Edgar Filing: IRIS INTERNATIONAL INC

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended

March 31, 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 17,501,521 shares of common stock issued and outstanding as of May 5, 2006.

IRIS INTERNATIONAL, INC.

INDEX TO FORM 10-Q


		Page
PART I	FINANCIAL INFORMATION

Item 1.	Financial Statements	3

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

	Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005 (unaudited)	4

	Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005 (unaudited)	5

	Consolidated Statements of Comprehensive Income for the three months ended March 31, 2006 and 2005 (unaudited)	6

	Notes to Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	29

Item 4.	Controls and Procedures	30

PART II	OTHER INFORMATION

Item 1A.	Risk Factors	31

Item 6.	Exhibits	31

Signature		32

PART I

FINANCIAL INFORMATION

Item 1.

Financial Statements

IRIS INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)


	March 31, 2006			December 31, 2005
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	18,431			19,145
Accounts receivable, net of allowance for doubtful accounts and sales returns of $283 and $288		11,331			11,874
Inventories, net		9,277			7,590
Prepaid expenses and other current assets		1,430			1,132
Investment in sales-type leases		1,799			1,455
Deferred tax asset		2,457			2,792

Total current assets		44,725			43,988
Property and equipment, at cost, net		4,460			4,076
Goodwill		189			189
Software development costs, net		1,433			1,570
Deferred tax asset		7,237			7,237
Inventories – long term portion		632			632
Investment in sales-type leases		6,440			5,841
Other assets		421			396

Total assets	$	65,537		$	63,929

Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	3,752		$	4,464
Accrued expenses		3,293			4,188
Deferred service contract revenue		1,520			1,457

Total current liabilities		8,565			10,109
Deferred service contract revenue, long term		25			51

Total liabilities		8,590			10,160
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par value – authorized: 50 million shares; issued and outstanding: 17,498 shares and 17,222 shares		175			172
Additional paid-in capital		73,023			70,856
Unearned compensation		(1,196	)		(546	)
Accumulated deficit		(15,055	)		(16,713	)

Total shareholders’ equity		56,947			53,769

Total liabilities and shareholders’ equity	$	65,537		$	63,929

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited – in thousands, except per share amounts)


	For the three months ended March 31,
	2006			2005
Sales of IVD instruments	$	5,915		$	5,939
Sales of IVD consumables and service		7,259			5,699
Sales of Sample Processing instruments and supplies		2,941			2,326

Net revenues		16,115			13,964

Cost of goods - IVD instruments		3,150			3,593
Cost of goods - IVD consumables and service		3,134			2,315
Cost of goods - Sample Processing instruments and supplies		1,540			1,162

Cost of goods sold		7,824			7,070

Gross margin		8,291			6,894

Marketing and selling expenses		2,322			2,391
General and administrative expenses		2,115			1,394
Research and development, net		1,488			1,083

Total operating expenses		5,925			4,868

Operating income		2,366			2,026
Other income (expense):
Interest income		263			53
Interest expense		(1	)		(5	)
Other income		3			44

Income before income taxes		2,631			2,118
Provision for income taxes		973			847

Net income	$	1,658		$	1,271

Basic net income per share	$	0.10		$	0.08

Diluted net income per share	$	0.09		$	0.07

Basic - average shares outstanding		17,409			16,218

Diluted – average shares outstanding		18,300			17,294

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 three months ended March, 31
	2006			2005
Cash flows from operating activities:
Net income	$	1,658		$	1,271
Adjustments to reconcile net income to net cash used in operating activities :
Deferred taxes, net		972			847
Depreciation and amortization		474			492
Common stock and stock option compensation		237			79
Gain on sale of investment		—			(43	)
Changes in operating assets and liabilities:
Accounts receivable		543			(1,443	)
Deferred service contract revenue		37			102
Inventories, net		(1,687	)		623
Prepaid expenses and other current assets		(298	)		(66	)
Sales-type leases		(943	)		—
Other assets		(25	)		(702	)
Accounts payable		(712	)		(970	)
Accrued expenses		(895	)		(728	)

Net cash used in operating activities		(639	)		(538	)

Cash flows from investing activities:
Acquisition of property and equipment		(721	)		(314	)
Sale of investments held for sale		—			102

Net cash used in investing activities		(721	)		(212	)

Cash flows from financing activities:
Issuance of common stock for cash		646			1,349
Payments of capital lease obligations		—			(10	)

Net cash provided by financing activities		646			1,339

Net increase (decrease) in cash and cash equivalents		(714	)		589
Cash and cash equivalents at beginning of period		19,145			12,839

Cash and cash equivalents at end of period	$	18,431		$	13,428

Supplemental schedule of non-cash financing activities:
Issuance of common stock and common stock warrants for services	$	858		$	228
Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	—		$	17
Cash paid for interest	$	1		$	—

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited – in thousands)


	For the three months ended March 31,
	2006		2005
Net income	$	1,658	$	1,271
Unrealized loss on investments, net of taxes		—		(11	)

Comprehensive income	$	1,658	$	1,260

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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

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.

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.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 March 31, 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 $632,000 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 five years, the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of their useful life or the remaining term of the lease.

Goodwill

Goodwill is recorded at cost. The realizability of goodwill is evaluated periodically, at least annually, or as events or circumstances indicates a possible inability to recover the carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections. The analysis necessarily involves significant management judgment to evaluate the capacity of an acquired business to perform within projections. At December 31, 2005, we evaluated goodwill and determined that fair value had not decreased below carrying value and no adjustment to impair goodwill was necessary in accordance with SFAS No. 142.

Software Development Costs

We capitalize 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 our design specifications are completed, and conclude 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 but recorded amortization expense of $137,000 and $170,000 during the three months ended March 31, 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 quarter March 31, 2006 and 2005.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 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.

Warranties

We recognize warranty expense, based on management’s estimate of expected cost, as an accrued liability at the time of sale. Warranty expenses amounted to $201,000 and $174,000 for the three months ended March 31, 2006 and 2005.

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.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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. We received costs reimbursements (government grants) of $477,000 and $405,000 during the three months ended March 31, 2006 and 2005.

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 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 earnings per share are computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares and common stock equivalents outstanding, calculated on the treasury stock method for options and warrants or the converted method for convertible preferred stock. Common stock equivalents (526,854 options) are excluded from the computation when their effect is antidilutive.

Stock Based Compensation

In December 2004, the Financial Accounting Standards Board (“FASB”) issued 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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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. For periods before the required effective date for which financial statements have not yet been issued, we had the option to elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required by Statement No. 123.

We adopted SFAS No. 123R effective January 1, 2006 and were required to expense previously issued equity awards for which service has not been rendered on that date. However, as of December 31, 2005, existing employee stock options were fully vested; accordingly there was no expense for such options that would be recognized in years subsequent to 2005.

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.

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.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3.	Stock Option Plans

Summary of Stock Based Compensation Plans

As of March 31, 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 March 31, 2006 there were stock options outstanding to purchase 75,000 shares of common stock that were issued under special inducement grants (“SIG”).

During the three months ended March 31, 2006, we incurred approximately $239,000 of stock based compensation relating to employee stock options and stock purchases. We anticipate that during future quarters during 2006 we will incur similar expenses of approximately $325,000 per quarter.

The following schedule sets forth options authorized, exercised, outstanding and available for grant under our three stock option plans and SIG as of March 31, 2006:


(In thousands)	Number of Option Shares
Plan	Authorized	Exercised	Outstanding	Available for Grant
1994 Plan	700	596	61	—
1997 Plan	600	545	55	—
1998 Plan	4,100	1,686	1,585	828
SIG	130	55	75	—

	5,530	2,882	1,776	828

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 $0.69 to $22.95 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:


	Quarter Ended		For the Year Ended December 31,
(In thousands)	March 31, 2006		2005		2004		2003
Risk free interest rate	4.7	%	4.3	%	3.6	%	3.2	%
Expected lives (years)	3		3		5		5
Expected volatility	41	%	40	%	39	%	44	%
Expected dividend yield	—		—		—		—

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.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Stock Option Activity

As summary of option activities under the stock option plans during the three months ended March 31, 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	219		$	22.65
Exercised	(159	)	$	3.83
Canceled or Expired	(1	)	$	8.58

Outstanding at March 31, 2006	1,776		$	9.09	3.93 yrs.	$	11,608

Exercisable at March 31, 2006	1,567		$	7.28	3.80 yrs.	$	13,122

Cash received from options exercised during the three months ended March 31, 2006 amounted to $620,000. There were options to purchase 219,000 share of common stock granted during the three months ended March 31, 2006 under the 1998 Stock Option Plan.

A summary of the status of the Company’s non-vested stock options during the three months ended March 31, 2006 is presented below:


Non-vested Options	Shares	Weighted- Average Grant-Date Fair Value
Non-vested at January 1, 2006	—
Granted	209	$	22.74
Exercised	—		—
Forfeited or expired	—		—

Non-vested at March 31, 2006	209	$	22.74

As of March 31, 2006, there was approximately $1,518,000 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 period of 4.0 years. The share-based compensation will be amortized based on the straight line method over the vesting period.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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. 123R, the Company’s net income and income per share would have been reduced to the pro forma amounts indicated below:


	For the three months ended March 31
(in thousands, except per-share data)	2006			2005
Net income as reported	$	1,658		$	1,271
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		151			47
Deduct: Total stock-based Employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(151	)		(213	)

Net income pro forma	$	1,658		$	1,105

Income per diluted share as reported	$	0.09		$	0.07

Income per diluted share pro forma	$	0.09		$	0.06

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 assets (primarily technology) of Leucadia Technologies, Inc., a molecular diagnostics company, for $10.1 million. With this acquisition, we acquired significant core technology and know-how. Pursuant to the acquisition agreement, the acquisition includes a cash payment of $3.1 million and approximately $7 million in IRIS Common Stock, $2 million of which is based on earn-out consideration.

Leucadia is a development stage company focused on in vitro diagnostic products based on two platform technologies. The acquisition of Leucadia will be folded into a new IRIS Molecular Diagnostics (IMD) subsidiary. The acquisition under the purchase accounting method, has the purchase price allocated on a preliminary basis, subject to adjustment, to the fair value of the assets acquired.

On June 2, 2005, we completed the acquisition of the assets (primarily technology and inventory) 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 $500,000 in cash and assumed approximately $34,000 in accrued liabilities. We also incurred approximately $243,000 in professional and other fees, the total acquisition cost amounting to $777,000. The acquisition was accounted for as a purchase with the purchase price allocated on a preliminary basis, subject to adjustment, to the fair value of the assets acquired. The preliminary 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 $777,000 allocated to the fair value of the inventory acquired.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

5.	Inventories

Inventories consist of the following:


(in thousands)	March 31, 2006			December 31, 2005
Finished goods	$	2,998		2,800
Work-in-process		292		337
Raw materials, parts and sub-assemblies		6,619		5,085

		9,909		8,222
Less non-current portion		(632	)	(632	)

Inventories – current portion	$	9,277		7,590

6.	Bank Loan Agreement

In May 2004, we signed a new credit facility with a major bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of March 31, 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 March 31, 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 March 31, 2006, there were outstanding and exercisable warrants to purchase 74,300 shares at a price of $7.80 per share.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

We enter into indemnification provisions under agreements with other companies in the ordinary course of business, typically with business partners, contractors, customers and landlords. Under such provisions we generally indemnify and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of our 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 us with regard to intellectual property rights. Such indemnification provisions generally survive termination of the underlying agreement. In addition, in some cases, we agree to reimburse employees for certain expenses and to provide salary continuation. The maximum potential amount of future payments we could be required to make under these indemnification provisions is unlimited. To date we have not incurred any material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no recorded liabilities for these agreements as of March 31, 2006.

10.

Segment and Geographic Information

Our continuing operations are organized on the basis of products and related services, and under SFAS No. 131, we operate in two segments: (1) IVD instruments 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. 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

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


(in thousands)	IVD Instruments		Sample Processing		Unallocated Corporate Expenses			Total
For the three months ended March 31, 2006
Revenues	$	13,174	$	2,941	$			$	16,115
Interest income		261		2					263
Interest expense		1							1
Depreciation and amortization*		564		53		64			681
Segment pre tax profit		3,052		650		(1,071	)		2,631
Segment assets		41,777		14,065		9,695			65,537
Investment in long-lived assets		13,073		502					13,575
For the three months ended March 31, 2005
Revenues	$	11,638	$	2,326	$	—		$	13,964
Interest income		51		2		—			53
Interest expense		2		—		3			5
Depreciation and amortization*		490		59		22			571
Segment pre tax profit		2,371		509		(762	)		2,118
Segment assets		37,624		3,119		8,474			49,217
Investment in long-lived assets		9,099		230					9,329

*	Included in depreciation and amortization above is amortization of deferred compensation in the amounts $207,000 and $79,000 for the three months ended March 31, 2006 and 2005.

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 $4.2 million and $3.8 million during the three months ended March 31, 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, Iris Diagnostics Division, designs, manufactures and markets in vitro diagnostics (IVD) systems, consumables and supplies for urinalysis and Advanced Digital Imaging and Research LLC (ADIR) assists in the advancement of proprietary imaging technology while conducting government-sponsored research and contract development in imaging and pattern recognition. Our other segment Sample Processing markets small centrifuges and other processing equipment and accessories for rapid specimen processing,

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 analyzers manufactured by us and urine chemistry analyzers purchased from a Japanese manufacturer. We sell the urine microscopy analyzers worldwide and fully automated urine chemistry analyzers domestically. In addition, we expect to initiate sales of our new semi-automated chemistry analyzer, the iChem 100 in the second quarter of 2006. 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 26% of consolidated revenues during the three months ended March 31, 2006 as compared to 30% 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 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 $0.8 million. 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.

intellectual property and know-how. Pursuant to the acquisition agreement, the acquisition includes a cash payment of $3.1 million and approximately $7 million in IRIS Common Stock, $2 million of which is based on earn-out consideration. Leucadia is a development stage company focused on in vitro diagnostic products based on two platform technologies in molecular technologies. The acquisition of Leucadia will be folded into a new Iris Molecular Diagnostics (IMD) subsidiary

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:


	For the three months ended March 31,
(in thousands)	2006			2005
Total product technology expenditures	$	1,965		$	1,488
Less: amounts reimbursed through grants for government sponsored research and development		(477	)		(405	)

Research and development expense as reported in the consolidated statements of operations	$	1,488		$	1,083

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 March 31,
	2006				2005
Revenues
IVD instruments	$	5,915	37	%	$	5,939	42	%
IVD consumables and service		7,259	45	%		5,699	41	%
Sample Processing instruments and supplies		2,941	18	%		2,326	17	%

Total revenues		16,115	100	%		13,964	100	%

Cost of Goods Sold
IVD instruments		3,150	53	%		3,593	60	%
IVD consumable and supplies		3,134	43	%		2,315	41	%
Sample Processing instruments and supplies		1,540	52	%		1,162	50	%

Total costs		7,824	49	%		7,070	51	%

Gross margin		8,291	51	%		6,894	49	%

Operating expenses
Marketing and selling		2,322	14	%		2,391	17	%
General and administrative		2,115	13	%		1,394	10	%
Research and development, net		1,488	9	%		1,083	8	%

Total operating expenses		5,925	37	%		4,868	35	%

Operating income		2,366	15	%		2,026	14	%

Net income	$	1,658	10	%		1,271	9	%

Comparison of the three months ended March 31, 2006 to 2005

Net revenues for the three months ended March 31, 2006 increased 15% over the prior year quarter. Revenues from the IVD urinalysis segment totaled $13.2 million in the current quarter, up from $11.6 million in the prior year quarter. Sales of IVD instruments remained at $5.9 million as compared to the prior year quarter. The constant instrument sales is due to unit sales of 101 iQ200 analyzers and systems during the current quarter as compared to unit sales of 100 iQ200 analyzers and systems during the prior year quarter. Sales of IVD consumables and service increased to $7.3 million from $5.7 million in the prior year quarter, an increase of $1.6 million or 27%, primarily due to the larger installed base of instruments. Revenues from the Sample Processing segment increased to $2.9 million from $2.3 million, or 26%. This increase is primarily due to increased unit sales of centrifuges and DNA processing workstations.

Consolidated gross profit margins improved to 51% of revenues as compared to 49% during the prior year quarter. IVD instruments margins improved to 47% as compared to 40% for the prior year quarter. The improvement was attributable to reduced material costs through the change in vendors for improved quality at lower costs, and negotiated lower prices with existing vendors. Margins on IVD consumables and service decreased to 57% of related revenues as compared to 59% during the prior year quarter, primarily as a result of higher sales to international independent distributors at lower margins than domestic sales and the impact of the chemistry strip manufacturing operation in Germany acquired last year which is currently operating below capacity and generated a negative profit margin of approximately $200,000. Margins on our Sample Processing instruments and supplies decreased to 48% during the current quarter from 50% due to customer mix.

Marketing and selling expenses decreased 3% to $2.3 million for the three months ended March 31, 2006 as compared to $2.4 million in the prior year quarter. As a percentage of sales such expenses during the current quarter were 14% of revenues compared to 17% during the prior year quarter. The decrease relates to fewer shows and promotional expenses in the current quarter compared to the prior year quarter. Outside services decreased by $41,000 due to the completion of market research study in the prior year.

General and administrative expenses increased in the quarter to $2.1 million from $1.4 million in the prior year quarter. The increase in general and administrative expense was comprised primarily of $398,000 in additional compensation expenses for additional personnel and pay-rate increases, approximately $100,000 in additional stock based compensation expense and $119,000 in additional recruiting costs. As a percentage of sales, general and administrative expenses were 13% during the current quarter as compared to 10% for the prior year quarter.

Net research and development expense increased to $1.5 million for the three months ended March 31, 2006 as compared to $1.1 million for the prior year quarter, a 37% increase. This includes an increase in payroll and related costs of $370,000 to support expansion of current and new research and development projects. Research and development expenses were net of reimbursed costs received from governmental research and development grants, which amounted to $477,000 and $405,000 during the three months ended March 31, 2006 and 2005. We expect to continue investing in research and development activities during the remainder of 2006 but at a higher rate than the current quarter. For fiscal 2006, we expect research and development expense to increase to approximately 13% of revenues as a result of our recent acquisition of Leucadia Technologies, as described in Note 4 to the financial statements.

Interest income during the quarter amounted to $263,000, an increase of $210,000 over the prior year quarter and relates primarily to our continued investment of excess funds during the quarter plus interest received on sales-type equipment leases.

During the first quarter of 2006 the income tax provision amounted to $973,000 as compared to $847,000 during the prior year quarter. As a percentage of pre-tax income, the provision for income taxes was 37% and 40% for the three months ended March 31, 2006 and 2005. The reduction results from increased R&D credits realized during the current 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 March 31, 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 supplies. During the first three months of 2006, our cash and cash equivalents decreased $714,000 to $18.4 million.

On April 3, 2006 we acquired the assets (primarily technology) of Leucadia Technologies, Inc., a molecular diagnostics company, for $10.1 million. With this acquisition, we acquired significant core technology, intellectual property and know-how. Pursuant to the acquisition agreement, the acquisition includes a cash payment of $3.1 million and approximately $7.0 million in IRIS Common Stock, $2.0 million of which is based on earn-out consideration.

Operating Cash Flows. Cash used in operations for the current year three-month period amounted to $639,000 compared to $538,000 in the prior year. Cash provided by operations for the three months included net income in the current year of $1.7 million, a reduction in receivables of $543,000, non-cash items consisting of deferred taxes of $982,000 and depreciation and amortization of $474,000. These sources of cash were offset by increases in inventories of $1.7 million due to anticipated demand for our products and $943,000 in additional sales-type leases financed internally.

The relationship of receivables to revenues has improved to 67 days sales in accounts receivable as compared to 69 days sales in accounts receivable at the beginning of the year. Inventories increased $1.7 million since the beginning of the year with the number of days sales in inventory increased to 107 days at the end of the first three months as compared to 86 days at the end of 2005. As mentioned above, the increase is due to anticipated demand.

Investing Activities. Cash used in investing activities totaled $721,000 during the three months ended March 31, 2006 compared to $212,000 in 2005, primarily for additions to property and equipment. During the current year quarter, we expanded our customer training facility in Chatsworth, California and added diagnostic consumable manufacturing capabilities at our Sample Processing facility in Massachusetts.

Financing Activities. For the three months ended March 31, 2006, financing activities provided $646,000 from the issuances of our common stock for option exercises. During the prior year quarter we received $1.3 million for similar issuances of our common shares.

We currently have a credit facility with a major bank consisting of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit available for acquisitions and product opportunities. Borrowings under the revolving line of credit are based on a percentage of eligible receivables and inventory. The credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of March 31, 2006, there were no borrowings under the new credit facility, however we are subject to certain financial covenants under the credit facility with the bank and as of March 31, 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 effect major changes in the healthcare system, nationally, at the state level or both. Future legislation, regulation or payment policies of Medicare, Medicaid, private health insurance plans, health maintenance organizations and other 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:

•

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

•

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

•

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

•

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 March 31, 2006, we have deferred tax assets of approximately $9.7 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:

•

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;

•

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

•

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

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

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

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

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

Our ability to capitalize on growth in international markets is subject to risks including:

•

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

•

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

•

unexpected changes in regulatory requirements; and

•

the difficulties associated with promoting products in unfamiliar cultures.

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

•

political instability;

•

changes in diplomatic and trade relationships;

•

general economic fluctuations in specific countries or markets; and

•

changes in regulatory schemes.

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 March 31, 2006.

Interest Rates

At March 31, 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 March 31, 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

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

SIGNATURE

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

Date: May 9, 2006


IRIS INTERNATIONAL, INC.

By:		/s/ Martin G. Paravato
		Martin G. Paravato Chief Financial Officer

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