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

September 30, 2006

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

For the transition period from to .

Commission File No. 1-11181

IRIS INTERNATIONAL, INC.

(Exact Name of Registrant as Specified in Its Charter)


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

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

(818) 709-1244

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer ¨ Accelerated filer x Non accelerated filer ¨

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

The registrant had 17,978,761 shares of common stock issued and outstanding as of November 9, 2006.

IRIS INTERNATIONAL, INC.

INDEX TO FORM 10-Q


		Page
PART I FINANCIAL INFORMATION

Item 1.	Financial Statements

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

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

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

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

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

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	33

Item 4.	Controls and Procedures	33

PART II OTHER INFORMATION

Item 1A.	Risk Factors	35

Item 4	Submission of Matters to a Vote of Security Holders	35

Item 6.	Exhibits	35

Signature		36

PART I

FINANCIAL INFORMATION

Item 1.

Financial Statements

IRIS INTERNATIONAL, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)


	September 30, 2006			December 31, 2005
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	16,724		$	3,169
Marketable Securities available for sale		541			15,976
Accounts receivable, net of allowance for doubtful accounts and sales returns of $435 and $205		13,627			11,874
Inventories, net		7,662			7,590
Prepaid expenses and other current assets		1,356			1,132
Investment in sales-type leases		2,018			1,455
Deferred tax asset		2,792			2,792

Total current assets		44,720			43,988
Property and equipment, at cost, net		6,048			4,076
Goodwill		2,428			189
Core technology, net		1,745			—
Software development costs, net		1,295			1,570
Deferred tax asset		5,467			7,237
Inventories – long term portion		440			632
Investment in sales-type leases		6,661			5,841
Other assets		410			396

Total assets	$	69,214		$	63,929

Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	3,081		$	4,464
Accrued expenses		4,882			4,188
Deferred service contract revenue		1,495			1,457

Total current liabilities		9,458			10,109
Deferred service contract revenue, long term		38			51

Total liabilities		9,496			10,160
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par value – authorized: 50 million shares; issued and outstanding: 17,971 shares and 17,222 shares		179			172
Additional paid-in capital		78,346			70,310
Accumulated deficit		(18,807	)		(16,713	)

Total shareholders’ equity		59,718			53,769

Total liabilities and shareholders’ equity	$	69,214		$	63,929

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

\IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited – in thousands)


	For the three months ended September 30,
	2006			2005
Sales of IVD instruments	$	7,477		$	6,347
Sales of IVD consumables and service		7,775			7,067
Sales of sample processing and supplies		2,756			2,588

Net revenues		18,008			16,002

Cost of goods - IVD instruments		4,432			3,540
Cost of goods - IVD consumables and service		3,976			3,030
Cost of goods - sample processing and supplies		1,460			1,324

Cost of goods sold		9,868			7,894

Gross margin		8,140			8,108

Marketing and selling expenses		2,718			2,659
General and administrative expenses		2,284			1,740
Research and development, net		2,173			1,321

Total operating expenses		7,175			5,720

Operating income		965			2,388
Other income (expense):
Interest income		267			189
Interest expense		(5	)		(2	)
Other income		1			(5	)

Income before income taxes		1,228			2,570
Provision for income taxes		454			1,028

Net income	$	774		$	1,542

Basic net income per share	$	0.04		$	0.09

Diluted net income per share	$	0.04		$	0.09

Basic - average shares outstanding		18,004			17,027

Diluted - average shares outstanding		18,574			18,067

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited – in thousands)


	For the nine months ended September 30,
	2006			2005
Sales of IVD instruments	$	$19,429		$	19,765
Sales of IVD consumables and service		22,779			18,653
Sales of sample processing and supplies		8,513			7,125

Net revenues		50,721			45,543

Cost of goods - IVD instruments		10,839			11,413
Cost of goods - IVD consumables and service		10,600			7,944
Cost of goods - sample processing and supplies		4,442			3,588

Cost of goods sold		25,881			22,945

Gross margin		24,840			22,598

Marketing and selling expenses		7,674			7,526
General and administrative expenses		7,229			4,783
Research and development, net		10,932			3,362

Total operating expenses		25,835			15,671

Operating income (loss)		(995	)		6,927
Other income (expense):
Interest income		773			365
Interest expense		(17	)		(14	)
Other (expense) income		34			39

Income (loss) before income taxes		(205	)		7,317
Provision for income taxes		1,840			2,927

Net income (loss)	$	(2,045	)	$	4,390

Basic net income (loss) per share	$	(0.11	)	$	0.26

Diluted net income (loss) per share	$	(0.11	)	$	0.25

Basic - average shares outstanding		17,793			16,628

Diluted - average shares outstanding		17,793			17,580

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 nine months ended September 30
	2006			2005
Cash flows from operating activities:
Net income (loss)	$	(2,045	)	$	4,390
Adjustments to reconcile net income (loss) to net cash provided by operations:
Non-cash in-process research and development charge		5,180			—
Deferred taxes, net		1,839			2,927
Foreign Translation loss		(49	)		—
Depreciation and amortization		1,546			1,651
Common stock and stock option compensation		1,076			(437	)
Gain on sale of investment		(30	)		(37	)
Changes in operating assets and liabilities:
Accounts receivable		(1,753	)		(2,728	)
Deferred service contract revenue		25			(24	)
Inventories, net		120			999
Prepaid expenses and other current assets		(224	)		(503	)
Sales-type lease and other assets		(1,397	)		(4,377	)
Accounts payable & accrued expenses		(689	)		(685	)

Net cash provided by operating activities		3,599			1,176

Cash flows from investing activities:
Acquisition of business, net of cash acquired		(3,568	)		—
Acquisition of property and equipment		(3,041	)		(697	)
Software development costs		(136	)		(171	)
Sale of investments held for sale		30			166
Marketable Securities Available for sale		15,435			(15,827	)

Net cash provided by (used in) investing activities		8,720			(16,529	)

Cash flows from financing activities:
Issuance of common stock for cash		1,236			3,539
Borrowings under line of credit		3,000			—
Repayments of line of credit		(3,000	)		—
Payments of capital lease obligations		—			(58	)
Sales of fixed assets		—			47

Net cash provided by financing activities		1,236			3,528

Net increase (decrease) in cash and cash equivalents		13,555			(11,825	)
Cash and cash equivalents at beginning of period		3,169			12,839

Cash and cash equivalents at end of period	$	16,724		$	1,014

Supplemental schedule of non-cash financing activities:
Issuance of common stock and common stock warrants for services	$	1,558		$	437
Issuance of common stock and deferred compensation units to acquire subsidiary	$	5,000		$	—
Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	34		$	4
Cash paid for interest	$	17		$	14

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

IRIS INTERNATIONAL, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited – in thousands)


	For the three months ended September 30,
	2006			2005
Net income	$	774		$	1,542
Unrealized loss on investments, net of taxes		—			14
Comprehensive income	$	774		$	1,556

	For the nine months ended September 30,
	2006			2005
Net income (loss)	$	(2,045	)	$	4,390
Unrealized gain (loss) on investments, net of taxes		—			(24	)
Comprehensive income (loss)	$	(2,045	)	$	4,366

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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

1.	Company History

IRIS International, Inc. was incorporated in California in 1979 and reincorporated during 1987 in Delaware under the name of International Remote Imaging Systems, Inc. We changed our name to IRIS International, Inc. in December 2003. We design, develop, manufacture and market in vitro diagnostic (“IVD”) equipment and related consumables, including IVD imaging systems based on patented and proprietary automated intelligent microscopy (“AIM”) technology, as well as special purpose centrifuges and other small instruments for automating microscopic procedures performed in clinical laboratories.

2.	Summary of Significant Accounting Policies

Basis of Presentation of Unaudited Interim Financial Statements

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

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

Use of Estimates

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

Principles of Consolidation

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

Cash Equivalents and Short-Term Investments

We invest available cash in short-term commercial paper, certificates of deposit and high-grade variable rate securities. Liquid investments with an original maturity of three months or less when purchased are considered to be cash equivalents.

Investments, including auction rate securities and certificates of deposit, with maturity dates greater than three months when purchased, which have readily determined fair values, are classified as available-for-sale investments and reflected in current assets as marketable securities available for sale. Auction rate securities are recorded at par value, which equals fair market value, as the rates on such securities reset generally every 7, 28, or 35 days.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

Accounts Receivable

We sell predominantly to entities in the healthcare industry. We grant uncollateralized credit to customers, primarily hospitals, clinical and research laboratories, and distributors. We perform ongoing credit evaluations of customers before granting uncollateralized credit. The U.S. Government represents more than 10% or more of our consolidated revenues or 10% or more of our accounts receivable at the balance sheet date.

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

Management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. We include accounts receivable balances that are determined to be uncollectible, along with a general reserve, in our allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. Based on the information available to us, we believe our allowance for doubtful accounts as of September 30, 2006 is adequate.

Inventories

Inventories are carried at the lower of cost or market on a first in, first out basis. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. We currently have approximately $440 of non-current inventory relating to spare parts for our legacy instruments which we no longer produce but continue to support and provide maintenance repairs for our customers. Other inventory that is considered excess inventory is fully reserved.

Property and Equipment and Depreciation

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

Goodwill and Core Technology

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

At December 31, 2005, 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 Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

Software Development Costs

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 its design specifications are completed, and concludes capitalization when the product is ready for general release. Research and development costs relating to software development are expensed as incurred. Amortization of capitalized software development costs is provided on a product-by-product basis at the greater of the amount computed using (a) the ratio of current revenues for a product to the total of current and anticipated future revenues or (b) the straight-line method over the remaining estimated economic life of the product up to five years. We had $136 of capitalized software development costs during the nine months ended September 30, 2006 and recorded amortization of software development costs of $411 and $384 during the nine months ended September 30, 2006 and 2005, respectively.

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 nine months ended September 30, 2006 and 2005, respectively.

Revenue recognition

For products, revenue is recognized when risk of loss transfers, when persuasive evidence of an arrangement exists, the price to the buyer is fixed and determinable and collectibility is reasonably assured. When a customer enters into an operating-type lease agreement, hardware revenue is recognized on a straight-line basis over the life of the lease, while the cost of the leased equipment is carried in customer leased equipment within property, plant and equipment and amortized over its estimated useful life. Under a sales-type lease agreement, hardware revenue is generally recognized at the time of shipment based on the present value of the minimum lease payments with interest income recognized over the life of the lease using the interest method. Instrument costs under a sales-type lease agreement are recognized at the time of shipment. Service revenues on maintenance contracts are recognized ratably over the life of the service agreement or as service is performed, if not under contract. For those instrument sales that include multiple deliverables, such as installation, training, after-market supplies or service, we allocate revenue based on the relative fair values of the individual components as determined in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21.

Our accounting for leases involves specific determinations under SFAS No. 13 “Accounting for Leases” (“SFAS 13”), which often involve complex provisions and significant judgments. The four criteria of SFAS 13 that we use in the determination of a sales-type lease or operating-type lease are 1) a review of the lease term to determine if it is equal to or greater than 75 percent of the economic life of the equipment; 2) a review of the minimum lease payments to determine if they are equal to or greater than 90 percent of the fair market value of the equipment; 3) a determination of whether or not the lease transfers ownership to the lessee at the end of the lease term; and 4) determination of whether or not the lease contains a bargain purchase option.

Additionally, before classifying a lease as a sales-type lease, we assess whether collectibility of the lease payments is reasonably assured and whether there are any significant uncertainties related to costs that we have yet to incur with respect to the lease. Generally, our leases that qualify as sales-type lease are non-cancelable leases with a term of 75 percent or more of the economic life of the equipment. Certain of our lease contracts are customized for larger customers and often result in complex terms and conditions that typically require significant judgment in applying the lease accounting criteria.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

The economic life of our leased instrument and its fair value require significant accounting estimates and judgment. These estimates are based on our historical experience. The most objective measure of the economic life of our leased instrument is the original term of a lease, which is typically five years, since a majority of the instruments are returned by the lessee at or near the end of the lease term and there is not a significant after-market for our used instruments without substantial remanufacturing. We believe that this is representative of the period during which the instrument is expected to be economically usable, with normal service, for the purpose for which it is intended. We regularly evaluate the economic life of existing and new products for purposes of this determination.

The fair market value of our leased instruments is determined by a range of cash selling prices or other verifiable objective evidence, if applicable. We regularly evaluate available objective evidence of instrument fair values using historical data.

We have certain government contracts with cancellation clauses or renewal provisions that are generally required by law, such as 1) those dependant on fiscal funding outside of a governmental unit’s control, 2) those that can be cancelled if deemed in the tax payers’ best interest or 3) those that must be renewed each fiscal year, given limitations that may exist on multi-year contracts that are imposed by statute. Under these circumstances and in accordance with the relevant accounting literature, as well as considering our historical experience, a thorough evaluation of these contracts is performed to assess whether cancellation is remote or whether exercise of the renewal option is reasonably assured.

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

Warranties

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

Research and Development Expenditures

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

From time to time we receive grants from agencies of the US Government. We do not recognize any revenue from such grants since they are cost reimbursement grants whereby we submit requests for reimbursement for certain costs incurred. There are no ongoing obligations or requirements with respect to the grants received, we retain ownership of any intellectual property that results from the research and development and the US Government receives a right to use the results of the research for government projects.

Income Taxes

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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

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 net income (loss) per share represents net income (loss) divided by the weighted average common stock outstanding during the period. Diluted net income (loss) per share represents net income (loss) divided by the weighted average common stock and non-antidilutive common stock equivalents outstanding during the period. Weighted average shares used in diluted net income (loss) per share include common stock equivalents, arising from stock options and warrants, under the treasury stock method. The weighted average number of outstanding antidilutive common stock options and warrants excluded from the computation of diluted net income (loss) per common share for the three and nine month periods ended September 30, 2006 was 653 and 1,390, respectively.

Stock Based Compensation

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

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

Due to the adoption of SFAS No. 123R, our results for the three and nine months ended September 30, 2006 include incremental share-based compensation expense totaling $277 and $622, respectively. As such, basic and diluted net income (loss) per share was impacted by $0.01 and $0.02 for the three and nine months ended September 30, 2006, respectively. Our results include total share based compensation expense of $403 and $1,076 for the three and nine months ended September 30, 2006 and $113 and $300 for the three and nine months ended September 30, 2005.

Segment Reporting

We determine and disclose industry segments in accordance with SFAS No. 131; “Disclosures about Segments of an Enterprise and Related Information,” which uses a “management” approach for determining business segments. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of our reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas, and major customers. See Note 10 — “Segment and Geographic Information”.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited - dollars in thousands except per share amounts)

Certain Risks and Uncertainties

We derive most of our revenues from the sale of the urinalysis analyzers, and related supplies and services. Relatively modest declines in unit sales or gross margins could have a material adverse effect on our revenues and profits.

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

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

New Accounting Pronouncement

In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 requires that companies recognize in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 on January 1, 2007, the beginning of our 2007 fiscal year. We do not expect the adoption of this statement to have a material impact on our financial statements.

In September 2006, the SEC issued SAB 108, “Topic 1N—Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which provides guidance on quantifying prior year errors for the purpose of evaluating materiality on current year financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006. We do not expect the adoption of this statement to have a material impact on our financial statements.

In September 2006, the FASB issued SFAS 157, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposed under generally accepted accounting principles. As a result of SFAS 157, there is a common definition of fair value to be used throughout GAAP, SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting SFAS 157 on our financial position and results of operations.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

3.	Stock Option Plans

Summary of Stock Based Compensation Plans

As of September 30, 2006, we have 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 September 30, 2006 there were stock options outstanding to purchase 75,000 shares of common stock that were issued under special inducement grants (“SIG”).

During the nine months ended September 30, 2006, we incurred approximately $1,076 of stock based compensation relating to employee stock options and stock purchases.

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


(In thousands) Plan	Number of Option Shares
(In thousands) Plan	Authorized	Exercised/ Canceled	Outstanding	Available for Grant
1994 Plan	700	665	35	—
1997 Plan	600	547	53	—
1998 Plan	4,100	1,746	1,735	619
SIG	130	55	75	—

	5,530	3,013	1,898	619

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 nine months. The options generally vest over either three or four years and expire either five or ten years from the date of grant. The exercise price for such options ranges from $0.88 to $26.02 per share.

Assumptions

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


	Nine Months Ended September 30, 2006		For the Year Ended December 31,
	Nine Months Ended September 30, 2006		2005		2004		2003
Risk free interest rate	4.6	%	4.3	%	3.6	%	3.2	%
Expected lives (years)	3		3		5		5
Expected volatility	45	%	40	%	39	%	44	%
Expected dividend yield	—		—		—		—

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

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

Stock Option Activity

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

(In thousands, except for per share)


Stock Options	Shares		Weighted- Average Exercise Price		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value
Outstanding at January 1, 2006	1,717		$	6.89	4.18 yrs.	$	25,718
Granted	438		$	18.01
Exercised	(246	)	$	4.59
Canceled or Expired	(11	)	$	18.15

Outstanding at September 30, 2006	1,898		$	9.69	3.99	$	3,449

Exercisable at September 30, 2006	1,245		$	7.19	3.42	$	6,297

Cash received from options exercised during the nine months ended September 30, 2006 amounted to $1,131. There were options to purchase 438 shares of common stock granted during the nine months ended September 30, 2006 under the 1998 Stock Option Plan.

A summary of the status of our non-vested stock options during the nine months ended September 30, 2006 is presented below:


Non-vested Options	Shares	Weighted- Average Grant- Date Fair Value
Non-vested at January 1, 2006	—
Granted	438	$	18.01
Exercised	—		—
Forfeited or expired	—		—

Non-vested at September 30, 2006	438	$	18.01

As of September 30, 2006, there was approximately $2,080 of accumulated unrecognized stock compensation based on fair value on the grant date related to non-vested options granted under the stock option plans. That cost is expected to be recognized during the weighted average service period of 4.0 years. The share-based compensation will be amortized based on the straight line method over the vesting period and the expense includes an estimate of the awards that will be forfeited.

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

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


	For the period ended September 30, 2005
(in thousands)	Three Months			Nine Months
Net income as reported	$	1,542		$	4,390
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		68			180
Deduct: Total stock-based Employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(254	)		(721	)

Net income pro forma	$	1,356		$	3,849

Income per diluted share as reported	$	0.09		$	0.26

Income per diluted share pro forma	$	0.09		$	0.25

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

4.	Acquisitions

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

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


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

Total assets acquired	$	4,044

Total liabilities – deferred tax liability	$	662

In-process Research and development expense	$	5,180

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

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

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

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


	Three months ended September 30,
(in thousands, except per share data)	2006			2005
Revenues	$	18,008		$	16,002
Net income		774			1,542
Net income per share	$	0.04		$	0.09

	Nine months ended September 30,
(in thousands, except per share data)	2006			2005
Revenues	$	50,721		$	46,115
Net income (loss)		(2,045	)		3,850
Net income (loss) per share	$	(0.11	)	$	(0.22	)

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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

5.	Inventories

Inventories consist of the following:


(in thousands)	September 30, 2006			December 31, 2005
Finished goods	$	2,642		$	2,800
Work-in-process		392			337
Raw materials, parts and sub-assemblies		5,068			5,085

		8,102			8,222
Less non-current portion		(440	)		(632	)

Inventories – current portion	$	7,662		$	7,590

6.	Bank Loan Agreement

In May 2004, we signed a credit facility with a commercial bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate.

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

7.	Income Taxes

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

Realization of deferred tax assets associated with net operating losses (“NOL”) and tax credit carry forward is dependent upon our being able to generate sufficient taxable income prior to their expiration. We believe 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. We will continue to review the estimates of taxable income and will make adjustments to the valuation allowance, when necessary.

Also, should 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.

8.	Capital Stock—Warrants

At September 30, 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

(unaudited – dollars in thousands except per share amounts)

9.	Contingencies

Litigation

From time to time, we are 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 (i) agreements with other companies in the ordinary course of business, typically with business partners, contractors, customers and landlords, and (ii) agreements with investors. Under such provisions we generally indemnify and hold 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 September 30, 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 industry segments: (1) IVD instruments and supplies and (2) sample processing instruments and related supplies.

The IVD instrument segment designs, develops, manufactures, markets and distributes IVD systems based on patented and proprietary technology for automating microscopic and chemistry procedures for urinalysis and conducts research and development for in vitro molecular diagnostics applications as well as imaging and pattern recognition. The segment also provides ongoing sales of supplies and services necessary for the operation of installed urinalysis workstations. In the United States, these products are sold through a direct sales force. Internationally, products are sold primarily through distributors.

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

IRIS INTERNATIONAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited – dollars in thousands except per share amounts)

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


(in thousands)	IVD Instruments			Sample Processing		Unallocated Corporate Expenses		Total
For the three months ended September 30, 2006
Revenues	$	15,252		$	2,756			18,008
Interest income	$	265		$	2			267
Interest expense	$	5		$	—			5
Depreciation and amortization*	$	614		$	69	37		720
Segment pre tax profit (loss)	$	651		$	577			1,228
Segment assets	$	56,937		$	4,018	8,259		69,214
Investment in long-lived assets	$	18,506		$	521	—		19,027
For the three months ended September 30, 2005
Revenues	$	13,414		$	2,588	—		16,002
Interest income	$	187		$	2	—		189
Interest expense	$	2		$	—	—		2
Depreciation and amortization*	$	521		$	40	13		574
Segment pre tax profit	$	2,840		$	600	(870	)	2,570
Segment assets	$	45,284		$	3,450	9,581		58,315
Investment in long-lived assets	$	12,326		$	243	—		12,569
For the nine months ended September 30, 2006
Revenues	$	42,208		$	8,513			50,721
Interest income	$	767		$	6			773
Interest expense	$	17		$	—			17
Depreciation and amortization*	$	2,035		$	304	283		2,622
Segment pre tax profit (loss)	$	(2,087	)	$	1,903	(21	)	(205	)
Segment assets	$	45,383		$	15,572	8,259		69,214
Investment in long-lived assets	$	18,506		$	521	—		19,027
For the nine months ended September 30, 2005
Revenues	$	38,418		$	7,125	—		45,543
Interest income	$	359		$	6	—		365
Interest expense	$	14		$	—	—		14
Depreciation and amortization*	$	1,461		$	133	57		1,651
Segment profit	$	8,328		$	1,486	(2,497	)	7,317
Segment assets	$	45,284		$	3,450	9,581		58,315
Investment in long-lived assets	$	12,326		$	243	—		12,569

*	Included in depreciation and amortization above is amortization of stock based compensation in the amounts $403 and $113 for the three months ended September 30, 2006 and 2005; and $1,076 and $300 for the nine months ended September 30, 2006 and 2005.

We ship 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 $15.3 million and $13.7 million during the nine months ended September 30, 2006 and 2005. Long-lived assets include property and equipment, goodwill, software development costs, long-term portion of inventory and other long-term assets. Deferred income tax is excluded from long-lived assets.

Item 2.

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

Overview

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

We generate revenues primarily from: sales of IVD instruments, IVD consumables and service and sample processing instruments and supplies. Revenues from IVD instruments include sales of urine microscopy and chemistry analyzers manufactured by us and urine chemistry analyzers purchased from a Japanese manufacturer. We sell our IVD urine microscopy analyzers and the iChem 100, our new semi-automated chemistry analyzer introduced in the third quarter of 2006 on a global basis. 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 and, spare parts from international customers. 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 of automated instruments are direct to the customer through our sales force, whereas international IVD sales, with the exception of France, are through independent distributors. Domestic sales of our new urine chemistry instrument and strips (iChem 100 and vChem) are through distributors with support from a third party sales organization. Sales in France are direct to end use customers. International IVD sales represented 28% of consolidated revenues during the nine months ended September 30, 2006 as compared to 28% during fiscal 2005 and 17% in fiscal 2004. Since the launch of our iQ200 product line, we have increased our sales efforts in the international marketplace, with the ultimate goal of balancing our urinalysis business between domestic and international markets. Since international IVD sales are made through independent distributors, gross profit margin is lower than domestic sales of the same products, but we do not incur sales and marketing costs for such sales. Our Sample Processing products are sold worldwide through distributors.

Effective January 1, 2006 we implemented the provisions of SFAS No. 123R, “Share-Based Payment,” that establishes standards for accounting for transactions in which a company exchanges its equity instruments for goods and services or incurs a liability in exchange for goods and services that is based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The primary focus of this pronouncement is on issuing share-based payments for services provided by employees. This pronouncement also requires recognition of compensation expense for new equity instruments awarded or for modifications, cancellations or repurchases of existing awards starting January 1, 2006. Compensation expense for new equity awards, in most cases, will be based on the fair value of the stock on the date of grant and will be recognized over the vesting service period. An award of a liability instrument, as defined by this pronouncement, will initially be recorded at fair value and will be adjusted each reporting period to the new fair value through the date of settlement. Under the terms of this pronouncement, we began to expense equity awards using a modified version of prospective application.

Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the fair value of those awards on their respective grant dates.

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

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

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

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

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


(in thousands)	For the three months ended September 30,						For the nine months ended September 30,
(in thousands)	2006			2005			2006			2005
Total product technology expenditures	$	2,657		$	1,789		$	12,337		$	4,834
Less: amounts capitalized during year to software development costs as reported in the consolidated statements of cash flow		(136	)		—			(136	)		(171	)
Less: amounts reimbursed through grants for government sponsored research and development		(348	)		(468	)		(1,269	)		(1,301	)

Research and development expense as reported in the consolidated statements of operations	$	2,173		$	1,321		$	10,932		$	3,362

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 includes 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 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.

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 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 September 30,								Nine months ended September 30,
	2006				2005				2006					2005
Revenues
IVD instruments	$	7,477	42	%	$	6,347	40	%	$	19,429		38	%	$	19,765	43	%
IVD consumables and service		7,775	43	%		7,067	44	%		22,779		45	%		18,653	41	%
Sample processing		2,756	15	%		2,588	16	%		8,513		17	%		7,125	16	%

Total revenues		18,008	100	%		16,002	100	%		50,721		100	%		45,543	100	%

Cost of Goods Sold
IVD instruments		4,432	59	%		3,540	56	%		10,839		56	%		11,413	58	%
IVD consumable and service		3,976	51	%		3,030	43	%		10,600		47	%		7,944	43	%
Sample processing		1,460	53	%		1,324	51	%		4,442		52	%		3,588	50	%

Total costs		9,868	55	%		7,894	49	%		25,881		51	%		22,945	50	%

Gross margin		8,140	45	%		8,108	51	%		24,840		49	%		22,598	50	%

Operating expenses
Marketing and selling		2,718	15	%		2,659	17	%		7,674		15	%		7,526	17	%
General and administrative		2,284	13	%		1,740	11	%		7,229		14	%		4,783	11	%
Research and development, net		2,173	12	%		1,321	8	%		10,932		22	%		3,362	7	%

Total operating expenses		7,175	40	%		5,720	36	%		25,835		51	%		15,671	35	%

Operating income (loss)		965	5	%		2,388	15	%		(995	)	-2	%		6,927	15	%

Net income	$	774	4	%	$	1,542	10	%	$	(2,045	)	-4	%	$	4,390	10	%

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

Net revenues for the three months ended September 30, 2006 increased 13% from the prior year quarter. Revenues from the IVD urinalysis segment totaled $15.3 million in the current quarter, up from $13.4 million in the prior year quarter. Sales of IVD instruments increased to $7.5 million from $6.3 million, an 18% increase from the prior year quarter. The increase in instrument sales is due primarily to a significant increase in domestic sales resulting in a higher mix of domestic versus international sales of iQ200 analyzers and systems during the current quarter as compared to sales during the prior year period. Sales of IVD consumables and service increased to $7.8 million from $7.1 million, an increase of $0.7 million or 10%, primarily due to the larger installed base of instruments. Revenues from the sample processing segment increased to $2.8 million from $2.6 million, or 6%. This increase is primarily due to increased unit sales of our new Express 3 centrifuge.

Consolidated gross profit margins decreased to 45% of revenues as compared to 51% during the prior year quarter. IVD instruments gross margin was 41%, a reduction from 44% for the same period a year ago The decline is primarily attributable to a $0.4 million charge during the quarter for estimated sales returns allowances of $0.4 million resulting from a concerted effort to upgrade certain customers who currently utilize our Legacy systems. Margins on IVD consumables and service declined to 49% as compared to 57% in the prior year quarter. The decline included the effects of higher spare parts usage of $0.2 million; an adjustment to our physical inventory of $0.2 million and continued low margins on the chemistry strips manufactured in Germany.

Marketing and selling expenses totaled $2.7 million for the three months ended September 30, 2006 approximately the same as in the prior year quarter. As a percentage of sales such expenses during the current quarter and prior year quarter were 15% and 17%, respectively. During the current quarter the company incurred additional stock based compensation expense of approximately $0.1 million resulting from the adoption of SFAS No. 123R.

General and administrative expenses increased in the quarter to $2.3 million from $1.7 million in the prior year quarter. The increase includes approximately $0.3 million of professional fees related to compliance with Sarbanes Oxley, $0.2 million of additional personnel costs during the quarter, and $0.1 million of costs associated with the adoption of SFAS No. 123R. As a percentage of sales, general and administrative expenses were 13% during the current quarter as compared to 11% for the prior year quarter.

Net research and development amounted to $2.2 million during the current quarter as compared to $1.3 million in the prior year quarter. Research and development expenses were net of reimbursed costs received from governmental research and development grants, which amounted to $0.4 million and $0.5 million the three months ended September 30, 2006 and 2005 respectively. The increase in research and development expense includes approximately $0.6 million relating to molecular diagnostics programs initiated with our acquisition of Leucadia Technologies and $0.3 million of incremental development expense related to the design of our new automated urine chemistry analyzer for the international market.

Interest income during the quarter amounted to $267, an increase from $189 in the prior year quarter and relates primarily to our investment of excess funds during the quarter plus interest received on sales-type equipment leases. Interest expense during the current quarter increased to $5 as compared to $2 in the prior year quarter.

During the third quarter of 2006 the income tax provision of $0.5 million was 37% of pre tax income versus 40% in the prior year quarter. The tax provision continues to be a non-cash item, since we have significant deferred tax assets relating to tax loss carryforwards.

Comparison of the nine months ended September 30, 2006 to 2005

Net revenues for the nine months ended September 30, 2006 increased 11% from the prior year period. Revenues from the IVD urinalysis segment totaled $42.2 million during the current year nine month period, up from $38.4 million in the prior year period. Sales of IVD instruments decreased to $19.4 million from $19.8 million, a 2% decrease from the prior year period. The decrease in instrument sales is a result of the reduction in international sales of the iQ200 analyzers during the current year nine month period as compared to the same period in 2005. As of the result of the increase in domestic sales in the third quarter, year to date domestic instrument sales recovered to end at the same level as the prior year period. Sales of IVD consumables and service increased to $22.8 million, up from $18.7 million, an increase of $4.1 million or 22%, primarily due to the larger installed base of instruments. Revenues from the sample processing segment increased to $8.5 million from $7.1 million, or 19%. This increase is primarily due to increased sales of our new Express 3 centrifuge and DNA processing stations.

Consolidated gross profit margins declined slightly to 49% of revenues as compared to 50% during the prior year nine month period. For the IVD instruments, margins improved to 44% of related revenues as compared to 42% for the prior year period. The increase in the instrument margins was associated with reduced material costs through change in suppliers and negotiated price reductions with the remaining supplier base. The margins on IVD consumables and service declined from 57% in 2005 to 53% in 2006. The decline is primarily a result of the chemistry strip manufacturing operation in Germany acquired last year operating below capacity as well as the previously mentioned adjustments which occurred in the third quarter. Margins on our sample processing instruments and supplies were two percentage points lower during the current year period due to an increase in OEM customer mix from the prior year period.

Marketing and selling expenses totaled $7.7 million for the nine months ended September 30, 2006 as compared to $7.5 million in the prior year nine month period, and as a percentage of sales such expenses were 15% in 2006 as compared to 17% in 2005. During the current year period, we incurred an additional $0.2 million of stock based compensation expense.

General and administrative expenses increased to $7.2 million from $4.8 million during the prior year period. The increase includes approximately $0.9 million of additional personnel costs, $0.4 million of professional fees related to compliance with Sarbanes Oxley, $0.4 million of stock based compensation, $0.4 million related to bad debt expense and $0.3 million of recruiting expense.

Net research and development expense as shown in the accompanying statements of operations amounted to $10.9 million during the current nine month period as compared to $3.4 million in the prior year nine month period. Research and Development expenses were net of reimbursed costs received from

governmental research and development grants, which amounted to $1.2 million and $1.3 million during the nine months ended September 30, 2006 and 2005.As a result of our acquisition of Leucadia Technologies on April 3, 2006, we acquired significant in-process research and development expense for bacteria and cancer detection applications which we valued at $5.2 million in the second quarter of 2006. The increase in research and development expense includes approximately $1.0 million relating to molecular diagnostics programs initiated with our acquisition of Leucadia Technologies, $0.4 million of incremental development expenses related to the design of our new automated urine chemistry analyzer for the international market.

Interest income during the nine months ended September 30, 2006 amounted to $773, an increase from $365 in the prior year and relates primarily to our investment of excess funds during the year plus interest received on sales-type equipment leases. Interest expense was $17 and $14 for the first nine months of 2006 and 2005, respectively.

During the first nine months of 2006, the income tax provision of $1.8 million resulted from the exclusion of $5.2 million of in-process research and development expense from taxable income. 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 September 30, 2006 and 2005, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Liquidity and Capital Resources

Our primary source of liquidity is cash from operations, which depends heavily on sales of our IVD urinalysis systems and the sales of consumables and service for these systems as well as the sale of sample processing instruments and related supplies. During the first nine months of 2006, our cash, cash equivalents. This decrease is mostly a result of the acquisition of Leucadia Technologies Inc. and facilities expansion in anticipation of new product development initiatives.

Operating Cash Flows

Cash provided by operations for the current year nine month period amounted to $3.6 million compared to cash provided by operations of $1.2 million in the prior year. Cash provided by operations for the nine months resulted primarily from the net loss adjusted for non-cash items ($5.5 million) partially offset by an increase in sales-type leases ($3.0 million) financed internally.

The relationship of receivables to revenues is unchanged at 69 days sales in accounts receivable as compared to the beginning of the year. The number of days of sales in inventory decreased to 70 days as compared to 86 days at the beginning of the year. The inventory turn rate is 5.2 times.

Investing Activities

Cash provided in investing activities totaled $8.7 million during the nine months ended September 30, 2006 primarily as a result of selling marketable securities of $15.4 million partially offset by cash paid to acquire Leucadia Technologies ($3.3 million) and additions to property and equipment of $3.0 million ($0.7 million in 2005). Capital expenditures in 2006 include $1.9 million for facility expansion and upgrading in our California and Massachusetts locations, and $300k in additions to production equipment.

Financing Activities

For the nine months ended September 30, 2006, financing activities provided $1.2 million of cash, compared to $3.5 million provided during the prior year. During the current year, we received $1.2 million from issuances of shares of common stock compared to $3.5 million in the prior year.

We currently have a credit facility with a commercial bank consisting of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and

inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of September 30, 2006, there were no borrowings under the new credit facility. We are subject to certain financial covenants under the credit facility with the bank and as of September 30, 2006, we were in compliance with such covenants.

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

Recent Accounting Pronouncements

Inflation

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

Healthcare Reform Policies

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

RISK FACTORS

Cautionary Statements and Risk Factors

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

These uncertainties and other factors include, among other things:

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

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

•

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 September 30, 2006, we have deferred tax assets of approximately $5.5 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 we believe that the deferred tax asset is recoverable, there is no assurance that we will be able to generate taxable income in the years that the differences reverse. Also, if we undergo an ownership change as defined in Section 382 of the Internal Revenue Code, NOLs generated prior to the ownership change would be subject to an annual limitation. If this occurs, a valuation allowance may be necessary.

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

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

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

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

The healthcare industry is highly competitive. We compete in this industry based primarily on product performance, service and price. Many of our competitors have substantially greater financial, technical and human resources than we do, and may also have substantially greater experience in developing products, obtaining regulatory approvals and manufacturing and marketing and distribution. As a result, they may be better able to compete for market share, even in areas in which our products may be superior. Further, our competitive position could be harmed by the establishment of patent protection by our competitors or other companies. The existing competitors or other companies may succeed in developing technologies and products that are more effective or affordable than those being developed by us or that would render our technology and products less competitive or obsolete. If we are unable to effectively compete in our market, our financial condition and results of operation will materially suffer.

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

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

Defective products may subject us to liability.

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

Business interruptions could adversely affect our business.

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

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

We have been experiencing significant growth in the scope of our operations. This growth has placed significant demands on our management, as well as operational resources. In order to achieve our business objectives, we anticipate that we will need to continue to grow. If this growth occurs, it will continue to place additional significant demands on our management and our operational resources, and will require that we continue to develop and improve our operational, financial and other internal controls both in the US and internationally. In particular, if our growth continues, it will increase the challenges in

implementing appropriate control systems, expanding our sales and marketing infrastructure capabilities, providing adequate training and supervision to maintain high quality standards, and preserving our cultural values. The main challenge associated with our growth has been the management of our expenses. Our inability to scale our business appropriately or otherwise adapt to growth, could cause our business, financial condition and results of operations to suffer.

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

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

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variation in demand for our products, including seasonality;

•

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

•

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

•

our ability to control costs;

•

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

•

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

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

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

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

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

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

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

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

•

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;

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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 September 30, 2006.

Interest Rates

At September 30, 2006, we did not have any outstanding indebtedness subject to interest rate fluctuations. All of our cash equivalents are held in United States bank accounts and we do not believe we have significant market risk exposure with regard to our investments.

Foreign Currencies

We are subject to some currency risk on purchases of products from a Japanese manufacturer. Our purchases of products from our Japanese supplier are negotiated annually and may be affected by changing foreign currency rates.

Item 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined by paragraph (e) of Exchange Act Rules 13a-15 or 15d-15, designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the SEC and to approve, summarize and disclose this information within the time periods specified in the rules of the SEC. Our Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining these procedures, and, as required by the rules of the SEC, evaluate their effectiveness. Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2006, the end of the period covered by this report, and based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

Changes in Internal Controls over Financial Reporting

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

accountability for access is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

Since the date of the most recent evaluation of our internal controls over financing reporting by the Chief Executive Officer and Interim Chief Financial Officer, we have identified certain significant deficiencies in such controls and plan to implement the following controls:

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Field Service Accounting—a deficiency in the area of field service inventory control was identified during the third quarter resulting in a significant third quarter adjustment. We have recently hired a new Vice President of Global Service who has implemented a number of changes to our control structure to strengthen this area in order to eliminate the deficiency.

•

Leasing Accounting—a deficiency in the area of lease contract administration was noted during the quarter resulting in a significant third quarter adjustment. We will implement the appropriate procedures during the fourth quarter to correct this deficiency.

Limitations on the Effectiveness of Controls

We maintain 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 Interim 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 4.

Submission of Matters to a Vote of Security Holders

On August 4, 2006, we held our 2006 Annual Meeting of Shareholders. At the annual meeting, there were 17,854,185 shares entitled to vote, including 17,854,185 shares of common stock. There were 15,549,881 shares (87.1% of the shares entitled to vote) represented at the meeting in person or by proxy. The only matters submitted to the shareholders at the annual meeting were (a) the election of 7 directors, and (b) the ratification of the appointment of BDO Seidman, LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2006.

Immediately prior to and following the meeting, the Board of Directors was comprised of Thomas H. Adams, Ph.D. , Steven M. Besbeck , César M. García, Michael D. Matte, Richard G. Nadeau, Ph.D., Stephen E. Wasserman, and Richard H. Williams.

The following summarizes vote results for those matters submitted to our stockholders for action at the annual meeting:

1. Proposal to elect Thomas H. Adams, Ph.D., Steven M. Besbeck , César M. García, Michael D. Matte, Richard G. Nadeau, Ph.D., Stephen E. Wasserman, and Richard H. Williams, for one year or until their successors have been elected:


Director	For	Withheld
Thomas H. Adams, Ph.D.	15,416,962	132,919
Steven M. Besbeck	15,411,790	138,091
César M. García	15,413,950	135,931
Michael D. Matte	15,480,903	68,978
Richard G. Nadeau, Ph.D.	15,444,820	105,061
Stephen E. Wasserman	15,480,253	69,628
Richard H. Williams	15,474,913	74,968

1. Proposal to ratify the appointment of BDO Seidman, LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2006:


For	Against	Abstained
15,502,237	29,557	18,087

Item 6.

Exhibits


Exhibit Number	Description	Reference Document

10.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Principal Accounting Officer	(1	)

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 Accounting 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 Accounting Officer	*

*	filed herewith

(1)	Filed as an Exhibit to our Current Report on Form 8-K dated September 20, 2006 (File No. 001-11181)

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: November 14, 2006


IRIS INTERNATIONAL, INC.

By:		/s/ CESAR M. GARCÍA
		César M. García
		President and Chief Executive Officer

By:		/s/ VERONICA O. TARRANT
		Veronica O. Tarrant
		Interim Chief Financial Officer