##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

QUARTERLY REPORT ON 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 JUNE 30, 2003

COMMISSION FILE NUMBER 0-21013

XYBERNAUT CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


|                             |  |                    
|---------------------------- |  | -------------------
|DELAWARE                     |  | 54-1799851         
|(STATE OR OTHER JURISDICTION |  | (I.R.S. EMPLOYER   
|OF INCORPORATION)            |  | IDENTIFICATION NO.)

12701 FAIR LAKES CIRCLE, FAIRFAX, VA 22033
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES WITH ZIP CODE)

(703) 631-6925
(REGISTRANTS TELEPHONE NUMBER, INCLUDING AREA CODE)

Check whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act 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 [ ]

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

The number of shares outstanding of the registrants Common Stock, $0.01
par value per share, as of August 8, 2003 was 158,931,722.





---



##### 



XYBERNAUT CORPORATION

QUARTERLY REPORT ON FORM 10-Q

|                               |                                                                                                |                                                             |    |      |   | 
|------------------------------ | ---------------------------------------------------------------------------------------------- | ----------------------------------------------------------- | -- | ---- | - | 
|                               |                                                                                                |                                                             |    | PAGE
|COVER PAGE                     |                                                                                                |                                                             | 1  |     
|INDEX                          |                                                                                                |                                                             | 2  |     
|PART I  FINANCIAL INFORMATION |                                                                                                |                                                             |    |     
|                               | Item 1 - Financial Statements                                                                  |                                                             |    |      |  
|                               |                                                                                                | Condensed Consolidated Balance Sheets (unaudited)           |    |      | 3 | 
|                               |                                                                                                | Condensed Consolidated Statements of Operations (unaudited) |    |      | 4 | 
|                               |                                                                                                | Condensed Consolidated Statements of Cash Flows (unaudited) |    |      | 5 | 
|                               |                                                                                                | Notes to Condensed Consolidated Financial Statements        |    |      | 6 | 
|                               | Item 2 - Managements Discussion and Analysis of Financial Condition and Results of Operations |                                                             |    | 12   |  
|                               | Item 3 - Quantitative and Qualitative Disclosures about Market Risk                            |                                                             |    | 22   |  
|                               | Item 4 - Controls and Procedures                                                               |                                                             |    | 23   |  
|PART II  OTHER INFORMATION    |                                                                                                |                                                             |    |     
|                               | Item 2 - Changes in Securities and Use of Proceeds                                             |                                                             |    | 23   |  
|                               | Item 6 - Exhibits and Reports on Form 8-K                                                      |                                                             |    | 23   |  
|SIGNATURES                     |                                                                                                |                                                             | 24 |     

2



---



##### 



XYBERNAUT CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)


|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |              |           |   |            | 
|------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------- | ------------------------------------------ | --------- | -------- | ---------- | ------------ | --------- | - | ---------- | 
|                                                 |                                                                                                                         |                            |         |                                            |           | June 30, |            | December 31,
|                                                 |                                                                                                                         |                            |         |                                            |           | 2003     |            | 2002        
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|ASSETS                                           |                                                                                                                         |                            |         |                                            |           |          |            |             
|Current assets:                                  |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 | Cash and cash equivalents                                                                                               |                            | $       | 5,329,525                                  |           |          | $          | 1,967,710    |          
|                                                 | Restricted cash                                                                                                         |                            |         | 875,554                                    |           |          |            | 500,000      |          
|                                                 | Accounts receivable, net of allowances of $204,948 and $202,911                                                         |                            |         | 3,175,092                                  |           |          |            | 3,410,871    |          
|                                                 | Inventory, net of reserves of $618,833 and $0                                                                           |                            |         | 3,790,948                                  |           |          |            | 2,393,465    |          
|                                                 | Prepaid and other current assets                                                                                        |                            |         | 525,188                                    |           |          |            | 804,102      |          
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total current assets                       |           |          | 13,696,307 |              |           |   | 9,076,148  | 
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|Property, equipment and demonstration units, net |                                                                                                                         |                            | 439,943 |                                            |           |          | 590,387    |             
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|Other assets:                                    |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 | Patent costs, net of accumulated amortization of $1,739,169
and $1,516,758                                              |                            |         | 948,057                                    |           |          |            | 1,052,518    |          
|                                                 | Tooling costs, net of accumulated amortization of
$498,168 and $141,122, and reserves of $250,000 and $250,000          |                            |         | 442,490                                    |           |          |            | 776,699      |          
|                                                 | Other                                                                                                                   |                            |         | 969,101                                    |           |          |            | 639,619      |          
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total other assets                         |           |          | 2,359,648  |              |           |   | 2,468,836  | 
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total assets                               |           | $        | 16,495,898 |              |           | $ | 12,135,371 | 
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|LIABILITIES AND STOCKHOLDERS EQUITY             |                                                                                                                         |                            |         |                                            |           |          |            |             
|Liabilities:                                     |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 | Current liabilities:                                                                                                    |                            |         |                                            |           |          |            |              |          
|                                                 |                                                                                                                         | Accounts payable           |         | $                                          | 2,252,713 |          |            | $            | 3,007,647 |  
|                                                 |                                                                                                                         | Accrued expenses and other |         |                                            | 2,417,428 |          |            |              | 1,473,506 |  
|                                                 |                                                                                                                         | Deferred revenue           |         |                                            | 252,844   |          |            |              | 88,460    |  
|                                                 |                                                                                                                         | Notes payable              |         |                                            | 3,072     |          |            |              | 8,376     |  
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total current liabilities                  |           |          | 4,926,057  |              |           |   | 4,577,989  | 
|                                                 | Long-term restructuring liability                                                                                       |                            |         | 87,200                                     |           |          |            | 119,295      |          
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total liabilities                          |           | $        | 5,013,257  |              |           | $ | 4,697,284  | 
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|Commitments and contingencies                    |                                                                                                                         |                            |         |                                            |           |          |            |             
|Stockholders equity:                            |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 | Common stock, $0.01 par value, 200,000,000 shares
authorized, 151,596,418 and 113,615,722 shares
issued and outstanding |                            | $       | 1,515,964                                  |           |          | $          | 1,136,157    |          
|                                                 | Additional paid-in capital                                                                                              |                            |         | 149,309,964                                |           |          |            | 137,181,587  |          
|                                                 | Foreign currency translation                                                                                            |                            |         | 315,216                                    |           |          |            | 143,502      |          
|                                                 | Accumulated deficit                                                                                                     |                            |         | (139,658,503                               | )         |          |            | (131,023,159 | )        
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total stockholders equity                 |           | $        | 11,482,641 |              |           | $ | 7,438,087  | 
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             
|                                                 |                                                                                                                         |                            |         | Total liabilities and stockholders equity |           | $        | 16,495,898 |              |           | $ | 12,135,371 | 
|                                                 |                                                                                                                         |                            |         |                                            |           |          |            |             

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

3



---



##### 



XYBERNAUT CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)


|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |           |             |             |  
|------------------------------------------ | ------------------------------- | ----------------------------------------------------------------- | ------------------------ | --------- | --------------------------- | ---------- | ------------------------- | --------- | ---------- | ---------- | -------- | --------- | ----------- | ---------- | ------- | --------- | ----------- | ----------- | -
|                                           |                                 |                                                                   |                          |           | Three Months Ended June 30, |            | Six Months Ended June 30,
|                                           |                                 |                                                                   |                          |           |                             |            |                          
|                                           |                                 |                                                                   |                          |           | 2003                        |            | 2002                      |           | 2003       |            | 2002    
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |         
|Revenue:                                   |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           | Hardware                        |                                                                   | $                        | 1,775,792 |                             |            | $                         | 1,158,423 |            |            | $        | 2,600,504 |             |            | $       | 2,918,615 |            
|                                           | Consulting, licensing and other |                                                                   |                          | 1,012,789 |                             |            |                           | 855,040   |            |            |          | 1,975,054 |             |            |         | 1,904,769 |            
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           | Total revenue                   |                                                                   |                          | 2,788,581 |                             |            |                           | 2,013,463 |            |            |          | 4,575,558 |             |            |         | 4,823,384 |            
|Cost of sales:                             |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           | Hardware                        |                                                                   |                          | 1,194,857 |                             |            |                           | 1,013,754 |            |            |          | 1,822,251 |             |            |         | 2,471,266 |            
|                                           | Consulting, licensing and other |                                                                   |                          | 623,249   |                             |            |                           | 563,059   |            |            |          | 1,229,861 |             |            |         | 1,228,524 |            
|                                           | Provision for inventory         |                                                                   |                          |          |                             |            |                           | 53,958    |            |            |          | 1,749,354 |             |            |         | 53,958    |            
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 | Gross income / (loss)                                             |                          |           | 970,475                     |            |                           |           | 382,692    |            |          |           | (225,908    | )          |         |           | 1,069,636   |            
|Operating expenses:                        |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 | Sales and marketing                                               |                          |           | 2,103,423                   |            |                           |           | 3,704,768  |            |          |           | 4,140,929   |            |         |           | 8,892,193   |            
|                                           |                                 | General and administrative                                        |                          |           | 975,837                     |            |                           |           | 1,623,100  |            |          |           | 1,980,375   |            |         |           | 3,276,462   |            
|                                           |                                 | Research and development                                          |                          |           | 858,193                     |            |                           |           | 1,619,372  |            |          |           | 2,000,328   |            |         |           | 3,524,138   |            
|                                           |                                 | Restructuring charges                                             |                          |           |                            |            |                           |           | 155,234    |            |          |           |            |            |         |           | 155,234     |            
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 |                                                                   | Total operating expenses |           |                             | 3,937,453  |                           |           |            | 7,102,474  |          |           |             | 8,121,632  |         |           |             | 15,848,027  |  
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 |                                                                   | Operating loss           |           |                             | (2,966,978 | )                         |           |            | (6,719,782 | )        |           |             | (8,347,540 | )       |           |             | (14,778,391 | )
|Interest and other (expense) / income, net |                                 |                                                                   | (289,741                 | )         |                             |            | 66,202                    |           |            |            | (287,545 | )         |             |            | 111,205 |          
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 | Loss before provision for income taxes                            |                          |           | (3,256,719                  | )          |                           |           | (6,653,580 | )          |          |           | (8,635,085  | )          |         |           | (14,667,186 | )          
|Provision for income taxes                 |                                 |                                                                   | 147                      |           |                             |            | 2,571                     |           |            |            | 259      |           |             |            | 4,605   |          
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 | Net loss                                                          |                          | $         | (3,256,866                  | )          |                           | $         | (6,656,151 | )          |          | $         | (8,635,344  | )          |         | $         | (14,671,791 | )          
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 | Net loss per share (basic and diluted)                            |                          | $         | (0.02                       | )          |                           | $         | (0.10      | )          |          | $         | (0.07       | )          |         | $         | (0.23       | )          
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          
|                                           |                                 | Weighted average number of shares
outstanding (basic and diluted) |                          |           | 136,577,988                 |            |                           |           | 66,217,557 |            |          |           | 128,242,872 |            |         |           | 63,510,622  |            
|                                           |                                 |                                                                   |                          |           |                             |            |                           |           |            |            |          |           |             |            |         |          

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

4



---



##### 



XYBERNAUT CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED)


|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |            |             |          |  
|------------------------------------------------------------ | --------------------------------------------------------------------------- | ---------------------------------------------------------- | -------------------------------------------------------------------------------------- | -------------------------------- | ---------- | ------------------------- | ---------- | ----------- | ---------- | ----------- | -------- | -
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            | Six Months Ended June 30,
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            | 2003                      |            | 2002       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |            
|Cash flows from operating activities:                        |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |            
|                                                             | Net loss                                                                    |                                                            | $                                                                                      | (8,635,344                       | )          |                           | $          | (14,671,791 | )         
|                                                             | Adjustments to reconcile net loss to net cash used in
operating activities: |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             |                                                            | Depreciation and amortization                                                          |                                  |            | 949,020                   |            |             |            | 1,123,949   |         
|                                                             |                                                                             |                                                            | Provision for inventory                                                                |                                  |            | 1,749,354                 |            |             |            | 53,958      |         
|                                                             |                                                                             |                                                            | Non-cash restructuring charges                                                         |                                  |            |                          |            |             |            | 50,000      |         
|                                                             |                                                                             |                                                            | Loss on disposal of assets                                                             |                                  |            | 38,306                    |            |             |            |            |         
|                                                             |                                                                             |                                                            | Non-cash charges for equity securities issued for services                             |                                  |            | 175,658                   |            |             |            | 591,673     |         
|                                                             |                                                                             |                                                            | Amortization of note discount                                                          |                                  |            | 393,594                   |            |             |            |            |         
|                                                             |                                                                             |                                                            | Changes in assets and liabilities:                                                     |                                  |            |                           |            |             |            |             |         
|                                                             |                                                                             |                                                            |                                                                                        | Inventory                        |            |                           | (1,918,783 | )           |            |             | (50,134  | )
|                                                             |                                                                             |                                                            |                                                                                        | Accounts receivable              |            |                           | 245,071    |             |            |             | 676,395  |  
|                                                             |                                                                             |                                                            |                                                                                        | Prepaid and other current assets |            |                           | 286,511    |             |            |             | (282,948 | )
|                                                             |                                                                             |                                                            |                                                                                        | Other assets                     |            |                           | (354,018   | )           |            |             | (37,357  | )
|                                                             |                                                                             |                                                            |                                                                                        | Accounts payable                 |            |                           | (805,124   | )           |            |             | (443,354 | )
|                                                             |                                                                             |                                                            |                                                                                        | Accrued expenses and other       |            |                           | (87,606    | )           |            |             | (9,912   | )
|                                                             |                                                                             |                                                            |                                                                                        | Restructuring liability          |            |                           | (43,855    | )           |            |             |         |  
|                                                             |                                                                             |                                                            |                                                                                        | Deferred revenue                 |            |                           | 164,384    |             |            |             | 24,313   |  
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             |                                                            | Net cash used in operating activities                                                  |                                  | $          | (7,842,832                | )          |             | $          | (12,975,208 | )       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|Cash flows from investing activities:                        |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |            
|                                                             |                                                                             | Note receivable from officer, net                          |                                                                                        |                                  |           |                           |            |             | (30,300    | )          
|                                                             |                                                                             | Acquisition of property, equipment and demonstration
units |                                                                                        |                                  | (161,596   | )                         |            |             | (523,112   | )          
|                                                             |                                                                             | Acquisition of patents and trademarks                      |                                                                                        |                                  | (119,268   | )                         |            |             | (367,964   | )          
|                                                             |                                                                             | Restricted cash                                            |                                                                                        |                                  | (375,554   | )                         |            |             |           |            
|                                                             |                                                                             | Capitalization of tooling costs                            |                                                                                        |                                  | (20,000    | )                         |            |             | (26,217    | )          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             | Net cash used in investing activities                      |                                                                                        | $                                | (676,418   | )                         |            | $           | (947,593   | )          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|Cash flows from financing activities:                        |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |            
|                                                             | Proceeds from:                                                              |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             | Common stock offerings, net                                |                                                                                        |                                  | 6,921,095  |                           |            |             | 12,700,000 |            
|                                                             |                                                                             | Exercise of warrants                                       |                                                                                        |                                  | 3,104,167  |                           |            |             | 772,180    |            
|                                                             |                                                                             | Exercise of stock options                                  |                                                                                        |                                  | 15,119     |                           |            |             | 3,047      |            
|                                                             |                                                                             | Notes and loans                                            |                                                                                        |                                  | 1,750,000  |                           |            |             | 250,000    |            
|                                                             | Payments for capitalization of loan costs                                   |                                                            |                                                                                        | (15,304                          | )          |                           |            | (10,000     | )         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             | Net cash provided by financing activities                  |                                                                                        | $                                | 11,775,077 |                           |            | $           | 13,715,227 |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|Effect of exchange rate changes on cash and cash equivalents |                                                                             |                                                            | 105,988                                                                                |                                  |            |                           | (186,513   | )          
|Net increase / (decrease) in cash and cash equivalents       |                                                                             |                                                            | 3,361,815                                                                              |                                  |            |                           | (394,087   | )          
|Cash and cash equivalents, beginning of period               |                                                                             |                                                            | 1,967,710                                                                              |                                  |            |                           | 3,172,609  |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|Cash and cash equivalents, end of period                     |                                                                             | $                                                          | 5,329,525                                                                              |                                  |            | $                         | 2,778,522  |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|Supplemental disclosure of cash flow information:            |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |            
|                                                             |                                                                             |                                                            | Cash paid for interest                                                                 |                                  | $          | 579                       |            |             | $          | 1,359       |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             |                                                            | Cash paid for taxes                                                                    |                                  | $          | 585                       |            |             | $          | 16,508      |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|Supplemental disclosure of non-cash financing activities:    |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |            
|                                                             |                                                                             |                                                            | Equity securities issued for future services, recorded
as prepaid expenses when issued |                                  | $          |                          |            |             | $          | 1,866,296   |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             |                                                            | Equity securities issued for services rendered, expensed
in periods issued             |                                  | $          | 160,325                   |            |             | $          | 86,345      |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           
|                                                             |                                                                             |                                                            | Equity securities issued to repay principal on note payable                            |                                  | $          | 1,750,000                 |            |             | $          |            |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |            |                           |            |             |           

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

5



---



##### 



XYBERNAUT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.     BASIS OF PRESENTATION

The accompanying unaudited, condensed and consolidated financial
statements of Xybernaut Corporation, a Delaware Corporation (the Company),
have been prepared in accordance with accounting principles generally accepted
in the United States of America (U.S. GAAP) for interim financial information
and instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
these statements do not include all of the information and footnotes required
by U.S. GAAP for complete financial statements. In the opinion of Company
management, these unaudited, condensed and consolidated financial statements
reflect all adjustments of a normal, recurring nature necessary to present
fairly the financial position of the Company and its subsidiaries at June 30,
2003 and December 31, 2002, and the results of their operations and cash flows
for the three and six months ended June 30, 2003 and 2002. Results of
operations for the three and six months ended June 30, 2003 are not necessarily
indicative of results of operations expected for the full fiscal year ending
December 31, 2003. Please refer to the Companys Annual Report on Form 10-K/A
for the complete financial statements.

2.     THE COMPANY AND FINANCING REQUIREMENTS

The Company is engaged in the research, development, manufacture,
marketing and sale of mobile, wearable computing and communication systems as
well as software and service solutions designed to enhance productivity and
improve product management, asset management, and the accuracy, timeliness and
utilization of captured data. The Company offers solutions with a software and
services focus through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(U.S.). The Company offers solutions with a hardware focus through its U.S.
operations and through its wholly-owned subsidiaries Xybernaut K.K. (Japan) and
Xybernaut GmbH (Germany). Introduced in 1995, the Mobile Assistant® (MA®)
series is the Companys primary line of wearable computer hardware products,
the current versions of which are the MA V and MA TC. Introduced in 2002, the
Atigo product line is a family of mobile wireless web panels that can be used
either as stand-alone handheld personal computers (PCs) or as displays for an
MA system, a laptop or a conventional PC. Since their commercial introductions,
the Company has recognized revenue of approximately $23,000,000 on sales of
approximately 5,800 MA and Atigo systems.

The Company was originally incorporated in 1990 and completed its initial
public offering in July 1996. In April 2000, Xybernaut acquired Selfware, Inc,
which subsequently changed its name to Xybernaut Solutions, Inc. (XSI). The
merger was accounted for as a pooling of interests.

The Company has recorded significant net losses since its inception and
will require additional capital to fund its business plan and meet its ongoing
obligations for 2003 and/or beyond. Management believes the Company will be
successful in its efforts to obtain such capital, having raised approximately
$15,000,000 between January 1, 2003 and the date of this filing, and based on
debt and equity financings currently available to the Company. However, there
can be no assurance that the Company will not incur additional losses or will
not require significant amounts of additional capital. In addition, the Company
has reduced its operating expenses by significant amounts through an ongoing
restructuring program. If the Company is unable to obtain sufficient additional
financing, it will be required to reduce spending further in order to maintain
its operations at a reduced level. Management believes that it will be able to
reduce spending if required but there can be no assurances that it can
successfully do so.

3.     Summary of Significant Accounting Policies

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. 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 period. Actual results could differ
from those estimates.

Cash, Cash Equivalents and Restricted Cash

The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. At June 30,
2003 and December 31, 2002, the Company had $875,554 and $500,000,
respectively, in restricted cash. The balance at December 31, 2002 consisted
of a $500,000 cash deposit that secures a long-term services contract. The
balance at June 30, 2003 consisted of this same balance in addition to a
$375,554 cash deposit and interest that secures a letter of credit held by a
vendor. Under its current contracts, the restrictions on the $500,000 deposit
will lapse in late 2003 and the restrictions on the $375,554 deposit will lapse
in the first quarter of 2004. The restrictions on the $500,000 deposit may be
extended if the Company is successful in obtaining a follow-on services
contract with the customer.

Inventory

At June 30, 2003, inventory consisted primarily of wearable computer
component parts held for resale and allocated tooling costs, and is

6



---



##### 



comprised
primarily of finished goods. Inventory is stated at the lower of cost or
market, with cost being determined on a first-in, first-out
basis. Management periodically assesses the need to provide for obsolescence of
inventory and adjusts the carrying value of inventory to its net realizable
value when required.

For the three months ended March 31, 2003, a charge of $1,749,354 was
recorded to reflect managements estimate of losses to be incurred on the
systems in inventory and on the total remaining production run of the MA V
product line. The Company anticipates that it will be required to sell the MA V
systems and components at prices that are less than their production costs in
order to sell the quantities of inventory on hand as well as the inventory to
be delivered according to its current manufacturing contracts. Of this charge,
$233,178 was recorded as an inventory reserve and represented a reduction in
the net carrying value of existing MA V systems and components in inventory at
March 31, 2003. The remaining systems and components had not been received by
the Company as of March 31, 2003, and were therefore not recorded as an asset.
Accordingly, the Company recorded the expected losses on these future shipments
in the first quarter of 2003, which was the period in which the underlying
contracts were entered into. This charge was recorded as an accrued liability
which will be reclassified to an inventory reserve or write-off as MA V systems
and components are received during 2003. Included in the charge and related
accrual was $610,000 established for microchips that were purchased for the
production of the MAV product line but that are now unlikely to be used in such
production and $906,176 established for the MA V systems. During the three
months ended June 30, 2003, MA V systems and microchips were received into
inventory resulting in a reclassification of $299,238 and $86,417,
respectively, from accrued inventory reserve to inventory reserve. MAV systems
sold and capitalized as demonstration units reduced the accrued inventory
reserve balance by $38,957 and $1,694, respectively.

The Companys inventory reserves at June 30, 2003 and December 31, 2002
were $618,833 and $0, respectively. Included in accrued liabilities at June
30, 2003 and December 31, 2002 were $1,089,870 and $0, respectively, related to
the inventory charges discussed above.

The Companys management believes that it can sell its wearable/mobile
computer inventory at amounts that approximate current net carrying values,
which have been or will be reduced as a result of the above charges. To
determine the size of the charges to record, management reviewed the carrying
value of its inventory in light of the introduction of new product lines, its
ability to sell the quantities of inventory on hand as well as the quantities
expected to be received in the future and the sales prices it ultimately
expects to achieve. This analysis took into account estimated price concessions
which management believes are likely to be necessary in disposing of this
inventory. As a result of this review, it was determined that certain of the
Companys inventory is slow-moving, risked becoming obsolete or will likely be
sold at below its historical cost. Based upon a specific review of the carrying
costs for the inventory items, management estimated the quantity of each
inventory item that the Company was expected to be able to sell and also
quantified inventory amounts that may not be recoverable. Management does not
expect to record significant profits or losses upon the ultimate sale of this
inventory.

As of June 30, 2003, net of the effect of write-offs and reserves, the
Companys inventory consisted of $2,701,570 in MA V systems, $906,056 in MA TC
systems, $145,474 in Atigo systems and $37,848 in poma®systems.

Tooling Costs

Capitalized tooling costs consist of payments made to third-party vendors
for their products and services that are used in the manufacture of the
Companys proprietary hardware products. Tooling costs are systematically
allocated to inventory or property and equipment and are amortized as a
component of cost of sales or depreciation based upon the number of units sold
or used as demonstration units in a given period compared to the total number
of units management expects to make in a products production run.

Managements expectation of the number of units to be made during a given
products production run is based on a number of assumptions and estimates,
including but not limited to those related to the introduction of new product
lines, the Companys ability to procure and sell the quantities of inventory,
the introduction of competing products, customer demand and general economic
conditions.

Management periodically assesses the need to provide for obsolescence of
tooling costs and adjusts the carrying values to their net realizable value
when required through a process similar to that discussed in the Inventory
section above. During the three and six months ended June 30, 2003 and 2002,
the Company recognized no charges related to its capitalized tooling assets.
As of both June 30, 2003 and December 31, 2002, the Companys tooling reserve
totaled $250,000. This reserve was established in 2002 to provide for an
estimated decline in value of the inventory associated with the MA V product
line. In the event that the anticipated production run size or sales of a
product do not materialize, additional adjustment may be necessary to write
down the carrying value of the Companys tooling costs.

As of June 30, 2003, net of the effects of accumulated amortization,
reserves and write-offs, the Companys tooling costs asset consisted of $407,999 for
MA V systems and $34,491 for MA TC systems. Capitalized tooling costs during
the six months ended June 30, 2003 and 2002 were $22,837 and $36,580,
respectively. Amortization to cost of goods sold or depreciation, depending on
classification of tooling costs as inventory or property and equipment, was
$308,973 and $230,016, for the three months ended and $380,694 and $281,151,
for the six months ended June 30, 2003 and 2002, respectively.

Revenue Recognition

During the three months ended June 30, 2003, the Company entered into the
high-volume electronic component parts distribution business. Revenue from
this distribution business is accounted for based on the
facts and
circumstances of each individual transaction in accordance with Emerging Issues
Task Force (EITF) Issue No. 99-19, Reporting Revenue Gross as a Principal
versus Net as an Agent. Based upon the

7



---



##### 



facts and circumstances of the
transactions entered into during the three months ended June 30, 2003, the
Company recorded consulting, licensing and other revenue of $13,600, such
amount representing the net fees the Company earned for services performed
during this period.
On a gross basis, the transactions totaled $323,600 during the three months
ended June 30, 2003. There have been no changes to the Companys other revenue
recognition policies as disclosed in the Companys previously filed Form
10-K/A.

Net Loss Per Share

The Company computes net loss per share in accordance with Statement of
Financial Accounting Standards (SFAS) No. 128, Earnings Per Share and SEC
Staff Accounting Bulletin (SAB) No. 98. Under the provisions of SFAS No. 128
and SAB 98, basic net loss per share is computed by dividing the net loss
available to common stockholders for the period by the weighted average number
of common shares outstanding during the period. Diluted net loss per share is
computed by dividing the net loss available to common stockholders for the
period by the weighted average number of common and dilutive common equivalent
shares outstanding during the period. Diluted net loss per share adjusts the
weighted average number of outstanding shares for the potential dilution that
could occur if stock options, warrants or other convertible securities were
exercised or converted into common stock. If the Company posted a net income
instead a net loss, the impact of the Companys outstanding stock options,
warrants or other convertible securities would have a negative effect on
diluted net income per share. As the Company had a net loss in each of the
periods presented, basic and diluted net loss per share is the same.

Stock-Based Compensation

In December 2002 the Financial Accounting Standards Board (FASB) issued
SFAS No. 148, Accounting for Stock Based Compensation-Transition and
Disclosure, an amendment to SFAS No. 123, Accounting for Stock-Based
Compensation. SFAS No. 148 amends the disclosure provisions to require
prominent disclosure about the effects on reported net income of an entitys
accounting policy decisions with respect to stock-based compensation. Stock
options are accounted for using the intrinsic method in accordance with
Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to
Employees, as interpreted, whereby if options are priced at fair market value
or above at the date of grant, no compensation expense is recognized. The pro
forma information is as follows:

|                      |                                                                                                      |   |                             |          |                           |   |            |            |      |   |            |          |   |   |             |            |  
|--------------------- | ---------------------------------------------------------------------------------------------------- | - | --------------------------- | -------- | ------------------------- | - | ---------- | ---------- | ---- | - | ---------- | -------- | - | - | ----------- | ---------- | -
|                      |                                                                                                      |   | Three Months Ended June 30, |          | Six Months Ended June 30,
|                      |                                                                                                      |   |                             |          |                          
|                      |                                                                                                      |   | 2003                        |          | 2002                      |   | 2003       |            | 2002
|                      |                                                                                                      |   |                             |          |                           |   |            |            |     
|Net loss, as reported |                                                                                                      | $ | (3,256,866                  | )        |                           | $ | (6,656,151 | )          |      | $ | (8,635,344 | )        |   | $ | (14,671,791 | )         
|                      | Add: Stock-based employee
compensation expense included in
net loss, as reported                     |   |                             | 43,412   |                           |   |            | 50,000     |      |   |            | 150,325  |   |   |             | 50,000     |  
|                      | Deduct: Stock-based employee
compensation expense determined
under fair value method of SFAS No. 123 |   |                             | (464,683 | )                         |   |            | (1,067,383 | )    |   |            | (893,458 | ) |   |             | (2,120,250 | )
|                      |                                                                                                      |   |                             |          |                           |   |            |            |      |   |            |          |   |   |             |           
|Net loss, pro forma   |                                                                                                      | $ | (3,678,137                  | )        |                           | $ | (7,673,534 | )          |      | $ | (9,378,477 | )        |   | $ | (16,742,041 | )         
|                      |                                                                                                      |   |                             |          |                           |   |            |            |      |   |            |          |   |   |             |           
|Net loss per share:   |                                                                                                      |   |                             |          |                           |   |            |            |      |   |            |          |   |   |             |           
|                      | Basic and diluted net loss per
share  as reported                                                   |   | $                           | (0.02    | )                         |   | $          | (0.10      | )    |   | $          | (0.07    | ) |   | $           | (0.23      | )
|                      |                                                                                                      |   |                             |          |                           |   |            |            |      |   |            |          |   |   |             |           
|                      | Basic and diluted net loss per
share  pro forma                                                     |   | $                           | (0.03    | )                         |   | $          | (0.12      | )    |   | $          | (0.07    | ) |   | $           | (0.26      | )
|                      |                                                                                                      |   |                             |          |                           |   |            |            |      |   |            |          |   |   |             |           

Issuance of Equity Securities for Services

The Company periodically issues equity securities to certain employees,
consultants and companies for services provided to, or goods received by, the
Company. These securities include shares of common stock and warrants and
options to purchase shares of common stock. These transactions were
individually valued based upon the fair value of the securities issued or the
services or goods provided, whichever was more reliably measured. In the three
months ended June 30, 2003 and 2002, the Company recorded prepaid assets for
future services or goods to be provided of $0 and $234,509, respectively, which
was expensed in 2002. In the six months ended June 30, 2003 and 2002, the
Company recorded prepaid assets for future services or goods to be provided of
$0 and $1,866,296, respectively, which was expensed in 2002. Included
in prepaid and other assets at June 30, 2003 and December 31, 2002 are equity
securities issued for payment of future services of $0 and $19,167,
respectively.

Restructuring

The Company recorded restructuring charges in accordance with EITF Issue
No. 94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring), and Staff Accounting Bulletin (SAB) No. 100, Restructuring
and Impairment Charges. During the second, third and fourth quarters of 2002,
management adopted various restructuring plans which established the plans of
termination, the benefits available to terminated employees and communicated
these benefits

8



---



##### 



to the terminated employees. The employee severance costs and
outplacement services according to these plans were recorded as restructuring
charges and totaled $434,308. As part of the restructuring plans, office space
was reduced by moving XSI employees to the Companys headquarters and preparing
the vacated space for sublease. The present value of the future cash flows of
the office rent for the life of the contract less an estimate that the space
can be subleased at 50% of total rent totaled $223,305. Further consolidation
and subleasing of office space at headquarters resulted in an additional
restructuring charge of $10,199. In the fourth quarter, the Company closed its
branch operations in Japan, resulting in a $213,041 restructuring charge (the
Companys wholly-owned subsidiary operating in Japan, Xybernaut KK, was not
closed). Also, in the fourth quarter, management performed a cost-benefit
analysis of its patent portfolio and recorded a $157,307 charge related to the
write-off of certain patent costs. Of these 2002 restructuring charges,
$245,546 was paid in cash and $188,762 was paid by the issuance of equity
securities during the last three quarters of 2002. At June 30, 2003, of the
remaining unpaid balance of $153,884, $66,684 is included in accrued expenses
and will be paid within one year of the balance sheet. The remaining balance of
$87,200 is classified as a long-term liability on the balance sheet and will be
paid in 2004 and 2005. The original charge for outplacement services extended
to severed employees was reduced by $4,536 in 2002 as outplacement services
expired resulting in no expense to the Company. Management may establish and
implement additional restructuring plans in 2003 depending on business
conditions.

The components of the restructuring charge in 2002 are as follows:

|                                    |  |   |           | 
|----------------------------------- |  | - | --------- | 
|Severance and outplacement services |  | $ | 434,308   | 
|Lease obligations                   |  |   | 233,504   | 
|Closing of branch operations        |  |   | 213,041   | 
|Write-down of certain patent costs  |  |   | 157,307   | 
|                                    |  |   |           | 
|                                    |  | $ | 1,038,160 | 
|                                    |  |   |           | 

Reclassifications

Certain 2002 balances and disclosures have been reclassified to conform to
the 2003 presentation.

3. Liquidity and Operations

The Company has recorded net losses since its inception, including during
the periods presented in this Form 10-Q. These losses are primarily
attributable to the operating expenses incurred by the Company to design,
develop, market and sell its mobile and wearable computer products and to provide general
and administrative support for these operating activities. During these
periods, the Companys revenues and gross margins have not been sufficient to
fund these operating activities. As a result, the Company has consistently
recorded negative cash flows from operating activities and net losses and had
an accumulated deficit of $139,658,503 at June 30, 2003. The combination of
the Companys operating losses and its working capital requirements has
severely impacted the Companys financial position and
liquidity. During 2003 and 2002, the Company has funded its operating and investing
activities through its financing activities, which consist primarily of private
placements of common stock, warrant and stock option exercises and borrowings.

The Companys management has taken steps that it believes are necessary to
improve the Companys operations and raise additional capital, both of which
are needed to enhance its ability to meet its cash flow needs through December
31, 2003 and thereafter. Beginning in April 2002, management has performed
reviews of the Companys operations and implemented various cost cutting
programs to significantly reduce the Companys operating expenses.

Assuming there are no significant changes to the Companys business plan,
management expects to maintain savings of over 50% from annualized fourth
quarter 2001 levels. During the fourth quarter of 2002 and the first
and second quarters of
2003, management met its current target to reach a quarterly operating expense
level of between approximately $4,000,000 and $5,000,000.

Management believes that the Companys current staffing and resources will
be sufficient to carry out its business plan for the foreseeable future. In
addition to the cost cutting initiatives already undertaken, management
continues to review all aspects of the Companys operations and may take
additional actions to reduce operating expenses further. Future significant
fluctuations may still occur as a result of non-recurring charges associated
with cost-saving initiatives as well as the Companys research and development
activities, which will vary depending on the Companys wearable/mobile computer
product development cycle during any given period.

Based on historical results and the forecasted levels discussed above,
management expects that the Company will incur operating expenses of
between $16,000,000 and $18,000,000 during 2003. However, there can be no
assurances that actual operating expenses will not
be significantly higher. The Company will also be required to fund inventory
procurement and other expenditures. While management expects to fund a portion
of these activities through gross profits resulting from revenues, the Company
will be required to obtain most of such amounts through outside financings.
Potential sources of additional financing include private equity offerings,
warrant exercises, strategic investments and various forms of debt financing.
In certain instances, concurrently with the exercise of certain of these
warrants, the exercise prices were reduced. Such reduction has resulted in the
issuance of substantially more shares of common stock than would have occurred
had the exercise price of the warrants not been reduced. The Company may reduce
the exercise price of additional warrants in the future. If additional funds
are raised through the issuance of equity securities, the percentage of
ownership of current stockholders of the Company will be reduced and if
additional funds are raised at current prices for the Companys stock, such
dilution could be significant. If additional funds are raised through

9



---



##### 



borrowings, the Company will be subject to interest charges and principal
repayments, will likely be required to comply with financial covenants or other
restrictions, and will likely have to collateralize such borrowings with its
assets, which could be taken by the lender in the event of default.

From January 1, 2003 through the date of this filing, the Company raised
approximately $15,000,000 through sales of its common stock to institutional
investors, through warrant and stock option exercises and through borrowings.
Due in large part to the Companys current stock price, the depressed general
capital markets and the cost-cutting efforts, the individual equity financings
that the Company has completed in recent quarters have been of a smaller size
when compared to those transacted in previous periods.

The Companys management believes that the combination of cash on hand,
cash flows from operations and outside funding will provide sufficient
liquidity to meet the Companys ongoing cash requirements. This is based both
on the Companys historical ability to raise capital and on debt and equity
financings currently available to the Company. However, there can be no
assurance that the Company can or will obtain sufficient funds from operations
or from additional financings on terms acceptable to the Company.

4.     BORROWINGS

On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note that bore interest at 3.5% per annum. In
connection with this borrowing, the Company issued to the lender warrants to
purchase 1,750,000 shares of common stock at an exercise price of $1.25 per
share and warrants to purchase 2,000,000 shares of common stock at an exercise
price of $0.43 per share. Based on the relative fair values of the securities
issued, these warrants were assigned a value of $393,594, which amount was
recorded as a note discount to be amortized into interest expense over the life
of the note. On May 30, 2003, the Company repaid $860,000 in principal when
the lender elected to exercise the 2,000,000 warrants at $0.43 per share.
Subsequent to this partial repayment, the lender provided the Company with a
10% discount on the remaining unpaid principal to induce the Company to repay
the remaining principal prior to its original maturity date. The remaining
principal was repaid on May 30, 2003 through the: i) $89,000 discount, ii)
application of the $560,000 aggregate exercise price related to the exercise of the warrants to purchase 1,750,000 shares of common stock
at $0.32 per share, a reduction from the original $1.25 per share exercise
price, and iii) issuance of 651,351 shares of common stock valued at $241,000,
or $0.37 per share. The Company repaid the accrued interest on the note
through the issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share. During the three and six months ended June 30, 2003, the
Company recorded interest expense of $10,222 and $11,229, respectively. During
the three and six months ended June 30, 2003, the Company recorded additional
interest expense related to the amortization of note discount of $387,124 and
$393,594, respectively, which six-month amortization balance includes the
write-off of the remaining discount at the time of repayment. The Company had
no outstanding principal or interest related to this note at either June 30,
2003 or December 31, 2002.

5.     STOCKHOLDERS EQUITY

During March 2002, the Company received gross proceeds of $9,000,000
through a private placement of 5,625,000 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,406,250 shares of common stock at an
exercise price of $3.00 per share. In connection with this placement, the
Company paid $270,000 in cash to financial advisors.

During June 2002, the Company received gross proceeds of $4,000,000
through a private placement of 6,666,666 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,666,666 shares of common stock at an
exercise price of $1.50 per share. In connection with this placement, the
Company issued 740,740 shares of its common stock to financial and business
development advisors.

During February 2003, the Company received gross proceeds of $2,000,000
through a private placement of 6,666,667 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor callable warrants to purchase 3,333,333 shares of common stock at an
exercise price of $1.25 per share.

During May 2003, the Company received gross proceeds of $3,000,000 through
a private placement of 9,375,000 shares of its common stock to certain
investors. The shares were sold at $0.32 per share, representing an approximate
20% discount to the closing price of the shares for the ten trading days
immediately prior to the date of the agreement. In connection with this private
placement, the Company issued to the investors three-year callable warrants to
purchase 3,281,250 shares of common stock. These warrants have an exercise
price of $0.45 if exercised in the first year, $0.90 if exercised in the second
year and $1.35 if exercised in the third and final year.

During June 2003, the Company received gross proceeds of $2,000,000
through a private placement of 5,405,405 shares of its common stock to an
investor. The shares were sold at $0.37 per share, representing an approximate
10% discount to the closing price of the shares for the ten trading days
immediately prior to the date of the agreement. In connection with this private
placement, the Company issued to the investor
three-year callable warrants to purchase 4,054,054 shares of common stock.
These warrants have an exercise price of $0.75 if exercised in the first year,
$1.50 if exercised in the second year and $2.25 if exercised in the third and
final year.

The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings. The
Company received gross proceeds of $1,000,000 and $3,354,167 through the
issuance of 3,333,333 and 11,875,001 shares of its common stock during the
three and six months ended June 30, 2003, respectively, and $772,180 through
the issuance of 1,544,361 shares of its common stock during both the three and
six months ended June 30, 2002, exclusive of the exercises made in connection
with the note

10



---



##### 



repayment discussed in Borrowings above. Concurrently with
their exercise, the exercise price of such warrants was reduced from a weighted
average of $1.25 per share to $0.28 per share during the six months ended June
30, 2003 and $3.16 per share to $0.50 per share during the six months ended
June 30, 2002. At June 30, 2003, the Company had warrants outstanding to
purchase 11,785,840 shares of its common stock at prices that range from $0.45
to $5.00 per share, with a weighted average of $1.94 per share.

6.     SEGMENT AND ENTERPRISE WIDE REPORTING

The Company discloses certain financial and supplementary information
about its operating segments, products and services, geographic areas and major
customers pursuant to SFAS No. 131, Disclosures About Segments of an
Enterprise and Related Information. Operating segments are defined as
components of an enterprise about which separate discrete financial information
is evaluated regularly by the chief operating decision maker or decision making
group, in deciding how to allocate resources and assess performance. The
financial information disclosed herein materially presents all of the financial
information related to the Companys principal operating segments as a provider
of wearable computing and communications systems and software and service
solutions.

Revenues by geographical destination as a percentage of total revenues for
the three and six months ended June 30, 2003 and 2002 are as follows:

|                            |  |                             |    |                           |  |      |    |      |  |  |    |   |  |  |    |  
|--------------------------- |  | --------------------------- | -- | ------------------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                            |  | Three Months Ended June 30, |    | Six Months Ended June 30,
|                            |  |                             |    |                          
|                            |  | 2003                        |    | 2002                      |  | 2003 |    | 2002
|                            |  |                             |    |                           |  |      |    |     
|United States               |  |                             | 92 | %                         |  |      | 90 | %    |  |  | 85 | % |  |  | 79 | %
|Europe, principally Germany |  |                             | 8  | %                         |  |      | 8  | %    |  |  | 11 | % |  |  | 15 | %
|Asia, principally Japan     |  |                             | 0  | %                         |  |      | 2  | %    |  |  | 4  | % |  |  | 6  | %

Operations in various geographical areas are summarized as follows:

|               |                     |  |                                |            |                              |  |      |            |      |  |   |            |   |  |   |             |  
|-------------- | ------------------- |  | ------------------------------ | ---------- | ---------------------------- |  | ---- | ---------- | ---- |  | - | ---------- | - |  | - | ----------- | -
|               |                     |  | As of and for the Three Months |            | As of and for the Six Months
|               |                     |  | Ended June 30,                 |            | Ended June 30,              
|               |                     |  |                                |            |                             
|               |                     |  | 2003                           |            | 2002                         |  | 2003 |            | 2002
|               |                     |  |                                |            |                              |  |      |            |     
|North America: |                     |  |                                |            |                              |  |      |            |      |  |   |            |   |  |   |            
|               | Total revenue       |  | $                              | 2,562,738  |                              |  | $    | 1,814,620  |      |  | $ | 3,892,627  |   |  | $ | 3,836,088   |  
|               | Net loss            |  |                                | (2,899,802 | )                            |  |      | (5,478,951 | )    |  |   | (7,943,421 | ) |  |   | (12,575,618 | )
|               | Identifiable assets |  |                                | 15,039,431 |                              |  |      | 13,241,773 |      |  |   | 15,039,431 |   |  |   | 13,241,773  |  
|Europe (1):    |                     |  |                                |            |                              |  |      |            |      |  |   |            |   |  |   |            
|               | Total Revenue       |  | $                              | 216,364    |                              |  | $    | 152,721    |      |  | $ | 515,006    |   |  | $ | 714,824     |  
|               | Net loss            |  |                                | (332,869   | )                            |  |      | (1,036,364 | )    |  |   | (655,114   | ) |  |   | (1,876,312  | )
|               | Identifiable assets |  |                                | 1,025,254  |                              |  |      | 3,736,920  |      |  |   | 1,025,254  |   |  |   | 3,736,920   |  
|Asia:          |                     |  |                                |            |                              |  |      |            |      |  |   |            |   |  |   |            
|               | Total revenue       |  | $                              | 9,479      |                              |  | $    | 46,122     |      |  | $ | 167,925    |   |  | $ | 272,472     |  
|               | Net loss            |  |                                | (24,195    | )                            |  |      | (140,836   | )    |  |   | (36,809    | ) |  |   | (219,861    | )
|               | Identifiable assets |  |                                | 431,213    |                              |  |      | 474,865    |      |  |   | 431,213    |   |  |   | 474,865     |  



| | (1) |  | Included in the Companys operations in Europe are expenses related to research and development
activities conducted by a branch of the Company operating in Germany. These expenses were $284,597 and
$400,752 for the three months ended June 30, 2003 and 2002, respectively, and $505,550 and $748,706 for
the six months ended June 30, 2003 and 2002, respectively.
| | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The following table summarizes the number of customers that individually
comprise greater than 10% of total revenue or total accounts
receivable and their aggregate percentage of the Companys total revenue or
total accounts receivable.

|                     |                                      |  |                         |    |                       |  |      |    |      |  |  |    |   |  |  |    |  
|-------------------- | ------------------------------------ |  | ----------------------- | -- | --------------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                     |                                      |  | As of and for the Three |    | As of and for the Six
|                     |                                      |  | Months Ended June 30,   |    | Months Ended June 30,
|                     |                                      |  |                         |    |                      
|                     |                                      |  | 2003                    |    | 2002                  |  | 2003 |    | 2002
|                     |                                      |  |                         |    |                       |  |      |    |     
|Revenue:             |                                      |  |                         |    |                       |  |      |    |      |  |  |    |   |  |  |   
|                     | Number of Customers                  |  |                         | 1  |                       |  |      | 3  |      |  |  | 1  |   |  |  | 2  |  
|                     | Percent of Total Revenue             |  |                         | 45 | %                     |  |      | 40 | %    |  |  | 31 | % |  |  | 22 | %
|Accounts Receivable: |                                      |  |                         |    |                       |  |      |    |      |  |  |    |   |  |  |   
|                     | Number of Customers                  |  |                         | 2  |                       |  |      | 3  |      |  |  | 2  |   |  |  | 3  |  
|                     | Percent of Total Accounts Receivable |  |                         | 65 | %                     |  |      | 69 | %    |  |  | 65 | % |  |  | 69 | %

11



---



##### 



7.     TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES

The Company has entered into various agreements with IBM. The Company has
contracted with IBM to design, develop and manufacture certain components of
the MA V product line, including the computer portion and two versions of FPDs
(the Engineering and Inventory Agreement). Under the Engineering and
Inventory Agreement, the Company was obligated to purchase certain components
of the MA V system, including 24,000 computing units, as well as various
numbers of FPDs and other accessories. The total cost to the Company of these
purchases would have been over approximately $40,000,000. Under the Engineering
and Inventory Agreement, the Company had the right to cancel this purchase
commitment by paying a cancellation fee in an amount of approximately
$4,000,000. In March 2003, the Company entered into an agreement with IBM under
which the Company was released of its obligation to pay the penalty or procure
this inventory other than $4,910,000 in MA V computing units, FPDs, peripherals
and component parts. The final pricing provided to the Company represents a
discount from the original contractual prices. Under the March 2003 agreement,
IBM agreed to ship inventory monthly from March 2003 through December 2003 and
the Company agreed to remit payments monthly from March 2003 through January
2004. IBM Global Finance provided a credit facility to the Company which
provides credit to the Company for purchases of inventory under the March 2003
agreement. In connection with this credit facility, IBM Global Finance was
granted a security interest in certain of the Companys assets and the Company
obtained a letter of credit from a third party lender for the benefit of IBM
Global Finance in the amount of $375,000, for which the Company posted an equal
amount of restricted cash. This security interest does not include patents and
intellectual property. The Company has also entered into agreements with IBM
under which IBM purchases MA V and Atigo products from the Company and markets
and sells the systems worldwide to its own customers (the Sales and Marketing
Agreement). During the three and six months ended June 30, 2003, the Company
paid $1,306,942 and $2,073,299, respectively, to IBM related to design and
development services and inventory purchases. During the same periods in 2002,
the Company paid $340,706 and $1,370,017, respectively by IBM related to design
and development services and inventory purchases. During the three and six
months ended June 30, 2003, the Company recorded revenues of $30,453 and
$36,615, respectively, related to sales of MA V and Atigo products to IBM.
During the same periods in 2002, the Company recorded revenues of $10,141 and
$99,795, respectively, related to sales of MAV products to IBM. Before
selecting IBM as its partner for the Engineering and Inventory Agreement, the
Company reviewed IBMs proposal to provide such services, which included
discussion of the estimated costs to be incurred, IBMs track-record of
bringing new technologies to market, IBMs reputation for quality and other
customary evaluations. The Sales and Marketing Agreement was reached with
similar terms and conditions provided to other volume resellers of the
Companys products. As a result, the Companys management believes that the
Engineering and Inventory Agreement and the Sales and Marketing Agreement
contain arms-length terms and conditions.

Certain of the end-users of the Companys wearable computer products are
universities and other not-for-profit entities (collectively, the End-Users)
that purchase these products from a Value Added Reseller (the VAR) of
Xybernaut GmbH. The Company also contracts with certain of the End-Users to
provide research and development and sales and marketing services to the
Company. The research and development services provided to the Company include
activities such as hardware and software development, product testing and
evaluation. The sales and marketing services include activities such as Company
participation in and sponsorship of industry trade shows, the preparation of
competitive market analysis and the use of the End-Users as named reference
accounts. During the three and six months ended June 30, 2003, the Company
recorded revenues of approximately $161,898 and $414,554, respectively, related
to sales of its products to the VAR. During the three and six months ended June
30, 2003, the Company recorded total research and development and sales and
marketing expenses of $166,894 and $409,891, respectively, related to services
performed by the End-Users. During the three and six months ended June 30,
2002, the Company
recorded revenues of approximately $15,074 and $488,859, respectively, related
to sales of its products to the VAR. During the three and six months ended June
30, 2002, the Company recorded total research and development and sales and
marketing expenses of $318,842 and $397,617, respectively, related to services
performed by the End-Users. The Company compares the cost of the projects
performed by the End-Users against the cost it would likely incur if it were to
obtain these services from entities other than the End-Users. Management also
evaluates the cost if the Company performed these services in-house, including
expenses that would be incurred for salary and benefits, training, travel,
supplies and equipment, and overhead. As a result, the Companys management
believes that the agreements and contracts underlying both the sale of the
products and the performance of the services contain arms-length terms and
conditions.

8.     SUBSEQUENT EVENTS

Subsequent to June 30, 2003, the Company received gross proceeds of
approximately $3,000,000 through the issuance of 7,335,304 shares of its common
stock upon the exercise of outstanding warrants. Concurrently with their
exercise, the exercise price of 4,054,054 of such warrants was reduced from
$0.75 per share to $0.40 per share.

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

To keep investors informed of the Companys future plans and objectives,
this Quarterly Report on Form 10-Q and other reports and statements issued by
the Company and its officers from time to time contain certain statements
concerning the Companys future results, future performance, intentions,
objectives, plans and expectations that are, or may be deemed to be,
forward-looking statements. The Companys ability to do this has been
fostered by the Private Securities Litigation Reform Act of 1995 which provides
a safe harbor for forward-looking statements to encourage companies to
provide prospective information so long as those statements are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those discussed in the statement.
Such

12



---



##### 



forward-looking statements are subject to a number of known and unknown
risks and uncertainties that, in addition to general economic and business
conditions, could cause the Companys actual results, performance, and
achievements to differ materially from those described or implied in the
forward-looking statements. Factors that could cause or contribute to such
differences include, but are not limited to, the Companys ability to execute
its business strategy, to profit from its products and services as expected, to
compete, to maintain superior technological capability, to foresee changes and
to continue to identify, develop and commercialize innovative and competitive
products and services, to penetrate different markets and successfully expand
its revenue, to attract and retain technologically qualified personnel,
particularly in the areas of research and development, and the Companys
ability to generate such cash flow and obtain financing to support its
operations and growth (see generally Managements Discussion and Analysis of
Financial Condition and Results of Operations and Liquidity and Capital
Resources contained therein) and other risks described in this Quarterly
Report on Form 10-Q and other filings with the SEC.

OVERVIEW

Xybernaut Corporation, a Delaware corporation (Xybernaut or the
Company), is engaged in the research, development, manufacture, marketing and
sale of mobile, wearable computing and communication systems as well as
software and service solutions designed to enhance productivity and improve
product management, asset management, and the accuracy, timeliness and
utilization of captured data. The Company offers solutions with a software and
services focus through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(XSI). The Company offers solutions with a hardware focus through its U.S.
operations and through its wholly-owned subsidiaries Xybernaut K.K. (Japan) and
Xybernaut GmbH (Germany).

The Company was originally incorporated in 1990 and completed its initial
public offering (IPO) in July 1996. In April 2000, Xybernaut acquired XSI.
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries: XSI (Virginia, U.S.), Xybernaut Development
Corporation (Virginia, U.S.), Xybernaut K.K. (Yokohama, Japan), and Xybernaut
GmbH (Böblingen, Germany). All significant intercompany accounts and
transactions have been eliminated in the consolidation.

Introduced in 1995, the Mobile Assistant® (MA®) series is the Companys
primary line of wearable computer hardware products, the current versions of
which are the MA V and MA TC. Introduced in 2002, the Atigo product line is a
family of mobile wireless web panels that can be used either as stand-alone
handheld personal computers (PCs) or as displays for an MA system, a laptop
or a conventional PC. The Company derives its revenues from sales of its
wearable computers, software products and consulting services. In the future,
the Company expects to obtain additional revenues from the licensing of its
intellectual property. Since their commercial introductions, the Company has
recognized revenue of approximately $23,000,000 on sales of approximately 5,800
MA and Atigo systems.

A number of trends are expected to have a significant effect on the
Companys operations in the future. In recent quarters, many of the Companys
large customers deferred or delayed anticipated purchases of Company products
because of uncertain economic conditions. If these conditions persist or
worsen, it is possible that more potential customers will defer, delay or
cancel scheduled purchases, which would have an adverse effect on Company
operations. While the Company expects general economic conditions to begin
improving during the second half of 2003 and early 2004, there can be no
assurance that this expectation will be realized. Additionally, to the extent
that potential customers have concerns about purchases from smaller suppliers
as a result of challenging economic conditions for small capitalization
technology companies, such concerns could have a negative impact on the
Companys revenues.

Beginning with the widespread use of the internet on desktop computers,
there has been an increasing demand for mobile computing and wireless
communications devices that can bring the desktop internet experience to mobile
users. The rapid growth of internet-enabled cell phones, PDAs, interactive
pagers and similar products result in a growing number of devices that cater to
the mobile data user and which may compete with the Companys products and
which may also present opportunities for licensing in the future.

The Company believes that sales of its wearable and mobile computers will
rely to a large extent on the availability of wireless broadband services that
can take advantage of the extensive processing power and display capabilities
of the Companys hardware products. Wireless local area networks (LANs) are
now well established in commercial markets worldwide that provide broadband
capabilities over a limited physical range in places such as corporate offices,
warehouses, factory floors and airfields. However, wide-range wireless access
that allows a user to move freely over large geographic areas and still
maintain broadband access (commonly referred to as Third Generation or 3G)
is still only available in limited areas, including Japan and parts of Europe.
The Company predicts that 3G service will be available in large metropolitan
areas worldwide in the next few years. For example, NTT DoCoMo has announced
plans to launch 3G service in select U.S. cities in 2004. The Company believes
that while the commercial markets can still be successfully penetrated prior to
the widespread introduction of wireless broadband access, such service will be
needed prior to successful large-scale sales in the far larger consumer
markets.

RESULTS OF OPERATIONS

The following table sets forth certain consolidated financial data as a
percentage of revenues for the three and six months ended June 30, 2003 and
2002.

13



---



##### 



|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |       | 
|----------------------------------- | -------------------------- |  | --------------------------- | ---- | ------------------------- |  | ------ | ----- | ---- |  | ------ | ---- | - |  | ------ | ----- | 
|                                    |                            |  | Three months ended June 30, |      | Six months ended June 30,
|                                    |                            |  | 2003                        |      | 2002                      |  | 2003   |       | 2002
|                                    |                            |  |                             |      |                           |  |        |       |     
|Revenue                             |                            |  | 100.0                       | %    |                           |  | 100.0  | %     |      |  | 100.0  | %    |   |  | 100.0  | %    
|Cost of sales                       |                            |  | 65.2                        |      |                           |  | 78.3   |       |      |  | 66.7   |      |   |  | 76.7   |      
|Provision for inventory and tooling |                            |  |                            |      |                           |  | 2.7    |       |      |  | 38.2   |      |   |  | 1.1    |      
|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      
|                                    | Gross income / (loss)      |  |                             | 34.8 |                           |  |        | 19.0  |      |  |        | (4.9 | ) |  |        | 22.2  | 
|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      
|Operating expenses:                 |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      
|                                    | Sales and marketing        |  |                             | 75.4 |                           |  |        | 184.0 |      |  |        | 90.5 |   |  |        | 184.4 | 
|                                    | General and administrative |  |                             | 35.0 |                           |  |        | 80.6  |      |  |        | 43.3 |   |  |        | 67.9  | 
|                                    | Research and development   |  |                             | 30.8 |                           |  |        | 80.4  |      |  |        | 43.7 |   |  |        | 73.1  | 
|                                    | Restructuring charges      |  |                             |     |                           |  |        | 7.7   |      |  |        |     |   |  |        | 3.2   | 
|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      
|Total operating expenses            |                            |  | 141.2                       |      |                           |  | 352.7  |       |      |  | 177.5  |      |   |  | 328.6  |      
|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      
|Interest and other                  |                            |  | (10.4                       | )    |                           |  | 3.2    |       |      |  | (6.3   | )    |   |  | 2.2    |      
|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      
|Net loss                            |                            |  | (116.8                      | %)   |                           |  | (330.6 | %)    |      |  | (188.7 | %)   |   |  | (304.2 | %)   
|                                    |                            |  |                             |      |                           |  |        |       |      |  |        |      |   |  |        |      

THREE MONTHS ENDED JUNE 30, 2003 AND JUNE 30, 2002

REVENUE. The Company derives its revenue from product sales of its wearable and
mobile computers and components, product sales of software and consulting
services. Total revenue for the three months ended June 30, 2003 was
$2,788,581, an increase of $775,118, or 39%, compared to the three months ended
June 30, 2002. Sales from the Companys mobile/wearable computers increased
$617,369, or 53%, to $1,775,792 for the three months ended June 30, 2003
compared to the same period in 2002. This growth in hardware revenues was
driven primarily from the Companys U.S. operations which increased $632,732
from the prior year. This growth was due to increased Atigo sales of
$1,175,676, partially offset by a $469,367 decrease in sales of MA V systems
and a $73,577 decrease in MA IV and poma®. European hardware sales increased
16%, or $23,421, in the second quarter of 2003 compared with the same period in
2002, due primarily to a $89,820 increase in sales of MA V and Atigo systems
and accessories offset by a $66,399 decrease in sales of MA IV and MA TC
systems. Hardware revenues from Asia, consisting primarily of MA V systems in
the second quarter of 2003, decreased by $38,784 compared with the same period
in 2002, which consisted of both MA V and pomasystems. There were no software
revenue sales in either the second quarter of 2003 or 2002. Revenue from
software products generally consists of a few large transactions that
periodically occur that are unrelated to the Companys hardware products. The
Companys consulting, licensing and other revenue for the three months ended
June 30, 2003 was $1,012,789, an increase of $157,749, or 18%, from revenue for
the three months ended June 30, 2002. This increase is largely due to a
$115,386 increase in consulting sales related to U.S. operations due to
approximately $70,000 of increased activity on large consulting contracts in
2003 compared with 2002 and $32,500 in configuration and customization services
related to 2003 Atigo sales for which there were no comparable sales in 2002.

COST OF SALES. The Companys cost of sales includes the costs of components for
the Companys wearable and mobile computer product lines, purchased software,
direct labor and materials, amortization of tooling costs, warranty costs,
fulfillment and shipping costs, and inventory and tooling reserves. Total cost
of sales for the three months ended June 30, 2003 was $1,818,106, an increase
of $187,335, or 11%, compared to the three months ended June 30, 2002. This
increase is primarily the result of an increase in hardware cost of sales of
$181,103, or 18%, for the second quarter of 2003 compared to the same period in
2002. Included in total cost of sales for the three months ended June 30, 2002
is a $53,958 provision for inventory and tooling for which no such provision is
recorded in 2003. Total gross margins, excluding the provision for inventory,
were 35% and 22%, for the second quarter of 2003 and 2002, respectively. Gross
margins from hardware sales from the second three months of 2003 were 33%
compared to 12% for 2002. The more favorable gross margin in 2003 can be
attributed to sales of the Atigo product line, which was introduced in the
third quarter of 2002, since margins are typically highest following a
products commercial launch. Also contributing to the favorable gross margin in
2003 compared to 2002 is a $138,276 warranty cost in 2002 compared to $26,961
in 2003. Consulting cost of sales in the second quarter of 2003 compared to the
same period in 2002 increased $60,190, or 11%. Consulting, licensing and other
gross margins were 38% and 34% for the 2003 and 2002 periods, respectively.
Gross margins on consulting contracts in 2003 were more favorable compared to
margins in 2002 due to increased billing rates for consulting labor that became
effective beginning in the third quarter of 2002.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the three months
ended June 30, 2003 were $2,103,423, a decrease of $1,601,345, or 43%, compared
to the corresponding period in 2002. In the U.S. operations, sales and
marketing expenses in the second quarter of 2003 relating to salaries and
benefits, consulting, promotional items and travel expenses decreased
approximately $397,000, $300,000, $56,000 and $72,000, respectively, compared
to the same period in 2002. This was primarily the result of cost saving
measures. Additional cost saving measures in the Companys European and Asian
operations resulted in decreases of approximately $410,000 in salaries and
benefits, facilities and consulting in the second quarter of 2003 compared to
the second quarter of 2002. Another decrease of $196,640 was related to
non-cash marketing expenses for outside services funded through the issuance of
the Companys equity securities for the three months ended June 30, 2003 of
$43,265 compared to $239,905 during the same period in 2002.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the three months ended June 30, 2003 were

14



---



##### 



$975,837, a decrease of $647,263, or
40%, compared to the same period in 2002. As a result of the Companys cost
saving measures, general and administrative expenses in the second quarter of
2003 relating to salaries and benefits, insurance and consulting decreased
approximately $238,000, $67,000 and $98,000, respectively, compared to the same period in
2002.

RESEARCH AND DEVELOPMENT EXPENSES. The Companys research and development
expenses consist primarily of personnel costs, the purchase of test equipment
and payments to consultants and other third-parties which provide research and
development services for general mobile and wearable computing technologies.
Research and development expenses for the three months ended June 30, 2003 were
$858,193, a decrease of $761,179, or 47%, compared to the corresponding period
in 2002. This decrease resulted largely from an approximate $393,000 decline in
outside research services for general wearable technology. There was an
additional decrease resulting from an approximate $80,000 decline in
expenditures to third parties and consultants for design and development of the
Companys mobile/wearable product lines. Expenditures during the 2002 period
related to the Atigo product line. In addition, the research and development
expenses related to salaries and benefits of the Companys U.S. and Asian
operations decreased by $179,000 and $28,000, respectively, from the three
months ended June 30, 2002 to 2003 due to cost saving measures.

INTEREST AND OTHER, NET. Net interest and other expense for the three months
ended June 30, 2003 was $289,741, a decrease of $355,943 compared to net
interest and other income of $66,202 the same period in 2002. Included in the
2003 net interest and other expense balance is $321,345 in non-cash
amortization of a note discount recorded for early repayment of debt.

PROVISION FOR INCOME TAXES. The provision for income taxes for the three months
ended June 30, 2003 was $147, a decrease of $2,424, compared to the income tax
provision for the three months ended June 30, 2002. These amounts relate to the
operations of the Companys foreign subsidiaries. The Companys U.S. operations
had a net loss during these periods and, therefore, no provision for U.S.
income taxes was made.

NET LOSS. As a result of the factors described above, the net loss for the
three months ended June 30, 2003 was $3,256,866, a decrease of $3,399,285 or
51%, compared to the three months ended June 30, 2002.

SIX MONTHS ENDED JUNE 30, 2003 AND JUNE 30, 2002

REVENUE. The Company derives its revenue from product sales of its wearable and
mobile computers and components, product sales of software and consulting
services. Total revenue for the six months ended June 30, 2003 was $4,575,558,
a decrease of $247,826, or 5%, compared to the six months ended June 30, 2002.
Sales from the Companys mobile/wearable computers decreased $318,111, or 11%,
to $2,600,504 for the six months ended June 30, 2003 compared to the same
period in 2002. Hardware revenues from U.S. operations increased slightly by
$40,050 in the first two quarters of 2003 compared with the same period in
2002. Atigo sales for U.S. operations increased $1,330,101 in the six months
ended June 30, 2003 compared to the same period in 2002. This increase is
partially offset by a decline of $926,315 related to sales of MAV, MA IV and
pomasystems in 2003 compared to 2002. In addition, the revenues for the
first half of 2002 include $363,736 of revenues related to the bulk sale of
components for the MA V system for which there was no corresponding revenues in
2003. There was also a $254,865 decrease in European hardware sales in the
first half of 2003 compared with the same period in 2002, due primarily to a
decrease of $343,609 in sales of MA systems which is offset by an increase in
Atigo systems sales of $88,744. Hardware revenues from Asia, consisting
primarily of MA V systems, decreased by $103,296 in the first half of 2003
compared with the same period in 2002. There were no software revenue sales in
either the first half of 2003 or 2002. Revenue from software products
generally consists of a few large transactions that periodically occur that are
unrelated to the Companys hardware products. The Companys consulting,
licensing and other revenue for the six months ended June 30, 2003 was
$1,975,054, an increase of $70,285, or 4%, from revenue for the six months
ended June 30, 2002.

COST OF SALES. The Companys cost of sales includes the costs of components for
the Companys wearable and mobile computer product lines, purchased software,
direct labor and materials, amortization of tooling costs, warranty costs,
fulfillment and shipping costs, and inventory and tooling reserves. Total cost
of sales for the six months ended June 30, 2003 was $4,801,466, an increase of
$1,047,718, or 28%, compared to the six months ended June 30, 2002. This
increase resulted from the $1,749,354 provision for inventory related to the MA
V product line recorded in the first quarter of 2003 compared to a $53,958
provision for inventory and tooling recorded in the second quarter of 2002.
Total gross margins, excluding the provision for inventory, were 33% and 23%,
for the first half of 2003 and 2002, respectively. The cost of sales related to
the Companys hardware products decreased by $649,015, or 26%, from the six
months ended June 30, 2003 compared to the same period in 2002. This decrease
in hardware product cost of sales is more than the 10% decrease in hardware
product sales. Gross margins from hardware sales from the first half of 2003
were 30% compared to 15% for 2002. The favorable gross margin in 2003 can be
attributed to gross margins related to sales of the Atigo product line, which
was introduced in the third quarter of 2002, since margins are typically
highest following a products commercial launch. Also, the $363,736 sale of
components for the MA V system in the first quarter of 2002 had less than a 1%
margin because the components were deemed obsolete in 2001 and were written
down to their estimated net realizable value. Consulting, licensing and other
gross margins were consistent at 38% and 36% for the 2003 and 2002 periods,
respectively.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the six months
ended June 30, 2003 were $4,140,929, a decrease of $4,751,264, or 53%, compared
to the corresponding period in 2002. Sales and marketing expenses in the U.S.
in the first half of 2003 relating to salaries and benefits, consulting,
conferences, promotional items and travel expenses decreased approximately
$1,639,000, $606,000, $826,000, $120,000 and $165,000, respectively, compared
to the same period in 2002. This was primarily the result of cost saving
measures undertaken in the last three quarters of 2002. The reduction in
conference expenses was primarily due to the fact that the Companys
International Conference on Wearable Computing (ICWC) was held at Chicago
Comdex during 2002; a similar event did not occur during

15



---



##### 



the 2003 period.
Additional cost savings measures in the Companys European and Asian operations
resulted in decreases of approximately $866,000 in salaries and benefits,
facilities and consulting in the first half of 2003 compared to the first half
of 2002. Another decrease of $341,542 was related to non-cash marketing
expenses for outside services funded through the issuance of the Companys
equity securities for
the six months ended June 30, 2003 of $60,001 compared to $401,543 during the
same period in 2002.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the six months ended June 30, 2003 were $1,980,375, a decrease of $1,296,087,
or 40%, compared to the same period in 2002. As a result of the cost saving
measures, general and administrative expenses in the first quarter of 2003
relating to salaries and benefits, insurance and consulting decreased
approximately $467,000, $82,000 and $253,000, respectively, compared to the
same period in 2002.

RESEARCH AND DEVELOPMENT EXPENSES. The Companys research and development
expenses consist primarily of personnel costs, the purchase of test equipment
and payments to consultants and other third-parties which provide research and
development services for general mobile and wearable computing technologies.
Research and development expenses for the six months ended June 30, 2003 were
$2,000,328, a decrease of $1,523,810, or 43%, compared to the corresponding
period in 2002. This decrease resulted largely from an approximate $671,000
decline in outside research services for general wearable technology. There was
an additional decrease resulting from an approximate $218,000 decline in
expenditures to third parties and consultants for design and development of the
Companys mobile/wearable product lines. Expenditures during the 2002 period
related to the Atigo product line. In addition, the research and development
expenses related to salaries and benefits of the Companys U.S. and Asian
operations decreased by $407,000 and $75,000, respectively, from the three
months ended June 30, 2002 to 2003 due to cost saving measures.

INTEREST AND OTHER, NET. Net interest and other expense for the six months
ended June 30, 2003 was $287,545, a decrease of $398,750, compared to net
interest and other income of $111,205 for the same period in 2002. Included in
the 2003 net interest and other expense balance is $393,594 in non-cash
amortization of a note discount recorded for early repayment of debt.

PROVISION FOR INCOME TAXES. The provision for income taxes for the six months
ended June 30, 2003 was $259, a decrease of $4,346, compared to the income tax
provision for the six months ended June 30, 2002. These amounts relate to the
operations of the Companys foreign subsidiaries. The Companys U.S. operations
had a net loss during these periods and, therefore, no provision for U.S.
income taxes was made.

NET LOSS. As a result of the factors described above, the net loss for the six
months ended June 30, 2003 was $8,635,344, a decrease of $6,036,447 or 41%,
compared to the six months ended June 30, 2002.

OTHER OPERATING ACTIVITIES

For the six months ended June 30, 2003, the Companys operating activities
used cash of $7,842,832 as a result of its net loss of $8,635,344 and net
working capital requirements of $2,513,420, offset by non-cash expenses of
$3,305,932. The Companys investing activities used cash of $676,418. These
activities were funded through the Companys financing activities which
provided cash of $11,775,077 through the private placement of common stock,
exercise of warrants and borrowings. As a result, the Companys cash balance
increased to $5,329,525 at June 30, 2003 from $1,967,710 at December 31, 2002.

For the six months ended June 30, 2002, the Companys operating activities
used cash of $12,975,208 as a result of its net loss of $14,671,791 and net
working capital requirements of $122,997, offset by non-cash expenses of
$1,819,580. The Companys investing activities used cash of $947,593. These
activities were funded through the Companys financing activities which
provided cash of $13,715,227, principally through the private placement of
common stock, exercise of warrants and borrowings. As a result, the Companys
cash balance decreased to $2,778,522 at June 30, 2002 from $3,172,609 at
December 31, 2001.

For hardware product sales, the Company generally provides standard
warranties of one-year on parts and six-months on labor. The Company also
offers additional extended warranties. The Companys suppliers for the
significant components of the MA and Atigo products generally provide the
Company with similar warranties. A provision for estimated future warranty
costs is recorded at the time of shipment as a component of cost of sales. The
provision represents an estimate of costs to be incurred above and beyond the
warranties offered to the Company by its suppliers. In the event that the
Company is not able to obtain from its suppliers the necessary products or
services to meet its warranty obligations, the Company may incur warranty
expenses in the future that are significantly greater than those incurred in
the past.

The Companys consolidated financial statements contain a provision for
income tax expense related to its operations outside the United States. Subject
to realization, the Company has generated net operating losses in the U.S. that
can be used to offset taxable operating income in the future. The Companys
future operations, if profitable, will be subject to income tax expense not
previously incurred by the Company. At December 31, 2002, the Company had
approximately $116,312,000 and $6,560,000 of net operating loss carry forwards
for U.S. federal and foreign income tax purposes, respectively. The U.S. losses
will begin to expire in 2010 and the losses from foreign operations do not
expire. The use of the U.S. carryforwards may be limited in any one year under
Internal Revenue Code Section 382 if significant ownership changes occur.

The Company is involved in routine legal and administrative proceedings
and claims of various types. While any such proceeding or claim contains an
element of uncertainty, management does not expect that they will have a
material adverse effect on the Companys results of operations or financial
position.

16



---



##### 



TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES

Between November 2000 and February 2001, the Company loaned a net balance
of $940,188 to the Companys former President and current Chief Executive
Officer and Chairman of the Board of Directors. The proceeds were used to
prevent a forced sale of a portion of this
officers personal common stock holdings of the Company that secured a personal
margin loan from an investment bank. The loan was made pursuant to a promissory
note that was secured by shares of the officers personal common stock holdings
of the Company and accrued interest at 8% per year. On December 31, 2001, the
Companys Board of Directors increased the number of shares securing the loan
from 200,000 shares to 250,000 shares, extended the maturity date from December
31, 2001 to December 31, 2002 and reduced the interest rate to 6%, reflective
of a general decline in interest rates over this period. On December 17, 2002,
the $1,086,891 in outstanding principal and interest was repaid in full through
the i) transfer by the officer to the Company of 1,108,343 shares of the
Companys common stock personally held by the officer, which amount includes
the shares that were pledged as collateral, which were valued at $681,631, and
ii) cancellation of all of the officers 742,049 options to purchase shares of
the Companys common stock that had been granted prior to the date of
repayment, which were valued at $405,260. Effective December 31, 2002, the
Company cancelled the 1,108,343 shares of common stock transferred through this
repayment. To determine the fair market value of the transfer of shares of
stock and the cancellation of stock options, the Company used the market price
of the Companys common stock on the date of repayment and the Black-Scholes
option-pricing model, respectively. The variables used in the Black-Scholes
option-pricing model were as follows: i) the risk free rate was 3.03%, which
was the yield of 5-year Treasury Notes issued November 15, 2002, and ii) the
standard deviation of stock return was 131.25%, which was the volatility of the
Companys stock calculated using the end of the month stock price for the
period from January 1, 2000 through December 31, 2002. The outstanding
principal and interest owed by the officer to the Company under this promissory
note totaled $0 at both June 30, 2003 and December 31, 2002.

LIQUIDITY AND CAPITAL RESOURCES

From its inception until the completion of its initial public offering
(IPO), the Company financed its operations through the private sale of its
equity securities, vendor credit, and short-term loans received from
management, stockholders and others. During and subsequent to the IPO, the
Company has financed its operations from public and private sales of its common
and preferred stock, borrowings from financial institutions, management and
investors, proceeds from the exercise of warrants and stock options, and sales
of its products and services. The Companys financing and borrowing activities
for the twelve months ended December 31, 2002 and the six months ended June 30,
2003 are provided below.

Common Stock

During March 2002, the Company received gross proceeds of $9,000,000
through a private placement of 5,625,000 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,406,250 shares of common stock at an
exercise price of $3.00 per share. In connection with this placement, the
Company paid $270,000 in cash to financial advisors.

During June 2002, the Company received gross proceeds of $4,000,000
through a private placement of 6,666,666 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,666,666 shares of common stock at an
exercise price of $1.50 per share. In connection with this placement, the
Company issued 740,740 shares of its common stock to financial and business
development advisors.

During August 2002, the Company received gross proceeds of $2,000,000
through a private placement of 5,714,286 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 5,714,286 shares of common stock at an
exercise price of $0.70 per share and callable warrants to purchase 5,714,286
shares of common stock at an exercise price of $1.50 per share. A portion of
the proceeds from this private placement was used to repay a $250,000 note
payable.

During November 2002, the Company received gross proceeds of $4,100,000
through a private placement of 17,083,332 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 8,541,668 shares of common stock at an
exercise price of $1.25 per share.

During February 2003, the Company received gross proceeds of $2,000,000
through a private placement of 6,666,667 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor callable warrants to purchase 3,333,333 shares of common stock at an
exercise price of $1.25 per share.

During May 2003, the Company received gross proceeds of $3,000,000 through
a private placement of 9,375,000 shares of its common stock to certain
investors. The shares were sold at $0.32 per share, representing an approximate
20% discount to the closing price of the shares for the ten trading days
immediately prior to the date of the agreement. In connection with this private
placement, the Company issued to the investors three-year callable warrants to
purchase 3,281,250 shares of common stock. These warrants have an exercise
price of $0.45 if exercised in the first year, $0.90 if exercised in the second
year and $1.35 if exercised in the third and final year.

During June 2003, the Company received gross proceeds of $2,000,000
through a private placement of 5,405,405 shares of its common stock to an
investor. The shares were sold at $0.37 per share, representing an approximate
10% discount to the closing price of the shares for the ten trading days
immediately prior to the date of the agreement. In connection with this private
placement, the Company issued to the investor

17



---



##### 



three-year callable warrants to
purchase 4,054,054 shares of common stock. These warrants have an exercise
price of $0.75 if exercised in the first year, $1.50 if exercised in the second
year and $2.25 if exercised in the third and final year.

The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings. The
Company received gross proceeds of $3,354,167 and $3,146,183 through the
issuance of 11,875,001 and 17,350,627 shares of
its common stock during the six months ended June 30, 2003 and twelve months
ended December 31, 2002, respectively, exclusive of the exercises made in
connection with the note repayment discussed in Borrowings below.
Concurrently with their exercise, the exercise price of such warrants was
reduced from a weighted average of $1.25 per share to $0.28 per share during
2003 and $1.61 per share to $0.18 per share during 2002. At June 30, 2003, the
Company had warrants outstanding to purchase 11,785,840 shares of its common
stock at prices that range from $0.45 to $5.00 per share, with a weighted
average of $1.94 per share.

Borrowings

During June 2002, the Company received $250,000 in cash from an investor
that was recorded by the Company as a note payable. This note bore interest at
6.0% per annum and was due on or before June 30, 2003. This note was repaid in
August 2002 from the proceeds of a private placement.

On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note that bore interest at 3.5% per annum. In
connection with this borrowing, the Company issued to the lender warrants to
purchase 1,750,000 shares of common stock at an exercise price of $1.25 per
share and warrants to purchase 2,000,000 shares of common stock at an exercise
price of $0.43 per share. Based on the relative fair values of the securities
issued, these warrants were assigned a value of $393,594, which amount was
recorded as a note discount to be amortized into interest expense over the life
of the note. On May 30, 2003, the Company repaid $860,000 in principal when
the lender elected to exercise the 2,000,000 warrants at $0.43 per share.
Subsequent to this partial repayment, the lender provided the Company with a
10% discount on the remaining unpaid principal to induce the Company to repay
the remaining principal prior to its original maturity date. The remaining
principal was repaid on May 30, 2003 through the: i) $89,000 discount, ii)
application of the $560,000 aggregate exercise price related to the exercise of the warrants to purchase 1,750,000 shares of common stock
at $0.32 per share, a reduction from the original $1.25 per share exercise
price, and iii) issuance of 651,351 shares of common stock valued at $241,000,
or $0.37 per share. The Company repaid the accrued interest on the note
through the issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share. During the three and six months ended June 30, 2003, the
Company recorded interest expense of $10,222 and $11,229, respectively. During
the three and six months ended June 30, 2003, the Company recorded additional
interest expense related to the amortization of note discount of $387,124 and
$393,594, respectively, which six-month amortization balance includes the
write-off of the remaining discount at the time of repayment. The Company had
no outstanding principal or interest related to this note at either June 30,
2003 or December 31, 2002.

Commitments

Inventory.At June 30, 2003, the Company had commitments to purchase
inventory, tooling and/or engineering and other services from its suppliers and
manufacturers related to its current and future hardware product lines. The
Company expects that it will enter into similar commitments in the future as it
designs, develops and procures future mobile and wearable computer product lines.

Under its original agreements with IBM, the Company was obligated to
purchase certain components of the MA V system, including 24,000 computing
units, as well as various numbers of FPDs and other accessories. The total cost
to the Company of these purchases would have been over approximately
$40,000,000. Under the original agreements, the Company had the right to cancel
this purchase commitment by paying a cancellation fee in an amount of
approximately $4,000,000. In March 2003, the Company entered into an agreement
with IBM under which the Company was released of its obligation to pay the
penalty or procure this inventory other than $4,910,000 in MA V computing
units, FPDs, peripherals and component parts. The final pricing provided to the
Company represents a discount from the original contractual prices. Under the
March 2003 agreement, IBM agreed to ship inventory monthly from March 2003
through December 2003 and the Company agreed to remit payments monthly from
March 2003 through January 2004. IBM Global Finance provided a credit facility
to the Company which provides credit to the Company for purchases of inventory
under the March 2003 agreement. In connection with this credit facility, IBM
Global Finance was granted a security interest in certain of the Companys
assets and the Company obtained a letter of credit from a third party lender
for the benefit of IBM Global Finance in the amount of $375,000, for which the
Company posted an equal amount of restricted cash. This security interest does
not include patents and intellectual property.

In addition to the above obligation to IBM related to the MA V, the
Company has commitments to purchase computing units, flat panel and head
mounted displays, miscellaneous computing components as well as engineering and
other services from its various vendors related to the MA V, Atigo, MA TC and
future product lines. The Company believes that, if needed, the timing and
amount of many of these shipments, services and payments may be adjusted
through the payment of cancellation fees, contract negotiations or the
satisfaction of obligations through the issuance of the Companys equity
securities. However, there can be no assurance that the Company can or will
successfully modify these contracts or commitments.

Excluding the potential impact of contract modifications, the Company
estimates that it will make total payments of approximately $4,000,000 during
the period from July 2003 through January 2004 related to inventory commitments
as of June 30, 2003, which amount includes the commitment to purchase the
additional MA V products from IBM discussed above. The Company may enter into
similar inventory and engineering commitments in the future as it designs,
develops and procures future mobile and wearable computer product lines.

18



---



##### 



Operating Leases and Other.
The Company leases operating facilities and
equipment under operating leases expiring on various dates through
2005. Future
minimum payments under noncancelable operating leases as of June 30, 2003 are:

|                                 |  |   |        
|-------------------------------- |  | - | -------
|For the Year Ending December 31, |  |   |        
|                                
|2003                             |  | $ | 240,428
|2004                             |  |   | 205,987
|2005                             |  |   | 160,366
|2006                             |  |   |       
|2007                             |  |   |       
|                                 |  |   |        
|                                 |  | $ | 606,781
|                                 |  |   |        

Other Liquidity and Capital Resources Disclosures

At June 30, 2003, the Company had accounts receivable, net of allowances
and unbilled accounts receivable, of $2,696,096, an increase of $415,431, or
18%, from the December 31, 2002 balance of $2,280,665. This increase is
caused in part by the 7% increase in total revenues from the three months ended
December 31, 2002 of $2,604,850 to the three months ended June 30, 2003 of
$2,788,581. Also, included in the accounts receivable at June 30, 2003 is a
large accounts receivable from one customer of $1,253,992 from second quarter
sales that the Company substantially collected on in the third quarter, compared to a
large sale in December to one customer that accounted for a $1,103,200 balance
in accounts receivable at December 31, 2002 for which the Company collected the
balance in 2003. Management does not believe this increase in
accounts receivable was caused by
qualitative factors related to the Companys business such as changes in credit
terms, slower paying customers or the impact of a change in economic
environment. In addition, accounts receivable at June 30, 2003 and December
31, 2002 include $478,996 and $1,130,206, respectively, of unbilled accounts
receivable representing amounts earned and recorded under the percentage of
completion method of accounting on a long-term contract of XSI. The Company
expects to bill this amount in 2003 upon reaching certain
milestones in the contract.

At June 30, 2003, the Company had inventory, net of reserves, of
$3,790,948, an increase of $1,397,483, or 58%, from the December 31, 2002
balance of $2,393,465. This increase was primarily due to the receipt of MA
V inventory from IBM under the March 2003 agreement discussed in the
Commitments section above and is evidenced by the $1,047,065 increase in MA V
inventory of $2,701,570 at June 30, 2003 from $1,654,505 at December 31, 2002.

The deferred revenue balances at June 30, 2003 and December 31, 2002
result primarily from billings to customers that were in excess of revenue
recognized on service contracts and hardware warranties. Such deferred revenue
will be recognized as revenue as the revenue recognition criteria are met.

The Company has recorded net losses since its inception, including during
the periods presented in this Form 10-Q. These losses are primarily
attributable to the operating expenses incurred by the Company to design,
develop, market and sell its mobile and wearable computer products and to provide general
and administrative support for these operating activities. During these
periods, the Companys revenues and gross margins have not been sufficient to
fund these operating activities. As a result, the Company has consistently
recorded negative cash flows from operating activities and net losses and had
an accumulated deficit of $139,658,503 at June 30, 2003.
The combination of the Companys operating losses and its working capital
requirements has severely impacted the Companys financial position and
liquidity. During 2003 and 2002, the Company has funded its operating and
investing activities through its financing activities, which consist primarily
of private placements of common stock, warrant and stock option exercises and
borrowings.

The Companys management has taken steps that it believes are necessary to
improve the Companys operations and raise additional capital, both of which
are needed to enhance its ability to meet its cash flow needs through December
31, 2003 and thereafter. Beginning in April 2002, management has performed
reviews of the Companys operations and implemented various cost cutting
programs to significantly reduce the Companys operating expenses.

Assuming there are no significant changes to the Companys business plan,
management expects to maintain savings of over 50% from annualized fourth
quarter 2001 levels. During the fourth quarter of 2002 and the first and second
quarters of 2003, management met its current target to reach a quarterly
net operating expense level of between approximately $4,000,000 and $5,000,000. Through the
second quarter of 2003, the Company had reduced its net operating expenses for six consecutive quarters, resulting in over a 60% decline from fourth quarter 2001 levels.

19



---



##### 



The term net operating expense represents a non-GAAP
financial measure within
the meaning of Securities and Exchange Commission (SEC) regulations. The
Companys management uses net operating expenses in reviewing the results of
its operations as well as in analyzing the impact of the various cost-saving
initiatives it has implemented or plans to implement in the future. When used
herein, net-operating expenses represent total operating expenses as reported
on the Companys consolidated statements of operations (as reported in
accordance with U.S. GAAP) as adjusted for restructuring charges (as reported
in accordance with U.S. GAAP) as well as certain other non-recurring
transactions (that do not meet the criteria for recordation as restructuring
charges). Management believes that by reviewing net operating expenses, it is
better able to focus on the Companys recurring operations than it would be if
it reviewed total operating expenses, which include charges such as severance
payments to terminated employees, charges related to reductions in facilities
and other large charges related to non-recurring activities. The net operating
expenses discussed or presented in the Companys press releases, SEC filings,
conference calls or other public disclosures reconcile to the total operating
expenses included on the Companys consolidated statements of operations as
follows:

|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|----------------------------------------------------------- |  | -------------- | ---------- | ------------- |  | -------------- | --------- | ------------- |  | - | --------- | - |  | - | ---------- | -
|                                                            |  | Fourth quarter |            | First quarter |  | Second quarter |           | Third quarter
|                                                            |  | of 2001        |            | of 2002       |  | of 2002        |           | of 2002      
|                                                            |  |                |            |               |  |                |           |              
|Total operating expenses                                    |  | $              | 10,114,109 |               |  | $              | 8,745,553 |               |  | $ | 7,102,474 |   |  | $ | 8,101,940  |  
|Restructuring charges                                       |  |                |           |               |  |                |          |               |  |   | (155,234  | ) |  |   | (361,227   | )
|Charges for cancellation of a
marketing and lease agreement |  |                |           |               |  |                |          |               |  |   |          |   |  |   | (729,511   | )
|(Reserve), and subsequent reversal,
of note receivable      |  |                |           |               |  |                |          |               |  |   |          |   |  |   | (1,015,575 | )
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|Net operating expenses                                      |  | $              | 10,114,109 |               |  | $              | 8,745,553 |               |  | $ | 6,947,240 |   |  | $ | 5,995,627  |  
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|                                                            |  | Fourth quarter |            | First quarter |  | Second quarter |           |               |  |  
|                                                            |  | of 2002        |            | of 2003       |  | of 2003        |           |               |  |  
|                                                            |  |                |            |               |  |                |           |               |  |  
|Total operating expenses                                    |  | $              | 4,092,317  |               |  | $              | 4,184,179 |               |  | $ | 3,937,453 |   |  |   |            |  
|Restructuring charges                                       |  |                | (521,699   | )             |  |                |          |               |  |   |          |   |  |   |            |  
|Charges for cancellation of a
marketing and lease agreement |  |                | (127,500   | )             |  |                |          |               |  |   |          |   |  |   |            |  
|(Reserve), and subsequent reversal,
of note receivable      |  |                | 1,015,575  |               |  |                |          |               |  |   |          |   |  |   |            |  
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|Net operating expenses                                      |  | $              | 4,458,693  |               |  | $              | 4,184,179 |               |  | $ | 3,937,453 |   |  |   |            |  
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  

20



---



##### 



Management believes that the Companys current staffing and resources will
be sufficient to carry out its business plan for the foreseeable future. In
addition to the cost cutting initiatives already undertaken, management
continues to review all aspects of the Companys operations and may take
additional actions to reduce operating expenses further. Future significant
fluctuations may still occur as a result of non-recurring
charges associated with cost-saving initiatives as well as the Companys
research and development activities, which will vary depending on the Companys
wearable/mobile computer product development cycle during any given period.

Based on historical results and the forecasted levels discussed above,
management expects that the Company will incur operating expenses of between
$16,000,000 and $18,000,000 during 2003. However, there can be no assurances
that actual operating expenses will not be significantly higher. The Company
will also be required to fund inventory procurement and other expenditures.
While management expects to fund a portion of these activities through gross
profits resulting from revenues, the Company will be required to obtain most of
such amounts through outside financings. Potential sources of additional
financing include private equity offerings, warrant exercises, strategic
investments and various forms of debt financing. In certain instances,
concurrently with the exercise of certain of these warrants, the exercise
prices were reduced. Such reduction has resulted in the issuance of
substantially more shares of common stock than would have occurred had the
exercise price of the warrants not been reduced. The Company may
reduce the exercise price of additional warrants in the future. If additional
funds are raised through the issuance of equity securities, the percentage of
ownership of current stockholders of the Company will be reduced and if
additional funds are raised at current prices for the Companys stock, such
dilution could be significant. If additional funds are raised through
borrowings, the Company will be subject to interest charges and principal
repayments, will likely be required to comply with financial covenants or other
restrictions, and will likely have to collateralize such borrowings with its
assets, which could be taken by the lender in the event of default.

From January 1, 2003 through
the date of this filing, the Company raised
approximately $15,000,000 through sales of its common stock to institutional
investors, through warrant and stock option exercises and through borrowings.
Based on the Companys cash balance and forecasted operations,
management does not believe that the Company will be required to
raise additional capital during the remainder of 2003.
 Due in large part to the Companys current stock
price, the depressed general capital markets and cost-cutting efforts described
above, the individual equity financings that the Company has completed in
recent quarters have been of a smaller size when compared to those transacted
in previous periods. The equity markets, especially for small capitalization
technology stocks, have remained depressed, and the U.S. and world economies
have generally been in a decline or recession. If a sustained decline in the
general equity markets, the price of the Companys common stock, or the U.S. or
world economy were to occur, the Company could face difficulties in its ability
to raise additional capital. Additionally, the Company has historically made
several private placements of its common stock per year, primarily to a limited
number of institutional investors who specialize in making similar types of
investments. If these institutional investors were to choose to not participate
in future private placements, the Company could face difficulties in its
ability to raise additional capital.

Certain of the Companys liabilities are past their stated terms of
payment, including those owed to vendors that provide services and inventory
which are required by the Company to execute its business plan. In general, any
company that does not pay its suppliers in a timely manner is at risk of being
forced into an involuntary bankruptcy proceeding instituted by creditors, which
may provide for the liquidation of assets or the reorganization of assets and
debts. The Company generally believes that it has a reasonably good
relationship with most of its vendors and creditors. However certain of its
vendors have filed legal actions to recover overdue accounts payables and
ceased providing services and products to the Company. There can be no
assurances that other vendors will not pursue similar actions.

On July 22, 2002, the Company received notice from Nasdaq that the
Companys common stock had closed below $1 per share for 30 consecutive trading
days. Effective October 29, 2002, the Company was granted a transfer to the
Nasdaq SmallCap® Market. Effective July 18, 2003, the Company was provided an
extension by Nasdaq until October 15, 2003 for the stock price to close above
$1 for ten consecutive trading days.

On January 30, 2003, Nasdaq issued a press release in which it announced
plans to extend a pilot program governing bid price rules for all Nasdaq
National Market® and Nasdaq SmallCap issuers. The proposal will allow
issuers that meet heightened financial requirements to benefit from extended
compliance periods for satisfying minimum bid price requirements. The proposed
rule changes would [amongst other changes] extend the bid price grace period
for SmallCap issuers demonstrating compliance with the core SmallCap initial
listing criteria from 180 to up to 540 days (approximately 18 months).
Compliance with this standard will be verified every 180 days. NASDAQ will
present the overall plan to the Securities and Exchange Commission for approval
prior to implementing the proposed changes.

The Companys management believes it is currently in compliance with all
such listing criteria and management anticipates it will remain in compliance
for the foreseeable future. However, there can be no assurances that the
Company will be able to remain in compliance in the future or that the SEC will
grant the Nasdaq the requisite approval to adopt this proposal. Prior to the
delisting of the Companys common stock, the Company can appeal Nasdaq for an
extension or for other remedies. If necessary, management intends to fully
exercise all of its rights and options to maintain its listing. If the Company
is unable to remain on the SmallCap Market or other national exchange, it may
trade on the Over the Counter Bulletin Board or Pink Sheets markets, which
would significantly reduce the liquidity in the stock and interest of potential
investors in purchasing the stock.

The Companys management believes that the combination of cash on hand,
cash flows from operations and outside funding will provide sufficient
liquidity to meet the Companys ongoing cash requirements. This is based both
on the Companys historical ability to raise capital and on debt and equity
financings currently available to the Company. However, there can be no
assurance that the Company can or will obtain sufficient funds from operations
or from additional financings on terms acceptable to the Company.

21



---



##### 



If the Company is unable to obtain sufficient additional financing, it
will be required to reduce spending in order to maintain its operations at a
reduced level. Management believes that it will be able to reduce spending if
required. However, such reduction would negatively impact progress on
implementing the Companys business plan, and may require substantial
reductions in the purchase commitments disclosed herein.

Contractual Obligations and Commercial Commitments

The Companys significant contractual obligations as of June 30, 2003 are
for lease payments related to a reduction in facilities classified as
restructuring in 2002, operating leases (primarily for office space) and
inventory commitments.

|                        |  |       |           |      |  |                         |           |      |  |      |         |      |  |   |         |  |  |   |   |  |  |   |   | 
|----------------------- |  | ----- | --------- | ---- |  | ----------------------- | --------- | ---- |  | ---- | ------- | ---- |  | - | ------- |  |  | - | - |  |  | - | - | 
|                        |  |       |           |      |  | Payments Due by Periods
|                        |  |       |           |      |  |                        
|                        |  | Total |           | 2003 |  | 2004                    |           | 2005 |  | 2006 |         | 2007
|                        |  |       |           |      |  |                         |           |      |  |      |         |      |  |   |         |  |  |   |   |  |  |   |   | 
|Restructuring Liability |  | $     | 153,884   |      |  | $                       | 34,589    |      |  | $    | 62,330  |      |  | $ | 56,965  |  |  | $ |  |  |  | $ |  | 
|Operating Leases        |  |       | 606,781   |      |  |                         | 240,428   |      |  |      | 205,987 |      |  |   | 160,366 |  |  |   |  |  |  |   |  | 
|Capital Lease           |  |       | 3,180     |      |  |                         | 3,180     |      |  |      |        |      |  |   |        |  |  |   |  |  |  |   |  | 
|Inventory Commitments   |  |       | 4,000,000 |      |  |                         | 3,500,000 |      |  |      | 500,000 |      |  |   |        |  |  |   |  |  |  |   |  | 
|                        |  |       |           |      |  |                         |           |      |  |      |         |      |  |   |         |  |  |   |   |  |  |   |   | 
|                        |  | $     | 4,763,845 |      |  | $                       | 3,778,197 |      |  | $    | 768,317 |      |  | $ | 217,331 |  |  | $ |  |  |  | $ |  | 
|                        |  |       |           |      |  |                         |           |      |  |      |         |      |  |   |         |  |  |   |   |  |  |   |   | 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk related to changes in foreign currency
exchange rates and changes in interest rates. The Company does not hold
investments or use derivative financial instruments for speculative or trading
purposes. All of the potential changes noted below are based on sensitivity
analyses performed on the Companys financial position at June 30, 2003. Actual
results may differ materially.

FOREIGN CURRENCY EXCHANGE RISK

The majority of the Companys revenue, expense, and capital purchasing
activities are transacted in U.S. dollars. However, as a result of the
Companys international manufacturing, research and development, sales and
marketing, inventory procurement, and other activities, the Company enters into
transactions denominated in other currencies, primarily the Japanese Yen and
the European Euro, or in which the U.S. Dollar equivalent is determined by the
values of such currencies. Prior to the adoption of the Euro, the Company also
regularly entered into transactions denominated in the German Deutsche Mark. As
of January 1, 2001, Xybernaut GmbH converted its functional currency from the
Deutsche Mark to the Euro. The effect of this conversion was an increase of
$151,123 on beginning accumulated deficit, which is included in the foreign
currency translation balance. Historically, the Company has not realized
significant gains or losses in transactions denominated in, or determined by,
foreign currencies. To date, the Company has not entered into foreign exchange
forward or option contracts to hedge its exposure to future movements in
foreign exchange rates because the Companys management believes that the
potential impact of these movements does not justify the costs of entering into
such contracts or the use of capital to collateralize these contracts. In the
future, the Company may enter into foreign exchange forward and option
contracts to hedge transactions denominated in a foreign currency if management
determines that the levels of international sales or operations justify the use
of such contracts. For the three and six months ended June 30, 2003, the
Companys operations in Europe comprised 7.8% and 11.3% of its total revenue
and 10.2% and 7.6% of its net loss, respectively, compared to 7.6% and 14.8% of
its total revenue and 15.6% and 12.8% of its net loss, respectively, in the
same periods for 2002. For the three and six months ended June 30, 2003, the
Companys operations in Asia comprised 0.3% and 3.7% of its total revenue and
0.7% and 0.4% of its net loss, respectively, compared to 2.3% and 5.6% of its
total revenue and 2.1% and 1.5% of its net loss, respectively, in the same
periods for 2002. At June 30, 2003, the Companys assets in Europe and Asia
comprised 6.2% and 2.6% of its total assets, respectively, compared to 21.4%
and 2.7% of its total assets at June 30, 2002, respectively. According to
published sources, the average fluctuation of the European Euro during the
three and six months ended June 30, 2003 was 3.9% and 4.9%, respectively,
compared to 5.1% and 0.8% for the same period in 2002, respectively. According
to published sources, the average fluctuation of the Japanese Yen during the
three and six months ended June 30, 2003 was 0.0% and -0.1%, respectively,
compared to 4.3% and 1.1% for the same period in 2002, respectively.
Management believes that these fluctuations did not have a material impact on
the Companys results of operations or financial position for 2003 and 2002.

INTEREST RATE SENSITIVITY

The Company is party to certain debt and credit instruments and continues
to explore various financing alternatives, including debt financings. If
additional funds are raised through borrowings, the Company will be subject to
additional interest charges. Interest rate increases may materially increase
the Companys interest expense, hinder the Companys ability to borrow
additional funds or have a negative effect on the ability of the Companys
customers to purchase its products. To date, the Company has not entered into
interest rate forward or option contracts to hedge its exposure to future
movements in interest rates because the Companys management believes that the
potential impact of these movements does not justify the costs of entering into
such contracts or the use of capital to collateralize these
contracts. If the
Companys exposure to interest rate fluctuations becomes more significant, it
may enter into interest rate forward and option contracts to hedge against such
fluctuations. According to published sources, the average prime interest rate
during the first two quarters of fiscal year 2003 was 4.25% for each period,
compared to a 4.75% average prime interest rate during the same periods in
2002, respectively. For 2003 and 2002, the prime interest rate fluctuation from
January 1 to June 30 of each year was 0%. Management believes that these
fluctuations did not have a material impact on the Companys results of
operations or financial position for 2003 and 2002.

22



---



##### 



ITEM 4. CONTROLS AND PROCEDURES

Within the 90 days prior to the date of this report, the Company carried
out an evaluation, under the supervision and with the participation of the
Companys management, including the Companys Chief Executive Officer, Chief
Financial Officer and President, of the effectiveness of the design and
operation of the Companys disclosure controls and procedures pursuant to
Exchange Act rules. Based upon that
evaluation, the Chief Executive Officer, Chief Financial Officer and President
concluded that the design and execution of the Companys disclosure controls
and procedures is effective. There were no significant changes in the Companys
internal controls or in other factors that could significantly affect these
controls subsequent to the date of their evaluation.

PART II  OTHER INFORMATION

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

During May 2003, the Company received gross proceeds of $3,000,000 through
a private placement of 9,375,000 shares of its common stock to certain
investors. The shares were sold at $0.32 per share, representing an approximate
20% discount to the closing price of the shares for the ten trading days
immediately prior to the date of the agreement. In connection with this private
placement, the Company issued to the investors three-year callable warrants to
purchase 3,281,250 shares of common stock. These warrants have an exercise
price of $0.45 if exercised in the first year, $0.90 if exercised in the second
year and $1.35 if exercised in the third and final year. The net proceeds of
the placement were used for working capital of the Company. The private
placement was exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933 and Rule 506 promulgated thereunder.

During June 2003, the Company received gross proceeds of $2,000,000
through a private placement of 5,405,405 shares of its common stock to an
investor. The shares were sold at $0.37 per share, representing an approximate
10% discount to the closing price of the shares for the ten trading days
immediately prior to the date of the agreement. In connection with this private
placement, the Company issued to the investor three-year callable warrants to
purchase 4,054,054 shares of common stock. These warrants have an exercise
price of $0.75 if exercised in the first year, $1.50 if exercised in the second
year and $2.25 if exercised in the third and final year. The net proceeds of
the placement were used for working capital of the Company. The private
placement was exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933 and Rule 506 promulgated thereunder.

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

A) EXHIBITS

|     |  |                                                                        
|---- |  | -----------------------------------------------------------------------
|31.1 |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     |  |                                                                        
|31.2 |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     |  |                                                                        
|31.3 |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     |  |                                                                        
|32   |  | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002

B) REPORTS ON FORM 8-K

On July 11, 2003, the Company filed a report on Form 8-K disclosing a press release that had been issued that announced certain preliminary information relating to revenues for the fiscal quarter ended June 30, 2003.

23



---



##### 



SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

|                                        |  |                     
|--------------------------------------- |  | --------------------
|XYBERNAUT CORPORATION                  
|                                        |  |                     
|By:                                     |  | /s/ EDWARD G. NEWMAN
|Edward G. Newman                       
|Chief Executive Officer and            
|Chairman of the Board of Directors     
|                                        |  |                     
|By:                                     |  | /s/ THOMAS D. DAVIS 
|Thomas D. Davis                        
|Senior Vice President and              
|Chief Financial Officer                
|                                        |  |                     
|By:                                     |  | /s/ STEVEN A. NEWMAN
|Steven A. Newman                       
|President, Chief Operating Officer and 
|Vice Chairman of the Board of Directors
|                                        |  |                     
|Date: August 13, 2003                  

24