accelerated vesting, effective as of December 31, 2005, of all unvested stock options granted to employees and non-employee directors from 2002 through 2005 under the Company’s 2000 Stock Incentive Plan, as well as options granted to the Company’s Chief Executive Officer under his original employment agreement. The acceleration of vesting of these options had the effect of reducing non-cash compensation expense that would have been recorded in the Company’s statement of operations in future periods in anticipation of the adoption of SFAS 123R. The Board’s decision was based on such factors as: 48% of the options were “out of the money”; the options generally would vest over the next three years; and the Company had decided to rely on restricted stock as opposed to options in future incentive compensation awards.

As a result of the acceleration, options to purchase approximately 381,000 shares of the Company’s common stock (which represented 23% of the Company’s then currently outstanding stock options) became exercisable on December 31, 2005. The accelerated options ranged in exercise price from $2.51 to $4.12 per share and, at December 31, 2005, the weighted average exercise price of the accelerated options was $3.41 per share. Of the 381,000 shares that became exercisable, approximately 199,000 of these shares were “in the money” as of December 27, 2005, meaning that the exercise price was at or below the price of the Company’s common stock on that date. The weighted average exercise price of the “in the money” shares at that date was $3.02. The options subject to acceleration included options to purchase approximately 222,000 shares held, in the aggregate, by executive officers and approximately 48,000 shares held, in the aggregate, by non-employee directors of the Company. Of these 270,000 shares, approximately 147,000 were “in the money” as of December 27, 2005. The fair value of the unvested portion of accelerated options at December 31, 2005 totaled $975 and would have been expensed in future years as follows: $682 in 2006, $228 in 2007 and $65 in 2008.

Consequently, the adoption of SFAS 123R did not have an impact on the Company’s results of operations and financial position in the first quarter of 2006.

The Company also considers the effect of expected forfeitures of equity grants in recording stock-based compensation expense under FAS 123R. Under the new standard, the Company estimates an expected forfeiture rate for grants of equity instruments, and adjusts stock-based compensation expense for its effect. This effect is adjusted to reflect actual forfeitures as equity instruments vest. Previously under APB No. 25, the Company recognized the actual effect of forfeitures when they occurred.

The new accounting standard also requires that certain income tax benefits realized upon the exercise of stock options, or the vesting of restricted stock, be reported as financing cash flows. Previously, the tax benefits resulting from the income tax deduction, recognized for financial reporting purposes, were reported as operating cash flows. The effect of this change is a decrease in operating cash flows and an increase in financing cash flows.

The Company anticipates determining the fair values of stock options awarded in the future by using the Black-Scholes valuation model.

The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards granted prior to the adoption of SFAS 123R.

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	Three Months Ended March 31, 2005
Net income	$	419
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		21
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(184	)
Net income - as adjusted	$	256
Earnings per share:
Basic—as reported	$	0.02
Basic—as adjusted	$	0.01
Diluted—as reported	$	0.02
Diluted—as adjusted	$	0.01

The weighted average fair value at the date of grant for options granted during the first quarter of 2005 of $2.25 was estimated using the Black-Scholes valuation model. The assumptions used in the Black-Scholes model were as follows: dividend yield of 0%, expected volatility of 86%, risk-free interest rate of 3.71% and an expected option life of 5 years.

Comprehensive Income

Comprehensive income consists of the following for each period:

	Three Months Ended March 31,
	2006		2005
Net income	$	92	$	419
Currency translation adjustment		10		(20	)
Total comprehensive income	$	102	$	399

2. BASIC AND DILUTED INCOME PER SHARE:

Basic earnings per share (EPS) is computed by dividing net income available for common stockholders by the weighted-average number of common shares outstanding during the period. Diluted EPS is similar to basic EPS, except that the dilutive effect of converting or exercising all potentially dilutive securities is also included in the denominator. The Company’s calculation of diluted EPS includes the dilutive effect of exercising stock options into common shares.

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	Three Months Ended March 31,
	2006	2005
Weighted avg. common shares outstanding	19,960,431	19,458,182
Shares used in computing basic net income per share	19,960,431	19,458,182
Stock options	153,005	155,603
Shares used in computing diluted net income per share	20,113,436	19,613,785

3. STOCK-BASED COMPENSATION

The Company has a stock incentive plan (the “2000 Plan”), which authorizes the granting of incentive and nonqualified stock options and restricted stock. Under the 2000 Plan, executives, key employees and outside directors receive awards of options to purchase common stock or restricted stock. Incentive stock options are granted at not less than 100% of fair market value at the date of grant (110% for stockholders owning more than 10% of the Company’s common stock). Nonqualified stock options are granted at not less than 85% of fair market value at the date of grant. A maximum of 4,000,000 shares of common stock are issuable under the 2000 Plan. Stock options granted under the 2000 Plan have a maximum contractual term of 10 years. The 2000 Plan provides for accelerated vesting if there is a change of control (as defined in the 2000 Plan).

The Company also has an Employee Stock Purchase Plan (the “ESPP”). The ESPP allows eligible full-time employees to purchase shares of common stock at 90 percent of the lower of the fair market value of a share of common stock on the first or last day of the quarter. Eligible employees are provided the opportunity to acquire Company common stock during each quarter. No more than 661,157 shares of common stock may be issued under the ESPP. Such stock may be unissued shares or treasury shares of the Company or may be outstanding shares purchased in the open market or otherwise on behalf of the ESPP. Under SFAS 123R, the Company’s ESPP is compensatory. Therefore, the Company is required to recognize compensation expense related to the discount from market value of shares sold under the ESPP.

Stock based compensation expense and associated income tax benefit recognized in the first quarter of 2006 primarily related to the amortization of restricted stock awards and totaled $66 and $26, respectively. Cash received from options exercised and employee purchases of common stock under the ESPP totaled $19 for the three months ended March 31, 2006.

The intrinsic value of options exercised during the three month period ended March 31, 2006 and 2005 was $8,576 and $40,500, respectively.

Information with respect to the activity of outstanding stock options granted under the 2000 Plan and options granted separately from the 2000 Plan for the three months ended March 31, 2006 is summarized as follows:

	Number of Shares		Price Range					Weighted Average Exercise Price
Balance, December 31, 2005	1,660,500		$	1.88	-	$	6.94	$	3.68
Cancelled	(105,000	)	$	3.15	-	$	4.08	$	3.83
Exercised	(6,400	)	$	1.88	-	$	1.88	$	1.88
Balance, March 31, 2006	1,549,100		$	1.88	-	$	6.94	$	3.67

During the three month period ended March 31, 2005 there were 98,500 options granted with a weighted average grant date fair value of $3.25 per share.

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The following table provides additional information about the Company’s stock options outstanding and exercisable at March 31, 2006:

				Options Outstanding Weighted Average				Options Exercisable Weighted Average
Range of Exercise Prices			Number of Options	Remaining Contractual Life	Exercise Price	Intrinsic Value	Number of Options	Remaining Contractual Life	Exercise Price	Intrinsic Value
$ 1.88	-	$ 2.65	290,600	3.9 Years	$ 2.19		290,600	3.9 Years	$ 2.19
$ 2.88	-	$ 4.69	1,107,250	6.7 Years	$ 3.71		1,107,250	6.7 Years	$ 3.71
$ 5.17	-	$ 6.94	151,250	5.3 Years	$ 6.23		151,250	5.3 Years	$ 6.23
$ 1.88	-	$ 6.94	1,549,100	6.0 Years	$ 3.67	$542,185	1,549,100	6.0 Years	$ 3.67	$ 542,185

A summary of the status of the Company’s unvested restricted stock as of December 31, 2005 and changes during the three month period ended March 31, 2006 is presented below.

	Number of Shares		Weighted Average Fair Value
Unvested at December 31, 2005	121,013		$	3.48
Vested	(7,000	)	$	3.35
Forfeited	(867	)	$	3.05
Unvested at March 31, 2006	113,146		$	3.47

During the three month period ended March 31, 2006, there was no restricted stock granted. At March 31, 2006, there were outstanding 194,567 shares of restricted stock with a value (based on the market price for the stock at the date of grant) totaling $711 and a weighted average remaining term of 1.13 years. Restricted stock granted is generally scheduled to vest over periods of two to five years. The cost of the grant is charged to operations over the vesting period. The total unamortized fair value of unvested restricted stock, at March 31, 2006, was $248. During the three month period ended March 31, 2005, there were 44,700 shares of restricted stock granted with a weighted-average grant date fair value of $3.05 per share.

4. INVENTORIES:

The Company’s inventories are valued at the lower of cost or market. For inventories that consist primarily of test kit components, bulk serum and antibody products, cost is determined using the first in, first out method. For inventories that consist of costs associated with the production of custom antibodies, cost is determined using the specific identification method. At March 31, 2006 and December 31, 2005, inventories consisted of the following:

	March 31, 2006		December 31, 2005
Raw materials	$	1,406	$	1,181
Work in progress		376		498
Finished goods		1,173		1,533
	$	2,955	$	3,212

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5. INTANGIBLE ASSETS:

At March 31, 2006 and December 31, 2005, intangible assets consisted of the following:

	March 31, 2006			December 31, 2005			Lives
Goodwill	$	4,863		$	5,168		N/A
Other		3,017			3,017		2-20
Less – accumulated amortization		(1,438	)		(1,385	)
Net intangible assets	$	6,442		$	6,800

6. DEBT:

On May 5, 2000, the Company entered into a financing agreement with a commercial bank. This agreement provides for up to a $5,000 revolving line of credit, none of which was outstanding and approximately $2,825 of which was available at March 31, 2006, based on eligible assets. The revolving line of credit bears a variable interest rate of between 1.75% and 2.75% over LIBOR depending upon the ratio of the Company’s funded debt to EBITDA, and is subject to a borrowing base determined by the Company’s eligible accounts receivable. The Company’s annual effective rate of interest on this line of credit, taking into account the variable interest rate and LIBOR, was approximately 6.57% at March 31, 2006.

On December 13, 2001, the Company entered into an agreement with a commercial bank to finance the construction of new facilities at its Windham, Maine location. This agreement provided for up to $1,500 in financing, $720 of which was outstanding at March 31, 2006, and is repayable over seven years, with principal payments that began on October 1, 2002. The loan bears a variable interest rate of between 2% and 3% over LIBOR depending upon the ratio of the Company’s funded debt to EBITDA, as defined. Payments are due monthly, with equal amortization of principal payments plus interest. The Company’s annual effective rate of interest on this loan at March 31, 2006 was approximately 6.82%.

Under the terms of the above financing, the Company is required to meet certain quarterly financial covenants that include a ratio of EBITDA to current maturities of debt plus interest and cash paid for taxes greater than 1.50 and a ratio of funded debt to EBITDA not to exceed 3.25. Under the covenant, the Company met all of its financial covenants with respect to this indebtedness at March 31, 2006 and expects that it will be able to meet all of its financial covenants with respect to this indebtedness for 2006.

At of March 31, 2006 and December 31, 2005, the outstanding balance on all of the Company’s commercial bank debt was $720 and $773, respectively. This indebtedness is secured by substantially all of the Company’s assets.

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

Forward-Looking Statements

This Form 10-Q contains certain forward-looking statements reflecting the current expectations of Strategic Diagnostics Inc. and its subsidiaries (the “Company” or “SDI”). These statements include, among others, statements regarding: the Company’s intentions with respect to future spending on research and development; the development, market acceptance and sales of tests for food-borne pathogens and related growth media; the size and nature of demand in the markets for the Company’s products and related effects on operating results; the need for water quality and toxicity tests; approval and validation by third parties of the Company’s food pathogen tests; the performance of the Company’s testing products; sales of the Company’s antibodies; timing of new product introductions and other information that may be predictive of future operating results; the Company’s ability to reduce operating expenses; and the Company’s ability to improve operating results thus enabling it to meet future loan covenants. In addition, when used in this Form 10-Q, the words “anticipate,” “enable,” “estimate,” “intend,” “expect,” “believe,” “potential,” “may,” “will,” “should,” “project” and similar expressions as they relate to the Company are intended to identify said forward-looking statements. Investors are cautioned that all forward-looking statements involve risks and uncertainties, which may cause actual results to differ from those anticipated at this time. Such risks and uncertainties include, without limitation, changes in demand for products, delays in product development, delays in market acceptance of new products, retention of customers, attraction and retention of management and key employees, adequate supply of raw materials, inability to obtain or delays in obtaining third party approvals, or required government approvals, the ability to meet increased market demand, competition, protection of intellectual property, non-infringement of intellectual property, seasonality, the ability to obtain financing and other factors more fully described in the Company’s public filings with the U.S. Securities and Exchange Commission.

10

Background

We provide bio-services and industrial bio-detection services. Bio-services include providing custom antibody production services and antibody reagents to the diagnostic, pharmaceutical, bio-medical and academic research and development markets. Industrial bio-detection services include providing test kits for assessing the health, safety and quality of food, water and the environment.

Our primary core competency is the development and manufacture of antibodies. Such antibodies are used by medical diagnostic and pharmaceutical companies, research institutions and incorporated into test kits manufactured by us for the detection of a wide variety of substances related to food safety and water quality.

Our food safety product group includes tests to detect specific traits in genetically engineered plants, tests to detect Genetically Modified (GM) traits in food ingredients and food fractions, tests to detect naturally occurring fungi in grains (mycotoxins) and tests for food pathogens.

Our water quality product group includes tests to detect toxicity in drinking water, industrial process water and wastewater, and tests to detect specific traits in soil and other waste matter for use at environmental remediation projects, hazardous waste operations and other applications.

Our antibody product group provides a wide array of antibodies and antibody services, including hybridoma development, calibrators, antigens and reagents and the production of monoclonal and polyclonal antibodies. Such antibodies are incorporated into test kits we manufacture as described above and diagnostic and therapeutic products, and used in clinical research.

We sell products and services in the food safety, water quality and antibody market categories through our U.S. direct sales force, a network of over 50 distributors in Canada, Mexico, Latin America, Europe and Asia and our corporate partners. These products and services are sold to a wide range of customers including water utilities, food processors, pharmaceutical, biotechnology and diagnostic companies and major biomedical research centers.

Adoption of New Accounting Pronouncement

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) 123R, “Share-Based Payment,” using the modified prospective transition method and, accordingly, has not retroactively adjusted results from prior periods. SFAS 123R revises SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123R requires that compensation costs related to share-based payment transactions be recognized in the financial statements (with limited exceptions).

In prior years, the Company applied the intrinsic-value-based method to account for its incentive plan stock options and had adopted only the disclosure requirements of SFAS No. 123. In recording stock-based compensation expense, the Company recognized the costs of restricted stock in its consolidated financial statements and those options wherein the current market price of the underlying stock, at the grant date, exceeded the exercise price. Under SFAS 123R, the Company recognizes stock-based compensation expense based on the fair value of both restricted stock and stock options. Stock-based compensation expense is recognized on a straight-line basis ratably over the respective vesting periods.

On December 27, 2005, the Board of Directors of the Company approved the accelerated vesting, effective as of December 31, 2005, of all unvested stock options granted to employees and non-employee directors from 2002 through 2005 under the Company’s 2000 Stock Incentive Plan, as well as options granted to the Company’s Chief Executive Officer under his original employment agreement. The acceleration of vesting of these options had the effect of reducing non-cash compensation expense that would have been recorded in the Company’s statement of operations in future periods in anticipation of the adoption of SFAS 123R. The Board’s decision was based on such factors as: 48% of the options were “out of the money”; the options generally would vest over the next three years; and the Company had decided to rely on restricted stock as opposed to options in future incentive compensation awards.

As a result of the acceleration, options to purchase approximately 381,000 shares of the Company’s common stock (which represented 23% of the Company’s then currently outstanding stock options) became exercisable on December 31, 2005. The accelerated options ranged in exercise price from $2.51 to $4.12 per share and, at December 31, 2005, the weighted average exercise price of the accelerated options was $3.41 per share. Of the 381,000 shares that became exercisable, approximately 199,000 of these shares were “in the money” as of December 27, 2005, meaning that the exercise price was at or below the price of the Company’s common stock on that date. The weighted average exercise price of the “in the money” shares at that date was $3.02. The options subject to acceleration included options to purchase approximately 222,000 shares held, in the aggregate, by executive officers and approximately 48,000 shares held, in the aggregate, by non-employee directors of the Company. Of these 270,000 shares, approximately 147,000 were “in the money” as of December 27, 2005. The fair value of the unvested portion of accelerated options at December 31, 2005 totaled $975 and would have been expensed in future years as follows: $682 in 2006, $228 in 2007 and $65 in 2008.

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Consequently, the adoption of SFAS 123R did not have an impact on the Company’s results of operations and financial position in the first quarter of 2006.

The Company also considers the effect of expected forfeitures of equity grants in recording stock-based compensation expense under FAS 123R. Under the new standard, the Company estimates an expected forfeiture rate for grants of equity instruments, and adjusts stock-based compensation expense for its effect. This effect is adjusted to reflect actual forfeitures as equity instruments vest. Previously under APB No. 25, the Company recognized the actual effect of forfeitures when they occurred.

The new accounting standard also requires that certain income tax benefits realized upon the exercise of stock options, or the vesting of restricted stock, be reported as financing cash flows. Previously, the tax benefits resulting from the income tax deduction, recognized for financial reporting purposes, were reported as operating cash flows. The effect of this change is a decrease in operating cash flows, and an increase in financing cash flows.

The Company anticipates determining the fair values of stock options awarded in the future by using the Black-Scholes valuation model.

Results of Operations

Three Months Ended March 31, 2006 versus March 31, 2005

Revenues for the first quarter of 2006 decreased 6.1% to $6.3 million, compared to $6.7 million for the same period in 2005. The negative impact on revenues in the first quarter of 2006 was primarily a result of lower volume in bulk antibody product sales, partially offset by a 55.4% increase in sales of products for the detection of food pathogens.

Gross profits (defined as total revenues less manufacturing costs) for the first quarter of 2006 were $3.3 million compared to $3.9 million in the year ago period. Gross margins were 53.1% and 57.8% for the first quarters of 2006 and 2005, respectively. The negative margin impact was also associated with the change in product mix, and increased manufacturing expenses within the antibody product group.

Operating expenses for the first quarter of 2006 increased 1.7% to $6.2 million, compared to $6.1 million for the first quarter of 2005.

Research and development spending was $697,000, or 11.1% of net revenues, in the first quarter of 2006, compared to $807,000, or 12.1%, in the first quarter 2005. First quarter 2005 research and development expense contained a $165,000 non-recurring expenditure in software upgrades for the Microtox^® test equipment.

Selling, general and administrative expenses were $2.6 million for the first quarter of 2006, compared to $2.5 million for the same quarter in 2005. The overall increase in expenses were associated with the Company’s previously announced plans to increase sales and marketing activity in support of its new Genomic Antibodies™ platform and the launch of new food safety products in the third quarter of this year.

The Company recorded interest income of $83,000 in the first quarter of 2006 compared to $27,000 in the prior year first quarter. The increase was primarily due to higher levels of invested cash and increased interest rates received on invested cash during the 2006 period.

Pre-tax income totaled $151,000 for the three months ended March 31, 2006 compared to pre-tax income of $605,000 for the same period in 2005. Net income in the first quarter of 2006 was $92,000, or $0.005 per diluted share, compared to $419,000, or $0.022 per diluted share, for the same period in 2005. Diluted shares utilized in these computations were 20.1 million and 19.6 million for the first quarters of 2006 and 2005, respectively.

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The Company’s effective tax rate of 39% for the first quarter of 2006 is above the federal and state statutory rates primarily due to expenses incurred that are not deductible for tax purposes.

Food Safety Products

Food safety revenues were $2.6 million in the first quarter of 2006, compared to $2.5 million in the first quarter of 2005, as a result of 55.4% growth in food pathogen test sales. The food safety product group includes the Company’s sales of food pathogen tests, and agricultural test products. Food pathogens now comprise approximately 34% of the total product group, compared to approximately 23% in the 2005 first quarter. The Company had previously announced that it anticipated these weaker sales it in fact experienced in its agricultural product line due to lost business in the Brazilian soy testing market.

Water and Environmental Products

Water and environmental products revenue decreased 5.4% in the first quarter of 2006 as compared to the same quarter in 2005, but was $1.2 million for both quarters. The decrease resulted from a continued reduction in the number of large remediation projects and pricing pressure from some niche competitors in the U.S. The 5.4% rate of attrition in 2006 is lower than the 16.4% attrition rate seen in the first quarter of 2005 as compared to the first quarter of 2004. Contributing to this improvement are the water quality revenues of our UK affiliate which grew 21.2% in the first quarter of 2006 compared to the same quarter in 2005.

Also, in February 2006 the Company announced that its Microtox^® Bioassay technology was awarded the Designation and Certification as an “Approved Anti-Terror Technology” under the Support Anti-Terrorism by Fostering Effective Technologies Act of 2002 through the Department of Homeland Security. Accordingly, Microtox^® has been placed on the “Approved Products List for Homeland Security,” which the Company believes will increase awareness among users seeking endorsed technologies to ensure the quality and security of drinking water supplies, and liability protection afforded under the SAFETY Act.

Antibody Products

Antibody revenues decreased 14.8% to $2.5 million for the first quarter of 2006, compared to $3.0 million for the same quarter in 2005. The Company believes that the decline was primarily due to cyclical order patterns for bulk antibodies. The Company recently announced that Berlex Inc., a U.S. affiliate of Schering AG, Germany, has extended and amended its Services Agreement to include SDI’s newly commercialized polyclonal and monoclonal Genomic Antibodies™.

Liquidity and Capital Resources

The net cash used in operating activities of $516,000 for the first quarter of 2006 was primarily the result of increases in current assets and decreases in accounts payable levels. The increase in current assets was primarily the result of the purchase of insurance for the 2006 business year, while the decrease in accounts payable is primarily attributable to the purchasing pattern used by the Company in the current three-month cycle.

Net cash used in investing activities of $80,000 for the first quarter of 2006 was primarily related to the capital expenditures for the period. This compares to net cash used in investing activities of $58,000 for the first quarter of 2005, which was driven by capital expenditures for the period of $41,000 and $17,000 for the purchase of technology licenses. The capital expenditures for 2006 and 2005 are primarily related to purchases of laboratory and manufacturing equipment.

Net cash used in financing activities of $34,000 for the first quarter of 2006 and net cash provided by financing activities for the first quarter of 2005 of $355,000 were primarily driven by proceeds from the exercise of stock options, which was partially offset by net repayments of outstanding debt.

The Company’s working capital, current assets less current liabilities, increased $315,000 to $15.87 million at March 31, 2006 from $15.55 million at December 31, 2005, primarily due to the increase in current assets and reduction in accounts payable as described above. Outstanding debt decreased $53,000 from $773,000 at December 31, 2005 to $720,000 on March 31, 2006, due to scheduled repayments.

On May 5, 2000, the Company entered into a financing agreement with a commercial bank. This agreement provides for up to a $5.0 million revolving line of credit, none of which was outstanding and approximately $2.82 million of which was available at March 31, 2006, based on eligible assets.

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The revolving line of credit bears a variable interest rate of between 1.75% and 2.75% over LIBOR depending upon the ratio of the Company’s funded debt to EBITDA, and is subject to a borrowing base determined by the Company’s eligible accounts receivable. The Company’s annual effective rate of interest on this line of credit, taking into account the variable interest rate and LIBOR, was approximately 6.57% at March 31, 2006.

On December 13, 2001, the Company entered into an agreement with a commercial bank to finance the construction of new facilities at its Windham, Maine location. This agreement provided for up to $1.5 million in financing, $720,000 of which was outstanding at March 31, 2006, and is repayable over seven years, with principal payments that began on October 1, 2002. The loan bears a variable interest rate of between 2% and 3% over LIBOR depending upon the ratio of the Company’s funded debt to EBITDA. Payments are due monthly, with equal amortization of principal payments plus interest. The Company’s annual effective rate of interest on this loan at March 31, 2006, was approximately 6.82%.

Under the terms of the above financing, the Company is required to meet certain quarterly financial covenants that include a ratio of EBITDA to current maturities of debt plus interest and cash paid for taxes greater than 1.50 and a ratio of funded debt to EBITDA not to exceed 3.25. The Company met all of its financial covenants with respect to this indebtedness at March 31, 2006.

For the quarter ended March 31, 2006, the Company satisfied all of its cash requirements from cash provided by operating activities, cash available and on-hand and from the financing agreements described above. At March 31, 2006, the Company had $509,000 in long-term debt and stockholders’ equity of $33.97 million. Although the Company has no material commitments for capital expenditures at March 31, 2006, it does anticipate that it may spend approximately $1.1 million in 2006 to upgrade or expand certain manufacturing, research & development and office equipment and systems that will drive productivity or generate cost savings, and also to introduce automation into certain manufacturing processes that are currently labor intensive.

Based upon its cash on hand, credit facilities, current product sales and the anticipated sales of new products, the Company believes it has, or has access to, sufficient resources to meet its operating requirements. The Company’s ability to meet its long-term capital needs will depend on a number of factors, including compliance with existing and new loan covenants, the success of its current and future products, the focus and direction of its research and development programs, competitive and technological advances, future relationships with corporate partners, government regulation, the Company’s marketing and distribution strategy, its successful sale of additional common stock and/or the Company successfully locating and obtaining other financing, and the success of the Company’s plan to make future acquisitions. Accordingly, no assurance can be given that the Company will be able to meet the future liquidity requirements that may arise from these inherent and similar uncertainties.

Non-GAAP Financial Measures

The Company presents an EBITDA measure as the Company believes this provides investors and the Company’s management with additional information to measure the Company’s liquidity. EBITDA measures are not a measure of performance under GAAP, and therefore should not be considered in isolation or as a substitute for net income or cash flows from operations. Additionally, the Company’s EBITDA calculations may differ from the EBITDA calculations for other companies.

The calculation of the Company’s EBITDA measure (as discussed above), and the reconciliation of the Company’s EBITDA measure to net cash provided by operating activities for the three months ended March 31, 2006 and 2005, respectively, is as follows (amounts in thousands):

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	Three Months Ended March 31,
	2006			2005
Net cash (used in) provided by operating activities	$	(516	)	$	(426	)
Changes in assets and liabilities:
Receivables		222			223
Inventories		(257	)		69
Other current assets		600			696
Other assets		—			3
Accounts payable		9			416
Accrued expenses		386			(114	)
Deferred revenue		21			—
Stock-based compensation expense		(66	)		(31	)
Interest income, net		(83	)		(27	)
EBITDA	$	316		$	809

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company has exposure to changing interest rates, and is currently not engaged in hedging activities. Interest on approximately $720,000 of outstanding indebtedness is at a variable rate of between 2% to 3% over the published London Interbank Offered Rate (LIBOR), based upon the Company’s ratio of funded debt to EBITDA, and was 3% over LIBOR on average for the year. At the Company’s current level of indebtedness, each 1% change in the variable interest rate will have an effect of $7,000 on the Company’s annual interest expense charges.

The Company conducts operations in United Kingdom. The consolidated financial statements of the Company are denominated in U.S. dollars and changes in exchange rates between foreign countries and the U.S. dollar will affect the translation of financial results of foreign subsidiaries into U.S. dollars for purposes of recording the Company’s consolidated financial results. Historically, the effects of translation have not been material to the consolidated financial results.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Act of 1934, as amended, as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2006, our disclosure controls and procedures were effective to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management, including our principal executive and financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

(b) Change in Internal Control over Financial Reporting

No change in the Company’s internal control over financial reporting occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 6. Exhibits

31.1 Certifications of the Chief Executive Officer of Strategic Diagnostics Inc. required by Rule 13a-14(a) under the Securities Exchange Act of 1934

31.2 Certifications of the Chief Financial Officer of Strategic Diagnostics Inc. required by Rule 13a-14(a) under the Securities Exchange Act of 1934

32.1 Certification of the Chief Executive Officer of Strategic Diagnostics Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002

32.2 Certification of the Chief Financial Officer of Strategic Diagnostics Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002

SIGNATURES

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

	STRATEGIC DIAGNOSTICS INC.
Date: May 15, 2006	/s/ Matthew H. Knight
	Matthew H. Knight President, Chief Executive Officer (Principal Executive Officer)

Date: May 15, 2006	/s/ Anthony J. Simonetta
	Anthony J. Simonetta Vice President – Finance and Chief Financial Officer (Principal Financial and Accounting Officer)

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