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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2003

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

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

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

Indicate by check mark whether 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 (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

Yes x No ¨

The aggregate market value of the voting and non-voting common equity held by non-affiliates of KFx Inc. as of June 30, 2003, the last business day of KFx Inc.’s most recently completed second fiscal quarter was $145,962,000 computed by reference to the price at which KFx Inc.’s common stock was last traded on that date, as reported on the American Stock Exchange.

At March 8, 2004, 54,428,153 shares of common stock of the Registrant were outstanding.

Documents Incorporated by Reference:

Portions of the definitive Proxy Statement for the 2004 Annual Meeting of Stockholders are incorporated by reference in Part III of this Report on Form 10-K.

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TABLE OF CONTENTS

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PART I

CAUTIONS ABOUT FORWARD LOOKING STATEMENTS

This Annual Report on Form 10-K includes forward-looking statements about events, products or financial performance that may not exist, or may not have occurred. For example, statements like we “expect,” we “believe,” we “plan,” we “intend” or we “anticipate” are forward-looking statements. Investors should be aware that our actual operating results and financial performance may differ materially from our expressed expectations because of risks and uncertainties about the future including risks related to economic and competitive conditions. In addition, we will not necessarily update the information in this Annual Report on Form 10-K if any forward-looking statement later turns out to be inaccurate. Details about risks affecting various aspects of our business are included throughout this Form 10-K. Investors should read all of these risks carefully, and should pay particular attention to risks affecting the following areas: competition issues discussed on page 11; government regulation discussed on pages 11 to 12; intellectual property and proprietary rights discussed on pages 8 to 11; specific risk factors discussed on pages 12 to 16; and commitments and contingent liabilities described in Note 13 to the financial statements included in this Form 10-K.

AVAILABLE INFORMATION

Our common stock is traded on the American Stock Exchange under the symbol “KFX.” Our principal executive office is located at 55 Madison Street, Suite 745, Denver, Colorado 80206 and our telephone number is (303) 293-2992.

Our web site address is www.kfx.com. Through this web site, we make available, free of charge, on the Investor Info section of our web site our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports, as soon as reasonably practicable after these reports are electronically filed with or furnished to the Securities and Exchange Commission (the “SEC”). We also make available through our web site other reports filed with the SEC under the Exchange Act, including our proxy statements and reports filed by officers and directors under Section 16(a) of that Act. We do not intend for information contained in our web site to be part of this Annual Report on Form 10-K.

FREQUENTLY USED TERMS

In this Annual Report on Form 10-K, we use the terms “KFx,” “the Company,” “our,” and “us” to refer to KFx and its subsidiaries. All references to K-Fuel, K-Fuel^™ and K-Fuel Plus^™ refer to our patented process and technology explained in detail throughout this Annual Report on Form 10-K. All references to years, unless otherwise noted, refer to our fiscal year, which ends on December 31.

OVERVIEW

We are a “clean energy” technology company with a patented process, which we refer to as K-Fuel^™ technology, that uses heat and pressure to physically and chemically transform low grade (or low BTU), high moisture content coal into high grade (or high BTU), low moisture content solid clean fuel. Our technology adds value to coal producers and the electric power generation industry by significantly improving the quality of low-grade 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. We maintain this facility to provide complex technological data and other similar information to our potential customers and governmental agencies in assessing the benefits of the K-Fuel^™ process.

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In the future, we plan to own and operate K-Fuel^™ production facilities both domestically and internationally, as well as to license the K-Fuel^™ technology to third parties. In January 2003, we announced a preliminary agreement with Arch Mineral Corporation (“Arch”) to develop a 750,000 ton-per-year K-Fuel^™ plant at Arch’s Black Thunder mine. In about June 2003, Arch and KFx began evaluating alternative sites because of the difficulty of integrating our initial smaller sized plant into Black Thunder’s 70 million ton per year mining operations and the likelihood of more favorable locations available to Arch and/or KFx. In July 2003 we began the design, engineering, and equipment fabrication for a 750,000 ton-per-year K-Fuel^™ plant to be constructed in the Powder River Basin of Wyoming. Since then we have filed and continue to file for the long lead-time permits for the most likely sites under consideration for the first plant. We expect to complete our evaluation of the alternative sites and to announce our selection for the initial K-Fuel^™ plant after the end of the first quarter of 2004.

Recent Developments

Equity Exchange of Pegasus Technologies and K-Fuel LLC

On November 26, 2003 we completed an equity exchange transaction with Kennecott Energy Company (“Kennecott”). In accordance with terms contained in the Equity Exchange Agreement, Kennecott transferred to KFx its 49% membership interest in K-Fuel LLC 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 K-Fuel LLC. K-Fuel LLC was a joint venture between KFx and Kennecott which was intended to be the vehicle for further technical advancement and the commercialization of business opportunities arising out of the K-Fuel^™ technology, including research and development, sublicensing, marketing and consulting, but not including the construction of facilities to produce K-Fuel^™ products on a commercial basis. In exchange, KFx transferred its ownership interests in Pegasus Technologies, Inc. (“Pegasus”) to Kennecott. KFx had previously held approximately 65% ownership in Pegasus. Pegasus’ primary business is to provide software solutions for electric utilities, which improved coal-fired boiler efficiency and air emissions. KFx retained no ownership interest in Pegasus.

Under the terms 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, Kennecott repaid KFx approximately $1 million, plus accrued interest, that KFx had loaned to Pegasus during the first nine months of 2003, under a working capital line of credit. Kennecott also paid to the Chairman and CEO of KFx $184,595 to retire indebtedness owed by Pegasus and $301,138 to a director of KFx and his company to retire indebtedness owed by Pegasus.

In connection with the Equity Exchange 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 a note receivable from Pegasus and the remaining 50% was added to the contingent obligations due from Pegasus. The Company recognized an additional $250,000 in the note receivable from Pegasus as a result (See Note 3 to the consolidated financial statements). Kennecott also received a license and all necessary rights to build and operate up to three commercial K-Fuel^™ plants (1 domestic and 2 outside the Western Hemisphere except in India) 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.

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Summary Financial Information

In previous periods we reported financial information about our Pegasus and K-Fuel^™ as segments. We are now reporting the discontinued operations of Pegasus separately in the financial statements in Note 2. Summary information for our consolidated operations for 2003, 2002 and 2001 follow:

During each of the three years ending December 31, substantially all of our operating activities were conducted domestically.

Industry Overview

Domestic Market

As reported by the U.S. Department of Energy (“DOE”), the total domestic market for coal fuel is approximately 1.1 billion tons per year, of which electric utility companies use the majority of the tonnage (approximately 91%). Coal-fired electricity generation currently accounts for approximately 51% of the nation’s total electricity supply. At the 1.1 billion tons per year consumption rate, DOE estimates that there are over 250 years of proven recoverable coal reserves in the US. Our K-Fuel^™ technology is marketed to coal producers and the electric power generation industry to beneficiate lower grade coal production and facilitate compliance with air emission standards. For a number of years various regulations and other requirements have placed increasingly stringent standards on the air emissions generated by the electric power generation industry and others. In addition, there will be increasing pressure from regulatory agencies and competitive market forces to meet such air emission standards in more cost effective ways and to improve the overall efficiency of electric power generation. A discussion of the regulations and standards affecting air emissions which could create potential market opportunities for KFx is provided below:

Air Emission Standards. The Clean Air Act of 1970, as amended in 1990 (the “Clean Air Act”), has been the primary historical stimulus for the developing United States market for beneficiated clean coal fuel products, such as K-Fuel^™. A number of regulations issued under the Clean Air Act have the potential for driving the demand for our products. Among other things, the Clean Air Act requires reductions in acid rain precursor emissions (sulfur dioxide (“SO₂”) and nitrogen oxide (“NOx”)) from existing sources, particularly large, older power plants that were exempted from certain requirements of the Clean Air Act. Specifically, beginning January 1, 2000, NOx emissions from utilities are to be reduced by an additional 15% or 900,000 tons per year beyond the 1.2 million tons per year required by EPA in its 1995 rule. According to EPA, electric utilities are a major contributor to NOx emissions nationwide and approximately 90% of electric utility NOx is from coal-fired plants. EPA’s 2000 rule targets dry bottom wall-fired burners, wet bottom boilers, cyclones, cell burner boilers, and vertically fired boilers. The SO₂ requirements were structured in two phases, with Phase I beginning in 1995 and Phase II, which began in 2000. As in the case of NOx emissions, the SO₂ rules have tightened the annual limits on the large plants, and set restrictions on smaller, cleaner plants and all new plants. In addition, the SO₂ rules provide for stringent caps on emissions, but permit trading SO₂ emissions.

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Acid Rain Program. Title IV of the Clean Air Act established an innovative emissions trading program (the “Acid Rain Program”) to achieve reductions of SO₂ from fossil-fuel fired electric utility boilers. Under this program, existing electric generating units subject to the program are allocated “allowances”; each allowance equals a right to emit one ton of SO₂. New units generally must acquire allowances from the market. Each year, facilities are required to hold allowances equal to their SO₂ emissions. The program now encompasses over 2,500 fossil-fuel fired electric generating units at 1,000 plants. Although the ultimate impact of the implementation of the Acid Rain Program on the demand for K-Fuel^™ technology is not clearly determinable, management believes the program will create demand for KFx’s technology.

Our United States marketing emphasis is directed primarily at electric utilities under EPA scrutiny located in the industrial Midwest and Eastern states. In these states there are approximately 300 utility-operated coal-fired boiler units with each having a power generation capacity of 200 MW or greater. The combustion characteristics of cyclone furnace boilers, a common boiler type used by Midwestern utilities, are particularly well suited to the K-Fuel^™ product manufactured from Powder River Basin (“PRB”) coal.

In addition to marketing our product to the electric utility industry, we believe K-Fuel^™ could be marketed to manufacturers and other large-scale industrial coal users that are either subject to the NOx and SO₂ provisions of the Clean Air Act or that desire to improve their fuel combustion performance. Fuel combustion performance is becoming more important because of the need to cut costs and become more efficient in an increasingly competitive market environment.

NOx SIP Call. In 1998, the United States Environmental Protection Agency (“EPA”) issued a final rule, as amended in 2000, requiring certain states and the District of Columbia to revise their state implementation plans in order to achieve a significant reduction in emissions of “NOx” (the “SIP Call”). NOx is a primary component in ground-level smog and is also a contributor to acid rain. State plans developed to date have relied on achieving significant reductions from coal-fired electric utility power plants and the use of emissions trading. Although the SIP Call has survived a number of legal challenges, its complete implementation remains uncertain. Regardless, because full implementation is highly likely, compliance with the SIP Call requirements is expected to require a significant investment in emission control technologies.

Based on the results of a February 1999 commercial burn, fuel made using K-Fuel^™ technology can reduce NOx emissions (when using PRB coal as the feedstock) as compared to typical eastern coals by levels approximating 25%. We believe we are in a unique position to assist the electric power

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generation industry in achieving required reductions in NOx more cost effectively than various other solutions, some of which are highly capital intensive and also can add significant operating costs.

Revised National Ambient Air Quality Standards. In 1997, the EPA adopted a new national ambient air quality standard (“NAAQS”) to address emissions of fine particulate matter and also tightened the NAAQS for ozone. Although the revised fine particulate matter and ozone NAAQS were ultimately upheld, legal challenges to the standards have delayed their implementation. Once these regulations are effective, states will be required to revise their implementation plans to achieve attainment with the revised standards, which plans are likely to require additional emission reductions from facilities that are significant emitters of ozone precursors (such as NOx) and fine particulates (including NOx and SO2).

Greenhouse Gases. Carbon dioxide (“CO2”) is widely considered to be a primary component of greenhouse gases that have given rise to worldwide concerns of global warming. Global warming continues to be a concern and remains a policy issue that is regularly considered for possible government regulation. A very important by-product of the efficiency gains at electric power generation boiler units achievable through the use of K-Fuel^™ is a corresponding reduction in the level of CO₂. While we are not able to predict the likelihood of potential regulation of greenhouse gases, the impact of continued initiatives in this area should be positive on the demand for K-Fuel^™.

Hazardous Air Pollutants. On December 20, 2000, the EPA determined that it would regulate emissions of hazardous air pollutant emissions from coal and oil-fired electric utility steam generating units by designating these units as a source category under Section 112 of the Clean Air Act. The EPA has proposed regulations regarding mercury and to the extent necessary, other hazardous air pollutant emissions from electric utility steam generating units. Final regulations are proposed to be effective by December 15, 2004. According to a March 2003 report by Black & Veatch, an engineering and consulting firm, K-Fuel^™ provides an effective pre-combustion mercury reduction technology. According to this independent research, a significant level of mercury is removed from run-of-mine coal during the K-Fuel^™ production process. Based on these test results, if the EPA adopts regulations to restrict the level of mercury emissions, K-Fuel^™ may offer significant competitive advantages over other high-energy value coals.

Clear Skies Act. The Clear Skies Act was introduced in both Houses of Congress in February 2003. In the United States, power generation is responsible for 63% of SO_2, 22% of NOx and 37% of mercury released to the environment by human activity. To more effectively address the problems caused by power generation, EPA asserts a need for a national program and Clear Skies is such a national program. If approved, the Clear Skies Act would impose new strict mandatory emissions caps on SO₂ , NOx and mercury. Significant provisions of the proposed Clear Skies Act include:

The impact that current and more stringent laws and regulations, such as the NOx SIP Call, more stringent particulate matter and ozone national ambient air quality standards, regulation of mercury emissions and further limitations on NOx and SO₂ emissions that are contemplated in potential amendments to the Clean Air Act may have on the demand for K-Fuel^™ is not clearly determinable. Although we believe that such regulations will create demand for this technology, it is also possible that

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such regulations may cause power generators or other industrial users of coal to switch to other fuels, thus reducing the potential size of our market and our domestic growth opportunities.

International Market

The international coal-fired power generation industry is approximately four times the size of the United States coal-fired power generation industry. Our objective, with respect to international opportunities for K-Fuel^™, is to concentrate on markets where there is either a significant need for more energy efficient and environmentally responsible fuel products, or where abundant lower grade coal reserves can be utilized in conjunction with the K-Fuel^™ technology to develop a value-added export product. The principal benefit of the K-Fuel^™ technology in foreign markets is that low-rank indigenous coal reserves can be upgraded to provide a more cost effective and less environmentally damaging fuel source for power producers, manufacturers and households, either for internal markets or for export.

The KFP Facility

In August 1995, we and Thermo Ecotek Corporation, acting through respective wholly-owned subsidiaries, formed KFx Fuel Partners, L.P., a Delaware limited partnership and began the construction of a 500,000 ton per year K-Fuel^™ production facility (the “KFP Facility”) near Gillette, Wyoming, using our Series “C” Technology. We owned a 5% interest in KFx Fuel Partners, with the remaining 95% owned by Thermo Ecotek. The KFP Facility operated and produced commercially salable K-Fuel^™ in 1998 and 1999. The KFP Facility experienced certain problems relating to tar and fines residue build-up within the system during production and product quality issues related to product dusting. On May 24, 1999, Thermo Ecotek announced that in connection with certain strategic restructuring decisions it had decided to sell its interest in the KFP Facility. In June 1999, Thermo Ecotek suspended all K-Fuel^™ production at the KFP Facility. We have sold our interest in the KFP facility to Thermo Ecotek Corporation and accordingly, we have no ownership interest in the KFP Facility and have no further obligation to fund any capital or other costs. In September 2002 the major equipment at the KFP Facility was purchased by a third party and removed from the site.

K-Fuel LLC

In April 1996, we entered into a joint venture agreement (the “K-Fuel LLC Agreement”) with a wholly-owned subsidiary of Kennecott. The joint venture, a Delaware limited liability company named K-Fuel LLC, was intended to be the vehicle for further technical advancement and the commercialization of business opportunities arising out of the K-Fuel technology, including research and development, sublicensing, marketing and consulting, but not including the construction of facilities to produce K-Fuel^™ products on a commercial basis (“Commercial Projects”). Worldwide exclusive licenses for all of the K-Fuel^™ technology were granted to K-Fuel LLC. Commercial Projects will be constructed by KFx or separate entities, which will be granted a sublicense from K-Fuel LLC for the K-Fuel^™ technology. Under the Equity Exchange of Pegasus and K-Fuel LLC, KFx now owns 100 percent of K-Fuel LLC and the related technologies.

Research and Development

Over the years KFx has obtained patents for several versions of the K-Fuel^™ technology using a variety of methods to apply heat and pressure to beneficiate high moisture coal feedstocks. We have three series of primary patents related to the K-Fuel^™ technology. The initial series, Series “A” and Series “B” Technology patents, were based on hot gas and steam heat-transfer media, respectively, in direct contact with the feedstock for heat transfer and beneficiation. The second series, the Series “C” Technology patents are based on a nitrogen gas atmosphere combined with an indirect hot-oil heat transfer system medium and use a simplified design with respect to the manufacturing equipment and facilities, resulting in lower capital costs. Our joint venture with Kennecott and K-Fuel LLC developed further improvements

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to coal beneficiation technology, including continuous operations and lower processing temperature and pressure during the process. We refer to the improvements made in the Series “C” Technology as K-Fuel Plus^™, our third series of primary patents, which is expected to be used in future K-Fuel^™ manufacturing facilities. Further research may result in viable improvements to one or more of the three patent series. We are currently focusing our commercialization efforts on the development of projects for the manufacture of coal fuel product using the Series “C” and K-Fuel^™ Plus technology. Although the Series “A” and “B” Technology patents are approaching expiration, because these patents covered earlier versions of the technology, we do not believe that expiration of the patents will have a material adverse effect on us or the value of the Series “C” Technology due to the superior performance observed by employing the Series “C” Technology and the K-Fuel LLC improvements.

We have patents or patent applications for the K-Fuel^™ technology registered in the United States and in over 40 foreign countries. These include applications for patents developed by us and seven patents and patent applications developed by K-Fuel LLC. We have assigned the seven United States counterparts to K-Fuel LLC. All licensing rights to the K-Fuel^™ technology are property of K-Fuel LLC.

In late 2000, we demonstrated the K-Fuel^™ process and K-Fuel Plus^™ technology using PRB coal, which typically has the lowest mercury content of any naturally available coal. Analysis of the K-Fuel Plus^™ product produced during the demonstration indicated that the K-Fuel Plus^™ process produced lower amounts of SO₂, NO_X, mercury and chlorine than was produced by untreated PRB coal. Analysis of this demonstration also indicates that an improved process could be designed to produce improved K-Fuel^™ within potentially attractive economic constraints, with improved reliability and have lower capital and operating costs than any previous K-Fuel^™ plant design. The BTU value of the K-Fuel Plus^™ product tested was approximately 11,200 to 11,600 BTU’s per pound. Upon combustion, the K-Fuel Plus^™ product produced approximately 20% lower NO_X emissions and lower mercury emissions, as compared to untreated PRB coal and SO₂ emissions, well below the 1.0 lb per million BTU limit contained in Phase II of the Clean Air Act.

We are pursuing the possible advantages of blending the K-Fuel Plus^™ product and untreated PRB coal. The dust and self-heating behaviors of this blend of K-Fuel Plus^™ and untreated PRB coal appear to be similar to untreated PRB coal, without the need for oil or other treatment, as was the case in the Series C product. The NO_X, SO₂ and mercury reduction benefits of this blend can be adjusted by moderating the amount of K-Fuel Plus^™ product added to the blend. Therefore, a commercial plant for the new product may be leveraged to provide considerably higher volumes of blended product for the market place.

During the years ended December 31, 2003, 2001 and 2000, our K-Fuel^™ Demonstration Plant research and development costs were approximately $321,000, $230,000 and $221,000, respectively. In addition, relating to the initial development of our K-Fuel^™ Production Plant and related processes, we incurred approximately $1,295,000 of general engineering and design costs during 2003.

Licenses and Royalty Agreements

We have granted certain rights and limited licenses for the use of different versions of the K-Fuel^™ technology to the following parties: (i) the party that purchased the KFP Facility (Series “C” Technology), (ii) K-Fuel LLC (Series “C” Technology and subsequent improvements), (iii) Kennecott (Series “C” Technology and subsequent improvements), (iv) Heartland Fuels Corporation (Series “A” and “B” Technologies), and (v) certain investors (the “Investors”) who entered into five separate transactions for common stock and warrants during the period March 28, 2002 through August 21, 2002 (Series “C” Technology and subsequent improvements).

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A predecessor entity of KFx acquired the Series “A” and “B” Technologies from Mr. Koppelman, the inventor of the K-Fuel^™ technology, and other investors (the “Koppelman Group”) in 1984 for $10 million in cash and a royalty agreement. In June 1996, we entered into a royalty amendment agreement with Mr. Edward Koppelman. As a result of the amended agreement, Mr. Koppelman’s estate is now entitled to a royalty of 25% of our worldwide royalty and license fee revenue. The royalty to Mr. Koppelman’s estate will cease when the cumulative payments to him reach the sum of approximately $75,222,000. As consideration for the royalty amendment agreement, in June 1996, we paid Mr. Koppelman $300,000 cash and issued a promissory note for $200,000; see Note 7 to the consolidated financial statements. The resulting $500,000 prepaid royalty is amortized as licenses to K-Fuel^™ technology are sold. Also as part of the royalty agreement, Mr. Koppelman indemnified us for any claims made by the Koppelman Group. During 2001, we reacquired the 12% patent interest held by the State of Wyoming for a cash payment approximating $1,162,000.

The third parties set forth in the table below are entitled to share in the royalty and licensing revenues received by KFX. These licensing and royalty revenues are a small percentage of the gross revenues received from the sale of K-Fuel production. The following table illustrates our royalty obligations with respect to these parties expressed as a percentage of the gross revenues from the sale of K-Fuel production (the percentages shown below assume a 3 percent royalty payment to KFx for K-Fuel production sales which is the typical percentage used in recent negotiations and agreements):

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Material Relationships

Effective January 2, 2003, we signed an exclusive business development and intellectual property rights agreement with Lurgi South Africa (Pty) Limited (“Lurgi”) to combine the K-Fuel^™ technology with Lurgi’s technical services and equipment to beneficiate low-grade coal into clean, high-BTU K-Fuel Plus^™. We expect this relationship to accelerate the commercialization of K-Fuel^™ and significantly improve the economics of future plants. Existing Lurgi gasification equipment will be modified using our proprietary technology to produce K-Fuel^™. We believe that Lurgi’s 50 plus years of experience in designing and building coal processing plants, including more than 450 process plants and equipment installations since the first unit was constructed in 1927, add significant expertise to the commercial implementation of the K-Fuel^™ process. Lurgi is providing, under a related professional services agreement, the engineering, design, and project management services for the process portion of the K-Fuel^™ plant currently being fabricated.

Competition

We believe that there are no competitors producing significant commercial quantities of beneficiated clean coal fuel products either in the United States or international markets. However, there are other clean coal technology (“CCT”) companies, primarily in the United States, that are developing fuel combustion and product technologies that would reduce emission pollutants and/or increase the heat value of coal feedstock fuel sources. Many of these CCT competitors have greater financial, technical and operational resources than us. We believe none of these other efforts have yet resulted in an economically viable and commercially acceptable beneficiated coal product with the economic and commercial potential of K-Fuel^™. Potential customers may choose to install pollution control equipment to reduce or remove the emissions from the coal supplies they are currently burning. This could include flue gas desulfurization and cleanup equipment (scrubbers), selective catalytic reduction, fabric filters and/or baghouses, electrostatic precipitators, and electro catalytic oxidation. K-Fuel^™ also competes with naturally occurring high-Btu coal and with other fuels for electrical generation, including oil, natural gas, nuclear power and wind. Most of the producers of these fuels are much larger than we are in terms of capital, revenue and access to financial markets. While current trends in prices for these competing energy sources improve the viability of our K-Fuel^™ product, there can be no assurance these trends will continue.

Government And Environmental Regulation

The activities involved in generating electricity from coal include mining, transport to power plants and burning of the coal in power plants. Initially, coal is extracted from surface or underground mines and, then is often cleaned or washed at the coal mine to remove impurities before it is transported to the power plant. Finally, at the power plant, coal is burned in boilers to produce steam and the steam is funneled through a turbine to generate electricity. The K-Fuel^™ technology may not be involved in all

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aspects of generating electricity from coal since the “beneficiating process” transforms already mined coal to low moisture content coal, thereby, reducing certain harmful emissions.

In the United States, the K-Fuel^™ product is not expected to be subject to unusual levels of local, state or federal regulation with respect to its transportation and distribution. However, any future United States production plants will require numerous permits, approvals and certificates from appropriate federal, state and local governmental agencies before construction of each facility can begin, and will be required to comply with applicable environmental laws and regulations (including obtaining operating permits) once facilities begin production. The types of permits that are typically required for commercial production facilities include an operating and construction permit under the Clean Air Act, a wastewater discharge permit under the Clean Water Act, and a treatment, storage and disposal permit under the Resource Conservation Act. Some of the federal programs have been delegated to the states and, as a result, facilities may be required to secure state permits. Finally, the construction of new facilities will likely trigger federal or state action and; therefore, will require review under the National Environmental Policy Act (NEPA) or a state equivalent.

Future international K-Fuel^™ production plants will also be subject to various permitting and operational regulations specific to each country. Generally, environmental permitting and operating regulations in countries outside the United States that we are currently pursuing for international development are not as stringent as those that are within the United States. Nevertheless, international initiatives, such as the Kyoto Protocol, are expected to create increasing pressures on the electric power generation industry on a world-wide basis to reduce emissions of various pollutants, which management expects will create additional demand for its products and services.

Employees

At March 8, 2004, we had approximately 12 full-time employees. We consider our relations with all employees to be good.

Risk Factors

We have a history of losses, deficits, working capital deficits and negative operating cash flows.

At December 31, 2003, we had working capital of approximately $21.2 million and an accumulated deficit of approximately $118 million. At December 31, 2003 we had a stockholders’ equity of approximately $31.1 million. In prior years, the Company had significant accumulated deficits and working capital deficits. We incurred net losses from continuing operations of approximately $10.2 million, $18.4 million, and $11.1 million in 2003, 2002, and 2001, respectively. We have experienced negative operating cash flow of approximately $6.9 million, $4 million, and $6.7 million in 2003, 2002 and 2001, respectively. Further, the report from our former independent accountants for the year ended December 31, 2001 contained an explanatory paragraph regarding our ability to continue as a going concern. We have not yet achieved significant K-Fuel^™ licensing, royalty or product sale revenue.

We expect to incur significant additional operating losses and continued negative cash flows from operations at least through 2004. We have made, and will continue to make, very significant expenditures well before our revenues increase sufficiently to cover these additional costs. We are not able to estimate when, if ever, our revenue will increase sufficiently to cover these costs. Further, we may not achieve or maintain profitability or generate cash from operations in future periods.

As a result, we have been and continue to be very dependent on strategic relationships and sales of our debt and equity securities to fund the operating costs associated with our business. Our continuation is dependent on our ability to utilize existing resources and to generate sufficient cash flows to meet our obligations on a timely basis, to obtain financing or refinancing as may be required, to attain

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profitability, or a combination thereof. A lack of adequate financing may adversely affect our ability to respond to changing business and economic conditions and competitive pressures, absorb negative operating results, and fund capital expenditures or increased working capital requirements.

We have contractual limitations on our ability to secure additional funding.

Our ability to secure additional financing is limited by the terms of a common stock and warrant purchase agreement for the sale of 6.76 million shares of common stock in 2002. Under the terms of this agreement and a related investors rights agreement we are prohibited from selling and issuing any of our preferred stock until the investors no longer hold any shares of common stock or warrants, or obtain a waiver to sell and issue preferred stock from at least two-thirds of these investors. The terms of this agreement have subsequent dilutive offering protections that are triggered if we sell common stock at a price below $2.50 per share. The investors under this common stock and warrant purchase agreement also have the first right of purchase related to potential sales of our common stock until August 21, 2004.

Technical and operational problems may adversely impact our ability to develop K-Fuel^™ projects or facilities.

There have been past significant technical and operational problems with the construction of a K-Fuel^™ facility. The construction of the first commercial-scale K-Fuel^™ production facility (the “ KFP” Facility”) began in 1995, which was completed and began operations in April 1998. The facility experienced a series of construction problems during and after it began operations, including a 1996 fire at the facility and issues relating to the flow of materials within the facility and the design and operation of pressure release equipment. Following the commencement of operations, the KFP Facility experienced problems relating to tar and residue build-up within the system during production and product quality issues related to product dusting. As a result of these problems, operations at the KFP Facility were suspended. In 2000, we tested an improved K-Fuel^™ production process using Powder River Basin (“PRB”) coals, which resulted in an improved K-Fuel^™ product which is low in SO₂, NO_x, mercury and chlorine. Analysis of this improved K-Fuel^™ product indicated that this improved K-Fuel^™ production process can be more reliable than the process used by the KFP Facility. Additionally, the improved K-Fuel^™ production facilities would require less capital and have lower operating costs than previous K-Fuel^™ plant designs. However, there can be no assurance that any future K-Fuel^™ production facilities will not experience technical or operational problems similar to or in addition to those experienced at the KFP Facility. To the extent that other technical or operational problems materialize, our ability to develop other K-Fuel^™ projects or facilities would be jeopardized.

The K-Fuel^™ technology has not yet shown economic viability.

We have only recently finished the development of the current K-Fuel^™ technology. Our future success depends upon our ability to successfully construct and operate commercial K-Fuel^™ production facilities.

The process of developing, financing and constructing K-Fuel^™ production facilities, including obtaining necessary regulatory permits and approvals, is complex, lengthy and costly and subject to numerous risks, uncertainties and factors beyond our control, including cost overruns, delays, damage and technical delays. In addition, local opposition to a particular project can substantially increase the cost and time associated with developing the project, and can, potentially, render a project unfeasible or uneconomical. Future projects for the development of K-Fuel^™ production facilities may incur substantial costs or delays or may be unsuccessful as a result of such opposition.

Only a small percentage of the potential projects that are considered and pursued may ultimately result in operating plants that are sufficiently successful to provide us with project revenues and equity

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participation income, license fee income, and royalty fee income. As a result, we may not be able to recover any expenses that we incur in the evaluation and development of certain projects.

The market for the K-Fuel^™ technology and products is unclear.

Although we believe that a substantial market will develop both domestically and internationally for clean coal fuel products, no established market for beneficiated fuel products exists. As a result, the availability of accurate and reliable pricing information and transportation alternatives is not fully known. The future success of our K-Fuel^™ technology will depend on our ability to establish a market for clean coal fuel products among potential customers such as electrical utility companies and industrial coal users. The value of our products in the marketplace, while presently very attractive, may be reduced if the large differential between the price of higher grade eastern coals and lower grade western coals narrows significantly. Further, potential users of our fuel products may be able to choose among alternative fuel supplies. The market viability for the K-Fuel^™ technology will not be known until we complete construction of one or more commercial-scale production facilities, either in the United States or internationally, that produce, on a consistent basis, commercial quantities of fuel that meet certain minimum performance specifications. There is a risk that commercial-scale production facilities when completed will be unable to generate sufficient market interest to continue in business. Further, there can be no assurance that a commercial-scale K-Fuel^™ facility will be economically successful. If we are unable to complete construction and successfully operate a commercial K-Fuel^™ production facility, we will not be able to sustain our operations or achieve future growth.

Deregulation in the United States power industry may result in increased competition for our products.

We expect that deregulation in the United States power industry will result in utilities and other power generators placing a high emphasis on reducing costs in their operations. This situation may, in turn, result in increased competition from other producers of beneficiated coal products, other clean fuel sources, and other products, services and technologies designed to provide environmental and operating cost benefits similar to those which we believe are available from our K-Fuel^™ technology.

Our markets are competitive.

We face competition from other companies in the clean coal and alternative fuel technology industries as well as the emission control equipment industry. Many of these companies have financial and managerial resources much greater than ours and, therefore, may be able to offer products more competitively priced and more widely available than ours. Also, competitors’ products may make our technology and products obsolete or non-competitive. We may also face competition for new K-Fuel plants from third parties with licenses for the K-Fuel^™ technology, although we would receive licensing and royalty revenues. Our future success may depend on our ability to adapt to such changing technologies and competition.

We are subject to risks of changing laws.

A significant factor driving the creation of the United States market for K-Fuel^™, and other beneficiated coal products, is the Clean Air Act, as amended, which specifies various air emission requirements for electrical utility companies and industrial coal users. Significantly, EPA along with the United States Department of Justice announced enforcement actions against various utility companies operating coal-fired power plants in the Midwest and Southeast sections of the United States, charging that the plants were illegally releasing high amounts of certain air pollutants. Although this enforcement initiative was announced in 1999, similar initiatives may be forthcoming. We believe that compliance with the air emission regulations and limitations can be fully or partially met through the use of clean-burning fuel technologies, like K-Fuel^™. We are unable to predict future regulatory changes and their impact on the demand for our products. While more stringent laws and regulations, including, without

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limitation, new mercury emission limitation standards, the capping of SO₂ emissions and new limits on NOx emissions may increase demand for our products, such regulations may result in reduced coal use and reliance on alternative fuel sources. Similarly, amendments to the Clean Air Act that would have the effect of relaxing emission limitations, or a repeal of the Clean Air Act (which is unlikely) would have a material adverse effect on our prospects.

Our inability to adequately protect and defend our proprietary technology could harm our business.

Our success depends upon our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret rights to establish and protect our proprietary rights. We currently have a series of patents on our K-Fuel^™ technology, however, competitors may successfully challenge the validity or scope of one or more of our patents or any future allowed patents. These patents alone may not provide us with any significant competitive advantage.

Third parties could copy or otherwise obtain and use our technology without authorization or develop similar technology independently. The protection of our proprietary rights may be inadequate and our competitors could independently develop similar technology, duplicate our solutions or design around any patents or other intellectual property rights we hold.

Any actions taken by us to enforce our patents or other property rights could result in significant expense to us as well as the diversion of management time and other resources. In addition, detecting infringement and misappropriation of patents or intellectual property can be difficult, and there can be no assurance that we would detect any infringement or misappropriation of our proprietary rights. Even if we are able to detect infringement or misappropriation of our proprietary rights, litigation to enforce our rights could cause us to divert significant financial and other resources from our business operations, and may not ultimately be successful. If we are required to divert significant resources or time to the enforcement of our proprietary rights, even if the enforcement is successful, our business, results of operation and financial condition could be materially adversely affected.

We rely on key personnel and must be able to retain or attract qualified personnel.

We believe that our performance is substantially dependent on the performance of a very small group of senior managers and key technical personnel. The inability to retain key managerial and technical personnel or attract and retain additional highly qualified managerial or technical personnel in the future could harm our business or financial condition.

Local opposition to K-Fuel^™ projects could substantially delay or prevent development of new K-Fuel^™ facilities.

Development, construction and operation of K-Fuel^™ production facilities require numerous environmental and other permits. The process of obtaining these permits can be lengthy and expensive. In addition, local opposition to a particular project can substantially increase the cost and time associated with developing a project, and can, potentially, render a project unfeasible or uneconomical. We may incur substantial costs or delays or may be unsuccessful in developing K-Fuel^™ production facilities as a result of such opposition.

Any overseas development of the K-Fuel^™ businesses is subject to international risks.

Although our current operations are primarily in the United States, we believe a portion of the growth opportunity for the K-Fuel^™ business lies outside the United States. Doing business in foreign countries exposes us to many risks that are not present in the United States and with which we lack significant experience, including political, military, privatization, technology piracy, currency exchange and repatriation risks, and higher credit risks associated with customers. In addition, it may be more

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difficult for us to enforce legal obligations in foreign countries and we may be at a disadvantage in any legal proceeding within the local jurisdiction. Local laws may also limit our ability to hold a majority interest in the projects that we develop.

Our ability to take advantage of net operating losses if we achieve profitability could be limited.

Under Section 382 of the Internal Revenue Code (“IRC”), the use of prior net operating losses is limited after an “ownership change,” as defined in Section 382. The limitation, if applicable, is equal to the value of the loss corporation’s outstanding stock immediately before the date of the ownership change multiplied by a long-term interest rate specified by the IRC. The quoted market value of a stock is a factor to consider, but not necessarily a conclusive factor, in determining the fair value of a corporation’s stock. Additional issuances of equity interests by us, or on the exercise of outstanding warrants or options to purchase our common stock may result in an ownership change that is large enough to trigger the Section 382 limitations. In the event we achieve profitable operations and taxable income, any significant limitation on the use of our net operating losses to offset taxable income would have the effect of increasing our tax liability and reducing net income and available cash resources.

We are required to pay third parties a portion of licensing and royalty revenues with respect to K-Fuel^™ technology.

We anticipate that a portion of our future revenues with respect to the K-Fuel^™ technology will be in the form of licensing and royalty payments from third party licensees operating commercial-scale production facilities of K-Fuel^™. Pursuant to various agreements we have executed, we are required to pay third parties a substantial portion of these licensing and royalty revenues that we receive. The Estate of Edward Koppelman is entitled to 25% of all license fees and royalty revenues, with a maximum of approximately $75.2 million; Fort Union Ltd. is entitled to 20% of royalty revenues in the United States, Canada and Mexico, not to exceed $1.5 million; and Ohio Valley Electric is entitled to 0.5% of royalty revenues using an earlier version of the technology only. As of December 31, 2003, the Estate of Edward Koppelman has received a cumulative total of approximately $280,000 in licensing fees and royalties. Amounts due under these agreements will decrease our revenues from the commercialization of the K-Fuel^™ technology.

We do not pay cash dividends.

We have never paid any cash dividends and do not anticipate paying cash dividends in the foreseeable future.

Our principal executive offices consist of approximately 5,715 square feet of office space leased through December 31, 2006, located at 55 Madison Street, Suite 745, Denver, Colorado 80206. The current base rent under the lease is $7,858.13 per month, increasing to $8,334.38 per month by the final year of the lease. We are also obligated to pay, as additional rent, allocable operating costs.

We are party to two leases relating to our former principal executive offices. Through June 30, 2003, our principal executive offices consisted of approximately 2,600 square feet of office space leased under a sublease, located at 3300 East First Avenue, Suite 290, Denver, Colorado 80206. The base rent under the lease through its expiration on August 31, 2004 is $3,540 per month. We are also obligated to pay, as additional rent, allocable operating costs.

Additionally, we are party to a lease relating to executive offices, which consisted of approximately 5,900 square feet of office space located at 1999 Broadway, Suite 3200, Denver, Colorado 80202. The lease for this office space expires in September 2004. The base rent under the lease through

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the expiration date is $11,593 per month. Effective October 1, 2000 to September 30, 2004, we subleased this office space to a third party for an average of $11,100 per month. We are also obligated to pay, as additional rent, allocable operating costs, most of which will also trigger additional rental income from the sublessee.

We have leased approximately 2,300 square feet of office space through June 30, 2005, located at 2300 Clarendon Boulevard, Suite 401, Arlington, Virginia 22201. The current base rent under the lease is approximately $5,600 per month. We are also obligated to pay, as additional rent, an allocable share of increases in certain operating costs. We have the option to renew the lease for one additional five-year term. A majority of this office space is sublet under short-term leases to third parties.

We, through our KFx Technology, Inc. (“KFxT”) subsidiary, own a demonstration plant and through leases from Landrica Development Corp., a subsidiary of Black Hills Corporation (for nominal rental payments), a research and development laboratory. This facility is located on approximately 80 acres of land, inside the rail loop of Fort Union Mine, in Campbell County, Wyoming, approximately 5 miles northeast of Gillette, Wyoming. The facility is comprised of three buildings totaling approximately 7,100 square feet.

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 seeks 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. No material adverse affect on KFx is expected from this litigation.

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.

No matters were submitted to a vote of security holders during the fourth quarter of 2003.

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PART II

Principal Market and Price Range of Common Stock

Our common stock trades on the American Stock Exchange under the trading symbol “KFX.” The following table presents the reported sales prices on the American Stock Exchange for periods ended:

As of March 8, 2004, we had approximately 233 holders of record of the common stock. This does not include holdings in street or nominee names. On March 8, 2004, the closing price of our common stock on the American Stock Exchange was $9.75 per share.

Dividend Policy

We have never paid cash dividends and do not anticipate paying dividends in the foreseeable future. We expect that we will retain all available earnings generated by our operations for the development and growth of our business. Any future determination as to payment of dividends will be made at the discretion of our Board of Directors and will depend on our operating results, financial condition, capital requirements, general business conditions and such other factor as the Board of Directors deems relevant.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table shows our common stock authorized for issuance under our equity compensation plans as of December 31, 2003:

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Recent Sales of Unregistered Securities

During 2003, we issued or granted the following securities in private transactions pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended (“Securities Act”) under Section 4(2) of the Securities Act:

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The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7. The consolidated statement of operations data for each of the three years in the period ended December 31, 2003 and the consolidated balance sheet data at December 31, 2003 and 2002 are derived from the audited consolidated financial statements, beginning on page F-1. The consolidated balance sheet data related to 2001, 2000 and 1999 and the consolidated income statement data related to 2000 and 1999 reflect the revised results of our continuing operations only.

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Introduction

The following discussion and analysis is focused on the 2003 events and trends that management believes had the most significant impact on our business. First of all, our financial position has changed considerably as a result of the significant inflows of cash from the sale and issuances of our common stock and the exercise of warrants and options by numerous parties. Secondly, we disposed of our Pegasus operations in an equity exchange transaction that resulted in KFx owning 100% of KFL and provided a significant reduction in cash outflows as well as in debt, goodwill and intangibles, deferred revenue and minority interests. We recognized a gain on this equity exchange and have presented the results of the Pegasus operations as discontinued operations in our Consolidated Balance Sheets and Statements of Operations. Finally, we made significant progress toward the construction of our first K-Fuel^™ plant, including the addition of key members to our management team and the continued development of a strategic relationship with Lurgi South Africa (Pty) Limited (“Lurgi”), a key technical partner in the development of the K-Fuel^™ technology.

Issuances of Common Stock for Cash Consideration

During March 2003 we sold 7,745,000 shares of common stock for approximately $18.3 million, net of transaction costs of approximately $1.1 million. In addition, during 2003, proceeds from the exercise of warrants and options exceeded $14 million.

Equity Exchange Transaction and Discontinued Operations

On November 26, 2003 we 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. KFx now owns 100% of KFL and all of the K-Fuel^™ technology. In exchange, KFx transferred its ownership interests in Pegasus Technologies, Inc. (“Pegasus”) to Kennecott. KFx retained no interest in Pegasus. We recognized a gain on the disposal of Pegasus of approximately $3.4 million, net of transaction costs of approximately $428,000 (See Note 2). While the disposition of Pegasus has eliminated our principal source of revenue, it has also eliminated a consistent outflow of cash and affords KFx’s management the opportunity to focus on the development of the K-Fuel^™ technology, the initial K-Fuel plant, and then the desired ramp up of future plants, in the US and internationally.

As a result of this transaction we have reported the discontinued operations of Pegasus and the related assets held for sale and liabilities associated with discontinued operations separately in the Statements of Operations and Consolidated Balance Sheets, respectively. Accordingly, for purposes of this discussion and analysis of these statements we have excluded the results of Pegasus and reported on the continuing operations of our business. However, in certain instances in this discussion and analysis, we have made reference to transactions that were generally consummated between third parties and KFx or its consolidated subsidiaries that relate to the previously held Pegasus operations. These references are for the purpose of providing information regarding transactions that affect KFx and its subsidiaries reflected in the audited financial statements and related footnotes. Our reporting on the Consolidated Statement of Cash Flows has not changed significantly from that previously reported other than to highlight cash provided by or used in discontinued operations.

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K-Fuel^™ Plant Construction

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 low-grade (or low BTU), high moisture content coal into high-grade (or high BTU), low moisture content coal. This beneficiated 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 a decrease in operating costs and a reduction in their regulated air emissions. In addition, we believe our product may provide many utilities that have had to rely on declining sources of high-grade coal with an important competitive alternative.

After the end of the first quarter 2004, we expect to complete our evaluation of the alternative sites under consideration for the initial K-Fuel^™ plant and announce our site selection. During 2004 we will focus substantial efforts on developing this site for production of K-Fuel^™, including permitting, site development, construction of the K-Fuel^™ plant and joining the plant with the necessary infrastructure to receive feed stock coal from our selected supplier. This process will require significant capital investment.

In late 2002 we began working with Lurgi who has over 50 years experience designing, building and operating coal processing plants similar to our future K-Fuel^™ plants. We are combining Lurgi’s existing “off-the-shelf” equipment design with our proven K-Fuel^™ processes to help reduce our time to completion and decrease engineering, construction, and development costs. Our five-year exclusive relationship with Lurgi has continued to be an important source of engineering, design and construction support for our plant and we expect to continue to gain additional value throughout the project.

We expect the total cost of the initial K-Fuel^™ plant construction project to be approximately $30 million with construction substantially completed by the end of 2004. This cost estimate and schedule could be adversely affected by (i) delays or adverse conditions/requirements in the site selection and the necessary permits and agreements, (ii) significant increases in the costs of materials such as steel, and (iii) currency risks associated with equipment purchased from foreign suppliers. As of December 31, 2003 we have capitalized approximately $6.3 million toward the construction of this plant and expensed an additional $1.3 million for general engineering and technical services. The capitalized costs were incurred for the following major plant components:

Management Team and Board of Directors

In January 2004 we hired and appointed a new President and Chief Operating Officer, C. Scott Hobbs. Mr. Hobbs last served as Executive Vice President, COO and Member of the Board of Directors of Colorado Interstate Gas Co., Colorado Springs, Colorado, and President and CEO of CIG Resources Co., both subsidiaries of The Coastal Corporation. Prior to that he held a number of positions over 24 years with The Coastal Corporation. Mr. Hobbs began his career as a CPA for Price Waterhouse & Co.

In April 2003, we engaged the consulting services of Rick Van Zyl as our director of projects. Mr. Van Zyl has been employed with Lurgi and/or SASOL for the last 20 years. During that time he specialized in the construction of coal gasification and related plants. His greater than thirty years of total

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experience in the coal processing industry provides us with a tremendous advantage in the construction of our K-Fuel^™ plant.

Our Board of Directors was also strengthened during the year with the appointment of James Schlesinger and John Lovoi.

Mr. Schlesinger has held several high-level government positions, including Secretary of Energy, Secretary of Defense, Director of the CIA, and Chairman of Atomic Energy Commission. He is currently a senior advisor to Lehman Brothers, chairman of the Executive Committee of the Nixon Center, and counselor and trustee to the Center for Strategic and International Studies. He presently serves as chairman of MITRE Corporation, as a director of BNFL, Inc., Peabody Energy, and Sandia Corporation. Mr. Schlesinger graduated from Harvard University with an AB summa cum laude (1950), AM (1952), Ph.D. (1956). He has received the Dwight D. Eisenhower Distinguished Service Medal, the George Catlett Marshall Medal, the H. H. Arnold Award, the Navy League’s National Meritorious Citation, the Military Order of the World Wars Distinguished Service Award, the Jimmy Doolittle Award, William Oliver Baker Award National Security Medal, five Department and Agency medals, and eleven honorary degrees.

Mr. Lovoi has held numerous positions in the energy business, primarily in the areas of investment banking and equity research. He served as the head of Morgan Stanley’s Global Oil and Gas investment banking practice and, prior to that, head of Morgan Stanley’s Global Oil and Gas Equity research franchise. Earlier in his career, he served as senior financial executive at Baker Hughes and as an energy investment banker with Credit Suisse First Boston. Mr. Lovoi currently is founder of JVL Partners, a private oil and gas investment partnership.

Significant Trends and Developments

One of the significant developments in the potential value of K-Fuel^™ has been the increase over the last 12 months in the price of naturally occurring higher Btu compliance coal (generally from Appalachian mines) in the marketplace. This higher grade coal, in part, establishes the value of K-Fuel^™, subject to the relative costs of transporting these fuels to market. While the price for these higher grade coals has increased dramatically, the price for our lower grade feedstock coal to the K-Fuel^™ process (principally coal from the PRB) has remained at very low levels. This price differential is a key indicator for the value of K-Fuel^™ along with the value of reduced air emissions (e.g., NOx, SO₂, and mercury reductions) provided by our process. The value of these emission reductions can vary depending on a coal burning plant’s permits, local regulations, the availability of trading allowances for these pollutants, as well as the capital and operating costs to install pollution control equipment to reduce the emissions. These are key indicators that management follows very closely to assess the value of the K-Fuel^™ process.

Over the last year Congress has considered, in the proposed Energy bill, and other proposed legislation, the possibility of granting tax credits to technologies that refine or clean coal. As presently proposed in the current Energy bill under consideration, K-Fuel^™ would qualify for a production tax credit of $10 to $12 per ton. While we cannot determine whether a production tax credit similar to that currently under consideration will ultimately be implemented, it would provide a strong impetus for the more rapid development of new K-Fuel^™ plants.

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Results of Operations

Year Ended December 31, 2003 vs. Year Ended December 31, 2002

Continuing Operations

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

The consolidated operating loss in 2003 of $9,518,000 was $3,033,000, or 47%, greater than the 2002 operating loss. The increase is primarily due to an additional $1,913,000 of marketing, general, and administrative costs and an additional $885,000 in engineering and technical service costs during 2003. Essentially all of the increase in marketing, general, and administrative costs was attributable to a significant increase in professional fees for legal, financial, and project development consulting services. All of the increase in engineering and technical service costs related to professional services received from a variety of companies helping the Company continue to develop and refine our K-Fuel^™ technology.

Non-operating items added only $727,000 to our loss from continuing operations in 2003, a decrease of $11,173,000, or 93%, compared to 2002. The decrease is a direct result of a reduction in other income and expenses and interest expense of $7,815,000 and $3,342,000, respectively. Other expenses in 2002 included: (i) $2,798,000 due to the recognition of the warrant penalty incurred as part of our private equity investments, (ii) $10,574,000 due to the recognition of expense relating to the grant of the warrants pursuant to the July 19, 2002 and August 21, 2002 private equity transactions, partially offset by (iii) $4,230,000 in other income resulting from the revaluation of warrants at June 30, 2002 and again at August 30, 2002. Interest expense in 2002 included approximately $1,024,000 related to our repurchase obligation of Pegasus preferred stock and $2,074,000 paid on debentures, both of which were no longer outstanding in 2003.

As a result of the above factors, our loss from continuing operations of $10,245,000 ($.22 per share) for 2003 was $8,140,000, or 44%, less than the loss from continuing operations of $18,385,000 ($.52 per share) in 2002. Included in the year to date losses from continuing operations for 2003 and 2002 were significant non-cash charges related to depreciation and amortization, amortization of debt discount, the cost of common stock and warrants issued for services, among others.

Discontinued Operations

Loss from discontinued operations decreased $3,652,000, or 72% in 2003 compared to 2002. This loss relates to the discontinued operations of Pegasus. The decrease was primarily related to significant decreases in: (i) marketing, general and administrative expenses of approximately $1,300,000; (ii) depreciation and amortization of approximately $440,000; and (iii) other one-time expenses incurred in 2002 of approximately $1,500,000 which were not incurred in 2003. In addition, we recognized a gain on the disposal of Pegasus of $3,377,000, net of transaction costs of approximately $428,000 (See Note 2).

Net Loss Available to Common Stockholders

Our net loss available to common stockholders decreased by 79% or $31,704,000 in 2003 compared to 2002. The improvement in net loss was the result of the items described above combined with the reduction of non-cash charges of $16,536,000 recognized during 2002 to accrete redeemable common stock, pursuant to the put options (later terminated), to its redemption value and to recognize expense relating to the reduction of the exercise price and extension of the term of an outstanding warrant.

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This non-cash expense increased the net loss available to common shareholders to $39,987,000, or $1.14 per share, in 2002 compared to $.18 per share in 2003.

Deferred Tax Benefit

We have not recorded a deferred tax benefit from net operating loss carryforwards, which approximate $66.5 million at December 31, 2003 since based on the weight of available evidence, both positive and negative, management has determined that it is more likely than not that our deferred tax assets may not be realized. Certain limitations apply to the annual amount of net operating losses that can be used to offset taxable income, after certain ownership changes, as defined in Section 382 of the Internal Revenue Code (“Section 382”). Although management does not believe Section 382 places significant limitations on the use of our net operating loss carryforwards presently, transactions that may be consummated in order to obtain needed financing may result in ownership changes that are large enough to trigger the Section 382 limitations. In the event we achieve profitable operations and taxable income, any significant Section 382 limitation would have the effect of increasing our income tax liability and reducing available cash resources.

Year Ended December 31, 2002 vs. Year Ended December 31, 2001

The consolidated operating loss in 2002 of $6,485,000 was $355,000, or 6%, greater than the 2001 operating loss. The increase in the operating loss for 2002 was primarily due to the recognition of $1,822,000 for the appreciation of outstanding stock appreciation rights and higher consulting and legal fees associated with the sale of 6.76 million shares of common stock in 2002 offset by lower depreciation and amortization expense of $1,542,000 in 2002 because of lower patent amortization and no depreciation expense recorded at the K-Fuel^™ demonstration plant in 2002. Total operating costs and expenses fluctuated by approximately the same amount as our operating loss due to the immateriality of our operating revenues.

Our loss from continuing operations increased in 2002 by $7,329,000, or 66%, compared to 2001. The increase is primarily due to an increase in other expense of $7,696,000 offset by a decrease in interest expense of $733,000 because of the debenture payoff and conversion. Other expense increased $2,798,000 due to the recognition of the warrant penalty incurred as part of private equity investments, $10,574,000 due to the recognition of expense relating to the grant of the warrants pursuant to the July 19, 2002 and August 21, 2002 private equity transactions offset by an increase of $4,230,000 in other income resulting from the revaluation of warrants at June 30, 2002 and again at August 30, 2002.

Discontinued Operations

Our loss from discontinued operations increased $945,000, or 23% in 2002 compared to 2001. This loss relates to the discontinued operations of Pegasus. The increase was the result of increases in marketing, general and administrative expenses and other expenses of approximately $1,900,000 offset by an increase in gross margin in the discontinued operations of Pegasus of approximately $900,000.

Net Loss Available to Common Stockholders

Additional non-cash expense of $16,536,000 was recognized during 2002 to accrete the redeemable common stock, pursuant to the put options, to its redemption value and to recognize expense relating to the reduction of the exercise price and extension of the term of an outstanding warrant. This non-cash expense increased the net loss available to common stockholders to $39,987,000 or $1.14 per share compared to $.58 per share in 2001

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Liquidity and Capital Resources

At December 31, 2003, our working capital was approximately $21.2 million compared to a working capital deficit at December 31, 2002 of approximately $756,000, adjusted for classification of assets held for discontinued operations. The increase in working capital of approximately $22 million is primarily attributable to the $18.3 million (net of transaction costs) received from the issuance of stock during 2003 and $14.5 million of proceeds from the exercise of outstanding options and warrants. Approximately $7.6 million of this new capital was spent on our K-Fuel^™ plant project and engineering and technical services in the amounts of $6.3 million and $1.3 million, respectively. In addition, we paid notes payable in the amount of $695,000. As of December 31, 2003, we had cash and cash equivalents of $23,701,000 compared to $2,758,000 at December 31, 2002.

Statements of Cash Flows

While our Consolidated Balance Sheets and Statements of Operations were presented with specific line items for discontinued operations our Consolidated Statements of Cash Flows presentation did not change considerably from prior periods. However, the following discussion primarily focuses on cash provided by or used in our continuing operations.

Cash Used in Operating Activities

Our cash used in operating activities increased from $3,994,000 to $6,941,000 during 2003, despite experiencing a much smaller net loss of $8,283,000 compared to $23,451,000 in 2002. The primary reason for this disparity are the non-cash charges, gain on disposal and significant changes in our working capital during the 2002 and 2003. During 2003 we disposed of our Pegasus operations and recognized a gain of $3,377,000, net of transaction costs. Additionally, we recognized an increase of $1,050,000 in common stock and warrants issued for services to $2,398,000 in 2003. An increase in accounts payable and accrued expenses of $1,954,000, an improvement in cash from operating activities, was partially offset by an increase in accounts receivable, unbilled revenue and deferred job costs of $1,410,000, which had a net effect of an increase of $544,000 in our net cash position.

During 2002 we incurred charges of $9,141,000, $1,822,000 and $3,421,000 for warrants issued with redeemable common stock, stock appreciation rights and amortization of debt discount. These non-cash charges of $14,384,000 were not incurred in 2003. Additionally, we experienced additional expenses related to depreciation and amortization and accretion of maturity premium charges of $606,000 and $454,000, respectively, in 2002 compared to 2003. Finally, our deferred revenue decreased by approximately $1,729,000 in 2002. These non-cash charges included in our net loss and the significant change in deferred revenue reduced our net loss substantially when reconciled to cash used in operating activities.

Cash Used in Investing Activities

Cash used in Investing Activities increased by $1,448,000 compared to 2002. This increase is primarily the result of $6.3 million spent on our K-Fuel plant in 2003 compared to $5,205,000 spent on business acquisitions during 2002. The cash spent on the acquired business in 2002 related to the acquisition of a segment of Pavilion Technologies, Inc. by our discontinued Pegasus operations.

Future cash expenditures in 2004 are anticipated to be primarily for the development and construction of the initial K-Fuel plant. The estimated capital expenditures for a K-Fuel production facility of 750,000 tons per year are approximately $30 million. Such expenditures will be financed with existing cash balances and, if necessary, potential debt, or equity from the future exercise of outstanding warrants and stock options.

Cash Provided by Financing Activities

Cash provided by financing activities increased to $34,351,000 in 2003, compared to $12,231,000 in 2002. The increase of $21,120,000 was primarily due to net proceeds of $18.3 million received from the issuance of common stock in two private placements in March 2003 and $14.5 million from the exercise of options and warrants into common stock during 2003. In the prior year, we raised approximately $19.6 million from the issuance of common stock and warrants; however, we made significant repayments on convertible debentures, purchased preferred stock and made payments on borrowings in the amounts of $3.4, $3.8 and $2.2 million, respectively. These payments significantly absorbed the amount of cash provided from financing activities in 2002.

As discussed above, in March 2003 we completed two equity-financing transactions. We sold a total of 7,745,000 shares of common stock at a price of $2.50 per share, for proceeds of $18.34 million (net of transaction costs), in a series of private placements to several institutional investors. Under the terms of the agreements, the investors also received warrants for the purchase of an aggregate of 1,549,000 million shares of common stock at a purchase price of $2.75 per share (subject to adjustment) which expire five

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years after the date of the grant. The proceeds from the sale of these securities will be used to partially fund the development of a K-Fuel^™ production facility and for general corporate purposes.

Future Sources and Uses of Cash

We do not expect to derive a significant amount of cash from operations in 2004. We will seek to meet our cash requirements over the next fiscal year with respect to day-to-day operations and the construction of our K-Fuel^™ plant through (i) cash on hand; (ii) proceeds from the exercise of outstanding options and warrants; (iii) potential partners in connection with opportunities to expand our product offerings; (iv) potential debt and/or equity offerings; and (v) potential fees from licensing new K-Fuel^™ facilities. Such transactions may be on better or worse terms than previously negotiated on similar transactions. From January 1, 2004 through March 8, 2004, we have received approximately $4.7 million in additional cash from the exercise of warrants and options.

There are no assurances that any of these potential funding sources will continue or materialize in the future. If the overall outcome of the various uncertainties affecting us is not favorable, we may be forced to seek debt and/or equity financing on terms and conditions that may be unfavorable to us, if available at all. Our former independent accountants’ report on our consolidated 2001 financial statements contained an explanatory paragraph related to our ability to continue as a going concern.

Below are the details of our obligations and the maturity of those obligations as of December 31, 2003:

Operating leases primarily relate to the lease of our corporate offices in Denver, Colorado.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon 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 of the Notes to 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 restated financial statements resulting from the disposal of the Pegasus operations. For purposes of discontinued operations presentation in these consolidated financial statements we have separately identified the assets and liabilities of the Pegasus operations. Pegasus was previously reported and accounted for as an operating segment. The assets and liabilities of this former operating segment have been separately classified as “Assets held for sale” and “Liabilities associated with discontinued operations” on the Consolidated Balance Sheet as of December 31, 2002. The loss from operating Pegasus has been

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aggregated for reporting purposes into a single line on the Consolidated Statements of Operations called “Loss from discontinued operations” for each of the three years ended December 31, 2003. 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 in November 2003 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 significant 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. 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. The Company begins 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

In April 2003, the FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS 149 clarifies the accounting for derivatives, amending the previously issued SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”. SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative, amends the definition of an underlying contract and clarifies when a derivative contains a financing component in order to increase the comparability of accounting practices under SFAS 133. SFAS 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial position or results of operations.

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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 no 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 hedging activities and other means considered appropriate. We are indirectly 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.

The financial statements required pursuant to this item are included in Item 15 of this Annual Report on Form 10-K and begin on page F-1. The supplementary financial information required by this item is included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

On February 5, 2003, we selected Deloitte & Touche LLP to serve as our independent accountants and dismissed PricewaterhouseCoopers LLP. This change in accountants was previously reported in our Form 8-K filed February 6, 2003 and in our Form 10-K filed April 15, 2003.

(a) Evaluation of disclosure controls and procedures

Our Chief Executive Officer and the Principal Financial and Accounting Officer evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2003 in accordance with Rule 13a-15 under the Exchange Act. Based on their evaluation, the Chief Executive Officer and the Principal Financial and Accounting Officer concluded that KFx’s disclosure controls and procedures enable us to:

(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 December 31, 2003 that have materially affected, or are reasonable likely to materially affect, KFx’s internal control over financial reporting.

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PART III

The required information for this item is incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.

Our Board of Directors has adopted a Code of Ethics that applies to our directors, executives, officers and employees. Our Code of Ethics is filed with this Report as Exhibit 14.

We undertake to provide to any person without charge, upon request, a copy of our Code of Ethics. Requests should be submitted in writing to the attention of Scott Hobbs at 55 Madison Street, Suite 745, Denver, Colorado 80206.

The required information for this item is incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.

The required information for this item is incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.

The required information for this item is incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.

The required information for this item is incorporated by reference to our Proxy Statement for the 2004 Annual Meeting of Stockholders, since such Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of our fiscal year pursuant to Regulation 14A.

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PART IV

The following consolidated financial statements of KFx, Inc. are filed as part of this report:

None

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On November 18, 2003, KFx furnished a Form 8-K under Item 12 to report its financial results for its third quarter ended September 30, 2003.

On December 11, 2003, KFx furnished a Form 8-K under Item 2 to announce that it completed its transaction with Kennecott Energy Company regarding the transfer of Kenecott’s interest in K-Fuel L.L.C. to KFx and KFx’s transfer of its interest in Pegasus Technologies, Inc. to Kennecott.

On February 5, 2004, KFx furnished a Form 8-K under Item 5 to announce that it hired and appointed C. Scott Hobbs as its President and Chief Operating Officer.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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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POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Theodore Venners and Rudolph G. Swenson, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place, stead, in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, including all amendments thereto, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

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To the Stockholders and Board of Directors of KFx Inc.

Denver, Colorado

We have audited the accompanying consolidated balance sheets of KFx Inc. and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity (deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2003 and 2002, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 2 to the consolidated financial statements, the Company discontinued the Pegasus segment of its operations in November 2003 when it disposed of Pegasus Technologies, Inc. on November 26, 2003. The gain on the disposition and the results of Pegasus prior to the disposition are included in income from discontinued operations in the accompanying consolidated financial statements.

As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets in 2002 with the implementation of Statement of Financial Accounting Standards No. 142.

/s/ Deloitte & Touche LLP

Denver, Colorado

March 15, 2004

F-1

REPORT OF INDEPENDENT AUDITORS

To the Stockholders and Board of Directors

of KFx, Inc.

In our opinion, the consolidated statement of operations, stockholders’ deficit, and cash flows for the year ended December 31, 2001, listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the results of operations and cash flows of KFx, Inc. and its subsidiaries for the year ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

As discussed in Note 2 to the consolidated financial statements, the Company discontinued the Pegasus segment of its operations when it disposed of Pegasus Technologies, Inc. on November 26, 2003. The results of the Pegasus segment prior to the disposition are included in loss from discontinued operations in the accompanying consolidated financial statements for the year ended December 31, 2001.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses and negative cash flows from operations. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ PricewaterhouseCoopers LLP

Denver, Colorado

April 12, 2002, except for Note 2 as to which the date is March 15, 2004

F-2

KFX INC.

CONSOLIDATED BALANCE SHEETS