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U. S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------



For the quarterly period ended June 30, 2004, or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to
.



Commission File Number 1-11860



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Focus Enhancements, Inc.

(Name of Issuer in its Charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 04-3144936                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)



1370 Dell Ave

Campbell, CA 95008

(Address of Principal Executive Offices)



(408) 866-8300

(Issuers Telephone Number, Including Area Code)



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Securities registered pursuant to Section 12(b) of Act:



Title of Each Class

Common Stock, $0.01 par value



Name of Exchange on which Registered

NASDAQ



Securities registered pursuant to Section 12(g) of the Act: None



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Check whether the Issuer (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such other 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.    x  Yes     No ̈



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



As of the close of business on August 11, 2004, there were 53.2 million shares
of Focus Enhancements common stock issued and outstanding.



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##### Table of Contents

FOCUS ENHANCEMENTS, INC.



INDEX



|                               |  |                                                                                       |  |           
|------------------------------ |  | ------------------------------------------------------------------------------------- |  | ----------
|                               |  |                                                                                       |  | PageNumber
|PART I -
FINANCIAL INFORMATION |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Financial Statements:                                                                 |  |           
|                               |  |                                                                                      
|                               |  | Condensed Consolidated Statements of Operations                                       |  | 3         
|                               |  |                                                                                      
|                               |  | Condensed Consolidated Balance Sheets                                                 |  | 4         
|                               |  |                                                                                      
|                               |  | Condensed Consolidated Statements of Comprehensive Loss                               |  | 5         
|                               |  |                                                                                      
|                               |  | Condensed Consolidated Statements of Cash Flows                                       |  | 6         
|                               |  |                                                                                      
|                               |  | Notes to Condensed Consolidated Financial Statements                                  |  | 7         
|                               |  |                                                                                      
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 15        
|                               |  |                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 29        
|                               |  |                                                                                      
|Item 4.                        |  | Controls and Procedures                                                               |  | 29        
|                               | 
|PART II -
OTHER INFORMATION    |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Legal proceedings                                                                     |  | 30        
|                               |  |                                                                                      
|Item 2.                        |  | Changes in securities                                                                 |  | 30        
|                               |  |                                                                                      
|Item 3.                        |  | Defaults upon senior securities                                                       |  | 30        
|                               |  |                                                                                      
|Item 4.                        |  | Submission of matters to a vote of security holders                                   |  | 30        
|                               |  |                                                                                      
|Item 5.                        |  | Other information                                                                     |  | 30        
|                               |  |                                                                                      
|Item 6.                        |  | Exhibits and reports on Form 8-K                                                      |  | 31        
|                               | 
|SIGNATURES                     |  | 32                                                                                   
|                               | 
|CERTIFICATIONS                 |  |                                                                                      



2



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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



Focus Enhancements, Inc.



Condensed Consolidated Statements of Operations



(In thousands, except per-share amounts)



(Unaudited)



|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|---------------------------------------------------- |  | ------------------ | ------ | - | ---------------- | - | ------ | ------------- |  | - | ------------- | - |  | - | ------ | -
|                                                     |  | Three Months Ended |        |   | Six Months Ended |  
|                                                     |  | June 30, 2004      |        |   | June 30, 2003    |   |        | June 30, 2004 |  |   | June 30, 2003 |  
|Net revenue                                          |  | $                  | 5,024  |   |                  | $ | 4,301  |               |  | $ | 9,118         |   |  | $ | 8,391  |  
|Cost of revenue                                      |  |                    | 3,223  |   |                  |   | 2,440  |               |  |   | 5,985         |   |  |   | 4,843  |  
|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Gross margin                                         |  |                    | 1,801  |   |                  |   | 1,861  |               |  |   | 3,133         |   |  |   | 3,548  |  
|                                                     |  |                    |        |  
|Operating expenses:                                  |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Sales, marketing and support                         |  |                    | 1,273  |   |                  |   | 1,089  |               |  |   | 2,327         |   |  |   | 2,087  |  
|General and administrative                           |  |                    | 908    |   |                  |   | 436    |               |  |   | 1,465         |   |  |   | 813    |  
|Research and development                             |  |                    | 1,666  |   |                  |   | 1,047  |               |  |   | 2,772         |   |  |   | 2,104  |  
|Amortization of intangible assets                    |  |                    | 243    |   |                  |   | 132    |               |  |   | 407           |   |  |   | 304    |  
|In-process research and development                  |  |                    | 300    |   |                  |   |       |               |  |   | 300           |   |  |   |       |  
|Restructuring recovery                               |  |                    |       |   |                  |   | (29    | )             |  |   |              |   |  |   | (29    | )
|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|                                                     |  |                    | 4,390  |   |                  |   | 2,675  |               |  |   | 7,271         |   |  |   | 5,279  |  
|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Loss from operations                                 |  |                    | (2,589 | ) |                  |   | (814   | )             |  |   | (4,138        | ) |  |   | (1,731 | )
|Interest expense, net                                |  |                    | (14    | ) |                  |   | (51    | )             |  |   | (60           | ) |  |   | (102   | )
|Other net income                                     |  |                    | 14     |   |                  |   | 95     |               |  |   | 20            |   |  |   | 95     |  
|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Loss before income tax expense                       |  |                    | (2,589 | ) |                  |   | (770   | )             |  |   | (4,178        | ) |  |   | (1,738 | )
|Income tax expense                                   |  |                    | 1      |   |                  |   |       |               |  |   | 1             |   |  |   | 2      |  
|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Net loss                                             |  | $                  | (2,590 | ) |                  | $ | (770   | )             |  | $ | (4,179        | ) |  | $ | (1,740 | )
|                                                     |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Net loss per share                                   |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Basic and diluted                                    |  | $                  | (0.05  | ) |                  | $ | (0.02  | )             |  | $ | (0.09         | ) |  | $ | (0.05  | )
|                                                     |  |                    |        |  
|Weighted average common and common equivalent shares |  |                    |        |   |                  |   |        |               |  |   |               |   |  |   |        |  
|Basic and diluted                                    |  |                    | 50,027 |   |                  |   | 37,184 |               |  |   | 46,466        |   |  |   | 37,146 |  



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



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##### Table of Contents

Focus Enhancements, Inc.



Condensed Consolidated Balance Sheets



(In
thousands, except per-share amounts)



(Unaudited)



|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                                                            |  | June 30,2004 |         |   | December 31,2003 |  
|Assets                                                                                                                                                                                      |  |              |         |   |                  |   |         |  
|Current assets:                                                                                                                                                                             |  |              |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                   |  | $            | 6,000   |   |                  | $ | 3,731   |  
|Accounts receivable, net of allowances of $426 and $384                                                                                                                                     |  |              | 3,053   |   |                  |   | 2,385   |  
|Inventories                                                                                                                                                                                 |  |              | 3,056   |   |                  |   | 3,493   |  
|Receivable from Visual Circuits Corporation Liquidating Trust                                                                                                                               |  |              | 400     |   |                  |   |        |  
|Prepaid expenses and other current assets                                                                                                                                                   |  |              | 386     |   |                  |   | 368     |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|Total current assets                                                                                                                                                                        |  |              | 12,895  |   |                  |   | 9,977   |  
|                                                                                                                                                                                            |  |             
|Long-term assets:                                                                                                                                                                           |  |              |         |   |                  |   |         |  
|Property and equipment, net                                                                                                                                                                 |  |              | 468     |   |                  |   | 146     |  
|Other assets                                                                                                                                                                                |  |              | 52      |   |                  |   | 151     |  
|Intangible assets, net                                                                                                                                                                      |  |              | 2,180   |   |                  |   | 635     |  
|Goodwill                                                                                                                                                                                    |  |              | 12,788  |   |                  |   | 5,191   |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|Total long-term assets                                                                                                                                                                      |  |              | 15,488  |   |                  |   | 6,123   |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|                                                                                                                                                                                            |  | $            | 28,383  |   |                  | $ | 16,100  |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                                        |  |              |         |   |                  |   |         |  
|                                                                                                                                                                                            |  |             
|Current liabilities:                                                                                                                                                                        |  |              |         |   |                  |   |         |  
|Accounts payable                                                                                                                                                                            |  | $            | 2,566   |   |                  | $ | 2,292   |  
|Accrued liabilities                                                                                                                                                                         |  |              | 2,199   |   |                  |   | 1,989   |  
|Current portion of long-term debt                                                                                                                                                           |  |              | 31      |   |                  |   |        |  
|Borrowings under line-of-credit                                                                                                                                                             |  |              | 306     |   |                  |   |        |  
|Loan payable                                                                                                                                                                                |  |              | 251     |   |                  |   |        |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                                   |  |              | 5,353   |   |                  |   | 4,281   |  
|                                                                                                                                                                                            |  |             
|Long-term liabilities:                                                                                                                                                                      |  |              |         |   |                  |   |         |  
|Convertible promissory notes payable to shareholder                                                                                                                                         |  |              |        |   |                  |   | 3,867   |  
|Long-term debt, net of current portion                                                                                                                                                      |  |              | 191     |   |                  |   |        |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|Total long-term liabilities                                                                                                                                                                 |  |              | 191     |   |                  |   | 3,867   |  
|                                                                                                                                                                                            |  |             
|Stockholders equity:                                                                                                                                                                       |  |              |         |   |                  |   |         |  
|Preferred stock, $0.01 par value; authorized 3,000,000 shares; 3,161 and 1,904 shares issued at June 30, 2004 and December 31, 2003,
respectively (aggregate liquidation preference $3,917) |  |              |        |   |                  |   |        |  
|Common stock, $0.01 par value; 100,000,000 shares authorized, 53,691,698 and 42,800,240 shares issued at June 30, 2004 and December 31, 2003,
respectively                                  |  |              | 537     |   |                  |   | 428     |  
|Additional paid-in capital                                                                                                                                                                  |  |              | 90,195  |   |                  |   | 71,295  |  
|Accumulated deficit                                                                                                                                                                         |  |              | (67,200 | ) |                  |   | (63,021 | )
|Cumulative foreign currency translation adjustments                                                                                                                                         |  |              | 57      |   |                  |   |        |  
|Treasury stock at cost, 497,055 shares at June 30, 2004 and December 31, 2003, respectively                                                                                                 |  |              | (750    | ) |                  |   | (750    | )
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                                                                  |  |              | 22,839  |   |                  |   | 7,952   |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  
|                                                                                                                                                                                            |  | $            | 28,383  |   |                  | $ | 16,100  |  
|                                                                                                                                                                                            |  |              |         |   |                  |   |         |  



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



4



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##### Table of Contents

Focus Enhancements, Inc.



Condensed Consolidated Statements of Comprehensive Loss



(In thousands)

(Unaudited)



|                                              |  |                    |        |   |                  |   |      |               |  |   |               |   |  |   |        |  
|--------------------------------------------- |  | ------------------ | ------ | - | ---------------- | - | ---- | ------------- |  | - | ------------- | - |  | - | ------ | -
|                                              |  | Three Months Ended |        |   | Six Months Ended |  
|                                              |  | June 30, 2004      |        |   | June 30, 2003    |   |      | June 30, 2004 |  |   | June 30, 2003 |  
|Net loss                                      |  | $                  | (2,590 | ) |                  | $ | (770 | )             |  | $ | (4,179        | ) |  | $ | (1,740 | )
|Foreign currency translation adjustments, net |  |                    | 58     |   |                  |   |     |               |  |   | 57            |   |  |   |       |  
|                                              |  |                    |        |   |                  |   |      |               |  |   |               |   |  |   |        |  
|Comprehensive loss                            |  | $                  | (2,532 | ) |                  | $ | (770 | )             |  | $ | (4,122        | ) |  | $ | (1,740 | )
|                                              |  |                    |        |   |                  |   |      |               |  |   |               |   |  |   |        |  



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



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##### Table of Contents

Focus Enhancements, Inc.



Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)



|                                                                                                  |  |                   |        |   |               |   |        |  
|------------------------------------------------------------------------------------------------- |  | ----------------- | ------ | - | ------------- | - | ------ | -
|                                                                                                  |  | Six Months Ended, |       
|                                                                                                  |  | June 30, 2004     |        |   | June 30, 2003 |  
|Cash flows from operating activities:                                                             |  |                   |        |   |               |   |        |  
|Net loss                                                                                          |  | $                 | (4,179 | ) |               | $ | (1,740 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                       |  |                   |        |   |               |   |        |  
|Depreciation and amortization                                                                     |  |                   | 457    |   |               |   | 405    |  
|Stock-based compensation                                                                          |  |                   | 32     |   |               |   |       |  
|Changes in assets and liabilities:                                                                |  |                   |        |   |               |   |        |  
|Decrease (increase) in accounts receivable                                                        |  |                   | 272    |   |               |   | (625   | )
|Decrease (increase) in inventories                                                                |  |                   | 1,016  |   |               |   | (70    | )
|Decrease (increase) in prepaid expenses and other assets                                          |  |                   | 154    |   |               |   | (94    | )
|Increase (decrease) in accounts payable                                                           |  |                   | (429   | ) |               |   | 593    |  
|Increase in accrued liabilities                                                                   |  |                   | 343    |   |               |   | 296    |  
|                                                                                                  |  |                   |        |   |               |   |        |  
|Net cash used in operating activities                                                             |  |                   | (2,334 | ) |               |   | (1,235 | )
|                                                                                                  |  |                  
|Cash flows from investing activities:                                                             |  |                   |        |   |               |   |        |  
|Acquisition of COMO Computer and Motion GmbH net of cash acquired                                 |  |                   | (5     | ) |               |   |       |  
|Acquisition of Visual Circuits Corporation                                                        |  |                   | (440   | ) |               |   |       |  
|Purchases of property and equipment                                                               |  |                   | (206   | ) |               |   | (51    | )
|                                                                                                  |  |                   |        |   |               |   |        |  
|Net cash used in investing activities                                                             |  |                   | (651   | ) |               |   | (51    | )
|                                                                                                  |  |                  
|Cash flows from financing activities:                                                             |  |                   |        |   |               |   |        |  
|Payments of short-term debt                                                                       |  |                   | (149   | ) |               |   |       |  
|Payments under capital lease obligations                                                          |  |                   |       |   |               |   | (24    | )
|Proceeds from exercise of common stock options and warrants                                       |  |                   | 155    |   |               |   | 162    |  
|Net proceeds from private offerings of common stock                                               |  |                   | 5,191  |   |               |   |       |  
|                                                                                                  |  |                   |        |   |               |   |        |  
|Net cash provided by financing activities                                                         |  |                   | 5,197  |   |               |   | 138    |  
|                                                                                                  |  |                  
|Effect of exchange rate changes on cash                                                           |  |                   | 57     |   |               |   |       |  
|                                                                                                  |  |                  
|Increase (decrease) in cash and cash equivalents                                                  |  |                   | 2,269  |   |               |   | (1,148 | )
|Cash and cash equivalents at beginning of period                                                  |  |                   | 3,731  |   |               |   | 1,310  |  
|                                                                                                  |  |                   |        |   |               |   |        |  
|Cash and cash equivalents at end of period                                                        |  | $                 | 6,000  |   |               | $ | 162    |  
|                                                                                                  |  |                   |        |   |               |   |        |  
|Non-Cash Activity                                                                                 |  |                   |        |   |               |   |        |  
|                                                                                                  |  |                  
|Conversion of notes payable and accrued interest to related party into common and preferred stock |  | $                 | 4,454  |   |               | $ |       |  
|                                                                                                  |  |                   |        |   |               |   |        |  



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



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##### Table of Contents

Focus Enhancements, Inc.



Notes
to Condensed Consolidated Financial Statements



1. Basis of
Presentation  Unaudited Interim Financial Information



The
condensed consolidated financial statements of Focus Enhancements, Inc. (Focus or the Company) as of June 30, 2004 and December 31, 2003, and for the three and six months ended June 30, 2004 and 2003, are unaudited and should
be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2003 included in Focus Annual Report on Form 10-K for the year ended December 31, 2003.



In the opinion of management, the condensed consolidated financial statements include all
adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of Focus financial position, operating results and cash flows for the periods presented. The results of operations for the three and six months
ended June 30, 2004 and 2003 and cash flows for the six months ended June 30, 2004 and 2003 are not necessarily indicative of the results that may be expected for any future period.



Focus fiscal year ends on December 31 and the interim quarters include 13 weeks and end on the last Sunday of the quarter. For
convenience, the accompanying condensed consolidated financial statements are shown as ending on June 30, 2004 and 2003, although the second quarters of fiscal year 2004 and 2003 ended on July 4, 2004 and June 29, 2003, respectively.



2. Consolidation and Foreign Currency Translation



The interim unaudited condensed consolidated financial statements include Focus
accounts and those of its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated upon consolidation.



The functional currency of Focus foreign subsidiary, COMO Computer & Motion (COMO  see Note 5, Business Combinations), is the
Euro. Gains and losses resulting from the translation of COMOs financial statements are reported as a separate component of stockholders equity. Gains and losses resulting from foreign currency transactions are included in net loss.



3. Pro Forma Stock Compensation Expense



Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation, encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the fair value of the award and is recognized over the
service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date over the amount an employee must pay to acquire the stock. Stock options
issued under Focus stock option plans have no intrinsic value at grant date. Accordingly, under APB Opinion No. 25, no compensation cost is recognized.



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



Focus has elected to continue with the accounting prescribed in APB Opinion No. 25 and, as a result, must make pro forma disclosures of net
income and earnings per share and other disclosures as if the fair value based method of accounting had been applied. The estimated fair value of the options is amortized to expense over the vesting period of the option. The following table presents
the effect on reported net loss and net loss per share of accounting for employee stock options under the fair value method:



|                                                                            |               |                    |        |               |                  |   |               |   |  |               |        |   |  |   |        |  
|--------------------------------------------------------------------------- | ------------- | ------------------ | ------ | ------------- | ---------------- | - | ------------- | - |  | ------------- | ------ | - |  | - | ------ | -
|(In thousands, except per-share data)                                       |               | Three Months Ended |        |               | Six Months Ended |  
|                                                                            | June 30, 2004 |                    |        | June 30, 2003 |                  |   | June 30, 2004 |   |  | June 30, 2003 |       
|Reported net loss                                                           |               | $                  | (2,590 | )             |                  | $ | (770          | ) |  | $             | (4,179 | ) |  | $ | (1,740 | )
|Deduct: Stock-based compensation expense determined under fair value method |               |                    | (306   | )             |                  |   | (188          | ) |  |               | (579   | ) |  |   | (396   | )
|                                                                            |               |                    |        |               |                  |   |               |   |  |               |        |   |  |   |        |  
|Pro forma net loss                                                          |               | $                  | (2,896 | )             |                  | $ | (958          | ) |  | $             | (4,758 | ) |  | $ | (2,136 | )
|                                                                            |               |                    |        |               |                  |   |               |   |  |               |        |   |  |   |        |  
|Basic and diluted reported net loss per share                               |               | $                  | (0.05  | )             |                  | $ | (0.02         | ) |  | $             | (0.09  | ) |  | $ | (0.05  | )
|                                                                            |               |                    |        |               |                  |   |               |   |  |               |        |   |  |   |        |  
|Basic and diluted pro forma net loss per share                              |               | $                  | (0.06  | )             |                  | $ | (0.03         | ) |  | $             | (0.10  | ) |  | $ | (0.06  | )
|                                                                            |               |                    |        |               |                  |   |               |   |  |               |        |   |  |   |        |  



Common stock equivalents have been
excluded from all calculations of net loss per share and pro forma net loss per share for the periods presented because the effect of including them would be anti-dilutive.



4. Managements Plans



The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. For the six months ended June 30, 2004 and the year ended December 31, 2003, Focus incurred a net loss of $4.2 million and $1.7 million, respectively, and used net cash in operating
activities of $2.3 million and $2.6 million, respectively. Additionally, in January 2004, Microsoft ceased placing orders for Focus FS454 product. Shipments of the FS454, which were primarily to this significant customer, represented 11% and
37% of Focus total revenues for the six months ended June 30, 2004 and the year ended December 31, 2003, respectively. These factors indicate that Focus may potentially be unable to continue as a going concern.



The condensed consolidated financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should Focus be unable to continue as a going concern. The Companys continuation as a going concern is
dependent upon its ability to generate sufficient cash flows to meet its obligations on a timely basis, to obtain additional financing as may be required, and ultimately to return to profitability and significant positive cash flows.



Focus has historically met cash needs from the proceeds of debt, the sale of common stock in
private placements and the exercise of employee stock options and warrants. Management continues to assess its product lines in light of technology trends and economic conditions, to identify how to enhance existing product lines or create new
distribution channels.



Focus management believes that net proceeds of
$5.2 million received in April 2004 from a private equity placement transaction (see Note 9, Stockholders Equity), in addition to current cash balances, are unlikely to meet all currently planned expenditures and operations through
December 31, 2004. Focus continued significant investment in research and development, primarily in the area of Ultra Wideband, and working capital needs, will require it to find a partner to fund a portion of the continued development in
Ultra Wideband and/or raise additional capital before year end. Focus anticipates that this will be so regardless of whether it partners with an experienced semiconductor design house or manufacturer.



There is no assurance that managements plans will be successful or if successful, that
they will result in Focus continuing as a going concern.



8



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



5. Business Combinations



Visual Circuits Corporation



On May 28, 2004, Focus acquired substantially all the assets and assumed certain liabilities of Visual Circuits Corporation (Visual Circuits) pursuant to an
Agreement and Plan of Reorganization. The transaction was accounted for as a purchase business combination at a total cost of approximately $9.3 million. Founded in 1991, Visual Circuits is a manufacturer and developer of integrated hardware,
software and network products that manage, schedule, distribute, store and present digital video in a wide range of commercial media applications.



Under the terms of the agreement, Visual Circuits, located in Minneapolis, Minnesota, received 3,805,453 shares of voting common stock of Focus. In connection with this
transaction, Focus paid vFinance Investments, Inc., (a related party) a success fee of $168,000 and 80,000 shares of Focus common stock. The agreement also required Visual Circuits Corporation Liquidating Trust, formerly Visual Circuits, to
reimburse Focus for all transaction costs paid by Visual Circuits prior to the acquisition. Accordingly, an amount of $400,000 has been recorded as a current asset in Focus condensed consolidated balance sheets as of June 30, 2004.



Visual Circuits results of operations are included in Focus financial
statements from the date of acquisition, and the assets and liabilities were recorded based on their fair values as of the date of acquisition. There were no employee stock options or warrants assumed as a result of the acquisition.



The purchase price of approximately $9.3 million consisted of the fair value of 3,885,453
shares of Focus common stock, which included the 80,000 shares distributed to vFinance Investments, Inc., and acquisition costs of approximately $440,000. The purchase price has been allocated based on the preliminary estimated fair value of net
tangible and intangible assets acquired and liabilities assumed as well as in-process research and development costs. As of the acquisition date, technological feasibility of the in-process technology had not been established and the technology had
no alternative future use. Therefore, Focus expensed $300,000 of the purchase price as in-process research and development expense in the second quarter of fiscal year 2004. The purchase price has been allocated as follows:



|                                      |  |                          |       |  
|------------------------------------- |  | ------------------------ | ----- | -
|(In thousands)                        |  | Purchase PriceAllocation |      
|Assets acquired                       |  | $                        | 1,604 |  
|Intangible asset: Existing technology |  |                          | 1,060 |  
|Goodwill                              |  |                          | 6,839 |  
|Liabilities assumed                   |  |                          | (539  | )
|In-process research and development   |  |                          | 300   |  
|                                      |  |                          |       |  
|                                      |  | $                        | 9,264 |  
|                                      |  |                          |       |  



Existing technology is being amortized
on a straight-line basis over an estimated useful life of three years.



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



The following pro forma information presents the results of operations of Focus as if the transaction had occurred on January 1, 2003:



|                                       |               |                    |        |               |                  |   |               |   |  |               |        |   |  |   |        |  
|-------------------------------------- | ------------- | ------------------ | ------ | ------------- | ---------------- | - | ------------- | - |  | ------------- | ------ | - |  | - | ------ | -
|(In thousands, except per-share data)  |               | Three Months Ended |        |               | Six Months Ended |  
|                                       | June 30, 2004 |                    |        | June 30, 2003 |                  |   | June 30, 2004 |   |  | June 30, 2003 |       
|Revenue                                |               | $                  | 5,709  |               |                  | $ | 5,289         |   |  | $             | 10,899 |   |  | $ | 10,404 |  
|Net loss                               |               | $                  | (2,818 | )             |                  | $ | (1,133        | ) |  | $             | (4,620 | ) |  | $ | (2,606 | )
|Net loss per share - basic and diluted |               | $                  | (0.06  | )             |                  | $ | (0.03         | ) |  | $             | (0.10  | ) |  | $ | (0.07  | )



COMO Computer & Motion GmbH



On February 27, 2004, Focus
completed the acquisition of COMO, located in Kiel, Germany, pursuant to which COMO became a wholly owned subsidiary of Focus. The acquisition was accounted for as a purchase business combination at a total cost of approximately $1.0 million. Under
the terms of the agreement, Focus acquired COMO through the issuance of 185,069 shares of its common stock and approximately $359,000 in cash to COMOs shareholders. Focus may also issue up to an additional 46,266 shares of its common stock to
COMOs shareholders, in the event certain conditions are met at the end of 2004 and 2005. In connection with this transaction, Focus paid vFinance Investments, Inc. (a related party), a success fee of $100,000 and 30,000 shares of Focus
common stock.



Founded in 1990, COMO develops, manufactures and distributes
digital video solutions. The acquisition will enable Focus to add new features to its video technology product line, including content storage and management functionality, and will provide the presence of an office in Germany, thereby facilitating
support of Focus European distributors and customers.



COMOs
results of operations are included in Focus financial statements from the date of acquisition, and the assets and liabilities were recorded based on their fair values as of the date of acquisition. There were no employee stock options or
warrants assumed as a result of the acquisition. Pro forma results of operations have not been presented because the effect of the acquisition was not material to Focus financial position or results of operations.



The purchase price of approximately $1.0 million, consisting of 231,335 shares of Focus
common stock issued to the COMO shareholders including the earn-out shares, 30,000 shares of Focus common stock issued to vFinance, cash paid to the COMO shareholders, and acquisition costs of approximately $220,000, has been allocated based on the
estimated fair value of net tangible and intangible assets acquired, and liabilities assumed. The earn-out shares are included in the purchase price because Focus management believes it is probable that the conditions under which such shares would
become payable will be met. A summary of the allocation of the purchase price to the assets acquired and liabilities assumed is as follows:



|                                      |  |                          |        |  
|------------------------------------- |  | ------------------------ | ------ | -
|(In thousands)                        |  | Purchase PriceAllocation |       
|Assets acquired                       |  | $                        | 782    |  
|Intangible asset: Existing technology |  |                          | 890    |  
|Goodwill                              |  |                          | 758    |  
|Liabilities assumed                   |  |                          | (1,420 | )
|                                      |  |                          |        |  
|                                      |  | $                        | 1,010  |  
|                                      |  |                          |        |  



Existing technology is being amortized
on a straight-line basis over an estimated useful life of three years.



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



6. Goodwill and Intangible Assets



The following table provides a summary of the change in the carrying amount of goodwill:



|                                                           |  |          |       
|---------------------------------------------------------- |  | -------- | ------
|(In thousands)                                             |  | Goodwill
|Balance as of December 31, 2003                            |  | $        | 5,191 
|Goodwill resulting from the acquisition of COMO            |  |          | 758   
|Goodwill resulting from the acquisition of Visual Circuits |  |          | 6,839 
|                                                           |  |          |       
|Balance as of June 30, 2004                                |  | $        | 12,788
|                                                           |  |          |       



The following tables provide a summary
of the carrying amounts of intangible assets:



|                    |  |               |       |                         |   |        |           |  |   |      
|------------------- |  | ------------- | ----- | ----------------------- | - | ------ | --------- |  | - | -----
|(In thousands)      |  | June 30, 2004
|                    |  | GrossAmount   |       | AccumulatedAmortization |   |        | NetAmount
|Existing technology |  | $             | 3,945 |                         | $ | (1,789 | )         |  | $ | 2,156
|Tradename           |  |               | 176   |                         |   | (152   | )         |  |   | 24   
|                    |  |               |       |                         |   |        |           |  |   |      
|                    |  | $             | 4,121 |                         | $ | (1,941 | )         |  | $ | 2,180
|                    |  |               |       |                         |   |        |           |  |   |      



|                    |  |                   |       |                         |   |        |           |  |   |    
|------------------- |  | ----------------- | ----- | ----------------------- | - | ------ | --------- |  | - | ---
|                    |  | December 31, 2003
|                    |  | GrossAmount       |       | AccumulatedAmortization |   |        | NetAmount
|Existing technology |  | $                 | 1,995 |                         | $ | (1,406 | )         |  | $ | 589
|Tradename           |  |                   | 176   |                         |   | (130   | )         |  |   | 46 
|                    |  |                   |       |                         |   |        |           |  |   |    
|                    |  | $                 | 2,171 |                         | $ | (1,536 | )         |  | $ | 635
|                    |  |                   |       |                         |   |        |           |  |   |    



The total expected future amortization
related to intangible assets is provided in the table below:



|                                   |  |              |      
|---------------------------------- |  | ------------ | -----
|(In thousands)                     |  | Amortization
|Six months ended December 31, 2004 |  | $            | 588  
|Fiscal year 2005                   |  |              | 724  
|Fiscal year 2006                   |  |              | 682  
|Fiscal year 2007                   |  |              | 186  
|                                   |  |              |      
|Total                              |  | $            | 2,180
|                                   |  |              |      

|
|

|
|

|
|



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



7. Inventories



Inventories are stated at lower of cost (first-in, first-out) or market:



|                |  |               |       |                   |   |      
|--------------- |  | ------------- | ----- | ----------------- | - | -----
|(In thousands)  |  | June 30, 2004 |       | December 31, 2003
|Raw materials   |  | $             | 1,646 |                   | $ | 2,048
|Work in process |  |               | 136   |                   |   | 72   
|Finished goods  |  |               | 1,274 |                   |   | 1,373
|                |  |               |       |                   |   |      
|                |  | $             | 3,056 |                   | $ | 3,493
|                |  |               |       |                   |   |      



8. Borrowings and
Commitments



Borrowings consisted of the following:



|                                                    |  |               |     |                   |   |      
|--------------------------------------------------- |  | ------------- | --- | ----------------- | - | -----
|(In thousands)                                      |  | June 30, 2004 |     | December 31, 2003
|Short-term debt:                                    |  |               |     |                   |   |      
|Current portion of notes payable to bank            |  | $             | 31  |                   | $ |     
|Borrowings under line-of-credit                     |  |               | 306 |                   |   |     
|Loan payable                                        |  |               | 251 |                   |   |     
|                                                    |  |               |     |                   |   |      
|                                                    |  |               | 588 |                   |   |     
|Long-term debt:                                     |  |               |     |                   |   |      
|Notes payable to bank (long-term portion)           |  |               | 191 |                   |   |     
|Convertible promissory notes payable to shareholder |  |               |    |                   |   | 3,867
|                                                    |  |               |     |                   |   |      
|                                                    |  |               | 191 |                   |   | 3,867
|                                                    |  |               |     |                   |   |      
|                                                    |  | $             | 779 |                   | $ | 3,867
|                                                    |  |               |     |                   |   |      



Short- and long-term debts were
assumed by Focus as a result of the acquisition of COMO in February 2004  see Note 5, Business Combinations.



The short-term debt consists of the current portion of two notes payable, which in aggregate, and including the long-term portion, total approximately $222,000, a
line-of-credit with an outstanding balance of approximately $306,000 and a loan with a German small business lending institution for $251,000. The notes payable and line-of-credit are denominated in Euros and are both with a local German bank.
Interest is payable on the notes at an average of 6% and on the line-of-credit at 10%. The two notes of $172,000 and $50,000 will be paid through December 2011 and December 2006, respectively. The notes payable and line-of-credit are secured by
personal guarantees from the two shareholders from whom Focus purchased the shares of COMO common stock. These personal guarantees total approximately $600,000.



The loan with the German small business lending institution consists of two contracts of similar amounts signed in 1995 and 1996. As a result of Focus
acquisition of COMO, the lending institution requested that COMO repay these loans, and accordingly the loans with an outstanding balance of $251,000 were repaid in July 2004.



12



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



Convertible Promissory Notes



Convertible promissory notes payable at December 31, 2003 consisted of three promissory notes totaling $3.9 million payable to Carl Berg, a
Company director and shareholder. The notes bore interest at prime plus 1%, payable quarterly, and were collateralized by substantially all of the assets of Focus. Focus was obligated under certain circumstances, including at the election of Mr.
Berg and Focus, to convert the outstanding balances of the notes, and any unpaid interest, into shares of Focus common stock or preferred stock, as specified in the respective note agreements.



On March 19, 2004, Mr. Berg converted his approximately $3.9 million of debt and $587,000 of
accrued interest into common and preferred stock. This conversion resulted in the issuance of 2,173,193 shares of Focus common stock and 840 shares of Series B preferred stock and 417 shares of Series C preferred stock, which are convertible
into an additional 840,000 and 417,000 shares of Focus common stock, respectively.



General



From time to time, Focus is party to certain claims and legal proceedings that arise in the ordinary course of business which, in the opinion of management, will not have
a material adverse effect on Focus financial position or results of operations.



Focus indemnifies its customers from third party claims alleging patent or copyright infringement relating to the use of the Companys products. Such indemnification provisions are accounted for in accordance with SFAS No. 5 and are
generally limited to the amount paid by the customer. Historically, costs related to these indemnification arrangements have not been significant.



In June 2004, Focus entered into a development and license agreement under which Focus agreed to pay $664,000 to a third party for engineering services and the rights to
certain intellectual property that will be used in the research and development of Ultra Wideband technology. Payments will be made upon the achievement of specific development milestones by the third party, which are expected to be completed by
January 2005. Focus recorded approximately $85,000 associated with this arrangement to research and development expense in June 2004, under the percentage of completion method of accounting.



9. Stockholders Equity



The acquisition of substantially all of the assets and assumption of liabilities of Visual
Circuits on May 28, 2004 resulted in the issuance of 3,885,453 shares of Focus common stock, consisting of 3,805,453 shares issued to Visual Circuits shareholders and 80,000 shares issued to vFinance Investments, Inc. (a related party),
for investment banking services related to the acquisition.



On April 6, 2004,
Focus announced that it had obtained binding commitments to sell approximately 3.9 million shares of its common stock to a group of third party investors in a private placement transaction, receiving proceeds of approximately $5.2 million, net of
offering costs of approximately $400,000. The shares were issued at $1.45 per share, an approximate 11% discount to the closing price of Focus common stock on April 5, 2004. In connection with the private placement, Focus issued warrants to
the investors and to a placement agent to purchase a total of approximately 1.0 million shares of common stock at an exercise price of $2.00 per share. No compensation expense was recorded given that the warrants were issued in connection with the
issuance of common stock.



The acquisition of COMO on February 27, 2004
resulted in the issuance of 261,335 shares of Focus common stock, consisting of 231,335 shares issued to COMOs shareholders, including 46,266 earn-out shares held in escrow, and 30,000 shares issued to vFinance Investments, Inc., for
investment banking services related to the acquisition. Additionally, Focus issued 610,096 common shares, held in escrow, (the Escrow shares) to COMOs two former shareholders (the sellers) who became employees of Focus.
In exchange for the Escrow shares, the Sellers issued non-interest bearing, non-recourse, demand notes payable to Focus in the aggregate amount of $1.1 million. After registration of the shares, the two former shareholders of COMO can sell the
Escrow shares at no less than the then current fair market value, with all proceeds to be remitted to Focus in exchange for cancellation of the outstanding note obligations regardless of whether such proceeds are greater than or less than the
balance of the notes. For accounting purposes, the Escrow shares are reported in the accompanying financial statements as outstanding, subscribed shares. The proceeds from the sale of such shares as eventually remitted to Focus by the Sellers will
be recorded as an increase in capital when received. The note receivable from the Sellers is not recorded in the accompanying condensed consolidated financial statements, as it will be cancelled upon receipt of the proceeds from the Escrow shares.



On March 19, 2004, Carl Berg, a Company director and shareholder, converted
his approximately $3.9 million of convertible promissory notes and $587,000 of accrued interest into common and preferred stock, as discussed in Note 8, Commitments.



13



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##### Table of Contents

Focus Enhancements, Inc.



Notes to Condensed Consolidated Financial Statements



10. Related Party Transactions



vFinance Investments Inc.



Focus has engaged the services of vFinance Investments Inc., to act as the Companys financial advisor. Timothy Mahoney, a member of Focus Board of Directors,
is the Chairman and C.O.O. of vFinance, Inc., the parent company to vFinance Investments and vFinance Consulting, and owns approximately 20% of the shares of vFinance Inc. Focus paid vFinance Investments $268,000 in fees and 110,000 shares of common
stock in the six months ended June, 2004 related to merger and acquisition services.



In February 2003, Focus engaged vFinance Consulting to assist it in preparing a Strategic Business Plan. Focus recorded $35,000 and $50,000 in the three and six months ended June 30, 2003, respectively, related to the preparation of this
plan.



14



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##### Table of Contents

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



The following information should be read in conjunction with the condensed consolidated financial statements and notes thereto in Part I, Item 1 of this Quarterly Report
and with Managements Discussion and Analysis of Financial Condition and Results of Operations contained in Focus Annual Report on Form 10-K for the year ended December 31, 2003.



Certain Factors That May Affect Future Results



Discussions of certain matters in this Quarterly Report on Form 10-Q may constitute
forward-looking statements within the meaning of the Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the Exchange Act), and as such, may involve risks and
uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words or phrases such as believe, plan,
expect, intend, anticipate, estimate, project, forecast, may increase, may fluctuate, may improve and similar expressions or future or
conditional verbs such as will, should, would, and could.



In particular, statements contained in this document that are not historical facts (including, but not limited to, statements concerning anticipated revenues, anticipated operating expense levels, potential new
products and orders, and such expense levels relative to our total revenues) constitute forward-looking statements and are made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Our actual results of
operations and financial condition have varied and may in the future vary significantly from those stated in any forward-looking statements. Factors that may cause such differences include, without limitation, the availability of capital to fund our
future cash needs, reliance on major customers, history of operating losses, market acceptance of our products, technological obsolescence, competition, successful integration of acquisitions, component supply problems and protection of proprietary
information, as well as the accuracy of our internal estimates of revenue and operating expense levels. For a discussion of these factors and some of the factors that might cause such a difference see also  - Risks Factors. These factors
should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. We do not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect
occurrences or unanticipated events or circumstances after the date of such statements.



RESULTS OF OPERATIONS



Net revenue



|                       |  |                    |       |                     |   |       |                       |   |     |   |  |      |  
|---------------------- |  | ------------------ | ----- | ------------------- | - | ----- | --------------------- | - | --- | - |  | ---- | -
|                       |  | Three Months Ended |       | Increase/(decrease) |   |       | % increase/ -decrease |  
|(Dollars in thousands) |  | June 30, 2004      |       | June 30, 2003       |   |      
|System products        |  | $                  | 4,273 |                     | $ | 3,513 |                       | $ | 760 |   |  | 21.6 | %
|Semiconductor products |  |                    | 751   |                     |   | 788   |                       |   | (37 | ) |  | -4.7 | %
|                       |  |                    |       |                     |   |       |                       |   |     |   |  |      |  
|                       |  | $                  | 5,024 |                     | $ | 4,301 |                       | $ | 723 |   |  | 16.8 | %
|                       |  |                    |       |                     |   |       |                       |   |     |   |  |      |  



15



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##### Table of Contents

|                       |  |                  |       |                     |   |       |                       |   |     |   |  |      |  
|---------------------- |  | ---------------- | ----- | ------------------- | - | ----- | --------------------- | - | --- | - |  | ---- | -
|                       |  | Six Months Ended |       | Increase/(decrease) |   |       | % increase/ -decrease |  
|(Dollars in thousands) |  | June 30,2004     |       | June 30,2003        |   |      
|System products        |  | $                | 7,120 |                     | $ | 7,161 |                       | $ | (41 | ) |  | -0.6 | %
|Semiconductor products |  |                  | 1,998 |                     |   | 1,230 |                       |   | 768 |   |  | 62.4 | %
|                       |  |                  |       |                     |   |       |                       |   |     |   |  |      |  
|                       |  | $                | 9,118 |                     | $ | 8,391 |                       | $ | 727 |   |  | 8.7  | %
|                       |  |                  |       |                     |   |       |                       |   |     |   |  |      |  



Revenue for the three months ended
June 30, 2004 was $5.0 million, an increase of $723,000 compared with the three months ended June 30, 2003. Revenue for the six months ended June 30, 2004 was $9.1 million, an increase of $727,000 compared with the six months ended June 30, 2003.



For the three months ended June 30, 2004, sales of system products
(professional and consumer) to distributors, retailers and VARs were approximately $4.3 million compared to $3.5 million for the same period in 2003, an increase of $760,000. This increase in sales of our systems products mainly reflects sales
of products resulting from the acquisitions of COMO in February 2004 and Visual Circuits in May 2004, as well as the introduction of new products, including FireStore, partially offset by a decrease in sales of our consumer scan conversion products.
The decrease in sales of system products of $41,000 in the six-month comparison reflects those same factors affecting the three-month comparison, as well as significantly lower Mixer sales. The decrease in Mixer product sales occurred primarily in
Asia, as video enthusiasts move from stand-alone editing systems to computer based or non-linear editing systems. Although this shift in technology began in the United States and Europe in prior years, certain markets, including Asia, were initially
slower to adopt non-linear editing. Our consumer scan conversion product sales have decreased as an increasing number of personal computers and televisions now incorporate scan conversion technology.



Sales of semiconductor products to distributors and OEM customers of approximately $751,000
in the three months ended June 30, 2004 were relatively flat compared to $788,000 for the comparative period in 2003. The $768,000 increase in sales of semiconductor products in the six-month comparison reflects sales of our FS454 chip in the first
quarter of 2004 to Microsoft for use in its Xbox, partially offset by decreased sales of our FS401 chip. In January 2004, Microsoft ceased placing orders for our FS454 product. Shipments of the FS454, which were primarily to this significant
customer, represented 11% and 37% of Focus total revenues for the six months ended June 30, 2004 and the year ended December 31, 2003, respectively. There were no sales of our FS454 chip to Microsoft in the three months ended June 30, 2004 and
2003.



As of June 30, 2004, we had a sales order backlog of approximately $1.4
million, an increase of $1.1 million compared to the first quarter of 2004. The backlog at June 30, 2004 consisted primarily of products resulting from the acquisition of Visual Circuits and semiconductor chips.



One customer accounted for 16% of our revenue in the three months ended June 30, 2004. One
customer accounted for 17% of our revenue for the three months ended June 30, 2003. In the six months ended June 30, 2004, two customers with sales in excess of 10% of our revenue accounted for 26% of total revenue. In the six months ended June 30,
2003, one customer accounted for 13% of our total revenue.



16



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##### Table of Contents

Gross margin



|                       |  |                    |       |   |                      |   |       |   |  |   |      |  
|---------------------- |  | ------------------ | ----- | - | -------------------- | - | ----- | - |  | - | ---- | -
|                       |  | Three Months Ended |       |   | Increase/ (decrease) |  
|(Dollars in thousands) |  | June 30, 2004      |       |   | June 30, 2003        |   |      
|Gross margin           |  | $                  | 1,801 |   |                      | $ | 1,861 |   |  | $ | (60  | )
|                       |  |                    |       |   |                      |   |       |   |  |   |      |  
|Gross margin rate      |  |                    | 35.8  | % |                      |   | 43.3  | % |  |   | -7.5 | %
|                       |  |                    |       |   |                      |   |       |   |  |   |      |  



|                       |  |                  |       |   |                      |   |       |   |  |   |      |  
|---------------------- |  | ---------------- | ----- | - | -------------------- | - | ----- | - |  | - | ---- | -
|                       |  |                 
|                       |  | Six Months Ended |       |   | Increase/ (decrease) |  
|(Dollars in thousands) |  | June 30, 2004    |       |   | June 30, 2003        |   |      
|Gross margin           |  | $                | 3,133 |   |                      | $ | 3,548 |   |  | $ | (415 | )
|                       |  |                  |       |   |                      |   |       |   |  |   |      |  
|Gross margin rate      |  |                  | 34.4  | % |                      |   | 42.3  | % |  |   | -7.9 | %
|                       |  |                  |       |   |                      |   |       |   |  |   |      |  



Our gross margin rate in the three
months ended June 30, 2004 decreased by 7.5 percentage points to 35.8% from 43.3% in the three months ended June 30, 2003. Our gross margin rate in the six months ended June 30, 2004 decreased to 34.4% from 42.3% in the six months ended September
29, 2002, a decrease of 7.9 percentage points.



The decrease in the gross
margin rate in the three-month comparison reflects inventory write-downs of $80,000 for excess and obsolete inventory, a charge of $140,000 associated with a fair value adjustment to Visual Circuits inventory upon acquisition and an accrual of
$100,000 for a royalty payment based on the achievement of certain sales volumes. In addition to these factors, the decrease in the gross margin rate in the six-month comparison was affected by the below average gross margin business that we
conducted with Microsoft in the three months ended March 31, 2004, which did not occur in three months ended March 31, 2003. This significant customer represented approximately 25% of our revenue for the three months ended March 31, 2004. Sales to
this customer were made at a gross profit margin percentage of less than 30%, primarily as a result of volume discounts provided.



Operating expenses



|                                    |  |                    |       |             |               |   |  |          |       |             |  |      |   |  |             |       |  |      |  
|----------------------------------- |  | ------------------ | ----- | ----------- | ------------- | - |  | -------- | ----- | ----------- |  | ---- | - |  | ----------- | ----- |  | ---- | -
|                                    |  | Three Months Ended |       |             |               |  
|(Dollars in thousands)              |  | June 30, 2004      |       |             | June 30, 2003 |   |  | Increase |      
|                                    |  |                    |       | % ofrevenue |               |   |  |          |       | % ofrevenue |  |      |   |  | % ofrevenue |      
|Sales, marketing and support        |  | $                  | 1,273 |             | 25.3          | % |  | $        | 1,089 |             |  | 25.3 | % |  | $           | 184   |  | 0.0  | %
|General and administrative          |  |                    | 908   |             | 18.1          | % |  |          | 436   |             |  | 10.1 | % |  |             | 472   |  | 8.0  | %
|Research and development            |  |                    | 1,666 |             | 33.2          | % |  |          | 1,047 |             |  | 24.3 | % |  |             | 619   |  | 8.9  | %
|Amortization of intangible assets   |  |                    | 243   |             | 4.8           | % |  |          | 132   |             |  | 3.1  | % |  |             | 111   |  | 1.7  | %
|In-process research and development |  |                    | 300   |             | 6.0           | % |  |          |      |             |  | 0.0  | % |  |             | 300   |  | 6.0  | %
|Restructuring recovery              |  |                    |      |             | 0.0           | % |  |          | (29   | )           |  | -0.7 | % |  |             | 29    |  | 0.7  | %
|                                    |  |                    |       |             |               |   |  |          |       |             |  |      |   |  |             |       |  |      |  
|                                    |  | $                  | 4,390 |             | 87.4          | % |  | $        | 2,675 |             |  | 62.2 | % |  | $           | 1,715 |  | 25.2 | %
|                                    |  |                    |       |             |               |   |  |          |       |             |  |      |   |  |             |       |  |      |  



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|                                    |  |                  |       |             |               |   |  |          |       |             |  |      |   |  |             |       |  |      |  
|----------------------------------- |  | ---------------- | ----- | ----------- | ------------- | - |  | -------- | ----- | ----------- |  | ---- | - |  | ----------- | ----- |  | ---- | -
|                                    |  | Six Months Ended |       |             |               |   |  |         
|(Dollars in thousands)              |  | June 30, 2004    |       |             | June 30, 2003 |   |  | Increase |      
|                                    |  |                  |       | % ofrevenue |               |   |  |          |       | % ofrevenue |  |      |   |  | % ofrevenue |      
|Sales, marketing and support        |  | $                | 2,327 |             | 25.5          | % |  | $        | 2,087 |             |  | 24.9 | % |  | $           | 240   |  | 0.6  | %
|General and administrative          |  |                  | 1,465 |             | 16.1          | % |  |          | 813   |             |  | 9.7  | % |  |             | 652   |  | 6.4  | %
|Research and development            |  |                  | 2,772 |             | 30.4          | % |  |          | 2,104 |             |  | 25.1 | % |  |             | 668   |  | 5.3  | %
|Amortization of intangible assets   |  |                  | 407   |             | 4.5           | % |  |          | 304   |             |  | 3.6  | % |  |             | 103   |  | 0.9  | %
|In-process research and development |  |                  | 300   |             | 3.3           | % |  |          |      |             |  | 0.0  | % |  |             | 300   |  | 3.3  | %
|Restructuring recovery              |  |                  |      |             | 0.0           | % |  |          | (29   | )           |  | -0.3 | % |  |             | 29    |  | 0.3  | %
|                                    |  |                  |       |             |               |   |  |          |       |             |  |      |   |  |             |       |  |      |  
|                                    |  | $                | 7,271 |             | 79.7          | % |  | $        | 5,279 |             |  | 62.9 | % |  | $           | 1,992 |  | 16.8 | %
|                                    |  |                  |       |             |               |   |  |          |       |             |  |      |   |  |             |       |  |      |  



Sales, marketing and support



Sales, marketing and support expenses for the three months ended June 30,
2004 were $1.3 million compared to $1.1 million in the three months ended June 30, 2003, an increase of $184,000. Sales, marketing and support expenses for the six months ended June 30, 2004 were $2.3 million, compared to $2.1 million for the six
months ended June 30, 2003, an increase of $240,000.



The increase in sales,
marketing and support expenses in the three- and six-month comparisons reflects an increase in headcount resulting from the acquisitions of COMO and Visual Circuits in February and May of 2004, respectively, partially offset by lower public
relations and advertising expenditures.



General and administrative



General and administrative expenses for the three months ended June 30, 2004
were $908,000, compared to $436,000 in the three months ended June 30, 2003, an increase of $472,000. General and administrative expenses for the six months ended June 30, 2004 were $1.5 million, compared to $813,000 for the six months ended June
30, 2003, an increase of $652,000.



The increase in general and administrative
expenses in the three- and six-month comparisons was mainly due to additional headcount associated with the acquisitions of COMO and Visual Circuits and corporate compliance initiatives, the change in classification of certain personnel costs from
research and development in 2003 to general and administrative in 2004, and to a lesser extent, an increase in public relations and legal fees. The increase in legal fees was associated with Ultra Wideband patent applications and the timing of our
annual shareholders meeting.



Research and development



Research and development expenses for the three months ended June 30, 2004 were $1.7
million, compared to $1.0 million in the three months ended June 30, 2003, an increase of $619,000. Research and development expenses for the six months ended June 30, 2004 were $2.8 million, compared to $2.1 million for the six months ended June
30, 2003, an increase of $668,000.



The increase in research and development
expenses in the three- and six month comparisons mainly reflects additional headcount and expenditure related to our investment in Ultra Wideband technology as well as the acquisitions of COMO and Visual Circuits in February and May of 2004,
respectively. This increase in our investment in Ultra Wideband technology was the primary factor that resulted in our Semiconductor Business increasing its research and development spending to $770,000 for the three months ended June 30, 2004
compared to $515,000 for the second quarter of 2003. These increases in research and development expenses were partially offset by a change in classification of certain personnel costs year-over-year from research and development in 2003 to general
and administrative in 2004.



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Amortization



Amortization expense for the three months ended June 30, 2004 was $243,000, an increase of $111,000 from $132,000 for the three months ended June 30, 2003. Amortization
expense for the six months ended June 30, 2004 was $407,000, an increase of $103,000 from $304,000 for the six months ended June 30, 2003. The increase in amortization expense for the three-month comparison reflects additional amortization expense
associated with the intangible assets that resulted from the acquisitions of DV Unlimited in September 2003, COMO in February 2004 and Visual Circuits in May 2004. In the six-month comparison, this additional amortization expense was partially
offset by the completion of amortization on certain intangible assets in 2003.



Interest expense, net and Other income, net



|                       |  |                    |     |   |               |   |      |          |  |   |            |   |  |       |  
|---------------------- |  | ------------------ | --- | - | ------------- | - | ---- | -------- |  | - | ---------- | - |  | ----- | -
|                       |  | Three Months Ended |     |   |               |   |      |          | 
|(Dollars in thousands) |  | June 30, 2004      |     |   | June 30, 2003 |   |      | Decrease |  |   | % decrease |  
|Interest expense, net  |  | $                  | (14 | ) |               | $ | (51  | )        |  | $ | (37        | ) |  | -72.5 | %
|                       |  |                    |     |   |               |   |      |          |  |   |            |   |  |       |  
|Other income, net      |  |                    | 14  |   |               |   | 95   |          |  |   | (81        | ) |  | -85.3 | %
|                       |  |                    |     |   |               |   |      |          |  |   |            |   |  |       |  
|                       |  |                    |    
|                       |  | Six Months Ended   |     |   |               |   |      |          | 
|(Dollars in thousands) |  | June 30, 2004      |     |   | June 30, 2003 |   |      | Decrease |  |   | % decrease |  
|Interest expense, net  |  | $                  | (60 | ) |               | $ | (102 | )        |  | $ | (42        | ) |  | -41.2 | %
|                       |  |                    |     |   |               |   |      |          |  |   |            |   |  |       |  
|Other income, net      |  |                    | 20  |   |               |   | 95   |          |  |   | (75        | ) |  | -78.9 | %
|                       |  |                    |     |   |               |   |      |          |  |   |            |   |  |       |  



Net interest expense for the three
months ended June 30, 2004 was $14,000, compared to $51,000 in the three months ended June 30, 2003. Net interest expense for the six months ended June 30, 2004 was $60,000, compared to $102,000 in the three months ended June 30, 2003. The decrease
in net interest expense in both the three- and six-month comparisons reflect the conversion in March 2004 of convertible promissory notes into common and preferred stock, partially offset by interest expense associated with short- and long-term debt
assumed with the acquisition of COMO in February 2004.



Other income for the
three and six months ended June 30, 2004 and 2003 primarily consists of the settlement of vendor obligations for less than original amounts.



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LIQUIDITY AND CAPITAL RESOURCES



The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization
of assets and the satisfaction of liabilities in the normal course of business. For the six months ended June 30, 2004 and the year ended December 31, 2003, we incurred net losses of $4.2 million and $1.7 million, respectively, and used cash in
operating activities of $2.3 million, and $2.6 million, respectively. These factors indicate that we may potentially be unable to continue as a going concern.



The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and
classification of liabilities that might be necessary should we be unable to continue as a going concern. Our continuation as a going concern is dependent upon our ability to generate sufficient cash flows to meet our obligations on a timely basis,
to obtain additional financing as may be required, and ultimately to return to profitability and significant positive cash flows.



Since inception, we have financed our operations primarily through the public and private sale of common stock, proceeds from the exercise of options and warrants,
short-term borrowings from private lenders, and favorable credit arrangements with vendors and suppliers.



First Six Months of Fiscal Year 2004 compared to the First Six Months of Fiscal Year 2003



|                                          |  |                               |        |   |                   |   |        |  
|----------------------------------------- |  | ----------------------------- | ------ | - | ----------------- | - | ------ | -
|                                          |  | As of or for Six Months Ended |       
|(Dollars in thousands)                    |  | June 30, 2004                 |        |   | December 31, 2003 |  
|Cash and cash equivalents                 |  | $                             | 6,000  |   |                   | $ | 3,731  |  
|Working capital                           |  | $                             | 7,542  |   |                   | $ | 5,696  |  
|                                          |  |                              
|                                          |  | June 30, 2004                 |        |   | June 30, 2003     |  
|Days sales outstanding (DSO)              |  |                               | 54.7   |   |                   |   | 52.5   |  
|                                          |  |                              
|Inventory turns - annualized              |  |                               | 4.2    |   |                   |   | 2.8    |  
|                                          |  |                              
|Net cash used in operating activities     |  | $                             | (2,334 | ) |                   | $ | (1,235 | )
|Net cash used in investing activities     |  | $                             | (651   | ) |                   | $ | (51    | )
|Net cash provided by financing activities |  | $                             | 5,197  |   |                   | $ | 138    |  



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Net cash used in operating activities



|                                                         |  |                      |        |   |                      |   |        |                                |  |   |        |  
|-------------------------------------------------------- |  | -------------------- | ------ | - | -------------------- | - | ------ | ------------------------------ |  | - | ------ | -
|                                                         |  | Six Months Ended,    |        |   |                      |  
|(In thousands)                                           |  | June 30, 2004        |        |   | June 30, 2003        |   |        | Change in cash (used),provided | 
|                                                         |  | cash (used),provided |        |   | cash (used),provided |   |       
|Net loss                                                 |  | $                    | (4,179 | ) |                      | $ | (1,740 | )                              |  | $ | (2,439 | )
|Non-cash income statement items                          |  |                      | 489    |   |                      |   | 405    |                                |  |   | 84     |  
|Decrease (increase) in accounts receivable               |  |                      | 272    |   |                      |   | (625   | )                              |  |   | 897    |  
|Decrease (increase) in inventories                       |  |                      | 1,016  |   |                      |   | (70    | )                              |  |   | 1,086  |  
|Decrease (increase) in prepaid expenses and other assets |  |                      | 154    |   |                      |   | (94    | )                              |  |   | 248    |  
|Increase (decrease) in accounts payable                  |  |                      | (429   | ) |                      |   | 593    |                                |  |   | (1,022 | )
|Increase in accrued liabilities                          |  |                      | 343    |   |                      |   | 296    |                                |  |   | 47     |  
|                                                         |  |                      |        |   |                      |   |        |                                |  |   |        |  
|                                                         |  | $                    | (2,334 | ) |                      | $ | (1,235 | )                              |  | $ | (1,099 | )
|                                                         |  |                      |        |   |                      |   |        |                                |  |   |        |  



Net cash used in operating activities
for the six months ended June 30, 2004 and 2003 was $2.3 million and $1.2 million, respectively. The increase in net cash used in operating activities mainly reflects an increase in the net loss as well as an increase in cash used for accounts
payable, partially offset by an increase in cash provided from accounts receivable and inventories. The increase in cash used for accounts payable in the six months ended June 30, 2004, reflects payments relating to payable balances outstanding at
December 31, 2003 associated with FS454 chip production, which was primarily used in Microsoft Xbox. In January 2004, Microsoft ceased placing orders for the FS454 chip from us. The increase in cash provided by accounts receivable and
inventories reflects significant decreases in our accounts receivable and inventories balances from December 31, 2003. These decreases are a result of a decrease in FS454 production and related sales, which were primarily to Microsoft.



One customer had an accounts receivable balance in excess of 10% of our total accounts
receivable at June 30, 2004 and this customer accounted for 20% of our total accounts receivable at that date.



We expect that our operating cash flows may fluctuate in future periods as a result of fluctuations in our operating results, shipment timetable and accounts receivable collections, inventory management, and the
timing of payments among other factors.



Net cash used in investing activities



Net cash used in
investing activities was $651,000 for the six months ended June 30, 2004, compared to $51,000 for the six months ended June 30, 2003. The increase in cash used in investing activities mainly reflects transaction costs incurred during the six months
ended June 30, 2004 with respect to the acquisitions of Visual Circuits and COMO, as well as an increase in capital expenditures primarily related to our investment in Ultra Wideband.



Net cash provided by financing activities



Net cash provided by financing activities was $5.2 million for the six months ended June 30,
2004, compared to $138,000 for the six months ended June 30, 2003. This increase primarily reflects net proceeds of $5.2 million received in April 2004 from a private equity placement transaction.



Capital Resources and Liquidity Outlook



We have incurred losses and used net cash in operating activities for the six months ended
June 30, 2004 and each of the two years in the period ended December 31, 2003, and as such, have been dependent upon raising money for short- and long-term cash needs through debt, proceeds from the exercise of options and warrants, and the sale of
our common



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stock in private placements. For the year ended December 31, 2003, we received approximately $1.9 million in net proceeds
from private offerings of common stock. In April 2004 we received net proceeds of approximately $5.2 million from the sale of approximately 3.9 million shares of our common stock to a group of third party investors in a private placement
transaction.



At December 31, 2003, we owed Carl Berg, a Company director and
shareholder, approximately $4.4 million in principal and accrued interest on various notes. On March 19, 2004, Mr. Berg converted the outstanding principal and accrued interest balance into common and preferred stock. At June 30, 2004, our remaining
debt obligations consisted of approximately $779,000 in Euro-denominated short- and long-term debt assumed in connection with the acquisition of COMO  see Note 8, Borrowings and Commitments.



In January 2004, Microsoft ceased placing orders for our FS454 product. Shipments of the
FS454, which were primarily to this significant customer, represented 11% and 37% of our total revenues for the six months ended June 30, 2004 and the year ended December 31, 2003, respectively. We recorded gross margins as a percentage of sales,
before commissions and selling expenses, of below 30% relative to sales of the FS454 chip. The loss of Microsoft orders for the FS454 will have a material adverse effect on our revenues, operating profit and liquidity, especially when compared to
the third and fourth quarter of 2003 and the first quarter of 2004, as we began our initial shipments to the customer in the third quarter of 2003 and continued sales through the first quarter of 2004. However, as the product was manufactured by one
of our contract manufacturers, we were able to meet the customers requirements without an increase in our staffing and operations. Although there can be no assurances, we do not anticipate any significant adjustments to our staffing or
operations or significant adjustments to the carrying value of our FS454 inventory, as a result of this loss.



In addition to regularly reviewing our cost structure, we have recently announced new product introductions, which are expected to generate additional revenue in 2004 and beyond, and are continually reviewing our
product lines to identify how to enhance existing, or create new, distribution channels. There can be no assurances as to the amount of revenue these new products will produce.



We believe that net proceeds of $5.2 million received in April 2004 from a private equity placement transaction (see Note 9,
Stockholders Equity), in addition to current cash balances, are unlikely to meet all currently planned expenditures and operations through December 31, 2004. Our continued significant investment in research and development, primarily in
the area of Ultra Wideband, and working capital needs, will require us to find a partner to fund a portion of the continued development in Ultra Wideband and/or raise additional capital before year end. We anticipate that this will be so regardless
of whether we partner with an experienced semiconductor design house or manufacturer.



Summary of Certain Contractual Obligations as of June 30, 2004



|                 |  |          |     |           |   |           |  |       |     |  |   |      
|---------------- |  | -------- | --- | --------- | - | --------- |  | ----- | --- |  | - | -----
|(In thousands)   |  | < 1 year |     | 2-3 years |   | > 3 years |  | Total
|Operating leases |  | $        | 434 |           | $ | 161       |  | $     |    |  | $ | 595  
|Notes payable    |  |          | 31  |           |   | 63        |  |       | 128 |  |   | 222  
|Loan payable     |  |          | 251 |           |   |          |  |       |    |  |   | 251  
|                 |  |          |     |           |   |           |  |       |     |  |   |      
|                 |  | $        | 716 |           | $ | 224       |  | $     | 128 |  | $ | 1,068
|                 |  |          |     |           |   |           |  |       |     |  |   |      



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RISK FACTORS



Risks Related to Our Business



We have a long history of operating losses.



As of June 30, 2004, we had an accumulated deficit of $67.2 million. We incurred net losses of $4.2 million, $1.7 million and $6.0 million for the six months ended June
30, 2004 and the years ended December 31, 2003 and 2002, respectively. There can be no assurance that we will ever become profitable. Additionally, our auditors have included an explanatory paragraph in their report on our financial statements for
the year ended December 31, 2003 with respect to substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of that uncertainty.



We may need to raise additional capital through equity securities placements, which will
result in further dilution of existing and future stockholders.



Historically, we have met our short- and long-term extra cash needs through debt and the sale of common stock in private placements because cash flow from operations has been insufficient to fund our operations.



Future capital requirements will depend on many factors, including cash flow from operations,
continued progress in research and development programs, competing technological and market developments, and our ability to market our products successfully. If we require additional equity or debt financing in the future, there can be no assurance
that sufficient funds will be raised. Moreover, any equity financing or convertible debt would result in dilution to our then-existing stockholders and could have a negative effect on the market price of our common stock. Furthermore, any additional
debt financing will result in higher interest expense.



We completed the
acquisitions of COMO and Visual Circuits in the first and second quarters of 2004, respectively. These acquisitions were effected through the issuance of common stock, and the businesses associated with these acquisitions are not currently
profitable. Although in April 2004 we raised net proceeds of approximately $5.2 million through the sale of approximately 3.9 million shares of our common stock to a group of third party investors in a private placement transaction, we may require
additional sales of securities in the future.



We are dependent upon a
significant stockholder to meet our interim financing needs.



We have
relied upon the ability of Carl Berg, a director and significant owner of our common stock, for interim financing needs. As of December 31, 2003, we had an aggregate of approximately $4.4 million in debt and accrued interest outstanding to Mr. Berg.
On March 19, 2004, Mr. Berg converted this debt and accrued interest to common and preferred stock. Additionally, Mr. Berg has provided Samsung Semiconductor Inc., our contracted ASIC manufacturer, with a personal guarantee to secure our working
capital requirements for ASIC purchase order fulfillment. There can be no assurances that Mr. Berg will continue to provide such interim financing or personal guarantees, should we need additional funds or increased credit facilities with our
vendors.



We have a significant amount of convertible securities that will
dilute existing stockholders upon conversion.



At August 5, 2004, we had
3,161 shares of preferred shares issued and outstanding, and 1.4 million warrants and 6.1 million options, which are all exercisable into shares of common stock. The 3,161 shares of preferred stock are convertible into approximately 3.2 million
shares of our voting common stock. See Note 10, Related Party Transactions. Furthermore, 408,000 additional stock options were available for grant to our employees, officers, directors and consultants under our current stock option
plans. The 2004 Stock Incentive Plan was approved at the annual shareholders meeting on August 6, 2004, resulting in a further 2.5 million stock options being made available for issuance. We also may issue additional shares in acquisitions. Any
additional grant of options under existing or future plans or issuance of shares in connection with an acquisition will further dilute existing stockholders.



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Any acquisitions of companies or
technologies by us, including our recently completed acquisitions of COMO and Visual Circuits may result in distraction of our management and disruptions to our business.



We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise, as
was the case in February 2004 when we acquired the stock of COMO and in May 2004 when we acquired substantially all the assets of Visual Circuits. From time to time, we may engage in discussions and negotiations with companies regarding the
possibility of acquiring or investing in their businesses, products, services or technologies. We may not be able to identify suitable acquisition or investment candidates in the future, or if we do identify suitable candidates, we may not be able
to make such acquisitions or investments on commercially acceptable terms or at all. If we acquire or invest in another company, we could have difficulty assimilating that companys personnel, operations, technology or products and service
offerings. In addition, the key personnel of the acquired company may decide not to work for us. These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect the results of
operations. Furthermore, we may incur indebtedness or issue equity securities to pay for any future acquisitions and/or pay for the legal, accounting or finders fees, typically associated with an acquisition. The issuance of equity securities could
be dilutive to our existing stockholders. In addition, the accounting treatment for any acquisition transaction may result in significant goodwill, which, if impaired, will negatively affect our consolidated results of operations. The accounting
treatment for any potential acquisition may also result in a charge for in-process research and development expense, as was the case with the acquisition of Visual Circuits, which will negatively affect our consolidated results of operations.



We rely on certain vendors for a significant portion of our manufacturing.



Approximately 34% of the components for our products are manufactured on
a turnkey basis by two vendors, Furthertech Company Ltd. and Samsung Semiconductor Inc. In addition, a single vendor in Mexico assembles certain of our products. If these vendors experience production or shipping problems for any reason, we in turn
could experience delays in the production and shipping of our products, which would have an adverse effect on our results of operations.



We are dependent on our suppliers.



We purchase all of our parts from outside suppliers and from time to time experience delays in obtaining some components or peripheral devices. Additionally, we are
dependent on sole source suppliers for certain components. There can be no assurance that labor problems, supply shortages or product discontinuations will not occur in the future which could significantly increase the cost, or delay shipment, of
our products, which in turn could adversely affect our results of operations.



We depend on a few customers for a high percentage of our revenues and the loss or failure to pay of any one of these customers could result in a substantial decline in our revenues and profits.



For the six months ended June 30, 2004, our largest five customers in aggregate provided 39%
of our total revenues and as of June 30, 2004 comprised 39% of our accounts receivable balance. We presently have no reason to believe that these customers lack the financial resources to pay. We do not have long-term contracts requiring any
customer to purchase any minimum amount of products. There can be no assurance that we will continue to receive orders of the same magnitude as in the past from existing customers or will be able to market our current or proposed products to new
customers. However, the loss of any major customer, the failure of any such identified customer to pay us, or to discontinue issuance of additional purchase orders, would have a material adverse effect on our revenues, results of operation, and
business as a whole absent the timely replacement of the associated revenues and profit margins associated with such business. Furthermore, many of our products are dependent upon the overall success of our customers products, over which we
often have no control.



To that point, in January 2004, Microsoft ceased
placing orders for our FS454 product. Shipments of the FS454, which were primarily to this significant customer, represented 11% and 37% of our total revenues for the six months ended June 30, 2004 and the year ended December 31, 2003, respectively.
The loss of Microsoft orders for the FS454 will have a material adverse effect on our revenues, operating profit and liquidity, especially when compared to the third and



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fourth quarter of 2003 and the first quarter of 2004, as we began our initial shipments to Microsoft in the third quarter
of 2003 and continued sales through the first quarter of 2004. However, as the product was manufactured by one of our contract manufacturers, we were able to meet Microsofts requirements without an increase in our staffing and operations.
Although there can be no assurances, we do not anticipate any significant adjustments to our staffing or operations or significant adjustments to the carrying value of our FS454 inventory, as a result of this loss.



Our quarterly financial results are subject to significant fluctuations.



We have been unable in the past to accurately forecast our operating expenses or
revenues. Revenues currently depend heavily on volatile customer purchasing patterns. If actual revenues are less than projected revenues, we may be unable to reduce expenses proportionately, and our operating results, cash flows and liquidity would
likely be adversely affected.



Our products may become obsolete very
quickly.



The computer peripheral markets are characterized by extensive
research and development and rapid technological change resulting in short product life cycles. Development by others of new or improved products, processes or technologies may make our products or proposed products obsolete or less competitive. We
must devote substantial efforts and financial resources to enhance our existing products and to develop new products, including our investment in Ultra Wideband technology, which is expected to increase significantly through the remainder of 2004.
There can be no assurance that we will succeed with these efforts.



We may
not be able to protect our proprietary information.



As of June 30, 2004,
we held four patents and one pending application, which combined five previous provisional patent applications, in the United States. Certain of these patents have also been filed and issued in countries outside the United States. We treat our
technical data as confidential and rely on internal non-disclosure safeguards, including confidentiality agreements with employees, and on laws protecting trade secrets, to protect our proprietary information. There can be no assurance that these
measures will adequately protect the confidentiality of our proprietary information or prove valuable in light of future technological developments.



Delays in product development could adversely affect our market position or customer relationships.



We have experienced delays in product development in the past and may experience similar delays in the future. Given the short product life
cycles in the markets for our products, any delay or unanticipated difficulty associated with new product introductions or product enhancements could cause us to lose customers and damage our competitive position. Prior delays have resulted from
numerous factors, such as:



| |  | changing product specifications;
| | - | --------------------------------



| |  | difficulties in hiring and retaining necessary personnel;
| | - | ---------------------------------------------------------



| |  | difficulties in reallocating engineering resources and other resource limitations;
| | - | ----------------------------------------------------------------------------------



| |  | difficulties with independent contractors;
| | - | ------------------------------------------



| |  | changing market or competitive product requirements;
| | - | ----------------------------------------------------



| |  | unanticipated engineering complexity;
| | - | -------------------------------------



| |  | undetected errors or failures in software and hardware; and
| | - | -----------------------------------------------------------



| |  | delays in the acceptance or shipment of products by customers.
| | - | --------------------------------------------------------------



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If we are unable to respond to rapid technological change in a timely manner, then we may lose customers to our
competitors.



To remain competitive, we must continue to enhance and
improve the responsiveness, functionality and features of our products. Our industry is characterized by rapid technological change, changes in user and customer requirements and preferences and frequent new product and service introductions. If
competitors introduce products and services embodying new technologies, or if new industry standards and practices emerge, then our existing proprietary technology and systems may become obsolete. Our future success will depend on our ability to do
the following:



| |  | both license and internally develop leading technologies useful in our business;
| | - | --------------------------------------------------------------------------------



| |  | enhance our existing technologies;
| | - | ----------------------------------



| |  | develop new services and technology that address the increasingly sophisticated and varied needs of our prospective customers; and
| | - | ----------------------------------------------------------------------------------------------------------------------------------



| |  | respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis.
| | - | ---------------------------------------------------------------------------------------------------------------------



To develop our proprietary technology entails significant technical and business risks. We
may use new technologies ineffectively, or we may fail to adapt our proprietary technology and transaction processing systems to customer requirements or emerging industry standards. If we face material delays in introducing new services, products
and enhancements, then our customers may forego the use of our services and use those of our competitors.



We typically operate without a significant amount of backlog.



We typically operate with a small amount of backlog. Accordingly, we generally do not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that
quarter. Any significant weakening in current customer demand would therefore have and has had in the past an almost immediate adverse impact on our operating results.



During much of the first half of 2003, our common stock did not meet the minimum bid price requirement to remain listed on the Nasdaq
SmallCap Market. If we were to be delisted, it could make trading in our stock more difficult.



Our voting common stock is traded on the Nasdaq SmallCap Market. There are various quantitative listing requirements for a company to remain listed on the Nasdaq SmallCap Market.



We are required to maintain a minimum bid price of $1.00 per share for our common stock.
Between January 31, 2003 and May 2, 2003, Focus voting common stock closed below $1.00 on all trading days. On March 18, 2003, we were notified by the Nasdaq that our common stock did not meet the minimum bid price requirement to remain listed on
the Nasdaq SmallCap Market. However, on May 21, 2003, we received notification from Nasdaq that we had regained compliance and the matter was closed.



We must maintain stockholders equity of $2.5 million. At June 30, 2004, we had total stockholders equity of $22.7 million. To the extent we incur net losses
and do not raise additional capital, our stockholders equity will be reduced.



If we fail to meet these Nasdaq SmallCap requirements, our common stock could be delisted, eliminating the only established trading market for our shares. Any sales of our voting common stock at a discount to market may reduce the trading
price of our common stock to a level below the Nasdaq minimum bid price requirement.



In the event we are delisted from the Nasdaq SmallCap Market, we would be forced to list our shares on the OTC Electronic Bulletin Board or some other quotation medium, such as pink sheets, depending on our ability to meet the specific
listing requirements of those quotation systems. As a result an investor might find it more difficult to dispose of, or to obtain accurate price quotations for, such shares. Delisting might also reduce the visibility, liquidity, and price of our
voting common stock.



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Our common stock price is volatile.



The market price for our voting common stock is volatile and has fluctuated significantly to date. For example, between January 1, 2003 and
June 30, 2004, the per share price has fluctuated between $0.50 and $4.20 per share, closing at $1.09 on August 11, 2004. The trading price of our voting common stock is likely to continue to be highly volatile and subject to wide fluctuations in
response to factors including the following:



| |  | actual or anticipated variations in our quarterly operating results;
| | - | --------------------------------------------------------------------



| |  | announcements of technological innovations, new sales formats or new products or services by us or our competitors;
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | cyclical nature of consumer products using our technology;
| | - | ----------------------------------------------------------



| |  | changes in financial estimates by us or securities analysts;
| | - | ------------------------------------------------------------



| |  | changes in the economic performance and/or market valuations of other multi-media, video scan companies;
| | - | --------------------------------------------------------------------------------------------------------



| |  | announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments;
| | - | ---------------------------------------------------------------------------------------------------------------



| |  | additions or departures of key personnel;
| | - | -----------------------------------------



| |  | additions or losses of significant customers; and
| | - | -------------------------------------------------



| |  | sales of common stock or issuance of other dilutive securities.
| | - | ---------------------------------------------------------------



In addition, the securities markets have experienced extreme price and volume fluctuations in recent times, and the market prices of the securities of technology
companies have been especially volatile. These broad market and industry factors may adversely affect the market price of common stock, regardless of actual operating performance. In the past, following periods of volatility in the market price of
stock, many companies have been the object of securities class action litigation, including us. If we are sued in a securities class action, then it could result in additional substantial costs and a diversion of managements attention and
resources.



Risks Related to Our Industry



International sales are subject to significant risk.



Our revenues from outside the United States are subject to inherent risks related thereto,
including currency rate fluctuations, the general economic and political conditions in each country. There can be no assurance that the economic crisis and currency issues currently being experienced in certain parts of the world will not reduce
demand for our products and therefore have a material adverse effect on our revenue or operating results.



Our businesses are very competitive.



The computer peripheral markets are extremely competitive and are characterized by significant price erosion over the life of a product. We currently compete with other developers of video conversion products and with video-graphic
integrated circuit developers. Many of our competitors have greater market recognition and greater financial, technical, marketing and human resources. Although we are not currently aware of any announcements by our competitors that would have a
material impact on our operations, there can be no assurance that we will be able to compete successfully against existing companies or new entrants to the marketplace.



The video production equipment market is highly competitive and is characterized by rapid technological change, new product development and
obsolescence, evolving industry standards and significant price erosion over the life of a product. Competition is fragmented with several hundred manufacturers supplying a variety of products to this market. We anticipate increased competition in
the video post-production equipment market from both existing manufacturers and new market entrants. Increased competition could result in price reductions, reduced margins and loss of market share, any of which could materially and adversely affect
our business, financial condition and results of operations. There can be no assurance that we will be able to compete successfully against current and future competitors in this market.



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Often our competitors have greater financial, technical, marketing, sales and customer support resources, greater name
recognition and larger installed customer bases than we possess. In addition, some of our competitors also offer a wide variety of video equipment, including professional video tape recorders, video cameras and other related equipment. In some
cases, these competitors may have a competitive advantage based upon their ability to bundle their equipment in certain large system sales.



We are exposed to general economic conditions that have resulted in significantly reduced sales levels. If such adverse economic conditions were to continue or worsen,
our business, financial condition and operating results could be adversely impacted.



If the adverse economic conditions in the United States and throughout the world continue or worsen, we may continue to experience a material adverse impact on our business, operating results, and financial condition.
We continue to take actions and charges to reduce our cost of sales and operating expenses in order to address these adverse conditions. A prolonged continuation or worsening of sales trends may require additional actions and charges to reduce cost
of sales and operating expenses in subsequent quarters. We may be unable to reduce cost of sales and operating expenses at a rate and to a level consistent with such a future adverse sales environment. If we must undertake further expense
reductions, we may incur significant incremental special charges associated with such expense reductions that are disproportionate to sales, thereby adversely affecting our business, financial condition and operating results. Continuing weakness in
the economy could decrease demand for our products, increase delinquencies in payments and otherwise have an adverse impact on our business.



Recent corporate bankruptcies, accounting irregularities, and alleged insider wrong doings have negatively affected general confidence in the stock markets and the
economy, causing the U.S. Congress to enact sweeping legislation, which will increase the costs of compliance.



In an effort to address these growing investor concerns, the U.S. Congress passed, and on July 30, 2002, President Bush signed into law, the Sarbanes-Oxley Act of 2002.
This sweeping legislation primarily impacts investors, the public accounting profession, public companies, including corporate duties and responsibilities, and securities analysts. Some highlights include establishment of a new independent oversight
board for public accounting firms, enhanced disclosure and internal control requirements for public companies and their insiders, required certification by CEOs and CFOs of SEC financial filings, prohibitions on certain loans to offices
and directors, efforts to curb potential securities analysts conflicts of interest, forfeiture of profits by certain insiders in the event financial statements are restated, enhanced board audit committee requirements, whistleblower
protections, and enhanced civil and criminal penalties for violations of securities laws. Such legislation and subsequent regulations will increase the costs of securities law compliance for publicly traded companies such as us.



Continued terrorism threats and war in the Middle East have had a negative impact on the
U.S. economy.



The adverse consequences of war and the effects of
terrorism have had a negative affect on the U.S. economy. Further conflicts in the Middle East could negatively impact our ability to raise additional funds if needed and our revenues will be adversely affected if consumers and businesses continue
to cut back spending.



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Item 3. Quantitative and Qualitative Disclosures about Market Risk



At June 30, 2004 we did not hold any short-term investments that would be exposed to market risk from adverse movements in interest rates.



We have approximately $779,000 in Euro-denominated short- and long-term debt resulting from acquisition of COMO. The average interest rate
applicable to these debt obligations is 8%.



Also as a result of the COMO
acquisition, we had net tangible liabilities, including the previously mentioned debt obligations, of approximately $667,000 as of June 30, 2004, which were denominated primarily in Euros.



Item 4. Controls and Procedures



Management of
the Company, with the participation of the President and Chief Executive Officer and the Chief Financial Officer (its principal executive officer and principal financial officer, respectively), evaluated Focus disclosure controls and
procedures as of the end of the period covered by this Report.



Based on that
evaluation, the President and Chief Executive Officer and the Chief Financial Officer have concluded that, as of the end of the period covered by this Report, Focus disclosure controls and procedures are effective to ensure that information
required to be disclosed by Focus in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and
include controls and procedures designed to ensure that information required to be disclosed by Focus in such reports is accumulated and communicated to Focus management, including the President and Chief Executive Officer and the Chief
Financial Officer of Focus, as appropriate to allow timely decisions regarding required disclosure.



There was no change in Focus internal control over financial reporting that occurred during Focus second fiscal quarter of 2004 that has materially affected, or is reasonably likely to materially affect,
Focus internal control over financial reporting.



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PART II - OTHER INFORMATION



Item 1. Legal proceedings



From
time to time, Focus is party to certain other claims and legal proceedings that arise in the ordinary course of business of which, in the opinion of management, do not have a material adverse effect on Focus financial position or results of
operation.



Item 2. Changes in securities



(a) to (e)    None



Item 3. Defaults upon senior securities



None.



Item 4. Submission of matters to a vote of security holders



Focus held its annual meeting of shareholders at its corporate headquarters located at 1370 Dell Avenue, Campbell, California, on Friday, August 6, 2004. Shareholders of record on June 11, 2004 were entitled to vote
on matters to be considered at the meeting. Focus mailed its proxy materials to shareholders on or about July 9, 2004.



Following are the proposals voted upon at the meeting, and the number of votes cast for, against or withheld, as well as the number of abstentions for
each such proposal:



Election of the following as a director of Focus:



|                       |  |          |   |  |            |  |          
|---------------------- |  | -------- | - |  | ---------- |  | ---------
|                       |  |          |   |  | Votes     
|Name                   |  | Term     |   |  | For        |  | Withheld 
|N. William Jasper Jr., |  | (3 years | ) |  | 46,248,319 |  | 3,663,501
|Carl E. Berg           |  | (3 years | ) |  | 46,161,482 |  | 3,750,338



The following
directors terms continued after the meeting: Brett A. Moyer, William B. Coldrick, Michael L. DAddio and Tommy Eng.



|                                                                                                                                              |  |            |  |           |  |           |  | 
|--------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------- |  | --------- |  | --------- |  | 
|                                                                                                                                              |  | For        |  | Against   |  | Abstained
|Proposal to adopt the Focus Enhancements, Inc. 2004 Stock Incentive Plan.                                                                     |  | 14,493,305 |  | 1,389,741 |  | 99,483   
|                                                                                                                                              |  |            | 
|Ratify the selection of Deloitte & Touche, LLP as Focus independent registered public accounting firm for the year
ending December 31, 2004. |  | 49,734,360 |  | 89,562    |  | 87,898   



Item 5. Other information



None.



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Item 6. Exhibits and reports on Form 8-K.



| | (a) | Exhibits
| | --- | --------



Exhibit 31.1 - Rule 13a-14(a) Certification of CEO



Exhibit 31.2 - Rule 13a-14(a) Certification of CFO



Exhibit 32.1  CEO 906 Certification



Exhibit 32.2  CFO 906 Certification



| | (b) | Reports on Form 8-K
| | --- | -------------------



On May 11, 2004, Focus issued a press release discussing its results of operations for the three months ended March 31, 2004.



On June 2, 2004, Focus. announced that it had completed the acquisition of
substantially all of the assets and assumed certain liabilities of Visual Circuits Corporation pursuant to an Agreement and Plan of Reorganization.



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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.



|                |  |                          |  |                                      
|--------------- |  | ------------------------ |  | -------------------------------------
|August 16, 2004 |  | Focus Enhancements, Inc.
|Date            |  | Registrant              
|                |  |                         
|                |  | By:                      |  | /s/ Brett A. Moyer                   
|                |  |                          |  | Brett A. Moyer                       
|                |  |                          |  | Chief Executive Officer and President
|                |  |                          |  | (Principal Executive Officer)        
|                |  |                         
|                |  | By:                      |  | /s/ Gary L. Williams                 
|                |  |                          |  | Gary L. Williams                     
|                |  |                          |  | Vice President of Finance,           
|                |  |                          |  | Chief Financial Officer              
|                |  |                          |  | (Principal Accounting Officer)       



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