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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended June 30, 2004

For the transition period from              to             

Commission File Number: 0-23634

KFX INC.

(Exact name of registrant as specified in its charter)

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

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

On August 2, 2004 there were 59,946,903 shares of the registrant’s common stock, $.001 par value, outstanding.

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KFX INC.

FORM 10-Q QUARTERLY REPORT

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

KFX INC.

CONSOLIDATED BALANCE SHEETS

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

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KFX INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

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

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KFX INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

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

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KFX INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Dollars and Shares in Thousands)

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

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KFX INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

Six Months Ended June 30, 2004:

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

Six Months Ended June 30, 2003:

None

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KFX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(UNAUDITED)

NOTE 1. BASIS OF PRESENTATION

Nature of Operations

KFx Inc. is a “clean energy” technology company with a patented process, which we refer to as K-Fuel^™ (“K-Fuel”) technology that adds value to coal producers and the electric power generation industry by significantly improving the quality of 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. This facility provides critical information to our potential customers and governmental agencies in assessing the benefits of the K-Fuel process.

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

Consolidation Policy

The consolidated financial statements include the accounts of KFx and its wholly-owned subsidiaries, K-Fuel LLC (“KFL”), KFx Technology, Inc. (“KFxT”) and Advanced Coal Processing, Inc. (“ACP”), formerly KFx Wyoming, Inc. For the quarter and six months ended June 30, 2004 the consolidated financial statements also include the accounts of KFx’s wholly-owned subsidiary, Landrica Development Company (“LDC”) and majority-owned subsidiary KFx-Lurgi (Pty) Ltd (“KLL”), a South African registered entity. The consolidated Statement of Operations and Statement of Cash Flows (for cash provided by discontinued operations) for the period ended June 30, 2003 were revised to reflect the discontinued operations of Pegasus Technologies, Inc. (“Pegasus”). A detailed description of the equity transfer transaction involving Pegasus and KFL is provided in Note 2. Prior to November 26, 2003, the operations of KFL were accounted for as an equity investment since the 49% partner, Kennecott Energy Company, had certain participative rights.

Revenue

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

Pegasus Software License and Services Revenue

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

Where services were essential to the functionality of the delivered software, the license fee and services revenue was generally recognized using the percentage-of-completion method of accounting, as prescribed by SOP 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” The percentage of completion for each contract was determined based on the ratio of direct labor hours incurred to total estimated direct labor hours required to complete the contract. The Company may have periodically encountered changes in costs, estimated costs and other factors that may have led to a change in the original estimated profitability of a fixed-price contract. In such circumstances, adjustments to cost and profitability estimates were made in the periods in which the underlying factors requiring such revisions became known. If such revisions indicated a loss on a contract, the entire loss was recorded at such time. Amounts billed in advance of services being performed were recorded as deferred revenue. Unbilled work-in-progress

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represents revenue earned but not yet billable under the terms of fixed price contracts and all such amounts were expected to be billed in accordance with performance milestones specified in the contract and collected within twelve months. Deferred job costs represent up-front hardware costs incurred that would be amortized to expense over the term of related revenue recognition.

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

Engineering and Technical Services

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

Minority Interest in Subsidiaries

Minority interest in the accompanying Consolidated Statements of Operations represents the share of loss of KLL attributable to the minority stakeholder in KLL. The minority interest in the accompanying Consolidated Balance Sheets reflects the amount of the underlying net assets of KLL attributable to the minority shareholder.

Loss From Discontinued Operations

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

Cash and Cash Equivalents

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

Restricted Cash

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

Fair Value of Financial Instruments

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

Long-Lived Assets

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

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Property, Plant, and Equipment

K-Fuel Plant Under Construction

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

Other Property, Plant, and Equipment

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

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

Asset Retirement Cost and Obligation

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

As further discussed in Note 4 below, the Company acquired LDC in May 2004. As part of the purchase agreement the Company agreed to assume the reclamation liability associated with the non-operating coal mine assets owned by LDC. The fair value of this liability is determined from time-to-time by the DEQ. This reclamation liability was recorded at its fair value as determined by the DEQ on the date of acquisition and an equivalent amount was added to the asset cost. Since the Company has elected to rely on the DEQ assessment of reclamation cost, no accretion to the liability has been recognized. Instead, adjustments to the liability will be made if, and when, the DEQ changes its assessment. The Company has estimated the useful life of the asset retirement cost as the approximate weighted average expected useful life of the underlying plant assets purchased from LDC, which approximate 12 years. Therefore, the Company has begun depreciating this asset on a straight-line basis over a 12-year useful life.

Patents

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

Stock Based Compensation

The Company periodically grants qualified and non-qualified stock options to certain executive officers and other key employees, non-employee directors and certain consultants under four stock option plans as well as outside the plans. Stock options granted to employees and non-employee directors are accounted for in accordance with Accounting Principles Board Opinion No. 25,

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

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

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

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

Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Management, with respect to the realizability of the Company’s property, plant and equipment, patents, notes receivable and prepaid royalty, has made significant estimates. Actual results could differ from these estimates, making it possible that a change in these estimates could occur in the near term.

Revisions and Reclassifications

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

NOTE 2. DISCONTINUED PEGASUS OPERATIONS

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

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

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

The Company accounted for the disposal of these operations in accordance with SFAS No. 144 (See “Discontinued Operations Including Assets Held for Disposal” policy in Note 1).

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

NOTE 3. NOTE RECEIVABLE

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

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

On September 11, 2003, Cinergy elected to convert its advance to Pegasus into common stock of KFx. The advance balance from Cinergy to Pegasus was $2.4 million on September 11, 2003, and was converted into approximately 871,000 shares of KFx common stock at a price of $2.75 per share, in accordance with the terms of the agreement. At conversion of this note receivable Pegasus became indebted to KFx for the remainder of the balance outstanding. As additional consideration to KFx in the Agreement described in Note 2, $250,000 of the payment made by KFx to Pavilion was added to the note receivable due KFx. The note accrues interest at 7% per annum, payable monthly. Payments on the note are due pursuant to an assignment of certain cash proceeds due to Pegasus from Cinergy. The Company has certain rights to collect payments under this note from Pegasus and to demand payment upon certain events of default. During the quarter and six months ended June 30, 2004 the Company collected $32,000 and $173,000 in principal payments, respectively. During the quarter and six months ended June 30, 2004 the Company collected $41,000 and $68,000 in interest payments, respectively.

NOTE 4. PURCHASE OF LANDRICA DEVELOPMENT COMPANY

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

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

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

NOTE 5. PROPERTY, PLANT, AND EQUIPMENT

Property, plant and equipment consisted of the following:

The K-Fuel demonstration plant was fully depreciated as of June 30, 2004 and December 31, 2003; however, since it continues to be a significant source of testing and demonstration for the Company’s potential customers we have presented its original cost basis and accumulated depreciation for informational purposes.

NOTE 6. STOCK OPTION PLANS

The Company has four qualified stock option plans (“Option Plans”): the Amended and Restated 1992 Stock Option Plan (the “1992 Plan”) the 1996 Stock Option and Incentive Plan (the “1996 Plan”); the 1999 Stock Incentive Plan (the “1999 Plan”) and the 2002 Stock Incentive Plan (the “2002 Plan”). These plans are administered by the Compensation Committee of the Company’s Board of Directors (“Committee”), which has the authority to determine the specific terms of awards under these plans, including grant price, vesting and term, subject to certain restrictions of the Internal Revenue Code regarding incentive stock options (“ISO”).

The 1992 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of non-qualified stock options (“NSO”) and ISOs. Stock options granted under the 1992 Plan generally vest 20% on the date of grant, with an additional 20% vesting on each anniversary date thereafter until fully vested. The Committee can accelerate the vesting of an outstanding option at its sole discretion, and is required to accelerate the vesting of all outstanding options outstanding under the 1992 Plan in the event of a change in control. As a result of Thermo Ecotek Corporation’s (“TCK”) investment in the Company on January 31, 1997, which increased its ownership in the Company to in excess of 15%, which constituted a change

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in control, all options outstanding under the 1992 Plan became fully vested. Stock options granted under the 1992 Plan generally expire not more than ten years from the date of grant. The Company has reserved 1 million shares of common stock for issuance under the 1992 Plan, of which 578,000 options remain available for grant as of June 30, 2004. There were no grants under the 1992 Plan during the six months ended June 30, 2004.

The 1996 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of NSOs, ISOs, stock appreciation rights (“SAR”) and restricted stock. Stock options granted under the 1996 Plan generally vest 20% on the first anniversary date of the grant, and an additional 20% each anniversary date thereafter until fully vested. The Committee has similar discretionary authority to accelerate the vesting of any outstanding option as described above under the 1992 Plan, except there are no specific change in control vesting requirements. Stock options granted under the 1996 Plan generally expire not more than ten years from the date of grant. The Company has reserved 1.5 million shares of common stock for issuance under the 1996 Plan, of which approximately 1,000 options remain available for grant at June 30, 2004. There were 200,000 and 530,000 options granted under the 1996 Plan during the quarter and six months ended June 30, 2004, respectively. Of the options granted during these periods, 230,000 were granted to non-employee directors of the Company and 300,000 were granted to officers of the Company. The options granted to non-employee directors vested immediately.

The 1999 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of various forms of equity based compensation including ISOs, NSOs, SARs, or restricted stock. The Committee has similar discretionary authority to accelerate the vesting of any outstanding option as described above under the 1992 Plan, except that vesting is not required upon a change in control. The Company has reserved 2 million shares of common stock for issuance under the 1999 Plan, of which 25,000 options remain available for grant at June 30, 2004. There were no grants under the 1999 Plan during the six months ended June 30, 2004.

The 2002 Plan provides for the award to the Company’s executive officers and other key employees, non-employee directors and consultants and others of various forms of equity based compensation including ISOs, NSOs, SARs, or restricted stock. The Committee has similar discretionary authority to accelerate the vesting of any outstanding option as described above under the 1992 Plan, except that vesting is not required upon a change in control. The Company has reserved 2 million shares of common stock for issuance under the 2002 Plan. During the six months ended June 30, 2004, 530,000 options were granted and approximately 88,000 options were cancelled and returned to the plan. Of the options granted during this period, 30,000 were granted to a non-employee director of the Company and the remainder were granted to officers of the Company. The options granted to non-employee director vested immediately. Additionally, 3,000 unrestricted and 100,000 restricted shares were granted to officers of the Company. The restricted share grant vests pro-rata at 20% per year beginning in January 2005. For the quarter and six months ended June 30, 2004 the Company recognized $0 and $28,000 and $39,000 and $78,000 of compensation expense on the unrestricted and restricted share grant, respectively. As of June 30, 2004, the 2002 Plan had approximately 52,000 options remaining.

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

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

All stock options granted during the six months ended June 30, 2004 and for the year ended December 31, 2003 were at exercise prices that were equal to or greater than the fair market value of the Company’s common stock on the date of grant.

NOTE 7. WARRANTS TO PURCHASE COMMON STOCK

Associated with various financing transactions and professional service agreements, the Company has issued transferable warrants to purchase common stock. In May 2003, the Company issued a warrant for the purchase of 1 million common shares of the Company at an exercise price of $2.75 per share to a consultant as part of a 3-year services agreement. The warrant vests as follows: (i) 2/9ths or approximately 222,000 shares vested on the date of the agreement, March 1, 2003 and (ii) remaining warrants vest 1/36, or approximately 28,000 on the first day of each month thereafter for a total of 28 months. At June 30, 2004, the right to purchase approximately 639,000 shares of our common stock had vested under this services agreement. The Company recognized $237,000 and $475,000 of expense for these services during the quarter and six months ended June 30, 2004 based on the fair value of the warrants that vested during the period.

On June 25, 2004 the Company entered into agreements to raise capital proceeds from two of its warrant holders. In return for 1.3 million additional warrants at an exercise price of $11.00 per share, these warrant holders agreed to exercise 3.9 million of their warrants before their contractual exercise date. On June 28, 2004 the Company received $7.2 million of proceeds from the exercise of 2.6 million of these warrants. As a direct cost of this transaction the Company decreased additional paid-in capital by $1.2 million, which was equal to the Black-Scholes value of the 900,000 additional warrants issued, and increased additional paid-in capital by the same amount for the value of the additional warrants issued. As of June 30, 2004 the Company recognized a stock subscription receivable and an increase in additional paid-in capital for the expected proceeds from execution of the agreement with the other warrant holder. As more fully described in Note 10 this other warrant holder closed his agreement on July 22, 2004 and remitted proceeds to the Company on that date. Neither the warrants exercised by this holder nor the additional warrants issued to this holder are included in the warrant activity schedule below.

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

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NOTE 8. COMMITMENTS AND CONTINGENT LIABILITIES

Litigation

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

Royalties

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

The Company is contingently liable to Ohio Valley Electric Corporation (“OVEC”) for an overriding royalty of 0.5% to OVEC on the gross revenues generated by the sale of fuel produced from any production plant (excluding the KFP Facility) located in the United States in which the feedstock is coal and which uses the Company’s older Series “C” K-Fuel technology to produce fuel. The Company is contingently liable to Fort Union for 20% of the Company’s North American royalty proceeds, to a maximum of $1.5 million. No payments or accruals have been required through June 30, 2004 under these agreements.

NOTE 9. RELATED PARTY TRANSACTIONS

The Company has a consulting agreement with Venners & Company, Ltd. for public relations and governmental affairs services. Venners & Company, Ltd. is controlled by John P. Venners, the brother of Theodore Venners, our Chairman and CEO. Prior to April 1, 2004 the agreement provided for monthly consulting fees of $12,000, reimbursement of expenses related to our business and certain performance based bonuses. Effective April 1, 2004 the Company negotiated a revised agreement with Venners & Company for the provision of these services at a fixed cost of $18,000 per month. Either party can terminate the agreement upon written notice. During the quarter and six months ended June 30, 2004, the Company paid Venners & Company, Ltd. approximately $54,000 and $90,000, respectively, in cash for consulting fees and $5,000 and $10,000, respectively, for reimbursement of expenses. The expenses paid in cash during the quarter ended June 30, 2004 related to expenses incurred by Mr. Venners during March 2004. During the quarter and six months ended June 30, 2003, the Company paid Venners & Company, Ltd. approximately $48,000 and $88,000, respectively, in cash for consulting fees and $23,000 and $35,000, respectively, for reimbursement of expenses incurred related to our business.

The Company also is obligated to pay certain royalties to Theodore Venners as discussed in Note 8.

NOTE 10. SUBSEQUENT EVENT

On June 25, 2004 the Company entered into an agreement to raise proceeds through the exercise of warrants from two of its warrant holders. As of June 30, 2004 one of the warrant holders had not closed his agreement. Therefore, the Company recorded a stock subscription receivable for the proceeds expected upon closing. This transaction closed on July 22, 2004 and on that date the Company received $3.4 million of proceeds from the exercise of 1.25 million warrants and relieved the stock subscription receivable. As a direct cost of this transaction the Company decreased additional paid-in capital by $472,000, which was equal to the Black-Scholes value of the 415,000 additional warrants issued, and increased additional paid-in capital by the same amount for the Black-Scholes value of the additional warrants issued.

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

FORWARD-LOOKING INFORMATION MAY PROVE INACCURATE

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

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

Introduction

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

Issuances of Common Stock for Cash Consideration

During the second quarter of 2004, for the exercise of 3.7 million warrants and 138,000 options, including 76,000 options that were previously converted from SARs in 2003, we received $10.5 million in cash proceeds, net of transaction costs of approximately $21,000. Additionally, we sold 245,400 shares of common stock to Arch Coal, Inc. for proceeds of approximately $2 million. Cash from equity transactions has increased from the first quarter of 2004, when we received proceeds of approximately $5.2 million from the exercise of approximately 1.1 million warrants and 457,000 options, including 20,000 options that were converted from SARs in 2003.

Purchase of Landrica Development Company

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

K-Fuel Plant Construction at Fort Union Site

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 improved coal provides significant value to coal-burning electric utilities because it improves efficiency in their steam generating boilers and decreases their emissions. Therefore, we believe our product will provide a competitive advantage to those utilities requiring 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.

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

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continue development of this site including permitting, site development, design and construction of the K-Fuel plant including the necessary infrastructure to receive feed stock coal from the nearby coalmines. This process will require significant capital investment.

We estimate the total cost of the initial K-Fuel plant construction project to be approximately $41 million with initial production shortly after the end of the first quarter of 2005. This cost estimate and schedule could be adversely affected by delays in obtaining the necessary permits, adverse weather conditions, and significant increases in the costs of materials and construction. Capitalized costs incurred through June 30, 2004 were for the following major plant components:

RESULTS OF OPERATIONS

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

Continuing Operations

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

Consolidated operating costs and expenses for the three months ended June 30, 2004 decreased as compared to the three months ended June 30, 2003 by $945,000 or 36%. This decrease is the result of two factors: (a) a decrease in marketing, general and administrative costs relating primarily to a decrease in legal and consulting fees and (b) a decrease in general engineering and technical services. In the comparative quarter of 2003 we incurred significant legal and consulting fees related to the defense of the lawsuit more fully described in Part II, Item 1 of this report. In the quarter ended June 30, 2004 legal fees also decreased because of the reversal of a $221,000 accrual for legal fees related to the litigation settled during the quarter, which were ultimately not incurred. Additionally, general corporate legal and consulting fees were higher during 2003 compared to 2004, as we had not disposed of Pegasus operations until November 2003.

During the second quarter of 2003 we were evaluating the technological feasibility of combining our proprietary K-Fuel technology with existing equipment and technology used by Lurgi South Africa (Pty) Limited (“Lurgi”) in their coal processing plants to develop an integrated K-Fuel plant. During this period we expensed approximately $313,000 for conceptual engineering and technical services related to the development of this technology. In the latter part of 2003 we completed our feasibility studies and began fabrication of the K-Fuel plant and evaluation of specific sites to locate the plant. As a result, the amount of conceptual engineering and technical services expensed for financial statement purposes has decreased significantly on a comparative basis between the two periods. The change in legal and consulting fees and the decrease in conceptual engineering and technical services caused substantially all of the decline in operating expenses and improvement in the operating loss for the quarter.

We recognized non-operating income of $284,000 during the quarter ended June 30, 2004 compared to net non-operating expense of $61,000 in the quarter ended June 30, 2003. This $345,000 improvement was primarily related to an increase in net interest income of $177,000 and the recognition of $168,000 of other income from the sale of scrap and settlement of outstanding litigation. The increase in net interest income is a direct result of the reduction of our interest bearing obligations since June 30, 2003 and a significant increase in our interest-earning cash balance during the same period. During the second quarter of 2004 we received approximately $31,000 from the sale of scrap metal that we had previously impaired and received $157,000 from the settlement of the litigation more fully described in Part II, Item 1, below. This other income was partially offset by insignificant other expenses.

As a result of the above factors, the consolidated loss from continuing operations of $1.4 million ($0.03 per share) for the second quarter of 2004 was $1.3 million less than the loss from continuing operations for the second quarter of 2003.

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Discontinued Operations

The loss from discontinued operations of $448,000 for the quarter ended June 30, 2003 is more fully described in Note 2 to the financial statements. Since the operations of Pegasus were disposed of during 2003 there is no discontinued operations presentation for the quarter ended June 30, 2004.

SIX MONTHS ENDED JUNE 30, 2004 VS. SIX MONTHS ENDED JUNE 30, 2003

Continuing Operations

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

Consolidated operating costs and expenses for the six months ended June 30, 2004 decreased as compared to the six months ended June 30, 2003 by $1.5 million or 35%. This decrease is the result of similar factors as the quarter ended June 30, 2004 including: (a) a decrease in marketing, general and administrative costs relating primarily to a decrease in legal and consulting fees and (b) a decrease in general engineering and technical services. During the first half of 2003 we incurred significant legal and consulting fees related to the defense of the lawsuit more fully described in Part II, Item 1 of this report and higher legal fees related to patent maintenance. In the six months ended June 30, 2004 legal fees also decreased because of the reversal of a $521,000 accrual for legal fees related to the litigation settled during the quarter, which were ultimately not incurred. Additionally, general corporate legal and consulting fees were higher during the comparative period of 2003 compared to 2004, as we had not disposed of Pegasus operations until November 2003.

For most of 2003 we were evaluating the technological feasibility of combining our proprietary K-Fuel technology with existing equipment and technology used by Lurgi South Africa (Pty) Limited (“Lurgi”) in their coal processing plants to develop an integrated K-Fuel plant. During the six months ended June 30, 2003 we expensed approximately $820,000 for conceptual engineering and technical services related to the development of this technology. In the latter part of 2003 we completed our feasibility studies and began fabrication of the K-Fuel plant and evaluation of specific sites to locate the plant. As a result, the amount of conceptual engineering and technical services expensed for financial statement purposes has decreased significantly on a comparative basis between the two periods. The change in legal and consulting fees and the decrease in conceptual engineering and technical services caused substantially all of the decline in operating expenses and improvement in the operating loss for the quarter.

We recognized non-operating income of $401,000 during the six months ended June 30, 2004 compared to net non-operating expense of $177,000 in comparative period of 2003. This $578,000 improvement was primarily related to an increase in net interest income in the comparable period of $409,000 and other income from the sale of scrap metal and the settlement of outstanding litigation. The increase in net interest income is a direct result of the reduction of our interest bearing obligations since June 30, 2003 and a significant improvement in our interest-earning cash balance. As a result of the above factors, the consolidated loss from continuing operations of $2.4 million ($0.04 per share) for the first half of 2004 was $2.1 million less than the loss from continuing operations for the first half of 2003.

Discontinued Operations

The loss from discontinued operations of $776,000 for the six months ended June 30, 2003 is more fully described in Note 2 to the financial statements. Since the operations of Pegasus were disposed of during 2003 there is no discontinued operations presentation for the six months ended June 30, 2004.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2004, our working capital was $30.1 million compared to working capital of $21.2 million at December 31, 2003. The increase in working capital of 42%, or $8.9 million during the six months ended June 30, 2004 reflects a continued improvement in our balance sheet compared to 2003. The improvement was primarily due to the $17.7 million of proceeds received from the exercise of options and warrants and sale of common stock. Inflows from cash proceeds were offset by a reduction of cash and cash equivalents of $2.7 million that was restricted as pledged assets for the reclamation liability, approximately $3.9 million of purchases for the K-Fuel plant construction and significant net payments on accounts payable and reduction of accrued expenses of approximately $2 million.

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Cash Used in Operating Activities

Cash used in operating activities during the six months ended June 30, 2004 of $3.5 million was $1.2 million greater than the $2.3 million used during the six months ended June 30, 2003. The increase in cash used in operating activities resulted from the lack of a significant increase in accounts receivable as compared to the prior period of $748,000 offset by a significant increase in the payment of accounts payable and accrued expenses of $2 million and a reduction in net loss of $3 million.

Cash Used in Investing Activities

Cash used in investing activities during the six months ended June 30, 2004 increased by $5.8 million. This increase is a result of incurring approximately $3.1 million more in capital expenditures related to the K-Fuel plant (See discussion of progress on the K-Fuel Plant above) compared to the prior period, an increase in restricted cash of $2.7 million related to the reclamation liability incurred on the Landrica Development Company (“LDC”) acquisition and $523,000 for the purchase of LDC (See Note 4). The increase in cash used in investing activities from these additional payments totaling $6.3 million was partially offset by collections on the note receivable due from Pegasus (See Note 4) of $173,000.

Cash Provided by Financing Activities

Cash provided by financing activities during the six months ended June 30, 2004 was $17.7 million compared to approximately $19 million for the six months ended June 30, 2003. As previously discussed we raised approximately $17.7 million of proceeds from the exercise of options and warrants and sale of common stock during the first half of 2004. In the comparative period of 2003 the Company issued 7.7 million shares of KFx common stock in private placements at a price of $2.50 per share, which resulted in cash proceeds to the Company of $19 million, net of transaction costs.

Future Sources and Uses of Cash

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

It is estimated that construction of the initial K-Fuel Plant will be completed shortly after the end of the first quarter of 2005. Upon commencement of operations, we expect to generate revenue from the sale of K-Fuel product and positive net cash flows from operations. We have also begun negotiations and preliminary engineering to support the development of future K-Fuel facilities at several different locations under consideration. As these projects develop, we will require additional funding which we expect to obtain from one or more of the sources described above.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires KFx to make estimates and judgments that affect both the results of operations as well as the carrying values of our assets and liabilities. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. We base estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities as of the date of the financial statements that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies are described in Note 1 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 revised financial statements resulting from the disposal of the Pegasus operations. For purposes of the discontinued operations presentation in the Consolidated Statement of Operations for the six months ended June 30, 2003, the loss from operating Pegasus has been aggregated for reporting purposes into a single line called “Loss from discontinued operations.” We have made the determination to account for the disposal of these operations as discontinued in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” because (a) it has been determined that the operations and cash flows of Pegasus were eliminated from our on-going operations and (b) we will not have any significant continuing involvement in the operations of Pegasus after the disposal transaction.

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

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