##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 QUARTERLY REPORT ON FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 COMMISSION FILE NUMBER 0-21013 XYBERNAUT CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE
(STATE OR OTHER JURISDICTION
OF INCORPORATION)
    
    54-1799851
(I.R.S. EMPLOYER
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 [x] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [x] No [  ] The number of shares outstanding of the registrants Common Stock, $0.01
par value per share, as of August 3, 2004 was 179,147,116.




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##### 



XYBERNAUT CORPORATION QUARTERLY REPORT ON FORM 10-Q PAGECOVER PAGE
        
        
        1INDEX
        
        
        2PART I  FINANCIAL
            INFORMATIONItem 1 - Financial
            StatementsCondensed Consolidated
            Balance Sheets (unaudited)
        
        
        3Condensed Consolidated
            Statements of Operations (unaudited)
        
        
        4Condensed Consolidated
            Statements of Cash Flows (unaudited)
        
        
        5Notes to Condensed
            Consolidated Financial Statements
        
        
        6Item 2 - Managements
            Discussion and Analysis of Financial Condition and Results of Operations
        
        
        11Item 3 - Quantitative
            and Qualitative Disclosures about Market Risk
        
        
        18Item 4 - Controls
            and Procedures
        
        
        19PART II  OTHER
            INFORMATIONItem 1- Legal Proceedings
        
        
        19Item 2 - Changes
            in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
        
        
        19Item 6 - Exhibits
            and Reports on Form 8-K
        
        
        19SIGNATURES
        
        
        20
 2




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##### 



PART I  FINANCIAL INFORMATION
Item 1  Financial Statements XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED) June 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    13,251,416
    
    
    $
    9,524,541Restricted cash
    
    
    500,000
    
    
    
    1,257,554Accounts receivable, net of allowances of $507,584 and $557,679
    
    
    2,617,249
    
    
    
    4,883,899Inventory, net of reserves of $3,272,716 and $3,272,716
    
    
    1,578,910
    
    
    
    2,131,436Prepaid and other current assets
    
    
    765,766
    
    
    
    984,425Total current assets
    
    
    18,713,341
    
    
    
    18,781,855Long-term assets:Property, equipment and demonstration units, net
    
    
    464,508
    
    
    
    382,792Patent costs, net of accumulated amortization of $2,190,929
and $1,963,971
    
    
    916,033
    
    
    
    945,126Other
    
    
    724,247
    
    
    
    710,294Total long-term assets
    
    
    2,104,788
    
    
    
    2,038,212Total assets
    
    $
    20,818,129
    
    
    $
    20,820,067LIABILITIES AND STOCKHOLDERS EQUITYLiabilities:Current liabilities:Accounts payable
    
    $
    2,148,513
    
    
    $
    3,068,374Accrued expenses and other
    
    
    1,380,729
    
    
    
    1,283,200Deferred revenue
    
    
    386,299
    
    
    
    332,884Total current liabilities
    
    
    3,915,541
    
    
    
    4,684,458Long-term liabilities:Restructuring liability
    
    
    27,632
    
    
    
    62,330Deferred revenue
    
    
    193,507
    
    
    
    163,754Total long-term liabilities
    
    
    221,139
    
    
    
    226,084Total liabilities
    
    $
    4,136,680
    
    
    $
    4,910,542Minority interest
    
    $
    210,629
    
    
    $
    Commitments and contingenciesStockholders equity:Common stock, $0.01 par value, 200,000,000
shares authorized, 179,147,116 and 172,358,223
shares issued and outstanding
    
    
    1,791,471
    
    
    
    1,723,582Additional paid-in capital
    
    
    171,941,039
    
    
    
    163,362,829Foreign currency translation
    
    
    301,045
    
    
    
    430,502Accumulated deficit
    
    
    (157,562,735
    )
    
    
    (149,607,388
    )Total stockholders equity
    
    $
    16,470,820
    
    
    $
    15,909,525Total liabilities and stockholders equity
    
    $
    20,818,129
    
    
    $
    20,820,067
 The accompanying notes are an integral part of these
condensed consolidated financial statements 3




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##### 



XYBERNAUT CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED) Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Revenue:Hardware
    
    $
    1,928,711
    
    
    $
    1,775,792
    
    
    $
    4,866,033
    
    
    $
    2,600,504Consulting, licensing and other
    
    
    1,451,650
    
    
    
    1,012,789
    
    
    
    2,909,012
    
    
    
    1,975,054Total revenue
    
    
    3,380,361
    
    
    
    2,788,581
    
    
    
    7,775,045
    
    
    
    4,575,558Cost of sales:Hardware
    
    
    1,949,284
    
    
    
    1,194,857
    
    
    
    4,456,052
    
    
    
    1,822,251Consulting, licensing and other
    
    
    832,952
    
    
    
    623,249
    
    
    
    1,653,654
    
    
    
    1,229,861Provision for inventory
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,749,354Gross income / (loss)
    
    
    598,125
    
    
    
    970,475
    
    
    
    1,665,339
    
    
    
    (225,908
    )Operating expenses:Sales and marketing
    
    
    3,120,381
    
    
    
    2,103,423
    
    
    
    5,933,513
    
    
    
    4,140,929General and administrative
    
    
    1,031,516
    
    
    
    975,984
    
    
    
    1,954,834
    
    
    
    1,980,634Research and development
    
    
    1,021,336
    
    
    
    858,193
    
    
    
    1,953,101
    
    
    
    2,000,328Total operating expenses
    
    
    5,173,233
    
    
    
    3,937,600
    
    
    
    9,841,448
    
    
    
    8,121,891Operating loss
    
    
    (4,575,108
    )
    
    
    (2,967,125
    )
    
    
    (8,176,109
    )
    
    
    (8,347,799
    )Interest and other income / (expense), net
    
    
    24,813
    
    
    
    (289,741
    )
    
    
    66,584
    
    
    
    (287,545
    )Loss before minority interest
    
    
    (4,550,295
    )
    
    
    (3,256,866
    )
    
    
    (8,109,525
    )
    
    
    (8,635,344
    )Minority interest
    
    
    154,178
    
    
    
    
    
    
    
    154,178
    
    
    
    Net loss
    
    $
    (4,396,117
    )
    
    $
    (3,256,866
    )
    
    $
    (7,955,347
    )
    
    $
    (8,635,344
    )Net loss per share (basic and diluted)
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    (0.05
    )
    
    $
    (0.07
    )Weighted average number of shares
outstanding (basic and diluted)
    
    
    176,957,341
    
    
    
    136,577,988
    
    
    
    175,362,337
    
    
    
    128,242,872
 The accompanying notes are an integral part of these
condensed consolidated financial statements 4




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##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED) Six Months Ended June 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (7,955,347
    )
    
    $
    (8,635,344
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    576,162
    
    
    
    949,020Provision for inventory
    
    
    
    
    
    
    1,749,354Loss on disposal of assets
    
    
    
    
    
    
    38,306Non-cash charges for equity securities issued for services
    
    
    84,584
    
    
    
    175,658Amortization of note discount
    
    
    
    
    
    
    393,594Minority interest
    
    
    154,178
    
    
    
    Changes in assets and liabilities:Inventory
    
    
    513,184
    
    
    
    (1,918,783
    )Accounts receivable
    
    
    2,244,570
    
    
    
    245,071Prepaid and other current assets
    
    
    229,456
    
    
    
    286,511Other assets
    
    
    (159,308
    )
    
    
    (354,018
    )Accounts payable
    
    
    (914,856
    )
    
    
        (1,055,124
    )Accrued expenses and other
    
    
    27,084
    
    
    
    (87,606
    )Deferred revenue, current
    
    
    116,880
    
    
    
    120,930Restructuring liability, long-term
    
    
    (32,095
    )
    
    
    (43,855
    )Deferred revenue, long-term
    
    
    29,754
    
    
    
    43,454Net cash used in operating activities
    
    $
    (5,085,754
    )
    
    $
        (8,092,832
    )Cash flows from investing activities:Acquisition of property, equipment and demonstration
units
    
    
    (341,123
    )
    
    
    (161,596
    )Acquisition of patents and trademarks
    
    
    (197,865
    )
    
    
    (119,268
    )Restricted cash
    
    
    757,554
    
    
    
    (375,554
    )Capitalization of tooling costs
    
    
    
    
    
    
    (20,000
    )Net cash provided by / (used in) investing
activities
    
    $
    218,566
    
    
    $
    (676,418
    )Cash flows from financing activities:Proceeds from:Common stock offerings, net
    
    
    5,961,440
    
    
    
    6,921,095Exercise of warrants
    
    
    2,541,317
    
    
    
        3,354,167Exercise of stock options
    
    
    58,755
    
    
    
    15,119Notes and loans
    
    
    
    
    
    
    1,750,000Payments for:Capitalization of loan costs
    
    
    
    
    
    
    (15,304
    )Net cash provided by financing activities
    
    $
    8,561,512
    
    
    $
        12,025,077Effect of exchange rate changes on cash and cash equivalents
    
    
    32,551
    
    
    
    105,988Net increase in cash and cash equivalents
    
    
    3,726,875
    
    
    
    3,361,815Cash and cash equivalents, beginning of period
    
    
    9,524,541
    
    
    
    1,967,710Cash and cash equivalents, end of period
    
    $
    13,251,416
    
    
    $
    5,329,525Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    
    
    
    $
    579Cash paid for taxes
    
    $
    646
    
    
    $
    585Supplemental disclosure of non-cash financing activities:Equity securities issued for services rendered, expensed
in periods issued
    
    $
    84,584
    
    
    $
    160,325Equity securities issued for settlement of notes payable
    
    $
    
    
    
    $
    1,661,000
 The accompanying notes are an integral part of these
condensed consolidated financial statements 5




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##### 



XYBERNAUT CORPORATION
NOTES TO CONDENSED 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 the Companys
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,
2004 and December 31, 2003, the results of their operations
for the three and six months ended June 30, 2004 and 2003 and cash flows
for the six months ended June 30, 2004 and 2003. Results of operations for the
three and six months ended June 30, 2004 are not necessarily indicative of
results of operations expected for the full fiscal year ending December 31,
2004. Please refer to the Companys Annual Report on Form 10-K, as amended on
Form 10-K/A, for the complete financial statements for the period
ended December 31, 2003. 2. THE COMPANY, LIQUIDITY AND OPERATIONS 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 critical enterprise 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). In February 2004, the Company began
actively marketing its mobile and wearable hardware solutions in the Peoples
Republic of China through its 60% ownership in Xybernaut China Limited, a joint
venture with Softbank Investment International (Strategic) Ltd. (Xybernaut
China). The Company was originally incorporated in 1990 and completed its
initial public offering in July 1996. 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 $31,000,000 on sales of approximately 9,500
MA and Atigo systems. The Company has recorded net losses since its inception. 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.
The Companys revenues and gross margins have not been sufficient to fund these
operating activities. As a result, the Company has consistently reported
negative cash flows from operating activities and net losses and had an
accumulated deficit of $157,562,735 at June 30, 2004. The Companys management has taken steps that it believes are necessary to
improve operations and raise additional capital, both of which are needed to
meet its cash flow needs through December 31, 2004 and thereafter. During 2002
and 2003, management performed reviews of the Companys operations and
implemented various cost cutting programs to reduce the Companys operating
expenses to better align costs with current and expected business volume.
Management believes that the Companys current staffing and resources will be
sufficient to carry out its business plan for the foreseeable future. The Companys management believes that the combination of cash on hand,
cash flows from operations and outside additional funding from third party
investors will provide sufficient liquidity to meet the Companys ongoing cash
requirements. This is based on the Companys historical ability to raise funds
in the form of debt and equity financings. 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. 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 would be able to reduce spending if required,
however, 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, the 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 6




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The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. At June 30,
2004 and December 31, 2003, the Company had $500,000 and $1,257,554,
respectively, in restricted cash. The balance at June 30, 2004 consisted of a
$500,000 cash deposit that secures a long-term services contract. The balance
at December 31, 2003 consisted of i) this same $500,000 cash deposit, ii) a
$376,442 cash deposit and interest that secured a letter of credit held by a
vendor and iii) $381,112 held in escrow representing a December 2003 payment
made by the Company for inventory that was delivered during 2004. The
restrictions on the $500,000 deposit are scheduled to lapse in late 2004, at
which point the cash deposit is expected to be returned to the Company. The
restrictions on the $376,442 deposit lapsed in the first quarter of 2004 and
the amount was returned to the Companys unrestricted cash balance. The
$381,112 escrow balance was remitted to the vendor as the inventory was
delivered during the first quarter of 2004. Inventory and Tooling At June 30, 2004, inventory consisted primarily of wearable computer
component parts held for resale and allocated tooling costs, and is comprised
primarily of finished goods. 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
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 expected in a products production run. Inventory and tooling are
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 tooling and adjusts the carrying value to its
net realizable value when required. During the three months ended March 31, 2003, the Company recognized a
$1,749,354 charge on its consolidated statement of operations related to its MA
V inventory and related components. The Company did not recognize any such
charges during the three or six months ended June 30, 2004 or the three months
ended June 30, 2003. The Company had a $3,272,716 inventory reserve on its consolidated balance
sheet at both June 30, 2004 and December 31, 2003. This balance represents a
$3,022,716 reserve against MA V systems and a $250,000 reserve against MA TC
systems. 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 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.
The significant majority of the Companys recent inventory and tooling charges
were recorded against the MA V product line. Even after the successful
renegotiation of certain of the MA V manufacturing contracts during 2003, the
Company had commitments to purchase significant quantities of inventory. The
Company was required to write-down and reserve a substantial portion of the MA
V inventory as historical and forecasted sales were not sufficient to sell such
quantities of inventory. As a result of this review, it was determined that
certain of the Companys inventory was slow-moving, risked becoming obsolete or
would 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. To the
extent that actual future events are different from the assumptions and
estimates used by management, additional charges, reserves or adjustments may
be recorded by the Company. Management does not expect to record significant
profits or losses upon the ultimate sale of this inventory. As of June 30, 2004, net of the effect of reserves and write-offs, the
Companys inventory consisted of $883,215 in MA V systems, $372,871 in MA TC
systems and $322,824 in Atigo systems. As of December 31, 2003, all of the
Companys tooling assets had been allocated to inventory or property and
equipment. Capitalized tooling costs during the six months ended June 30, 2004
and 2003 were $0 and $20,000, respectively. Amortization to cost of goods sold
or depreciation, depending on classification of tooling costs as inventory or
property and equipment, was $70,940 and $113,763 for the three and six months
ended June 30, 2004 and $308,973 and $380,694 for the three and six months
ended June 30, 2003, respectively. Stock-Based Compensation In December 2002 the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards (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 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: 7




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##### 



Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (4,396,117
    )
    
    $
    (3,256,866
    )
    
    $
    (7,955,347
    )
    
    $
    (8,635,344
    )Stock-based employee compensation cost included in
net loss as reported
    
    
    
    
    
    
    43,412
    
    
    
    22,954
    
    
    
    150,325Stock-based employee compensation expense under
fair value method of SFAS No. 123
    
    
    (158,626
    )
    
    
    (464,683
    )
    
    
    (282,356
    )
    
    
    (893,458
    )Net loss pro forma
    
    $
    (4,554,743
    )
    
    $
    (3,678,137
    )
    
    $
        (8,214,749
    )
    
    $
        (9,378,477
    )Net loss per share basic and diluted  as reported
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    (0.05
    )
    
    $
    (0.07
    )Net loss per share basic and diluted  pro forma
    
    $
    (0.03
    )
    
    $
    (0.03
    )
    
    $
    (0.05
    )
    
    $
    (0.07
    )
 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. For the three
months and six months ended June 30, 2004, equity securities related to
consulting services and employee severance were issued in payment of $61,460
and $84,584, respectively, compared to $57,245 and $175,658 for the same
periods in 2003. Reclassifications Certain 2003 balances and disclosures have been reclassified to conform to
the 2004 presentation. 4. BORROWINGS On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note which accrued 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 and 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 and interest was repaid on May 30, 2003 through the: i) $89,000
discount, which was applied against the Companys Additional Paid-In Capital,
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, iii)
issuance of 651,351 shares of common stock valued at $241,000, or $0.37 per
share, and iv) issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share, as repayment of accrued interest. 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 amortization of note discount of $387,124 and
$393,594, respectively. The Company had no outstanding principal or interest
related to this note at June 30, 2004 or December 31, 2003. 5. MINORITY INTEREST In February 2004, the Company began actively marketing its mobile and
wearable hardware solutions in the Peoples Republic of China (the PRC)
through Xybernaut China, a joint venture with Softbank Investment International
(Strategic) Ltd. (Softbank Strategic). The Company owns 60% of Xybernaut
China and Softbank Strategic owns the remaining 40%. Xybernaut China has the
exclusive right to manufacture, market, sell and distribute the Companys
products throughout the PRC. The Company has assigned all of its existing
agreements and relationships in the PRC to Xybernaut China and is providing it
with certain limited management resources,
know-how and technical assistance. The Company has licensed its
intellectual property to Xybernaut China for a five year period. Softbank Strategic is providing the start-up
funding for Xybernaut China and is assisting with its day-to-day operations.
The Companys consolidated financial statements for the three and six months
ended June 30, 2004 include the operations of Xybernaut China. During the six
months ended June 30, 2004, Softbank Strategic provided funding to Xybernaut
China of $364,807, which amount was recorded as Minority Interest on the
Companys consolidated balance sheet and reduced by Softbank Strategics
$154,178 share of Xybernaut Chinas net loss. 6. STOCKHOLDERS EQUITY 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. 8




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##### 



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. 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 had 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. 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 had an exercise price of $1.25 if exercised in the first
year, $2.50 if exercised in the second year and $3.75 if exercised in the third and final year. During March 2004, the Company received gross proceeds of $5,000,000
through the private placement of 3,731,343 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 1,865,671 shares of common
stock at $1.52 per share and six-month callable warrants to purchase 1,865,671
shares of common stock at $1.52 per share. During March 2004, the Company received gross proceeds of $1,000,000
through the private placement of 662,252 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 331,126 shares of common
stock at $1.52 per share and six-month callable warrants to purchase 331,126
shares of common stock at $1.52 per share. The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings. Exclusive
of the transactions discussed in Borrowings above, the Company received
through the exercise of warrants net proceeds of $2,526,317 and $2,541,317
through the issuance of 2,196,797 and 2,221,797 shares of its common stock
during the three and six months ended June 30, 2004, respectively, and
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. Concurrently with their exercise during the six
months ended June 30, 2004, the exercise price of 2,196,797 of the warrants was
reduced from a weighted average of $1.52 per share to $1.15 per share.
Concurrently with their exercise during the six months ended June 30, 2003, the
exercise price of the warrants was reduced from a weighted average of $1.25 per
share to $0.28 per share. At June 30, 2004, the Company had warrants
outstanding to purchase 6,289,536 shares of its common stock at prices that
range from $0.70 to $5.00 per share, with a weighted average of $2.86 per
share. Employees and consultants of the Company have exercised stock options that
had been issued pursuant to the Companys various stock incentive plans. During
the six months ended June 30, 2004 and 2003, the Company received net proceeds
of $58,755 and $15,119, respectively, and issued 109,501 and 62,999 shares of
its common stock, respectively, related to these exercises. 7. 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 mobile/wearable computing and communications systems and software and
service solutions. Revenues by geographical destination as a percentage of total revenues are
as follows: For the Three Months Ended June 30,
    
    For the Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003North America
    
    
    68
    %
    
    
    92
    %
    
    
    80
    %
    
    
    85
    %Europe
    
    
    27
    %
    
    
    8
    %
    
    
    16
    %
    
    
    11
    %Asia, excluding China
    
    
    3
    %
    
    
    0
    %
    
    
    3
    %
    
    
    4
    %China
    
    
    2
    %
    
    
    0
    %
    
    
    1
    %
    
    
    0
    %
 Operations in various geographical areas are summarized as follows: 9




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##### 



As of and for the
    
    As of and for theThree Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003North America:Total revenue
    
    $
    2,303,067
    
    
    $
    2,562,738
    
    
    $
    6,238,244
    
    
    $
    3,892,627Net loss
    
    
    (3,811,392
    )
    
    
    (2,899,802
    )
    
    
    (6,930,984
    )
    
    
    (7,943,421
    )Identifiable assets
    
    
    18,493,873
    
    
    
    15,039,431
    
    
    
    18,493,873
    
    
    
    15,039,431Europe (1):Total revenue
    
    $
    928,249
    
    
    $
    216,364
    
    
    $
    1,199,840
    
    
    $
    515,006Net loss
    
    
    (390,122
    )
    
    
    (332,869
    )
    
    
    (729,241
    )
    
    
    (655,114
    )Identifiable assets
    
    
    1,900,774
    
    
    
    1,025,254
    
    
    
    1,900,774
    
    
    
    1,025,254Asia, excluding China:Total revenue
    
    $
    84,588
    
    
    $
    9,479
    
    
    $
    231,148
    
    
    $
    167,925Net loss
    
    
    (34,019
    )
    
    
    (24,195
    )
    
    
    (63,856
    )
    
    
    (36,809
    )Identifiable assets
    
    
    357,538
    
    
    
    431,213
    
    
    
    357,538
    
    
    
    431,213China (2):Total revenue
    
    $
    64,457
    
    
    $
    
    
    
    $
    105,813
    
    
    $
    Net loss
    
    
    (160,584
    )
    
    
    
    
    
    
    (231,266
    )
    
    
    Identifiable assets
    
    
    65,944
    
    
    
    
    
    
    
    65,944
    
    
    
    
 (1) Included in the Companys operations in Europe for the three months and six
months ended June 30, 2004, were expenses related to research and development
activities conducted by a branch of the Company operating in Germany of
$116,750 and $202,863, respectively, compared to $117,998 and $117,076 for the
same periods in 2003. (2) The Companys operations in China include minority interest of $154,178 for
the three and six months ended June 30, 2004. 8. TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES 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 SixMonths Ended June 30,
    
    Months Ended June 30,2004
    
    2003
    
    2004
    
    2003Revenue:Number of Customers
    
    
    2
    
    
    
    1
    
    
    
    3
    
    
    
    1Percent of Total Revenue
    
    
    42
    %
    
    
    45
    %
    
    
    46
    %
    
    
    31
    %Accounts Receivable:Number of Customers
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    2Percent of Total Accounts Receivable
    
    
    46
    %
    
    
    65
    %
    
    
    46
    %
    
    
    65
    %
 Xybernaut China has entered into an agreement with New Tech & Telecom
Investment Ltd. (New Tech & Telecom). Softbank Strategic, the Companys joint
venture partner in Xybernaut China, is a significant investor in New Tech &
Telecom. Under the terms of the agreement, New Tech & Telecom provides
Xybernaut China with certain operating services (including sales, marketing,
business development, product, fulfillment, accounting and secretarial) and
general and administrative resources (including office space, information
technology, telecommunications and insurance). Xybernaut China is charged
monthly fees totaling approximately $32,000 for such services. The Company
believes that it is able to more effectively and quickly start up operations in
the PRC by outsourcing the majority of its operations to New Tech & Telecom,
which already has a presence and relationships within the PRC. The Company also
evaluated the cost and time required if the Company performed these services
in-house, including expenses and activities related to salary and benefits,
recruitment, training, rent and other overhead. As a result, the Companys
management believes that the arrangement with New Tech & Telecom contains
reasonable terms and conditions. Unrelated to the above agreement, New Tech &
Telecom purchased approximately $76,000 in mobile computing products from the
Company during the six months ended June 30, 2004. 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 10




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##### 



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 months and
six months ended June 30, 2004, the Company recorded revenues of approximately
$60,000 and $258,000, respectively, related to sales of its products to the
VAR. During the three and six months ended June 30, 2004, the Company recorded
total research and development and sales and marketing expenses of
approximately $155,000 and
$315,000, respectively, related to services performed by the End-Users. During
the three months and six months ended June 30, 2003, the Company recorded
revenues of approximately $162,000 and $415,000, 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 approximately $167,000 and $410,000, 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 reasonable terms and
conditions. 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
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 (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
critical enterprise data. The Company offers solutions with a software and
services focus through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(Virginia, U.S.). The Company offers solutions with a hardware focus through
its U.S. operations and through its wholly-owned subsidiaries Xybernaut K.K.
(Yokohama, Japan) and Xybernaut GmbH (Böblingen, Germany). In February 2004,
the Company began actively marketing its mobile and wearable hardware solutions
in the Peoples Republic of China through its 60% ownership in Xybernaut China
Limited (Hong Kong, China), a joint venture with Softbank Investment
International (Strategic) Ltd. (Softbank Strategic). The Company was
originally incorporated in 1990 and completed its initial public offering
(IPO) in July 1996. The consolidated financial statements include the accounts of the Company
and its subsidiaries: Xybernaut Solutions, Inc. (XSI), Xybernaut K.K.,
Xybernaut GmbH and Xybernaut China Limited (Xybernaut China). 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. Since their commercial introductions, the Company has
recognized revenue of approximately $31,000,000 on sales of approximately 9,500
MA and Atigo systems. 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. A number of trends are expected to have a significant effect on the
Companys operations in the future. In the past, many of the Companys large
customers deferred or delayed anticipated purchases of the Companys products
because of uncertain economic conditions and other concerns. Regardless of
economic conditions, potential customers may have concerns about purchases from
smaller vendors. While the Company believes that general economic conditions
began to improve during late 2003 and expects that they will continue to
improve during 2004, there can be no assurance that this expectation will be
realized. If economic conditions and issues persist or worsen, it is possible
that more potential customers will defer, delay or cancel scheduled purchases,
which would have an adverse effect on the Companys revenues and operations. 11




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##### 



A significant percentage of the Companys revenues has typically been
concentrated among a relatively small number of customers. As a result, it is more likely
that the Companys revenues will fluctuate from period to period than if the
Company had a larger number of smaller sales. This also makes it more difficult
for the Company to accurately forecast future revenues. Significant quarterly
fluctuations can occur, for example, if the Company ships a large hardware
order at the beginning of one quarter as opposed to the end of the preceding
quarter. 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 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 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 3G) is still only widely available in certain
areas, including Japan and parts of Europe. In July 2004, AT&T Wireless and NTT
DoCoMo launched 3G service in four U.S. cities and plan to expand into
additional U.S. cities in the future. The Company predicts that 3G service will
be available in large metropolitan areas worldwide in the next few years. The
Company believes that while the commercial markets can 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
consumer markets. RESULTS OF OPERATIONS The following table sets forth certain consolidated financial data as a
percentage of revenues: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of sales
    
    
    82
    
    
    
    65
    
    
    
    79
    
    
    
    67Provision for inventory
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    38Gross income / (loss)
    
    
    18
    
    
    
    35
    
    
    
    21
    
    
    
    (5
    )Operating expenses:Sales and marketing
    
    
    92
    
    
    
    75
    
    
    
    76
    
    
    
    91General and administrative
    
    
    31
    
    
    
    35
    
    
    
    25
    
    
    
    43Research and development
    
    
    30
    
    
    
    31
    
    
    
    25
    
    
    
    44Total operating expenses
    
    
    153
    
    
    
    141
    
    
    
    127
    
    
    
    178Interest and other income / (expense), net
    
    
    1
    
    
    
    (10
    )
    
    
    1
    
    
    
    (6
    )Minority interest
    
    
    5
    
    
    
    0
    
    
    
    2
    
    
    
    0Net loss
    
    
    -130
    %
    
    
    -117
    %
    
    
    -102
    %
    
    
    -189
    %
 THREE MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003 REVENUE. The Company derives its revenue from product sales of mobile/wearable
computers and components, product sales of software and consulting services.
Total revenue for the three months ended June 30, 2004 was $3,380,361, an
increase of $591,780, or 21%, compared to the three months ended June 30, 2003.
Sales from mobile/wearable computers increased $152,919, or 9%, to $1,928,711
for the three months ended June 30, 2004 compared to the same period in 2003.
This increase in hardware revenues was driven by the Companys European
operations, which increased $693,626 from the prior year. This growth was due
to increased sales of Atigo and MA V systems of $669,830 and $116,590,
respectively, which were offset by a decrease in sales of MA TC systems of
$92,794. Hardware sales in the U.S. decreased 39%, or $628,625, in the second
quarter of 2004 compared with the same period in 2003, due to decreases of
$518,035 and $110,590, respectively, in sales of Atigo and MA V systems.
Hardware revenues from Japan, consisting primarily of MA V systems, in the
second quarter of 2004 increased by $24,185 compared with the same period in
2003. Hardware revenues in China, consisting primarily of Atigo and MA V sales,
were $63,733 and $0, respectively, during the three months ended June 30, 2004
and 2003. The Companys consulting, licensing and other revenue for the three
months ended June 30, 2004 was $1,451,650, an increase of $438,861, or 43%,
from revenue for the three months ended June 30, 2003. This increase is largely
due to a $369,678, or 38%, increase in consulting sales related to U.S.
operations due to a new consulting contract and increased activity on an
existing contract in 2004 compared with 2003. COST OF SALES. The Companys cost of sales includes the costs of components for
mobile/wearable computer systems, 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, 2004 was $2,782,236, an
increase of $964,130, or 53%, compared to the three months 12




---



##### 



ended June 30, 2003.
This increase resulted in part from the 21% increase in total revenue for the
three months ended June 30, 2004 compared to the same period in 2003 and in
part due to lower margin hardware sales. Total gross margins were 18% and 35%,
for the second quarter of 2004 and 2003, respectively. Gross margins from
hardware sales for the second quarter of 2004 were -1% compared to 33% for
2003. Second quarter 2004 hardware margins were negatively impacted by a large
European sale of Atigo systems which was approximately break-even after initial
discounts. Also contributing to the decrease in gross margin were negative
margins on sales of MA V systems as well as a general decline in margins on
other Atigo sales. Consulting cost of sales in the second quarter of 2004
compared with 2003 increased $209,703, or 34%, which is less than the 43%
increase in consulting revenue in the same period. As a result, consulting,
licensing and other gross margins increased 5% and were 43% and 38% for the
2004 and 2003 periods, respectively. The increased margins were the result of
favorable billing rates on certain large consulting contracts. SALES AND MARKETING EXPENSES. Sales and marketing expenses for the three months
ended June 30, 2004 were $3,120,381, an increase of $1,016,958, or 48%,
compared to the corresponding period in 2003. In the U.S. operations, sales and
marketing expenses in the second quarter of 2004 relating to salaries,
commissions, and benefits increased approximately $136,000 compared to the same
period in 2003 due primarily to a headcount increase in the sales force.
Additionally, costs related to travel of sales and sales operations
personnel in the U.S. also increased approximately $119,000
supporting the Companys increase in sales activity. In June 2004, the Company
hosted the International Conference for Wearable Computing (ICWC) in Washington
D.C. and an Asian Tech Forum. As a result, conference expenses increased approximately $269,000 for
which there was no such amount in the second quarter of 2003. The U.S.
operations also increased general marketing efforts resulting in an approximate
$91,000 increase in expenses relating to consultants, meetings, advertising and
promotional items. Sales and marketing expenses increased approximately
$330,000 in the second quarter of 2004 compared to the same period in 2003 due
to the start-up of Xybernaut China in the first quarter of 2004. In addition,
sales and marketing expenses related to the Companys operations in Japan
increased $67,000 due to an increase in headcount. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the three months ended June 30, 2004 were $1,031,516, an increase of $55,532,
or 6%, compared to the same period in 2003. This increase resulted primarily
from international travel expenses. 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 mobile and wearable computing technologies. Research
and development expenses for the three months ended June 30, 2004 were
$1,021,336, an increase of $163,143, or 19%, compared to the corresponding
period in 2003. Research and development expenses related to salaries and
benefits, legal review of agreements and travel of personnel in the Companys U.S.
operations increased by approximately $80,000, $40,000 and $29,000,
respectively, while salaries and benefits of the German operations decreased by
$20,000 in the second quarter of 2004 compared to the same period in 2003. The
Company also had an approximate $16,000 increase in expenditures to third
parties and consultants for design and development of the Companys
mobile/wearable product lines for the second quarter of 2004 compared to the
second quarter of 2003. INTEREST AND OTHER INCOME / EXPENSE, NET. Net interest and other income for the
three months ended June 30, 2004 was $24,813, an increase of $314,554 compared
to net interest and other expense of $289,741 for the same period in 2003. This
increase is due to a $321,345 non-cash amortization of a note discount included
in net interest and other expense for the three months ended June 30, 2003 for
which there is no such amount in 2004. MINORITY INTEREST. Minority interest for the three months ended June 30, 2004
was $154,178, which represents Softbank Strategics share of the losses in
Xybernaut China. No such amounts were recorded in the 2003 period. NET LOSS. As a result of the factors described above, the net loss for the
three months ended June 30, 2004 was $4,396,117, an increase of $1,139,251, or
35%, compared to the three months ended June 30, 2003. SIX MONTHS ENDED JUNE 30, 2004 AND JUNE 30, 2003 REVENUE. The Company derives its revenue from product sales of mobile/wearable
computers and components, product sales of software and consulting services.
Total revenue for the six months ended June 30, 2004 was $7,775,045, an
increase of $3,199,487, or 70%, compared to the six months ended June 30, 2003.
Sales from mobile/wearable computers increased $2,265,529, or 87%, to
$4,866,033 for the six months ended June 30, 2004 compared to the same period
in 2003. This growth in hardware revenues was driven by the Companys U.S.
operations, which increased $1,512,449. This growth was due to increased Atigo
and Alternative Solutions sales of $1,345,816 and $374,039, respectively, which
were offset by a $207,406 decrease in sales of the Companys wearable
computers, mainly MA V systems. Alternative Solutions consist of sales of
non-proprietary mobile/wearable hardware based on a customers specific needs
and requirements. European hardware sales increased 154%, or $656,366, in the
first six months of 2004 compared with the same period in 2003, due primarily
to one large sale of Atigo systems. Hardware revenues from Japan, consisting
primarily of MA V systems, in the first six months of 2004 decreased by $9,099
compared with the same period in 2003. Hardware revenues in China, consisting
of Atigo and MA V sales, were $76,336 and $29,477, respectively, for the six
months ended June 30, 2004 and $0 for the same period in 2003. The Companys
consulting, licensing and other revenue for the six months ended June 30, 2004
was $2,909,012, an increase of $933,958, or 47%, from 2003. This increase is
largely due to a $833,168, or 44%, increase in consulting sales related to U.S.
operations from two new contracts and increased activity on other large
consulting contracts in 2004 compared with 2003. COST OF SALES. The Companys cost of sales includes the costs of components for
mobile/wearable computer systems, 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, 2004 was $6,109,706, an
increase of $1,308,240, or 27%, compared to the same period in 13




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##### 



2003. This
increase resulted from the 70% increase in total revenue for the six months
ended June 30, 2004 compared to the same period in 2003, which was offset by a
$1,749,354 provision for inventory and tooling recorded in the first quarter of
2003. No such provision was recorded in 2004. Total gross margins, excluding
the provision for inventory, were 21% and 33%, for the first six months of 2004
and 2003, respectively. Gross margins from hardware sales for the first six
months of 2004 were 8% compared to 30% for 2003. Margins during the first two
quarters of 2004 were negatively impacted by certain low-margin Atigo sales
that were made for strategic purposes as well as lower margin sales on other
Atigo sales. The Company also sold MA V systems at below cost which also
reduced overall hardware gross margins. Consulting cost of sales in the first
six months of 2004 compared to 2003 increased $423,793, or 34%, which is less
than the 47% increase in consulting revenue in the same period. As a result,
consulting, licensing and other gross margins increased 5% and were 43% and 38%
for the 2004 and 2003 periods, respectively. The increased margins were the
result of favorable billing rates on large consulting contracts. SALES AND MARKETING EXPENSES. Sales and marketing expenses for the six months
ended June 30, 2004 were $5,933,513, an increase of $1,792,584, or 43%,
compared to the corresponding period in 2003. In the U.S. operations, sales and
marketing expenses relating to salaries, commissions, benefits and related
recruiting expenses for the six months ended June 30, 2004 increased
approximately $516,000 compared to the same period in 2003 due primarily to a
headcount increase in the sales force and commissions on increased sales.
Additionally, costs related to travel of sales and sales operations
personnel in the U.S. also increased approximately $267,000
supporting the Companys increase in sales activity. In June 2004, the Company
hosted the International Conference for Wearable Computing (ICWC) in Washington
D.C. and an Asian Tech Forum. As a result, conference expenses increased approximately $269,000 for
which there was no such event in the same period in 2003. The U.S. operations
also increased general marketing efforts resulting in an approximate $197,000
increase in expenses relating to consultants, meetings, advertising and
promotional items. Sales and marketing expenses also increased approximately
$415,000 due to the start-up of Xybernaut China in the first half of 2004. The
Companys U.S. operations also incurred approximately $83,000 in costs related
to its participation in the creation and start-up of Xybernaut China. In
addition, sales and marketing expenses related to the Companys operations in
Japan increased $114,000 due to an increase in headcount. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the six months ended June 30, 2004 were $1,954,834, a decrease of $25,800, or
1%, compared to the same period in 2003. During these periods there were not
significant fluctuations in the components that make up general and
administrative expenses. 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 mobile and wearable computing technologies. Research
and development expenses for the six months ended June 30, 2004 were
$1,953,101, a decrease of $47,227, or 2%, compared to the corresponding period
in 2003. This decrease resulted largely from an approximate $205,000 decline in
expenditures to third parties and consultants for design and development of the
Companys mobile/wearable product lines. Offsetting this decrease, research and
development expenses related to salaries and benefits and travel of
personnel in the
Companys U.S. operations increased by $129,000 and $43,000, respectively, from
the six months ended June 30, 2003 to 2004. INTEREST AND OTHER INCOME / EXPENSE, NET. Net interest and other income for the
six months ended June 30, 2004 was $66,584, an increase of $354,129, or 123%,
compared to net interest and other expense of $287,545 for the same period in
2003. This increase is due to a $393,594 non-cash amortization of a note
discount included in net interest and other expense for the six months ended
June 30, 2003 for which there is no such amount in 2004. MINORITY INTEREST. Minority interest for the six months ended June 30, 2004 was
$154,178, which represents Softbank Strategics share of the losses in
Xybernaut China. No such amounts were recorded in the 2003 period. NET LOSS. As a result of the factors described above, the net loss for the six
months ended June 30, 2004 was $7,955,347, a decrease of $679,997 or 8%,
compared to the six months ended June 30, 2003. OTHER OPERATING ACTIVITIES For the six months ended June 30, 2004, the Companys operating activities
used cash of $5,085,754 as a result of its net loss of $7,955,347, offset by an
increase in net working capital of $2,054,669 and non-cash expenses of
$814,924. The Companys investing activities provided cash of $218,566 through
a reduction in restricted cash balances. These operating activities were
primarily funded through the Companys financing activities which provided cash
of $8,561,512 through the private placement of common stock, exercise of
warrants and stock options. As a result, the Companys cash balance increased
to $13,251,416 at June 30, 2004 from $9,524,541 at December 31, 2003. For the six months ended June 30, 2003, the Companys operating activities
used cash of $8,092,832 as a result of its net loss of $8,635,344 and working
capital requirement of $2,763,420, 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
$12,025,077, principally 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. 14




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In December 2003, the IRS filed a tax lien against the Company totaling
$1,132,198. This lien covers taxes, penalties and interest that the IRS alleges
the Company owes related to certain payroll tax filings during 2000. The
Company believes that all such taxes were remitted to the IRS during 2000 and
does not believe that such taxes are still owed to the IRS. The Company is in
ongoing discussions with the IRS related to this matter and has filed returns
and statements with the IRS supporting its position. The Company has received
notification from the IRS that the original amount of the lien was incorrect
and that the IRS has substantially reduced the amount it believes is still
owed. The Company has formally requested that the lien be withdrawn. The
Company believes that the probability of future payment of the taxes is remote
and therefore the Company has not accrued any liability or charges. The Company
believes that any related interest or penalties will not be material. LIQUIDITY AND CAPITAL RESOURCES The Company finances its operations from private sales of its common
stock, borrowings, 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, 2003 and the six months
ended June 30, 2004 are discussed below. Common Stock 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. 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 had 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. 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 had an exercise price of $1.25 if exercised in the first
year, $2.50 if exercised in the second year and $3.75 if exercised in the third
and final year. During September 2003, the Company received gross proceeds of $5,000,000
through a private placement of 6,849,315 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 3,424,658 shares of common
stock. These warrants had an exercise price of $0.91 if exercised in the first
year, $1.82 if exercised in the second year and $2.73 if exercised in the third
and final year. During September 2003, the Company received gross proceeds of $2,000,000
through a private placement of 1,600,000 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 800,000 shares of common
stock. These warrants have an exercise price of $1.25 if exercised in the first
year, $2.50 if exercised in
the second year and $3.75 if exercised in the third and final year. 15




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##### 



During March 2004, the Company received gross proceeds of $5,000,000
through the private placement of 3,731,343 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 1,865,671 shares of common
stock at $1.52 per share and six-month callable warrants to purchase 1,865,671
shares of common stock at $1.52 per share. During March 2004, the Company received gross proceeds of $1,000,000
through the private placement of 662,252 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 331,126 shares of common
stock at $1.52 per share and six-month callable warrants to purchase 331,126
shares of common stock at $1.52 per share. The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings. Exclusive
of the transactions discussed in Borrowings below, the Company received
through the exercise of warrants net proceeds of $2,541,317 and $10,392,282
through the issuance of 2,221,797 and 23,847,427 shares of its common stock
during the six months ended June 30, 2004 and twelve months ended December 31,
2003, respectively. Concurrently with their exercise during the six months
ended June 30, 2004, the exercise price of 2,196,797 of the warrants was
reduced from a weighted average of $1.52 per share to $1.15 per share.
Concurrently with their exercise during the twelve months ended December 31,
2003, the exercise price of 17,116,852 warrants was reduced from a weighted
average of $1.14 per share to $0.34 per share. At June 30, 2004, the Company
had warrants outstanding to purchase 6,289,536 shares of its common stock at
prices that range from $0.70 to $5.00 per share, with a weighted average of
$2.86 per share. Employees and consultants of the Company have exercised stock options that
had been issued pursuant to the Companys various stock incentive plans. During
the six months ended June 30, 2004 and twelve months ended December 31, 2003,
the Company received net proceeds of $58,755 and $109,269, respectively, and
issued 109,501 and 248,996 shares of its common stock, respectively, related to
these exercises. Borrowings On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note which accrued 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 and 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 and interest was repaid on May 30, 2003 through the: i) $89,000
discount, which was applied against the Companys Additional Paid-In Capital,
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, iii)
issuance of 651,351 shares of common stock valued at $241,000, or $0.37 per
share, and iv) issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share, as repayment of accrued interest. 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 amortization of note discount of $387,124 and
$393,594, respectively. The Company had no outstanding principal or interest
related to this note at December 31, 2003 or June 30, 2004. Commitments Inventory.From time to time, the Company has 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s commitments are typically highest during periods of product design
and when the Company is procuring inventory related to anticipated sales. The
Company expects that it will continue to enter into such commitments during
2004 and thereafter as it designs, develops and procures future mobile/wearable
computer product lines. During 2003, the Company entered into an agreement with IBM under which
the Company agreed to purchase approximately $4,900,000 in MA V computing
units, flat panel displays, peripherals and component parts. During 2003 the
Company received all of this inventory and made payments of $4,363,458. During
January 2004, the Company made the final payments required by this agreement. At June 30, 2004, the Company had commitments to purchase approximately
$1,000,000 in inventory related primarily to the Atigo product line. The
Company currently expects to maintain a level of Atigo inventory on hand
approximately equal to this commitment balance. The Company believes that this
level of inventory will provide it with the ability to more rapidly deploy
product to customers and also expects that it can be sold within a reasonable
period after purchase. A significant portion of this inventory will likely
consist of work in process materials. The Company believes there are several
benefits to purchasing work in process materials as opposed to finished goods.
First, the Company typically expects to purchase only the long lead-time or
hard to find components and is therefore able to defer the capital outlay
needed to procure the remaining readily available materials. This strategy also
reduces the risk of obsolescence since component parts are only purchased at
the time they are needed in the manufacturing process, can often be used in
other product lines and can be sold separately if needed. Finally, the Company
maintains flexibility to customize its products based on specific customer
requirements since modifications can be made at the component level prior to
final assembly. Operating Leases.The Company leases operating facilities and equipment
under operating leases expiring on various dates through 2007. 16




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Future minimum
payments under noncancelable operating leases as
of June 30, 2004 are as follows: As of June 30, 20042004
    
    
    425,6442005
    
    
    402,7602006
    
    
    46,7052007
    
    
    23,190$
    898,299
 Other Liquidity and Capital Resources Disclosures At June 30, 2004, the Company had accounts receivable, net of allowances,
of $2,617,249, a decrease of $2,266,650, or 46%, from the December 31, 2003
balance of $4,883,899. This fluctuation is explained partly by the 9% decrease
in total revenues from the quarter ended December 31, 2003 to June 30, 2004.
Also, included in the accounts receivable balance at December 31, 2003 is
$1,554,828 associated with two fourth quarter sales for which the Company
collected the balance in the first quarter of 2004. Typically, the Companys
large hardware sales occur in the last month of the quarter however, in the
second quarter of 2004, $568,865 representing three large sales were
billed and collected during the second quarter. Accounts receivable at June 30,
2004 and December 31, 2003 included $263,251 and $322,152, respectively, of
unbilled accounts receivable representing amounts earned and recorded under the
percentage of completion method of accounting. Included in the December 31,
2003 balance was $297,220 which has been billed in the first two quarters of
2004. The Company expects to bill such amounts in their entirety upon reaching
certain milestones in the contract. At June 30, 2004, the Company had total accounts payable of $2,148,513,
representing a decrease of $919,861 from the December 31, 2003 balance of
$3,068,374. This decrease was primarily due to the first quarter 2004 payments
of liabilities resulting from large 2003 inventory purchases, including the
amounts owed to IBM discussed in the Commitments section. The deferred revenue balances at June 30, 2004 and December 31, 2003
result from billings to customers that were in excess of revenue recognized on
service contracts and from warranty revenue on hardware products. Deferred
revenue on service contracts will be recognized as revenue as the revenue
recognition criteria are met, for example as services are provided. At June 30,
2004 and December 31, 2003, $198,560 and $200,864, respectively, were recorded
as deferred revenue from service contracts, of which $111,487 and $140,858 were
classified as short-term liabilities at June 30, 2004 and December 31, 2003,
respectively. Warranty revenue on hardware products is recorded as deferred
revenue and recognized on a straight-line basis over the life of the warranty.
At June 30, 2004 and December 31, 2003, $381,246 and $295,774, respectively,
were recorded as deferred revenue from warranties, of which $193,507 and
$163,754, were classified as long-term liabilities at June 30, 2004 and
December 31, 2003, respectively. The Company has recorded net losses since its inception. 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.
The Companys revenues and gross margins have not been sufficient to fund these
operating activities. As a result, the Company has consistently reported
negative cash flows from operating activities and net losses and had an
accumulated deficit of $157,562,735 at June 30, 2004. 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 2004,
the Company funded its operating 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 operations and raise additional capital, both of which are needed to
meet its cash flow needs through December 31, 2004 and thereafter. During 2002
and 2003, management performed reviews of the Companys operations and
implemented various cost cutting programs to reduce the Companys operating
expenses to better align costs with current and expected business volume.
The Companys management currently estimates that future
operating expenses will approximate or exceed the level recorded
during the current quarter but there can be no assurances that actual
operating expenses during 2004 or later periods will not increase
significantly. Future increases may also occur as a result of the Companys
research and development activities, which will vary depending on the Companys
wearable and mobile computer product development cycle,
as well as sales, marketing and other activities. Additionally, the Companys
new operations in China will increase the Companys operating
expenses. The Company is also required to fund inventory procurement
and other cash expenditures. Management believes that the Companys current staffing and resources
will be sufficient to carry out its business plan for the foreseeable future. Management expects to fund these activities
through cash on hand, gross profits and 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 warrants, the exercise prices have been
reduced. Such reduction has resulted in the issuance of substantially more
shares of common stock than would have occurred had the exercise 17




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##### 



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 and historical 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. During the twelve months ended December 31, 2003 and the six months ended
June 30, 2004, the Company raised approximately $35 million through sales of
its common stock to institutional investors, through warrant and stock option
exercises and through borrowings. 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. The Companys Certificate of Incorporation
limits its ability to issue more than 200,000,000 shares of common stock. The
Company will be required to obtain shareholder approval to increase this
number. There can be no assurance that such approval will be obtained. A
limitation on the number of authorized shares may hinder the Companys ability
to obtain additional equity financing. The Companys management believes that the combination of cash on hand,
cash flows from operations and outside additional funding from third party
investors will provide sufficient liquidity to meet the Companys ongoing cash
requirements. This is based on the Companys historical ability to raise funds
in the form of debt and equity financings. 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. 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 would be able to reduce spending if required,
however, there can be no assurances that it can successfully do so. Contractual Obligations and Commercial Commitments The Companys significant contractual obligations as of June 30, 2004 are
for lease payments related to a reduction in facilities classified as
restructuring in 2002, operating leases (primarily for office space), inventory
commitments and a five-year services agreement under which the
Company agreed to pay approximately $200,000 per year for certain sales,
marketing and joint business development services. The Company can terminate
this services agreement with a 90 day notice. Payments Due by PeriodsTotal
    
    Less than 1 year
    
    1-3 years
    
    3-5 yearsRestructuring Liability
    
    $
    88,711
    
    
    $
    61,079
    
    
    $
    27,632
    
    
    $
    Operating Leases
    
    
    898,299
    
    
    
    425,644
    
    
    
    472,655
    
    
    
    Services Agreement
    
    
    1,000,000
    
    
    
    200,000
    
    
    
    400,000
    
    
    
    400,000Inventory Commitments
    
    
    1,000,000
    
    
    
    1,000,000
    
    
    
    
    
    
    
    $
        2,987,010
    
    
    $
    1,686,723
    
    
    $
        900,287
    
    
    $
    400,000
 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, 2004. 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,
European Euro and Hong Kong Dollar or in which the U.S. Dollar equivalent is
determined by the values of such currencies. The Company began operations in
China in February 2004. 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,
2004, the Companys operations in Europe comprised 27% and 15% of its total
revenue and 9% and 9% of its net loss, respectively, compared to 8% and 11% of
its total revenue and 10% and 8% of its net loss, respectively, in the same
periods for 2003. For the three and six months ended June 30, 2004, the
Companys operations in Asia, excluding China, comprised 3% of its total
revenue and 1% of its net loss, respectively, compared to 0% and 4% of its
total revenue and 1% and 0% of its net loss, respectively, in the same period
for 2003. For the three and six months ended June 30, 2004, the Companys
operations in China comprised 2% and 1% of its total revenue and 4% and 3% of
its net loss, respectively. At June 30, 2004, the Companys assets in Europe,
Asia (excluding China), and China comprised 9%, 2% and 0% of its total assets,
respectively, compared to 6%, 3% and 0% of its total assets at June 30, 2003,
respectively. According to published sources, the average fluctuation of the
European 18




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##### 



Euro during the three and six months ended June 30, 2004 was -1.0% and
-2.3%, respectively, compared to 3.9% and 4.9% for the same period in 2003,
respectively. According to published sources, the average fluctuation of the
Japanese Yen during the three and six months ended June 30, 2004 was -3.7% and
-1.3%, respectively, compared to 0.0% and 0.1% for the same period in 2003,
respectively. According to published sources, the average fluctuation of the
Hong Kong Dollar during the three and six months ended June 30, 2004 was 0.0%
and -0.3%, respectively. Management believes that these fluctuations did not
have a material impact on the Companys results of operations or financial
position for 2004 and 2003. INTEREST RATE SENSITIVITY From time to time, 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 2004 was
4.04%, compared to a 4.25% average prime interest rate during the same periods
in 2003, respectively. For 2004 and 2003, the prime interest rate fluctuation
from January 1 to June 30 of each year was 0.25% and 0.0%, respectively.
Management believes that these fluctuations did not have a material impact on
the Companys results of operations or financial position for 2004 and 2003. ITEM 4. CONTROLS AND PROCEDURES As of the end of the fiscal quarter ended June 30, 2004, 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 Rule 13a-15. Based upon that evaluation, the Chief Executive
Officer, Chief Financial Officer and President concluded that the Companys
disclosure controls and procedures are effective, as of such date, to ensure
that required information will be disclosed on a timely basis in its reports
under the Exchange Act. There were no significant changes in the Companys internal control over
financial reporting during the last quarter that have materially affected, or
are reasonably likely to materially affect, the Companys internal control over
financial reporting. PART II  OTHER INFORMATION ITEM 1: LEGAL PROCEEDINGS The Company is involved in litigation with Zykronix, Inc. in the Circuit
Court of Fairfax, Virginia. In that action, Zykronix filed suit against the
Company seeking payment of $238,000 allegedly owed by the Company to Zykronix.
The Company filed a counter suit against Zykronix seeking $1,700,000 in damages
for defective products. The Virginia suit is currently pending. Zykronix has
brought a separate action related to this same matter in the District Court for
the City and County of Denver, Colorado. In the Colorado action, Zykronix
filed suit against Edward G. Newman, the Companys Chairman and Chief Executive
Officer, seeking enforcement of a personal guaranty that Mr. Newman provided to
Zykronix on the behalf of the Company to guaranty liabilities allegedly owed by
the Company to Zykronix. Whether or not any such amounts are owed by the
Company to Zykronix is the subject of the Virginia action. In April 2004, the
Denver District Court entered an Order of Judgment in favor of Zykronix and
against Mr. Newman in the amount of $170,053. In May 2004, the Denver District
Court entered a separate Order awarding Zykronix an additional $1,902 in
attorneys fees and costs against Mr. Newman. Mr. Newman has appealed both
Orders to the Colorado Court of Appeals. The Denver District Court has entered
a stay of execution of the Orders pending the outcome of the appeal. Based on
the pendency of the appeal, the Company, on Mr. Newmans behalf, furnished a
cash supersedeas bond in the amount of $206,750 to the Denver District Court in
July 2004. The cash supersedeas bond will be returned to the Company in the
event of a successful appeal. The Company believes that it has substantive
defenses in the Virginia action, and that Mr. Newman has grounds for appeal in
the Denver action, and that no amounts will ultimately be owed to Zykronix by
the Company or Mr. Newman. Mr. Newman intends vigorously to pursue his appeal
in the Denver action and the Company is vigorously defending, and expects to
continue to vigorously defend, the Virginia action. In December 2003, the Company filed a lawsuit against Viewsonic
Corporation (Viewsonic) in the United States District Court for the Eastern
District of Virginia. The suit alleged that Viewsonic infringed the Companys
U.S. Patent Number 6,421,232 B2, one of the Companys Dual-Use Computing Device
patents (the 232 Patent). The suit requested unspecified damages and an
injunction against Viewsonic from infringing the 232 Patent.
Effective July 23, 2004, the Company and ViewSonic entered into a Settlement and License
Agreement (the Agreement) which settled the lawsuit. Pursuant to the
Agreement, ViewSonic paid to the Company the amount of $237,500 in exchange for
the grant of a non-exclusive license to ViewSonic to make, use, sell, export,
import or dispose of articles covered by the 232 Patent and the continuations,
extensions or renewals thereof. Pursuant to the Agreement, ViewSonic and the
Company have exchanged mutual releases and have agreed to dismiss the action. The Company is involved in routine legal and administrative proceedings
and claims of various types. The Company has no material pending legal or
administrative proceedings, other than as discussed above or ordinary routine
litigation incidental to the Companys business, to which the Company or any of
its subsidiaries is a party or of which any property is the subject. While any
proceeding or claim contains an element of uncertainty, management does not
expect that any such proceeding or claim will have a material adverse effect on
the Companys results of operations or financial position. ITEM 2: CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES None. ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K A) EXHIBITS 31.1
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.3
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232
    
    Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 B) REPORTS ON FORM 8-K On May 4, 2004, the Company filed a Report on Form 8-K under Items 7 and
12 disclosing a press release that was issued announcing the Companys
financial results for the fiscal quarter ended March 31, 2004. 19




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##### 



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 CORPORATIONBy:
/s/ EDWARD G. NEWMANEdward G. NewmanChief Executive Officer andChairman of the Board of DirectorsBy: /s/ THOMAS D. DAVISThomas D. DavisSenior Vice President andChief Financial OfficerBy: /s/ STEVEN A. NEWMANSteven A. NewmanPresident, Chief Operating Officer andVice Chairman of the Board of DirectorsDate: August 6, 2004
 20