IRIS INTERNATIONAL INC - 10-Q Quarterly Report

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

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

The registrant had 15,951,333 shares of common stock issued and outstanding as of November 2, 2004.

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

IRIS International, Inc., (collectively “IRIS” or the “Company”) was incorporated in California in 1979 and reincorporated during 1987 in Delaware under the name of International Remote Imaging Systems, Inc. The Company changed its name to IRIS International, Inc. in December 2003. The Company designs, develops, manufactures and markets in vitro diagnostic (“IVD”) equipment, including IVD imaging systems based on patented and proprietary automated intelligent microscopy (“AIM”) technology, as well as special purpose centrifuges and other small instruments for automating microscopic procedures performed in clinical laboratories.

In the opinion of management, the accompanying unaudited consolidated financial statements contain all normal recurring adjustments necessary to present fairly the financial position of the Company as of September 30, 2004 and the results of its operations for the three and nine-month periods then ended. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s latest annual report on Form 10-K. Interim results are not necessarily indicative of results for a full year.

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

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

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

Accounts receivable are customer obligations due under normal trade terms. IRIS sells predominantly to entities in the healthcare industry. IRIS grants uncollateralized credit to its customers, primarily hospitals, clinical and research laboratories, and distributors. IRIS performs ongoing credit evaluations of its customers before granting uncollateralized credit. The Company may require its customers to provide letters of credit in certain circumstances. The Company does not have any single customer which accounts for 10% or more of its consolidated revenues or 10% or more of its accounts receivable at the balance sheet date.

Senior management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. The Company includes any accounts receivable balances that are determined to be uncollectible, along with a general reserve, in its overall allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. Based on the information available to the Company, the Company believes its allowance for doubtful accounts as of September 30, 2004 is adequate.

Inventories are carried at the lower of cost or market on a first in, first out basis. Provision for potentially obsolete or slow-moving inventory is made based on management’s analysis of inventory levels and future sales forecasts. The Company classifies inventories that are not expected to be utilized or sold within the next twelve months as long-term in the accompanying consolidated balance sheet.

Management classifies the investment in the common shares of Applied Imaging Corporation (NASDAQ: AICX), as available for sale. Investments in available for sale securities are reported at fair value with unrealized holding gains and losses, net of tax, reported as a separate component of shareholders’ equity until realized, or until management believes a permanent decline in value has occurred. Realized gains and losses are included in earnings. At September 30, 2004, management determined that a permanent decline in value had taken place and wrote down the value of the investment by $531,000.

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

Goodwill is recorded at cost. The realizability of the goodwill is evaluated at least annually, or as events or circumstances indicate a possible inability to recover the carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections. The analysis necessarily involves significant management judgment to evaluate the capacity of an acquired business to perform within projections. At September 30, 2004, the Company evaluated its goodwill and determined that fair value had not decreased below carrying value and no adjustment to impair goodwill was necessary in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.”

The Company capitalizes certain software development costs for new products and product enhancements once all planning, designing, coding and testing activities necessary to establish that the product can be produced to meet its design specifications are completed, and concludes capitalization when the product is ready for general release. Research and development costs relating to software development are expensed as incurred. Amortization of capitalized software development costs is provided on a product-by-product basis at the greater of the amount computed using (a) the ratio of current revenues for a product to the total of current and anticipated future revenues or (b) the straight-line method over the remaining estimated economic life of the product up to five years. The Company capitalized $46,195 and $423,775 of software development costs and recorded amortization of software development costs of $375,000 and $000,000 during the nine months ended September 30, 2004 and 2003.

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

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

If compensation expense for the stock options had been determined using “fair value” at the grant date for awards during 2004 and 2003, consistent with the provisions of SFAS No. 123, the Company’s net income (loss) and income (loss) per share would have been reduced to the pro forma amounts indicated below:

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.

Revenues are derived from the sale of IVD instruments, sales of consumable supplies and services for its IVD systems as well as sales of small laboratory devices and related supplies. Revenue is

recognized once all of the following conditions have been met: a) an authorized purchase order has been received in writing with a fixed and determinable sales price, b) customer credit worthiness has been established, and c) delivery of the product based on shipping terms. The majority of domestic IVD instrument sales generally require installation and training to be performed.

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

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

IRIS records the estimated cost of warranty expense at the time of product delivery.

Except for certain capitalized software development costs 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 grants and contracts.

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

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

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

Basic earnings per share are computed by dividing net income or loss by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income by the weighted average number of common shares and common stock equivalents outstanding, calculated on the treasury stock method for options and warrants. Common stock equivalents for the nine months ended September 30, 2004 included 821,585 from stock options and 535,958 from warrants. Common stock equivalents for the previous year’s period have been excluded from the computation because their effect is antidilutive.

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

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

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

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

In May 2004, the Company signed a new credit facility with a major bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. Borrowings under the revolving line of credit are limited to a percentage of eligible receivables and inventory. The entire credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender’s prime rate. As of September 30, 2004, there were no borrowings under the new credit facility. The Company is subject to certain financial covenants under the credit facility with the bank and as of September 30, 2004, the Company was in compliance with such covenants.

The income tax provision for the nine-month period ended September 30, 2004 was $965,900 as compared to a benefit of $407,090 for the comparable period last year. The income tax provision differs from the federal statutory rate due primarily to state income taxes and permanent differences between income reported for financial statement and income tax purposes.

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

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

On April 16, 2004, the Company signed an agreement with an investment bank for the private placement of 2,130,000 shares of the Company’s common stock at a price of $5.85 per share (a 10% discount to market). In addition, each of the investors received a 5-year warrant to purchase 3 additional shares of common stock for each 20 shares of common stock purchased in the offering. The agreement requires the Company to file a registration statement within 30 days of closing and to have the registration statement declared effective within 90 days of closing. In May 2004, the Company filed a registration statement, which was declared effective on May 21, 2004. The Company realized net proceeds (after deducting offering expense of $1.0 million) of approximately $11.5 million. The Company used approximately $5.5 million of the net proceeds to retire all of its outstanding indebtedness to its former bank and subordinated note holder.

During the nine months ended September 30, 2004, the Company (i) issued 961,395 shares of common stock from the exercise of options, (ii) issued options to purchase 183,000 shares of common stock and (iii) cancelled and forfeited options to purchase 40,817 shares of common stock. At September 30, 2004, options to purchase 2,094,318 shares of common stock were issued and still outstanding. Outstanding options will expire at various dates through the end of 2012. The exercise price for such options ranges from $0.69 to $7.08 per share. At September 30, 2004, there were 366,158 shares of common stock available for the granting of future options under the Company’s stock option plans.

At September 30, 2004, the following warrants to purchase common stock were outstanding and exercisable:

On July 14, 2004, a warrant for 853,040 shares was fully exercised by the holder and the Company received $1,620,776 in proceeds.

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

In November 2002, the Financial Accounting Standards Board (“FASB”) issued FIN No. 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others — an interpretation of FASB Statements No. 5, 57 and 107 and rescission of FIN 34.” The following is a summary of the Company’s agreements that it has determined are within the scope of FIN 45.

The Company enters into indemnification provisions under (i) agreements with other companies in the ordinary course of business, typically with business partners, contractors, customers and landlords, and (ii) agreements with investors. Under such provisions the Company generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of the Company’s activities or, in some cases, as a result of the indemnified party’s activities under the agreement. Indemnification provisions often include indemnifications relating to representations made by the Company with regard to intellectual property rights. Such indemnification provisions generally survive termination of the underlying agreement. In addition, in some cases, the Company agrees to reimburse employees for certain expenses and to provide salary continuation. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is unlimited. To date, the Company has not incurred any material costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no recorded liabilities for these agreements as of September 30, 2004.

A competitor previously developed several urine sediment analyzers under license agreements using the Company’s technology. The Company received royalties under the license of $336,249 and $395,616 for the nine months ended September 30, 2004 and 2003.

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

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

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

The Company ships products from two locations in the United States. Substantially all long-lived assets were located in the United States and totaled $6,978,732 at September 30, 2004. Sales to international customers amounted to approximately $5.9 million and $2.2 million during the nine months ended September 30, 2004 and 2003.

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

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:

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

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

We currently generate revenues primarily from two segments: IVD instruments, which includes instruments, consumables supplies and service, and small laboratory device instruments and supplies. We released our newest product, the iQ200 IVD urine analyzer, in the third quarter of 2003. Although we continue to support our legacy models, we expect sales of consumables for our legacy models to diminish gradually as they are replaced by the iQ200 and future upgrades.

Our IVD business has been in a transition since the introduction of the iQ200 platform product in August 2003. During this transitional period, recurring revenues were impacted by a number of factors, including (i) a four and a half month time lag between instrument shipment and consumable generation, and (ii) a delay in service contract and parts revenue due to a 15-month warranty period. Commencing in the third quarter of 2004, we experienced an increase in sales of IVD consumables as our installed base of iQ200 instruments began to generate recurring revenues. We expect revenues and earnings to continue to improve in future periods as the installed base of iQ200 instruments continues to increase.

Approximately 80% of our revenues are derived from our IVD business, of which consumables supplies and services contribute higher gross margins than revenues from instrument sales. Consumables products include chemical reagents and urine test strips. Service revenues are derived primarily from annual service contracts purchased by our domestic customers. Once our analyzers and systems are installed, we generate recurring revenue from sales of consumables and service (including parts), which should continue to expand as the installed base of related instruments expands.

Sales of small laboratory devices and supplies, sold by StatSpin, primarily consist of centrifuge systems and a new DNA workstation and related supplies. Sales of StatSpin’s products are made worldwide through distributors.

We continue to make significant investments in research and development for new products and enhancements to existing products. We internally fund our research and development programs, and through our ADIR subsidiary, we receive grants from the National Institute of Science and Technology and, to a lesser extent, contracts from third parties.

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

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

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

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

We record revenue in accordance with EITF Statement No. 00-21, “Revenue Arrangements with Multiple Deliverables,” and SAB No. 104, “Revenue Recognition in Financial Statements,” which generally require 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. We value training services based on hourly rates that we charge for these services when sold separately from hardware sales. Accordingly, we allocate revenue to each element in a multiple-element arrangement based on the element’s respective fair value, with the fair value determined by the price charged when that element is sold and specifically defined in a quotation or contract.

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

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 a new urine analyzer in the iQ200, an installed base of the legacy products still exist. We maintain a base supply of service parts for these products, a portion of which is classified as long-term 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. We account for such software development in accordance with 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.

Comparison of quarter ended September 30, 2004 to quarter ended September 30, 2003

Sales of IVD instruments are made both domestically and internationally. Our own sales staff makes domestic sales directly to the customer, whereas international sales are made through independent distributors. International sales represented 20% of consolidated net revenues during the three months ended September 30, 2004 compared to 17% during the three months ended September 30, 2003. With the launch of our new iQ200 analyzer, we have increased our focus on the international marketplace, with the ultimate goal of balancing our urinalysis business between domestic and international markets. Since our international sales are made through independent distributors, our gross profit margin on such sales is lower than domestic sales of the same products.

Net revenues for the quarter ended September 30, 2004 increased by $3.3 million to $11.8 million or 40% over the same period in the prior year. Revenues from the IVD urinalysis segment totaled $9.4 million or 80% of consolidated revenue in the current year, up from $6.9 million or 82% of consolidated revenue in the prior year, and included sales of IVD instruments which increased to $4.0 million from $2.3 million, an increase of 73% over the third quarter of 2003. The increase is primarily due to sales of the iQ200, which first became available in the third quarter of 2003. Sales of the iQ200 Automated Urine Microscopy Analyzers and the iQ200 Automated Urinalysis Systems accounted for nearly all of the instrument sales in the current period. Sales of IVD system consumables and services increased in the quarter to $5.3 million from $4.4 million during the prior year quarter, an increase of $957,000, primarily due to the larger installed base of IVD instruments. Revenues also include royalty and license fees, which decreased to $18,000 from $177,000 in the comparable period from the prior year. Revenues from the small laboratory devices segment increased to $2.4 million from $1.5 million, an increase of $842,000 or 55%. This increase is primarily due to increased sales of centrifuges, and the new ThermoBrite^® DNA workstation.

Consolidated cost of goods sold increased as a percentage of consolidated net revenues to 51% in the third quarter of 2004 compared to 49% in the third quarter of 2003, which resulted in consolidated net margins of 49% for the current quarter as compared to 51% in the third quarter of 2003.

IVD Instruments’ cost of goods sold as a percentage of related sales amounted to 66% in the current quarter as compared to 79% for the same period in the prior year, which resulted in net margins of 34% and 21%. In the prior year quarter, costs were impacted by the lower volume of instrument sales, whereby fixed overhead was allocated to fewer units as compared to the current quarter. In the current year quarter, revenues were impacted by higher sales through distributors internationally, which generally generate lower gross margins. In addition, we incurred approximately $50,000 in reserves for potential product returns and upgrades.

IVD Consumables and Services’ cost of goods sold as a percentage of related sales was 39% for the current quarter as compared to 35% in the same period last year, which resulted in net margins of 61% and 65%. This increase is primarily due to discounts given to international distributors and an increasing proportion of service activity covered by initial warranties on the new iQ200.

Small Laboratory Instruments’ cost of goods sold as a percentage of sales amounted to 52% for the current quarter, as compared to 49% for the third quarter of last year, which resulted in net margins of 48% and 51%. The lower profit margin results from increased sales of lower margin products.

As a percentage of net revenues, marketing and selling expenses were 15% in the quarter ended September 30, 2004, down from 18% in the same period last year. Marketing and selling expenses totaled $1.8 million, compared to $1.6 million for the comparable prior year period, an increase of $270,000. The increase is due primarily to increased commissions due to higher revenues ($53,000), additional sales and technical support personnel costs ($121,000), and additional travel costs ($2,000), all associated with the increased sales activity following the launch of the iQ200. In addition, the current quarter includes $55,000 of costs related to our international sales and support infrastructure, which was first established in July 2003.

General and administrative expenses increased $244,000 to $1.6 million from $1.4 million in the comparable period in the prior year. General and administrative expenses for the period as a percentage of net revenue were 14% as compared to 16% in the same period in the prior year. The increase is due primarily to $181,000 expended in the current year’s quarter to comply with provisions of Section 404 of the Sarbanes-Oxley Act of 2002. The Company expects to incur at least $100,000 in additional costs during the fourth quarter of 2004.

These expenses increased slightly to $1.1 million for the current quarter from $1.0 million in the third quarter of last year. We expect to continue to invest in research and development during 2004 at a slightly reduced rate as compared to 2003, with our primary focus on enhancements to our existing products.

Interest income increased to $35,000 during the quarter as compared to $7,000 for the prior year quarter due to the increased cash and cash equivalents available for investment. Interest expense decreased to $4,400 in the quarter ended September 30, 2004 from $83,000 in the comparable quarter of the prior year, primarily due to the repayment of all our outstanding debt with a portion of the proceeds from the private placement in 2004.

Other income (expense) decreased to an expense of $531,000 during the quarter as compared to income of $486 for the prior year quarter, due to the write down in the third quarter in the amount of approximately $534,000 on an investment available for sale. The income tax provision for the quarter ended September 30, 2004 amounted to $321,000, as compared to $86,000 for the quarter ended September 30, 2003. The change is a function of the taxable income or loss. The tax provision is a non-cash item, as we have significant deferred tax assets resulting from tax net loss carryforwards.

Comparison of nine months ended September 30, 2004 to nine months ended September 30, 2003

Net revenues for the nine months ended September 30, 2004 increased by $10.4 million to $31.5 million or 49% over the same period in the prior year. Revenues from the IVD urinalysis segment totaled $25.2 million or 80% of consolidated revenue in the current year, up from $16.8 million or 80% of consolidated revenue in the prior year quarter, and included sales of IVD instruments, which increased to $10.1 million from $3.7 million, an increase of 170% over the first nine months of 2003. The increase is primarily due to sales of the iQ200, which first became available in the third quarter of 2003. Sales of the iQ200 Automated Urine Microscopy Analyzers and the iQ200 Automated Urinalysis Systems accounted for nearly all of the instrument sales in the current period. In spite of a reduction in service revenue due to the disproportional increase in the number of iQ200’s under warranty, sales of IVD system consumables and services increased in the period to $14.7 million from $12.7 million during the prior year period, an increase of $2.0 million, primarily due to the larger installed base of IVD instruments. IVD urinalysis segment revenues also include royalty and license fees, which decreased to $336,000 from $396,000 in the comparable period from the prior year. Revenues from the small laboratory devices segment increased to $6.3 million from $4.3 million, an increase of $2.0 million or 48%. This increase is primarily due to increased sales of centrifuges and the new ThermoBrite^® DNA denaturation and hybridization station.

Consolidated cost of goods sold as a percentage of net revenues increased to 51% in the first nine months of 2004 compared to 48% in the first nine months of 2003, which resulted in consolidated net margins of 49% and 52% for the nine-month periods.

IVD Instruments’ cost of goods sold as a percentage of related sales amounted to 70% in the nine-month period as compared to 89% during the same period in the prior year, which resulted in gross profit margins of 30% and 11% for the nine-month periods. A much lower volume of instrument sales impacted the prior year period. In the current year period, cost of goods sold as a percentage of revenues resulted from higher revenues through distributors internationally, which generate lower gross margins. In addition we incurred, approximately $300,000 in additional costs stemming from engineering and retrofit charges for product improvements and approximately $250,000 in reserves for potential product returns and upgrades. The impact of these charges reduced our gross margins by 5% during the nine-month period of 2004.

IVD Consumables and Services’ cost of goods sold for as a percentage of related sales was 40% for the current year nine-month period as compared to 37% in the same period last year, which resulted in gross profit margins of 60% and 63% for the nine-month periods. This increase is primarily due to higher international sales through distributors and an increasing proportion of service activity covered by initial warranties on the new iQ200.

Small Laboratory Instruments’ cost of goods for as a percentage of sales totaled 51% for the current period, as compared to 51% in the first nine months of last year, which resulted in gross profit margins of 49% in both periods.

Marketing and selling expenses, as a percentage of net revenues were 16% in the nine months ended September 30, 2004, down from 18% in the same period last year. Marketing and selling expenses totaled $5.1 million, compared to $3.7 million for the comparable prior year period, an increase of $1.3 million. The increase is due primarily to increased commissions due to higher revenues ($303,000), additional sales and technical support personnel costs ($439,000), and additional travel costs ($93,000), all associated with the increased sales activity following the launch of the iQ200. In addition, the current period includes $337,000 of costs related to our international sales and support infrastructure, which was first established in July 2003.

General and administrative expenses decreased $390,000 to $4.0 million from $4.4 million in the comparable period in the prior year. The decrease includes non-recurring costs of $400,000 incurred in the prior year period associated with a management restructuring and a reduction of board related expenses of $76,000 in the current year period which was partially offset by $181,000 of increased professional fees in 2004 associated with compliance with provisions of the Sarbanes-Oxley Act of 2002. General and administrative expenses for the period as a percentage of net revenue were 13% as compared to 21% in the same period in the prior year.

Research and development expenses decreased to $3.1 million for the nine months ended September 30, 2004 from $3.5 million in the same period last year. The decrease is due primarily to a reduction in the expenditures related to the iQ200, released in the third quarter of 2003. We expect to continue to invest in research and development during 2004 at a slightly reduced rate as compared to 2003, with our primary focus being on enhancements to our existing products.

Interest expense decreased to $239,000 in the nine months ended September 30, 2004 from $270,000 in the comparable period of the prior year primarily due to the fact that we repaid our outstanding debt in April 2004, partially offset by the write off of $121,000 of deferred financing charges at that time.

Other income (expense) decreased to an expense of $533,000 in the nine months ended September 30, 2004 from income of $524 in the nine months ended September 30, 2003, due to the write down in the third quarter in the amount of approximately $534,000 on the investment available for sale.

The income tax provision for the nine months ended September 30, 2004 amounted to $966,000, as compared to a benefit of $407,000 for the nine months ended September 30, 2003. The change is a function of the taxable income or loss. This tax provision is a non-cash item, as we have significant deferred tax assets resulting from the use of tax loss carryforwards.

At September 30, 2004 and 2003, 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.”

The following table aggregates the Company’s expected contractual obligations and commitments subsequent to September 30, 2004:

Our primary source of liquidity is cash flow generated from operations, which depends heavily on sales of our IVD urinalysis systems and subsequent sales of consumables and service for these systems, as well as the sale of small laboratory devices and supplies. During the nine months ended September 30, 2004, we also realized $9.5 million in cash from financing activities, as described below. Cash and cash equivalents amounted to $13.3 million at September 30, 2004, up from $2.4 million at December 31, 2003.

Cash provided by operations for the nine months ended September 30, 2004 amounted to $1.5 million as compared to cash used in operations of $670,000 in the prior year, a $2.2 million improvement. The primary reason for the improvement is we had pretax income of $2.4 million during the current year period compared to a pretax loss of $1.0 million during the same period of the prior year, a $3.4 million improvement which was offset by an increase in receivables of $828,000 million plus a $666,000 reduction in accounts payable and accrued expenses during the current year. In addition during the nine months ended September 30, 2004, operating cash flow was impacted by the non-cash charge resulting from the write down of the investment held for sale in the amount of approximately $534,000.

Cash used in investing activities totaled $438,000 during the first nine months of 2004 as compared to $1.5 million used in the same period of the prior year. The decrease is due to the reduction in expenditures for property and equipment and capitalized software development from prior year levels, partially offset by $197,000 realized from the sale of short-term investments.

Net cash provided by financing activities amounted to $9.8 million during the first nine months of 2004 as compared to $860,000 during the same period of the prior year. During the current year we raised $11.5 million from the private placement of Company stock and an additional $3.3 million from the exercise of stock options, warrants and the sale of stock to employees through our Employee Stock Purchase Plan partially offset by repayment of outstanding debt.

On April 22, 2004, we completed the private placement of 2,130,000 shares of our common stock at $5.85 per share. Each investor received a 5-year warrant to purchase 3 additional shares of common stock at $7.80 per share for each 20 shares of common stock purchased in the offering. We realized net proceeds (after deducting offering expenses of $1.0 million) of approximately $11.5 million. We used approximately $5.5 million of the net proceeds to retire our outstanding indebtedness to our former bank and subordinated note holder.

In May 2004, we signed a new credit facility with a commercial bank, consisting of a $10.0 million line of credit for acquisitions and product opportunities and a $6.5 million revolving line of credit for working capital. As of September 30, 2004, there were no borrowings under the new credit facility. We are subject to certain financial covenants under the credit facility and as of September 30, 2004, we were in compliance with all such covenants.

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

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

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

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

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

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

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

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

Patents. Our commercial success depends in part on our ability to protect and maintain our Automated Intelligent Microscopy (or AIM) and other proprietary technology. We have received patents with respect to portions of the technologies of AIM. However, ownership of technology patents may not insulate us from potentially damaging competition. Patent litigation relating to clinical laboratory instrumentation patents (like the ones we own) often involves complex legal and factual questions. Therefore, we can make no assurance that claims under patents currently held by us, or our pending or

future patent applications, will be sufficiently broad to adequately protect what we believe to be our proprietary rights. Additionally, one or more of our patents could be circumvented by a competitor. We believe that our proprietary rights do not infringe upon the proprietary 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 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. 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 need additional capital in the future. If additional capital is not available, we may have to curtail or cease operations.

We have limited capital and will require substantial capital resources to execute our business strategy. Also, there can be no assurance that all or even a significant portion of the capital sought can be raised. Any additional equity financings may be dilutive to our existing stockholders and may involve the issuance of securities that have rights, preferences or privileges senior to those of our current stockholders. A debt financing, if available, may involve restrictive covenants on our business that could limit our operational and financial flexibility, and the amount of debt incurred could make us more vulnerable to economic downturns or operational difficulties and limit our ability to compete. Furthermore, financing may not be available when needed and, if available, may not be on terms acceptable to us.

We have a history of significant operating losses and we may incur losses in the future.

We have incurred significant losses since our inception and, as of December 31, 2003, we had accumulated a deficit of approximately $25.0 million. We may not achieve profitability in the future and further losses may arise. Our ability to achieve profitable operations in the future will depend on our ability to sell our products at sufficient volumes and with sufficient margins to be profitable. If we are unable to do so, we will not be profitable and our financial condition and results of operation will suffer.

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

As of September 30, 2004, IRIS has deferred tax assets of approximately $7.7 million resulting from the differences between the financial statement and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. There is no assurance that we will be able to generate taxable income in the years that the differences reverse.

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

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

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

Certain of our components are obtained from outside vendors, and the loss or breakdown of our relationships with these outside vendors could subject us to substantial delays in the delivery of our products to our customers. Furthermore certain key components of our instruments are manufactured by only one supplier. For example, ARKRAY is the single source supplier for our new line of urine chemistry analyzers and related consumable products and spare parts. Roche Diagnostics is the sole source for

our proprietary CHEMSTRIP/IRIStrip urine test strips and related urine test strip readers, both used in the Model 500 and 939 UDx urinalysis workstations. Because these suppliers are the only vendors with which we have a relationship for a particular component, we may be unable to sell products if one of these suppliers becomes unwilling or unable to deliver components meeting our specifications. Our inability to sell products to meet delivery schedules could have a material adverse effect on our reputation in the industry as well as our financial condition and results of operation.

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 workstations for six years after termination of these contracts or 2009. The failure to successfully and timely complete the phase out of their strips and readers with the introduction of our new iQ200 analyzers would have a material adverse affect on our instrument sales and the revenue growth for system supplies and service.

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

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

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

premiums; however, we cannot guarantee that this will continue to be the case. In addition, any failure to comply with Federal Drug Administration regulations governing manufacturing practices could hamper our ability to defend against product liability lawsuits.

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

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

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

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

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

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

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

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

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

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

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

We are exposed to certain foreign currency risks in the importation of goods from Japan The new line of urine chemistry analyzers, some 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 dominated in Japanese Yen. These components represent a significant portion of our material costs. Fluctuations in the U.S. Dollar/ Japanese Yen exchange rate could result in increased costs for our key components. Any such increases would reduce our gross margins and would be likely to result in a material adverse effect on our revenues and financial condition. Similarly, we are also exposed to currency fluctuations with respect to the exportation of our products. All of our sales are denominated in U.S. Dollars. Accordingly, any fluctuation in the exchange rate between the U.S. Dollar and the currency of the country with which we are exporting products could also reduce our gross margins and may result in a material adverse effect on our financial condition and results of operation.

Our Certificate of Incorporation and Bylaws could delay or prevent an acquisition or sale of our company.

Our Certificate of Incorporation empowers the Board of Directors to establish and issue a class of preferred stock, and to determine the rights, preferences and privileges of the preferred stock. Our Certificate of Incorporation also prohibits stockholder action by written consent. These provisions give the

Board of Directors the ability to deter, discourage or make more difficult a change in control of our Company, even if such a change in control would be in the interest of a significant number of our stockholders or if such a change in control would provide our stockholders with a substantial premium for their shares over the then-prevailing market price for the 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.

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.

At September 30, 2004, 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.

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

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

We maintain a system of internal controls designed to provide reasonable assurance that transactions are executed in accordance with management’s general or specific authorization; transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with

generally accepted accounting principles, (2) to maintain accountability for assets, and (3) to ensure that access to assets is permitted only in accordance with management’s general or specific authorization; and the recorded accountability for access is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.

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

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

During the three months ended September 30, 2004, the following Form 8-Ks were filed:

Current report on Form 8-K, reporting Items 7.01 and 9.01, filed on September 15, 2004

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.


IRIS INTERNATIONAL, INC.

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


For the quarterly period ended		Commission File No.
September 30, 2004		No. 1-9767


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


		Page
PART I	FINANCIAL INFORMATION

Item 1.	Financial Statements	3

	Consolidated Balance Sheet as of September 30, 2004 (unaudited) and December 31, 2003	3

	Consolidated Statements of Operations for the three months ended September 30, 2004 and 2003 (unaudited)	4

	Consolidated Statements of Operations for the nine months ended September 30, 2004 and 2003 (unaudited)	5

	Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited)	6

	Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2004 and 2003 (unaudited)	7

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30

Item 4.	Controls and Procedures	30

PART II	OTHER INFORMATION

Item 6.	Exhibits and Reports on Form 8-K	32

	(a) Exhibits	32

	(b) Reports on Form 8-K	32

Signature		33


	September 30, 2004			December 31, 2003
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	13,258,733		$	2,443,995
Accounts receivable, net of allowance for doubtful accounts and sales returns of $477,174 and $312,066		7,859,002			7,193,058
Inventories, net		6,175,308			5,352,601
Prepaid expenses and other current assets		641,611			461,706
Investment available for sale		179,616			581,910
Deferred tax asset		1,573,431			1,573,431

Total current assets		29,687,701			17,606,701
Property and equipment, at cost, net of accumulated depreciation of $6,009,465 and $5,510,111		3,695,232			3,613,233
Goodwill		188,911			188,911
Software development costs, net of accumulated amortization of $2,048,008 and $1,655,458		2,050,496			2,396,851
Deferred tax asset		6,121,169			7,220,407
Inventories – long term portion		403,745			973,593
Other assets		1,044,093			480,734

Total assets	$	43,191,347		$	32,480,430

Liabilities And Shareholders’ Equity
Current liabilities:
Accounts payable	$	3,154,500		$	3,635,696
Accrued expenses		2,729,870			2,955,955
Short-term borrowings		—			2,900,000
Current portion of long-term debt		—			350,000
Deferred revenue		1,020,906			1,150,643

Total current liabilities		6,905,276			10,992,294

Long-term debt		—			1,782,192
Deferred revenue, long term		224,552			238,498

Total liabilities		7,129,828			13,012,984

Commitments and contingencies

Shareholders’ equity:
Common stock, $.01 par value, authorized: 50,000,000 shares, issued and outstanding shares: 15,877,463 and 11,901,461		158,724			119,013
Additional paid-in capital		59,698,813			44,717,090
Unearned compensation		(121,061	)		(44,843	)
Accumulated other comprehensive income (loss)		—			(200,008	)
Accumulated deficit		(23,674,957	)		(25,123,806	)

Total shareholders’ equity		36,061,519			19,467,446

Total liabilities and shareholders’ equity	$	43,191,347		$	32,480,430


	For the three months ended September 30,
	2004			2003
Sales of IVD instruments	$	4,033,995		$	2,330,079
Sales of IVD consumables and service		5,335,880			4,379,321
Sales of small laboratory devices and supplies		2,376,489			1,534,873
Royalty and license revenues		17,523			176,660

Net revenues		11,763,887			8,420,933

Cost of goods - IVD instruments		2,664,169			1,850,473
Cost of goods - IVD consumables and service		2,062,531			1,552,308
Cost of goods - small laboratory devices and supplies		1,226,021			754,192

Cost of goods sold		5,952,721			4,156,973

Gross margin		5,811,166			4,263,960

Marketing and selling expenses		1,821,455			1,551,107
General and administrative expenses		1,627,711			1,383,649
Research and development, net		1,059,880			1,039,511

Total operating expenses		4,509,046			3,974,267

Operating income		1,302,120			289,693

Other income (expense):
Interest income		35,259			6,944
Interest expense		(4,398	)		(83,358	)
Other (expense) income		(531,366	)		486

Income before income taxes		801,615			213,765

Provision for income taxes		320,646			85,506

Net income	$	480,969		$	128,259

Basic and diluted net income per share	$	0.03		$	0.01

Basic - average shares outstanding		15,706,922			11,208,431

Diluted – average shares outstanding		16,708,906			12,450,707

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	For the nine months ended September 30,
	2004			2003
Sales of IVD instruments	$	10,094,038		$	3,735,792
Sales of IVD consumables and service		14,731,901			12,691,198
Sales of small laboratory devices and supplies		6,301,833			4,263,300
Royalty and license revenues		336,249			395,616

Net revenues		31,464,021			21,085,906

Cost of goods - IVD instruments		7,116,244			3,340,848
Cost of goods - IVD consumables and service		5,825,949			4,650,072
Cost of goods - small laboratory devices and supplies		3,226,886			2,173,331

Cost of goods sold		16,169,079			10,164,251

Gross margin		15,294,942			10,921,655

Marketing and selling expenses		5,052,678			3,740,814
General and administrative expenses		4,041,369			4,431,778
Research and development, net		3,080,424			3,526,836

Total operating expenses		12,174,471			11,699,428

Operating income (loss)		3,120,471			(777,773	)

Other income (expense):
Interest income		67,063			29,982
Interest expense		(239,300	)		(270,457	)
Other (expense) income		(533,483	)		524

Income (loss) before income taxes (benefit)		2,414,751			(1,017,724	)

Provision (benefit) for income taxes		965,900			(407,090	)

Net income (loss)	$	1,448,851		$	(610,634	)

Basic net income (loss) per share	$	0.10		$	(0.06	)

Diluted net income (loss) per share	$	0.09		$	(0.06	)

Basic - average shares outstanding		13,970,499			11,088,869

Diluted – average shares outstanding		15,328,041			11,088,869


	For the nine months ended September 30
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	1,448,851		$	(610,634	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operations:
Deferred taxes, net		965,900			(446,652	)
Depreciation and amortization		1,128,587			681,334
Common stock and stock option compensation		102,986			57,738
Loss on sale/write down of investment		538,436			—
Changes in operating assets and liabilities:
Accounts receivable		(828,019	)		(1,164,138	)
Service contracts, net		18,392			322,948
Inventories, net		(252,859	)		(337,905	)
Prepaid expenses and other current assets		(179,905	)		(162,225	)
Other assets		(776,796	)		(27,438	)
Accounts payable		(481,196	)		532,891
Accrued expenses		(185,274	)		484,070

Net cash provided by (used in) operating activities		1,499,103			(670,011	)

Cash flows from investing activities:
Acquisition of property and equipment		(588,876	)		(1,187,908	)
Loan to related party		—			125,000
Software development costs		(46,195	)		(423,775	)
Sale of short term investments		197,204			—

Net cash used in investing activities		(437,867	)		(1,486,683	)

Cash flows from financing activities:
Issuance of common stock for cash		14,842,229			506,897
Borrowings under line of credit		2,900,000			7,000,000
Repayments of line of credit		(5,800,000	)		(5,500,000	)
Repayments of term loan		(1,079,165	)		(235,485	)
Repayments of notes payable		(1,068,750	)		(875,250	)
Payments of capital lease obligations		(40,812	)		(36,508	)

Net cash provided by financing activities		9,753,502			859,654

Net increase (decrease) in cash and cash equivalents		10,814,735			(1,297,040	)
Cash and cash equivalents at beginning of period		2,443,995			2,336,973

Cash and cash equivalents at end of period	$	13,258,733		$	1,039,933

Supplemental schedule of non-cash financing activities:
Issuance of common stock for services	$	179,204		$	152,596

Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	56,118		$	56,064
Cash paid for interest	$	96,586		$	146,723


	For the three months ended September 30,						For the nine months ended September 30,
	2004			2003			2004			2003
Net income (loss) as reported	$	480,969		$	128,259		$	1,448,851		$	(610,634	)
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		27,705			11,811			61,792			34,643

Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(147,238	)		(107,972	)		(607,391	)		(417,099	)

Net income (loss) pro forma	$	361,436		$	32,128		$	903,252		$	(993,090	)

Income (loss) per diluted share as reported	$	0.03		$	0.01		$	0.09		$	(0.06	)

Income (loss) per diluted share pro forma	$	0.02		$	0.00		$	0.06		$	(0.09	)


	September 30, 2004			December 31, 2003
Finished goods	$	1,730,580		$	1,851,895
Work-in-process		680,616			702,666
Raw materials, parts and sub-assemblies		4,167,857			3,771,633

		6,579,053			6,326,194
Less non-current portion		(403,745	)		(973,593	)

Inventories – current portion	$	6,175,308		$	5,352,601


Number of Shares	Per Share Price		Expiration Date
50,000	$	2.13	October 31, 2005
45,045	$	2.22	October 1, 2006
34,722	$	1.92	October 1, 2007
319,500	$	7.80	April 23, 2009


	IVD Instruments		Small Laboratory Devices		Unallocated Corporate Expenses			Total
For the three months ended Sept. 30, 2004
Revenues	$	9,387,398	$	2,376,489	$	—		$	11,763,887
Interest income	$	33,867	$	1,392	$	—		$	35,259
Interest expense	$	1,168	$	—	$	3,230		$	4,398
Depreciation and amortization	$	301,538	$	32,787	$	20,960		$	355,285
Segment profit	$	1,250,077	$	610,406	$	(1,058,868	)	$	801,615
Segment assets	$	32,250,609	$	3,246,138	$	7,694,600		$	43,191,347
Investment in long-lived assets	$	71,074	$	37,986	$	—		$	109,060

For the three months ended Sept. 30, 2003
Revenues	$	6,886,060	$	1,534,873	$	—		$	8,420,933
Interest income	$	780	$	164	$	—		$	944
Interest expense	$	1,988	$	—	$	81,370		$	83,358
Depreciation and amortization	$	241,316	$	22,536	$	20,030		$	283,882
Segment profit (loss)	$	842,803	$	235,894	$	(864,932	)	$	213,765
Segment assets	$	17,502,865	$	2,350,654	$	8,869,391		$	28,722,910
Investment in long-lived assets	$	617,234	$	8,295	$	—		$	625,529


	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
Research and development expense, net	$	1,060,000	$	1,040,000	$	3,080,000	$	3,527,000
Capitalized software development costs		15,000		144,000		46,000		424,000
ADIR research and development grants and contracts		456,000		333,000		856,000		676,000

Total product technology expenditures	$	1,531,000	$	1,517,000	$	3,982,000	$	4,627,000


	Payments Due by Period (in thousands)
	2004		2005		2006		2007		Totals
Contractual Obligations

Long term debt	$	—	$	—	$	—	$	—	$	—
Short term borrowings		—		—		—		—		—
Capital lease commitments		16		40		18		3		77
Operating lease commitments		132		462		428		—		1,022

Total Contractual cash commitments	$	148	$	502	$	446	$	3	$	1,099


Exhibit Number	Description	Reference Document
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer	*

31.2	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by Principal Financial Officer	*

32.1	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Chief Executive Officer	*

32.2	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Principal Financial Officer	*