SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549-1004

FORM 10-Q

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

For the Quarter Ended June 30, 2004
Commission File Number 1-10515

JMAR TECHNOLOGIES, INC.

5800 Armada Drive
Carlsbad, CA 92008
(760) 602-3292

Indicate by check mark whether the registrant 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, and has been subject to the filing requirements for at least the past 90 days.

Yes x No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date (August 9, 2004).

Common Stock, $.01 par value: 30,891,787 shares

INDEX

1

PART I – FINANCIAL INFORMATION

JMAR TECHNOLOGIES, INC.

The accompanying notes to these consolidated financial statements are an integral part of these consolidated balance sheets.

2

JMAR TECHNOLOGIES, INC.

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

3

JMAR TECHNOLOGIES, INC.

During the six months ended June 30, 2004, the holder of Series C and D Convertible Preferred Stock converted $3,500,000 of the preferred stock into 2,003,205 shares of common stock of the Company. The Company recorded $1,769,759 related to the discount representing the beneficial conversion feature of the redeemable convertible preferred stock and debt and the fair value of warrants issued in connection with the preferred stock and debt (see Notes 9 and 10). In addition, during the six months ended June 30, 2004, $1,254,500 of the Company’s working capital line of credit was converted into 1,048,913 shares of common stock of the Company (see Note 9). Also, during the six months ended June 30, 2004, the Company repaid $364,239 in convertible notes and $3,034 in accrued interest with the issuance of 118,121 shares of common stock (see Note 9).

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

4

JMAR TECHNOLOGIES, INC.

(1) Basis of Presentation and Financial Condition

     The accompanying consolidated financial statements include the accounts of JMAR Technologies, Inc. (the “Company” or “JMAR”) and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

     JMAR Technologies, Inc. develops, manufactures, and supports advanced laser, sensor, and custom systems for applications in the semiconductor, biotech, homeland security, nanotechnology and utility infrastructure markets. The U.S. Department of Defense is the principal source of funds for the Company’s Collimated Plasma Lithography (CPL) light source, X-ray stepper systems, and X-ray mask research and development programs. In addition to the development of the above tools, JMAR provides semiconductor fabrication process integration and maintenance support to the Department of Defense’s Defense Microelectronics Activity in Sacramento, California.

     In the first quarter of 2002, the Company decided to discontinue the standard semiconductor products business. Also, during the later half of 2002, the Company concluded that its precision equipment business did not fit with the strategic direction of the Company and that the markets for that business’ products would continue to be slow in the near term. Therefore, in December, 2002, the Company decided to initiate the process of selling the precision equipment business and, in July 2003, the Company completed the sale of that business.

     The standard semiconductor products business and the precision equipment business have been accounted for in the accompanying consolidated financial statements as discontinued operations (see Note 8).

     The accompanying consolidated financial statements as of and for the three and six months ended June 30, 2004 and 2003 have been prepared by the Company and are unaudited. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the accompanying consolidated financial statements include all adjustments of a normal recurring nature which are necessary for a fair presentation of the results of operations for the interim periods presented. Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to such rules and regulations.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Although the Company believes that the disclosures are adequate to make the information presented not misleading, it is suggested that these interim consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Form 10-K for the year ended December 31, 2003. The results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year.

(2) Recent Accounting Pronouncements

     In September 2001, FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (SFAS No. 143). This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It applies to (a) all entities and (b) legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal operation of long-lived assets, except for certain obligations of lessees. This statement amends FASB Statement No. 19, “Financial Accounting and Reporting by Oil and Gas Producing Companies,” and is effective for financial statements issued for fiscal years

5

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

beginning after September 15, 2002. The Company has implemented SFAS No. 143 effective January 1, 2003. The impact of such adoption did not have a material effect on the Company’s financial statements.

     Statement of Financial Accounting Standards No. 146 (SFAS 146), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses accounting and reporting costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” This statement requires that a liability for a cost associated with an exit or disposal activity shall be recognized and measured initially at its fair value in the period which the liability is incurred. This statement is effective for exit or disposal activities that are initiated after December 31, 2002. The Company has implemented SFAS No. 146 effective January 1, 2003. The impact of such adoption did not have a material effect on its financial statements.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS No. 123.” This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting,” to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has implemented SFAS No. 148 effective January 1, 2003 regarding disclosure requirements for condensed financial statements for interim periods (see Note 3).

     The FASB has issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” – an interpretation of FASB Nos. 5, 57 and 107 and rescission of FASB Interpretation No. 34. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Implementation of these provisions of the Interpretation is not expected to have a material impact on the Company’s consolidated financial statements. The disclosure requirements of the Interpretation are effective for financial statements of interim or annual periods ended after December 15, 2002, and have been adopted in the accompanying consolidated financial statements, with no additional disclosure required.

     The FASB has issued Interpretation No. 46, “Consolidation of Variable Interest Entities” – an interpretation of Accounting Research Bulletin (ARB) No. 51. This Interpretation defines a variable interest entity and provides that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities, and results of the activities of the variable interest entity should be included in consolidated financial statements with those of the business enterprise. Furthermore, the Board indicates that the voting interest approach of ARB No. 51 is not effective in identifying controlling financial interests in entities that are not controllable through voting interest or in which the equity investors do not bear the residual economic risk. This Interpretation applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after September 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The implementation of this Interpretation did not have a material effect on the Company’s financial statements.

     In November 2002, the EITF reached a consensus on Issue 00-21, titled “Accounting for Revenue Arrangements with Multiple Deliverables,” which addresses how to account for arrangements that involve the delivery or performance of multiple products, services, and/or rights to use assets. Revenue arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the arrangement meet the following criteria: (1) the delivered item has value to the customer on a standalone basis; (2) there is objective and reliable evidence of the fair value of undelivered items; and (3) delivery of any undelivered item is probable. Arrangement consideration should be allocated among the separate units of accounting

6

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

based on their relative fair values, with the amount allocated to the delivered item being limited to the amount that is not contingent on the delivery of additional items or meeting other specified performance conditions. The new standard was required to be adopted for all new applicable revenue arrangements no later than the third quarter of 2003. The implementation of EITF 00-21 did not have a material effect on the Company’s financial statements.

     In May 2003 FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which requires that certain financial instruments previously presented as equity or temporary equity be presented as liabilities. Such instruments include mandatory redeemable preferred and common stock, and certain options and warrants. SFAS 150 is effective for financial instruments issued, entered into or modified after May 31, 2003 and was generally effective at the beginning of the first interim period beginning after September 15, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s financial statements.

     In December 2003 the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104 (SAB No. 104), “Revenue Recognition” to update SAB No. 101, “Revenue Recognition in Financial Statements”. SAB No. 104 revises or rescinds portions of the interpretive guidance included in SAB No. 101 in order to make SAB No. 101 consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The principal revisions relate to the recission of material no longer necessary because of private sector developments in U.S. generally accepted accounting principles. SAB No. 104 also rescinds the Revenue Recognition in Financial Statements Frequently Asked Questions and Answer document issued in conjunction with SAB No. 101 and incorporates related portions of that document into SAB No. 104. The adoption of SAB No. 104 did not have a material effect on the Company’s financial statements.

(3) Stock-Based Compensation Plans

     The Company has six stock option or warrant plans, the 1991 Stock Option Plan (the “1991 Plan”), the 1999 Stock Option Plan (the “1999 Plan”), the Management Anti-Dilution Plan (the “Anti-Dilution Plan”), two incentive plans which provide for the issuance of options and warrants to Research Division employees (the “Research Division Plans”) and an incentive plan which provided for the issuance of warrants to JPSI employees (the “JPSI Plans”). The Company is also a party to non-plan option and warrant agreements with several individuals. The Company accounts for these plans under APB Opinion No. 25, using the intrinsic value method, under which no compensation cost has been recognized. Had compensation cost for these plans been determined using the fair value method under SFAS No. 123, the Company’s loss applicable to common stock and loss per share would have been the following pro forma amounts (unaudited):

     The fair value of each option and warrant grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of approximately 2.74 percent; expected dividend yields of 0 percent; and expected lives of 6 years. For grants in 2004 and 2003, the expected volatility used was 259 percent and 275 percent, respectively.

     The Company was authorized to grant options or warrants to its employees (including directors) and consultants for up to 1,480,000 shares under the 1991 Plan, 1,900,000 shares under the 1999 Plan, 806,637 shares under the Anti-Dilution Plan, 350,000 shares under the Research Division Plans and 450,000 shares under the JPSI Plan (Plans). In addition, 613,000 non-qualified options have been granted to five employees outside of the above plans. Except as noted below, under all Plans, the option or warrant exercise price was

7

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

equal to or more than the stock’s market price on date of grant for grants made during the three and six months ended June 30, 2004 and 2003 and no compensation expense was recognized. Options for a total of 7,500 shares were granted to the Company’s directors in payment of meeting fees in the six months ended June 30, 2004, which had an exercise price of $1.00 below the market price resulting in compensation expense that was not significant. Options usually have a term of ten years and vest one-third per year after date of grant. During the three and six months ended June 30, 2004, 80,500 and 83,500 options, respectively, were granted pursuant to the 1999 Plan.

(4) Inventories

     Inventories are carried at the lower of cost (on the first-in, first-out basis) or market and are comprised of materials, direct labor and applicable manufacturing overhead. At June 30, 2004 and December 31, 2003, inventories consisted of the following:

(5) Accounts Receivable

     At June 30, 2004 and December 31, 2003, accounts receivable consisted of the following:

     All unbilled receivables at June 30, 2004 are expected to be billed and collected within one year except for withheld contract fees of $168,027 which will be billed and collected at the completion of the applicable contract. Payment to the Company for performance on certain U.S. Government contracts is subject to progress payment audits by the Defense Contract Audit Agency and are recorded at the amounts expected to be realized. Included in the unbilled amount is $2,329,522 related to the Company’s contract with DARPA. The Company expects DARPA to release $5.4 million in funding against its DARPA contract in 2004. Of the remaining balance of unbilled receivables, $348,167 is related to withheld fees for prior contracts to be billed pending DCAA audit, and $317,447 is related to the normal billing cycle.

(6) Property and Equipment

     At June 30, 2004 and December 31, 2003, property and equipment consisted of the following:

8

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

(7) Segment Information

     The Company operates in three business segments, as follows:

     Research Division (formerly JMAR Research) – Located in San Diego, California, this segment carries out contract research and development involving JMAR’s patented high brightness (Britelight) lasers and laser-produced plasma (LPP) technology. The results of this R&D are applied to the Company’s CPL light source, EUV generators, and related laser product developments including X-ray microscopy and X-ray nano probe instruments. Until recently, the exclusive focus of the Research Division’s R&D efforts has been on advanced semiconductor lithography applications. In 2003, the Company embarked on an effort to identify additional applications for its laser and LPP technologies. Substantially all of the Research Division’s R&D is funded by contracts from the Defense Advanced Research Projects Agency (DARPA) of the U.S. Department of Defense. During the six months ended June 30, 2004 and 2003, this segment accounted for approximately 40% and 31%, respectively, of the Company’s revenues.

     The technologies developed at the Research Division are transitioned to JMAR’s Systems Division for product engineering and future production.

     Systems Division (formerly JMAR/SAL NanoLithography) – Located in Vermont, this Division serves as JMAR’s product design and manufacturing arm, carrying out the engineering, production, and integration of JMAR’s CPL light sources and CPL stepper systems. The Systems Division also applies its engineering and manufacturing expertise to the development of new products using a combination of JMAR and third party technology, as in the case of its design and manufacture of alpha and beta READ sensors for FemtoTrace, Inc. for environmental and homeland security applications. During the six months ended June 30, 2004 and 2003, this segment accounted for approximately 28% and 42%, respectively, of the Company’s revenues.

     Microelectronics Division (formerly JMAR Semiconductor) – This segment provides process integration and maintenance support for the Defense Microelectronics Activity’s semiconductor fabrication facility in Sacramento, California. It also designs and produces application specific integrated circuits (ASICs) for military and commercial markets. During the six months ended June 30, 2004 and 2003, this segment accounted for approximately 32% and 27%, respectively, of the Company’s revenues.

     The accounting policies of the reportable segments are the same as those described in Note 2 of the Company’s consolidated financial statements included in the Form 10-K for the year ended December 31, 2003. The Company evaluates the performance of its operating segments primarily based on revenues and operating income. Corporate costs are generally allocated to the segments.

     Segment information for the three and six months ended June 30, 2004 and 2003 (excluding discontinued operations) is as follows:

9

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

     The asset writedown for 2004 of $49,576 relates to patent costs. The asset writedowns for 2003 include $200,056 related to an asset held by the Research Division that will not be used by the Company in the future and $106,093 of patent costs written off.

     Sales to the United States Government totaled $1,856,315, $3,498,711, $3,722,605 and $6,458,456 for the three and six months ended June 30, 2004 and 2003, respectively. In addition, sales to General Dynamics Advanced Information Systems were $915,325, $1,950,106, $1,058,881 and $2,556,107 for the three and six months ended June 30, 2004 and 2003, respectively.

(8) Discontinued Operations

     The income from operations of discontinued operations of $74,546 and $12,449 for the three and six months ended June 30, 2004, respectively, is related to the former facility of the standard semiconductor products business. The loss from operations of discontinued operations of $(686,830) and $(1,146,817) for the three and six months ended June 30, 2003 includes $270,761 and $311,977, respectively, related to the standard semiconductor products business and $416,069 and $834,840, respectively, related to the precision equipment business. In July 2003, the Company sold JMAR Precision Systems, Inc. (“JPSI”) to several private investors. Under the terms of the sale, JMAR received $500,000 in a combination of cash and promissory notes, and the buyer assumed 14 of the remaining 25 months of JPSI’s facility lease. The notes are secured by the assets of JPSI and the lease obligation is secured by personal property of the buyers. In addition, all JPSI receivables as of the closing were assigned to JMAR and JMAR agreed to pay all trade and employee related liabilities existing as of the closing and unknown liabilities, if any. The buyers have assumed all other ongoing commitments of JPSI. The results of operations of the precision equipment business for 2003 through the sale date are reported in discontinued operations in 2003. The decrease in the loss of operations of discontinued operations is due to the sale of JPSI in July 2003.

     Prior to December 31, 2001, as the level of business expected from the standard semiconductor products business did not materialize, the Company decided to take action to sublease the Irvine facility and move the standard semiconductor products business into a smaller facility and recorded a reserve against the Irvine facility lease. The lease provides for rent and related expenses of approximately $36,000 per month through August 2005. In June 2004, the Company subleased the facility for the remaining term of the lease and reduced the Company’s reserve for this facility by approximately $112,000.

10

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

     At June 30, 2004 and December 31, 2003, net liabilities of assets discontinued consisted of the following:

(9) Line of Credit and Notes Payable

     In March 2003, the Company entered into a Revolving Fixed Price Convertible Note (Working Capital Line) with Laurus Master Fund (Laurus). The Working Capital Line allows the Company to borrow from time-to-time up to 85% of eligible accounts receivable of the Company to a maximum of $3 million. Advances in excess of this formula are allowed, however, with the consent of Laurus. Laurus can convert any portion of the principal outstanding to common stock at a fixed price per share (Conversion Price) any time the market price of the Company’s common stock is in excess of the Conversion Price. The Company can convert a portion of the principal outstanding to common stock at the Conversion Price if the market price of the Company’s common stock averages 118% of the Conversion Price or higher for 22 consecutive trading days. The initial terms of the Working Capital Line provided that after $2 million of conversions into equity, the Conversion Price would be increased. The Conversion Price initially was $.92, but was increased to $2.85 in January 2004 after $2 million of the Working Capital Line had been converted at which time the Company granted additional warrants for the purchase of 100,000 shares of its common stock. During the six months ended June 30, 2004, $827,000 of the Working Capital Line was converted into common stock at $.92 per share, or 898,913 shares, and $427,500 was converted into common stock at $2.85 per share, or 150,000 shares (see Note 10). There was no balance outstanding under the line at June 30, 2004.

     In connection with the Working Capital Line, the Company issued warrants to Laurus to purchase 400,000 and 100,000 shares of common stock in March 2003 and January 2004, respectively, at prices ranging from $1.06 to $5.15 and paid fees of $74,400 in March 2003. The Company recorded a discount of $412,633 and $502,761 in March 2003 and January 2004, respectively, representing the intrinsic value of the beneficial conversion feature and fair value of warrants. At June 30, 2004, the unamortized discount and fees of $390,314 was included in “prepaid expenses and other” in the accompanying Consolidated Balance Sheet. In addition, there will be an additional beneficial conversion feature in the amount of $210,923 recorded as additional borrowings are made against the Working Capital Line. The discount is amortized over the remaining life of the Working Capital Line or upon conversion, resulting in $66,098 and $390,203 of interest expense for the three and six months ending June 30, 2004.

     In February 2004, the Company repaid $1.2 million in convertible notes, plus accrued interest, issued to the former shareholders of SAL, by retiring a total of $364,239 in notes and $3,034 in accrued interest with the issuance of 118,121 shares of common stock valued at $3.11 per share and repaying the remaining amount of $835,761 in notes and accrued interest of $6,961 with cash.

(10) Equity Transactions

     In January 2004, the Company sold for cash $1.5 million of 8 percent Series E Convertible Preferred Stock (Series E Preferred) to Laurus at a fixed conversion price of $2.85 per share. The Series E Preferred is redeemable in cash or stock (if the closing market price of the Company’s common stock is 118% of the Conversion Price or higher for the 11 trading days prior to the redemption date) in eighteen equal monthly installments starting in August 2004, if not previously converted. Conversions to equity are offset against the

11

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

required repayments. Except for the conversion price, the conversion terms of the Series E Preferred are the same as the conversion terms of the Working Capital Line (see Note 9).

     In February 2004, the Company sold for cash $8 million of 2 percent Convertible Preferred Stock (Series F, G and H Preferred) to Laurus at a fixed conversion price of $3.11 to $3.47 per share (depending upon the Series), with an average conversion price of $3.34 per share. The Series F, G and H Preferred is redeemable in cash or stock (if the closing market price of the Company’s common stock is 118% of the Conversion Price or higher for the eleven trading days prior to the redemption date) in twenty-five equal monthly installments of $150,000 starting in January 2005 with the balance redeemable in February 2007, if not previously converted. Conversions to equity are offset against the required repayments. Except for the conversion price, the conversion terms of the Series F, G and H Preferred are the same as the conversion terms of the Working Capital Line (see Note 9).

     As of August 9, 2004, the total outstanding preferred stock, warrants and Working Capital Line held by Laurus are convertible or exercisable into approximately 4.4 million shares.

     In connection with the above financing transactions with Laurus, the Company issued to Laurus warrants to purchase 290,000 shares of common stock at prices ranging from $3.42 to $5.00. In addition, in connection with the adjustment to the conversion price on the Working Capital Line (see Note 9), the Company issued to Laurus warrants to purchase 100,000 shares of common stock at an exercise price of $5.15.

     As a result of the convertible preferred stock and warrants issued in 2004, the Company recorded a discount representing the beneficial conversion feature and the fair value of the warrants issued of approximately $1.3 million. The beneficial conversion feature was recognized during the first quarter of fiscal year 2004 as a reduction of preferred stock and will be amortized to loss applicable to common stock over the earlier of the redemption period or the conversion dates.

     The following table summarizes the preferred stock activity through June 30, 2004.

     All of the preferred stock, warrants and the Working Capital Line (the “Securities”) held by Laurus contain provisions that restrict the right of Laurus to convert or exercise its JMAR securities in order to limit its percentage beneficial ownership. If Laurus were to waive these beneficial ownership limitations the Securities would be convertible for or exercisable into more than 4.99% of the outstanding shares of the Company’s common stock. However, Laurus has not requested such a waiver. Laurus has also agreed that none of the Securities shall be converted or exercised to the extent that conversion or exercise of the Securities would result in Laurus beneficially owning more than 19.9% of the Company’s outstanding number of shares of common stock unless and until the Company obtains stockholder approval in accordance with NASDAQ corporate governance rules, or an exemption from the applicable provision of NASDAQ corporate governance rules.

12

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

     In connection with all of the financing transactions with Laurus during 2003 and 2004, the Company issued warrants to Laurus to purchase a total of 1,390,000 shares of common stock at prices ranging from $1.058 to $5.15. In addition, Laurus was granted the right to receive a warrant to purchase one share of common stock at $3.13 for every $20 of principal of the Working Capital Line converted to equity in excess of the first $2 million up to a total of 50,000 shares.

     During the six months ending June 30, 2004, the Company received proceeds of $157,275 for the exercise of warrants and options into 71,933 shares of common stock. During the six months ended June 30, 2004 and 2003, the Company issued 2,322 and 8,304 shares of common stock for services. These issuances were valued based upon the fair market value of the Company’s common stock at the date of issue.

     Included in the loss applicable to common stock in the Statement of Operations for the three and six months ended June 30, 2004 and 2003 are preferred stock dividends of $535,098, $1,704,381, $224,030 and $229,453, respectively. The amount for the three and six months ended June 30, 2004 represents $65,471 and $125,472, respectively, of preferred stock dividends paid or payable in cash and $469,627 and $1,578,909, respectively, related to the discount representing the beneficial conversion feature of the redeemable convertible preferred stock and the fair value of warrants issued in connection with the preferred stock. The amount for the six months ended June 30, 2003 represents $27,604 of preferred stock dividends paid or payable in cash and $201,849 related to the discount representing the beneficial conversion feature of the redeemable convertible preferred stock and the fair value of warrants issued in connection with the preferred stock.

     If not previously converted, the Series E through H Preferred Stock are redeemable as follows:

     On August 2, 2004, $85,000 of the Series E Preferred was redeemed for cash.

(11) Earnings Per Share

     The Company accounts for earnings per share in accordance with SFAS No. 128, “Earnings per Share”. Basic earnings per common share were computed by dividing loss applicable to common stock by the weighted average number of shares of common stock outstanding during the period. For the three and six months ended June 30, 2003 the denominator in the diluted loss per share computation was the same as the denominator for basic loss per share due to antidilutive effects of the Company’s warrants, stock options, convertible debt and convertible preferred stock. As of June 30, 2004 and 2003, the Company had shares issuable under outstanding warrants, stock options, convertible debt and convertible preferred stock of 8,119,830 and 9,256,312, respectively.

(12) Intangible Assets

     The Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets” (SFAS 142) effective January 1, 2002. In accordance with SFAS 142, the Company does not amortize goodwill. The Company’s goodwill of $3,790,907 at June 30, 2004 and December 31, 2003 is related to the Systems Division, acquired

13

JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

in August, 2001. As of June 30, 2004, the Company had the following amounts related to other intangible assets:

     Aggregate amortization expense of the intangible assets with determinable lives was $72,749 and $144,451 for the three and six months ended June 30, 2004, respectively. The unamortized balance of intangible assets is estimated to be amortized as follows:

(13) BioSentry Development

     During the second quarter of 2004, the Company entered into an alliance agreement with The LXT Group (LXT) to produce an early-warning system (BioSentry™) for the drinking water industry. As part of the agreement, JMAR loaned the two principals of LXT $62,500 each and agreed to provide a maximum financial commitment of $1 million, subject to the achievement of milestones by LXT. Through June 30, 2004, the Company had provided approximately $224,000 of financial support for costs incurred related to BioSentry, of which $213,520 was expensed. The majority of the remainder of the $1 million committed is expected to be provided by the Company during 2004. Also, upon satisfaction of certain conditions, the Company and LXT agreed to execute a purchase agreement for the purchase by the Company of the LXT business. The purchase agreement is intended to be signed in August 2004 with a closing expected in January 2005 after certain milestones are met and will provide for the purchase of all of the assets of LXT for consideration consisting of $125,000 in cash, cancellation of $125,000 in promissory notes held by the two principals of LXT in favor of JMAR, 180,000 shares of JMAR common stock and certain contingent earn-out payments based on future revenues and residual income generated by the LXT business.

(14) Subsequent Event

     Under the Merger Agreement entered into with the former shareholders and creditors of SAL, Inc. (now operating as the Company’s Systems Division), those persons could earn up to three contingent earnout payments upon the satisfaction of three earnout conditions. For the first earnout, the SAL creditors were eligible to receive $500,000 in convertible notes upon the satisfaction of a “stepper limited” throughput test (without the CPL light source) by June 30, 2002. This requirement was not met by the June 30, 2002 deadline, and, therefore, the Company did not have to issue the $500,000 in convertible notes. For the second earnout, the SAL shareholders could have earned $500,000 in convertible notes upon the satisfaction of a lithography demonstration milestone. This milestone was to be met 90 days after the Company’s CPL beta source satisfied certain negotiated source performance criteria. In successful tests of the integrated system in March 2004, the source demonstrated improved reliability and performance;

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JMAR TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued
(Unaudited)

however, the specific source performance criteria specified in the Merger Agreement have not yet been met. If issued, the $500,000 in Convertible Notes would have been due 24 months after issuance and would have a conversion price equal to 120% of the average of the closing prices for the ten days prior to issuance.

     The third earnout condition could have resulted in payment of up to 354,736 JMAR shares and up to $1.2 million in convertible notes upon receipt by the Company of a qualifying order for a CPL system from a commercial customer and delivery to the customer. Under the Merger Agreement, the deadline for receipt of this order was 180 days after the CPL source satisfied the above mentioned source performance criteria. If earned, this earnout payment would have been payable 30 days after delivery and acceptance of the system by the customer.

     On July 9, 2004, the Company sent a letter to former shareholders and creditors (Holders) of SAL, Inc. proposing a final resolution of the second and third earnouts through payment of a total of $625,000 in shares of common stock, valued at the average of the closing prices of JMAR’s common stock for the five days during the period August 18, 2004 to August 24, 2004. Although the Company has continued to improve the CPL source and it has recently demonstrated improved lithographic performance, the CPL source does not yet meet the specific technical criteria set forth in the Merger Agreement and, therefore, the time to commence the required demonstration has not yet begun. Specifically, although the CPL source has demonstrated throughput approaching that required by the earnout, it has done so using a more sensitive resist than that required by the earnout. Because of the open-ended nature of the earnout, the payment of the second and third earnouts could be delayed for an indeterminate time. Because of this uncertainty, the Company believed that the current situation was unsatisfactory for both JMAR and the Holders. As of July 31, 2004, holders of more than 99 percent of the earnout interests had accepted the Company’s offer to receive the final payment of $625,000 in common stock in full satisfaction of all remaining amounts owed under the Merger Agreement. The value of the final payment will increase goodwill on the accompanying Consolidated Balance Sheet for the quarter ended September 30, 2004.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Item 2.

Overview

     JMAR Technologies, Inc. develops, manufactures, and supports advanced laser, sensor, and custom systems for applications in the semiconductor, biotech, homeland security, nanotechnology and utility infrastructure markets. The U.S. Department of Defense is the principal source of funds for the Company’s collimated plasma lithography (CPL™) light source, X-ray stepper systems, and X-ray mask research and development programs. In addition to the development of the above tools, JMAR provides semiconductor fabrication process integration and maintenance support to the Department of Defense’s Defense Microelectronics Activity (DMEA) in Sacramento, California.

Sources of Revenue

     Currently, over 90 percent of the Company’s revenues are derived as the prime contractor or subcontractor for government contracts. The most significant ongoing contract has been the contract issued to JMAR’s Research Division by the U.S. Army Research Laboratory sponsored by DARPA for further development of the Company’s CPL system (DARPA Contract). Through June 30, 2004, a total of $18.2 million has been received under this contract and the Company expects to receive an additional $5.4 million in funding in 2004. Although the funds are appropriated by Congress, DARPA controls the timing of the funding. In late March and early April 2004, DARPA released $1.6 million out of a total of $7 million in funding upon the successful completion of a reliability and performance test which was completed on March 21, 2004. The release of the remaining $5.4 million during 2004 is also subject to milestones related to the further improvement of the beta source. The Company believes that it will meet the milestones for release of all of the remaining $5.4 million. No program funding related to the DARPA Contract is included in the United States Government’s fiscal year 2005 budget and the Company expects no further funding under this contract after the receipt of the remaining $5.4 million.

     JMAR’s next most significant contract is a $10 million contract issued to JMAR’s Systems Division by Naval Air Warfare Center AD to procure sub-100 nm X-ray masks used in the development and production of high performance GaAs MMICs (“NAVAIR Contract”). Through June 30, 2004, a total of $6.4 million has been received under this contract, and the Company expects to receive $2.1 million in funding in 2004. The funding for this contract has also been appropriated by Congress.

     The third major ongoing revenue source involves the subcontract between JMAR’s Microelectronics Division and General Dynamics Advanced Information Systems (GDAIS) to enhance and maintain the semiconductor wafer fabrication processes installed at the McClellan Air Force Base in Sacramento for the DMEA (GDAIS Contract). This work, which started in 1998, has resulted in a new subcontract each year out of funds available in the DMEA’s budget as an element of the Department of Defense’s Advanced Technology Support Program. The Company received $5 million and $3.5 million in contracts in 2003 and 2004, respectively, for this program.

     The DARPA Contract has enabled the Company to carry out the science, engineering, and characterization of a unique solid state laser based X-ray source for advanced lithography. DARPA’s mission has been fulfilled and it is now up to the Company to turn the results of the R&D into new products and growth for the Company. Our CPL X-ray generator provides the basis for compact, short-wavelength light sources for a number of bio-science and nanotechnology applications. For example, we are developing an innovative X-ray microscope for use by the bio-science and chemical industries. In addition, we are developing a soft X-ray Nano Probe for characterization of nanostructures.

     Unrelated to JMAR’s work for DARPA, we are preparing to enter the environmental and homeland security markets. The BioSentry™ sensor we are developing with The LXT Group for continuous monitoring of drinking water for microorganisms has successfully passed proof of concept testing. A technologically advanced U.S. water utility is working with us to plan for installation and testing of Beta units in early 2005. On the chemical side, we are currently testing the Alpha Model READ sensor. JMAR designed,

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manufactured, and integrated this highly sensitive chemical detection system for FemtoTrace and is looking forward to manufacturing a number of beta and initial production units in 2005.

Results of Operations

     Revenues. Total revenues for the three months ended June 30, 2004 and 2003 were $3,011,437 and $5,027,654, respectively. Total revenues for the six months ended June 30, 2004 and 2003 were $6,046,813 and $9,761,368, respectively. Revenues by segment for the three and six months ended June 30, 2004 and 2003 were as follows:

     The decrease in revenues for the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003 was primarily attributable to a decrease in the NAVAIR Contract revenues of $1,132,342 and $1,849,456, respectively, at the Systems Division due to the delay in replacing IBM as the subcontractor on that contract, a decrease in revenues of the Research and Systems Divisions related to the DARPA Contract of $573,618 and $675,172, respectively, due to lower funding received on that contract, a decrease of $232,676 and $787,358, respectively, related to two contracts at the Systems Division that are nearing completion and a decrease in contract revenues at the Microelectronics Division of $143,556 and $606,001, respectively, related to less equipment installations under the GDAIS Contract in 2004. The Company will continue to experience flat or lower revenues for the remainder of 2004 and into 2005 until new product sales offsets the decline in our DARPA funding for CPL.

     Losses. The net loss for the three months ended June 30, 2004 and 2003 was $(786,903) and $(1,337,184), respectively. The loss from continuing operations for those same periods was $(861,449) and $(650,354), respectively, while the loss from operations for those same periods was $(768,006) and $(567,520), respectively. The net loss for the six months ended June 30, 2004 and 2003 was $(1,741,578) and $(2,243,841), respectively. The loss from continuing operations for those same periods was $(1,754,027) and $(1,097,024), respectively, while the loss from operations for those same periods was $(1,282,424) and $(932,655), respectively.

     Included in the net loss for the three and six months ended June 30, 2004 is a gain from discontinued operations of $74,546 and $12,449, respectively. Included in the net loss and loss from operations for the three and six months ended June 30, 2004 are costs associated with the LXT BioSentry development (see further discussion below) of $213,520 and an asset write down of $49,576. Included in the net loss and loss from continuing operations for the three and six months ended June 30, 2004 is a non-cash interest charge of $102,653 and $470,508, respectively. Included in the net loss for the three and six months ended June 30, 2003 is a loss from discontinued operations of $(686,830) and $(1,146,817), respectively. Included in the net loss and loss from operations for the three and six months ended June 30, 2003 are asset write downs of $200,056 and $306,149, respectively. Included in the net loss and loss from continuing operations for the three and six months ended June 30, 2003 is a non-cash interest charge of $46,633 and $153,142, respectively.

     Gross Margins. Gross margins for the six months ended June 30, 2004 and 2003 were 22.1% and 19.3%, respectively. Gross margins for the three months ended June 30, 2004 and 2003 were 22.2% and 19.3%, respectively. The Company’s margins are low because the majority of its revenues are from contract revenues, which inherently generate lower margins than product revenues. The primary increase in the gross margin for the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003 is due to lower revenues in 2004 on the lower margin NAVAIR Contract (i.e., the lower margin NAVAIR Contract represented a greater percentage of revenues in 2003). The low margins on the NAVAIR Contract were due to the high subcontract component of that contract and the

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Company’s absorption of some of the costs incurred due to limited funding on that contract. In addition, the gross margin on the GDAIS Contract was higher for the six months ended June 30, 2004 due to lower material costs in 2004 and a $70,000 contract cost overrun in 2003. These improvements were offset in part by a contract reserve of $100,000 and $271,000 for the three and six months ended June 30, 2004, respectively, related to a contract at the Systems Division. The majority of the Company’s revenues for the remainder of 2004 and 2005 will be derived from contracts, so gross margins are expected to continue at similar levels.

     Selling, General and Administrative (SG&A). SG&A expenses for the six months ended June 30, 2004 and 2003 were $2,285,849 and $2,287,477, respectively. SG&A expenses for the three months ended June 30, 2004 and 2003 were $1,160,075 and $1,219,960, respectively. The decrease in SG&A expenses for the three months ended June 30, 2004 compared to the three months ended June 30, 2003 of $59,885 is primarily related to a decrease in SG&A costs of approximately $225,000 at the Systems Division due to staff and other cost reductions, offset in part by higher accounting and legal fees, insurance costs and ISO 9000 costs.

     Research, Development and Engineering Program (RD&E). The Company’s RD&E consists of two types: customer-funded RD&E (U.S. government and other companies) and company-funded RD&E. Both types of RD&E costs are expensed when incurred. Customer-funded RD&E costs incurred, included in “Costs of Sales”, totaled $1,394,040 and $3,134,489 for the three months ended June 30, 2004 and 2003, respectively, and $2,724,722 and $5,541,764 for the six month periods ended June 30, 2004 and 2003. The decrease in customer-funded RD&E expenditures for the three and six months ended June 30, 2004 consists of a decrease of $1,271,429 and $1,991,255, respectively, related to the Navair Contract, decreases in two contracts winding down at the Systems Division of $39,222 and $368,338, respectively, and a decrease of $429,798 and $469,609, respectively, related to the DARPA Contract.

     Company-funded RD&E costs are shown in “Operating Expenses” and totaled $14,677 and $119,323 for the three months ended June 30, 2004 and 2003, respectively, and $68,774 and $221,832 for the six months ended June 30, 2004 and 2003, respectively. In addition, included in “costs associated with the BioSentry development” are $125,138 of research and development costs for the three and six months ended June 30, 2004. Hence, total RD&E expenditures for the three month periods were $1,533,855 and $3,253,812 for 2004 and 2003, respectively, and $2,918,634 and $5,763,596 for the six month periods in 2004 and 2003. Total RD&E expenditures as a percentage of revenues were 50.9% and 64.7% for the three months ended June 30, 2004 and 2003, respectively, and 48.3% and 59.0% for the six months ended June 30, 2004 and 2003, respectively. These expenditures are primarily related to the continued development of collimated plasma lithography systems for the semiconductor industry. The RD&E expenditures as a percentage of revenues have been historically higher than that for a commercially oriented company because much of the Company’s revenues has been R&D contract revenues.

     In February 2004, the Company received $8 million in financing from Laurus. JMAR intends to use these funds to initiate and advance new product research and development efforts and to acquire or license products, technologies or businesses. Specifically, during the second quarter of 2004 the Company has started product development on the BioSentry product line, and during the third quarter of 2004, the Company has initiated the product development of the X-ray Microscope and X-ray Nano Probe product lines. Accordingly, the Company expects company-funded RD&E to increase significantly for the remainder of 2004 and into 2005.

     Costs Associated with the BioSentry Development. During the second quarter of 2004, the Company entered into an alliance agreement with The LXT Group (LXT) to produce an early-warning system (BioSentry™) for the drinking water industry. As part of this agreement, JMAR agreed to provide a maximum financial commitment of $1 million, subject to the achievement of specific product development milestones by a joint LXT/JMAR team. For the second quarter, the Company had expensed $213,520 of costs incurred related to BioSentry product development. The majority of the remainder of the $1 million commitment is expected to be invested by the Company during 2004.

     Discontinued Operations. The income from discontinued operations of $74,546 and $12,449 for the three and six months ended June 30, 2004, respectively, is related to the standard semiconductor products

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business. The loss from discontinued operations of $686,830 and $1,146,817 for the three and six months ended June 30, 2003, respectively, includes $270,761 and $311,977, respectively, related to the standard semiconductor products business and $416,069 and $834,840, respectively, related to the precision equipment business. The decrease in the loss from discontinued operations is due to the sale of JPSI in July 2003.

     Prior to December 31, 2001, as the level of business expected from the standard semiconductor products business did not materialize, the Company decided to take action to sublease the Irvine facility and move the standard semiconductor products business into a smaller facility and recorded a reserve against the Irvine facility lease. The lease provides for rent and related expenses of approximately $36,000 per month through August 2005. In June 2004, the Company subleased the facility for the remaining term of the lease and reduced the Company’s reserve for this facility by approximately $112,000.

     Interest and Other Expense. Interest and other expense for the three months ended June 30, 2004 and 2003 was $115,120 and $125,700, respectively, and for the six months ended June 30, 2004 and 2003 was $565,111 and $230,826, respectively. Interest and other expense is higher for the six months ended June 30, 2004 versus the six months ended June 30, 2003 primarily due to the financing transactions the Company entered into in late March 2003 and January 2004 (see “Consolidated Liquidity and Financial Condition” below). Included in interest expense for the three and six months ended June 30, 2004 is $66,098 and $390,203, respectively, and $65,857 for the three and six months ended June 30, 2003 related to the beneficial conversion feature and fair value of warrants issued in connection with the Working Capital Line, and was charged to expense using the effective yield method based on the life of the debt, over the period from the issuance date to the conversion dates. Also, interest expense for the three and six months ended June 30, 2004 and 2003 includes $36,555, $80,305, $46,633 and $87,285, respectively, related to the discounted liability for the retirement in August 2002 of the Company’s former Chairman and Chief Executive Officer.

     Preferred Stock Dividends. Included in the loss applicable to common stock in the Statement of Operations for the three and six months ended June 30, 2004 and 2003 are preferred stock dividends of $535,098, $1,704,381, $224,030 and $229,453, respectively. The amount for the three and six months ended June 30, 2004 represents $65,471 and $125,472, respectively, of preferred stock dividends paid or payable in cash and $469,627 and $1,578,909, respectively, related to the discount representing the beneficial conversion feature of the redeemable convertible preferred stock and the fair value of warrants issued in connection with the preferred stock. The amount for the six months ended June 30, 2003 represents $27,604 of preferred stock dividends paid or payable in cash and $201,849 related to the discount representing the beneficial conversion feature of the redeemable convertible preferred stock and the fair value of warrants issued in connection with the preferred stock.

Consolidated Liquidity and Financial Condition

     Cash and cash equivalents at June 30, 2004 was $8,737,301. The increase in cash and cash equivalents during the six months ended June 30, 2004 of $4,566,122 resulted primarily from net proceeds from the issuance of preferred and common stock of $9,065,093, offset in part by the repayment in cash of $835,761 of the notes to the former SAL noteholders and cash used in continuing operations of $2,753,872 (primarily related to operating losses and an increase in accounts receivable), and cash used in discontinued operations of $547,896.

     JMAR will continue to use cash in 2004 and into 2005 for, among other requirements, 1) product research and development efforts, including BioSentry development, and to acquire or license products, technologies or businesses; 2) funding delays related to government contracts; 3) corporate costs, primarily related to the cost of being a public company; 4) preferred stock redemptions and dividends; and 5) other working capital needs. As a result of the financing activity discussed below, management believes that the Company has adequate resources to fund working capital requirements through June 30, 2005. However, the Company has determined that it will require additional financing to complete or accelerate the development of some of its high value emerging new products. Working capital as of June 30, 2004 and December 31, 2003 was $12,076,239 and $2,427,166, respectively. The increase in working capital is primarily due to gross proceeds from the issuance of preferred stock of $9.5 million and the

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conversion into common stock of $1,254,500 of the Company’s line of credit, offset in part by the Company’s losses.

     In March 2003, the Company entered into a Revolving Fixed Price Convertible Note (Working Capital Line) with Laurus. The Working Capital Line allows the Company to borrow from time-to-time up to 85% of eligible accounts receivable of the Company to a maximum of $3 million. Advances in excess of this formula are allowed, however, with the consent of Laurus. Laurus can convert any portion of the principal outstanding to common stock at a fixed price per share (Conversion Price) any time the market price of the Company’s common stock is in excess of the Conversion Price. The Company can convert a portion of the principal outstanding to common stock at the Conversion Price if the market price of the Company’s common stock averages 118% of the Conversion Price or higher for 22 consecutive trading days. The initial terms of the Working Capital Line provided that after $2 million of conversions into equity, the Conversion Price would be increased. The Conversion Price initially was $.92, but was increased to $2.85 in January 2004 after $2 million of the Working Capital Line had been converted.

     The interest rate on the Working Capital Line is equal to the prime rate (4% at June 30, 2004) plus 0.75 percent, subject to a floor of 5.00 percent. Accrued interest is payable monthly. The Working Capital Line requires that the Company’s quick ratio, as defined, be 0.90 or higher. The quick ratio is defined as the sum of cash and accounts receivable divided by the sum of current liabilities, exclusive of current liabilities of discontinued operations. The Company’s quick ratio was 6.29 at June 30, 2004. As of June 30, 2004, there was no amount outstanding under the Working Capital Line. The term of the Working Capital Line runs until March, 2006. The available borrowings under the Working Capital Line were approximately $2.1 million at June 30, 2004, all of which was unused at June 30, 2004.

     In 2003 and 2004, the Company sold the following series of Preferred Stock to Laurus for cash:

     The Series E, F, G and H Preferred Stock are redeemable in cash (or common stock if the closing market price of the Company’s common stock is 118% of the Conversion Price or higher for the 11 trading days prior to the redemption date) at various amounts and dates (see below under “Commitments”), if not previously converted. Conversions to equity are offset against the required repayments. Except for the conversion price, the conversion terms of the Series E through H Preferred Stock are the same as the conversion terms of the Working Capital Line.

     In connection with all of the above financing transactions with Laurus, the Company issued warrants to Laurus to purchase a total of 1,390,000 shares of common stock at prices ranging from $1.058 to $5.15. In addition, Laurus was granted the right to receive a warrant to purchase one share of common stock at $3.13 for every $20 of principal of the Working Capital Line converted to equity in excess of the first $2 million up to a total of 50,000 shares.

     The shares of common stock issuable to Laurus under all of the preferred stock and warrants described above have been included in registration statements declared effective by the Securities and Exchange Commission.

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     The Company’s stockholders’ equity was $8,820,510 as of June 30, 2004. In May, 2003, the Company transferred to the Nasdaq SmallCap Market, where it is required to maintain no less than $2.5 million of stockholders’ equity to retain its listing. Substantial continued losses without increases in equity would cause the Company to fall below this NASDAQ requirement, which would require it to come into compliance or face delisting. The delisting of the Company’s stock could adversely affect its ability to raise funds in the future. The Company believes that it has available to it several potential sources of capital to meet NASDAQ listing standards, particularly the above-described financings.

     In February 2004 the Company received approximately $3.5 million in additional contracts from General Dynamics and in late March 2004 and early April 2004, DARPA released $1.6 million in funding. In addition, JMAR expects to receive approximately $5.4 million in additional CPL contract funding from DARPA and another $2.1 million in funds from NAVAIR.

Commitments

     Future minimum annual commitments under non-cancellable operating leases (net of subleases), BioSentry development costs and post-employment benefits as of June 30, 2004 are as follows (unaudited):

     The operating leases are primarily for office facilities. The post-employment benefits are presented at the total amount to be paid, whereas the liability has been discounted for financial reporting purposes.

     Excluded from the above table are redemption obligations under Series E, F, G and H Preferred Stock in the gross amount of $9.5 million. Also excluded from the above table is the Company’s $3 million Working Capital Line, of which none was outstanding at June 30, 2004. If not previously converted, the Series E through H Preferred Stock are redeemable as follows:

     Under the Merger Agreement entered into with the former shareholders and creditors of SAL, Inc. (now operating as the Company’s Systems Division), those persons could earn up to three contingent earnout payments upon the satisfaction of three earnout conditions. For the first earnout, the SAL creditors were eligible to receive $500,000 in convertible notes upon the satisfaction of a “stepper limited” throughput test (without the CPL light source) by June 30, 2002. This requirement was not met by the June 30, 2002 deadline, and, therefore, the Company did not have to issue the $500,000 in convertible notes. For the second earnout, the SAL shareholders could have earned $500,000 in convertible notes upon the satisfaction of a lithography demonstration milestone. This milestone was to be met 90 days after the Company’s CPL beta source satisfied certain negotiated source performance criteria. In successful tests of the integrated system in March 2004, the source demonstrated improved reliability and performance; however, the specific source performance criteria specified in the Merger Agreement have not yet been met.

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If issued, the $500,000 in Convertible Notes would have been due 24 months after issuance and would have a conversion price equal to 120% of the average of the closing prices for the ten days prior to issuance.

     The third earnout condition could have resulted in payment of up to 354,736 JMAR shares and up to $1.2 million in convertible notes upon receipt by the Company of a qualifying order for a CPL system from a commercial customer and delivery to the customer. Under the Merger Agreement, the deadline for receipt of this order was 180 days after the CPL source satisfied the above mentioned source performance criteria. If earned, this earnout payment would have been payable 30 days after delivery and acceptance of the system by the customer.

     On July 9, 2004, the Company sent a letter to former shareholders and creditors (Holders) of SAL, Inc. proposing a final resolution of the second and third earnouts through payment of a total of $625,000 in shares of common stock, valued at the average of the closing prices of JMAR’s common stock for the five days during the period August 18, 2004 to August 24, 2004. Although the Company has continued to improve the CPL source and it has recently demonstrated improved lithographic performance, the CPL source does not yet meet the specific technical criteria set forth in the Merger Agreement and, therefore, the time to commence the required demonstration has not yet begun. Specifically, although the CPL source has demonstrated throughput approaching that required by the earnout, it has done so using a more sensitive resist than that required by the earnout. Because of the open-ended nature of the earnout, the payment of the second and third earnouts could be delayed for an indeterminate time. Because of this uncertainty, the Company believed that the current situation was unsatisfactory for both JMAR and the Holders. As of July 31, 2004, holders of more than 99 percent of the earnout interests had accepted the Company’s offer to receive the final payment of $625,000 in common stock in full satisfaction of all remaining amounts owed under the Merger Agreement.

     During the second quarter of 2004, the Company entered into an alliance agreement with The LXT Group (LXT) to produce an early-warning system (BioSentry™) for the drinking water industry. As part of the agreement, JMAR loaned the two principals of LXT $62,500 each and agreed to provide a maximum financial commitment of $1 million, subject to the achievement of milestones by LXT. Through June 30, 2004, the Company had provided approximately $224,000 of financial support for costs incurred related to BioSentry. The majority of the remainder of the $1 million committed is expected to be provided by the Company during 2004. Also, upon satisfaction of certain conditions, the Company and LXT agreed to execute a purchase agreement for the purchase by the Company of the LXT business. The purchase agreement is intended to be signed in August 2004 with a closing expected in January 2005 after certain milestones are met and will provide for the purchase of all of the assets of LXT for consideration consisting of $125,000 in cash, cancellation of $125,000 in promissory notes held by the two principals of LXT in favor of JMAR, 180,000 shares of JMAR common stock and certain contingent earn-out payments based on future revenues and residual income generated by the LXT business.

     At December 31, 2003, the Company had approximately $57 million of Federal net operating loss carryforwards subject to certain annual limitations, which expire from 2004 through 2023. To the extent the Company has taxable income in the future, these carryforwards may be used by the Company to reduce its cash outlay for taxes.

Critical Accounting Policies and Estimates

     Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses JMAR’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.

     On an ongoing basis, management evaluates its estimates and judgments, including those related to revenues, goodwill and intangible assets, beneficial conversion feature, deferred taxes, litigation accrual and stock based compensation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or

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conditions. Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenues

     Product revenues are recognized when the product is shipped FOB shipping point, all risks of ownership have passed to the customer and the Company has performed all obligations in accordance with Staff Accounting Bulletin No 101, “Revenue Recognition in Financial Statements” (SAB No. 101).

     Contract revenues are recognized based on the percentage of completion method wherein income is recognized pro-rata over the life of the contract based on the ratio of total incurred costs to anticipated total costs of the contract. The program manager prepares a statement of work, schedule and budget for each contract. At least monthly, actual costs are compared to budget and technical progress is compared to the planned schedule. The Company prepares an estimate of costs to complete for each contract at least quarterly. Estimated losses based on this review are fully charged to operations when identified. Actual costs could differ from these estimated costs.

Goodwill and Intangible Assets

     In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002, the Company has established reporting units and applies a two-step fair value approach to evaluating goodwill impairment, using at least an annual assessment. The Company compares the fair value of the business unit with the carrying amount of the assets associated with the business unit. The fair value of each business unit is determined using a risk adjusted discount rate to compute a net present value of estimated future cash flows and a consideration of market capitalization of the Company. The second step measures the amount of the impairment, if any. Patent costs capitalized are amortized over ten years, and other intangible assets are amortized over not more than five years. Patent costs capitalized are reviewed quarterly for realizability.

Beneficial Conversion Feature

     In accordance with Financial Accounting Standards Board (FASB) Emerging Issues Task Force Issue (EITF) No. 98-5 and FASB EITF No. 00-27, the Company records a beneficial conversion feature (BCF) related to the issuance of convertible preferred stock and convertible debt that have conversion features at fixed rates that are in-the-money when issued and records the fair value of warrants issued with those instruments. The BCF for the convertible instruments and fair value of warrants is recognized and measured by allocating a portion of the proceeds to additional paid-in capital and as a discount to the convertible instrument equal to the intrinsic value of the conversion features. Such amount is calculated at the issuance date as the difference between the conversion price and the relative fair value of the common stock and warrants into which the security is convertible or exercisable.

     For convertible preferred stock and related warrants, the recorded discount is recognized as a dividend from the date of issuance to the earlier of the redemption dates or the conversion dates using the effective yield method. For convertible debt and related warrants, the recorded discount is recognized as interest expense using the effective yield method based on the life of the debt, over the period from the issuance date to the conversion dates.

Deferred Taxes

     JMAR records a valuation allowance to reduce its deferred tax assets to the amount that management believes is more likely than not to be realized in the foreseeable future, based on estimates of foreseeable future taxable income and taking into consideration historical operating information. In the event management estimates that it will not be able to realize all or part of its net deferred tax assets in the foreseeable future, a valuation allowance is recorded through a charge to income in the period such determination is made. Likewise, should management estimate that it will be able to realize its deferred tax assets in the future in excess of its net recorded asset, an adjustment to reduce the valuation allowance would increase income in the period such determination is made.

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Litigation Accrual

     Estimated amounts for litigation reserves that are probable and can be reasonably estimated are recorded as liabilities. Estimates are based upon the facts and circumstances of each case and, in part, on advice from legal counsel regarding probable outcomes, if determinable. Management reviews its estimates on a quarterly basis.

Stock-Based Compensation Plans

     The Company accounts for its stock option and warrant plans under APB Opinion No. 25, using the intrinsic value method, under which no compensation cost has been recognized for issuances to employees. Options and warrants issued to non-employees (other than directors) are accounted for based on the fair value of the equity instrument issued. The fair value is calculated based on the Black-Scholes pricing model. The resulting value is amortized over the service period.

“Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995

     Certain statements contained in this Form 10-Q which are not related to historical results, including statements regarding JMAR’s future sales or profit growth, competitive position or products, projects or processes currently under development, the ability of the Company to successfully introduce new products into the commercial marketplace or to apply those products, projects or processes to alternative applications are forward-looking statements. These forward-looking statements are based on certain assumptions and are subject to certain risks and uncertainties that could cause actual future performance and results to differ materially from those stated or implied in the forward-looking statements.

     In addition to the several risks and uncertainties described in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, additional risks and uncertainties include the following:

	•		delays and unanticipated technological or engineering difficulties in the Company’s new product development efforts, which involve lengthy and capital intensive programs that are subject to many unforeseen risks, delays, problems and costs and uncertainties as to the market’s demand for such new products;
	•		the risk that the technologies related to our new product development activities may infringe on issued patents held by others;
	•		the lack of funds to support our CPL business area due to delays in funding or cancellation of government contracts;
	•		delays in securing, or inability to secure other financing, whether from the public or private debt or equity markets or from commercial lenders or otherwise, for working capital needs or for development of the Company’s new products;
	•		the inability to achieve the levels of power and reliability in its CPL source required to enter the GaAs market, despite the expenditure of additional significant funds;
	•		the continued delay in the recovery of the GaAs chip market resulting in further delays in the demand for the increased throughput offered by the Company’s CPL system;
	•		despite substantial technical, marketing and sales efforts and the expenditure of significant funds by the Company, the failure to convince semiconductor manufacturers to adopt the Company’s CPL technology over other existing and possible future alternative lithography technologies, including the use of electron beam systems for GaAs chip manufacturing, 193 immersion lithography for silicon contact hole processing and EUV lithography for future mainstream silicon manufacturing;

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	•		the lack of availability of critical components from third party suppliers, including laser diodes, x-ray optics, x-ray masks and photo-resist, or the inability to obtain such components at acceptable costs;
	•		fluctuations in margins, or the failure to lower manufacturing costs sufficiently to achieve acceptable margins;
	•		the failure of pending patents to be issued and uncertainties as to the breadth or degree of protection of existing or future patents covering the Company’s x-ray and other technologies and applications; and
	•		other risks detailed in the Company’s Form 10-K for the year ended December 31, 2003 and in the Company’s other filings with the Securities and Exchange Commission.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

     The Company’s exposure to interest rate risk is minimal due to the relatively small amount of investments and variable rate debt. The Company has no investments in derivative financial instruments.

Item 4. Controls and Procedures.

     The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

     The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness as of June 30, 2004 of the design and operation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)). Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective in timely alerting them to material information required to be included in the Company’s reports filed or submitted under the Exchange Act of 1934.

     There have been no significant changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

     The Company is not an “accelerated filer” and, therefore, the internal controls certification and attestation requirements of Section 404 of the Sarbanes-Oxley Act are not applicable to the Company until 2005. However, during the second quarter of 2004, the Company has been reviewing and testing its internal control procedures and it retained an outside firm to assist in this process.

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PART II – OTHER INFORMATION

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.

(c)(i) Pursuant to the Non-Employee Directors’ Equity Plan approved by the Company’s Shareholders on June 25, 2004, on that date the Company issued a total of 2,322 shares of Common Stock to its outside directors as compensation for services as directors. These transactions were exempt under Section 4(2) of the Securities Act of 1933.

Item 4. Submission of Matters to a Vote of Security Holders.

At the Company’s Annual Meeting of Shareholders held on June 25, 2004, the following matters were voted on:

(a) The following directors were elected: C. Neil Beer (27,063,850 affirmative votes and 2,105,058 votes withheld); Vernon H. Blackman (27,075,900 affirmative votes and 2,093,008 votes withheld); Charles A. Dickinson (27,080,025 affirmative votes and 2,088,883 votes withheld); John S. Martinez (26,960,335 affirmative votes and 2,208,573 votes withheld); Edward P. O’Sullivan II (28,299,759 affirmative votes and 869,149 votes withheld); Barry Ressler (27,090,834 affirmative votes and 2,078,074 votes withheld); Ronald A. Walrod (27,196,004 affirmative votes and 1,972,904 votes withheld).

(b) The proposal to ratify the selection of Grant Thornton, LLP as the Company’s independent auditor for the fiscal year ending December 31, 2004 was approved with 28,883,851 affirmative votes, 134,831 negative votes and 150,226 abstaining votes. There were no broker non-votes for this item.

(c) The proposal to approve an amendment to the Company’s Certificate of Incorporation to increase the authorized Common Stock from 40,000,000 to 80,000,000 shares was approved with 26,804,159 affirmative votes, 2,218,503 negative votes and 146,246 abstaining votes. There were no broker non-votes for this item.

(d) The proposal to approve the Non-Employee Directors’ Equity Plan to authorize a total of 100,000 shares of Common Stock for the payment of Board and Committee meeting fees was passed with 6,327,663 affirmative votes, 1,984,505 negative votes, 233,207 abstaining votes and 20,623,533 broker non-votes.

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

(a) Exhibits

(b) Reports on Form 8-K

The Company filed a Report on Form 8-K on April 1, 2004 related to the announcement of its financial results for the year ended December 31, 2003.

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SIGNATURE

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.

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