UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q

(Mark one)

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

For the quarterly period ended September 30, 2004

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

For the transition period from ___________ to ____________

Commission File Number: 0-23634

KFX INC.
(Exact name of registrant as specified in its charter)

Registrant’s Telephone Number, Including Area Code: (303) 293-2992

Indicate by check mark whether the registrant: (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, and (2) has been subject to such filing requirements for the past 90 days. Yes  x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes x No ¨

On November 4, 2004, 2004 there were 60,445,903 shares of the registrant’s common stock, $.001 par value, outstanding.

KFX INC.
FORM 10-Q QUARTERLY REPORT
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

		Page No.
ITEM 1.	FINANCIAL STATEMENTS
	Consolidated Balance Sheets – September 30, 2004 (Unaudited) and December 31, 2003	3
	Consolidated Statements of Operations - Three Months Ended September 30, 2004 and 2003 (Unaudited)	4
	Consolidated Statements of Operations – Nine Months Ended September 30, 2004 and 2003 (Unaudited)	5
	Consolidated Statements of Changes in Stockholders’ Equity – Year Ended December 31, 2003 and Nine Months Ended September 30, 2004 (Unaudited)	6
	Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2004 and 2003 (Unaudited)	7
	Notes to Consolidated Financial Statements (Unaudited)	9
ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	22
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	28
ITEM 4.	CONTROLS AND PROCEDURES	29
PART II.  OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS	30
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	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	31

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PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

KFX INC.
CONSOLIDATED BALANCE SHEETS

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

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KFX INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

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

4

KFX INC.
CONSOLIDATED STATEMENTS OF OPERATIONS

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

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

6

KFX INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

Nine Months Ended September 30, 2004:

       The Company incurred a note payable obligation of $52,000 on the purchase of a vehicle during the nine months ended September 30, 2004.

Nine Months Ended September 30, 2003:

       Convertible debt with an outstanding balance of $2,394,994 was converted into 870,907 shares of common stock of KFx Inc. (“KFx” or the “Company”) at a conversion price of $2.75 per share on September 11, 2003. In connection with this conversion, KFx recorded additional interest expense of $627,030 during the nine months ended September 30, 2003 to write-off the debt discount associated with this convertible debt.

       During the nine months ended September 30, 2003, the Company applied approximately $93,000 of invoices for products and services to the outstanding convertible long-term debt.

       During the nine months ended September 30, 2003, the Company issued 68,300 shares of common stock to consultants with a fair value of $281,582.

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KFX INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(UNAUDITED)

NOTE 1.  BASIS OF PRESENTATION

Nature of Operations

       KFx Inc. is a “clean energy” technology company with a patented process, which we refer to as K-Fuel^™(“K-Fuel”) technology that adds value to coal producers and the electric power generation industry by significantly improving the quality of lower heating value coal and facilitating the industry’s compliance with air emission standards. We operate a research, development, and demonstration facility near Gillette, Wyoming that includes a Class A laboratory and pilot plants capable of processing all types of source coal into K-Fuel using our proprietary technology. This facility provides critical information to our potential customers and governmental agencies in assessing the benefits of the K-Fuel process.

       Currently, we are designing, engineering and fabricating a K-Fuel plant. The K-Fuel plant will employ our patented K-Fuel technology which uses heat and pressure to physically and chemically transform high-moisture, low-energy value coal into a low-moisture, high-energy solid clean fuel – K-Fuel. While our primary business is construction and operation of our own plant, we may also license K-Fuel technology domestically and internationally to various parties that desire to construct and operate K-Fuel production facilities.

Consolidation Policy

       The consolidated financial statements include the accounts of KFx and its wholly-owned subsidiaries, K-Fuel LLC (“KFL”), KFx Technology, Inc. (“KFxT”), Landrica Development Company (“LDC”) and Advanced Coal Processing, Inc. (“ACP”), formerly KFx Wyoming, Inc. On August 31, 2004 the Company acquired the remaining interest in its majority-owned subsidiary, KFx-Lurgi (Pty) Ltd (“KLL”), a South African registered entity.  Immediately after acquisition KLL was dissolved, and the impact on the Company’s consolidated financial statements was not significant.  Prior to its dissolution, the consolidated financial statements included the accounts of this former majority-owned subsidiary.  On August 1, 2004 the Company acquired COGAS LLC (“COGAS”), a Wyoming Limited Liability Company.  Prior to acquisition COGAS had no operations.  The accounts of COGAS are included in the consolidated financial statements of KFx for the period ended September 30, 2004.  The consolidated Statement of Operations and Statement of Cash Flows (for cash provided or used by discontinued operations) for the period ended September 30, 2003 were revised to reflect the discontinued operations of Pegasus Technologies, Inc. (“Pegasus”). A detailed description of the equity transfer transaction involving Pegasus and KFL is provided in Note 2. Prior to November 26, 2003, the operations of KFL were accounted for as an equity investment since the 49% partner, Kennecott Energy Company, had certain participative rights.

Revenue

       The Company recognizes revenue from K-Fuel licenses when an agreement has been signed, all significant obligations have been satisfied and the fee is fixed or determinable. KFx recognizes contract revenue related to contracts performed by its demonstration facility as the services are performed under third party contracts. When realized, this revenue is comprised of multiple contracts and those contracts are entered into intermittently.

Pegasus Software License and Services Revenue

       Prior to the disposition of Pegasus, more fully discussed in Note 2, the Company recognized revenue in the operations of Pegasus in accordance with the provisions of Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” as amended by SOP 98-9, “Modification of Statement of Position 97-2, Software Revenue Recognition, with Respect to Certain Transactions.” The Company derived revenues from license fees, for the Company’s NeuSIGHT^®and Power Perfecter^®software, and services, including installation, implementation, maintenance and training, under the terms of both fixed-price and time-and-materials contracts. Revenues were not recognized until persuasive evidence of an arrangement existed, either by way of a signed contract or signed purchase order, collectibility was reasonably assured, delivery had occurred or services had been rendered and the price was fixed or determinable.

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       Where services were essential to the functionality of the delivered software, the license fee and services revenue was generally recognized using the percentage-of-completion method of accounting, as prescribed by SOP 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” The percentage of completion for each contract was determined based on the ratio of direct labor hours incurred to total estimated direct labor hours required to complete the contract. The Company may have periodically encountered changes in costs, estimated costs and other factors that may have led to a change in the original estimated profitability of a fixed-price contract. In such circumstances, adjustments to cost and profitability estimates were made in the periods in which the underlying factors requiring such revisions became known. If such revisions indicated a loss on a contract, the entire loss was recorded at such time. Amounts billed in advance of services being performed were recorded as deferred revenue. Unbilled work-in-progress represented revenue earned but not yet billable under the terms of fixed price contracts and all such amounts were expected to be billed in accordance with performance milestones specified in the contract and collected within twelve months. Deferred job costs represented up-front hardware costs incurred that were amortized to expense over the term of related revenue recognition.

       Services revenue provided under fixed-price contracts was generally recognized using the percentage-of-completion method of accounting described above. Revenue from other services provided pursuant to time-and-materials contracts was recognized as the services were performed. Annual maintenance revenue was recorded as deferred revenue and recognized ratably over the service period, which was generally twelve months.

Engineering and Technical Services

       Conceptual engineering and technical services costs relating to the development of K-Fuel and other technologies are expensed as incurred. Such costs are expensed as incurred until the commercial feasibility of the product, process or improvements is established.  After commercial feasibility is established, expenditures related to the design, engineering, purchase or fabrication of the facilities to produce the product are capitalized according to the property, plant and equipment policy below.

Loss From Discontinued Operations

       Prior to its disposal in November 2003, Pegasus was reported and accounted for as an operating segment. For purposes of the Consolidated Statement of Operations for the quarter and nine months ended September 30, 2003, the loss from operating Pegasus has been aggregated into a single line called “Loss from discontinued operations.” The Company has made the determination to account for the disposal of these operations as discontinued in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” because (a) it has been determined that the operations and cash flows of this asset were eliminated from our on-going operations and (b) the Company does not expect to have any significant continuing involvement in the operations of Pegasus in the future. As a result of this disposition KFx only operates in a single business segment.

Cash and Cash Equivalents

       Cash and cash equivalents consist of highly liquid investments that consist primarily of taxable, short-term money market instruments and overnight deposits with insignificant interest rate and credit risk and original maturities of three months or less at the time of purchase.

Restricted Cash

       The Company has $2.7 million in restricted cash set aside in a joint custody account for the benefit of the Wyoming Department of Environmental Quality (“DEQ”).  This cash serves as collateral pledged toward the Asset Retirement Obligation assessed by the DEQ on the non-operating mine assets owned by LDC.  Until the Asset Retirement Obligation is relieved this cash will remain restricted.  Furthermore, if and when the Asset Retirement Obligation assessment increases or decreases the Company may be required to pledge additional cash collateral or may be allowed to un-restrict this cash as the case may be.

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Fair Value of Financial Instruments

       The carrying amount of cash and cash equivalents, restricted cash, note receivable, accounts payable, accrued liabilities and the notes payable in the consolidated financial statements approximate fair value because of the short-term maturity of the instruments.

Long-Lived Assets

       The Company evaluates long-lived assets based on estimated future undiscounted net cash flows whenever significant events or changes in circumstances occur which indicate the carrying amount may not be recoverable. If that evaluation indicates that impairment has occurred, any loss is measured based on a comparison of discounted cash flows or fair values, whichever is more readily determinable, to the carrying value of the related asset.

Property, Plant, and Equipment

K-Fuel Plant Under Construction

       All costs that are directly related to the design, engineering, purchase or fabrication of K-Fuel plant equipment and construction of a commercial K-Fuel plant project are capitalized in “Plant construction in progress”. All costs that are directly related and/or allocable to developing a specific K-Fuel plant site for a commercial plant project are capitalized and separately identified as belonging to that site. If it is determined the site will not generate future cash flows or is expected to generate less cash flow than originally expected the capitalized costs are evaluated for impairment. Costs that are not directly related to the development of the K-Fuel plant or development of a specific site are expensed. The Company begins recognizing depreciation on plant assets once the assets are put into use. Accordingly, no depreciation has been recognized on K-Fuel plant assets to date.

Other Property, Plant, and Equipment

       Other property, plant, and equipment consist of buildings, furniture and fixtures, computers, vehicles and leasehold improvements.  As of September 30, 2004 the coal handling, water treatment, injection wells, land and asset retirement cost purchased in the acquisition of Landrica Development Company (collectively “non-operating mine assets”) more fully described in Note 4 below were included in other property, plant and equipment as well.

       Expenditures that extend the useful lives of assets are capitalized. Repairs and maintenance that do not extend the useful lives of the assets are expensed as incurred. Depreciation expense is computed using the straight-line method over the following estimated useful lives for other property and equipment:

Asset Retirement Cost and Obligation

        In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (FAS 143).  FAS 143 provides accounting and disclosure requirements for retirement obligations associated with long-lived assets and was effective January 1, 2003.   FAS 143 requires that the fair value of the retirement obligation be recorded as a liability with an equivalent amount added to the asset cost and depreciated over an appropriate period.  The liability is then accreted over time by applying an interest method of allocation to the liability.  Cumulative accretion and accumulated depreciation should be recognized from the date the liability would have been recognized had the provisions of FAS 143 been in effect, to the date of its adoption.  The cumulative effect, if any, of initially applying FAS 143 should be recognized as a change in accounting principle.

        As further discussed in Note 4 below, the Company acquired LDC in May 2004.  As part of the purchase agreement the Company agreed to assume the reclamation liability associated with the non-operating coal mine assets owned by LDC.  The fair value of this liability is determined from time-to-time by the Wyoming Department of Environmental Quality (“DEQ”).  This reclamation liability was recorded at its fair value as determined by the DEQ on the date of acquisition and an equivalent amount was added to the asset cost.  Since the Company has elected to rely on the DEQ assessment of reclamation cost, no accretion to the liability has been recognized.

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Instead, adjustments to the liability will be made if, and when, the DEQ changes its assessment.  The Company has estimated the useful life of the asset retirement cost as the approximate weighted average expected useful life of the underlying plant assets purchased from LDC, which approximate 12 years.  Therefore, the Company has begun depreciating this asset on a straight-line basis over a 12-year useful life.

Patents

       The costs of obtaining new patents are capitalized. The costs of defending and maintaining patents are expensed as incurred. Patents are amortized over the expected useful lives of the patents which is generally 17 to 20 years for domestic patents and 5 to 20 years for foreign patents.

Stock Based Compensation

       The Company periodically grants qualified and non-qualified stock options to certain executive officers and other key employees, non-employee directors and certain consultants under four stock option plans as well as outside the plans. Stock options granted to employees and non-employee directors are accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations, which generally provide that no compensation expense is recorded in connection with the granting of stock options if the options are granted at prices at least equal to the fair value of the common stock at the date of grant. Stock options and other equity instruments granted to non-employees and consultants are accounted for in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation” and Emerging Issues Task Force Abstract No. 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods or Services” (“EITF 96-18”). Accordingly, stock options granted to non-employees are measured using a Black-Scholes option-pricing model and are expensed over the expected service period.

       Had compensation expense for the Company’s stock options granted to employees and non-employee directors been recognized based on the fair value over the vesting period for the awards consistent with the method of SFAS 123, the Company’s pro forma net loss and net loss per share would have been as follows:

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       For pro forma calculations in the three months ended September 30, 2004 and 2003, respectively, the fair value of each stock option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for the grants:

       For pro forma calculations for the nine months ended September 30, 2004 and 2003, the fair value of each stock option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for the grants:

Estimates

       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 as of the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Management, with respect to the realizability of the Company’s property, plant and equipment, patents, notes receivable and prepaid royalty, has made significant estimates. Actual results could differ from these estimates, making it possible that a change in these estimates could occur in the near term.

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Revisions and Reclassifications

       As a result of KFx’s disposition of its Pegasus operations in 2003, the Company’s previously reported Consolidated Statements of Operations for the quarter and nine months ended September 30, 2003 and Statement of Cash Flows (for cash provided in discontinued operations) for the period ended September 30, 2003 have been revised to present the discontinued Pegasus operations separate from continuing operations (See Note 2). Additionally, certain reclassifications have been made to the 2003 Consolidated Balance Sheet to conform to the current period presentation.

NOTE 2. DISCONTINUED PEGASUS OPERATIONS

       On November 26, 2003, the Company completed an equity exchange transaction with Kennecott Energy Company (“Kennecott”). In accordance with terms contained in the Equity Exchange Agreement (“Agreement”) Kennecott transferred to KFx its 49% membership interest in KFL and the full ownership of all related technology developed by Kennecott. Prior to the consummation of this transaction, KFx owned a 51% membership interest in KFL. In exchange, KFx transferred its ownership interests in Pegasus to Kennecott. KFx had previously held approximately 65% ownership in Pegasus.

       In connection with the Agreement, KFx paid $500,000 to Pavilion Technologies, Inc. (“Pavilion”) to obtain agreement from Pavilion to waive their right to demand acceleration of royalty obligations due to Pavilion from Pegasus upon the change in control of Pegasus. KFx is to be repaid 50% of this amount as part of the note receivable from Pegasus (see Note 3) and the remaining 50% was included in the contingent obligations due from Pegasus. Kennecott also received a license and all necessary rights to build and operate up to three commercial K-Fuel plants and to market K-Fuel or other production from those plants. Each plant can have annual capacity of up to three million tons and Kennecott will pay applicable royalty and license fees for these three plants.

       Additionally, as part of this transaction, an intercompany working capital loan from KFx to Pegasus with an outstanding balance of approximately $9.4 million was exchanged for a contingent earn-out agreement of up to $9.4 million in the aggregate, plus accrued interest (prime rate plus 500 basis points), payable out of a portion of future cash flows generated by Pegasus. Due to the contingent nature of this potential stream of future cash flows the Company has not recognized an asset or any associated income. Pursuant to the terms of the Agreement, at closing, Kennecott repaid KFx approximately $1 million, plus accrued interest, that KFx had loaned to Pegasus during the first nine months of 2003, under this working capital line of credit. Kennecott also paid, at closing, to the Chairman and CEO of KFx $185,000 to retire indebtedness owed by Pegasus and $301,000 to a director of KFx and his company to retire indebtedness owed by Pegasus.

       The Company accounted for the disposal of these operations in accordance with SFAS No. 144 (See “Loss from Discontinued Operations” in Note 1).

       The following table presents the summarized results of Pegasus’ discontinued operations for the Consolidated Statement of Operations for the three and nine months ended September 30, 2003:

NOTE 3. NOTE RECEIVABLE

       On July 25, 2001, Cinergy Corporation (“Cinergy”) advanced $3.5 million to Pegasus against an existing contract between Pegasus and Cinergy. The advance earned interest at 7% per annum, payable monthly. Per the terms of the agreement, Cinergy could elect to apply future Pegasus invoices against the advance or convert the balance of the advance into either KFx or Pegasus common stock. Cinergy also had the right to require repayment of the advance under certain circumstances. As additional consideration Cinergy received warrants to purchase 200,000

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shares of KFx common stock, with beneficial re-pricing rights, contingent on the Company repaying its convertible debentures.

       In relation to the above transaction, the Company granted a warrant for professional services rendered to purchase approximately 69,000 shares of the Company’s common stock at an exercise price of $3.00 per share, expiring 5 years from the date of grant. The estimated fair value of the warrant of approximately $127,000 based, on the Black-Scholes option-pricing model, was recorded as debt issue costs and was being amortized over the expected term of the related note. During 2003, this warrant was cancelled as part of a settlement transaction. As such the Company amortized the remaining debt issuance costs of $66,000 during 2003.

       On September 11, 2003, Cinergy elected to convert its advance to Pegasus into common stock of KFx. The advance balance from Cinergy to Pegasus was $2.4 million on September 11, 2003, and was converted into approximately 871,000 shares of KFx common stock at a price of $2.75 per share, in accordance with the terms of the agreement. At conversion of this note receivable Pegasus became indebted to KFx for the remainder of the balance outstanding. As additional consideration to KFx in the Agreement described in Note 2, $250,000 of the payment made by KFx to Pavilion was added to the note receivable due KFx. The note accrues interest at 7% per annum, payable monthly. Payments on the note are due pursuant to an assignment of certain cash proceeds due to Pegasus from Cinergy. The Company has certain rights to collect payments under this note from Pegasus and to demand payment upon certain events of default. During the quarter and nine months ended September 30, 2004 the Company collected $64,000 and $237,000 in principal payments, respectively.  During the quarter and nine months ended September 30, 2004 the Company collected $40,000 and $108,000 in interest payments, respectively.

NOTE 4. PURCHASE OF LANDRICA DEVELOPMENT COMPANY

       On May 21, 2004, the Company acquired all of the outstanding stock of Landrica Development Company (“LDC”) from Wyodak Resources Development Corporation (“WRD”) for cash of $523,000 and assumption of a reclamation liability of $2.7 million.  The assumption of the reclamation liability was secured with cash and is presented as restricted cash on the Consolidated Balance Sheet as of September 30, 2004.  The results of LDC have been included in the consolidated financial statements from the date of acquisition.  LDC owns a non-operating coal mine facility with assets that include land, buildings, coal handling equipment, a railroad loop and other pieces of equipment and property.

       The purchase price allocation has been prepared on a preliminary basis, and reasonable changes are expected as additional information becomes available.  Following is a summary of the estimated fair values of the assets acquired and liabilities assumed as of the date of the acquisition:

        Since LDC was not operating the mine during 2003 or 2004 the operating results, including revenue and net income are insignificant.  Therefore, pro-forma results as if the acquisition had occurred at the beginning of the respective period are not presented.

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NOTE 5. PROPERTY, PLANT, AND EQUIPMENT

       Property, plant and equipment consisted of the following:

       Of the $12.7 million of expenditures for plant construction in progress at September 30, 2004 approximately $1.1 million has been paid to Lurgi S.A (Pty) Ltd for payment of goods and services not yet fully received from vendors.  The K-Fuel demonstration plant was fully depreciated as of September 30, 2004 and December 31, 2003; however, since it continues to be a significant source of testing and demonstration for the Company’s potential customers we have presented its original cost basis and accumulated depreciation for informational purposes.

NOTE 6. PATENTS

        Patents consisted of the following:

        Patent amortization expense, including abandoned patents pending, was $19,000 in the quarter and $124,000 in the nine months ended September 30, 2004 compared to $29,000 in the quarter and $88,000 in the nine months ended September 30, 2003.

        Most of our early patents are near their expiration dates.  Our later patents will not expire until 2018 through 2021.  We have filed a new patent application covering the technology to be used in our K-Fuel Plant project, which if granted, will not expire until 2024.  However, our on-going research and development activities often lead to new methods of applying heat and pressure to beneficiate coal, and new patent applications are filed for many of these new methods.  Even as the Company is constructing commercial plants, we will continue our efforts to find new and better ways to improve efficiency in our technology.

NOTE 7. STOCK OPTION PLANS

       The Company has four qualified stock option plans (“Option Plans”): the Amended and Restated 1992 Stock Option Plan (the “1992 Plan”); the 1996 Stock Option and Incentive Plan (the “1996 Plan”); the 1999 Stock Incentive Plan (the “1999 Plan”); and the 2002 Stock Incentive Plan (the “2002 Plan”). These plans are administered by the Compensation Committee of the Company’s Board of Directors (“Committee”), which has the authority to

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determine the specific terms of awards under these plans, including grant price, vesting and term, subject to certain restrictions of the Internal Revenue Code regarding incentive stock options (“ISO”).

       The 1992 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of non-qualified stock options (“NSO”) and ISOs. Stock options granted under the 1992 Plan generally vest 20% on the date of grant, with an additional 20% vesting on each anniversary date thereafter until fully vested. The Committee can accelerate the vesting of an outstanding option at its sole discretion, and is required to accelerate the vesting of all options outstanding under the 1992 Plan in the event of a change in control. As a result of Thermo Ecotek Corporation’s (“TCK”) investment in the Company on January 31, 1997, which increased its ownership in the Company to in excess of 15%, which constituted a change in control, all options outstanding under the 1992 Plan became fully vested. Stock options granted under the 1992 Plan generally expire not more than ten years from the date of grant. During the three months and nine months ended September 30, 2004 the Company granted a total of 70,000 options under the 1992 Plan to three consultants, all of which were immediately exercisable.  The Company has reserved 1 million shares of common stock for issuance under the 1992 Plan, of which 508,000 options remain available for grant as of September 30, 2004.

       The 1996 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of NSOs, ISOs, stock appreciation rights (“SAR”) and restricted stock. Stock options granted under the 1996 Plan generally vest 20% on the first anniversary date of the grant, and an additional 20% each anniversary date thereafter until fully vested. The Committee has similar discretionary authority to accelerate the vesting of any outstanding option as described above under the 1992 Plan, except there are no specific change in control vesting requirements. Stock options granted under the 1996 Plan generally expire not more than ten years from the date of grant. The Company has reserved 1.5 million shares of common stock for issuance under the 1996 Plan, of which approximately 1,000 options remain available for grant at September 30, 2004. There were 530,000 options granted under the 1996 Plan during the nine months ended September 30, 2004.  Of the options granted during these periods, 230,000 were granted to non-employee directors of the Company and 300,000 were granted to officers of the Company.  The options granted to non-employee directors vested immediately.

       The 1999 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of various forms of equity based compensation including ISOs, NSOs, SARs, or restricted stock. The Committee has similar discretionary authority to accelerate the vesting of any outstanding option as described above under the 1992 Plan, except that vesting is not required upon a change in control. During the three and nine months ended September 30, 2004 there were 20,000 options granted to a non-employee director of the Company, all of which were immediately exercisable.  The Company has reserved 2 million shares of common stock for issuance under the 1999 Plan, of which 5,000 options remain available for grant at September 30, 2004.

       The 2002 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of various forms of equity based compensation including ISOs, NSOs, SARs, or restricted stock. The Committee has similar discretionary authority to accelerate the vesting of any outstanding option as described above under the 1992 Plan, except that vesting is not required upon a change in control. The Company has reserved 2 million shares of common stock for issuance under the 2002 Plan. There were 50,000 and 580,000 options granted during the three months and nine months ended September 30, 2004, respectively.  Additionally, approximately 87,000 options were cancelled and returned to the plan during the nine months ended September 30, 2004. Of the options granted during this period, 80,000 were granted to non-employee directors of the Company and the remainder were granted to an officer of the Company.  The options granted to non-employee directors vested immediately.  Additionally, 3,000 unrestricted and 100,000 restricted shares were granted to officers of the Company. The restricted share grant vests pro-rata at 20% per year beginning in January 2005. For the quarter and nine months ended September 30, 2004 the Company recognized $0 and $28,000 and $39,000 and $116,000 of compensation expense on the unrestricted and restricted share grant, respectively. As of September 30, 2004, the 2002 Plan had approximately 2,000 options remaining.

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       The following table summarizes the Company’s stock option activity for the period December 31, 2003 to September 30, 2004:

       Stock options outstanding and exercisable as of September 30, 2004 are summarized below:

       In previous periods the Company disclosed options and SARs converted to options separately.  However, for the period ended September 30, 2004 all options outstanding and exercisable are included in the table above.  As of December 31, 2003 there were 2,937,000 options and 1,516,000 SARs converted to options outstanding, respectively, for a total of 4,453,000 options outstanding.  Additionally, as of December 31, 2003 there were 2,507,000 options and 1,516,000 SARs converted to options exercisable, respectively, for a total of 4,023,000 options exercisable.  All stock options granted during the nine months ended September 30, 2004 and for the year ended December 31, 2003 were at exercise prices that were equal to or greater than the fair market value of the Company’s common stock on the date of grant.

NOTE 8. WARRANTS TO PURCHASE COMMON STOCK

       Associated with various financing transactions and professional service agreements, the Company has issued transferable warrants to purchase common stock. In May 2003, the Company issued a warrant for the purchase of 1 million common shares of the Company at an exercise price of $2.75 per share to a consultant as part of a 3-year services agreement. The warrant vests as follows: (i) 2/9ths or approximately 222,000 shares vested on the date of the agreement, March 1, 2003 and (ii) remaining warrants vest 1/36, or approximately 28,000 on the first day of each month thereafter for a total of 28 months. At September 30, 2004, the right to purchase approximately 722,000 shares of our common stock had vested under this services agreement. The Company recognized $237,000 and $712,000 of expense for these services during the quarter and nine months ended September 30, 2004 based on the fair value of the warrants that vested during the period.

       On June 25, 2004 the Company entered into agreements to raise capital proceeds from two of its warrant holders.  In return for 1.3 million additional warrants at an exercise price of $11.00 per share, these warrant holders agreed to exercise 3.9 million of their warrants before their contractual exercise date.  On June 28, 2004 the

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Company received $7.2 million of proceeds from the exercise of 2.6 million of these warrants.  As a direct cost of this transaction the Company decreased additional paid-in capital by $1.2 million, which was equal to the Black-Scholes value of the 900,000 additional warrants issued, and increased additional paid-in capital by the same amount for the value of the additional warrants issued.  On July 22, 2004 the Company received $3.4 million of proceeds from the exercise of the remaining 1.2 million warrants from the other warrant holder.  As a direct cost of this transaction the Company decreased additional paid-in capital by $600,000, which was equal to the Black-Scholes value of the 415,000 additional warrants issued, and increased additional paid-in capital by the same amount for the value of the additional warrants issued.

       The following table summarizes the Company’s warrant activity for the period December 31, 2003 to September 30, 2004:

NOTE 9. COMMITMENTS AND CONTIGENT LIABILITIES

The following table summarizes our future commitments, excluding repayments of debt, as of September 30, 2004:

Operating Leases

        The Company is obligated under non-cancelable operating leases with initial terms exceeding one year relating to office space and certain equipment and vehicle leases. Rent expense in the nine months ending September 30, 2004 was $208,000 compared to $205,000 in the same period of 2003.  Through September 30, 2004 certain of the leased property, principally office space, was sublet to third parties under a non-cancelable operating sublease.  Sublease income was $124,000 in the nine months ending September 30, 2004 compared to $97,000 in the same period of 2003.  The sublease expired in September 2004.

Purchase Commitment Obligations

        The Company has purchase commitments for K-Fuel plant-related equipment and services of approximately $6.0 million as of September 30, 2004.  Additionally, the Company has previously negotiated purchase commitments of approximately $375,000 for corporate and engineering consulting services over the next two years.

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Litigation

       Leon S. Segen, derivatively on behalf of KFx v. Westcliff Capital Management, LLC, Richard S. Spencer III, KFx Inc. and others, United States District Court Southern District of New York, filed March 7, 2003. A stockholder suing derivatively on our behalf filed a civil complaint against Westcliff Capital Management, LLC, Richard S. Spencer, a member of our Board, KFx and others pursuant to Section 16(b) of the Securities Exchange Act of 1934 for disgorgement of alleged short-swing profits of at least $5.3 million purported to have arisen in connection with a series of transactions between us and certain investors completed in 2002. The action sought disgorgement of profits, interest, attorneys’ fees and costs. Based on settlements negotiated between KFx and the other defendants, the court granted the defendants’ motion for summary judgment on January 20, 2004 and dismissed all claims with prejudice. The plaintiff, Leon S. Segen, derivatively on behalf of KFx, filed a notice of appeal on January 29, 2004. The matter was settled before final arguments were presented to the Court of Appeals.  KFx received $185,000 from the other defendants under the court approved settlement agreements and paid fees of $28,000 to the plaintiff as its share of the settlement expense.  The net proceeds of $157,000 is included in other income.

Royalties

       In 1996, the Company entered into a royalty amendment agreement with Edward Koppelman, the inventor of the K-Fuel technology. As a result of the amendment, Mr. Koppelman’s royalty is 25% of the Company’s worldwide royalty and license fee revenue. The royalty to Mr. Koppelman will cease when the cumulative payments to him reach the sum of approximately $75.2 million. Mr. Koppelman is now deceased and his estate holds all royalty rights. Mr. Koppelman bequeathed 50% of his total royalties to Theodore Venners, Chairman and CEO of the Company. Subject to the Limited Liability Agreement of K-Fuel LLC dated January 29, 1999, as amended, the royalties due the Estate of Edward Koppelman may be subordinated until a 15% rate of return is achieved on the initial plant constructed under that agreement. The total amount paid under this agreement through September 30, 2004 was approximately $280,000.

       The Company is contingently liable to Ohio Valley Electric Corporation (“OVEC”) for an overriding royalty of 0.5% to OVEC on the gross revenues generated by the sale of fuel produced from any production plant (excluding the KFP Facility) located in the United States in which the feedstock is coal and which uses the Company’s older Series “C” K-Fuel technology to produce fuel. We do not believe the technology being utilized for the K-Fuel plant currently under construction would require any royalty payments to OVEC. The Company is also contingently liable to Fort Union for 20% of the Company’s North American royalty proceeds, to a maximum of $1.5 million. No payments or accruals have been required through September 30, 2004 under these agreements.

Consulting Agreements

       The Company has consulting agreements with political and environmental consultants to advise the Company on proposed legislation and regulations and advocate its interests before the U.S. Congress and regulatory agencies. These agreements can generally be terminated upon no more than 30 days notice. Some of these agreements provided for bonus compensation if certain legislation favorable to KFx was enacted by Congress.  Congress recently passed H.R. 4520 which was signed into law on October 22, 2004.  Based on a preliminary review by the Company’s tax counsel, the law could provide a tax credit of approximately $5.35 per ton (as escalated for inflation) for each ton of K-Fuel produced from plants placed into service before January 1, 2009 for a period of 10 years from such in-service date. Under this law, our initial K-Fuel Plant could generate approximately $4 million per year of tax credits, while a more optimum sized facility at 8 million tons per year would generate over $42 million per year of tax credits for the applicable 10-year period. There are specific qualifications that must be met for a product to qualify for the tax credit and the credit is subject to a “phase out” formula that, under certain circumstances, could reduce or eliminate the tax credit. While we believe these tax credits will provide significant value to the Company, there can be no assurances that the Company will receive these benefits.

       Because of the significant potential benefits provided to KFx, the Company may be required to provide bonus compensation to certain consultants. However, because the final provisions of H.R. 4520 are not as favorable as the goals described in the consulting agreements, the amounts due under these agreements are not certain and will need to be determined. In the unlikely event that the maximum amount of bonus compensation is due, the Company would be required to (i) make cash payments of approximately $100,000, (ii) extend four of the currently active consulting agreements for periods of 12 to 43 months at an aggregate cost of approximately $1.1 million, (iii) issue

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approximately 19,300 shares of common stock for services provided, and (iv) issue warrants for the purchase of a total of 700,000 shares at an average exercise price of $7.43 per share with a term of three years. The proceeds to the Company from the exercise of these warrants would be approximately $5.2 million and the non-cash expense, based on the Black-Scholes option-pricing model (assuming a weighted average risk free interest rate of 2.85%, expected option life of 3 years, expected volatility of 46.64% and no dividends), for issuing these warrants would be approximately $2.7 million. The Company believes the final bonus compensation costs will be significantly less than these amounts and has initiated an independent review of these consulting agreements and the new law to determine what liability it may have under these agreements.

NOTE 10. RELATED PARTY TRANSACTIONS

      The Company has a consulting agreement with Venners & Company, Ltd. for governmental affairs services, primarily for advice on proposed legislation and regulations and to advocate the Company’s interests before the U.S. Congress and regulatory agencies. Venners & Company, Ltd. is controlled by John P. Venners, the brother of Theodore Venners, our Chairman and CEO. Prior to April 1, 2004, the agreement provided for monthly consulting fees of $12,000, reimbursement of expenses related to our business and certain performance-based bonuses.  Effective April 1, 2004, the Company negotiated a revised agreement with Venners & Company, Ltd. for the provision of these services at a fixed cost of $18,000 per month. Either party can terminate the agreement upon written notice.  During the quarter and nine months ended September 30, 2004, the Company paid Venners & Company, Ltd. approximately $54,000 and $144,000, respectively, in cash for consulting fees and $0 and $10,000, respectively, for reimbursement of expenses.  During the quarter and nine months ended September 30, 2003, the Company paid Venners & Company, Ltd. approximately $43,000 and $131,000, respectively, in cash for consulting fees and $10,000 and $45,000, respectively, for reimbursement of expenses incurred related to our business. 

       Venners and Company, Ltd. is one of the consulting firms, identified in Note 9 above, that may be entitled to bonus compensation as a result of the passage of H.R. 4520 establishing certain tax credits. Because the final provisions of H.R. 4520 are not as favorable as the goals described in this consulting agreement, the amounts due under this agreement are not certain and will need to be determined. In the unlikely event that the maximum amount of bonus compensation is due, the Company would be required to (i) make cash payments of approximately $25,000, (ii) extend the currently active consulting agreement for a period of 43 months at an aggregate cost of approximately $322,000, (iii) issue approximately 4,800 shares of common stock for services provided, and (iv) issue warrants for the purchase of 150,000 shares at an average exercise price of $7.35 per share with a term of three years. The proceeds to the Company from the exercise of these warrants would be approximately $1.1 million and the non-cash expense, based on the Black-Scholes option-pricing model (assuming a weighted average risk free interest rate of 2.85%, expected option life of 3 years, expected volatility of 46.64% and no dividends), for issuing these warrants would be approximately $587,000. The Company believes the final bonus compensation costs will be significantly less than these amounts and has initiated an independent review of this consulting agreement and the new law to determine what liability it may have under this agreement.

       The Company also is obligated to pay certain royalties to Theodore Venners as discussed more fully in Note 9.

NOTE 11. SUBSEQUENT EVENTS

       H.R. 4520 was signed into law on October 22, 2004, and included a tax credit for refined coal.  Based on a preliminary review by the Company’s tax counsel, the law could provide a tax credit of approximately $5.35 per ton (as escalated for inflation) for each ton of K-Fuel produced from plants placed into service before January 1, 2009 for a period of 10 years from such in-service date. Under this law, our initial K-Fuel Plant could generate approximately $4 million per year of tax credits, while a more optimum sized facility at 8 million tons per year would generate over $42 million per year of tax credits for the applicable 10-year period. There are specific qualifications that must be met for a product to qualify for the tax credit and the credit is subject to a “phase out” formula that, under certain circumstances, could reduce or eliminate the tax credit. While we believe these tax credits will provide significant value to the Company, there can be no assurances that the Company will qualify for these benefits.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING INFORMATION MAY PROVE INACCURATE

       Some of the information presented in this Quarterly Report on Form 10-Q constitutes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements that include terms such as “may,” “will,” “intend,” “anticipate,” “estimate,” “expect,” “continue,” “believe,” “plan,” or the like, as well as all statements that are not historical facts. Forward-looking statements are inherently subject to risks and uncertainties that could cause actual results to differ materially from current expectations. Although we believe our expectations are based on reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results will not differ materially from expectations.

       For additional factors that could affect the validity of our forward-looking statements, you should read our Annual Report on Form 10-K for the year ended December 31, 2003 and the Consolidated Financial Statements contained therein. The forward-looking statements included in this quarterly report are subject to additional risks and uncertainties not disclosed in this quarterly report, some of which are not known or capable of being known by the Company. The information contained in this quarterly report is subject to change without notice. Readers should review future reports that we file with the Securities and Exchange Commission. In light of these and other risks, uncertainties and assumptions, actual events or results may be very different from those expressed or implied in the forward-looking statements in this quarterly report or may not occur. We have no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

Introduction

       The following discussion and analysis is focused on the events and trends that we believe had the most significant impact on our business during the first three quarters of 2004.  The highlights of this year to date include raising significant proceeds from the exercise of warrants and options, continued construction of the K-Fuel Plant, selection of the KFx Mine Site for location of the first K-Fuel Plant and the purchase of Landrica Development Company.

Issuances of Common Stock for Cash Consideration

       During the third quarter of 2004, for the exercise of 1.3 million warrants and 475,000 options, we received $5.4 million in cash proceeds, net of transaction costs of approximately $28,000.   Cash from equity transactions during this quarter has decreased from the second quarter of 2004, when we received proceeds of approximately $10.5 million from the exercise of approximately 3.7 million warrants and 138,000 options.  Additionally, we sold 245,400 shares of common stock to Arch Coal, Inc. for proceeds of approximately $2 million during the prior period.

Purchase of Landrica Development Company

       On May 21, 2004, we acquired all of the outstanding stock of Landrica Development Company (“LDC”) from Wyodak Resources Development Corporation (“WRD”) for cash of $523,000 and assumption of a reclamation liability of $2.7 million.  The assumption of the reclamation liability was secured with cash and is presented as restricted cash on the Consolidated Balance Sheet as of September 30, 2004.  The results of LDC have been included in the consolidated financial statements from the date of acquisition.  LDC owns a non-operating coal mine facility with assets that include land, buildings, coal handling equipment, a railroad loop and other pieces of equipment and property.  The purchase price allocation is described in Note 4 to the consolidated financial statements.

K-Fuel Plant Construction at the KFx Mine Site (Fort Union)

       Substantially all of our operations now relate to the commercial development of our patented K-Fuel technology and construction of an operational K-Fuel production plant. Once completed the K-Fuel plant will use our proprietary process to convert lower heating value (or low BTU), high moisture content coal into higher heating value (or high BTU), low moisture content coal. This improved coal provides significant value to coal-burning electric utilities because it improves efficiency in their steam generating boilers and decreases their emissions. Therefore, we believe our product will provide a competitive advantage to those utilities requiring lower costs and

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lower regulated air emissions. In addition, we believe our product may provide many utilities that have had to rely on declining sources of higher heating value coal with an important competitive alternative.

       In June 2004, we announced our decision to locate the initial K-Fuel Plant at the Fort Union site (now known as the KFx Mine Site) which was acquired as part of the purchase of Landrica Development Company.

       Construction at the KFx Mine Site is awaiting approval of the air emissions permit from the Wyoming Department of Environmental Quality. We expect to receive this permit the week of November 8, 2004 and will begin construction immediately thereafter. The fabrication of the steam boiler and major process equipment is over 80% complete with delivery scheduled over the next few months.  While our schedule could be further delayed by adverse weather, we expect to complete construction and begin operations in the Summer of 2005.

       We estimate the cost of the initial K-Fuel plant construction project will increase by $7 million to approximately $48 million. This cost estimate has been revised to reflect additional costs for the purchase versus lease of a gas-fired boiler, additional engineering and permitting costs, and increases in materials and equipment costs and related sales and use taxes. While this represents our best estimate of the project construction costs, it could likewise be adversely affected by adverse weather conditions and additional increases in the costs of materials and construction. Capitalized costs incurred through September 30, 2004 were for the following major plant components:

Other Events

                Tax Legislation

       H.R. 4520 was signed into law on October 22, 2004, and included a tax credit for refined coal.  Based on a preliminary review by the Company’s tax counsel, the law could provide a tax credit of approximately $5.35 per ton (as escalated for inflation) for each ton of K-Fuel produced from plants placed into service before January 1, 2009 for a period of 10 years from such in-service date. Under this law, our initial K-Fuel Plant could generate approximately $4 million per year of tax credits, while a more optimum sized facility at 8 million tons per year would generate over $42 million per year of tax credits for the applicable 10-year period. There are specific qualifications that must be met for a product to qualify for the tax credit and the credit is subject to a “phase out” formula that, under certain circumstances, could reduce or eliminate the tax credit. While we believe these tax credits will provide significant value to the Company, there can be no assurances that the Company will qualify for these benefits.

                Consulting Agreements

       The Company has consulting agreements with political and environmental consultants to advise the Company on proposed legislation and regulations and advocate its interests before the U.S. Congress and regulatory agencies. These agreements can generally be terminated upon no more than 30 days notice. Some of these agreements provided for bonus compensation if certain legislation favorable to KFx was enacted by Congress, such as H.R. 4520 discussed above.

       Because of the significant potential benefits of H.R. 4520 provided to KFx, the Company may be required to provide bonus compensation to certain consultants.  However, because the final provisions of H.R. 4520 are not as favorable as the goals described in the consulting agreements, the amounts due under these agreements are not certain and will need to be determined. In the unlikely event that the maximum amount of bonus compensation is due, the Company would be required to (i) make cash payments of approximately $100,000, (ii) extend four of the

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currently active consulting agreements for periods of 12 to 43 months at an aggregate cost of approximately $1.1 million, (iii) issue approximately 19,300 shares of common stock for services provided, and (iv) issue warrants for the purchase of a total of 700,000 shares at an average exercise price of $7.43 per share with a term of three years. The proceeds to the Company from the exercise of these warrants would be approximately $5.2 million and the non-cash expense, based on the Black-Scholes option-pricing model, for issuing these warrants would be approximately $2.7 million. The Company believes the final bonus compensation costs will be significantly less than these amounts and has initiated an independent review of these consulting agreements and the new law to determine what liability it may have under these agreements.

       As described in more detail in Note 10 to the consolidated financial statements, Venners & Company Ltd is one of the consultants that may be entitled to receive bonus compensation as a result of the enactment of H.R. 4520. Venners & Company, Ltd. is controlled by John P. Venners, the brother of Theodore Venners, our Chairman and CEO.

RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2004 VS. THREE MONTHS ENDED SEPTEMBER 30, 2003

                Continuing Operations

       As a result of the disposal of our Pegasus operations we have an insignificant amount of revenue to report.

       Consolidated operating costs and expenses for the three months ended September 30, 2004 decreased as compared to the three months ended September 30, 2003 by $58,000 or 2.8%. This decrease is the result of two factors: a decrease in general engineering and technical services of $218,000 offset by an increase in marketing, general and administrative costs of $149,000.

       During the third quarter of 2003 we were evaluating the technological feasibility of combining our proprietary K-Fuel technology with existing equipment and technology used by Lurgi South Africa (Pty) Limited (“Lurgi”) in their coal processing plants to develop an integrated K-Fuel plant. During this period we expensed approximately $326,000 for conceptual engineering and technical services related to the development of this technology. In the latter part of 2003 we completed our feasibility studies and began fabrication of the K-Fuel plant and evaluation of specific sites to locate the plant. As a result, the amount of conceptual engineering and technical services expensed for financial statement purposes has decreased significantly on a comparative basis between the two periods. Marketing, general and administrative costs increased in the current period as a direct result of an increase in payroll related costs and consulting costs related to the construction of the K-Fuel Plant and an increase in costs related to the Company’s Sarbanes-Oxley compliance efforts.

       We recognized non-operating income of $157,000 during the quarter ended September 30, 2004 compared to net non-operating expense of $666,000 in the quarter ended September 30, 2003. This $823,000 improvement was primarily related to an increase in net interest income of $773,000. The increase in net interest income is a direct result of the reduction of our interest bearing obligations since September 30, 2003 and a significant increase in our interest-earning cash and cash equivalents balance during the same period.  Other income during the current period was comprised of a gain of $29,000 on the acquisition of the minority interest of KLL, $16,000 of rental income at LDC and other minor items.

       As a result of the above factors, the consolidated loss from continuing operations of $1.8 million ($0.03 per share) for the third quarter of 2004 was $856,000 less than the loss from continuing operations for the third quarter of 2003.

                Discontinued Operations

       The loss from discontinued operations of $428,000 for the quarter ended September 30, 2003 is more fully described in Note 2 to the consolidated financial statements. Since the operations of Pegasus were disposed of during 2003 there is no discontinued operations presentation for the quarter ended September 30, 2004.

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NINE MONTHS ENDED SEPTEMBER 30, 2004 VS. NINE MONTHS ENDED SEPTEMBER 30, 2003

                 Continuing Operations

       As a result of the disposal of our Pegasus operations we have an insignificant amount of revenue to report.

       Consolidated operating costs and expenses for the nine months ended September 30, 2004 decreased as compared to the nine months ended September 30, 2003 by $1.6 million or 24.7%. This decrease is primarily the result of a decrease in marketing, general and administrative costs of $783,000 and a decrease in general engineering and technical services of $913,000.

       During the first three quarters of 2003 we incurred significant legal fees related to the defense of a lawsuit more fully described in Part II, Item 1 of this report.  In the first two quarters of 2004 we recognized a $521,000 negotiated reduction in previously accrued legal costs primarily related to the defense of this litigation.  Additionally, during the comparative period of 2003 we incurred approximately $633,000 more consulting fees related to the vesting of warrants granted to a consultant, more fully described in Note 8 to the consolidated financial statements.  These decreases in legal and consulting fees of approximately $1.2 million were offset by an increase of approximately $371,000 of additional payroll costs, other employee compensation and general corporate expenses focused on the construction of our K-Fuel Plant.

       For most of 2003 we were evaluating the technological feasibility of combining our proprietary K-Fuel technology with existing equipment and technology used by Lurgi South Africa (Pty) Limited (“Lurgi”) in their coal processing plants to develop an integrated K-Fuel plant. During the nine months ended September 30, 2003 we expensed approximately $1.1 million for conceptual engineering and technical services related to the development of this technology compared to $233,000 for the comparative period ended September 30, 2004. In the latter part of 2003 we completed our feasibility studies and began fabrication of the K-Fuel plant and evaluation of specific sites to locate the plant. As a result, the amount of conceptual engineering and technical services expensed for financial statement purposes has decreased significantly on a comparative basis between the two periods.

       We recognized non-operating income of $559,000 during the nine months ended September 30, 2004 compared to net non-operating expense of $843,000 in the comparative period of 2003. This $1.4 million improvement was primarily related to an increase in net interest income in the comparable period of $1.2 million and $218,000 of other income primarily from the sale of scrap metal and the settlement of outstanding litigation.  The increase in net interest income is a direct result of the reduction of our interest bearing obligations since September 30, 2003 and a significant improvement in our interest-earning cash balance.  Additionally, during the second quarter of 2004 we received approximately $31,000 from the sale of scrap metal that we had previously impaired and received $157,000 from the settlement of the litigation more fully described in Part II, Item 1, below.

       As a result of the above factors, the consolidated loss from continuing operations of $4.3 million ($0.08 per share) for the first three quarters of 2004 was $2.9 million less than the loss from continuing operations for the first three quarters of 2003.

                Discontinued Operations

       The loss from discontinued operations of $1.2 million for the nine months ended September 30, 2003 is more fully described in Note 2 to the consolidated financial statements. Since the operations of Pegasus were disposed of during 2003 there is no discontinued operations presentation for the nine months ended September 30, 2004.

LIQUIDITY AND CAPITAL RESOURCES

       At September 30, 2004, our working capital was $31.3 million compared to working capital of $21.2 million at December 31, 2003. The increase in working capital of 47.6%, or $10.1 million during the nine months ended September 30, 2004 reflects a continued improvement in our balance sheet compared to 2003.  The improvement was primarily due to the $23.2 million of proceeds received from the exercise of options and warrants and sale of common stock.   Inflows from cash proceeds were offset by:

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	•	A reduction of cash and cash equivalents of $2.7 million that was restricted as pledged assets for the reclamation liability,
	•	Expenditures of $6.4 million on purchases for the K-Fuel plant construction,
	•	Significant net payments on accounts payable and reduction of accrued expenses of approximately $1.8 million,
	•	The purchase of Landrica Development Company for $523,000, and
	•	A $690,000 reduction of the current portion of the note receivable from Pegasus Technologies Inc.

                Cash Used in Operating Activities

       Cash used in operating activities of $4.6 million for the period ended September 30, 2004 primarily consisted of our net loss ($4.3 million) adjusted for $1.4 million of non-cash charges (including depreciation, amortization, asset impairment and common stock and warrants issued for services among other minor amounts) offset by approximately $1.7 million of changes in working capital and other activities.  Working capital changes were primarily the result of a decrease in accounts payable and accrued expenses.  Payments on these current liabilities increased during the current period due to a significant improvement in cash available to the Company.  For the same period in 2003 compared to 2004 the improvement in cash used in operating activities was primarily the result of a lower net loss and non-cash adjustments offset by only $230,000 of changes in working capital and other activities.

                Cash Used in Investing Activities

       Cash used in investing activities during the nine months ended September 30, 2004 increased by $6.4 million.  This increase is a result of:

	•	$3.8 million more in capital expenditures related to the K-Fuel plant (See discussion of progress on the K-Fuel Plant above) compared to the prior period,
	•	An increase in restricted cash of $2.7 million related to the reclamation liability incurred on the Landrica Development Company (“LDC”) acquisition,
	•	$177,000 more paid on the acquisition of businesses during the current period related to the purchase of LDC (See Note 4 to the consolidated financial statements), offset by
	•	Collections on the note receivable due from Pegasus (See Note 4 to the consolidated financial statements) of $237,000.

                Cash Provided by Financing Activities

       Cash provided by financing activities during the nine months ended September 30, 2004 was $23.2 million compared to approximately $22.3 million for the nine months ended September 30, 2003. As previously discussed we raised approximately $23.2 million of proceeds from the exercise of options and warrants and sale of common shares during the first three quarters of 2004. In the comparative period of 2003 the Company issued 7.7 million shares of KFx common stock in private placements at a price of $2.50 per share, which resulted in cash proceeds to the Company of approximately $19 million.   Additionally, during the third quarter of 2003 we raised $3.1 million of proceeds from the exercise of outstanding options and warrants.

                Future Sources and Uses of Cash

       We do not expect to derive cash from operations in 2004. We will seek to meet our cash requirements over the next year with respect to day-to-day operations and the construction of the K-Fuel plant through (i) cash on hand; (ii) proceeds from the exercise of outstanding options and warrants; (iii) potential partners in connection with the initial K-Fuel Plant or future plants; (iv) potential debt and/or equity offerings; and (v) potential fees from licensing

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new K-Fuel facilities. Such transactions may be on better or worse terms than previously negotiated on similar transactions.

       Upon commencement of successful operations of the initial K-Fuel Plant, we expect to generate revenue from the sale of K-Fuel product and positive net cash flows from operations.  We have also begun negotiations and preliminary engineering to support the development of future K-Fuel facilities at several different locations under consideration. As these projects develop, we will require additional funding which we expect to obtain from one or more of the sources described above.

                Commitments

       The following table summarizes our future commitments, excluding repayments of debt, as of September 30, 2004:

Operating Leases

        The Company is obligated for non-cancelable operating leases with initial terms exceeding one year relating to office space and certain equipment and vehicle leases.

Purchase Commitment Obligations

        The Company has purchase commitments for K-Fuel plant-related equipment and services of approximately $6.0 million as of September 30, 2004.  Additionally, the Company has previously negotiated purchase commitments of approximately $375,000 for corporate and engineering consulting services over the next two years.

        Additionally, the Company may be committed to additional consulting agreements as more fully described in “Consulting Agreements” above.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

       Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires KFx to make estimates and judgments that affect both the results of operations as well as the carrying values of our assets and liabilities. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. We base estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities as of the date of the financial statements that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies are described in Note 1 to our consolidated financial statements. Set forth below is a summary of our most critical accounting policies.

       Our policy regarding accounting for discontinued operations is significant because of the revised financial statements resulting from the disposal of the Pegasus operations. For purposes of the discontinued operations presentation in the Consolidated Statement of Operations for the nine months ended September 30, 2003, the loss from operating Pegasus has been aggregated for reporting purposes into a single line called “Loss from discontinued

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operations.” We have made the determination to account for the disposal of these operations as discontinued in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” because (a) it has been determined that the operations and cash flows of Pegasus were eliminated from our on-going operations and (b) we will not have any significant continuing involvement in the operations of Pegasus after the disposal transaction.

       Our policy regarding accounting for our plant under construction and for potential future plants is significant because of the capital expenditures we expect to incur. All costs that are directly related to the engineering, design, purchase or fabrication of plant equipment which are expected to be used in a commercial plant project are capitalized in “Plant construction in progress”. All costs that are directly related and/or allocable to developing a specific plant site for a commercial plant project are capitalized and separately identified as belonging to that site. If it is determined the site will not generate future cash flows or is expected to generate less cash flow than originally expected, the capitalized costs are evaluated for impairment. Any cost that is not directly related to specific equipment or development of a specific site is expensed. We begin recognizing depreciation on fixed assets once the assets are put into use. As such, no depreciation has been recognized on our plant assets to date. Expenditures that extend the useful lives of plant assets are capitalized. Repairs and maintenance that do not extend the useful lives of these assets are expensed as incurred.

       The valuation of our long-lived and intangible assets, including patents, is significant related to our results of operations and financial condition. We must assess the realizable value of these assets for potential impairment at least annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. In assessing the recoverability of these assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. In addition, we must make assumptions regarding the useful lives of these assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

NEW ACCOUNTING PRONOUNCEMENTS

       There were no new FASB pronouncements during the first three quarters of 2004 that we expect to have a material impact on our financial position or results of operations.

UNCERTAINTIES AND RISKS

                   Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on the market’s perception of our business and our ability to raise capital.

       We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our Independent Auditors addressing these assessments.  During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404.  In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act.  While we continue to dedicate significant resources and management time to ensuring that we have effective controls over financial reporting, failure to achieve and maintain an effective internal control environment could have a material adverse effect on the market’s perception of our business and our ability to raise capital.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

       We are not currently subject to a significant level of direct market risk related to interest rates, foreign currency exchange rates, commodity prices or equity prices. We own (or hold) no derivative instruments or floating rate debt and do not expect to derive a material amount of our revenues from interest bearing securities. Currently, we have insignificant foreign operations. To the extent that we establish significant foreign operations in the future, we will attempt to mitigate risks associated with foreign currency exchange rates contractually and through the use of

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hedging activities and other means considered appropriate. We are exposed to fluctuations in fuel commodity prices. To the extent that competitive fuel prices rise or fall, there may be greater or lesser demand for our K-Fuel production services. However, K-Fuel provides various environmental benefits that management believes could significantly mitigate the fuel commodity risk associated with our business. KFx holds no equity market securities, but does face equity market risk relative to its own equity securities.

ITEM 4. CONTROLS AND PROCEDURES

                (a)     Evaluation of disclosure controls and procedures

       Our Chief Executive Officer and the Chief Financial Officer evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2004 in accordance with Rule 13a-15 under the Exchange Act. As described below, the evaluation included certain internal control areas in which the Company is continuing to make changes to improve and enhance controls.  Based on their evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that KFx’s disclosure controls and procedures enable us to:

	•	record, process, summarize and report within the time periods specified in the Security and Exchange Commission’s rules and forms, information required to be disclosed by KFx in the reports that it files or submits under the Exchange Act; and
	•	accumulate and communicate to management, as appropriate to allow timely decisions regarding required disclosure, information required to be disclosed by KFx in the reports that it files or submits under the Exchange Act.

                (b)     Changes in internal control over financing reporting

        There were no changes in KFx’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2004 that have materially affected, or are reasonable likely to materially affect, KFx’s internal control over financial reporting.  However, during the preparation of the Company’s consolidated financial statements for the quarter ended September 30, 2004, the Company identified an error in the accounting for compensation expense related to transactions involving the exercise of non-qualified stock options by employees.  If this error had not been identified prior to the filing of its quarterly report, the net loss of the Company for the three and nine months ended September 30, 2004 would have been overstated.  After a review of transactions in prior reporting periods, the Company concluded this deficiency had not affected the accounting of previous transactions of this nature.  In order to correct this deficiency the Company developed a plan to procure additional resources to assist in the evaluation of certain accounting principles and their application to transactions performed by the Company.  Management believes this plan, when properly executed, will decrease the likelihood of improper accounting for these and other transactions, if any, in the future.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

       Leon S. Segen, derivatively on behalf of KFx v. Westcliff Capital Management, LLC, Richard S. Spencer III, KFx Inc. and others, United States District Court Southern District of New York, filed March 7, 2003. A stockholder suing derivatively on our behalf filed a civil complaint against Westcliff Capital Management, LLC, Richard S. Spencer, a member of our Board, KFx and others pursuant to Section 16(b) of the Securities Exchange Act of 1934 for disgorgement of alleged short-swing profits of at least $5.3 million purported to have arisen in connection with a series of transactions between us and certain investors completed in 2002. The action sought disgorgement of profits, interest, attorneys’ fees and costs. Based on settlements negotiated between KFx and the other defendents, the court granted the defendants’ motion for summary judgment on January 20, 2004 and dismissed all claims with prejudice. The plaintiff, Leon S. Segen, derivately on behalf of KFx, filed a notice of appeal on January 29, 2004.  During the quarter ended June 30, 2004, the matter was settled before final arguments were presented to the Court of Appeals.  KFx received $185,000 from the other defendants under the court approved settlement agreements and paid fees of $28,000 to the plaintiff as its share of the settlement expense.

       In addition, as with most business, there could be potential lawsuits incidental to our business, none of which are anticipated to have a material adverse impact on our financial position, results of operations, liquidity or cash flows.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

        During the quarter ended September 30, 2004, KFx issued the following securities in private transactions pursuant to an exemption from the registration requirements provided by Section 4(2) of the Securities Act of 1933, as amended:

(1)

On July 22, 2004, the Company received $3.4 million of proceeds from the exercise of 1.25 million warrants held by an existing warrant holder.  In return for exercising his warrants before the contractual exercise date, the Company granted him an additional 415,300 warrants at an exercise price of $11.00.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

       Not Applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS

       Not Applicable.

ITEM 5. OTHER INFORMATION

       Not Applicable.

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ITEM 6. EXHIBITS

*        Filed herewith.

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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.

	KFX INC.
Date: November 9, 2004	By:	/s/    THEODORE VENNERS
		THEODORE VENNERS CHAIRMAN AND CHIEF EXECUTIVE OFFICER
Date: November 9, 2004	By:	/s/    MATTHEW V. ELLEDGE
		MATTHEW V. ELLEDGE VICE PRESIDENT & CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER)

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