##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 QUARTERLY REPORT ON FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
 COMMISSION FILE NUMBER 0-21013 XYBERNAUT CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE
    
    54-1799851(STATE OR OTHER JURISDICTION
OF INCORPORATION)
    
    (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 o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes x No o The number of shares outstanding of the registrants Common Stock, $0.01
par value per share, as of May 5, 2004 was 176,860,152.




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XYBERNAUT CORPORATION QUARTERLY REPORT ON FORM 10-Q PAGECOVER PAGE
    
    
    1INDEX
    
    
    2PART I  FINANCIAL INFORMATIONItem 1 - Financial StatementsCondensed Consolidated Balance Sheets (unaudited)
    
    
    3Condensed Consolidated Statements of Operations (unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows (unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2 - Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    11Item 3 - Quantitative and Qualitative Disclosures about Market Risk
    
    
    17Item 4 - Controls and Procedures
    
    
    18PART II  OTHER INFORMATIONItem 2
- Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
    
    
    18Item 6 - Exhibits and Reports on Form 8-K
    
    
    19SIGNATURES
    
    
    19
 2




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##### 



PART I  FINANCIAL INFORMATION 
 Item 1  Financial Statements 
 XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED) March 31,
    
    December 31,2004
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    12,523,014
    
    
    $
    9,524,541Restricted cash
    
    
    500,000
    
    
    
    1,257,554Accounts receivable, net of allowances of $219,314 and $207,679
    
    
    3,727,736
    
    
    
    4,883,899Inventory, net of reserves of $3,272,716 and $3,272,716
    
    
    1,577,257
    
    
    
    2,131,436Prepaid and other current assets
    
    
    1,451,839
    
    
    
    984,425Total current assets
    
    
    19,779,846
    
    
    
    18,781,855Long-term assets:Property, equipment and demonstration units, net
    
    
    466,632
    
    
    
    382,792Patent costs, net of accumulated amortization of $2,077,248
and $1,963,971
    
    
    943,314
    
    
    
    945,126Other
    
    
    773,851
    
    
    
    710,294Total long-term assets
    
    
    2,183,797
    
    
    
    2,038,212Total assets
    
    $
    21,963,643
    
    
    $
    20,820,067LIABILITIES AND STOCKHOLDERS EQUITYLiabilities:Current liabilities:Accounts payable
    
    $
    1,746,681
    
    
    $
    3,068,374Accrued expenses and other
    
    
    1,229,991
    
    
    
    1,283,200Deferred revenue
    
    
    494,033
    
    
    
    332,884Total current liabilities
    
    
    3,470,705
    
    
    
    4,684,458Long-term liabilities:Restructuring liability
    
    
    42,080
    
    
    
    62,330Deferred revenue
    
    
    165,374
    
    
    
    163,754Total long-term liabilities
    
    
    207,454
    
    
    
    226,084Total liabilities
    
    $
    3,678,159
    
    
    $
    4,910,542Commitments and contingenciesStockholders equity:Common stock, $0.01 par value, 200,000,000
shares authorized, 176,860,152 and 172,358,223
shares issued and outstanding
    
    
    1,768,602
    
    
    
    1,723,582Additional paid-in capital
    
    
    169,366,176
    
    
    
    163,362,829Foreign currency translation
    
    
    317,324
    
    
    
    430,502Accumulated deficit
    
    
    (153,166,618
    )
    
    
    (149,607,388
    )Total stockholders equity
    
    $
    18,285,484
    
    
    $
    15,909,525Total liabilities and stockholders equity
    
    $
    21,963,643
    
    
    $
    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 March 31,2004
    
    2003Revenue:Hardware
    
    $
    2,937,322
    
    
    $
    824,712Consulting, licensing and other
    
    
    1,457,362
    
    
    
    962,265Total revenue
    
    
    4,394,684
    
    
    
    1,786,977Cost of sales:Hardware
    
    
    2,506,768
    
    
    
    627,394Consulting, licensing and other
    
    
    820,702
    
    
    
    606,612Provision for inventory
    
    
    
    
    
    
    1,749,354Gross income (loss)
    
    
    1,067,214
    
    
    
    (1,196,383
    )Operating expenses:Sales and marketing
    
    
    2,813,132
    
    
    
    2,037,506General and administrative
    
    
    923,318
    
    
    
    1,004,650Research and development
    
    
    931,765
    
    
    
    1,142,135Total operating expenses
    
    
    4,668,215
    
    
    
    4,184,291Operating loss
    
    
    (3,601,001
    )
    
    
    (5,380,674
    )Interest and other income, net
    
    
    41,771
    
    
    
    2,196Net loss
    
    $
    (3,559,230
    )
    
    $
    (5,378,478
    )Net loss per share (basic and diluted)
    
    $
    (0.02
    )
    
    $
    (0.04
    )Weighted average number of shares
outstanding (basic and diluted)
    
    
    173,767,333
    
    
    
    119,815,144
 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) Three Months Ended March 31,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (3,559,230
    )
    
    $
    (5,378,478
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    280,095
    
    
    
    399,112Provision for inventory
    
    
    
    
    
    
    1,749,354Loss on disposal of assets
    
    
    
    
    
    
    38,290Non-cash charges for equity securities issued for services
    
    
    23,124
    
    
    
    118,413Amortization of note discount
    
    
    
    
    
    
    6,470Changes in assets and liabilities:Inventory
    
    
    352,721
    
    
    
    (247,344
    )Accounts receivable
    
    
    1,145,534
    
    
    
    1,103,764Prepaid and other current assets
    
    
    (512,913
    )
    
    
    33,117Other assets
    
    
    (22,624
    )
    
    
    (10,355
    )Accounts payable
    
    
    (1,320,892
    )
    
    
    (1,083,907
    )Accrued expenses and other
    
    
    (91,934
    )
    
    
    (329,991
    )Deferred
revenue, current
    
    
    161,090
    
    
    
    7,099Restructuring
liability, long-term
    
    
    (16,287
    )
    
    
    (22,190
    )Deferred
revenue, long-term
    
    
    65,145
    
    
    
    Net cash used in operating activities
    
    $
    (3,496,171
    )
    
    $
    (3,616,646
    )Cash flows from investing activities:Acquisition of property, equipment and demonstration units
    
    
    (237,333
    )
    
    
    (58,956
    )Acquisition of patents and trademarks
    
    
    (111,466
    )
    
    
    (59,682
    )Restricted cash
    
    
    757,554
    
    
    
    (375,092
    )Capitalization of tooling costs
    
    
    
    
    
    
    (20,000
    )Net cash provided by (used in) investing activities
    
    $
    408,755
    
    
    $
    (513,730
    )Cash flows from financing activities:Proceeds from:Common stock
offerings, net
    
    
    5,961,440
    
    
    
    2,000,000Exercise of warrants
    
    
    15,000
    
    
    
    2,354,167Exercise of stock options
    
    
    48,800
    
    
    
    399Notes and loans
    
    
    
    
    
    
    1,750,000Payments for:Capitalization of loan costs
    
    
    
    
    
    
    (12,596
    )Net cash provided by financing activities
    
    $
    6,025,240
    
    
    $
    6,091,970Effect of exchange rate changes on cash and cash equivalents
    
    
    60,649
    
    
    
    69,038Net increase in cash and cash equivalents
    
    
    2,998,473
    
    
    
    2,030,632Cash and cash equivalents, beginning of period
    
    
    9,524,541
    
    
    
    1,967,710Cash and cash equivalents, end of period
    
    $
    12,523,014
    
    
    $
    3,998,342Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    
    
    
    $
    372Cash paid for taxes
    
    $
    663
    
    
    $
    590Supplemental disclosure of non-cash financing activities:Equity securities issued for services rendered, expensed
in periods issued
    
    $
    23,124
    
    
    $
    106,913
 The accompanying notes are an integral part of these
condensed consolidated financial statements 5




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##### 



XYBERNAUT CORPORATION 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited, condensed and consolidated financial
statements of Xybernaut Corporation, a Delaware Corporation (the Company),
have been prepared in accordance with accounting principles generally accepted
in the United States of America (U.S. GAAP) for interim financial information
and instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
these statements do not include all of the information and footnotes required
by U.S. GAAP for complete financial statements. In the opinion of 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 March 31,
2004 and December 31, 2003, and the results of their operations and cash flows
for the three months ended March 31, 2004 and 2003. Results of operations for
the three months ended March 31, 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. 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 $29,000,000 on sales of approximately 8,500
MA and Atigo systems. The Company has recorded net losses since its inception. These losses are
primarily attributable to the operating expenses incurred by the Company to
design, develop, market and sell its mobile and wearable computer products and
to provide general and administrative support for these operating activities.
The Companys revenues and gross margins have not been sufficient to fund these
operating activities. As a result, the Company has consistently reported
negative cash flows from operating activities and net losses and had an
accumulated deficit of $153,166,618 at March 31, 2004. The Companys management has taken steps that it believes are necessary to
improve operations and raise additional capital, both of which are needed to
meet its cash flow needs through December 31, 2004 and thereafter. During 2002
and 2003, management performed reviews of the Companys operations and
implemented various cost cutting programs to reduce the Companys operating
expenses to better align costs with current and expected business volume.
Management believes that the Companys current staffing and resources will be
sufficient to carry out its business plan for the foreseeable future. The Companys management believes that the combination of cash on hand,
cash flows from operations and outside additional funding from third party
investors will provide sufficient liquidity to meet the Companys ongoing cash
requirements. This is based on the Companys historical ability to raise funds
in the form of debt and equity financings. However, there can be no assurance
that the Company can or will obtain sufficient funds from operations or from
additional financings on terms acceptable to the Company. If the Company is
unable to obtain sufficient additional financing, it will be required to reduce
spending further in order to maintain its operations at a reduced level.
Management believes that it would be able to reduce spending if required,
however, there can be no assurances that it can successfully do so. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with U.S. GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those
estimates. 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 March 31,
2004 and December 31, 2003, the Company had $500,000 and $1,257,554,
respectively, in restricted cash. The balance at March 31, 2004 consisted of a
$500,000 cash deposit that secures a long-term services contract. The balance
at December 31, 2003 consisted of i) this same $500,000 cash deposit, ii) a
$376,442 cash deposit and interest that secured a letter of credit held by a
vendor and iii) $381,112 held in escrow representing a December 2003 payment
made by the Company for inventory to be delivered during 2004. The restrictions
on the $500,000 deposit are scheduled to lapse in late 2004, at which point the
cash deposit is expected to be returned to the Company. The restrictions on
the $376,442 deposit lapsed in the first quarter of 2004 and the amount was
returned to the Companys unrestricted cash balance. The $381,112 escrow
balance was remitted to the vendor as the inventory was delivered during the
first quarter of 2004. Inventory and Tooling At March 31, 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. The Company recognized a $1,749,354 charge on its consolidated statement
of operations during the three months ended March 31, 2003 related to its MA V
inventory and related components. The Company did not recognize any such
charges during the three months ended March 31, 2004. The Company had a $3,272,716 inventory reserve on its consolidated balance
sheet at both March 31, 2004 and December 31, 2003. This balance represents a
$3,022,716 reserve against MA V systems and a $250,000 reserve against MA TC
systems. The Companys management believes that it can sell its wearable/mobile
computer inventory at amounts that approximate current net carrying values,
which have been reduced as a result of the above charges. To determine the size
of the charges to record, management reviewed the carrying value of its
inventory in light of the introduction of new product lines, its ability to
sell the quantities of inventory on hand as well as the quantities expected to
be received in the future and the sales prices it ultimately expects to
achieve. This analysis took into account estimated price concessions which
management believes are likely to be necessary in disposing of this inventory.
The significant majority of the Companys recent inventory and tooling charges
were recorded against the MA V product line. Even after the successful
renegotiation of certain of the MA V manufacturing contracts during 2003, the
Company had commitments to purchase significant quantities of inventory. The
Company was required to write-down and reserve a substantial portion of the MA
V inventory as historical and forecasted sales are not sufficient to sell such
quantities of inventory. As a result of this review, it was determined that
certain of the Companys inventory is slow-moving, risked becoming obsolete or
will likely be sold at below its historical cost. Based upon a specific review
of the carrying costs for the inventory items, management estimated the
quantity of each inventory item that the Company was expected to be able to
sell and also quantified inventory amounts that may not be recoverable. To the
extent that actual future events are different from the assumptions and
estimates used by management, additional charges, reserves or adjustments may
be recorded by the Company. Management does not expect to record significant
profits or losses upon the ultimate sale of this inventory. As of March 31, 2004, net of the effect of reserves and write-offs, the
Companys inventory consisted of $1,210,945 in MA V systems, $219,103 in MA TC
systems and $147,210 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 three months ended March 31,
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 $45,365 and $70,393 for the three months ended
March 31, 2004 and 2003, respectively. Stock-Based Compensation In December 2002 the Financial Accounting Standards Board issued SFAS No.
148, Accounting for Stock Based Compensation-Transition and Disclosure, an
amendment to SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No.
148 amends the disclosure provisions to require prominent disclosure about the
effects on reported net income of an entitys accounting policy decisions with
respect to stock-based compensation. Stock options are accounted for using the
intrinsic method in accordance with Accounting Principles Board (APB) No. 25,
Accounting for Stock Issued to Employees, as interpreted, whereby if options
are priced at fair market value or above at the date of grant, no compensation
expense is recognized. The pro forma information is as follows: 7




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Three Months Ended March 31,2004
    
    2003Net loss, as reported
    
    $
    (3,559,230
    )
    
    $
    (5,378,478
    )Stock-based employee compensation cost included in
net loss as reported
    
    
    22,954
    
    
    
    106,913Stock-based employee compensation expense under
fair value method of SFAS No. 123
    
    
    (123,731
    )
    
    
    (428,775
    )Net loss pro forma
    
    $
    (3,660,007
    )
    
    $
    (5,700,340
    )Net loss per share basic and diluted  as reported
    
    $
    (0.02
    )
    
    $
    (0.04
    )Net loss per share basic and diluted  pro forma
    
    $
    (0.02
    )
    
    $
    (0.05
    )
 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 ended March 31, 2004 and 2003, equity securities were issued in payment
of $23,124 and $106,913, respectively, related to consulting services and
employee severance. 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. During the three months ended March 31, 2003, the Company
recorded interest expense of $1,007 and amortization of note discount of
$6,470. 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 2003, the Company
fully amortized the $393,594 note discount into interest expense. The Company
had no outstanding principal or interest related to this note at December 31,
2003 or March 31, 2004. 5. 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 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. The shares were sold at $1.34 per share, representing an approximate
20% discount to the closing market price of the Companys common stock. 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. The shares were sold at $1.51 per share, representing an approximate
10% discount to the closing market price of the Companys common stock. 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. 8




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##### 



The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings. The
Company received net proceeds of $15,000 and $2,354,167 through the issuance of
25,000 and 8,541,668 shares of its common stock through the exercise of
warrants during the three months ended March 31, 2004 and 2003, respectively.
Concurrently with their exercise during the three months ended March 31, 2003,
the exercise price of the warrants was reduced from a weighted average of $1.25
per share to $0.28 per share. At March 31, 2004, the Company had warrants
outstanding to purchase 8,486,333 shares of its common stock at prices that
range from $0.70 to $5.00 per share, with a weighted average of $2.51 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 three months ended March 31, 2004 and 2003, the Company issued 83,334 and
1,667 shares, respectively, of its common stock and received gross proceeds of
$48,800 and $399, respectively, related to these exercises. 6. XYBERNAUT CHINA 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). Xybernaut China has the exclusive
right to manufacture, market, sell and distribute the Companys products
throughout the PRC and is owned 60% by the Company and 40% by Softbank
Strategic. The Company has assigned all of its existing agreements and
relationships in the PRC to Xybernaut China and is providing it with
intellectual property, personnel, know-how and technical assistance. 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 months ended March 31, 2004 include the operations of
Xybernaut China. 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: Three Months EndedMarch 31,2004
    
    2003United States
    
    
    90
    %
    
    
    74
    %Europe
    
    
    6
    %
    
    
    17
    %Asia, excluding China
    
    
    3
    %
    
    
    9
    %China
    
    
    1
    %
    
    
    
 Operations in various geographical areas are summarized as follows: 9




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As of and for theThree Months EndedMarch 31,2004
    
    2003North America:Total revenue
    
    $
    3,935,177
    
    
    $
    1,329,889Net loss
    
    
    3,119,592
    
    
    
    5,043,619Identifiable assets
    
    
    20,842,824
    
    
    
    11,692,359Europe (1):Total Revenue
    
    $
    271,591
    
    
    $
    298,642Net loss
    
    
    339,119
    
    
    
    322,245Identifiable assets
    
    
    726,564
    
    
    
    1,058,995Asia (excluding China):Total revenue
    
    $
    146,560
    
    
    $
    158,446Net loss
    
    
    29,837
    
    
    
    12,614Identifiable assets
    
    
    378,800
    
    
    
    445,864China:Total revenue
    
    $
    41,356
    
    
    $
    Net loss
    
    
    70,682
    
    
    
    Identifiable assets
    
    
    15,455
    
    
    
    
 (1) Included in the Companys operations in Europe are $86,113 and $220,953,
respectively, in expenses related to the research and development activities
conducted by a branch of the Company operating in Germany. 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 ThreeMonths Ended March 31,2004
    
    2003Revenue:Number of Customers
    
    
    2
    
    
    
    2Percent of Total Revenue
    
    
    45
    %
    
    
    25
    %Accounts Receivable:Number of Customers
    
    
    2
    
    
    
    1Percent of Total Accounts Receivable
    
    
    63
    %
    
    
    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
monthly fees totaling approximately $32,000 for such services. The Company
believes that it is able to more effectively and quickly start up operations in
the PRC by outsourcing the majority of its operations to New Tech & Telecom,
which already has a presence and relationships within the PRC. The Company
also evaluated the cost and time required if the Company performed these
services in-house, including expenses and activities related to salary and
benefits, recruitment, training, rent and other overhead. As a result, the
Companys management believes that the arrangement with New Tech & Telecom
contains arms-length terms and conditions. Unrelated to the above agreement,
New Tech & Telecom purchased approximately $21,000 in mobile computing products
from the Company during the three months ended March 31, 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 10




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##### 



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 ended March 31, 2004 and 2003, the Company recorded revenues of
approximately $197,500 and $253,000, respectively, related to sales of its
products to the VAR. During the three months ended March 31, 2004 and 2003, the
Company recorded total research and development and sales and marketing
expenses of $160,200 and $243,000, 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 arms-length terms and conditions. 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS To keep investors informed of the Companys future plans and objectives,
this Quarterly Report on Form 10-Q and other reports and statements issued by
the Company and its officers from time to time contain certain statements
concerning the Companys future results, future performance, intentions,
objectives, plans and expectations that are, or may be deemed to be,
forward-looking statements. The Companys ability to do this has been
fostered by the Private Securities Litigation Reform Act of 1995 which provides
a safe harbor for forward-looking statements to encourage companies to
provide prospective information so long as those statements are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those discussed in the statement. Such
forward-looking statements are subject to a number of known and unknown risks
and uncertainties that, in addition to general economic and business
conditions, could cause the Companys actual results, performance, and
achievements to differ materially from those described or implied in the
forward-looking statements. Factors that could cause or contribute to such
differences include, but are not limited to, the Companys ability to execute
its business strategy, to profit from its products and services as expected, to
compete, to maintain superior technological capability, to foresee changes and
to continue to identify, develop and commercialize innovative and competitive
products and services, to penetrate different markets and successfully expand
its revenue, to attract and retain technologically qualified personnel,
particularly in the areas of research and development, and the Companys
ability to generate such cash flow and obtain financing to support its
operations and growth (see generally Managements Discussion and Analysis of
Financial Condition and Results of Operations and Liquidity and Capital
Resources contained therein) and other risks described in this Quarterly
Report on Form 10-Q and other filings with the SEC. OVERVIEW Xybernaut Corporation, a Delaware corporation (the Company), is engaged
in the research, development, manufacture, marketing and sale of
mobile/wearable computing and communication systems as well as software and
service solutions designed to enhance productivity and improve product
management, asset management, and the accuracy, timeliness and utilization of
critical enterprise data. The Company offers solutions with a software and
services focus through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(Virginia, U.S.). The Company offers solutions with a hardware focus through
its U.S. operations and through its wholly-owned subsidiaries Xybernaut K.K.
(Yokohama, Japan) and Xybernaut GmbH (Böblingen, Germany). In February 2004,
the Company began actively marketing its mobile and wearable hardware solutions
in the Peoples Republic of China through its 60% ownership in Xybernaut China
Limited (Hong Kong, China), a joint venture with Softbank Investment
International (Strategic) Ltd. The Company was originally incorporated in 1990
and completed its initial public offering (IPO) in July 1996. The consolidated financial statements include the accounts of the Company
and its wholly owned 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 $29,000,000 on sales of approximately 8,500
MA and Atigo systems. The Company derives its revenues from sales of its
wearable computers, software products and consulting services. In the future,
the Company expects to obtain additional revenues from the licensing of its
intellectual property. A number of trends are expected to have a significant effect on the
Companys operations in the future. In the past, many of the Companys large
customers deferred or delayed anticipated purchases of the Companys products
because of uncertain economic conditions and other concerns.
Regardless of economic conditions, potential
customers may have concerns about purchases from smaller vendors. While
the
Company believes that general economic conditions began to improve during late
2003 and expects that they will continue to improve during 2004, there can be
no assurance that this expectation will be realized. If economic conditions and
issues persist or worsen, it is possible that more potential customers will
defer, delay or cancel scheduled purchases, which would have an adverse effect
on the Companys revenues and 11




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##### 



operations. A significant percentage of the Companys revenues has typically been
concentrated among a relatively small number of customers. During the last
four quarters, between 39% and 45% of the Companys quarterly revenues have
been concentrated among between one and three 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 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 LANs are now well established in
commercial markets worldwide that provide broadband capabilities over a limited
physical range in places such as corporate offices, warehouses, factory floors
and airfields. However, wide-range wireless access that allows a user to move
freely over large geographic areas and still maintain broadband access
(commonly referred to as Third Generation or 3G) is still only available in
limited areas, including Japan and parts of Europe. The Company predicts that
3G service will be available in large metropolitan areas worldwide in the next
few years. For example, NTT DoCoMo and AT&T Wireless have announced plans to
launch 3G service in select U.S. cities by December 2004. 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 EndedMarch 31,2004
    
    2003Revenue
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    75.7
    
    
    
    69.1Provision for inventory
    
    
    
    
    
    
    97.9Gross income (loss)
    
    
    24.3
    
    
    
    (67.0
    )Operating expenses:Sales and marketing
    
    
    64.0
    
    
    
    114.0General and administrative
    
    
    21.0
    
    
    
    56.2Research and development
    
    
    21.2
    
    
    
    63.9Total operating expenses
    
    
    106.2
    
    
    
    234.2Interest and other
    
    
    1.0
    
    
    
    0.1Net loss
    
    
    (81.0
    %)
    
    
    (301.0
    %)
 THREE MONTHS ENDED MARCH 31, 2004 AND MARCH 31, 2003 REVENUE. The Company derives its revenue from product sales of mobile/wearable
computers and components, product sales of software and consulting services.
Total revenue for the three months ended March 31, 2004 was $4,394,684, an
increase of $2,607,707, or 146%, compared to the three months ended March 31,
2003. Sales from mobile/wearable computers increased $2,112,610,
or 256%, to $2,937,322 for the three months ended March 31, 2004 compared to
the same period in 2003. This growth in hardware revenues was driven by the
Companys U.S. operations, which increased $2,183,153 from the prior year. This
growth was due to increased Atigo and Alternative Solutions sales of $1,874,790
and $374,039, respectively. Alternative Solutions
consist of sales of non-proprietary mobile/wearable hardware based on a
customers specific needs and requirements. European hardware sales decreased
15%, or $37,260, in the first quarter of 2004 compared with the same period in
2003, due primarily to a $28,428 decrease in sales of MA TC systems. Hardware
revenues from Japan, consisting primarily of MA V systems, in the first quarter
of 2004 decreased by $33,284 12




---



##### 



compared with the same period in 2003. Hardware
revenues to China, consisting of Atigo and MA V sales, were $41,356
and $0, respectively, during the
three months ended March 31, 2004 and 2003. The Companys consulting, licensing and
other revenue for the three months ended March 31, 2004 was $1,457,362, an
increase of $495,097, or 51%, from revenue for the three months ended March 31,
2003. This increase is largely due to a $463,490, or 51%, increase in
consulting sales related to U.S. operations due to increased activity on large
consulting contracts in 2004 compared with 2003. COST OF SALES. The Companys cost of sales includes the costs of components for
mobile/wearable computer systems, purchased software, direct labor and
materials, amortization of tooling costs, warranty costs, fulfillment and
shipping costs, and inventory and tooling reserves. Total cost of sales for the
three months ended March 31, 2004 was $3,327,470, an increase of $344,110, or
12%, compared to the three months ended March 31, 2003. This increase resulted
from the 146% increase in total revenue for the three months ended March 31,
2004 compared to the same period in 2003 which was offset by a $1,749,354
provision for inventory and tooling recorded in the first quarter of 2003.
Total gross margins, excluding the provision for inventory, were 24% and 31%,
for the first quarter of 2004 and 2003, respectively. Gross margins from
hardware sales for the first quarter of 2004 were 15% compared to 24% for 2003.
Margins during the first quarter of 2004 were negatively impacted by two
low-margin Atigo sales that were made for strategic purposes as well as low
margins on MA V sales. Excluding the impact of these sales, hardware margins
would have been approximately 18%. Consulting cost of sales in the first
quarter of 2004 compared to the same period in 2003 increased $214,090, or 35%,
which is less than the 51% 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 were the result of favorable billing rates on large consulting
contracts. SALES AND MARKETING EXPENSES. Sales and marketing expenses for the three months
ended March 31, 2004 were $2,813,132, an increase of $775,626, or 38%, compared
to the corresponding period in 2003. In the U.S. operations, sales and
marketing expenses in the first quarter of 2004 relating to salaries,
commissions, benefits and related recruiting expenses increased approximately
$381,000 compared to the same period in 2003 due primarily to a headcount
increase in the sales force. Additionally, travel costs in the U.S. also
increased approximately $141,000 supporting the Companys increase in sales
activity. Sales and marketing expenses increased approximately
$85,000 due to the start-up of Xybernaut China in the first quarter
of 2004 for which there was no activity in 2003. In addition, sales
and marketing expenses related to the Companys operations in
Japan increased $47,000 due to an increase in headcount. The
Companys U.S. operations also incurred approximately $83,000 in costs related
to its participation in the creation and start-up of Xybernaut China during the
first quarter of 2004. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the three months ended March 31, 2004 were $923,318, a decrease of $81,332, or
8%, compared to the same period in 2003. This decrease resulted from general
and administrative expenses related to salaries and benefits, consulting and
travel of the Companys U.S. operations which decreased by approximately
$45,000, $22,000 and $10,000, respectively. 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 March 31, 2004 were
$931,765, a decrease of $210,370, or 18%, compared to the corresponding period
in 2003. This decrease resulted largely from an approximate $303,000 decline in
expenditures to third parties and consultants for design and development of the
Companys mobile/wearable product lines. Offsetting this decrease, research and
development expenses related to salaries and benefits of the Companys U.S. and
German operations increased by $49,000 and $25,000, respectively, from the
three months ended March 31, 2003 to 2004. INTEREST AND OTHER INCOME,
NET. Net interest and other income for the three months
ended March 31, 2004 was $41,771, an increase of $39,575 compared to net
interest and other income of $2,196 for the same period in 2003. This
increase is due to interest earned on higher levels of cash during
the three months ended March 31, 2004 compared to the same
period in 2003. NET LOSS. As a result of the factors described above, the net loss for the
three months ended March 31, 2004 was $3,559,230, a decrease of $1,819,248 or
34%, compared to the three months ended March 31, 2003. OTHER OPERATING ACTIVITIES For the three months ended March 31, 2004, the Companys operating
activities used cash of $3,496,171 as a result of its net loss of $3,559,230
and net working capital requirements of $240,160, offset by non-cash expenses
of $303,219. The Companys investing activities provided cash of $408,755.
These operating activities were primarily funded through the Companys financing activities which
provided cash of $6,025,240 through the private placement of common stock,
exercise of warrants and stock options. As a result, the Companys cash balance
increased to $12,523,014 at March 31, 2004 from $9,524,541 at December 31,
2003. For the three months ended March 31, 2003, the Companys operating
activities used cash of $3,616,646 as a result of its net loss
of $5,378,478 as offset by a net working capital increase of $549,807 and
non-cash expenses of $2,311,639. The Companys investing activities used cash
of $513,730. These activities were funded through the Companys financing
activities which provided cash of $6,091,970, principally through the private
placement of common stock, exercise of warrants and borrowings. As a result,
the Companys cash balance increased to $3,998,342 at March 31, 2003 from
$1,967,710 at December 31, 2002. 13




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##### 



The Company is involved in litigation with Zykronix, Inc. in the District
Court of Denver, Colorado and in the Circuit Court of Fairfax, Virginia. In the
Virginia case, 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. In the Colorado case,
Zykronix filed suit against Edward G. Newman, the Companys Chairman and Chief
Executive Officer, seeking enforcement of a personal guaranty. The personal
guaranty was provided to Zykronix by Mr. Newman 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 case. In April 2004, a judgment was entered in the favor of Zykronix
in the Colorado suit in the amount of $170,053. The Company intends to file a
Motion to Stay to delay enforcement of this judgment pending an
appeal and the outcome of the Virginia litigation. The
Company believes that it has substantive defenses in both of these cases and
believes that no amounts are owed to Zykronix. The Company is vigorously
defending, and expects to continue to defend, against both suits. In December 2003, the Company filed a lawsuit against Viewsonic
Corporation (Viewsonic) in the United States District Court for the Eastern
District of Virginia. The suit alleges that Viewsonic infringed one of the
Companys Dual-Use Computing Device patents. The suit requests unspecified
damages and an injunction against Viewsonic from infringing the patent. 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. 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. 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. 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 three months
ended March 31, 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. 14




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##### 



During March 2004, the Company received gross proceeds of $5,000,000
through the private placement of 3,731,343 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 1,865,671 shares of common
stock at $1.52 per share and six-month callable warrants to purchase 1,865,671
shares of common stock at $1.52 per share. During March 2004, the Company received gross proceeds of $1,000,000
through the private placement of 662,252 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 331,126 shares of common
stock at $1.52 per share and six-month callable warrants to purchase 331,126
shares of common stock at $1.52 per share. The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings.
Exclusive of the exercises made in connection with the note repayment discussed
in Borrowings below, the Company received net proceeds of $15,000 and
$10,392,282 through the issuance of 25,000 and 23,847,427 shares of its common
stock through the exercise of warrants during the three months ended March 31,
2004 and the twelve months ended December 31, 2003, respectively. 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 during 2003. At March 31, 2004, the Company
had warrants outstanding to purchase 8,486,333 shares of its common stock at
prices that range from $0.70 to $5.00 per share, with a weighted average of
$2.51 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 three months ended March 31, 2004 and twelve months ended December 31,
2003, the Company issued 83,334 and 248,996 shares, respectively, of its common
stock and received gross proceeds of $48,800 and $109,269, respectively,
related to these exercises. Borrowings On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note which accrued interest at 3.5% per annum. In
connection with this borrowing, the Company issued to the lender warrants to
purchase 1,750,000 shares of common stock at an exercise price of $1.25 per
share and warrants to purchase 2,000,000 shares of common stock at an exercise
price of $0.43 per share. Based on the relative fair values of the securities
issued, these warrants were assigned a value of $393,594, which amount was
recorded as a note discount and amortized into interest expense over the life
of the note. During the three months ended March 31, 2003, the Company
recorded interest expense of $1,007 and amortization of note discount of
$6,470. 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 2003, the Company
fully amortized the $393,594 note discount into interest expense. The Company
had no outstanding principal or interest related to this note at December 31,
2003 or March 31, 2004. Commitments Inventory.From time to time, the Company has commitments to purchase
inventory, tooling and/or engineering and other services from its suppliers and
manufacturers related to its current and future hardware product lines. The
Companys commitments are typically highest during periods of product design
and when the Company is procuring inventory related to anticipated sales. The
Company expects that it will continue to enter into such commitments during
2004 and thereafter as it designs, develops and procures future mobile/wearable
computer product lines. During 2003, the Company entered into an agreement with IBM under which
the Company agreed to purchase approximately $4,900,000 in MA V computing
units, FPDs, 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 March 31, 2004, the Company had commitments to purchase approximately
$1,400,000 in inventory related primarily to the Atigo product line. The
Company currently expects to maintain a level of Atigo inventory on hand
approximately equal to this commitment balance. The Company believes that this
level of inventory will provide it with the ability to more rapidly deploy
product to customers and also expects that it can be sold within a reasonable
period after purchase. A significant portion of this inventory will likely
consist of work in process materials. The Company believes there are several
benefits to purchasing work in process materials as opposed to finished goods.
First, the Company typically expects to purchase only the long lead-time or
hard to find components and is therefore able to defer the capital outlay
needed to procure the remaining readily available materials. This strategy
also reduces the risk of obsolescence since component parts are only purchased
at the time they are needed in the manufacturing process, can often be used in 15




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##### 



other product lines and can be sold separately if needed. Finally, the Company
maintains flexibility to customize its products based on specific customer
requirements since modifications can be made at the component level prior to
final assembly. Operating Leases and Other.The Company leases operating facilities and
equipment under operating leases expiring on various dates through 2005. Future
minimum payments under noncancelable operating leases at March 31, 2004 are: For the Year Ending December 31,2004
    
    
    481,1202005
    
    
    275,9682006
    
    
    20072008
    
    
    $
    757,088
 Other Liquidity and Capital Resources Disclosures At March 31, 2004, the Company had accounts receivable, net of allowances,
of $3,727,736, a decrease of $1,156,163, or 24%, from the December 31, 2003
balance of $4,883,899. This fluctuation is significantly less than the 18%
increase in total revenues from the quarter ended December 31, 2003 to March
31, 2004. Included in the accounts receivable balance at December 31, 2003 is
$1,554,828 associated with two fourth quarter sales for which the Company collected
the balance in the first quarter of 2004. Typically, the Companys large
hardware sales occur in the last month of the quarter however, in the first
quarter of 2004, $571,722 representing portions of two large sales were billed
and collected during the quarter. In addition, accounts receivable at March 31,
2004 and December 31, 2003 included $126,506 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 $226,568 which has been billed in the first quarter of 2004.
The Company expects to bill such amounts in their entirety upon reaching certain milestones in the contract. At
March 31, 2004, the Company had prepaid assets of $1,451,839, an
increase of $467,414, or 47%, from the December 31, 2003 balance of $984,425.
This fluctuation is due primarily to an increase in payments to a vendor of
Atigo products prior to the receipt of inventory. These shipments are expected
to be received in the second quarter of 2004. At March 31, 2004, the Company had total accounts payable of $1,746,681,
representing a decrease of $1,321,693 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 March 31, 2004 and December 31, 2003
result from billings to customers that were in excess of revenue recognized on
service contracts and from warranty revenue on hardware products. Deferred
revenue on service contracts will be recognized as revenue as the revenue
recognition criteria are met, for example as services are provided. At March 31, 2004 and December 31, 2003, $244,361
and $200,864, respectively, were recorded as deferred revenue from service
contracts. Warranty revenue on hardware products is recorded as deferred
revenue and recognized on a straight-line basis over the life of the warranty.
At March 31, 2004 and December 31, 2003, $415,046 and $295,774, respectively,
were recorded as deferred revenue from warranties, of which, $165,374 and
$163,754, were classified as long-term liabilities at March 31, 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 $153,166,618 at March 31, 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 and investing activities through its financing
activities, which consist primarily of private placements of common stock,
warrant and stock option exercises and borrowings. The Companys management has taken steps that it believes are necessary to
improve 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.
Assuming there are no significant future changes to the Companys business plan
and excluding the operations of Xybernaut China, management expects to maintain
a quarterly operating expense level of between $4.5 million and $5 million,
representing savings of over 50% from fourth quarter 2001 levels. Future
significant fluctuations may still 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 during any given period.
Additionally, the Companys new operations in China are 16




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expected to increase
the Companys operating expenses. Management believes that the Companys
current staffing and resources will be sufficient to carry out its business
plan for the foreseeable future. At the forecasted levels discussed above, management expects that the
Company will incur operating expenses of between $18 million and $20 million
during 2004. However, there can be no assurances that actual operating expenses
during 2004 or later periods will not be significantly higher. The Company will
also be required to fund inventory procurement and other expenditures.
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 three months
ended March 31, 2004, the Company raised approximately $32 million through
sales of its common stock to institutional investors, through warrant and stock
option exercises and through borrowings. If a sustained decline in the general
equity markets, the price of the Companys common stock, or the U.S. or world
economy were to occur, the Company could face difficulties in its ability to
raise additional capital. Additionally, the Company has historically made
several private placements of its common stock per year, primarily to a limited
number of institutional investors who specialize in making similar types of
investments. If these institutional investors were to choose to not participate
in future private placements, the Company could face difficulties in its
ability to raise additional capital. The Companys Certificate of Incorporation
limits its ability to issue more than 200,000,000 shares of common stock. The
Company will be required to obtain shareholder approval to increase this
number. There can be no assurance that such approval will be obtained. A
limitation on the number of authorized shares may hinder the Companys ability
to obtain additional equity financing. The Companys management believes that the combination of cash on hand,
cash flows from operations and outside additional funding from third party
investors will provide sufficient liquidity to meet the Companys ongoing cash
requirements. This is based on the Companys historical ability to raise funds
in the form of debt and equity financings. However, there can be no assurance
that the Company can or will obtain sufficient funds from operations or from
additional financings on terms acceptable to the Company. If the Company is
unable to obtain sufficient additional financing, it will be required to reduce
spending further in order to maintain its operations at a reduced level.
Management believes that it would be able to reduce spending if required,
however, there can be no assurances that it can successfully do so. Contractual Obligations and Commercial Commitments The Companys significant contractual obligations as of March 31, 2004 are
for lease payments related to a reduction in facilities classified as
restructuring in 2002, operating leases (primarily for office space) and
inventory commitments. Payments Due by PeriodsTotal
    
    Less than 1 year
    
    1-3 years
    
    3-5 years
    
    More than 5 yearsRestructuring Liability
    
    $
    103,008
    
    
    $
    60,928
    
    
    $
    42,080
    
    
    $
    
    
    
    $
    Operating Lease
    
    $
    757,088
    
    
    
    481,120
    
    
    
    275,968
    
    
    
    
    
    
    
    Inventory Commitments
    
    $
    1,400,000
    
    
    
    1,400,000
    
    
    
    
    
    
    
    
    
    
    
    $
    2,260,096
    
    
    $
    1,942,048
    
    
    $
    318,048
    
    
    $
    
    
    
    $
    
 
 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 March 31, 2004.
Actual results may differ materially. FOREIGN CURRENCY EXCHANGE RISK The majority of the Companys revenue, expense, and capital purchasing
activities are transacted in U.S. dollars. However, as a result of the
Companys international manufacturing, research and development, sales and
marketing, inventory procurement and other activities, the Company enters into
transactions denominated in other currencies, primarily the Japanese Yen,
European Euro and Hong 17




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##### 



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 through Xybernaut China. 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 months ended March 31, 2004,
the Companys operations in Europe comprised 6.2% of its total revenue and 9.5%
of its net loss, compared to 16.7% of its total revenue and 6.0% of its net
loss, in the same period for 2003. For the three months ended March 31, 2004,
the Companys operations in Asia, excluding China, comprised 3.3% of its total revenue and 0.8%
of its net loss, compared to 8.9% of its total revenue and 0.2% of its net
loss, in the same period for 2003. For the three months ended March 31, 2004,
the Companys operations in China comprised 0.9% of its total revenue and 2.0%
of its net loss. At March 31, 2004, the Companys assets in Europe, Asia, excluding China,
comprised 3.3%, 1.7% and 0.1% of its total assets, respectively, compared
to 8.0%, 3.4% and 0% of its total assets at March 31, 2003, respectively.
According to published sources, the average fluctuation of the European Euro
during the three months ended March 31, 2004 was -0.5%, compared to 2.2% for
the same period in 2003. According to published sources, the average
fluctuation of the Japanese Yen during the three months ended March 31, 2004
was -0.3%, compared to -0.2% for the same period in 2003, respectively.
According to published sources, the average fluctuation of the Hong Kong Dollar
during the three months ended March 31, 2004 was -0.2%. 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 quarter of fiscal year 2004 was 4.0%,
compared to a 4.25% average prime interest rate during the same periods in
2003, respectively. For both 2004 and 2003, the prime interest rate fluctuation
from January 1 to March 31 of each year was 0%. Management believes that these
fluctuations did not have a material impact on the Companys results of
operations or financial position for 2004 and 2003. 
 ITEM 4. CONTROLS AND PROCEDURES As of the end of the fiscal quarter ended March 31, 2004, the Company
carried out an evaluation, under the supervision and with the participation of
the Companys management, including the Companys Chief Executive Officer,
Chief Financial Officer and President, of the effectiveness of the design and
operation of the Companys disclosure controls and procedures pursuant to
Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive
Officer, Chief Financial Officer and President concluded that the Companys
disclosure controls and procedures are effective, as of such date, to ensure
that required information will be disclosed on a timely basis in its reports
under the Exchange Act. There were no significant changes in the Companys internal control over
financial reporting during the last quarter that have materially affected, or
are reasonably likely to materially affect, the Companys internal control over
financial reporting. 
 PART II  OTHER INFORMATION 
 ITEM 2: CHANGES IN
SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES 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. The shares were sold at $1.34 per share, representing an approximate
20% discount to the closing market price of the Companys common stock. 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. The net proceeds of the placement were used
for working capital of the Company. The private placement was exempt from
registration pursuant to Section 4(2) of the Securities Act of 1933 and Rule
506 promulgated thereunder. During 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. The shares were sold at $1.51 per share, representing an approximate
10% discount to the closing market price of the Companys common stock. 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 18




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##### 



common stock at $1.52 per share. The net proceeds of the placement were used
for working capital of the Company. The private placement was exempt from
registration pursuant to Section 4(2) of the Securities Act of 1933 and Rule
506 promulgated thereunder. 
 ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K A) EXHIBITS 31.1
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200231.3
    
    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 200232
    
    Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 B) REPORTS ON FORM 8-K The Company did not file any Report on Form 8-K during the three months ended
March 31, 2004. 
 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. DAVISThomas 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: May 7,
2004
 19