AVATECH SOLUTIONS INC - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2004

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

Commission file number: 001-31265

Avatech Solutions, Inc.

(Exact Name of Registrant as Specified in its Charter)


Delaware		84-1035353
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

11400 – A Cronridge Drive, Owings Mills, MD		21117
(Address of Principal Executive Offices)		(Zip Code)

(410) 581 - 8080

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.


Class		Outstanding at May 14, 2004
Common Stock, par value $.01 per share		9,460,378

AVATECH SOLUTIONS, INC. AND SUBSIDIARIES

INDEX


		Page

PART I	FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements

	Consolidated Balance Sheets – June 30, 2003 (Audited) and March 31, 2004 (Unaudited)	3

	Consolidated Statements of Operations – Three months ended March 31, 2003 and 2004 (Unaudited)	5

	Consolidated Statements of Operations – Nine months ended March 31, 2003 and 2004 (Unaudited)	6

	Consolidated Statement of Stockholders’ Deficit – Nine months ended March 31, 2004 (Unaudited)	7

	Consolidated Statements of Cash Flows – Nine months ended March 31, 2003 and 2004 (Unaudited)	8

	Notes to Consolidated Financial Statements – March 31, 2004 (Unaudited)	9

Item 2.	Management’s Discussion and Analysis of Results of Operations and Financial Condition	18

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	26

Item 4.	Controls and Procedures	26

PART II	OTHER INFORMATION

Item 1.	Legal Proceedings	27

Item 2.	Changes in Securities	27

Item 3.	Defaults upon Senior Securities	27

Item 4.	Submission of Matters to a Vote of Security Holders	27

Item 5.	Other Information	27

Item 6.	Exhibits and Reports on Form 8-K	28

SIGNATURES		31

Part I. Financial Information

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets


	June 30, 2003		March 31, 2004
	(audited)		(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	540,384	$	680,423
Accounts receivable, less allowance of $160,000 at June 30, 2003 and $145,000 at March 31, 2004		3,393,123		4,280,209
Inventory		146,877		314,384
Prepaid expenses		395,189		394,064
Other current assets		94,258		136,551

Total current assets		4,569,831		5,805,631
Property and equipment:
Computer software and equipment		2,925,159		2,756,422
Office, furniture and equipment		760,020		801,829
Leasehold improvements		207,661		210,032

		3,892,840		3,768,283
Less accumulated depreciation and amortization		3,255,361		3,303,581

		637,479		464,702
Goodwill		52,272		52,272
Other assets		12,385		56,674

Total assets	$	5,271,967	$	6,379,279

See accompanying notes.

Avatech Solutions, Inc. and Subsidiaries

Consolidated Balance Sheets (Continued)


	June 30, 2003			March 31, 2004
	(audited)			(unaudited)
Liabilities and stockholders’ deficit
Current liabilities:
Accounts payable and accrued expenses	$	5,089,207		$	4,380,397
Accrued compensation and related benefits		354,555			468,385
Borrowings under line-of-credit		1,634,709			1,800,831
Current portion of long-term debt		250,000			26,250
Deferred revenue		736,963			754,473
Other current liabilities		325,920			322,742

Total current liabilities		8,391,354			7,753,078
Long-term debt		—			1,666,438
Notes payable to related parties subject to refinancing		966,503			893,795
Other long-term liabilities		363,307			296,320
Commitments and contingencies		—			—
Minority interest		1,525,000			1,525,000
Stockholders’ deficit:
Series C Convertible Preferred Stock, $0.01 par value; 1,000,000 shares authorized and 172,008 issued and outstanding at June 30, 2003 and -0- shares authorized, issued and outstanding at March 31, 2004		1,720			—
Series D Convertible Preferred Stock, $0.01 par value; -0- shares authorized, issued and outstanding at June 30, 2003 and 1,297,537 shares authorized, issued and outstanding at March 31, 2004		—			12,975
Common stock, $0.01 par value; 22,500,000 shares authorized; 8,897,874 and 9,492,812 shares issued and outstanding at June 30, 2003 and March 31, 2004, respectively		88,980			94,928
Additional paid-in capital		3,242,454			3,771,272
Accumulated deficit		(9,307,351	)		(9,634,527	)

Total stockholders’ deficit		(5,974,197	)		(5,755,352	)

Total liabilities and stockholders’ deficit	$	5,271,967		$	6,379,279

See accompanying notes.

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations


	Three Months Ended March 31,
	2003			2004
	(unaudited and restated)			(unaudited)
Revenues:
Product sales	$	3,289,161		$	5,086,415
Service revenue		1,452,621			1,336,533
Commission revenue		1,326,651			1,413,097

		6,068,433			7,836,045

Cost of revenue:
Cost of product sales		2,247,821			3,472,919
Cost of service revenue		898,995			912,379

		3,146,816			4,385,298

Gross margin		2,921,617			3,450,747
Other expenses:
Selling, general and administrative		3,222,012			2,970,289
Depreciation and amortization		60,516			81,691

		3,282,528			3,051,980

Operating income (loss)		(360,911	)		398,767

Other income (expense):
Minority interest		(38,125	)		(38,125	)
Interest and other income		3,907			5,260
Interest expense		(59,989	)		(98,158	)

		(94,207	)		(131,023	)

Income (loss) from continuing operations before income taxes		(455,118	)		267,744
Income tax expense		—			10,828

Income (loss) from continuing operations		(455,118	)		256,916
Loss from operations of discontinued operating segments		(303,674	)		(86,554	)

Net income (loss)		(758,792	)		170,362
Preferred stock dividends		—			19,463

Earnings (loss) attributable to common stockholders	$	(758,792	)	$	150,899

Earnings (loss) from continuing operations per common share, basic	$	(0.05	)	$	0.03

Earnings (loss) per common share, basic	$	(0.08	)	$	0.02

Earnings (loss) from continuing operations per common share, diluted	$	(0.05	)	$	0.02

Earnings (loss) per common share, diluted	$	(0.08	)	$	0.01

See accompanying notes.

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Operations


	Nine Months Ended March 31,
	2003			2004
	(unaudited and restated)			(unaudited)
Revenues:
Product sales	$	9,344,490		$	13,774,812
Service revenue		4,488,949			4,096,710
Commission revenue		3,254,079			3,697,908

		17,087,518			21,569,430

Cost of revenue:
Cost of product sales		6,386,221			9,887,768
Cost of service revenue		2,708,834			3,019,153

		9,095,055			12,906,921

Gross margin		7,992,463			8,662,509
Other expenses:
Selling, general and administrative		8,989,109			8,135,275
Depreciation and amortization		290,705			231,317

		9,279,814			8,366,592

Operating income (loss)		(1,287,351	)		295,917

Other income (expense):
Gain on the extinguishment of debt		1,960,646			—
Minority interest		(56,016	)		(114,375	)
Interest and other income		13,232			9,553
Interest expense		(217,222	)		(258,642	)

		1,700,640			(363,464	)

Income (loss) from continuing operations before income taxes		413,289			(67,547	)
Income tax expense		400,365			31,828

Income (loss) from continuing operations		12,924			(99,375	)
Loss from operations of discontinued operating segments		(599,369	)		(227,801	)

Net loss		(586,445	)		(327,176	)
Preferred stock dividends		—			36,842

Net loss attributable to common stockholders	$	(586,445	)	$	(364,018	)

Earnings (loss) from continuing operations per common share, basic	$	0.00		$	(0.02	)

Loss per common share, basic	$	(0.08	)	$	(0.04	)

Earnings (loss) from continuing operations per common share, diluted	$	0.00		$	(0.02	)

Loss per common share, diluted	$	(0.08	)	$	(0.04	)

See accompanying notes.

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Deficit (Unaudited)


	Convertible Preferred Stock
	Series C					Series D			Common Stock
	Number of Shares		Par Value			Number of Shares	Par Value		Number of Shares	Par Value		Additional Paid-In Capital			Accumulated Deficit			Total
Balance at July 1, 2003	172,008		$	1,720		—	$	—	8,897,874	$	88,980	$	3,242,454		$	(9,307,351	)	$	(5,974,197	)
Issuance of common stock as compensation									594,938		5,948		74,169						80,117
Conversion of Series C Convertible Preferred Stock into Series D Convertible Preferred Stock	(172,008	)		(1,720	)	484,487		4,845					(3,125	)					—
Issuance of Series D Convertible Preferred Stock and warrants to purchase common stock						813,050		8,130					479,700						487,830
Preferred stock dividends													(36,842	)					(36,842	)
Issuance of warrants													14,916						14,916
Net loss																(327,176	)		(327,176	)

Balance at March 31, 2004	—		$	—		1,297,537	$	12,975	9,492,812	$	94,928	$	3,771,272		$	(9,634,527	)	$	(5,755,352	)

See accompanying notes.

Avatech Solutions, Inc. and Subsidiaries

Consolidated Statements of Cash Flows


	Nine Months Ended March 31,
	2003			2004
	(unaudited)
Cash flows from operating activities
Net income (loss)	$	(586,445	)	$	(327,176	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Provision for bad debts		57,390			74,349
Gain on extinguishment of debt		(1,960,646	)		—
Depreciation and amortization		483,734			231,317
Deferred income taxes		373,000			—
Write-off of in-process research and development		282,000			—
Non-cash stock compensation expense		—			80,117
(Gain) loss on disposal of property and equipment		(3,532	)		(1,291	)
Non-cash interest expense		2,883			52,073
Changes in operating assets and liabilities:
Accounts receivable		520,376			(961,435	)
Inventory		80,396			(167,507	)
Prepaid expenses and other current assets		(300,273	)		(41,168	)
Accounts payable and accrued expenses		200,434			(708,810	)
Accrued compensation and related benefits		(27,376	)		113,830
Deferred revenue		53,774			17,510
Other current liabilities		(36,597	)		(3,178	)
Other long-term liabilities		—			(66,987	)

Net cash used in operating activities		(860,882	)		(1,708,356	)

Cash flows from investing activities
Cash received in merger, net of acquisition costs		382,643			—
Purchase of property and equipment		(179,453	)		(103,426	)
Proceeds from sale of property and equipment		3,532			46,177

Net cash provided by (used in) investing activities		206,722			(57,249	)

Cash flows from financing activities
Proceeds from borrowings under line-of-credit		18,689,709			23,946,775
Repayments of borrowings under line-of-credit		(18,469,591	)		(23,775,559	)
Proceeds from issuance of debt		1,800,000			1,500,000
Proceeds from issuance of preferred stock		—			389,999
Payment of preferred stock dividends		(17,891	)		(36,842	)
Repayments of long-term debt		(1,000,000	)		(51,250	)
Change in other long-term liabilities		221,895			—
Change in other assets related to financing costs		—			(67,479	)

Net cash provided by financing activities		1,224,122			1,905,644

Net change in cash and cash equivalents		569,962			140,039
Cash and cash equivalents - beginning of period		222,562			540,384

Cash and cash equivalents - end of period	$	792,524		$	680,423

See accompanying notes.

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004

1. Basis of Presentation

Avatech Solutions, Inc. (the “Company”) provides design automation and data management software, hardware, training, technical support and professional services to corporations, government agencies and educational institutions throughout the United States.

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and in accordance with the instructions to Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules or regulations. The interim financial statements are unaudited, but reflect all adjustments (consisting of normal recurring accruals), which are, in management’s opinion, necessary to present a fair statement of results of the interim periods presented. These financial statements should be read in conjunction with the financial statements and the notes thereto in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2003. Operating results for the three and nine months ended March 31, 2004 are not necessarily indicative of results for any future period.

The consolidated financial statements include the accounts of Avatech Solutions, Inc. and its majority owned subsidiaries. One of the Company’s subsidiaries has issued and outstanding preferred stock, which is accounted for as minority interest. All intercompany accounts and transactions between the Company and its consolidated affiliated companies have been eliminated in consolidation.

2. Discontinued Operations of Certain Operating Segments

In June 2003, due to poor operating results, the Company closed a total of three offices located in New York, Michigan and Ohio. These locations were authorized software dealers subject to the Company’s channel partner agreement with its principal supplier. By virtue of these closings, the Company is no longer authorized to market or distribute software products subject to the channel partner agreements in those areas.

Additionally, the Company closed another office located in California in August 2003, which was also an authorized software dealer for which the Company is no longer authorized to market or distribute software products subject to the channel partner agreement with its principal supplier. In connection with the closing of the California office in August 2003, the Company did not incur a gain or loss.

The discontinued operations were components of the Company as the operations and cash flows were clearly distinguished, operationally and for financial reporting purposes, from the rest of the Company. The operations and cash flows of the components have been eliminated from the ongoing operations of the Company, and the Company will not have any significant continuing involvement in the operations of the components. Accordingly, the historical results of operations of these components are presented in the accompanying consolidated statements of operations as a separate component of operations classified as discontinued operations. All interim periods in fiscal year 2003 have been restated accordingly.

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

2. Discontinued Operations of Certain Operating Segments (continued)

Summarized operating results of the discontinued operations are as follows:


	Three months ended March 31,						Nine months ended March 31,
	2003			2004			2003			2004
Revenue	$	584,191		$	1,284		$	1,865,865		$	73,005
Net income (loss)	$	(303,674	)	$	(86,554	)	$	(599,369	)	$	(227,801	)

3. Debt, Commitments and Gain on Extinguishment of Debt

On September 11, 2003, the Company entered into a revolving line-of-credit agreement with a financial institution which expires September 2006, but is payable within 60 days of demand by the lender. This line of credit replaced the borrowing facility for $2.0 million that previously existed. The credit extended under this financing agreement is limited to the lesser of $2.0 million or 75% of the Company’s aggregate outstanding eligible accounts receivable. Borrowings under this line-of-credit bear interest at the higher of 7.5% or the prime rate plus 2.0% and are secured by the accounts receivable of the Company. In addition, the bank has the right to restrict any prepayment of other indebtedness by the Company.

In November 2003, the lender temporarily raised the credit limits to the lesser of $2.5 million or 75% of the Company’s eligible accounts receivable. These credit terms reverted back to the original $2.0 million limit in February 2004. The balance outstanding under this line-of-credit was $1.8 million at March 31, 2004.

On July 22, 2003, the Company entered into a marketing and channel distribution agreement with a software developer. Under this agreement, Avatech will provide marketing, distribution and related services for the developer’s products. In connection with this agreement, the software developer has agreed to fund certain marketing costs incurred by the Company. Additionally, the arrangement provides for a loan by the software developer to fund working capital needs related to the distribution of these products.

The terms of the loan agreement provide for a loan of $1,500,000 funded in two payments. Initial funding of $1,000,000 occurred on July 25, 2003 and the remaining $500,000 was provided on February 5, 2004. The loan agreement provides for repayment of principal plus interest at 6% per annum in thirty-five equal quarterly installments commencing in January 2005. The Company is required to meet certain financial and non-financial covenants in connection with this agreement.

At June 30, 2002, the Company was obligated to one of its suppliers under a note agreement in the amount of $2.96 million, bearing interest at 6.5% per annum. In August 2002, the Company entered into an agreement to extinguish the outstanding $2.96 million debt for a cash payment of $1.0 million and compliance with certain non-financial covenants. The gain on the extinguishment of the debt of $1.96 million was recorded in August 2002.

On January 1, 2004, the Company retired or refinanced $250,000 of subordinated notes payable. The Company paid $51,000 in cash to retire certain notes and issued new subordinated notes totaling $199,000. The new notes mature on July 1, 2005, with installment payments totaling $26,000 due on July 1, 2004. In conjunction with this refinancing, the Company issued 45,000 warrants to purchase common stock for $0.21 per share. These warrants expire on July 1, 2005 and were valued at $7,275.

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

3. Debt, Commitments and Gain on Extinguishment of Debt (continued)

On April 1, 2004, the Company refinanced a note payable to a director and shareholder. A $902,000 note was issued in satisfaction of the $893,795 aggregate balance outstanding on two $500,000 notes issued on May 28, 2003. The note accrues interest at a rate of 12% per annum, with quarterly interest payments due commencing July 1, 2004. Payment of the principle is due when the note matures on July 1, 2005.

Below is a summary of our contractual obligations and commitments at March 31, 2004:


	Payments due by Fiscal Period
	Total		2004		2005		2006		2007		2008 and thereafter
Contractual Obligations
Long-term debt and line-of-credit	$	4,387,314	$	1,800,831	$	111,964	$	1,231,661	$	171,428	$	1,071,430
Operating leases		4,313,464		244,697		901,546		837,874		726,720		1,602,627

Total obligations	$	8,700,778	$	2,045,528	$	1,013,510	$	2,069,535	$	898,148	$	2,674,057

4. Employee Stock Compensation Plans

The Company records compensation expense for all stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). Under APB No. 25, compensation expense is recorded over the vesting period to the extent that the fair value of the underlying stock on the date of grant exceeds the exercise or acquisition price of the stock or stock-based award. Financial Accounting Standards Board Statement No. 123, Accounting for Stock Based Compensation (“Statement 123”) encourages companies to recognize expense for stock-based awards based on their estimated fair value on the date of grant. Statement 123 requires the disclosure of pro forma income and earnings per share data in the notes to the financial statement if the fair value method is not adopted.

The following table illustrates the effect on net income (loss) and earnings (loss) per common share if the Company had applied the fair value recognition provisions of Statement 123 to stock-based employee compensation.


	Three Months Ended March 31,						Nine Months Ended March 31,
	2003			2004			2003			2004
Net income (loss), as reported	$	(758,792	)	$	170,362		$	(586,445	)	$	(327,176	)
Add: Stock-based employee compensation cost included in net income (loss), net of taxes		—			9,725			—			77,104
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of taxes		(32,222	)		(124,940	)		(124,337	)		(182,198	)

Pro forma net income (loss)		(791,014	)		55,147			(710,782	)		(432,270	)
Preferred stock dividends		—			9,463			—			36,842

Pro forma net income (loss) attributable to common stockholders	$	(791,014	)	$	35,684		$	710,782		$	(469,112	)

Net income (loss) per common share:
Basic – as reported	$	(0.08	)	$	0.02		$	(0.08	)	$	(0.04	)

Basic – pro forma	$	(0.09	)	$	0.00		$	(0.09	)	$	(0.05	)

Diluted – as reported	$	(0.08	)	$	0.00		$	(0.08	)	$	(0.04	)

Diluted – pro forma	$	(0.09	)	$	0.00		$	(0.09	)	$	(0.05	)

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

4. Employee Stock Compensation Plans (continued)

A summary of stock option activity during the nine months ended March 31, 2004 and related information is included in the table below:


	Options		Weighted- Average Exercise Price
Outstanding at July 1, 2003	554,386		$	1.88
Granted	862,866			0.41
Forfeited	(217,677	)		3.80

Outstanding at March 31, 2004	1,199,575		$	0.72

Exercisable at March 31, 2004	519,213		$	1.37

Weighted-average remaining contractual life	8.6 Years

Stock Option Cancellation Program and Fiscal Year 2004 Grants

In April 2003, the Company offered its employees a voluntary option to surrender and cancel certain outstanding stock option agreements. Under the terms of the arrangement, the employee, if still employed, was eligible to receive an equivalent number of stock options six months and a day after the specific cancellation periods with an exercise price equal to the market value of the common stock on the grant date. On November 4, 2003, the Company issued 274,486 options under this cancellation program that will vest over periods up to twenty-four months.

Employee Stock Purchase Plan

On September 24, 2003 the Company amended the Employee Stock Purchase Plan. The Plan allows for the board to provide offering periods, not to exceed 27 months in duration, to employees owning less than 5% of the total combined voting power or value of all classes of stock of the Company. Common shares sold under the Plan shall not exceed in the aggregate 450,000 shares. As of March 31, 2004, common stock sold under the Plan totaled 265,932 shares.

The Company initiated a six-month offering commencing January 1, 2004. Employees eligible to participate under the plan can accumulate funds, up to 15% of their compensation, to purchase common stock through payroll deductions. At the conclusion of the offering, shares will be purchased on behalf of the employees at a price per share equal to the lower of 85% of the quoted market value of the common stock on the first or last day of the offering.

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

4. Employee Stock Compensation Plans (continued)

Restricted Stock Award Plan

In July 2003, the Company issued 540,000 shares of restricted common stock with a quoted market value of $0.163 share, to certain officers as compensation. The common stock is restricted based on various vesting periods ranging from twelve to twenty-four months. Compensation expense for these awards of $93,000 is being recognized over the vesting period. The issuance resulted in compensation expense totaling $62,000 for the nine months ended March 31, 2004.

5. Stock Dividend

The Company’s Board of Directors authorized a three-for-one stock split in the form of a stock dividend, which was distributed to stockholders of record as of September 15, 2003 on October 1, 2003. All share and per share data included in the consolidated financial statements have been restated to reflect the stock split.

6. Preferred Stock

In the second quarter of fiscal year 2004, in connection with a Series D Convertible Preferred Stock (“Series D”) issuance, shareholders of Series C Convertible Preferred Stock were given the option to convert their shares to Series D Convertible Preferred Stock. On December 31, 2003, 172,008 shares of Series C Convertible Preferred Stock, representing all outstanding shares, were converted into 484,487 shares of Series D.

The Company also issued 813,050 shares of Series D for cash proceeds totaling $390,000 and a reduction in notes payable to a related party of $98,000. In connection with the issuance of Series D, 1.7 million warrants were granted to preferred shareholders. The warrants entitle the holder to purchase common stock at an exercise price of $0.45 per share during the warrant exercise period, not to exceed one year after the date of issuance.

The Series D Convertible Preferred shares outstanding at March 31, 2004 totaled 1,297,537, and were issued with the following terms:

Redemption Feature

The preferred stock is redeemable in the event that the Company is engaged in a business combination that is approved by the Board of Directors and subsequently submitted and approved by a vote of the Company’s shareholders. Any director who holds shares of Series D is not eligible to vote on the proposed business combination. The redemption price is $0.60 per share plus an amount equal to all declared and unpaid dividends accrued on such shares since the original issue date.

Voting Rights

Each holder of the preferred stock shall vote together with all other classes and series of stock of the Company as a single class on all actions. Each share shall entitle the holder to one vote per share of common stock into which the preferred stock is then convertible on each such action.

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

6. Preferred Stock (continued)

Dividend Rate

The holders of the Series D are entitled to receive cumulative dividends at a rate of 10.0% per annum when and as declared by the Board of Directors. Dividends are paid quarterly to preferred shareholders.

Conversion Feature

The preferred stock is convertible at any time beginning 120 days after the original issuance date at the option of the holder and automatically converts into common stock if the common stock trades for more than $2.25 per share for 60 consecutive trading days in such market.

Each share of preferred stock is convertible into shares of common stock by multiplying the appropriate conversion rate in effect by the number of shares of preferred stock being converted. Currently, the conversion rate is approximately two shares of common stock for each share of Series D; however, this rate may be further adjusted due to stock splits, dividends, and other events defined in the Certificate of Designation of Rights and Preferences of the Series D Convertible Preferred Stock.

Liquidation Preference

In the event of a liquidation, dissolution or winding up of the Company, the holders of Series D are entitled to receive for each share, prior and in preference to any distribution of any of the assets or surplus funds to the holders of common stock, an amount equal to $0.60 per share plus all accumulated but unpaid dividends. If upon the occurrence of such event, the assets and funds thus distributed among the holders are insufficient to permit the payment of the preferential amount, then the entire assets and funds of the Company legally available for distribution shall be distributed ratably among the preferred stockholders.

7. Stock Purchase Warrants

As of March 31, 2004, the Company has outstanding warrants to purchase common stock. A summary of the warrants is as follows:


Number of Shares	Exercise Price		Expiration Date
45,000	$	0.01	August 2013
97,200	$	0.27	June 2008
45,000	$	0.21	July 2005
180,000	$	43.33	February 2005
1,007,823	$	0.45	December 2004
722,220	$	0.45	November 2004
37,500	$	83.33	June 2004
18,750	$	6.67	June 2004

2,153,493

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

8. Earnings Per Share

Basic earnings (loss) per common share is computed as net income (loss) less preferred stock dividends divided by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share include the potential dilution that would occur from common shares issuable upon the exercise of outstanding stock options and warrants and the conversion of preferred stock.

The following summarizes the computations of basic and diluted earnings (loss) per share:


	Three Months Ended March 31,						Nine Months Ended March 31,
	2003			2004			2003			2004
Numerator used in basic earnings (loss) per common share:
Income (loss) from continuing operations	$	(455,118	)	$	256,916		$	12,924		$	(99,375	)
Less: preferred stock dividends		—			(19,463	)		—			(36,842	)

Income (loss) from continuing operations available to common stockholders		(455,118	)		237,453			12,924			(136,217	)
Income (loss) from discontinued operations, net of income taxes		(303,674	)		(86,554	)		(599,369	)		(227,801	)

Net income (loss) attributable to common stockholders	$	(758,792	)	$	150,899		$	(586,445	)	$	(364,018	)

Numerator used in diluted earnings (loss) per common share:
Income (loss) from continuing operations available to common stockholders	$	(455,118	)	$	237,453		$	12,924		$	(136,217	)
Effect of assumed conversion:
Preferred stock dividends		—			19,463			—			36,842
Income (loss) from continuing operations available to common stockholders, plus assumed conversions		(455,118	)		256,916			12,924			(99,375	)
Income (loss) from discontinued operations, net of income taxes		(303,674	)		(86,554	)		(599,369	)		(227,801	)

Income (loss) available to common stockholders, plus assumed conversions	$	(758,792	)	$	170,362		$	(586,445	)	$	(327,176	)

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

8. Earnings Per Share (continued)


	Three Months Ended March 31,						Nine Months Ended March 31,
	2003			2004			2003			2004
Denominators used in earnings (loss) per share calculations:
Denominator for basic earnings (loss) per share-weighted average shares outstanding		8,897,874			9,304,794			7,739,142			9,225,241

Effect of dilutive securities:
Stock options		—			170,923			—			89,399
Warrants		—			92,084			—			51,999
Restricted stock		—			212,500			—			233,773
Convertible preferred stock		—			2,597,236			—			980,417

Denominator for diluted earnings (loss)-weighted average shares outstanding and assumed conversion		8,897,874			12,377,537			7,739,142			10,580,829

Basic earnings (loss) per common share:
Income (loss) from continuing operations	$	(0.05	)	$	0.03		$	0.00		$	(0.02	)
Income(loss) from operations of discontinued operations, net of income taxes		(0.03	)		(0.01	)		(0.08	)		(0.02	)

Earnings (loss) per common share, basic	$	(0.08	)	$	0.02		$	(0.08	)	$	(0.04	)

Diluted earnings (loss) per common share:
Income (loss) from continuing operations	$	(0.05	)	$	0.02		$	0.00		$	(0.02	)
Income(loss) from operations of discontinued operations, net of income taxes		(0.03	)		(0.01	)		(0.08	)		(0.02	)

Earnings (loss) per common share, diluted	$	(0.08	)	$	0.01		$	(0.08	)	$	(0.04	)

Avatech Solutions, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

March 31, 2004 (continued)

9. Income Taxes

Income tax expense for the nine months ended March 31, 2003 and 2004 was approximately $400,000 and $32,000, respectively. In August 2002, the Company realized a $1.96 million taxable gain from the extinguishment of certain debt, which resulted in a net deferred tax asset of $373,000 being recorded at June 30, 2002. During the nine months ended March 31, 2003, the Company recorded deferred income tax expense of $373,000 related to the estimated reduction in deferred tax assets in fiscal year 2003. This increase in deferred income tax expense, coupled with certain state tax expense, resulted in the income tax expense for the nine months ended March 31, 2003. For the nine months ended March 31, 2004, income tax expense related solely to estimated state tax expense for the period.

10. Liquidity and Capital Resources

During fiscal year 2003, the Company incurred significant losses from its operations that depleted its capital resources. These losses were incurred primarily due to unexpected declines in revenue and losses and costs related to the acquisition of PlanetCAD Inc. In response, management has taken actions to close under-performing offices, significantly reduce overhead to improve operational efficiency, initiate new revenue programs and obtain additional financing. Management believes that the actions it has taken will allow the Company to aggressively pursue its business plan and return to profitability in the near term.

Based on an evaluation of the likely cash to be generated from operations in the near term and available capital resources, management believes that it has sufficient sources of working capital to fund its operations in the normal course of business through at least December 31, 2004.

11. Contingencies

The Company is a defendant in a lawsuit filed by a vendor for alleged breach of contract. The suit asks for actual damages totaling $178,000. Legal counsel engaged by the Company has advised that at this stage in the proceedings, they cannot offer an opinion as to the probable outcome, and accordingly, no amounts have been accrued at March 31, 2004. The Company believes the suit is without merit and is vigorously defending its position.

ITEM 2.

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

THE FOLLOWING DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS REPORT.

Certain statements set forth below constitute “forward-looking statements”. Such forward-looking statements involve known and unknown risk, uncertainties and other factors including, but not limited to, those discussed in our annual and quarterly reports, that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements implied by such forward-looking statements. These forward-looking statements may generally be identified by the use of the words “may”, “will”, “believe”, “should”, “expects”, “anticipates”, “estimates”, and similar expressions. Given these uncertainties, investors and prospective investors are cautioned not to place undue reliance on such forward-looking statements. We disclaim any obligation to update information contained in any forward-looking statement.

Overview

We are a leading provider of design automation and data management solutions for the manufacturing, building design, engineering, and total infrastructure and facilities management markets. We specialize in technical support, training and consulting aimed at improving design and documentation efficiencies and the seamless integration of workflow processes. These technology solutions enable our customers to enhance productivity, profitability and competitive position. We are one of the largest Autodesk software integrators worldwide and a leading provider of engineering document management solutions.

During the fall of 2003, we revised our growth strategy and began to focus on new ways of expanding our people resources, product offerings, and geographic “footprint.” We are accomplishing this strategy by:

•

restructuring our company to focus on three product groups: Design Automation (DA); Facility and Asset Management (F/AM); and Product Lifecycle Management (PLM),

•

employing highly qualified professionals in specialized areas,

•

expanding our product offerings to include SmarTeam PLM software, various F/AM software packages, and new internally-developed proprietary software to support our PLM solutions,

•

focusing on solutions and service selling.

This diversification strategy is intended to match our product and service offerings more precisely with the needs of our customers. In July 2003, we entered into an Authorized Reseller Agreement with Dassault Systèmes Corp., an international developer and distributor of PLM application software and services, whereby we will market and distribute Dassault’s SmarTeam PLM products in the United States. In connection with this agreement, Dassault provided us with certain financial assistance to create a dedicated PLM sales force and to conduct related marketing efforts. We plan to continue this strategy by expanding geographically through targeted mergers and acquisitions, opening new locations, and expanding international product distribution relationships.

Beginning in June 2003, we instituted a number of cost containment measures to align our selling, general and administrative expenses with our current revenue levels. We accomplished this plan by:

•

closing four underperforming offices;

•

terminating approximately 30 employees in June 2003; and

•

reducing our professional fees, telephone, supplies, marketing, and travel expenses.

In August 2003, we closed an additional office in California. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the results of operations of these operating units are treated as discontinued operations, and reported as a separate component of operating results in our consolidated statements of operations.

We considered these expense reduction measures necessary to help us reduce operating losses arising from the prolonged impact of economic recession on the software industry and also to help us achieve our revised strategy. Our consolidated financial statements for all interim periods and the fiscal years ended June 30, 2001, 2002 and 2003 have been restated to consistently present these operations as discontinued operations. Unless otherwise indicated, all amounts included in Management’s Discussion and Analysis of Financial Condition and Results of Operations are from continuing operations.

Product Sales. Our product sales consist primarily of the resale of packaged design software, including:

•

Autodesk design automation software for mechanical, architectural, civil, and discreet products;

•

Archibus facilities management software for space planning, strategic planning, and lease/property administration;

•

Cyco engineering data management solutions using meridian software; and

•

Dassault’s SmarTeam PLM software.

We also offer Autodesk’s subscription programs, which entitle subscribers to receive software upgrades, web support and eLearning lessons directly from Autodesk. Because we do not participate in the delivery of these subscription products or the web support and eLearning lesson benefits, we record the net fee we earn from the sale of Autodesk software subscriptions as revenue. Approximately 92% of our total product revenues are related to the resale of Autodesk products.

Service Revenue. We provide services in the form of training, consulting services, professional services and technical support to our design automation, PLM and Facilities/Asset Management customers. We employ a technical staff of 44 personnel associated with these types of services. In the third quarter of fiscal year 2004, we revised our sales commission plan to focus on increasing service sales while achieving higher service margins. Additionally, we also offer our customers an assessment tool to analyze the ability and knowledge of current and potential employees in computer aided design.

Commission Revenue. We generate commission revenue from the resale of Autodesk software to various customers, a number of which Autodesk considers “major accounts.” Autodesk designates these customers as major accounts based on specific criteria, primarily sales volume, and typically gives these customers volume discounts. We are responsible for managing and reselling Autodesk products to a number of these major account customers. Autodesk determines the price the customer pays for the product and ships the product directly to the customer. We then receive commissions upon shipment of the product from Autodesk to the customer based on the product sales price.

Cost of Product Sales. Our cost of product sales consists of the cost of purchasing products from software suppliers or hardware manufacturers. We also include the associated shipping and handling costs in cost of product sales.

Cost of Service Revenue. Cost of service revenue includes the direct costs associated with the implementation of software and hardware solutions as well as training, support services, and professional services. These costs consist primarily of compensation, benefits, travel, and the costs of third-party contractors engaged by us. Our cost of service revenue does not include an allocation of overhead costs.

Selling, General and Administrative Expense. Selling, general and administrative expense consists primarily of compensation and other expenses associated with management, finance, human resources, and information systems. We also include advertising and public relations expenses, as well as expenses for facilities such as rent and utilities, in selling, general and administrative expense.

Depreciation and Amortization Expense. Depreciation and amortization expense represents the period costs associated with our investment in property and equipment, consisting principally of computer equipment, software, furniture and fixtures, and leasehold improvements. We compute depreciation and amortization expense using the straight-line method over estimated useful lives. We lease all of our facilities and depreciate leasehold improvements over the lesser of the lease term or the useful life of the asset.

Interest Expense. Interest expense consists primarily of interest on our revolving line-of-credit and subordinated debt, which we incurred to fund operations over the past three years.

Critical Accounting Policies

General. Our consolidated financial statements are impacted by the accounting policies used and the estimates and assumptions made by management during their preparation. Critical accounting policies and estimates that impact the consolidated financial statements are those that relate to software revenue recognition and estimates of bad debts. We discuss all of these critical accounting policies with our Audit Committee on a periodic basis. Presented below is a description of the accounting policies that are most critical to an understanding of our consolidated financial statements.

Software Revenue Recognition. We derive most of our revenue from the resale of packaged software products. Our product sales may also include hardware that we may purchase for the convenience of our customers. Historically, we have not experienced significant customer returns. We earn service revenue from training and other professional services, which often are related to the products that we sell but are not essential to the functionality of the software. We offer annual support contracts to our customers for the software products that we sell, or we offer maintenance and support services under hourly billing arrangements.

We recognize revenue from software arrangements in accordance with the provisions of AICPA Statement of Position No. 97-2, “Software Revenue Recognition,” as amended by SOP No 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” Prior to recognizing any revenue under these arrangements, (1) persuasive evidence of an arrangement must exist, (2) delivery of the software or service must have occurred, (3) all fees must be assessed as fixed or determinable and (4) all fees must be probable of collection. We determine whether criteria (3) and (4) have been satisfied based on our judgment regarding the fixed nature of the fee charged for services rendered and products delivered and the collectibility of such fee. Revenue recognized in a reporting period could be adversely affected if future changes in conditions related to a transaction cause us to determine these criteria are not met. In the past, we have not needed to adjust our reported revenue due to changes in conditions, and we continue to evaluate current conditions that may affect the nature and timing of our revenue recognition.

Our customer arrangements can involve the sale of one or more elements. When this occurs, we allocate revenue to each element based on the relative fair value of each element. We limit the assessment of fair value to the price that we charge when the element is sold separately. All of the elements included in the multiple element arrangements have been analyzed by management, which may include products that are resold, training and other professional services, and support services. We have determined that sufficient evidence of the fair value based on these separate sales exists to allocate revenue to the specified elements. We recognize training and other professional services revenue as services are delivered and recognize support revenue ratably over the respective contract term. We include all unrecognized fees that have been billed in our deferred revenue.

Bad Debts. We maintain an allowance for doubtful accounts for estimated losses which may result from the inability of our customers to pay for purchased products and services or for disputes that affect our ability to fully collect our accounts receivable. We estimate this allowance by reviewing the status of our past-due accounts and record general reserves based on our historical bad debt expense. Our actual experience has not varied significantly from our estimates; however, if the financial condition of our customers were to deteriorate, resulting in their inability to pay for products or services, we may need to record additional allowances in future periods. To mitigate this risk, we perform ongoing credit evaluations of our customers.

Three and Nine Months Ended March 31, 2003 Compared to the Three and Nine Months Ended March 31, 2004

The following table sets forth a comparison of three and nine month selected item totals in the year 2004 compared to the same periods in the year 2003. These totals are represented by selected items reflected in our unaudited Consolidated Statements of Operations included elsewhere in this report. The three and nine months financial results are not necessarily indicative of future results.

Revenues. Our total revenues include product sales, service revenue and commission revenue.


	Three Months Ended March 31,
	2003		2004		%
Revenue:
Product sales	$	3,289,161	$	5,086,415	54.6	%
Service revenue		1,452,621		1,336,533	(8.0	)%
Commission revenue		1,326,651		1,413,097	6.5	%

Total revenue	$	6,068,433	$	7,836,045	29.1	%

	Nine Months Ended March 31,
	2003		2004		%
Revenue:
Product sales	$	9,344,490	$	13,774,812	47.4	%
Service revenue		4,488,949		4,096,710	(8.7	)%
Commission revenue		3,254,079		3,697,908	13.6	%

Total revenue	$	17,087,518	$	21,569,430	26.2	%

Revenues. Total revenue for the three months ended March 31, 2004 increased $1.8 million, or 29.1% to $7.8 million, compared to $6.1 million for the same period in 2003. Total revenue for the nine months ended March 31, 2004 increased $4.5 million, or 26.2% to $21.6 million, compared to $17.1 million for the same period in 2003.

Product sales for the three months ended March 31, 2004 increased $1.8 million, or 54.6% to $5.1 million, compared to $3.3 million for the same period in 2003. Product sales for the nine months ended March 31, 2004 increased $4.4 million, or 47.4% to $13.8 million, compared to $9.3 million for the same period in 2003. Our product sales have increased due to increased sales volume caused by several factors. During fiscal year 2004, demand for Autodesk products increased, caused in part by product upgrades required by our customers in order to continue to receive product maintenance services and an overall improvement in economic conditions. Also, during the month of October 2003, we reduced prices when Autodesk reduced the price we pay for products by 20% under a short-term promotional program which increased our volume of units delivered. Product retirement and price reduction has contributed to our increase in product sales.

Service revenue for the three months ended March 31, 2004 decreased $116,000, or 8.0% to $1.3 million, compared to $1.5 million for the same period in 2003. Service revenue for the nine months ended March 31, 2004 decreased $392,000 to $4.1 million, compared to $4.5 million for the same period in 2003. These decreases in service revenue are the result of the market focusing on product upgrades from discontinued products and a reduction in the number of service employees dedicated to service activities.

Commission revenue for the three months ended March 31, 2004 increased $86,000, or 6.5% to $1.4 million, compared to $1.3 million for the same period in 2003. Commission revenue for the nine months ended March 31, 2004 increased $444,000, or 13.6% to $3.7 million, compared to $3.3 million for the same period in 2003. The increase in commission revenues is consistent with the revenue increases we experienced in product sales resulting from an improved economy, Autodesk’s promotional activities, and demand caused by customers upgrading their software.

Cost of Revenue.


	Three Months Ended March 31,
	2003		2004		%
Cost of revenue:
Cost of product sales	$	2,247,821	$	3,472,919	54.5	%
Cost of service revenue		898,995		912,379	1.5	%

Total cost of revenue	$	3,146,816	$	4,385,298	39.4	%


	Nine Months Ended March 31,
	2003		2004		%
Cost of revenue:
Cost of product sales	$	6,386,221	$	9,887,768	54.8	%
Cost of service revenue		2,708,834		3,019,153	11.5	%

Total cost of revenue	$	9,095,055	$	12,906,921	41.9	%

Cost of Product Sales. Cost of product sales for the three months ended March 31, 2004 increased $1.2 million, or 54.5%, to $3.5 million, compared to $2.2 million for the same period in 2003. Cost of product sales for the nine months ended March 31, 2004 increased $3.5 million, or 54.8%, to $9.9 million, compared to $6.4 million for the same period in 2003. Although our revenues have increased in fiscal year 2004, our product margins have declined from 31.7% for the nine months ended March 31, 2003 to 28.2% for the nine months ended March 31, 2004. Our product margins decreased as a result of several factors. Our major vendor, Autodesk, changed our cooperative advertising program to increase the price we pay for Autodesk products, while increasing the payments we receive from Autodesk. This program is a supplemental marketing plan designed to help support our selling opportunities and develop increased Autodesk product sales. In addition, we have strategically reduced the price we charge our customers for certain products to obtain additional sales volume in the first nine months of fiscal year 2004.

Cost of Service Revenue. Cost of service revenue for three months ended March 31, 2004 remained consistent with the corresponding quarter in fiscal 2003. However, as a percentage of related service revenue, cost of service revenue increased to 68% from 62% in the same period last year. The decline in our service revenue margins is the direct result of an 8% reduction in service revenue, while our direct labor costs, the largest component of cost of service revenues, remained constant. For the nine months ended March 31, 2004 our cost of service revenue as a percentage of revenue increased to 74% from 60%. This decrease in service revenue margin is the result of a 9% decrease in service revenues from the same period in 2003 and our strategy of redirecting some service employees to our new lines of business. We are currently focused on developing our PLM and F/AM markets for products and related services, and until such time as we generate significant revenue from these new product and service offerings, our margins will be affected by our investment in a professional, well-trained service staff. We expect that as our service revenues from F/AM and PLM services increase, our margins will likely return to historical levels.

Other Expenses.


	Three Months Ended March 31,
	2003		2004		%
Other expenses:
Selling, general and administrative	$	3,222,012	$	2,970,289	(7.8	)%
Depreciation and amortization		60,516		81,691	35.0	%

Total other expenses	$	3,282,528	$	3,051,980	(7.0	)%


	Nine Months Ended March 31,
	2003		2004		%
Other expenses:
Selling, general and administrative	$	8,989,109	$	8,135,275	(9.5	)%
Depreciation and amortization		290,705		231,317	(20.4	)%

Total other expenses	$	9,279,814	$	8,366,592	(9.8	)%

Selling, General and Administrative. Selling, general and administrative expenses for the three months ended March 31, 2004 decreased $252,000 or 7.8%, to $3.0 million, compared to $3.2 million for the same period in 2003. Selling, general and administrative expenses for the nine months ended March 31, 2004 decreased $854,000 or 9.5%, to $8.1 million, compared to $9.0 million for the same period in 2003. We attribute this decrease in selling, general and administrative expenses to our restructuring efforts in the fourth quarter of 2003, as discussed more fully in our 2003 Annual Report on Form 10-K. Although we had increases in our insurance and professional fees of approximately $150,000, our decreases in other areas such as travel, facilities and maintenance, salaries and commissions, and marketing expenses significantly reduced our selling general and administrative expenses. The decrease in travel expenses was a result of our focusing on controlling travel expenses by contracting with a travel agency. Also, vendor cooperative marketing program credits are now being off set against marketing expenses.

Depreciation and Amortization. Depreciation and amortization expense for the three months ended March 31, 2004 increased $21,000 or 35%, to $82,000, compared to $61,000 for the same period in 2003. Depreciation and amortization expense for the nine months ended March 31, 2004 decreased $59,000, or 20.4%, to $231,000, compared to $291,000 for the same period in 2003. Depreciation and amortization of property and equipment for the three month period ending March 31, 2004 increased as a result of investing in our infrastructure. We increased capital expenditures for computer equipment and application software by $85,000. Depreciation and amortization of property and equipment for the nine month period ending March 31, 2003 decreased because of an increase in the number of fully depreciated assets compared to the prior period.

Other Income Expense.


	Three Months Ended March 31,
	2003			2004			%
Other income (expense)
Minority Interest	$	(38,125	)	$	(38,125	)	—
Interest and other income (expense)		3,907			5,260		34.6	%
Interest expense		(59,989	)		(98,158	)	59.6	%

	$	(94,207	)	$	(131,023	)	39.1	%


	Nine Months Ended March 31,
	2003			2004			%
Other income (expense)
Gain on extinguishment of debt	$	1,960,646		$	—		(100.0	)%
Minority interest		(56,016	)		(114,375	)	104.2	%
Interest and other income (expense)		13,232			9,553		(27.8	)%
Interest expense		(217,222	)		(258,642	)	18.5	%

	$	1,700,640		$	(363,464	)	(121.3	)%

Other Income (Expense). Other income (expense) for the three months ended March 31, 2004 decreased $37,000, or 39.1%, to $(131,000) compared to $(94,000) for the same period in 2003. Other income (expense) for the nine months ended March 31, 2004 decreased $2.1 million, to $(363,000), compared to $1.7 million for the same period in 2003. Included in other income for the nine month period ended March 31, 2003 was a $2.0 million gain from the extinguishment of debt resulting from the payment to a significant supplier of $1.0 million in full satisfaction of a $3.0 million loan made to us by that supplier in 1999. Due to an increase in our outstanding borrowings, we expect our interest expense to increase in 2004. As discussed more fully in Note 3 to the consolidated financial statements, we have borrowed $1.5 million with interest at 6% per annum to assist us with working capital needs, $500,000 of which was received in February 2004.

Income Tax Expense.


	Three Months Ended March 31,
	2003		2004		%
Income tax expense (benefit)	$	—	$	10,828	100	%


	Nine Months Ended March 31,
	2003		2004		%
Income tax expense (benefit)	$	400,365	$	31,828	(92.1	)%

Income Tax Expense. Income tax expense for the three months ended March 31, 2004 increased $11,000, compared to $0 for the same period in 2003. Income tax expense for the nine months ended March 31, 2004 decreased $369,000, or 92.1% to $32,000, compared to $400,000 for the same period in 2003. In August 2002, we realized a $2.0 million taxable gain from the extinguishment of certain debt (described above), which resulted in us recording a net deferred tax asset of $373,000 at June 30, 2002. In fiscal year 2003, we recorded deferred income tax expense of $373,000 related to the estimated reduction in deferred tax assets in 2003. Our income tax expense in fiscal year 2004 is expected to relate solely to state income tax expense, which we expect to be approximately $40,000 for the full year.

Discontinued Operations.


	Three Months Ended March 31,
	2003			2004			%
Discontinued Operations	$	(303,674	)	$	(86,554	)	(71.5	)%

	Nine Months Ended March 31,
	2003			2004			%
Discontinued Operations	$	(599,369	)	$	(227,801	)	(62.0	)%

Discontinued Operations. Discontinued operations for the three months ended March 31, 2004 decreased $217,000, or 71.5%, to $(87,000), compared to $(304,000) for the same period in 2003. Discontinued operations for the nine months ended March 31, 2004 decreased $372,000, or 62%, to $(228,000), compared to $(599,000) for the same period in 2003. All operating results for the offices closed in June of 2003 are included in discontinued operations. Also, in August of 2003, we closed the California office and the results from operations were included in discontinued operations. For the three and nine months period ended March 31, 2004, the results of discontinued operations consist primarily of the cost of closing offices, and legal costs and maintenance fees associated with PlanetCAD operations. We do not anticipate additional material expenses.

Liquidity and Capital Resources

Historically, we have financed our operations and met our capital expenditure requirements primarily through cash flows provided by operations, borrowings under short-term and long-term debt arrangements and sales of preferred stock. Our outstanding debt totaled $4.4 million at March 31, 2004, and we had a deficiency of working capital of $2.0 million.

Our deficiency of working capital is in large part caused by the classification of our line of credit as a current liability due to its demand provisions. Our line of credit with K Bank allows us to borrow up to $2.0 million (on November 24, 2003, this line of credit was temporarily increased to $2.5 million through January 31, 2004), limited to 75% of eligible accounts receivable. At March 31, 2004, our outstanding balance under this line-of-credit totaled $1.8 million. The line-of-credit expires in three years and is payable within 60 days of demand. Despite the existence of the 60-day demand provision on this line-of-credit, we do not believe it is likely that the bank will exercise the demand provisions of the agreement. In the event that the bank does so, we believe that other lenders would provide us with a line of credit with similar terms, as long as our financial position and results of operations have not significantly declined.

During the nine month period ended March 31, 2004, we used $1.7 million of cash in operations primarily as a result of our loss of $327,000 and working capital needs of $1.7 million. Our working capital needs increased as a result of increases in accounts receivable caused by higher revenues. During the nine month period ended March 31, 2004, our revenues increased about $4.3 million to $21.6 million compared

to $17.2 million recognized in the nine month period ended June 30, 2003, which led to a corresponding increase in our accounts receivable balance of about $961,000 between June 30, 2003 and March 31, 2004. In addition, our accounts payable and accrued expenses decreased by $706,000 since June 30, 2003, principally because we paid certain expenses related to our 2003 merger with PlanetCAD. We financed these operating cash requirements through borrowings of $1.5 million from a software developer and vendor, and the cash proceeds of $390,000 from the sale of preferred stock and stock purchase warrants. We purchase over 90% of the products we sell from Autodesk, which provides us with the ability to purchase up to $3.0 million of inventory under 60 to 90 day payment terms. Historically, we have been able to manage our average days sales outstanding in a range from 50 to 60 days. Our customary collection terms range from 30 to 60 days for all of our customers.

Prior to the merger with PlanetCAD, Inc., we had outstanding $1.7 million of 10% subordinated notes. The notes were to mature on July 1, 2003 and interest was payable quarterly until maturity or prepayment. On November 19, 2002, with the completion of the merger with PlanetCAD, subordinated note holders owning an aggregate of $1.5 million of subordinated notes exchanged their notes for preferred stock in Avatech Solutions, Inc. Subsidiary.

On July 22, 2003, we entered into a loan agreement with a software developer to borrow up to $1.5 million for working capital purposes. The loan was received in two payments, with the initial funding of $1.0 million occurring on July 25, 2003 and the remaining $500,000 provided on February 5, 2004. The loan agreement requires repayment of principal plus interest at 6% per annum in thirty-five equal quarterly installments beginning in January 2005. We must meet certain financial and non-financial covenants in connection with this agreement.

Additionally, we have outstanding borrowings of approximately $894,000 at March 31, 2004 that are payable to a director and shareholder. On April 1, 2004, the maturity date of these borrowings was extended to July 1, 2005. Currently, we expect to be able to pay down this outstanding debt as of the maturity date.

Our investment activities consist principally of investments in computer and office equipment. Our capital expenditures for the nine months ended March 31, 2004 were approximately $184,000 compared to $168,000 for the same period in 2003. In order to maintain current operations, we believe that our average annual outlay for investments in computer and office equipment will be consistent with the previous year.

As described more fully above, our financing activities in all periods have consisted principally of borrowings and repayments under our lines of credit. Net borrowings (repayments) under lines of credit were $220,000 in 2003 and $171,000 for nine months ended March 31, 2004.

We expect to generate income from our operations before non-cash charges for the remaining three months of fiscal year 2004. Our working capital needs are expected to stabilize, and we believe our needs can be met from the $500,000 of borrowings that we made in February 2004, as well as our available cash resources and line of credit. We do not have any material commitments to acquire property and equipment, and our capital equipment needs for the next twelve months are expected to be insignificant. Because of our reliance on Autodesk to supply us with the products that we sell, and due to the concentration of our revenues from the sale of Autodesk products, we cannot readily predict our ability to generate sufficient cash from our operations to meet our obligations beyond December 31, 2004. In the event that our operating results decline and we are unable to generate cash flows from our operations in the near term, then we may be unable to meet our existing obligations in the normal course of business and expand our operations to allow for continued long-term improvement in operating results.

Below is a summary of our contractual obligations and commitments at March 31, 2004:


	Payments due by Fiscal Period
	Total		2004		2005		2006		2007		2008 and thereafter
Contractual Obligations
Long-term debt and line-of-credit	$	4,387,314	$	1,800,831	$	111,964	$	1,231,661	$	171,428	$	1,071,430
Operating leases		4,313,464		244,697		901,546		837,874		726,720		1,602,627

Total obligations	$	8,700,778	$	2,045,528	$	1,013,510	$	2,069,535	$	898,148	$	2,674,057

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Avatech is exposed to market risk from changes in interest rates associated with its variable rate line-of-credit facility. At March 31, 2004, approximately 41% of the Company’s outstanding debt bears interest at variable rates. Accordingly, the Company’s earnings and cash flow are affected by changes in interest rates. Assuming the current level of borrowings at variable rates and assuming a 100 basis point changes in the 2004 average interest rate under these borrowings, it is estimated that the Company’s 2004 interest expense and net income would have changed by less than $20,000. In the event of an adverse change in interest rates, management would likely take actions to further mitigate its exposure. However, due to the uncertainty of the actions that would be taken and their possible effects, the analysis assumes no such actions. Further, the analysis does not consider the effects of the change in the level of overall economic activity that could exist in such an environment.

ITEM 4.

CONTROLS AND PROCEDURES

The Company maintains a system of disclosure controls and procedures that is designed to provide reasonable assurance that information, which is required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934, as amended, is accumulated and communicated to management in a timely manner. The Company’s Chief Executive Officer and Interim Chief Financial Officer have evaluated this system of disclosure controls and procedures as of the end of the period covered by this quarterly report, and believe that the system is operating effectively to ensure appropriate disclosure. There have been no changes in the Company’s internal controls over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

Part II. OTHER INFORMATION

Item 1.

Legal Proceedings

On October 15, 2003, we were sued by Inter-Tel Leasing, Inc. in the District Court in Harris County, Texas (Case No. 03-57866). The suit claims that we defaulted on the lease of equipment from Inter-Tel and demands $149,617 for the rental of the equipment, immediate possession of the leased property, and attorney fees estimated at $29,923.

We filed an answer, a verified denial and an affirmative defense on December 5, 2003 and have demanded that Inter-Tel dismiss the claim against Avatech because Inter-Tel has named the wrong party in this action. Although Spatial Technology, Inc. (“Spatial Technology”), a predecessor of Avatech, on June 2, 2000, entered into a Lease Agreement with Inter-Tel, Inter-Tel agreed on September 9, 2000 to Spatial Technology’s assignment of the Lease Agreement to Spatial Components, LLC (“Spatial Components”). Spatial Components was a wholly owned subsidiary of Spatial Technology, and was sold to Dassault Systemes Corporation in November of 2000. Spatial Components has since changed its name to Spatial Corp.

Inter-Tel is investigating adding Spatial Corp; as a defendant, but has not yet taken any action. If Inter-Tel does not dismiss the suit against us, we may file a cross-claim against Spatial Corp. We believe that we have meritorious defenses to this claim, but we are unable to assess our potential liability at this time.

Item 2.

Changes in Securities

On January 1, 2004, a consolidated subsidiary issued 10% subordinated notes for an aggregate total of $135,000 due on July 1, 2005 to three “accredited investors” in exchange for these investors’ agreement to cancel existing 10% subordinated notes for an aggregate total of $150,000 due on December 31, 2003 and cash totaling $15,000 in aggregate. Two of these 10% notes require an interim payment of $15,000 in aggregate, due on July 1, 2004. Each of these investors also received warrants to purchase 15,000 shares of our common stock at $0.21 per share, which expire on July 1, 2005.

Also on January 1, 2004, the same subsidiary issued 12% subordinated notes for an aggregate total of $63,750 due on July 1, 2005 to three “accredited investors” in exchange for those investors’ agreement to cancel existing 12% subordinated notes for an aggregate total of $75,000 due on December 31, 2003 and cash in the aggregate amount of $11,250. These 12% notes require an interim payment of $11,250 in aggregate, due on July 1, 2004.

Because these issuances were to “accredited investors” within the meaning of Rule 501 under the Securities Act, the offer and sale of these securities was exempt from registration under Rule 506 of the Securities Act.

On April 1, 2004, the Company issued a senior subordinated note in principal amount of $902,169 to an accredited investor in satisfaction of the balance outstanding on certain notes issued to that investor in May 2003. The new note accrues interest at a rate of 12% per annum, with quarterly interest payments due commencing July 1, 2004, and matures on July 1, 2005. Because this note was issued by the Company in exchange for notes originally issued by the Company to the note holder, and no commission or other remuneration was paid or given for soliciting the exchange, the offer and sale of this note was exempt from registration under Section 3(a)(9) of the Securities Act.

Item 3.

Defaults Upon Senior Securities

None

Item 4.

Submission of Matters to a Vote of Security Holders

None

Item 5.

Other Information

None

Item 6.

Exhibits and Reports on Form 8-K

(a) Exhibits required to be filed by Item 601 of Regulation S-K


Exhibit No.		Description of Exhibit

2.1		Agreement and Plan of Merger ^a

3.1		Restated Certificate of Incorporation ^b

3.2		First Amendment to Restated Certificate of Incorporation ^b

3.3		Reverse Split Amendment to Restated Certificate of Incorporation ^a

3.4		Amendment of PlanetCAD’s Certificate of Incorporation to change the name of PlanetCAD, Inc. to Avatech Solutions, Inc. ^a

3.5		Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock ^c

3.6		Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stock ^d

3.7		Certificate of Designation, Preferences and Rights of Series C Convertible Preferred Stock ^e

3.8		Certificate of Amendment to Certificate of Designation of Series C Convertible Preferred Stock ^h

3.9		Certificate of Designation, Preferences and Rights of Series D Convertible Preferred Stock ^h

3.10		Certificate of Elimination of Series A Junior Participating Preferred Stock ^h

3.11		Certificate of Elimination of Series C Convertible Preferred Stock ^h

3.12		Certificate of Amendment to Certificate of Designation of Series D Convertible Preferred Stock ^h

3.13		By-Laws ^b

10.01		Autodesk Authorized Channel Partner Agreement by and among Avatech Solutions, Inc. and Autodesk, Inc. effective as of February 1, 2003 ^h

10.02		Autodesk Authorized Channel Partner Agreement by and among Avatech Solutions, Inc. and Autodesk, Inc. effective as of February 1, 2004 ^h

10.03		Loan Agreement by and between Avatech Solutions Subsidiary, Inc. and a Strategic Partner dated July 22, as amended (portions of this exhibit have been omitted and filed separately with the U.S. Securities and Exchange Commission pursuant to a request for confidential treatment) ^f

10.04		Security Agreement by and between Avatech Solutions Subsidiary, Inc. and a Strategic Partner dated July 22, 2003 (portions of this exhibit have been omitted and filed separately with the U.S. Securities and Exchange Commission pursuant to a request for confidential treatment) ^f

10.05		Demand Promissory Note by and between Avatech Solutions Subsidiary, Inc. and Key Bank and Trust in the amount of $2,000,000 dated September 11, 2003 ^f

10.06		Loan and Security Agreement by and between Avatech Solutions Subsidiary, Inc. and Key Bank and Trust dated September 11, 2003 ^f

10.07		Master Lease Agreement by and between Allstate Leasing, Inc. and Avatech Solutions, Inc. dated July 17, 2001 ^a

10.08		Form of Promissory Note, principal amount $500,000.00, issued by Avatech Solutions, Inc. in favor of W. James Hindman dated May 28, 2003 ^f

10.09		Warrants to purchase up to 32,400 shares of Common Stock issued by Avatech to W. James Hindman dated May 28, 2003 ^f

10.10		Affidavit and Discharge of Indebtedness by W. James Hindman ^f


Exhibit No.		Description of Exhibit

10.11		Form of 10% Subordinated Note with attached Warrant issued by Avatech Solutions, Inc. to certain note holders in connection with Avatech Solutions Subsidiary, Inc.’s 1998 $2,600,000 Subordinated Debt Offering, dated January 1, 2004 ^h

10.12		Form of 12 % Subordinated Note issued by Avatech Solutions, Inc. to certain note holders in connection with Avatech Solutions Subsidiary, Inc.’s 1998 $2,600,000 Subordinated Debt Offering dated January 1, 2004 ^h

10.13		Form of Purchase Agreement for Series D Convertible Preferred Stock ^h

10.14		2002 Stock Option Plan ^a

10.15		Restricted Stock Award Plan ^e

10.16		Employment Agreement by and between Debra Keith and Avatech Solutions, Inc. dated as of April 4, 2003 ^f

10.17		Employment Agreement by and between Eric L. Pratt and Avatech Solutions, Inc. dated April 15, 2003 ^g

10.18		Employment Agreement by and between Scott N. Fischer and Avatech Solutions, Inc. dated as of March 17, 2003 ^f

10.19		Consulting Agreement by and between V. Joel Nicholson and Avatech Solutions, Inc. effective as of June 1, 2003 ^g

10.20		Employment Agreement by and between Donald R. “Scotty” Walsh and Avatech Solutions, Inc. dated July 1, 2003 ^f

10.21		Letter Agreement by and between Henry D. Felton and Avatech Solutions, Inc. dated August 21, 2003 ^f

10.22		Form of Promissory Note, principal amount $902,168.80, issued by Avatech Solutions, Inc. in favor of W. James Hindman dated April 1, 2004 *

10.23		Separation Agreement between Scott Fischer and Avatech Solutions, Inc. dated as of March 10, 2004 *

31.1		Certification of Donald R. “Scotty” Walsh, Chief Executive Officer *

31.2		Certification of Beth O. MacLaughlin, Chief Financial Officer *

32.1		Section 1350 Certifications *

*	Filed herewith

^a.	Incorporated by reference to our Registration Statement on form S-4 filed on May 30, 2002, File No. 333-89386.

^b.	Incorporated by reference to our Registration Statement on form SB-2 filed on November 21, 2000, File No. 333-50426.

^c.	Incorporated by reference to our Registration Statement on form 8-A filed on March 11, 2002, File No. 001-31265.

^d.	Incorporated by reference to our Current Report on form 8-K, filed on May 28, 2002, File No. 001-31265.

^e.	Incorporated by reference to our Amended Registration Statement on form S-1, filed on April 11, 2003, File No. 333-104035.

^f.	Incorporated by reference to our Annual Report on form 10-K, filed on October 3, 2003, File No. 001-31265.

^g.	Incorporated by reference to our Amended Registration Statement on form S-1, filed on June 4, 2003, File No. 333-104035.

^h.	Incorporated by reference to our Quarterly Report on form 10-Q, filed on February 13, 2004, File No. 001-31265.

(b) Reports on Form 8-K

Registrant filed Current Reports on Form 8-K during the quarter for which this report is filed:

On February 17, 2003, we filed a Report on Form 8-K to announce the filing of our Quarterly Report on Form 10-Q for the three-month period ended December 31, 2003.

On January 21, 2004, we filed a Report on Form 8-K to announce the closing of the private placement of Series D Convertible Preferred Stock and warrants.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	AVATECH SOLUTIONS, INC. AND SUBSIDIARIES

Date: May 17, 2004	By	/s/ Donald R. “Scotty” Walsh

		Donald R. “Scotty” Walsh Chief Executive Officer

Date: May 17, 2004	By	/s/ Beth MacLaughlin

		Beth MacLaughlin Interim Chief Financial Officer (principal financial and accounting officer)