Overview

IRIS International, Inc. (the "Company") consists of three operating units in two business segments as determined in accordance with FASB ASC Topic 280. 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, Inc., or Leucadia, in 2006 we created our Iris Molecular Diagnostics, or IMD, subsidiary 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 automated urine microscopy systems, with more than 2,400 iQ microscopy analyzers and approximately 1,000 automated chemistry analyzers shipped to date 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 urine chemistry analyzers sourced from a Japanese manufacturer. We sell our urine microscopy analyzers worldwide. We initiated sales of the iChem®VELOCITY™, our fully-automated chemistry analyzer internationally in September 2008. Sales of this instrument in the United States will be initiated upon us attaining U.S. Food and Drug Administration (FDA) clearance. We currently distribute the Japanese manufacturer's fully automated chemistry analyzers domestically. Consumables include products such as chemical reagents and urine test strips. Service revenues are derived primarily from annual service contracts purchased by our domestic customers after the initial year of sale, which is covered by product warranty and spare parts purchased by international customers. 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 consists of centrifuge systems, DNA processing workstations and blood analysis products.

During the first quarter of 2009, we decided to delay international shipments of the iChem VELOCITY chemistry analyzer, in order to implement product improvements based on customer feedback during the early stages of the product launch. In May 2009, we resumed full-scale shipments and initiated a retrofit program for the iChem VELOCITY and the iRICELL™ integrated urinalysis workstations following the completion of these product improvements and in-house validation process.

We submitted a 510(k) application with the FDA for market clearance of the iChem VELOCITY in the United States. After review of our pre-market notification
510(k), the FDA raised issues relating to the adequacy of certain of the performance attributes of the device and concluded that our iChemVELOCITY system is not substantially equivalent to other predicate devices in the market and therefore its commercialization in the United States cannot be initiated until a new 510(k) is submitted addressing the issues raised by the FDA. Based upon our testing of the instrument, the ability to make adjustments to enhance performance and the foreign experience with the instrument, we believe that the performance issues identified by FDA can be addressed and the instrument will be shown to FDA's satisfaction to be safe and effective and entitled to 510(k) clearance. We have secured sufficient inventory of the AUTION MAX AX-4280 to cover all domestic sales of fully automated chemistry analyzers for the balance of 2009 and into mid-2010.

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. In September 2009, we signed a letter of intent to acquire from our European distributor assets relating to its current distribution of IRIS products in the United Kingdom, Ireland and Germany. The assets to be purchased consist primarily of customer leases for installed IRIS

instruments and service contracts valued at inventory book value. This purchase will increase our direct sales presence within our international sales channels, and will serve as a template for further potential transactions in territories that represent new business opportunities for us. We expect to consummate the acquisition in January 2010. International sales represented 34% of consolidated revenues during the first nine months of 2009, as compared to 32% during the first nine months of 2008. 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 ultra-sensitive PSA assay for identifying prostatectomy patients with low risk of cancer recurrence from routine screening PSA assays. We met with the FDA to review our NADiA ProsVue™ Pre-Investigational Device Exemption (Pre-IDE) submission and reached an agreement in principle on the product claim and clinical end points to be used in a clinical study. In March 2009, we submitted a second Pre-IDE incorporating the results of the first stage of the referenced clinical study and refined the proposed prognostic claim. In April 2009, the FDA reviewed and commented on the second Pre-IDE submission and we incorporated these final recommendations into a retrospective clinical study for with a prognostic claim. We have secured Institutional Review Board (IRB) approval for NADiA® ProsVue™ from Eastern Virginia Medical School, University of Washington, Duke University Medical Center and Memorial Sloan-Kettering Cancer Institute. We commenced our larger multi-center clinical study consisting of approximately 300 patients and upon completion of the study, we will follow with a 510(k) submission.

In June 2009, we initiated a reduction in force of 19 full time equivalent personnel which resulted in a charge of $325,000 during the second quarter of 2009. The reduction in force is generating the expected annualized savings of more than $1.0 million with $450,000 expected to be realized in the second half of 2009.

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, 2008. There have been no material changes in these critical accounting policies since December 31, 2008.

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 taxes.



                                                     Three months ended                      Nine months ended
                                                       September 30,                           September 30,
(in thousands)                                 2009                2008                2009                2008
Revenues
IVD instruments                              $  5,136    23 %    $  8,335    36 %    $ 16,772    25 %    $ 24,091    35 %
IVD consumables and service                    13,254    60 %      11,537    49 %      38,658    59 %      34,319    50 %
Sample Processing instruments and supplies      3,796    17 %       3,552    15 %      10,673    16 %      10,405    15 %

Total revenues                                 22,186   100 %      23,424   100 %      66,103   100 %      68,815   100 %

Gross Profit (1)
IVD instruments                                 1,765    34 %       3,459    41 %       6,116    36 %      10,958    45 %
IVD consumables and service                     8,299    63 %       6,621    57 %      23,510    61 %      19,572    57 %
Sample Processing instruments and supplies      2,118    56 %       1,722    48 %       5,584    52 %       5,218    50 %

Gross profit                                   12,182    55 %      11,802    50 %      35,210    53 %      35,748    52 %

Operating expenses
Marketing and selling                           3,832    17 %       4,152    18 %      11,664    18 %      11,898    17 %
General and administrative                      3,165    14 %       2,736    12 %       9,689    15 %       8,378    12 %
Research and development, net                   2,870    13 %       2,754    12 %       8,549    13 %       8,010    12 %

Total operating expenses                        9,867    44 %       9,642    41 %      29,902    45 %      28,286    41 %

Operating income                                2,315    10 %       2,160     9 %       5,308     8 %       7,462    11 %
Other income                                      211     1 %         222     1 %         650     1 %         848     1 %

Income before for income taxes                  2,526    11 %       2,382    10 %       5,958     9 %       8,310    12 %
Income taxes (2)                                  610    24 %         764    32 %       1,639    28 %       2,663    32 %

Net income                                   $  1,916     9 %    $  1,618     7 %    $  4,319     7 %    $  5,647     8 %

(1) Gross profit margin percentages are based on the related sales of each category.

(2) Income tax percentage is computed based on the relationship of income taxes to pre-tax income.

Comparison of Three Months Ended September 30, 2009 to 2008

Consolidated revenues for the three months ended September 30, 2009 decreased 5% over the prior year quarter. Revenues in the IVD urinalysis segment decreased 7% to $18.4 million in the third quarter of 2009 from $19.9 million in the prior year quarter. Sales of IVD instruments decreased 38% to $5.1 million in the third quarter of 2009 from $8.3 million in the prior year quarter. The decrease in IVD instrument sales is primarily attributable to a reduction in domestic sales caused by a reduction in hospital and laboratory capital spending, delays in the approval process within the hospital and laboratory organizations and increased interest from customers in equipment leasing options, the impact of which is to defer the recognition of revenues from such leasing transactions over extended periods.

Revenues from IVD consumables and service increased 15% to a record $13.3 million in the third quarter of 2009 as compared to $11.5 million in the prior year quarter. The increase was driven primarily due to the larger installed base of instruments, and the success of converting expiring warranty agreements to service agreements. Revenues from sample processing instruments and supplies increased 7% to $3.8 million in the third quarter of 2009 as compared to $3.6 million in the prior year quarter. The increase was primarily attributable to increased sales to a major OEM customer. Total international revenue represented 34% of the 2009 consolidated third quarter revenue versus 30% in the same period a year ago.

Overall gross profit margin was 55% during the third quarter of 2009 compared to 50% in the prior year quarter. The improvement was due to an increase in consumables and service, reduced headcount related to the reduction in force in the second quarter of 2009, and an increase in gross margin of our Sample Processing division, partially offset by a decrease in gross margin for IVD instruments. The gross profit margin of our IVD instruments was 34% and 42% during the third quarter of 2009 and 2008, respectively. As compared to the prior year period, the third quarter of 2009 gross margin was impacted by $23,000 in sales promotions, $376,000 in costs related to iChem VELOCITY, which included Velocity retrofit costs of $150,000. The gross margin of our IVD consumables and services was 63% and 57% for the third quarter of 2009 and 2008, respectively, and included approximately $291,000 in international sales discounts. The IVD consumables and service gross margin improvement primarily resulted from economies of scale generated by our increasing volume of urinalysis microscopy consumables, increased sales of spare parts to our international distributors, improved efficiencies in our domestic service business, and a reduction in the unfavorable foreign currency fluctuations on purchases of dry chemistry strips denominated in Japanese Yen. Our chemistry strip manufacturing operation continues to operate below capacity, but we expect to improve its utilization with increased demand for our proprietary urine chemistry test strips as a result of an increasing installed base for our new iChem VELOCITY automated urine chemistry analyzers in the mid to high volume segment of the urinalysis market. Gross profit margin for our sample processing segment increased to 56% during the third quarter of 2009 from 48% during the third quarter of 2008 due primarily to price increases and reduced headcount related to the reduction in force in the second quarter of 2009.

Marketing and selling expenses totaled $3.8 million, or 17% of revenues, during the third quarter of 2009 as compared to $4.2 million, or 18% of revenues, during the third quarter of 2008. The decrease was due to lower commissions and GPO fees of $250,000, travel and entertainment expenses of $75,000 and outside professional services of $85,000, offset by an increase in additional personnel and related costs of $100,000. The increase in personnel and related costs is the result of our previous investments to enhance our internal sales staff and global marketing support in order to support the long-term growth of our 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 increased to $3.2 million, or 14% of revenues in the third quarter of 2009 from $2.7 million, or 12% of revenues, during the third quarter of 2008. This increase was due to an increase in personnel and related cost of $194,000, stock compensation expense of $160,000 and other expenses of $45,000.

Research and development expenses increased to $2.9 million, or 13% of revenues in the third quarter of 2009 as compared to $2.8 million, or 12% of revenues, in the third quarter of 2008. The increase was primarily attributable to $355,000 in prototype and research materials, as we continue to invest heavily in research and development for the continued development of our diagnostics product pipeline, including our NADiA platform and 3GEMS urinalysis and hematology programs with an offset of a reduction in personnel and related costs of $285,000.

Interest income decreased during the third quarter of 2009 to $215,000 from $276,000 during the third quarter of 2008, as a result of the lower interest rate environment.

Income tax expense during the third quarter of 2009 amounted to 24% of pre-tax income as compared to 32% during the prior year period as we have continued to benefit from deferred tax assets relating to research and development tax credits.

Comparison of Nine Months Ended September 30, 2009 to 2008

Consolidated revenues for the nine months ended September 30, 2009 decreased by 4% over the prior year period. Revenues in the IVD urinalysis segment decreased 5% to $55.4 million in 2009 from $58.4 million in the prior year period. Sales of IVD instruments decreased to $16.8 million from $24.1 million during the prior year period. International revenues accounted for approximately 34% of consolidated revenue during the nine months ended September 30, 2009 compared to 32% during the prior year period. IVD consumables and service revenue increased to $38.7 million from $34.3 million, an increase of $4.4 million or 13% over the prior year period. Revenues for the first nine months of 2009 and 2008 from the sample processing segment increased by 3% to $10.7 million in 2009 as compared to $10.4 million in the prior year period.

Overall gross profit margins for the first nine months increased to 53% during the current year period compared to 52% for the 2008 period. The gross profit margin of our IVD instruments decreased to 36% in the current year period compared to 45% during the prior year. IVD instrument gross margin was impacted by $266,000 in sales promotions, $988,000 in costs related to the iChem VELOCITY, which included Velocity retrofit costs of $393,000, and severance costs of approximately $40,000. The IVD instruments gross margin was also affected by a high proportion of international sales which typically carry a lower gross margin as they are primarily sold through distributors. The gross margin of our IVD consumables and services increased to 61% during the first nine months of 2009 compared to 57% during the prior year period, and included approximately $291,000 in international sales discounts and $100,000 in severance costs. The improvement in IVD gross margin is primarily due to strong demand for urinalysis consumables and improvements in service profitability. Gross profit margin for our sample processing segment increased to 52% in 2009 from 50% in 2008, as a result of product mix, price increases and reduced headcount related to the reduction in force in the second quarter of 2009.

Marketing and selling expenses totaled $11.7 million, or 18% of revenue, for the first nine months, as compared to $11.9 million, or 17% of revenue, in the same period of 2008. The increase in additional personnel and related costs of $505,000 and other expenses of $66,000 were offset by lower commissions and GPO fees of $505,000, outside professional services of $115,000 and travel related expenses of $200,000.

General and administrative expenses increased during the first nine months to $9.7 million, or 15% of revenue, compared to $8.4 million in the prior year, or 12% of revenue. The increase includes additional personnel and related cost of $440,000, stock-based compensation expense of $675,000 and professional fees of $170,000.

Research and development expense amounted to $8.5 million, or 13% of revenue, during the first nine months of 2009 compared to $8.0 million, or 12% of revenue, in the same period in the prior year. The increase includes research materials, consulting and clinical development of $450,000 as we continue to invest heavily in research and development for the continued development of our diagnostics product pipeline, including our NADiA platform and 3GEMS urinalysis and hematology programs.

Interest income for the first nine months of 2009 and 2008 amounted to $640,000 and $871,000, respectively, as a result of the lower interest rate environment and a lower cash balance as a result of the stock re-purchase program effected in the later part of 2008 and early 2009.

Income tax expense during the nine months of 2009 amounted to 28% of pre-tax income as compared to 32% during the prior year period and 33% for the full year ended December 31, 2008 as we have continued to benefit from deferred tax assets relating to research and development tax credits.

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, 2009, our cash and cash equivalents amounted to $31.0 million compared to $24.4 million at December 31, 2008.

Adverse global macro economic forces have been impacting our selling markets and the credit markets of our customers and distributors. The adverse impact of these macroeconomic forces has been more pronounced in the U.S. market in the second and third quarters of 2009 than in the first quarter of 2009. We may continue to face the following challenges: deferrals of purchases due to decreases in capital budgets of our customers, delays in the purchasing cycle due to greater scrutiny of deals and increased internal competition for limited capital dollars, and a significant increase in requests for quotes for operating leases. The aforementioned factors may lead to a decrease in revenue, an increase of deferred revenue, and/or could lead to installment cash collections that would affect our liquidity and capital resources.

Operating Cash Flows. Cash provided by operations for the nine months ended September 30, 2009 improved to $9.6 million compared to cash provided by operations of $8.6 million during the prior year nine month period. The improvement includes non-cash items consisting of higher depreciation and amortization of $223,000, stock-based compensation expense of $1.0 million, and tax benefits from stock options exercises of $1.5 million. In addition, we experienced a $2.6 million reduction in accounts receivable, a $1.5 million reduction in prepaid expenses and other current assets primarily due to a nonrecurring $1.5 million payment from IDEXX Labs, Inc. under the December 2008 manufacturing, supply and transition agreement, and a $143,000 reduction in investment in sales-type leases. The sources of cash were partially offset by a $1.3 million decrease in net income, an increase of $684,000 of deferred taxes, an increase of $1.7 million in inventories, and a decrease in accounts payable and accrued expenses of $2.1 million as compared to the prior year nine month period.

The number of days sales in accounts receivable increased to 68 days at the end of the first nine months of 2009 compared to 59 days for the prior year first nine months. The number of days sales in accounts receivable varies and extends due to extended payment terms for our international customers and the granting of an increased volume of extended payment terms for certain customers for our instrument sales.

Our cash flow has been favorably affected by tax credit carry forwards. As of December 31, 2008, we had federal and state tax credit carry forwards of approximately $1.8 million and $2.1 million, respectively, net of valuation allowances. We continue to realize tax deductions from the exercise of certain stock options. During the year ended December 31, 2008, we realized tax deductions of approximately $1.9 million relating to this item. During the three months and nine months ended September 30, 2009, we paid federal and state taxes totaling $720,000 and $2.0 million, respectively.

Investing Activities. Cash used by investing activities totaled $737,000 during the first nine months of 2009, a $2.3 million decrease over the prior year first nine months primarily as a result of the sale of short-term marketable securities totaling $2.2 million and a reduction in capitalization of software development costs of $291,000 partially offset by an increase in purchases of property and equipment of $109,000 as compared to the first nine months of the prior year.

Financing Activities. Cash used in financing activities totaled $2.5 million during the first nine months of 2009, a $896,000 decrease over the first nine months of the prior year primarily as a result of the reduction in the repurchase of common stock amounting to $4.3 million partially offset by a decrease from the issuance of common stock of $749,000 and a reduction in tax deduction benefits from the exercise of stock options of $2.7 million compared to the prior first nine months of 2008.

We currently have a credit facility with a commercial bank consisting of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. 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, 2009, there were no borrowings under the credit facility. We are subject to certain financial and non-financial covenants under the credit facility with the bank and as of September 30, 2009, we were in compliance with these covenants.

In November 2007, we filed with the SEC a shelf registration statement on Form S-3, which allows us to sell up to $125 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, 2009, no securities had been issued pursuant to this registration statement.

In fiscal year 2008, our board of directors authorized two stock repurchase plans. In March 2008, our board of directors authorized the first share repurchase and retirement plan of up to $15 million of our common stock over a 12-month period. Through September 30, 2008, we repurchased 492,068 shares of common stock for approximately $5.7 million under the first plan. On July 25, 2008, our board of directors terminated the first share repurchase and retirement plan.

On November 21, 2008, our board of directors authorized a second share repurchase and retirement plan of up to $10 million of common stock over a 12-month period and we repurchased 491,511 shares of common stock for approximately $6.2 million during the year ended December 31, 2008 against this second authorization. During the nine months ended September 30, 2009, we repurchased an additional 250,800 shares of common stock for approximately $2.5 million. As of September 30, 2009, under this second repurchase program, we had repurchased a cumulative total of 742,311 shares of common stock for approximately $8.7 million. We have authorization to repurchase an additional $1,340,000 of our common stock under the second plan before its expiration in November 2009.

Cumulatively between both share repurchase and retirement plans mentioned above, we purchased a total of 1,234,379 shares of common stock for approximately $14.4 million.

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 . . .