Overview

IRIS International, Inc. (the "Company") consists of three operating units in two business segments as determined in accordance with SFAS 131. Our in-vitro diagnostics, or IVD, segment also called Iris Diagnostics Division, designs, manufactures and markets IVD systems, consumables and supplies for urinalysis and body fluids. With the acquisition of Leucadia Technologies we created our Iris Molecular Diagnostics, or IMD, subsidiary in April 2006, whose operations are included as part of the Iris Diagnostics Division. Our Sample Processing segment markets small centrifuges and other processing equipment and accessories for rapid specimen processing.

The initial applications for our technology have been in the urinalysis market and we are the leading worldwide provider of urine microscopy systems, with an installed base of over 2,000 systems in over 50 countries. 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 a fully automated urine chemistry analyzer sold in the United States through a distribution relationship with a Japanese manufacturer. We sell the urine microscopy analyzers and the iChem100, our semi-automated chemistry analyzer on a global basis and we launched our fully automated urine chemistry analyzer, iChem VELOCITY™, to the international market and recognized commercial revenue from its sale internationally in September 2008. We will continue to distribute the Japanese manufacturer's fully automated chemistry analyzer domestically in 2009 but we plan to transition to sales in the United States of our iChem VELOCITY in 2009. Our IVD 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 usually after the initial year of sale, which is covered by product warranty, while international customers purchase spare parts as service is provided by our distributors. Once the analyzers are installed, we generate recurring revenue from sales of consumables. Consumable and service revenue should 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 consist of centrifuge systems, DNA processing workstations and blood analysis products.

Domestic sales of our urinalysis systems are direct to the customer through our sales force. International sales, with the exception of France and Puerto Rico where sales are direct to end use customers, are through independent distributors. International sales represented 32% of consolidated revenues during the first nine months of 2008 as compared to 31% during the first nine months of 2007. Since international sales are made through independent distributors, gross profit margin is lower than domestic sales of the same products, but we incur minimal sales and marketing costs for such sales. Our Sample Processing products are sold worldwide primarily through distributors.

We have introduced a new commercial name, NADiA ProsVue™, to clearly differentiate our NADiA PSA assay from routine screening PSA assays. We met with the U.S. Food and Drug Administration ("FDA"), to review the NADiA ProsVue™ Pre-Investigational Device Exemption submission and have reached an agreement in principle on the product claim and clinical surrogates to be used in a clinical study. We currently anticipate initiating the first part of this clinical study during the fourth quarter of 2008 and it is our expectation that the clinical study will take approximately two months to complete. We plan to submit a new 510(k) application to the FDA, seeking clearance of prognostic claim for indentifying patients with low-risk of prostate cancer recurrence post-prostatectomy, some time in the first quarter of 2009.

During the second quarter of 2007, we closed the operations of our Advanced Digital Imaging Research subsidiary, or ADIR, whose costs had previously been substantially covered by government sponsored grants. While the closing of ADIR resulted in a one-time charge of approximately $163,000 in the second quarter of 2007, it has resulted in a reduction in research and development expenses of $380,000 for the nine months ended September 30, 2008.

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 condensed consolidated financial statements and accompanying notes. 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.

A description of our critical accounting policies that represent the more significant judgments and estimates used in the preparation of our financial statements was provided in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2007. There have been no material changes in theses critical accounting policies since December 31, 2007.

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 gross profit margins, which are computed on related
revenue, and income taxes, which are based on income before income taxes.



                                                    Three months ended                   Nine months ended
                                                       September 30,                       September 30,
(in thousands)                                 2008              2007              2008              2007
Revenues (1)
IVD instruments                              $  8,335    36%   $  7,484    36%   $ 24,091    35%   $ 24,628    39%
IVD consumables and service                    11,537    49%      9,835    48%     34,319    50%     28,795    46%
Sample Processing instruments and supplies      3,552    15%      3,244    16%     10,405    15%      9,000    15%

Total revenues                                 23,424   100%     20,563   100%     68,815   100%     62,423   100%

Gross profit (2)
IVD instruments                                 3,459    41%      3,487    47%     10,958    45%     11,613    47%
IVD consumable and service                      6,621    57%      5,621    57%     19,572    57%     15,369    53%
Sample Processing instruments and supplies      1,722    48%      1,659    51%      5,218    50%      4,559    51%

Gross profit                                   11,802    50%     10,767    52%     35,748    52%     31,541    51%

Operating expenses
Marketing and selling                           4,152    17%      3,590    17%     11,898    17%      9,950    16%
General and administrative                      2,736    12%      2,725    13%      8,378    12%      7,403    12%
Research and development, net                   2,754    12%      2,355    12%      8,010    12%      7,791    12%

Total operating expenses                        9,642    41%      8,670    42%     28,286    41%     25,144    40%

Operating income                                2,160     9%      2,097    10%      7,462    11%      6,397    10%
Other income (expense)                            222     1%        388     2%        848     1%      1,083     2%

Income before income taxes                      2,382    10%      2,485    12%      8,310    12%      7,480    12%
Income taxes (3)                                  764    32%        867    35%      2,663    32%      2,607    35%

Net income                                   $  1,618     7%   $  1,618     8%   $  5,647     8%   $  4,873     8%

(1) The consolidated revenues include reclassification of freight revenue from cost of goods and marketing and selling expenses in accordance with EITF 00-10. The reclassification in consolidated revenues amounted to $259,000 and $372,00 for the three months ended September 30, 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, the freight revenue amounted to $748,000 and $1,133,000, respectively. See reclassification note in Note 2 of the Notes to the Consolidated Financial Statements.

(3) Income tax percentage is computed based on the relationship of income taxes to income before income taxes.

Comparison of Three Months Ended September 30, 2008 to 2007

Consolidated revenues for the three months ended September 30, 2008 increased by 14% over the prior year quarter. Revenues in the IVD urinalysis segment increased 15% to $19.9 million in the third quarter of 2008 from $17.0 million in the prior year quarter. Sales of IVD instruments increased 11% to $8.3 million in the third quarter of 2008 from $7.5 million in the prior year quarter, primarily due to over $1.0 million of incremental international revenue with the launch of the iChem VELOCITY and iRICELL™ integrated urinalysis workstation.

Revenues from IVD consumables and service increased to $11.5 million in the 2008 third quarter as compared to $9.8 million in the prior year quarter. The 17% increase was driven almost entirely by strong demand for our consumable products as a result of our growing installed base of instruments. Revenues from sample processing instruments and supplies during the third quarter of 2008 also experienced an increase to $3.6 million, a 9% increase as compared to $3.2 million for the same period a year ago. The increase was due to strong sales of the new StatSpin Express 4 centrifuge partially offset by a decline in the Express 2 and Express 3 centrifuge models. International revenue represented 30% of the 2008 consolidated third quarter revenue versus 27% in the same period a year ago.

Overall gross profit margins decreased to 50% during the third quarter of 2008 from 52% during the third quarter of 2007. The quarter's gross margin decrease resulted from an increase in the provision for obsolete inventory of $150,000 as we have experienced a faster than expected replacement of Legacy systems in 2008, unfavorable impact of foreign currency denominated in Japanese Yen of $175,000 and higher manufacturing costs associated with learning curves and small quantity procurement in the initial manufacturing batches of our new iChem VELOCITY automated urine chemistry analyzer of $125,000. The gross profit margin of our IVD instruments was 41% and 47% during the third quarter of 2008 and 2007, respectively. The gross margin of our IVD consumables and services was 57% for both the third quarter of 2008 and the third quarter of 2007. Continued strong reagent shipments and slightly improved gross margins in our service area were offset by unfavorable impact of foreign currency exchange rate due primarily to purchased strips denominated in Japanese yen and unfavorable Euro currency variances associated with operating our German manufacturing facility. Gross profit margin for our sample processing segment decreased to 48% during the third quarter of 2008 from 51% during the third quarter of 2007 as a result of product mix with the new Express 4 drawing slightly lower margins than previous versions of the product.

Marketing and selling expenses totaled $4.2 million, or 17% of revenues, during the third quarter of 2008 as compared to $3.6 million, or 17% of revenues during the third quarter of 2007. The increase includes additional personnel and related costs of $490,000 and $82,000 related to travel, trade shows, iChem VELOCITY launch-related expenses and the initiation of NADiA ProsVue market development activities. The increase in personnel and related costs is the result of our previous investments to enhance our sales and marketing support in order to meet the needs of our growing business. We expect to continue to invest in these areas to strengthen our global presence and support for the anticipated launches of our extensive product pipeline.

General and administrative expenses remained consistent and amounted to $2.7 million, or 12% and 13% of revenue during the third quarters ended 2008 and 2007, respectively.

Research and development expense for the third quarters in 2008 and 2007 amounted to $2.8 million and $2.4 million, respectively, or 12% of revenues in both quarters. During the current quarter, the increase was primarily attributable to $440,000 in personnel related costs and $130,000 in clinical development related expenses as we continue to invest heavily in research and development for the continued development of our diagnostics product pipeline, including our NADiA platform. This amount was partially offset by a $160,000 reduction in prototype and research materials related to the iChem VELOCITY and outside consulting expenses incurred in the third quarter of 2007.

Interest income decreased during the third quarter of 2008 to $276,000 from $402,000 during the third quarter of 2007, as a result of the lower interest rate environment.

Income tax expense during the third quarter of 2008 amounted to 32% of pre-tax income as compared to 35% during the prior year quarter. We have deferred tax assets relating to tax loss carry forwards and research and development tax credits.

Comparison of Nine Months Ended September 30, 2008 to 2007

Consolidated revenues for the nine months ended September 30, 2008 increased by 10% over the prior year period. Revenues in the IVD urinalysis segment increased 9% to $58.4 million in 2008 from $53.4 million in the prior year period. Sales of IVD instruments decreased to $24.1 million from $24.6 million during the prior year period. The decrease in instrument sales is mostly due to two large domestic customer orders during the nine months ended September 30, 2007, partially offset by over $1.0 million of incremental international revenue with the launch of the iChem VELOCITY and iRICELL™ integrated urinalysis workstation during the third quarter of 2008. International revenues accounted for approximately 32% of consolidated revenue during the nine months ended September 30, 2008 compared to 34% during the prior year. IVD consumables and service revenue increased to $34.3 million from $28.8 million, an increase of $5.5 million or 19% over the prior year, primarily due to record consumable shipments to support our larger installed base of instruments. Revenues during the first nine months from the sample processing segment increased to $10.4 million from $9.0 million, an increase of $1.4 million or 16% over the prior year, primarily due to strong sales of Express 4 centrifuges.

Overall gross profit margins for the first nine months increased to 52% during the current year period compared to 51% for the 2007 period. The gross profit margin of our IVD instruments decreased to 45% in 2008 compared to 47% during the prior year. The decrease is a result of the unfavorable impact of foreign currency denominated in Japanese Yen and lower margins associated with learning curves and small quantity procurement in the initial manufacturing batches of our new iChem VELOCITY automated urine chemistry analyzer. The gross margin of our IVD consumables and services increased to 57% during the first nine months of 2008 compared to 53% during the prior year period, primarily due to record demand for consumables and slight improvements in service profitability, despite an unfavorable foreign currency exchange variance. Gross profit margin for our sample processing laboratory instrument and supply segment decreased to 50% in 2008 from 51% in 2007, primarily due to product mix.

Marketing and selling expenses totaled $11.9 million, or 17% of revenue, for the first nine months, as compared to $10.0 million, or 16% of revenue, in the same period of 2007. The increase includes additional personnel and related costs of $1.6 million; $185,000 related to travel, trade shows and iChem VELOCITY launch-related charges; and higher fees paid to group purchasing organizations ("GPOs") of $119,000. The increase in personnel and related costs is the result of our previous investments to enhance our sales and marketing support in order to meet the needs of our growing business and the initiation of NADiA ProsVue (formerly NADiA PSA) market development activities. We expect to continue to invest in these areas to strengthen our global presence and support for the anticipated launches of our extensive product pipeline.

General and administrative expenses increased during the first nine months to $8.4 million compared to $7.4 million in the prior year. The increase includes additional personnel and related cost of $100,000, stock-based compensation expense of $510,000, and other corporate operating expenses of $270,000.

Research and development expense amounted to $8.0 million during the first nine months of 2008 compared to $7.8 million in the same period in the prior year. During the first nine months of 2008, payroll and related costs increased by $920,000 and clinical development related expenses increased by $300,000 offset by a reduction of prototype and research materials related to the iChem VELOCITY of $600,000 and $380,000 savings related to the closing of our ADIR imaging subsidiary in the second quarter of 2007.

Interest income for the first nine months of 2008 and 2007 amounted to $871,000 and $1.1 million respectively, as a result of the lower interest rates.

Income tax expense during the nine months of 2008 amounted to 32% of pre-tax income as compared to 35% during the prior year period. We have deferred tax assets relating to tax loss carry forwards and research and development tax credits.

Off-Balance Sheet Arrangements

At September 30, 2008 and 2007, 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.

We conduct business in certain foreign markets, primarily in the European Union and Asia. To mitigate the potential impact of adverse fluctuations in the U.S. Dollar exchange rate for these currencies, we periodically purchase foreign currency forward contracts. During the first three quarters of 2008, we entered into such contracts for Euros and Japanese Yen totaling $404,000 and $7.1 million, respectively. As of September 30, 2008, our remaining foreign currency forward contracts are for Japanese Yen and total $2.0 million, which we will utilize for future purchases from our Japanese IVD supplier. As of September 30, 2008, the notional amount in Japanese Yen under our foreign currency forward contracts totaled 64.5 million Yen. All outstanding foreign currency forward contracts are marked to market at the end of each fiscal period. Our realized gain or loss with respect to foreign currency fluctuations will depend on the foreign currency exchange rate changes and other factors in effect as the contracts mature. The net fair value of all these contracts as of September 30, 2008 was $(148,000). Losses and gains on the underlying transactions being hedged would largely offset any gains and losses on the fair value of foreign currency forward contracts.

Liquidity and Capital Resources

Our primary source of liquidity is cash from operations, which depends heavily on sales of our IVD instruments, consumables and service, as well as sales of sample processing instruments and supplies. At September 30, 2008, our cash and cash equivalents amounted to $30.1 million compared to $28.1 million at December 31, 2007.

Operating Cash Flows. Cash provided by operations for the nine months ended September 30, 2008 improved to $8.6 million compared to cash provided by operations of $639,000 during the prior year nine month period. In addition to a net income increase of $774,000, our improvement includes non-cash items consisting of higher depreciation and amortization of $499,000, and stock-based compensation expense of $766,000 and tax benefits from stock option exercises of $512,000. In addition, we experienced a $4.4 million reduction in accounts receivable, $396,000 reduction in inventories, $533,000 reduction in investment in sales-type leases, an increase of $1.4 million in accounts payable and accrued expenses and a $759,000 increase in deferred service contract revenue. The sources of cash were partially offset by a decrease of deferred taxes of $1.8 million.

The number of days sales in accounts receivable decreased to 59 days at the end of the first nine months compared to 74 days for the prior year nine months. The number of days sales in accounts receivable varies and extends due to the fact that our customers are subject to reimbursement delays attributed to government and third party payer compliance and regulation issues.

Our cash flow has been favorably affected by tax loss carry forwards. As of December 31, 2007, we had, net of valuation allowances, federal net operating loss carry forwards of approximately $2.1 million, which expire in various years through 2025. We also have federal and state tax credit carry forwards of $2.4 million and $2.3, respectively, net of valuation allowances. We continue to realize tax deductions from the exercise of certain stock options. During the nine months ended September 30, 2008, we realized tax deductions of approximately $1.8 million relating to this item. During the three months ended September 30, 2008, we paid federal and state taxes of $825,000 and $223,000, respectively. During the nine months ended September 30, 2008, we paid federal and state taxes of $1,445,000 and $427,000, respectively.

Investing Activities. Cash used in investing activities totaled $3.1 million for the nine months ended September 30, 2008, a $442,000 decrease over the prior year period primarily as a result of decreases in purchases of property and equipment of $797,000 in the first nine months of 2008 with partial offsets of capitalization of software development costs of $223,000 and purchases of short-term marketable securities in the prior period totaling $132,000.

Financing Activities. Cash used in financing activities totaled $3.4 million during the first nine months of 2008, which includes the repurchase of common stock totaling $5.7 million and a reduction in tax deduction benefits from the exercise of stock options of $512,000 and the issuance of common stock of $458,000 over the prior first nine months of 2007.

We currently have a credit facility with a commercial bank, which was renewed in May 2008, 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. The credit facility has variable interest rates, which will change from time to time based on changes to either the LIBOR rate or the lender's prime rate. As of September 30, 2008, there were no borrowings under the new credit facility. We are subject to certain financial and non-financial covenants under the credit facility with the bank and as of September 30, 2008, we were in compliance with these covenants.

In November 2007, we filed with the Securities and Exchange Commission a shelf registration statement on Form S-3, which allows us to sell up to $125.0 million in common stock, preferred stock or debt securities from time to time. In December 2007, the shelf registration statement was declared effective. As of September 30, 2008, no securities had been issued pursuant to this registration statement.

In March 2008, our board of directors authorized a share repurchase and retirement plan of up to $15 million of our common stock over a 12-month period. Through June 30, 2008, we had repurchased 492,068 shares of common stock for approximately $5,748,000 under the plan. Subsequent to June 30, 2008, we have not repurchased additional common stock. On July 25, 2008, our board of directors terminated the share repurchase and retirement plan.

On September 11, 2008, our Chief Executive Officer exercised a stock option to purchase an aggregate of 130,000 shares of common with an exercise price of $4.34 per share, on a net issue basis in a transaction approved by the compensation committee of our board of directors. We issued 62,081 shares of common stock to our Chief Executive Officer, and retained 67,919 shares of common stock with an aggregate market value of $1,219,000 based on the last closing price of our common stock immediately prior to exercise of $17.95 per share. Of this amount, $564,000 was applied in payment of the aggregate exercise price of the stock options and $655,000 was applied in payment of payroll taxes arising from the option exercise. These options had a term expiring on November 18, 2008.

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

In March 2008, the Financial Accounting Standards Board or FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities," which amends SFAS No. 133. The statement is intended to improve transparency in financial reporting by requiring enhanced disclosures of an entity's derivative instruments and hedging activities and their effects on the entity's financial position, financial performance, and cash flows. SFAS 161 is effective prospectively for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Currently, we have purchased foreign currency forward contracts to hedge foreign currency cash flows and plan to adopt the provisions of SFAS No. 161 on our consolidated financial statements in 2009.

In December 2007, the Financial Accounting Standards Board, or FASB issued SFAS No. 141 (revised 2007), "Business Combinations", which replaces SFAS No 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning July 1, 2009 and will apply prospectively to business combinations completed on or after that date.

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