UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2010

or

o		Transition Report Pursuant Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                      to                     .

Commission file number 1-11181

IRIS INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

Delaware		94-2579751
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

9158 Eton Avenue
Chatsworth, California 91311
(Address of principal executive offices, zip code)

(818) 527-7000
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller” reporting company” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o (Do not check if smaller reporting company)		Smaller reporting company o

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

As of October 26, 2010, the issuer had 18,138,216 shares of common stock issued and outstanding.

 

 

IRIS INTERNATIONAL, INC.
INDEX TO FORM 10-Q

		Page
PART I FINANCIAL INFORMATION			3
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2010 (unaudited) and December 31, 2009			3
Consolidated Statements of Operations for the three months ended September 30, 2010 and 2009 (unaudited)			4
Consolidated Statements of Operations for the nine months ended September 30, 2010 and 2009 (unaudited)			5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009 (unaudited)			6
Notes to Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
Item 3. Quantitative and Qualitative Disclosures About Market Risk			26
Item 4. Controls and Procedures			27
PART II OTHER INFORMATION			28
Item 1A. Risk Factors			28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			30
Item 6. Exhibits			31
Signatures			33
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

IRIS INTERNATIONAL, INC.

(in thousands, except for share data)

		September 30,				December 31,
		2010				2009
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	31,110			$	34,253
Accounts receivable, net of allowance for doubtful accounts and sales returns of $453 and $391			18,453				17,715
Inventories			12,304				10,866
Prepaid expenses and other current assets			1,745				1,045
Investment in sales-type leases, current portion			3,504				3,397
Deferred tax asset			4,195				4,238
Total current assets			71,311				71,514
Property and equipment, net of accumulated depreciation of $13,602 and $11,713			10,379				9,667
Goodwill			3,802				2,450
Intangibles, net of accumulated amortization of $444 and $336			6,146				1,454
Software development costs, net of accumulated amortization of $4,038 and $3,566			2,623				2,534
Deferred tax asset			2,566				1,898
Investment in sales-type leases, non-current portion			9,279				7,441
Other assets			940				832
Total assets		$	107,046			$	97,790
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable		$	4,912			$	4,479
Accrued expenses			8,697				5,761
Deferred service contract revenue, current portion			3,216				2,286
Total current liabilities			16,825				12,526
Deferred service contract revenue, non-current portion			48				42
Other liabilities			1,378				—
Total liabilities			18,251				12,568
Commitments and contingencies
Stockholders’ equity:
Common stock, $0.01 par value; authorized: 50 million shares; issued and outstanding: 18,123,000 shares and 18,147,000 shares			181				181
Preferred stock, $0.01 par value; authorized 3.0 million shares; Series A, $0.01 par value; authorized 250,000 shares; issued and outstanding: none			—				—
Additional paid-in capital			89,771				87,692
Other comprehensive income			59				560
Accumulated deficit			(1,216	)			(3,211	)
Total stockholders’ equity			88,795				85,222
Total liabilities and stockholders’ equity		$	107,046			$	97,790

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

IRIS INTERNATIONAL, INC.

(unaudited — in thousands, except for per share data)

		For the three months
		ended September 30,
		2010				2009
Revenues
IDD instruments		$	6,806			$	5,136
IDD consumables and service			15,558				13,254
Sample processing instruments and supplies			3,335				3,796
Personalized medicine services			27				—
Total revenues			25,726				22,186
Cost of Revenue
IDD instruments			4,447				3,371
IDD consumables and service			6,425				4,955
Sample processing instruments and supplies			1,521				1,678
Personalized medicine services			174				—
Total cost of revenue			12,567				10,004
Gross profit			13,159				12,182
Marketing and selling			4,956				3,832
General and administrative			4,202				3,165
Research and development, net			3,605				2,870
Total operating expenses			12,763				9,867
Operating income			396				2,315
Other income (expense):
Interest income			328				215
Interest expense			(2	)			(3	)
Foreign currency transaction gain (loss) and other			856				(1	)
Income before provision for income taxes			1,578				2,526
Provision for income taxes			654				610
Net income		$	924			$	1,916
Other comprehensive (loss) income
Change in cumulative translation adjustment			(225	)			121
Comprehensive income		$	699			$	2,037
Net income per share — basic		$	0.05			$	0.11
Net income per share — diluted		$	0.05			$	0.11
Weighted average common shares outstanding — basic			17,978				17,751
Weighted average common shares outstanding — diluted			18,044				17,893

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

IRIS INTERNATIONAL, INC.

(unaudited — in thousands, except for per share data)

		For the nine months
		ended September 30,
		2010				2009
Revenues
IDD instruments		$	22,107			$	16,772
IDD consumables and service			45,274				38,658
Sample processing instruments and supplies			10,986				10,673
Personalized medicine services			27				—
Total revenues			78,394				66,103
Cost of Revenue
IDD instruments			14,194				10,656
IDD consumables and service			18,168				15,148
Sample processing instruments and supplies			4,950				5,089
Personalized medicine services			174				—
Total cost of revenue			37,486				30,893
Gross profit			40,908				35,210
Marketing and selling			14,152				11,664
General and administrative			12,562				9,689
Research and development, net			11,138				8,549
Total operating expenses			37,852				29,902
Operating income			3,056				5,308
Other income (expense):
Interest income			844				640
Interest expense			(7	)			(10	)
Foreign currency transaction gain and other			183				20
Income before provision for income taxes			4,076				5,958
Provision for income taxes			1,486				1,639
Net income		$	2,590			$	4,319
Other comprehensive (loss) income
Change in cumulative translation adjustment			(501	)			229
Comprehensive income		$	2,089			$	4,548
Net income per share — basic		$	0.14			$	0.24
Net income per share — diluted		$	0.14			$	0.24
Weighted average common shares outstanding — basic			17,947				17,701
Weighted average common shares outstanding — diluted			18,056				17,874

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

IRIS INTERNATIONAL, INC.

(unaudited — in thousands)

		For the nine months
		ended September 30,
		2010				2009
Cash flows from operating activities:
Net income		$	2,590			$	4,319
Adjustments to reconcile net income to net cash provided by operating activities:
Loss on disposal of fixed assets			5				42
Deferred taxes			48				—
Tax (benefit) expense from stock option exercises			(48	)			609
Gain on foreign currency remeasurement			(105	)			—
Depreciation and amortization			3,084				2,606
Common stock and stock-based compensation			3,193				2,780
Changes in operating assets and liabilities:
Accounts receivable			(736	)			3,763
Inventories			(1,469	)			(3,417	)
Prepaid expenses and other assets			(725	)			838
Investment in sales-type leases			(1,963	)			127
Other assets			—				(100	)
Accounts payable			280				(1,507	)
Accrued expenses			1,737				(832	)
Deferred service contract revenue			845				324
Net cash provided by operating activities			6,736				9,552
Cash flows from investing activities:
Acquisition of business			(4,630	)			—
Purchase of assets from European distributor			(660	)			—
Acquisition of property and equipment			(2,029	)			(2,259	)
Software development costs capitalized			(554	)			(635	)
Sale of short-term investments in marketable securities			—				2,157
Net cash used in investing activities			(7,873	)			(737	)
Cash flows from financing activities:
Issuance of common stock and warrants for cash			31				750
Repurchase of common stock			(1,790	)			(2,638	)
Tax benefit (expense) from stock option exercises			48				(609	)
Net cash used in financing activities			(1,711	)			(2,497	)
Net foreign currency translation adjustments			(295	)			228
Net (decrease) increase in cash and cash equivalents			(3,143	)			6,546
Cash and cash equivalents at beginning of period			34,253				24,445
Cash and cash equivalents at end of period		$	31,110			$	30,991
Supplemental schedule of non-cash investing activities:
During the nine months ended September 30, 2010, the Company disposed of property and equipment with a cost and accumulated depreciation of $621 and $616, respectively
Fair value of contingent consideration in connection with business acquisition completed in the quarter ended September 30, 2010 was $1.2 million
Supplemental disclosure of cash flow information:
Cash paid for income taxes		$	2,066			$	1,872
Cash paid for interest		$	7			$	7

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

IRIS INTERNATIONAL, INC.

1. Company History

IRIS International, Inc. was incorporated in California in 1979 and reincorporated in 1987 in Delaware. The Company designs, develops, manufactures and markets in vitro diagnostic products, including imaging systems based on patented and proprietary neural network-based Automated Particle Recognition (APR™) software to enable high-speed digital processing to classify and display images and describe the morphology of microscopic particles, urine chemistry analyzers and related chemistry test strips and accessories, molecular diagnostics assays based on the Company’s Nucleic Acid Detection Immuno-Assay (NADiA) technology, as well as special purpose centrifuges and other small instruments for automating microscopic procedures and DNA processing performed in clinical laboratories. On July 28, 2010 the Company acquired a high complexity CLIA-certified molecular pathology laboratory offering differentiated, high value molecular diagnostic services in the rapidly growing field of personalized medicine. The laboratory provides a direct commercial channel for the Company’s NADIA^® technology, with applications in oncology and infectious disease.

2. Interim Financial Reporting

Basis of Presentation — The financial statements have been prepared in accordance with the instructions to Form 10-Q under the Securities Exchange Act of 1934, as amended, and do not include all of the information and note disclosures required by accounting principles generally accepted in the United States (“GAAP”). These financial statements should be read in conjunction with the Consolidated Financial Statements and accompanying notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

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

Use of Estimates — The preparation of financial statements in conformity with GAAP 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 allowance for doubtful accounts, inventory reserves, the useful lives, fair value and recoverability of carrying value of long-lived and intangible assets, including goodwill, unearned income on sales-type leases, accrued bonuses, estimated provisions for warranty costs, laboratory information system implementations and deferred tax assets. Actual results and outcomes may differ from management’s estimates and assumptions.

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

Earnings Per Share — The Company computes and presents earnings per share in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 260, Earnings per share. Basic earnings per share are computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share are 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 using the average market prices during the period. The weighted average number of outstanding antidilutive common stock options excluded from the computation of diluted net income per common share for the three and nine months ended September 30, 2010 were 2,533,000 and 1,823,000, respectively. The weighted average number of outstanding antidilutive common stock options and warrants excluded from the computation of diluted net income per common share for the three and nine months ended September 30, 2009 was 1,468,000. A reconciliation of the shares used in the calculation of basic and diluted earnings per common share is as follows:

		For the three								For the nine
		months ended								months ended
		September 30,								September 30,
(in thousands)		2010				2009				2010				2009
Weighted average common shares outstanding — basic			17,978				17,751				17,947				17,701
Dilutive stock options and warrants outstanding			66				142				109				173
Weighted average common shares outstanding — diluted			18,044				17,893				18,056				17,874

Foreign Currency Hedge — The Company conducts business in certain foreign markets, primarily in Europe and Asia. To mitigate the potential impact of adverse fluctuations in the U.S. Dollar exchange rate for these currencies, the Company may periodically purchase foreign currency forward contracts. The Company does not speculate in these hedging instruments in order to profit from foreign currency exchanges nor does the Company enter into trades for which there are no underlying exposures.

Under FASB ASC Topic 815, Accounting for Derivative Instruments and Hedging Activities, the Company documents all relationships between hedging instruments and hedged items, as well as its risk management objective for undertaking these hedging transactions. This process includes relating the forward contracts that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assesses, both at the inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged items.

At September 30, 2010 and 2009, the Company did not have any foreign currency forward contracts.

Foreign Currency Exchange Translation — The functional currencies of the Company’s foreign subsidiaries are primarily accounted for in their respective local currencies. The statements of operations of foreign operations are translated into U.S. dollars at rates of exchange in effect each month. The balance sheets of these subsidiaries are translated at period-end exchange rates, and the differences from historical exchanges rates are reflected in stockholders’ equity as other comprehensive income (loss). Foreign currency transaction gains and losses from certain intercompany transactions are recorded in foreign currency transaction gain (loss) and other. Transactions denominated in currencies other than the functional currency are recorded based on rates in effect at the time such transactions arise. Subsequent changes in exchange rates result in transaction gains and losses and are reflected in the accompanying consolidated statements of operations as unrealized (based on the applicable period-end exchange rate) or realized upon settlement of the transactions. All other foreign currency gains and losses are also recorded on foreign currency transaction gain (loss) and other. The Company recognized net foreign currency transaction gains of $856,000 and $164,000 for the three and nine months ended September 30, 2010 which were primarily attributable to volatility in the Euro and British Pound.

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

Reclassifications — The Company reclassified amounts in segment and geographic information in prior periods to add the new operating segment, Personalized Medicine (which is further described in the Segments and Geographic footnote), to conform to the presentation used in the current period. The Personalized Medicine composition includes the research and development operations of Iris Molecular Diagnostics which had been included with the Iris Diagnostics Division (“IDD”) segment in prior periods. These reclassifications had no impact on the Company’s previously reported income from operations, net income or basic or diluted earnings per share.

Certain Risks and Uncertainties — Financial instruments, which potentially expose the Company to concentration of credit risk, consist primarily of cash and cash equivalents, accounts receivable and investment in sales-type leases. Concentration of credit risk with respect to accounts receivable and investment in sales-type leases is mitigated by the Company’s performance of on-going credit evaluations of its customers and the Company maintains an allowance for doubtful accounts. Investments in sales-type leases are secured by the underlying instruments.

Cash balances on deposit with banks are guaranteed by the Federal Deposit Insurance Corporation up to $250,000. The Company may be exposed to risk for the amount of funds held in one bank in excess of the insurance limit.

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, respectively.

Certain of the Company’s components are obtained from outside vendors, and the loss or breakdown of the Company’s relationships with these outside vendors could subject the Company to substantial delays in the delivery of its products to its customers. Furthermore, certain key components of the Company’s instruments and certain consumables are manufactured by only one supplier. The Company’s inability to sell products to meet delivery schedules could have a material adverse effect on its reputation in the industry, as well as its financial condition and results of operation.

3. Acquisition

On July 28, 2010, the Company acquired AlliedPath, Inc. (“AlliedPath”). AlliedPath is a high complexity CLIA-certified molecular pathology laboratory offering differentiated, high value molecular diagnostic services in the rapidly growing field of personalized medicine. Pursuant to the terms of the merger agreement dated July 26, 2010, the Company acquired all the issued and outstanding stock of AlliedPath for an amount in cash equal to $4.7 million less certain indebtedness existing at the closing, with an additional earn-out of up to $1.3 million subject to the achievement of specific sales and earnings targets through December 2013. We did not assume any outstanding options or warrants of AlliedPath in connection with the acquisition. In September 2010, AlliedPath changed its name to Arista Labs, Inc. (“Arista”) which will operate under the Personalized Medicine reporting segment of the consolidated financial statements.

Through the acquisition of Arista, the Company seeks to achieve the following goals:

•

to expand beyond its initial molecular pathology test menu by adding other molecular panels, flow cytometry for the detection and monitoring of leukemia and lymphoma, (F)ISH testing, and proprietary new tests based on the Company’s NADiA technology platform;

•

to have better control of all aspects of the commercial operations of the NADiA platform, starting with NADiA ProsVue;

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

•

to enable the acceleration of the development efforts of the NADiA technology product pipeline; and

•

to enter the attractive personalized medicine market due to its significant growth potential.

The aggregate consideration paid for the acquisition of Arista is as follows:

(In thousands)
Cash		$	4,630
Fair value of contingent consideration			1,210
Total purchase price		$	5,840

Acquisition related expenses included in marketing and sales and general and administrative total $161,000 and $525,000 for the three and nine months ended September 30, 2010, respectively.

The following table summarizes the estimated fair values of assets acquired and liabilities assumed as of July 28, 2010.

(In thousands)
Current assets		$	74
Property and equipment			523
Existing technology			3,090
CLIA License			1,604
Customer relationships			6
Non-compete agreements			100
Goodwill			1,352
Other assets			31
Current liabilities			(316	)
Lease obligations			(178	)
Other liabilities			(61	)
Deferred tax liability, net			(385	)
Total purchase price		$	5,840

The purchase price allocations and pro forma adjustments above are based on preliminary estimates, available information and certain assumptions, and maybe revised as additional information becomes available.

In determining the purchase price allocation, the Company considered, among other factors, historical demand for products, estimates of future demand for those products, customer relationships, the revenue generating potential of existing technology, the assets’ useful lives, and agreements not to compete. The market, income and cost approaches were used to determine fair values of these intangibles. The rate used to discount the net cash flows to their present value was a 16.5% weighted average cost of capital for the business as a whole, and from 16.5% to 17.5% for the individual intangible assets depending on the risk associated with the asset’s potential to generate revenues and its projected remaining useful economic life. The weighted average cost of capital was determined after consideration of market rates of return on debt and equity capital of comparable companies, the weighted average return on invested capital and the risk associated with achieving forecasted sales related to technology and assets acquired. The fair value of the contingent consideration was determined considering the probability of payout and using a 3% discount rate. Property and equipment net book value was evaluated at approximately fair value on the acquisition date due to the nature and relative age of the assets acquired.

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

Acquired property and equipment are being depreciated on a straight-line basis with estimated remaining useful lives ranging from 1 year to 5 years. Intangible assets except the CLIA license are being amortized on a straight-line basis with estimated remaining useful lives ranging from 3 years to 15 years reflecting the expected future value. The CLIA license is considered to have an indefinite useful life. The purchase was structured as a stock purchase therefore the value assigned to the existing technology, CLIA license, customers relationships, non-compete agreements and goodwill is not deductible for tax purposes.

Revenue and net loss of Arista included in the Company’s consolidated financial statement since the laboratory’s acquisition on July 28, 2010 totaled $27,000 and $1,592,000, respectively, for the three and nine months ended September 30, 2010.

The following table summarizes unaudited pro forma financial information assuming the acquisition of Arista had occurred on January 1, 2009, in the corresponding period of the fiscal year immediately preceding the acquisition. This unaudited pro forma financial information does not necessarily represent what would have occurred if the transaction had taken place on January 1, 2009 and should not be taken as representative of the Company’s future consolidated results of operations or financial position.

		Three Months Ended								Nine Months Ended
		September 30,								September 30
(In thousands)		2010				2009				2010				2009
Revenue		$	25,731			$	22,186			$	78,425			$	66,103
Net income			587				1,250				930				2,602
Net income per basic and diluted share		$	0.03			$	0.07			$	0.05			$	0.15

4. Inventories

Inventories consist of the following:

		September 30,				December 31,
(in thousands)		2010				2009
Finished goods		$	4,656			$	2,595
Work-in-process			283				214
Raw materials, parts and sub-assemblies			7,365				8,057
Inventories		$	12,304			$	10,866

5. Sales-Type Leases

The components of net investment in sales-type leases consist of the following:

		September 30,				December 31,
(in thousands)		2010				2009
Total minimum lease payments		$	15,104			$	12,735
Less: unearned income			(2,321	)			(1,897	)
Net investment in sales-type leases			12,783				10,838
Less: current portion			(3,504	)			(3,397	)
Net investment in sales-type leases, non-current portion		$	9,279			$	7,441

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

Future minimum lease payments due from customers under sales-type leases for each of the five succeeding years:

(In thousands)
Years Ending December 31,
2010 (three months remaining)		$	1,013
2011			3,392
2012			2,852
2013			2,411
2014			1,976
Thereafter			1,139
		$	12,783

6. Bank Credit Facility

The Company has a credit facility with a commercial bank. The credit facility consists of a $6.5 million revolving line of credit for working capital and a $10.0 million line of credit for acquisitions and product opportunities. 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. Borrowings under the credit facility are secured by all of the Company’s assets and mature on June 30, 2012 and June 30, 2015, respectively.

As of September 30, 2010 and December 31, 2009, there were no borrowings under the credit facility. However, the Company is subject to certain financial and non-financial covenants under the credit facility with the bank and the Company was in compliance with these covenants as of September 30, 2010.

7. Income Taxes

On a quarterly basis, the Company estimates the effective tax rate for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the fiscal year progresses, the Company refines its estimate based on the facts and circumstances by each tax jurisdiction. The effective tax rates for the three and nine months ended September 30, 2010 were 41% and 36%, respectively. The effective tax rates for the three and nine months ended September 30, 2009 were 24% and 28%, respectively.

The Company will recognize potential interest and penalties related to income tax positions as a component of the provision for income taxes in the statements of operations in any future periods in which the Company must record such a liability. Since the Company has not recorded a liability at September 30, 2010, there was no impact on the Company’s effective tax rate.

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

8. Stock-Based Compensation

The Company accounts for stock-based compensation pursuant to FASB ASC Topic 718, Stock Compensation, which requires compensation costs related to share-based transactions, including employee stock options, to be recognized in the financial statements based on fair value. Share-based compensation expense for the nine months ended September 30, 2010 and 2009 includes incremental share-based compensation expense classified as follows:

		For the three								For the nine
		months ended								months ended
		September 30,								September 30,
(in thousands)		2010				2009				2010				2009
Cost of sales		$	90			$	113			$	278			$	311
Marketing and selling			151				161				526				451
General and administrative			533				493				1,764				1,540
Research and development			208				179				625				478
Stock-based compensation		$	982			$	946			$	3,193			$	2,780

Stock Options

The Company has a stock option plan under which the Company may grant future non-qualified stock options, incentive stock options and stock appreciation rights. No stock appreciation rights have been granted under any of the Company’s stock option plans. On July 13, 2007, the Company’s stockholders approved the adoption of the IRIS International, Inc. 2007 Stock Incentive Plan, which initially authorized the issuance of up to 1,750,000 shares of common stock pursuant to equity awards granted under the plan. On May 22, 2009, the Company’s stockholders approved an increase of 1,550,000 shares to the 2007 Stock Incentive Plan for a total of 3,300,000 authorized shares.

The following schedule sets forth options authorized, exercised, outstanding and available for grant under the Company’s existing stock option plans as of September 30, 2010:

		Number of Option Shares
(In thousands)														Available
Plan		Authorized				Exercised				Outstanding				for Grant
1994 Plan			700				680				20				—
1998 Plan			4,100				2,717				946				—
2007 Plan			3,300				—				1,725				947
			8,100				3,397				2,691				947

Stock option activity during the nine months ended September 30, 2010 is as follows:

						Weighted				Weighted
						Average				Average
						Exercise				Remaining				Aggregate
						Price Per				Contractual				Intrinsic
(in thousands, except for per share amounts)		Shares				Share				Term				Value
Outstanding at January 1, 2010			2,205			$	12.97			3.7 years				$	3,445
Granted			692			$	10.92
Exercised			(23	)		$	1.44
Canceled or expired			(183	)		$	13.31
Outstanding at September 30, 2010			2,691			$	12.51			4.0 years				$	1,164
Exercisable at September 30, 2010			1,576			$	13.63			2.7 years				$	1,063

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (the difference between the closing stock price on September 30, 2010 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders, had all option holders exercised their options on September 30, 2010. Total intrinsic value of options exercised for the nine months ended September 30, 2010 amounted to $201,000. As of September 30, 2010, total unrecognized stock-based compensation expense related to unvested stock options was $4,598,000, which is expected to be recognized over the remaining weighted average period of approximately 2.76 years.

The Compensation Committee of the board of directors determines the total value of the stock based compensation grants. The exercise price of options is the closing price on the date the options are granted. Payment of the exercise price may be made either in cash or with shares of common stock that have been held at least six months. The options generally vest over four years and expire between five and ten years from the date of grant. The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

		For the three
		months ended
		September 30,
		2010				2009
Risk free interest rate			1.46	%			2.1	%
Expected lives (years)			4.29				4.0
Expected volatility			56.1	%			61.6	%
Expected dividend yield			0	%			0	%

The expected volatilities are based on the historical volatility of the Company’s stock, which is calculated on a weekly basis. The expected terms of the stock options are based on the average vesting period on a basis consistent with the historical experience for similar option grants. The risk-free interest rate is consistent with the expected terms of the stock options and based on the U.S. Treasury yield curve in effect at the time of grant. The Company estimates forfeiture rates based on historical data.

A summary of the Company’s unvested stock options during the nine months ended September 30, 2010 is as follows:

						Weighted
						Average
						Grant Date
						Fair Value
(In thousands except for fair value per share)		Shares				Per Share
Unvested options at January 1, 2010			933			$	11.26
Granted			692			$	11.91
Vested			(403	)		$	11.40
Forfeited or expired			(107	)		$	7.76
Unvested options at September 30, 2010			1,115			$	10.93

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

Restricted Shares

The Company began awarding restricted shares of its common stock in 2006. In March 2009, the Company began to grant restricted stock units to its non-employee directors and to certain employees. Such awards generally require that certain performance conditions and service conditions be met before the awards vest. Restricted shares currently vest 25% after one year and 6¹/4% quarterly thereafter. Restricted stock units currently vest 25% after thirteen months and 6¹/4% quarterly thereafter. However, awards to non-employee directors are immediately vested on the grant date. Unvested restricted shares are forfeited if the recipient’s employment terminates for any reason other than death, disability or special circumstances as determined by the Compensation Committee of the Company’s board of directors. Restricted share activity during the nine months ended September 30, 2010 was as follows:

						Weighted Average
						Grant Date Fair
(in thousands, except for fair value per share)		Shares				Value Per Share
Non-vested shares at January 1, 2010			248			$	11.44
Granted			171			$	10.94
Vested			(110	)		$	11.59
Forfeited			(20	)		$	11.75
Non-vested shares at September 30, 2010			289			$	11.07

Fair value of the Company’s restricted shares is based on the Company’s closing stock price on the date of grant. As of September 30, 2010, total unrecognized stock-based compensation expense related to non-vested restricted share grants was $2,974,000 which is expected to be recognized over the remaining weighted average period of approximately 1.4 years.

9. Common Stock Repurchase Plan

On August 17, 2010, the Company’s board of directors authorized a share repurchase and retirement plan of up to $10 million of the Company’s common stock over a 12-month period. During the three months and nine months ended September 30, 2010, the Company repurchased 175,196 shares of common stock at an average price per share of approximately $9.13, for an aggregate amount of approximately $1.6 million.

Subsequent to September 30, 2010 and through November 2, 2010, the Company repurchased an additional 154,400 shares of common stock for approximately $1.4 million.

10. Shareholders’ Rights Plan

On September 24, 2010, the Company’s board of directors adopted a shareholders’ rights plan under which each holder of a share of common stock also has one right to purchase one one-thousandth of a newly created Series A preferred share at $100 per one one-thousandth of a share.

The rights are not presently exercisable. Upon the occurrence of certain “flip-in” events, each right becomes exercisable which then entitles its holder to receive the number of Series A preferred shares having an aggregate per share market value price equal to two times the purchase price. Upon certain “flip-over” events, each right when exercised entitles its holder to receive equity securities of the acquiring company having a value equal to two times the purchase price. A flip-in event includes the acquisition by a person or group (an “acquiring person”) of 20 percent or more of the Company’s common stock. Rights held by an acquiring person are void. The Company may redeem the rights for $0.001 per right and may amend the rights under the plan at any time prior to a triggering event. The rights expire on September 24, 2020.

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

11. Contingencies

Litigation

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

Guarantees

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 these 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. These indemnification provisions often include indemnifications relating to representations made by the Company with regard to intellectual property rights. These indemnification provisions generally survive termination of the underlying agreement. In addition, in some cases, the Company has agreed to reimburse employees for certain expenses and to provide salary continuation during short-term disability. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is unlimited. The Company reviews its exposure under these agreements no less than annually, or more frequently when events indicate. As a result, the Company believes the estimated fair value of these agreements is not material. Accordingly, the Company has not recorded any liabilities for these agreements as of September 30, 2010 or December 31, 2009.

12. Segments and Geographic Information

The Company’s operations are organized on the basis of products and related services and under FASB ASC Topic 280, Segment Reporting, the Company operates in three segments: (1) Iris Diagnostics Division (IDD), (2) Sample Processing and (3) Personalized Medicine.

The IDD segment designs, develops, manufactures, markets and distributes in-vitro diagnostic systems based on patented and proprietary technology for automating microscopic and clinical chemistry procedures for urinalysis. The segment also provides ongoing sales of consumables and services necessary for the operation of installed urinalysis workstations. In the United States, these products are mostly sold through a direct sales and service force. Internationally, these products are sold and serviced through distributors, with the exception of France, Germany, United Kingdom and Puerto Rico.

The Sample Processing 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, urinalysis and DNA processing. These products are sold worldwide through distributors.

The Personalized Medicine segment operates a CLIA-certified laboratory focused on oncology and molecular diagnostics services in personalized medicine. This segment also includes the research and development operations of Iris Molecular Diagnostics, or IMD.

The accounting policies of the segments are the same as those described in the “Summary of Significant Accounting Policies” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009. The Company evaluates the performance of its segments and allocates resources to them based on earnings before income taxes, excluding corporate charges.

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

The tables below present information about reported segments for the three and nine months ended September 30, 2010 and 2009:

														Unallocated
						Sample				Personalized				Corporate
(In thousands)		IDD				Processing				Medicine				Expenses				Total
For the three months ended September 30, 2010
Revenues		$	22,364			$	3,335			$	27			$	—			$	25,726
Gross profit			11,492				1,814				(147	)			—				13,159
Marketing and selling			4,166				338				452				—				4,956
General and administrative			1,582				370				657				1,593				4,202
Research and development, net			2,228				186				1,191				—				3,605
Total operating expenses			7,976				894				2,300				1,593				12,763
Operating income			3,516				920				(2,447	)			(1,593	)			396
Interest income			81				6				—				241				328
Interest expense			—				—				—				(2	)			(2	)
Depreciation and amortization			968				43				91				2				1,104
Segment pre-tax income (loss)			4,689				900				(2,783	)			(1,228	)			1,578
Segment assets			77,538				12,021				10,727				6,760				107,046
Investment in long-lived assets			25,761				433				10,481				—				36,675
For the three months ended September 30, 2009
Revenues		$	18,390			$	3,796			$	—			$	—			$	22,186
Gross profit			10,064				2,118				—				—				12,182
Marketing and selling			3,561				271				—				—				3,832
General and administrative			1,196				342				—				1,627				3,165
Research and development, net			1,496				239				1,135				—				2,870
Total operating expenses			6,253				852				1,135				1,627				9,867
Operating income			3,811				1,266				(1,135	)			(1,627	)			2,315
Interest income			9				5				—				201				215
Interest expense			—				—				—				(3	)			(3	)
Depreciation and amortization			854				67				—				5				926
Segment pre-tax income (loss)			3,803				1,246				(1,135	)			(1,388	)			2,526
Segment assets			57,574				26,711				4,239				4,929				93,453
Investment in long-lived assets			21,383				387				4,217				—				25,987

IRIS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — continued

														Unallocated
						Sample				Personalized				Corporate
(In thousands)		IDD				Processing				Medicine				Expenses				Total
For the nine months ended September 30, 2010
Revenues		$	67,381			$	10,986			$	27			$	—			$	78,394
Gross profit			35,019				6,036				(147	)			—				40,908
Marketing and selling			12,684				921				547				—				14,152
General and administrative			4,625				1,132				898				5,907				12,562
Research and development, net			6,686				504				3,948				—				11,138
Total operating expenses			23,995				2,557				5,393				5,907				37,852
Operating income			11,024				3,479				(5,540	)			(5,907	)			3,056
Interest income			119				23				—				702				844
Interest expense			—				—				—				(7	)			(7	)
Depreciation and amortization			2,716				137				221				10				3,084
Segment pre-tax income (loss)			11,204				3,425				(5,540	)			(5,013	)			4,076
Segment assets			77,538				12,021				10,727				6,760				107,046
Investment in long-lived assets			25,761				433				10,481				—				36,675
For the nine months ended September 30, 2009
Revenues		$	55,430			$	10,673			$	—			$	—			$	66,103
Gross profit			29,625				5,585				—				—				35,210
Marketing and selling			10,865				799				—				—				11,664
General and administrative			3,678				984				—				5,027				9,689
Research and development, net			4,620				681				3,248				—				8,549
Total operating expenses			19,163				2,464				3,248				5,027				29,902
Operating income			10,462				3,121				(3,248	)			(5,027	)			5,308
Interest income			18				20				—				602				640
Interest expense			—				—				—				(10	)			(10	)
Depreciation and amortization			2,393				201				—				12				2,606
Segment pre-tax income (loss)			10,440				3,076				(3,248	)			(4,310	)			5,958
Segment assets			57,574				26,711				4,239				4,929				93,453
Investment in long-lived assets			21,383				387				4,217				—				25,987

The Company ships products from two locations in the United States and one location in Germany. Substantially all long-lived assets are located in the United States. Sales to international customers amounted to approximately $26.3 million and $22.2 million during the nine months ended September 30, 2010 and 2009, respectively. Sales to international customers amounted to approximately $8.5 million and $7.5 million during the three months ended September 30, 2010 and 2009, respectively. Personalized medicine services are performed in the United States.

Segment assets attributed to corporate unallocated expenses are deferred taxes. Long-lived assets include property and equipment, intangible assets, long-term portion of inventory and other long-term assets. Deferred income tax is excluded from long-lived assets.

13. Subsequent Events

The Company considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. The Company evaluated subsequent events through the date the financial statements were issued.

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

This report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. All statements other than statements of historical facts are “forward-looking statements” for purposes of these provisions, including any projections of earnings, revenues or other financial items, any statement of the plans and objectives of management for future operations, any statements concerning proposed new products or strategic arrangements, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential,” “intends”, or “continue” or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained herein are reasonable, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including but not limited to the Risk Factors set forth under Item 1A, and for the reasons described elsewhere in this report. All forward-looking statements and reasons why results may differ included in this report are made as of the date hereof, and we assume no obligation to update these forward-looking statements or reasons why actual results might differ.

Overview

IRIS International, Inc. consists of three operating units in three business segments as determined in accordance with FASB ASC Topic 280, Segment Reporting. Our in-vitro diagnostics segment also called Iris Diagnostics Division (“IDD”), designs, manufactures and markets systems, consumables and supplies for urinalysis and body fluids. Our Sample Processing segment markets small centrifuges and other processing equipment and accessories for rapid specimen processing. With the acquisition of our CLIA laboratory in July 2010, we have created a Personalized Medicine segment combining the research and development operations of our Iris Molecular Diagnostics subsidiary and Arista Labs, Inc. (“Arista”). Under this new segment we consolidate all operations for the development and commercialization of cancer diagnostic testing services and related products.

Our core business is in the urinalysis market and we are the leading worldwide provider of automated urine microscopy systems, with more than 2,900 iQ microscopy analyzers shipped to date in over 50 countries. We generate revenues primarily from sales of instruments, consumables and service and sample processing instruments and supplies. Revenues from instruments include global sales of urine microscopy analyzers and sales of chemistry analyzers manufactured by us and a urine chemistry analyzer, the AUTION MAX AX-4280, sourced from a Japanese manufacturer for the U.S. market only. We have secured sufficient inventory of the AUTION MAX AX-4280 to cover our estimated U.S. sales of fully automated chemistry analyzers through the end of 2010. We initiated international sales of the iChem^®VELOCITY™, our proprietary fully-automated chemistry analyzer in September 2008 and have sold over 300 units to date. Sales of this instrument in the United States will be initiated upon us attaining U.S. Food and Drug Administration (FDA) clearance of our 510(k) application submitted on June 30, 2010. Our consumables offering includes products such as chemical reagents, urine test strips, calibrators and controls. 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 and consumables, which primarily consists of centrifuge systems, DNA processing workstations and blood analysis products.

In the United States, France, Germany, United Kingdom and Puerto Rico sales of our urinalysis systems are direct to the end-user through our sales force. All other international sales are through independent distributors. In January 2010, we completed the purchase of certain European assets relating to the distribution of products in the United Kingdom, Ireland and Germany. The assets purchased consisted primarily of installed instruments leased to customers, the related lease agreements and service contracts. We paid $660,000 for these assets and recorded them within property and equipment. Our incremental revenue relating to the acquired distributor’s business was $600,000 and $1,614,000 for the three and nine months ended September 30, 2010. International sales represented 34% of consolidated revenues during the nine month periods ended September 30, 2010 and 2009. Since the majority of 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 and OEM partners.

We are developing a prostate cancer prognostic diagnostic test, called NADiA ProsVue, to monitor levels of PSA, that presently are undetectable with current testing methods, in men with prostate cancer who have undergone radical prostatectomy, or removal of the prostate gland. We met with the FDA on several occasions 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 large clinical study. We conducted a multi-center retrospective clinical study consisting of approximately 300 patients with serially collected blood samples, retained over an eight year period and we believe the study data meets the pre-established primary and secondary end points. On April 28, 2010, we submitted our NADiA ProsVue 510(k) pre-market notification application to the FDA requesting clearance of a prognostic claim. In June 2010, we received a letter from the FDA requesting additional information on this matter. We have responded to the FDA’s additional information inquiry and met with the FDA in November 2010. At this meeting the FDA again requested additional information, which we expect to provide by year end.

On July 28, 2010, we acquired Arista Labs, Inc., a state-of-the—art high complexity CLIA-certified laboratory focused on oncology testing services for an amount in cash equal to $4.7 million less certain indebtedness existing at the closing, with an additional earn-out of up to $1.3 million subject to the achievement of specific sales and earnings targets through December 2013. Arista offers differentiated, high value molecular diagnostic services in personalized medicine. This acquisition strategically provides a direct commercial channel for our NADiA^® ultra-sensitive nucleic acid detection immunoassay platform, beginning with NADiA ProsVue and provides better control over all aspects of the commercial operations. In addition, we believe the laboratory should accelerate the development efforts of the current NADiA product pipeline.

Since the acquisition, the laboratory’s sales and marketing team has expanded to ten professionals. In addition, Arista is planning to expand its test menu with additional molecular panels, flow cytometry for detection and monitoring of leukemia and lymphoma, (F)ISH testing and proprietary new tests based on the NADIA technology platform.

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, 2009. There have been no material changes in these critical accounting policies since December 31, 2009.

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)		2010								2009								2010								2009
Revenues
IDD instruments		$	6,806				27%			$	5,136				23%			$	22,107				28%			$	16,772				25%
IDD consumables and service			15,558				60%				13,254				60%				45,274				58%				38,658				59%
Sample Processing instruments and supplies			3,335				13%				3,796				17%				10,986				14%				10,673				16%
Personalized medicine			27				0%				—				0%				27				0%				—				0%
Total revenues			25,726				100%				22,186				100%				78,394				100%				66,103				100%
Gross profit (1)
IDD instruments			2,359				35%				1,765				34%				7,913				36%				6,116				36%
IDD consumables and service			9,133				59%				8,299				63%				27,106				60%				23,510				61%
Sample Processing instruments and supplies			1,814				54%				2,118				56%				6,036				55%				5,584				52%
Personalized medicine			(147	)		nm					—				0%				(147	)		nm					—				0%
Gross profit			13,159				51%				12,182				55%				40,908				52%				35,210				53%
Operating expenses
Marketing and selling			4,956				19%				3,832				17%				14,152				18%				11,664				18%
General and administrative			4,202				16%				3,165				14%				12,562				16%				9,689				15%
Research and development, net			3,605				14%				2,870				13%				11,138				14%				8,549				13%
Total operating expenses			12,763				50%				9,867				44%				37,852				48%				29,902				45%
Operating income			396				2%				2,315				10%				3,056				4%				5,308				8%
Other (expense) income			1,182				5%				211				1%				1,020				1%				650				1%
Income before provision for income taxes			1,578				6%				2,526				11%				4,076				5%				5,958				9%
Provision for income taxes (2)			654				41%				610				24%				1,486				36%				1,639				28%
Net income		$	924				4%			$	1,916				9%			$	2,590				3%			$	4,319				7%