##### 



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 SEPTEMBER 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 November 4, 2004 was 179,202,035.




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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
    
    
    3Condensed Consolidated Statements of Operations
    
    
    4Condensed Consolidated Statements of Cash Flows
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2 - Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3 - Quantitative and Qualitative Disclosures about Market Risk
    
    
    21Item 4 - Controls and Procedures
    
    
    22PART II  OTHER INFORMATIONItem 1- Legal Proceedings
    
    
    23Item 2 - Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    23Item 6 - Exhibits
    
    
    23SIGNATURES
    
    
    24
 2




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##### 



PART I  FINANCIAL INFORMATION
Item 1  Financial Statements XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)September 30,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    6,007,537
    
    
    $
    9,524,541Restricted cash
    
    
    706,750
    
    
    
    1,257,554Accounts receivable, net of allowances of $533,436 and $557,679
    
    
    3,203,146
    
    
    
    4,883,899Inventory, net of reserves of $3,272,716 and $3,272,716
    
    
    2,637,345
    
    
    
    2,131,436Prepaid and other current assets
    
    
    2,409,136
    
    
    
    984,425Total current assets
    
    
    14,963,914
    
    
    
    18,781,855Long-term assets:Property, equipment and demonstration units, net
    
    
    650,721
    
    
    
    382,792Patent costs, net of accumulated amortization of $2,303,101
and $1,963,971
    
    
    914,798
    
    
    
    945,126Other
    
    
    540,080
    
    
    
    710,294Total long-term assets
    
    
    2,105,599
    
    
    
    2,038,212Total assets
    
    $
    17,069,513
    
    
    $
    20,820,067LIABILITIES AND STOCKHOLDERS EQUITYLiabilities:Current liabilities:Accounts payable
    
    $
    2,469,693
    
    
    $
    3,068,374Accrued expenses and other
    
    
    1,513,905
    
    
    
    1,283,200Deferred revenue
    
    
    230,379
    
    
    
    332,884Total current liabilities
    
    
    4,213,977
    
    
    
    4,684,458Long-term liabilities:Restructuring liability
    
    
    13,610
    
    
    
    62,330Deferred revenue
    
    
    320,167
    
    
    
    163,754Total long-term liabilities
    
    
    333,777
    
    
    
    226,084Total liabilities
    
    $
    4,547,754
    
    
    $
    4,910,542Minority interest
    
    $
    392,799
    
    
    $
    Commitments and contingenciesStockholders equity:Common stock, $0.01 par value, 200,000,000
shares authorized, 179,191,042 and 172,358,223
shares issued and outstanding
    
    
    1,791,910
    
    
    
    1,723,582Additional paid-in capital
    
    
    171,993,118
    
    
    
    163,362,829Foreign currency translation
    
    
    448,893
    
    
    
    430,502Accumulated deficit
    
    
    (162,104,961
    )
    
    
    (149,607,388
    )Total stockholders equity
    
    $
    12,128,960
    
    
    $
    15,909,525Total liabilities and stockholders equity
    
    $
    17,069,513
    
    
    $
    20,820,067
 The accompanying notes are an integral part of these
condensed consolidated financial statements 3




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##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Revenue:Hardware
    
    $
    1,587,442
    
    
    $
    1,621,532
    
    
    $
    6,453,475
    
    
    $
    4,222,036Consulting, licensing and other
    
    
    1,657,400
    
    
    
    1,081,589
    
    
    
    4,566,412
    
    
    
    3,056,643Total revenue
    
    
    3,244,842
    
    
    
    2,703,121
    
    
    
    11,019,887
    
    
    
    7,278,679Cost of sales:Hardware
    
    
    1,461,584
    
    
    
    1,302,490
    
    
    
    5,917,636
    
    
    
    3,124,741Consulting, licensing and other
    
    
    893,562
    
    
    
    690,998
    
    
    
    2,547,216
    
    
    
    1,920,859Provision for inventory and tooling
    
    
    
    
    
    
    1,500,000
    
    
    
    
    
    
    
    3,249,354Gross income / (loss)
    
    
    889,696
    
    
    
    (790,367
    )
    
    
    2,555,035
    
    
    
    (1,016,275
    )Operating expenses:Sales and marketing
    
    
    3,516,368
    
    
    
    2,058,762
    
    
    
    9,449,880
    
    
    
    6,199,691General and administrative
    
    
    1,250,291
    
    
    
    1,042,583
    
    
    
    3,205,126
    
    
    
    3,023,217Research and development
    
    
    789,197
    
    
    
    708,520
    
    
    
    2,742,298
    
    
    
    2,708,848Total operating expenses
    
    
    5,555,856
    
    
    
    3,809,865
    
    
    
    15,397,304
    
    
    
    11,931,756Operating loss
    
    
    (4,666,160
    )
    
    
    (4,600,232
    )
    
    
    (12,842,269
    )
    
    
    (12,948,031
    )Interest and other income / (expense), net
    
    
    20,244
    
    
    
    (74,007
    )
    
    
    86,828
    
    
    
    (361,552
    )Loss before minority interest
    
    
    (4,645,916
    )
    
    
    (4,674,239
    )
    
    
    (12,755,441
    )
    
    
    (13,309,583
    )Minority interest
    
    
    103,690
    
    
    
    
    
    
    
    257,868
    
    
    
    Net loss
    
    $
    (4,542,226
    )
    
    $
    (4,674,239
    )
    
    $
    (12,497,573
    )
    
    $
    (13,309,583
    )Net loss per share (basic and diluted)
    
    $
    (0.03
    )
    
    $
    (0.03
    )
    
    $
    (0.07
    )
    
    $
    (0.10
    )Weighted average number of shares
outstanding (basic and diluted)
    
    
    179,160,879
    
    
    
    158,635,685
    
    
    
    176,637,760
    
    
    
    138,485,139
 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) Nine Months Ended September 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (12,497,573
    )
    
    $
    (13,309,583
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    760,724
    
    
    
    1,520,926Provision for bad debts
    
    
    100,000
    
    
    
    Provision for inventory and tooling
    
    
    
    
    
    
    3,249,354Loss on disposal of assets
    
    
    
    
    
    
    38,341Non-cash charges for equity securities issued for services
    
    
    123,467
    
    
    
    202,980Amortization of note discount
    
    
    
    
    
    
    393,594Minority interest
    
    
    (257,868
    )
    
    
    Changes in assets and liabilities:Inventory
    
    
    (23,914
    )
    
    
    (2,815,251
    )Accounts receivable
    
    
    1,576,056
    
    
    
    1,228,285Prepaid and other current assets
    
    
    (1,633,138
    )
    
    
    130,906Other assets
    
    
    146,784
    
    
    
    (59,852
    )Accounts payable
    
    
    (594,565
    )
    
    
    (775,453
    )Accrued expenses and other
    
    
    230,927
    
    
    
    (53,906
    )Deferred revenue, current
    
    
    38,352
    
    
    
    268,445Restructuring liability, long-term
    
    
    (47,438
    )
    
    
    (60,641
    )Deferred revenue, long-term
    
    
    15,556
    
    
    
    (69,315
    )Net cash used in operating activities
    
    $
    (12,062,630
    )
    
    $
    (10,111,170
    )Cash flows from investing activities:Acquisition of property, equipment and demonstration units
    
    
    (608,080
    )
    
    
    (256,012
    )Acquisition of patents and trademarks
    
    
    (308,802
    )
    
    
    (211,156
    )Restricted cash
    
    
    550,804
    
    
    
    (376,111
    )Capitalization of tooling costs
    
    
    
    
    
    
    (20,000
    )Net cash used in investing activities
    
    $
    (366,078
    )
    
    $
    (863,279
    )Cash flows from financing activities:Proceeds from:Common stock offerings, net
    
    
    5,961,440
    
    
    
    13,770,035Exercise of warrants
    
    
    2,541,317
    
    
    
    6,445,343Exercise of stock options
    
    
    65,717
    
    
    
    26,878Notes and loans
    
    
    
    
    
    
    1,750,000Payments for:Capitalization of loan costs
    
    
    
    
    
    
    (18,376
    )Net cash provided by financing activities
    
    $
    8,568,474
    
    
    $
    21,973,880Effect of exchange rate changes on cash and cash equivalents
    
    
    343,230
    
    
    
    95,912Net (decrease) / increase in cash and cash equivalents
    
    
    (3,517,004
    )
    
    
    11,095,343Cash and cash equivalents, beginning of period
    
    
    9,524,541
    
    
    
    1,967,710Cash and cash equivalents, end of period
    
    $
    6,007,537
    
    
    $
    13,063,053Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    579
    
    
    $
    579Cash paid for taxes
    
    $
    631
    
    
    $
    585Supplemental disclosure of non-cash financing activities:Equity securities issued for services rendered, expensed
in periods issued
    
    $
    123,467
    
    
    $
    202,980Equity 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 September
30, 2004 and December 31, 2003, the results of their operations for the three
and nine months ended September 30, 2004 and 2003 and cash flows for the nine
months ended September 30, 2004 and 2003. Results of operations for the three
and nine months ended September 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 $32,000,000 on sales of approximately 9,700
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 $162,104,961 at September 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 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. 6




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Cash, Cash Equivalents and Restricted Cash The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. At
September 30, 2004 and December 31, 2003, the Company had $706,750 and
$1,257,554, respectively, in restricted cash. The balance at September 30, 2004
consisted of a i) $500,000 cash deposit that secures a long-term services
contract and ii) $206,750 cash supersedeas bond furnished in July 2004 to the
Denver District Court related to pending litigation. 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 the middle of 2005, 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 September 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 nine months ended September 30, 2003, the Company recognized a
$3,249,354 charge on its consolidated statement of operations related to
reserves established against its MA V inventory, related components and
tooling. The Company did not recognize any such charges during the 2004 period. The Company had a $3,272,716 inventory reserve on its consolidated balance
sheet at both September 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 mobile/wearable
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 the Companys inventory that has
been written down or reserved. As of September 30, 2004, net of the effect of reserves and write-offs,
the Companys inventory consisted of $933,941 in MA V systems, $331,386 in MA
TC systems and $1,372,018 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 nine months ended September 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 $10,243 and $124,006 for the three and nine
months ended September 30, 2004 and $180,943 and $299,431 for the three and
nine months ended September 30, 2003, respectively. 7




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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: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (4,542,226
    )
    
    $
    (4,674,239
    )
    
    $
    (12,497,573
    )
    
    $
    (13,309,583
    )Stock-based employee compensation under the
intrinsic value method included in net loss as reported
    
    
    5,521
    
    
    
    
    
    
    
    28,475
    
    
    
    150,325Stock-based employee compensation under fair value
method of SFAS No. 123
    
    
    (168,482
    )
    
    
    (473,931
    )
    
    
    (450,838
    )
    
    
    (1,367,389
    )Net loss pro forma
    
    $
    (4,705,187
    )
    
    $
    (5,148,170
    )
    
    $
    (12,919,936
    )
    
    $
    (14,526,647
    )Net loss per share basic and diluted  as reported
    
    $
    (0.03
    )
    
    $
    (0.03
    )
    
    $
    (0.07
    )
    
    $
    (0.10
    )Net loss per share basic and diluted  pro forma
    
    $
    (0.03
    )
    
    $
    (0.03
    )
    
    $
    (0.07
    )
    
    $
    (0.10
    )
 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 nine months ended September 30, 2004, equity securities related to
consulting services and employee severance were issued in payment of $38,883
and $123,467, respectively, compared to $39,905 and $202,980 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 nine
months ended September 30, 2003, the Company recorded interest expense of $0
and $11,229, respectively. During the three and nine months ended September 30,
2003, the Company recorded amortization of note discount of $0 and $393,594,
respectively. The Company had no outstanding principal or interest related to
this note at September 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 nine months ended September
30, 2004 include the operations of Xybernaut China. During the nine months
ended September 30, 2004, Softbank Strategic provided funding to Xybernaut
China of $650,667, which amount was recorded as Minority Interest on the
Companys consolidated balance sheet net of foreign currency fluctuation and
reduced by Softbank Strategics $257,868 share of Xybernaut Chinas net loss. 8




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##### 



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. 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. 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 $0 and $2,541,317 through the
issuance of 0 and 2,221,797 shares of its common stock during the three and
nine months ended September 30, 2004, respectively, and proceeds of $3,191,176
and $6,445,343 through the issuance of 7,722,768 and 19,597,769 shares of its
common stock during the three and nine months ended September 30, 2003,
respectively. Concurrently with their exercise during the nine months ended
September 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 nine months ended September 30, 2003, the
exercise price of 16,316,852 of the warrants was reduced from a weighted
average of $1.13 per share to $0.31 per share. At September 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 nine months ended September 30, 2004 and 2003, the Company received net
proceeds of $65,717 and $26,878, respectively, and issued 132,418 and 111,995
shares of its common stock, respectively, related to these exercises. 9




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##### 



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
    For the Nine Months EndedSeptember 30,
    September 30,2004
    
    2003
    
    2004
    
    2003North America
    
    
    79
    %
    
    
    87
    %
    
    
    79
    %
    
    
    86
    %Europe
    
    
    16
    %
    
    
    11
    %
    
    
    16
    %
    
    
    11
    %Asia, excluding China
    
    
    3
    %
    
    
    2
    %
    
    
    3
    %
    
    
    3
    %China
    
    
    2
    %
    
    
    0
    %
    
    
    2
    %
    
    
    0
    %
 Operations in various geographical areas are summarized as follows: As of and for the
    
    As of and for theThree Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003North America:Total revenue
    
    $
    2,553,316
    
    
    $
    2,372,537
    
    
    $
    8,791,560
    
    
    $
    6,265,164Net loss
    
    
    3,880,154
    
    
    
    4,346,372
    
    
    
    10,811,138
    
    
    
    12,289,793Identifiable assets
    
    
    14,167,787
    
    
    
    20,093,756
    
    
    
    14,167,787
    
    
    
    20,093,756Europe (1):Total Revenue
    
    $
    514,127
    
    
    $
    288,050
    
    
    $
    1,713,967
    
    
    $
    803,056Net loss
    
    
    470,174
    
    
    
    277,212
    
    
    
    1,199,415
    
    
    
    932,326Identifiable assets
    
    
    2,414,948
    
    
    
    1,072,214
    
    
    
    2,414,948
    
    
    
    1,072,214Asia, excluding China:Total revenue
    
    $
    107,693
    
    
    $
    42,534
    
    
    $
    338,841
    
    
    $
    210,459Net loss
    
    
    36,372
    
    
    
    50,655
    
    
    
    100,228
    
    
    
    87,464Identifiable assets
    
    
    376,203
    
    
    
    425,359
    
    
    
    376,203
    
    
    
    425,359China (2):Total revenue
    
    $
    69,706
    
    
    $
    
    
    
    $
    175,519
    
    
    $
    Net loss
    
    
    155,526
    
    
    
    
    
    
    
    386,792
    
    
    
    Identifiable assets
    
    
    110,575
    
    
    
    
    
    
    
    110,575
    
    
    
    
 (1) Included in the Companys operations in Europe for the three months and
nine months ended September 30, 2004, were expenses related to research and
development activities conducted by a branch of the Company operating in
Germany of $115,286 and $318,149, respectively, compared to $61,132 and
$178,208 for the same periods in 2003. (2) The Companys operations in China include minority interest of $103,690 and
$257,868 for the three and nine months ended September 30, 2004, respectively. 10




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##### 



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 NineMonths Ended September 30,
    
    Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Revenue:Number of Customers
    
    
    1
    
    
    
    2
    
    
    
    2
    
    
    
    2Percent of Total Revenue
    
    
    12
    %
    
    
    43
    %
    
    
    25
    %
    
    
    38
    %Accounts Receivable:Number of Customers
    
    
    1
    
    
    
    2
    
    
    
    1
    
    
    
    2Percent of Total Accounts Receivable
    
    
    26
    %
    
    
    48
    %
    
    
    26
    %
    
    
    48
    %
 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 fees
totaling approximately $32,000 per month 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 nine months ended September 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 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 nine months ended September 30, 2004, the
Company recorded revenues of approximately $106,000 and $363,000, respectively,
related to sales of its products to the VAR. During the three and nine months
ended September 30, 2004, the Company recorded total research and development
and sales and marketing expenses of approximately $29,000 and $344,000,
respectively, related to services performed by the End-Users. During the three
months and nine months ended September 30, 2003, the Company recorded revenues
of approximately $163,000 and $577,000, respectively, related to sales of its
products to the VAR. During the three and nine months ended September 30, 2003,
the Company recorded total research and development and sales and marketing
expenses of approximately $181,000 and $591,000, 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. 11




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##### 



9. SUBSEQUENT EVENT The Company entered into a Development, Manufacturing and Distribution
Agreement dated as of November 1, 2004 (the Manufacturing Agreement) with
Shenzhen Sunshine Hi-Tech Co. Ltd. (Sunshine), pursuant to which, among other
things, Sunshine has agreed to develop and manufacture, at its most favorable
prices, current and future products on behalf of the Company, in accordance
with the Companys specifications and technical requirements, for an initial
five year term. With respect to products developed to the Companys
satisfaction, the Company shall have a royalty-free license to market such
products worldwide, excluding the PRC, and Xybernaut China and Sunshine shall
have a royalty-free license (which is non-assignable in the case of Sunshine)
to market such products in the PRC. Sunshine has also guaranteed to invest
adequate funding in manufacturing of products as required by the Company.
Under the Manufacturing Agreement, Sunshine also granted the Company an
exclusive license to sell Sunshines operating system, which is used in China,
when used with existing or future Company products, throughout the world (other
than the PRC) for a royalty. In connection with, and as a part of the Manufacturing Agreement the
Company entered into a Securities Exchange Agreement dated as of November 1,
2004, as a supplementary agreement (the Exchange Agreement), with the
majority stockholders of Sunshine (the Investor Group) pursuant to which,
among other things, the Company, or at its option, Xybernaut China, acquired
twenty-four and nine-tenths percent (24.9%) of the equity interests of
Sunshine, on an as converted, fully diluted basis, in exchange for the issuance
to the Investor Group of such number of restricted shares of the Companys
common stock, par value $0.01 per share, having a market value of US$2,000,000,
which number of shares was based upon the average closing price of the
Companys common stock on the NASDAQ SmallCap Market for the twenty (20)
trading days immediately prior to the closing under the Exchange Agreement. The other documentation for the transaction provides that the Company has
the right to designate one member to the Board of Directors of Sunshine and
additional directors under certain circumstances. In addition, the Company has
the right to purchase additional equity securities of Sunshine to maintain its
percentage equity interest and the right to include its securities on any
registration or listing of Sunshine common stock for sale in any public
marketplace. In connection with the Exchange Agreement, the Company executed a
Registration Rights Agreement, dated as of November 1, 2004, by and between the
Company and the Investor Group, pursuant to which the Company is obligated to
use reasonable efforts to file a registration statement to register for resale
the shares of common stock issued to the Investor Group with the Securities and
Exchange Commission on or before December 31, 2004, and use its best efforts to
cause such registration statement to be declared effective by the Securities
and Exchange Commission not later than January 30, 2005. 12




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##### 



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 sales and 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
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 $32,000,000 on sales of approximately 9,700
MA and Atigo systems. The Company derives its revenues from sales of its
mobile/wearable computers and software products, consulting services and
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 2004 and expects that they will continue to improve
during 2005, 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 delay or cancel purchases, which would have an adverse
effect on the Companys revenues and operations. 13




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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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of sales
    
    
    73
    
    
    
    74
    
    
    
    77
    
    
    
    69Provision for inventory and tooling
    
    
    0
    
    
    
    55
    
    
    
    0
    
    
    
    45Gross income / (loss)
    
    
    27
    
    
    
    (29
    )
    
    
    23
    
    
    
    (14
    )Operating expenses:Sales and marketing
    
    
    108
    
    
    
    76
    
    
    
    86
    
    
    
    85General and administrative
    
    
    39
    
    
    
    39
    
    
    
    29
    
    
    
    42Research and development
    
    
    24
    
    
    
    26
    
    
    
    25
    
    
    
    37Total operating expenses
    
    
    171
    
    
    
    141
    
    
    
    140
    
    
    
    164Interest and other income / (expense), net
    
    
    1
    
    
    
    (3
    )
    
    
    1
    
    
    
    (5
    )Minority interest
    
    
    3
    
    
    
    0
    
    
    
    2
    
    
    
    0Net loss
    
    
    (140
    %)
    
    
    (173
    %)
    
    
    (113
    %)
    
    
    (183
    %)
 THREE MONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003 REVENUE. The Company derives its revenue from product sales of mobile/wearable
computers and components, product sales of software, consulting services and
licensing of its intellectual property. Total revenue for the three months
ended September 30, 2004 was $3,244,842, an increase of $541,721, or 20%,
compared to the three months ended September 30, 2003. This increase is due to
the Companys consulting, licensing and other revenue which increased 53% to
$1,657,400 for the three months ended September 30, 2004 compared to the same
period in 2003. Included in consulting, licensing and other revenue in the
third quarter of 2004 is $237,500 in cash received by the Company related to
the settlement of a lawsuit for which the Company was the plaintiff that
resulted in the grant of a non-exclusive license of one of the Companys
Dual-Use Computing Device patents. No similar amounts were recorded in the
2003 period. The remaining increase in the Companys consulting, licensing and
other revenue is due to increased consulting services in its U.S. operations on
new consulting contracts and increased activity on existing contracts in 2004
compared with 2003. Sales from mobile/wearable computers decreased $34,090, or
2%, to $1,587,442 for the three months ended September 30, 2004 compared to
2003. This decrease in hardware sales is due to several factors. Hardware sales
in the Companys U.S. operations decreased 24%, or $333,830, in the third
quarter of 2004 compared with the same period in 2003. This fluctuation is due
to a $597,934 decrease in 2004 sales of MA V systems compared to 2003 when the
Company had a large sale of MA V systems. This decrease is offset by increases
of $204,204 and $59,900 in U.S. sales of Atigo systems and Alternative
Solutions sales, respectively, in the third quarter of 2004 compared to 2003.
Alternative Solutions consist of sales of non-proprietary mobile/wearable
hardware based on a customers specific needs and requirements. Hardware
revenues in the Companys European operations increased $212,547 from the prior
year. This growth was due to a large Atigo system sale in the third quarter of
2004 resulting in an increase of $374,367 compared to
the same period in 2003. This increase was offset by a decrease in sales of MA
V, MA IV and MA TC systems of $161,820. Hardware revenues from Japan,
consisting primarily of MA V systems, in the third quarter of 2004 increased by
$17,487 compared with the same period in 2003. Hardware revenues in China,
consisting primarily of Atigo and MA V sales, were $69,706 and $0,
respectively, during the three months ended September 30, 2004 and 2003. 14




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##### 



COST OF SALES. The Companys cost of sales includes the costs of components for
mobile/wearable computer systems, purchased software, direct labor and
fringe, direct 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 September 30, 2004 was $2,355,146, a decrease of $1,138,342,
or 33%, compared to the three months ended September 30, 2003.
Total gross margins were 27% and -29%, for the third quarter of 2004 and 2003, respectively. The negative 2003 gross margin
was due to a $1,500,000 provision for inventory and tooling recorded in the third quarter
of 2003 for which there is no such charge for the third quarter of 2004.
Total gross margins, excluding the provision for inventory and tooling, were 27% and 26%,
for the three months ended September 30, 2004 and 2003, respectively. Hardware cost of sales
increased $159,094 for
the third quarter of 2004 compared to the same period of in 2003, resulting in
decreased hardware margins. Gross margins from hardware sales
for the third quarter of 2004 were 8% compared to 20% for 2003. Third quarter
2004 hardware margins were negatively impacted by a large European sale of
Atigo systems which was approximately break-even after initial discounts and
also by a general decline in margins on other Atigo sales. Also contributing to
the decrease in gross margins were Atigo and MA V systems provided free of
charge for customer satisfaction purposes and unrecouped shipping charges
totaling approximately $100,000. Absent these factors, hardware gross margins
for the three months ended September 30, 2004 were 14%. Cost of sales from
consulting, licensing and other activities increased $202,564, or 29%, in the
third quarter of 2004 compared with 2003, which is less than the 53% increase
in related revenue. As a result, consulting, licensing and other gross margins
increased to 46% in 2004 from 36% in 2003. The increase is attributable to the
$237,500 of licensing revenue recorded in 2004 related to the grant of a
non-exclusive license of a patent for which there is no related cost of sales.
Excluding this $237,500, gross margins on consulting, licensing and other
activities remained consistent at 37% and 36% for the 2004 and 2003 third
quarters, respectively. SALES AND MARKETING EXPENSES. Sales and marketing expenses for the three months
ended September 30, 2004 were $3,516,368, an increase of $1,457,606, or 71%,
compared to the corresponding period in 2003. In the U.S. operations, sales and
marketing expenses in the third quarter of 2004 relating to salaries,
commissions, and benefits increased approximately $232,000 compared to the same
period in 2003 due primarily to headcount increases. Additionally, costs
related to travel of sales and sales operations personnel in the U.S. also
increased approximately $261,000 supporting the Companys increase in headcount
and sales activity. The U.S. operations also increased general marketing
efforts by approximately $250,000 relating to consultants, meetings and
promotional items and increased general brand marketing by approximately
$195,000, consisting primarily of the sponsorship of the Alex Job Porsche
Racing Team. Sales and marketing expenses also increased approximately
$286,000 in the third 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 $48,000 due to an increase in headcount and expenses in Germany
increased $95,000 due to an increase in headcount and commissions from
increased sales. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the three months ended September 30, 2004 were $1,250,291, an increase of
$207,708, or 20%, compared to the same period in 2003. Included in this
increase was a $100,000 reserve recorded against accounts receivable in the
third quarter of 2004. Additionally, legal expenses of $114,447 were incurred
related to a lawsuit that resulted in the grant of a non-exclusive license of
one of the Companys Dual-Use Computing Device patents. 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 September 30, 2004 were
$789,197, an increase of $80,677, or 11%, compared to the corresponding period
in 2003. Salaries and benefits in the Companys German operations decreased by
$68,000 in the third quarter of 2004 compared to the same period in 2003. The
Company also had an approximate $58,000 increase in expenditures to third
parties and consultants for design and development of the Companys
mobile/wearable product lines and a $58,000 increase in travel of personnel for
the third quarter of 2004 compared to the third quarter of 2003. INTEREST AND OTHER INCOME / EXPENSE, NET. Net interest and other income for the
three months ended September 30, 2004 was $20,244, compared to net interest and
other expense of $74,007 for the same period in 2003. MINORITY INTEREST. Minority interest for the three months ended September 30,
2004 was $103,690, which represents Softbank Strategics share of the losses in
Xybernaut China. The joint venture was formed during fiscal year 2004. NET LOSS. As a result of the factors described above, the net loss for the
three months ended September 30, 2004 was $4,542,226, a decrease of $132,013,
or 3%, compared to the three months ended September 30, 2003. 15




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NINE MONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003 REVENUE. The Company derives its revenue from product sales of mobile/wearable
computers and components, product sales of software, consulting services and
the licensing of its intellectual property. Total revenue for the nine months
ended September 30, 2004 was $11,019,887, an increase of $3,741,208, or 51%,
compared to the nine months ended September 30, 2003. Sales from
mobile/wearable computers increased $2,231,439, or 53%, to $6,453,475 for the
nine months ended September 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 $1,178,619, or 35%. This net U.S. growth was due to increased Atigo
and Alternative Solutions sales of $1,550,020 and $433,939, respectively, which
were offset by a $805,340 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 134%, or $868,913, in the
first nine months of 2004 compared with the same period in 2003, due primarily
to a large sale of Atigo systems. Hardware revenues from Japan, consisting
primarily of MA V systems, in the first nine months of 2004 increased slightly
by $8,388 compared with the same period in 2003. Hardware revenues in China,
consisting of Atigo and MA V sales, were $92,058 and $83,461, respectively, for
the nine months ended September 30, 2004 and $0 for the same period in 2003.
The Companys consulting, licensing and other revenue for the nine months ended
September 30, 2004 was $4,566,412, an increase of $1,509,769, or 49%, from
2003. Included in consulting, licensing and other revenue in the third quarter
of 2004 is $237,500 in cash received by the Company related to the settlement
of a lawsuit for which the Company was the plaintiff that resulted in the grant
of a non-exclusive license of one of the Companys Dual-Use Computing Device
patents. No similar amounts were recorded in the 2003 period. The remaining
increase in the Companys consulting, licensing and other revenue of $1,272,269
is mainly due to increased consulting services in its U.S. operations on new
consulting contracts and increased activity on existing 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 fringe, direct
materials, amortization of tooling costs, warranty costs, fulfillment and
shipping costs, and inventory and tooling reserves. Total cost of sales for the
nine months ended September 30, 2004 was $8,464,852, an increase of $169,898,
or 2%, compared to the same period in 2003. Included in cost of sales for the
nine months ended September 30, 2003 was $3,249,354 provision for inventory and tooling for
which there is no such amount in 2004. Without the provision, the increase in
cost of sales for the first three quarters of 2004 compared to the same period
in 2003 is $3,419,252, or 68%. This increase resulted largely from the 51%
increase in total revenue for the nine months ended September 30, 2004 compared
to the same period in 2003. Total gross margins, excluding the provision for
inventory and tooling, were 23% and 31%, for the first nine months of 2004 and 2003,
respectively. Gross margins from hardware sales for the first nine months of
2004 were 8% compared to 26% for 2003. Margins during the first three quarters
of 2004 were negatively impacted by a large European sale of Atigo systems
which was approximately break-even after initial discounts and also by a
general decline in margins on other Atigo sales. Also contributing to the
decrease in gross margins were Atigo and MA V systems provided free of charge
for customer satisfaction purposes, warranty costs and unrecouped shipping
charges totaling approximately $233,000. Absent these factors, hardware gross
margins for the nine months ended September 30, 2004 were 12%. Consulting cost
of sales in the first nine months of 2004 compared to 2003 increased $626,357,
or 33%, which is less than the 49% increase in consulting revenue in the same
period. As a result, consulting, licensing and other gross margins increased 7%
and were 44% and 37% for the 2004 and 2003 periods, respectively. The increased
margins in part were the result of favorable billing rates on large consulting
contracts. The increase is also attributable to the $237,500 of licensing
revenue recorded in 2004 related to the grant of a non-exclusive license of a
patent for which there is no related cost of sales. 16




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SALES AND MARKETING EXPENSES. Sales and marketing expenses for the nine months
ended September 30, 2004 were $9,449,880, an increase of $3,250,189, or 52%,
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 nine months ended September 30, 2004 increased
approximately $719,000 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 $593,000 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 were no similar events in the same period in 2003. The U.S.
operations also increased general marketing efforts by approximately $330,000
relating to consultants, meetings and promotional items and increased general
brand marketing by approximately $195,000, consisting primarily of the
sponsorship of the Alex Job Porsche Racing Team. Sales and marketing expenses
also increased approximately $784,000 due to the start-up of Xybernaut China in
2004. In addition, sales and marketing expenses related to the Companys
operations in Japan increased $162,000 due to an increase in headcount.
Salaries and commissions increased $112,000 in the Companys operations in
Germany due to increased sales and sales activity. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the nine months ended September 30, 2004 were $3,205,126, an increase of
$181,909, or 6%, compared to the same period in 2003. Included in this increase
was a $100,000 reserve recorded against accounts receivable in the third
quarter of 2004. Additionally, legal expenses of $114,447 were incurred
related to a lawsuit that resulted in the grant of a non-exclusive license of
one of the Companys Dual-Use Computing Device patents. 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 nine months ended September 30, 2004 were
$2,742,298, an increase of $33,450, or 1%, compared to the corresponding period
in 2003. INTEREST AND OTHER INCOME / EXPENSE, NET. Net interest and other income for the
nine months ended September 30, 2004 was $86,828 compared to net interest and
other expense of $361,552 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 nine months ended September 30, 2003 for which there
is no such amount in 2004. MINORITY INTEREST. Minority interest for the nine months ended September 30,
2004 was $257,868, which represents Softbank Strategics share of the losses in
Xybernaut China. This joint venture was formed in 2004. NET LOSS. As a result of the factors described above, the net loss for the nine
months ended September 30, 2004 was $12,497,573, a decrease of $812,010 or 6%,
compared to the nine months ended September 30, 2003. OTHER OPERATING ACTIVITIES For the nine months ended September 30, 2004, the Companys operating
activities used cash of $12,062,630 as a result of its net loss of $12,497,573
and working capital requirements of $291,380, offset by an increase in non-cash
expenses of $726,323. The Companys investing activities used cash of $366,078
through property and patent acquisitions/capitalization which were offset by a
reduction in restricted cash balances. These operating activities were
primarily funded through the Companys financing activities which provided cash
of $8,568,474 through the private placement of common stock, exercise of
warrants and stock options. As a result, the Companys cash balance decreased
to $6,007,537 at September 30, 2004 from $9,524,541 at December 31, 2003. For the nine months ended September 30, 2003, the Companys operating
activities used cash of $10,111,170 as a result of its net loss of $13,309,583
and working capital requirement of $2,206,762, offset by non-cash expenses of
$5,405,175. The Companys investing activities used cash of $863,279. These
activities were funded through the Companys financing activities which
provided cash of $21,973,880, through the private placement of common stock,
exercise of warrants, stock options and borrowings. As a result, the Companys
cash balance increased to $13,063,053 at September 30, 2003 from $1,967,710 at
December 31, 2002. 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. 17




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##### 



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 nine months
ended September 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. 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 nine months ended September 30, 2004 and twelve months ended
December 31, 2003, respectively. Concurrently with their exercise during the
nine months ended September 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 September 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 nine months ended September 30, 2004 and twelve months ended December 31,
2003, the Company received net proceeds of $65,717 and $109,269, respectively,
and issued 132,418 and 248,996 shares of its common stock, respectively,
related to these exercises. 18




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##### 



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 nine
months ended September 30, 2003, the Company recorded interest expense of $0
and $11,229, respectively. During the three and nine months ended September 30,
2003, the Company recorded amortization of note discount of $0 and $393,594,
respectively. The Company had no outstanding principal or interest related to
this note at September 30, 2004 or December 31, 2003. Purchase 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 September 30, 2004, the Company had commitments to purchase
approximately $3,500,000 in inventory related primarily to the Atigo product
line. The Company currently expects to maintain a level of Atigo inventory on
hand of approximately $2,000,000 to $5,000,000. 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 future 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. 19




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##### 



Other Liquidity and Capital Resources Disclosures At September 30, 2004, the Company had accounts receivable, net of
allowances, of $3,203,146, a decrease of $1,680,753, or 34%, from the December
31, 2003 balance of $4,883,899. This fluctuation is explained partly by the 12%
decrease in total revenues from the quarter ended December 31, 2003 to
September 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 balances in the first quarter of 2004. Accounts
receivable at September 30, 2004 and December 31, 2003 included $178,970 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 $316,391 which has been billed in
the first three quarters of 2004. The Company expects to bill such amounts in
their entirety upon reaching certain milestones in the contract. Included in
the September 30, 2004 accounts receivable balance is $841,938 that was
collected in October 2004. The Company wrote off $136,403 of previously
reserved uncollectible accounts and recorded an additional $100,000 reserve
against remaining accounts receivable in the third quarter of 2004. At September 30, 2004, the Company had total accounts payable of
$2,469,693, representing a decrease of $598,681, or 20%, 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 September 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 is expected to be recognized as revenue as the
revenue recognition criteria are met, for example as services are provided. At
September 30, 2004 and December 31, 2003, $197,331 and $200,864, respectively,
were recorded as deferred revenue from service contracts, of which $149,331 and
$0 were classified as long-term liabilities at September 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 September 30, 2004 and December 31, 2003, $353,215 and $295,774,
respectively, were recorded as deferred revenue from warranties, of which
$170,836 and $163,754 were classified as long-term liabilities at September 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 $162,104,961 at September 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. 20




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##### 



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 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 nine months ended
September 30, 2004, the Company raised approximately $35 million, in aggregate, 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
currently limits its ability to issue more than 200,000,000 shares of common
stock. The Companys board of directors unanimously adopted a resolution
approving a proposal to amend the Certificate of Incorporation to increase the
number of authorized shares to 240,000,000. The Company has submitted to its
shareholders a proposal for such an amendment, which will require approval at
the Companys annual meeting currently scheduled for December 15, 2004. There
can be no assurance that such an approval will be obtained. A limitation on the
number of authorized shares will 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 September 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 yr
    
    1-3 years
    
    3-5 years
    
    ThereafterRestructuring liability
    
    $
    73,369
    
    
    $
    59,759
    
    
    $
    13,610
    
    
    $
    
    
    
    $
    Operating leases
    
    
    818,507
    
    
    
    589,112
    
    
    
    223,211
    
    
    
    6,184
    
    
    
    Services agreement
    
    
    992,000
    
    
    
    202,500
    
    
    
    435,500
    
    
    
    234,000
    
    
    
    120,000Inventory commitments
    
    
    3,500,000
    
    
    
    3,500,000
    
    
    
    
    
    
    
    
    
    
    
    $
    5,383,876
    
    
    $
    4,351,371
    
    
    $
    672,321
    
    
    $
    240,184
    
    
    $
    120,000
 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 September 30, 2004.
Actual results may differ materially. 21




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##### 



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 nine months ended September 30, 2004, the
Companys operations in Europe comprised 16% of its total revenue and 10% of
its net loss, respectively, compared to 11% of its total revenue and 6% and 7%
of its net loss, respectively, in the same periods for 2003. For the three and
nine months ended September 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 2% and 3% of its total revenue and 1% of its net
loss, respectively, in the same period for 2003. For the three and nine months
ended September 30, 2004, the Companys operations in China comprised 2% of its
total revenue and 3% of its net loss, respectively. At September 30, 2004, the
Companys assets in Europe, Asia (excluding China), and China comprised 14%, 2%
and 1% of its total assets, respectively, compared to 5%, 2% and 0% of its
total assets at September 30, 2003, respectively. According to published
sources, the average fluctuation of the European Euro during the three and nine
months ended September 30, 2004 was 1.2% and -2.5%, respectively, compared to
1.6% and 5.5% for the same period in 2003, respectively. According to published
sources, the average fluctuation of the Japanese Yen during the three and nine
months ended September 30, 2004 was
-1.4% and -1.7%, respectively, compared to 1.8% and 0.3% for the same period in
2003, respectively. According to published sources, the average fluctuation of
the Hong Kong Dollar during the three and nine months ended September 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 three quarters of fiscal year 2004 was
4.14%, compared to a 4.17% average prime interest rate during the same periods
in 2003. For 2004 and 2003, the prime interest rate fluctuation from January 1
to September 30 of each year was 0.5% and -0.25%, 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 September 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 Rules. 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. 22




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##### 



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. 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 EXHIBITS  31.1
    
    Certification Pursuant to Section 13a  14(a) of the Rules and
Regulations under the Securities Exchange Act of 193431.2
    
    Certification Pursuant to Section 13a  14(a) of the Rules and
Regulations under the Securities Exchange Act of 193431.3
    
    Certification Pursuant to Section 13a  14(a) of the Rules and
Regulations under the Securities Exchange Act of 193432
    
    Certification Pursuant to 18 U.S.C. Section 1350
 23




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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. Newman
Chief Executive Officer and
Chairman of the Board of DirectorsBy: /s/ THOMAS D. DAVIS
Thomas D. Davis
Senior Vice President and
Chief Financial OfficerBy: /s/ STEVEN A. NEWMANSteven A. Newman
President, Chief Operating Officer and
Vice Chairman of the Board of DirectorsDate: November 8, 2004
 24