##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

|    |  |                                                                                        
|--- |  | ---------------------------------------------------------------------------------------
|[X] |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2001

OR

|      |  |                                                                                         
|----- |  | ----------------------------------------------------------------------------------------
|[   ] |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 0-26825

N2H2, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

WASHINGTON
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)

91-1686754
(I.R.S. EMPLOYER IDENTIFICATION NO.)

900 FOURTH AVENUE, SUITE 3600, SEATTLE, WA 98164
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)

REGISTRANTS TELEPHONE NUMBER, INCLUDING AREA CODE: (206) 336-1501

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 [   ]

As of February 7, 2002, the registrant had outstanding 22,068,199 shares
of common stock, no par value.





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TABLE OF CONTENTS



|                              |                                                                                                |                                                                        |  |  |  |  |  | 
|----------------------------- | ---------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------- |  |  |  |  |  | 
|PART I FINANCIAL INFORMATION
|                              | ITEM 1. FINANCIAL STATEMENTS                                                                  
|                              |                                                                                                | CONDENSED CONSOLIDATED BALANCE SHEETS                                 
|                              |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
|                              |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                       
|                              |                                                                                                | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                  
|                              | ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
|                              | ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            
|PART II OTHER INFORMATION   
|                              | ITEM 1. LEGAL PROCEEDINGS                                                                     
|                              | ITEM 2(d). CHANGES IN SECURITIES AND USE OF PROCEEDS                                          
|                              | ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                       
|                              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   
|                              | ITEM 5. OTHER INFORMATION                                                                     
|                              | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                      
|SIGNATURES                   



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##### Table of Contents



N2H2, INC.

TABLE OF CONTENTS

|                             |                                                                                                |                                                                        |  |    |    |  |  | 
|---------------------------- | ---------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------- |  | -- | -- |  |  | 
|PART IFINANCIAL INFORMATION |                                                                                                |                                                                        |  |    | 3  | 
|                             | Item 1.  Financial Statements                                                                  |                                                                        |  | 3  |   
|                             |                                                                                                | CONDENSED CONSOLIDATED BALANCE SHEETS                                  |  |    | 3  | 
|                             |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS |  |    | 4  | 
|                             |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                        |  |    | 5  | 
|                             |                                                                                                | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                   |  |    | 6  | 
|                             | Item 2.  Managements Discussion And Analysis Of Financial Condition And Results Of Operations |                                                                        |  | 9  |   
|                             | Item 3.  Quantitative And Qualitative Disclosures About Market Risk                            |                                                                        |  | 12 |   
|PART II OTHER INFORMATION   |                                                                                                |                                                                        |  |    | 12 | 
|                             | Item 1.  Legal Proceedings                                                                     |                                                                        |  |    | 12 | 
|                             | Item 2.  Changes In Securities And Use Of Proceeds                                             |                                                                        |  |    | 12 | 
|                             | Item 3.  Defaults Upon Senior Securities                                                       |                                                                        |  |    | 12 | 
|                             | Item 4.  Submission Of Matters To A Vote Of Security Holders                                   |                                                                        |  | 12 |   
|                             | Item 5.  Other Information                                                                     |                                                                        |  | 12 |   
|                             | Item 6.  Exhibits And Reports On Form 8-K                                                      |                                                                        |  | 12 |   
|SIGNATURES                   |                                                                                                |                                                                        |  | 13 |   

2



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##### Table of Contents






PART I FINANCIAL INFORMATION




ITEM 1. FINANCIAL STATEMENTS




N2H2, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands)

|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |         |       |        | 
|------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------------ | ------- | ------------ | ------ | ------------- | ------- | ----- | ------ | 
|                                                  |                                                                                                                      |                            |                                            |         | DECEMBER 31, |        | SEPTEMBER 30,
|                                                  |                                                                                                                      |                            |                                            |         | 2001         |        | 2001         
|                                                  |                                                                                                                      |                            |                                            |         |              |        |              
|ASSETS:                                           |                                                                                                                      |                            |                                            |         |              |        |               |        
|Current assets:                                   |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  | Cash and cash equivalents                                                                                            |                            | $                                          | 5,325   |              |        | $             | 5,979   |      
|                                                  | Restricted cash and cash equivalents                                                                                 |                            |                                            | 675     |              |        |               | 675     |      
|                                                  | Accounts receivable, net of allowances                                                                               |                            |                                            | 949     |              |        |               | 2,066   |      
|                                                  | Prepaid expenses and other current assets                                                                            |                            |                                            | 566     |              |        |               | 774     |      
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  |                                                                                                                      | Total current assets       |                                            |         | 7,515        |        |               |         | 9,494 |       
|Property and equipment, net                       |                                                                                                                      |                            | 2,710                                      |         |              |        | 3,136         |        
|Other assets, net                                 |                                                                                                                      |                            | 140                                        |         |              |        | 140           |        
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  |                                                                                                                      |                            | Total assets                               |         | $            | 10,365 |               |         | $     | 12,770 | 
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|LIABILITIES AND SHAREHOLDERS EQUITY:             |                                                                                                                      |                            |                                            |         |              |        |               |        
|Current liabilities:                              |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  | Accounts payable                                                                                                     |                            | $                                          | 694     |              |        | $             | 807     |      
|                                                  | Accrued payroll & benefits                                                                                           |                            |                                            | 437     |              |        |               | 738     |      
|                                                  | Other accrued liabilities                                                                                            |                            |                                            | 344     |              |        |               | 342     |      
|                                                  | Deferred revenue                                                                                                     |                            |                                            | 5,437   |              |        |               | 6,136   |      
|                                                  | Note payable                                                                                                         |                            |                                            | 25      |              |        |               | 42      |      
|                                                  | Current portion of capital lease obligations                                                                         |                            |                                            | 176     |              |        |               | 203     |      
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  |                                                                                                                      | Total current liabilities  |                                            |         | 7,113        |        |               |         | 8,268 |       
|Deferred revenue                                  |                                                                                                                      |                            | 1,100                                      |         |              |        | 1,296         |        
|Capital lease obligations, net of current portion |                                                                                                                      |                            |                                           |         |              |        | 29            |        
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  |                                                                                                                      | Total liabilities          |                                            |         | 8,213        |        |               |         | 9,593 |       
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|Shareholders equity:                             |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  | Common stock, no par value; 250,000 shares
authorized, 22,068 and 22,060 shares issued and
outstanding, respectively |                            |                                            | 92,167  |              |        |               | 92,166  |      
|                                                  | Notes receivable from shareholders, net of allowances                                                                |                            |                                            | (55     | )            |        |               | (48     | )    
|                                                  | Deferred stock compensation                                                                                          |                            |                                            | (1,408  | )            |        |               | (2,030  | )    
|                                                  | Accumulated other comprehensive loss                                                                                 |                            |                                            | (103    | )            |        |               | (127    | )    
|                                                  | Accumulated deficit                                                                                                  |                            |                                            | (88,449 | )            |        |               | (86,784 | )    
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  |                                                                                                                      | Total shareholders equity |                                            |         | 2,152        |        |               |         | 3,177 |       
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        
|                                                  |                                                                                                                      |                            | Total liabilities and shareholders equity |         | $            | 10,365 |               |         | $     | 12,770 | 
|                                                  |                                                                                                                      |                            |                                            |         |              |        |               |        

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

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N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE LOSS
(unaudited, in thousands except per share amounts)

|                                                      |                                         |                                                  |                          |                    |       |                    |         |       |       |       |       |  
|----------------------------------------------------- | --------------------------------------- | ------------------------------------------------ | ------------------------ | ------------------ | ----- | ------------------ | ------- | ----- | ----- | ----- | ----- | -
|                                                      |                                         |                                                  |                          |                    |       | THREE MONTHS ENDED
|                                                      |                                         |                                                  |                          |                    |       | DECEMBER 31,      
|                                                      |                                         |                                                  |                          |                    |       |                   
|                                                      |                                         |                                                  |                          |                    |       | 2001               |         | 2000 
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Revenues:                                             |                                         |                                                  |                          |                    |       |                    |         |      
|                                                      |                                         | Internet filtering and consulting services       |                          | $                  | 2,893 |                    |         | $     | 2,183 |      
|                                                      |                                         | Advertising                                      |                          |                    |      |                    |         |       | 302   |      
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|                                                      |                                         |                                                  | Total Revenues           |                    |       | 2,893              |         |       |       | 2,485 |      
|Operating expenses:                                   |                                         |                                                  |                          |                    |       |                    |         |      
|                                                      |                                         | Internet filtering services and customer
support |                          |                    | 846   |                    |         |       | 1,487 |      
|                                                      |                                         | Educational content and advertising costs        |                          |                    |      |                    |         |       | 613   |      
|                                                      |                                         | Sales and marketing                              |                          |                    | 1,800 |                    |         |       | 4,058 |      
|                                                      |                                         | General and administrative                       |                          |                    | 985   |                    |         |       | 1,470 |      
|                                                      |                                         | Research and development                         |                          |                    | 437   |                    |         |       | 1,016 |      
|                                                      |                                         | Depreciation and amortization                    |                          |                    | 533   |                    |         |       | 1,266 |      
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|                                                      |                                         |                                                  | Total operating expenses |                    |       | 4,601              |         |       |       | 9,910 |      
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Loss from operations                                  |                                         |                                                  | (1,708                   | )                  |       |                    | (7,425  | )    
|Interest income, net of interest expense              |                                         |                                                  | 43                       |                    |       |                    | 243     |      
|Loss on disposal of property and equipment            |                                         |                                                  |                         |                    |       |                    | (156    | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Loss before change in accounting policy               |                                         |                                                  | (1,665                   | )                  |       |                    | (7,338  | )    
|Cumulative effect of change in accounting
policy      |                                         |                                                  |                         |                    |       |                    | (3,554  | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Net loss                                              |                                         | $                                                | (1,665                   | )                  |       | $                  | (10,892 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Foreign currency translation gain (loss)              |                                         |                                                  | 24                       |                    |       |                    | (45     | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Comprehensive loss                                    |                                         | $                                                | (1,641                   | )                  |       | $                  | (10,937 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Basic and diluted net loss per share:                 |                                         |                                                  |                          |                    |       |                    |         |      
|                                                      | Loss before change in accounting policy |                                                  | $                        | (0.08              | )     |                    | $       | (0.34 | )    
|                                                      | Effect of change in accounting policy   |                                                  |                          |                   |       |                    |         | (0.16 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|                                                      |                                         |                                                  |                          | Net loss per share |       | $                  | (0.08   | )     |       | $     | (0.50 | )
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      
|Basic and diluted weighted average shares
outstanding |                                         |                                                  | 21,725                   |                    |       |                    | 21,959  |      
|                                                      |                                         |                                                  |                          |                    |       |                    |         |      

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

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N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

|                                                                            |                                                       |                                              |        |                    |       |      |         |     |        |  
|--------------------------------------------------------------------------- | ----------------------------------------------------- | -------------------------------------------- | ------ | ------------------ | ----- | ---- | ------- | --- | ------ | -
|                                                                            |                                                       |                                              |        | THREE MONTHS      
|                                                                            |                                                       |                                              |        | ENDED DECEMBER 31,
|                                                                            |                                                       |                                              |        |                   
|                                                                            |                                                       |                                              |        | 2001               |       | 2000
|                                                                            |                                                       |                                              |        |                    |       |     
|Cash flows from operating activities:                                       |                                                       |                                              |        |                    |       |      |         |    
|Net loss                                                                    |                                                       | $                                            | (1,665 | )                  |       | $    | (10,892 | )  
|Adjustments to reconcile net loss to net cash used by operating activities: |                                                       |                                              |        |                    |       |      |         |    
|                                                                            |                                                       | Depreciation and amortization                |        |                    | 533   |      |         |     | 1,266  |  
|                                                                            |                                                       | Amortization of deferred stock compensation  |        |                    | 622   |      |         |     | 1,358  |  
|                                                                            |                                                       | Change in accounting policy                  |        |                    | (345  | )    |         |     | 2,708  |  
|                                                                            |                                                       | Loss on disposal of property and equipment   |        |                    |      |      |         |     | 156    |  
|                                                                            |                                                       | Shareholder loans forgiven                   |        |                    |      |      |         |     | 73     |  
|                                                                            |                                                       | Interest on shareholder loans                |        |                    | (7    | )    |         |     | (31    | )
|Changes in operating assets and liabilities:                                |                                                       |                                              |        |                    |       |      |         |    
|                                                                            |                                                       | Accounts receivable                          |        |                    | 1,117 |      |         |     | 418    |  
|                                                                            |                                                       | Prepaid expenses and other current assets    |        |                    | 208   |      |         |     | 521    |  
|                                                                            |                                                       | Other assets                                 |        |                    |      |      |         |     | 89     |  
|                                                                            |                                                       | Accounts payable                             |        |                    | (113  | )    |         |     | (1,059 | )
|                                                                            |                                                       | Accrued liabilities                          |        |                    | (299  | )    |         |     | 55     |  
|                                                                            |                                                       | Deferred revenue                             |        |                    | (550  | )    |         |     | 914    |  
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Net cash used by operating activities:                                      |                                                       |                                              | (499   | )                  |       |      | (4,424  | )  
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Cash flows from investing activities:                                       |                                                       |                                              |        |                    |       |      |         |    
|                                                                            |                                                       | Maturities of investments                    |        |                    |      |      |         |     | 8,986  |  
|                                                                            |                                                       | Purchases of investments                     |        |                    |      |      |         |     | (4,000 | )
|                                                                            |                                                       | Additions to property and equipment          |        |                    | (116  | )    |         |     | (711   | )
|                                                                            |                                                       | Proceeds from sale of property and equipment |        |                    | 9     |      |         |     |       |  
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Net cash provided by investing activities                                   |                                                       |                                              | (107   | )                  |       |      | 4,275   |    
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Cash flows from financing activities:                                       |                                                       |                                              |        |                    |       |      |         |    
|                                                                            |                                                       | Exercise of stock options                    |        |                    | 1     |      |         |     | 39     |  
|                                                                            |                                                       | Payments under capital lease obligations     |        |                    | (56   | )    |         |     | (34    | )
|                                                                            |                                                       | Repayments of notes payable                  |        |                    | (17   | )    |         |     | (366   | )
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Net cash used by financing activities                                       |                                                       |                                              | (72    | )                  |       |      | (361    | )  
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|                                                                            |                                                       | Effects of exchange rate changes             |        |                    | 24    |      |         |     | 16     |  
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Net decrease in cash                                                        |                                                       |                                              | (654   | )                  |       |      | (494    | )  
|Cash, beginning of period                                                   |                                                       |                                              | 5,979  |                    |       |      | 7,993   |    
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|Cash, end of period                                                         |                                                       | $                                            | 5,325  |                    |       | $    | 7,499   |    
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                            |                                                       |                                              |        |                    |       |      |         |    
|                                                                            | Cash paid for interest                                |                                              | $      | 5                  |       |      | $       | 120 |       
|                                                                            |                                                       |                                              |        |                    |       |      |         |    
|                                                                            | Stock received for notes receivable from shareholders |                                              | $      |                   |       |      | $       | 645 |       
|                                                                            |                                                       |                                              |        |                    |       |      |         |    

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

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N2H2, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

The accompanying condensed consolidated financial statements of N2H2, Inc.
and subsidiaries (the Company) are unaudited. In the opinion of management, the
financial statements include all adjustments, consisting only of normal
recurring adjustments, necessary for their fair presentation in conformity
with generally accepted accounting principles. Preparing financial statements
requires management to make estimates and assumptions that affect the reported
amounts of assets, liabilities, revenue, and expenses and the disclosure of
contingent assets and liabilities. Actual results may differ from these
estimates. Operating results for the three-month period ended December 31, 2001
are not necessarily indicative of results to be expected for a full year. The
information included in this Form 10-Q should be read in conjunction with
Managements Discussion and Analysis and financial statements and notes thereto
included in the Companys annual report on Form 10-K for the year ended
September 30, 2001.

The Company has experienced significant net operating losses from
inception. In fiscal 2001, the Company incurred operating losses of $28.7
million and used $12.3 million of cash in its operating activities. Management
expects that operating losses and negative cash flows will continue through
most or all of fiscal 2002 as the Company continues to develop its product
offerings and customer base. If the Company fails to develop revenues from new
products and expand its customer base, it will require additional debt or
equity financing to continue its operations beyond twelve months from the date
of this filing. Such financing may not be available on acceptable terms or at
all.

On January 18, 2002, the Company received a Nasdaq Staff Determination
indicating that N2H2 did not comply with the minimum stockholders equity
requirements for continued listing on the Nasdaq National Market as set forth
in Marketplace Rule 4450(a)(3), and that our securities are, therefore, subject
to delisting from the Nasdaq National Market. We have requested a hearing to
appeal the determination before the Nasdaq Listing Qualifications Panel, in
which we will propose that N2H2s stock listing be moved to the Nasdaq Small
Cap Market. The appeal, scheduled for February 21, 2002, will stay the
delisting of N2H2 securities pending a decision by the Qualifications Panel.
There is no assurance the Panel will grant our request for continued listing.

In addition, a minimum bid price of $1.00 is required for continued
listing on the Nasdaq National Market System. After the events of September 11,
2001, Nasdaq placed a moratorium on the $1.00 listing requirement, and Nasdaqs
previous delisting action with the Company was dropped. On January 1, 2002,
Nasdaq began again the process of enforcement of its listing requirements. At
the time of this filing, the Companys common stock bid price had closed below
$1.00 per share for a period of thirty consecutive business days from January
1, 2002. The Nasdaq National Market System grants a 90 day grace period, during
which time the Companys stock bid price must trade at or above $1.00 per share
for a minimum of ten consecutive business days in order to regain compliance.
In the event N2H2s stock price does not rise above $1.00 for the required ten
consecutive business days, Nasdaq would have the right to delist the stock and
then the Company would have the right to request a hearing to appeal a
determination that the stock should be delisted. There is no guarantee that the
Company would prevail in such a hearing.

If the Companys stock were delisted, the delisting would most likely
have a material adverse affect on the price of its common
stock, would adversely affect the liquidity of the shares held by its
shareholders, and would severely restrict any ability the Company
may have to raise additional capital.

Principles of Consolidation

The consolidated financial statements include the accounts of N2H2, Inc.
and its wholly owned subsidiaries, N2H2, Ltd. and N2H2 Pty Limited (formerly
Iseek Pty Limited). All inter-company accounts and transactions have been
eliminated in consolidation.

Use of 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
at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from
those estimates.

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Revenue Recognition

The Companys revenues are derived from its filtering, Internet
management, and content delivery services. These primarily consist of filtering
subscriptions, installation fees, maintenance fees and historically,
advertising.

Subscription revenues represent the fees associated with the right to use
the Companys software and hardware, and access to filtering updates.
Subscription revenues are recognized over the life of the subscription
contract. Subscription payments received in advance of revenue recognition are
recorded as deferred revenue.

Installation revenues represent fees associated with the customization and
installation of the Companys software on customer servers. Installation
revenues are recognized over the expected life of the customer relationship in
accordance with Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements.

Maintenance revenues represent fees associated with technical support
services provided to customers. Maintenance revenues are recognized over the
life of the maintenance contract. Maintenance payments received in advance of
revenue recognition are recorded as deferred revenue.

Advertising revenue contracts based on the number of impressions displayed
or click-throughs provided were recognized as services were rendered. Also
included in advertising revenues were barter revenues generated from exchanging
advertising services for a license. Revenues from barter transactions were
recognized at the fair value of advertisements delivered in the period when
advertising was provided, and services received were charged to expense on a
straight-line basis over the contract period. Barter revenues for the quarter
ended December 31, 2000 were $0.2 million. All contracts with advertisers have
been concluded or cancelled during fiscal 2001.

Reclassifications

Certain reclassifications of prior year balances have been made for
consistent presentation with the current year. Such reclassifications had no
effect on net loss, cash flows or shareholders equity as previously reported.

2. NET LOSS PER SHARE

Basic net loss per share is computed on the basis of the weighted average
number of common shares outstanding. Diluted net loss per share includes common
equivalent shares during the period, if dilutive. As the Company had a net loss
attributable to common shareholders in each of the periods presented, basic and
diluted net loss per share are the same.

The components of basic and diluted loss per share were as follows:

|             |                                                              |                                      |   |                        |       |      |   |         |       |  
|------------ | ------------------------------------------------------------ | ------------------------------------ | - | ---------------------- | ----- | ---- | - | ------- | ----- | -
|             |                                                              |                                      |   | THREE MONTHS          
|             |                                                              |                                      |   | ENDED
DECEMBER 31,    
|             |                                                              |                                      |   |                       
|             |                                                              |                                      |   | 2001                   |       | 2000
|             |                                                              |                                      |   |                        |       |     
|             |                                                              |                                      |   | (in thousands,        
|             |                                                              |                                      |   | except per share data)
|Numerator:   |                                                              |                                      |   |                        |       |      |   |        
|             | Net loss                                                     |                                      | $ | (1,665                 | )     |      | $ | (10,892 | )    
|Denominator: |                                                              |                                      |   |                        |       |      |   |        
|             | Basic and diluted weighted average
common shares outstanding |                                      |   | 21,725                 |       |      |   | 21,959  |      
|             |                                                              |                                      |   |                        |       |      |   |        
|             |                                                              | Basic and diluted net loss per share |   | $                      | (0.08 | )    |   | $       | (0.50 | )
|             |                                                              |                                      |   |                        |       |      |   |        

Warrants for 539,280 shares, options for 3,066,333 shares, and 341,192
restricted shares have been excluded from the calculation of diluted loss per
share at December 31, 2001 because they are anti-dilutive. Warrants for
539,280 shares, options for 4,946,184 shares, and 512,000 restricted shares
have been excluded from the calculation of diluted loss per share at December
31, 2000 because they were anti-dilutive.

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3. CHANGE IN ACCOUNTING POLICY

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB
101). SAB 101 requires that up-front installation fees be deferred and
recognized over the term of the customer relationship. In fiscal 2000 and
previous years, the Company recognized installation revenue upon completion of
the installation. Effective at the beginning of fiscal 2001, in accordance
with the provisions of SAB 101, the Company began deferring installation
revenue over the expected life of the customer relationship periods. The
adoption of SAB 101 resulted in a one-time, non-cash charge of $3.6 million on
October 1, 2000 for the cumulative effect of the change in accounting policy.
The cumulative effect was recorded as deferred revenue and is being recognized
as revenue over the remaining customer relationship periods. The amount of
related deferred revenue which was recognized as revenue during the three-month
periods ended December 31, 2001 and 2000 was $345,000 and $847,000,
respectively. The remainder of the related deferred revenue will be recognized
as revenue as follows: $418,000 over the remainder of fiscal 2002 and $229,000
in fiscal 2003.

4. RESTRICTED CASH AND CASH EQUIVALENTS

The Company has a revolving line of credit facility with Comerica
(formerly Imperial Bank), which allows for draws up to a maximum short-term
borrowing of $2.5 million if specified conditions are met. Current commitments
against the line of credit consist of an irrevocable standby letter of credit
for our leased office space in the amount of $665,000, which expires on July
31, 2005, and a $10,000 deposit held by Comerica for the issuance of corporate
credit cards. The total of these commitments is in excess of our borrowing
base as of December 31, 2001. As a result, the Company is unable to draw upon
the credit facility at this time. To cover the over-advance against the line
of credit, we established a $675,000, 30-day, automatically renewing
certificate of deposit, which is pledged as collateral to Imperial Bank. The
cash restriction will remain in effect until such time as our over-advance is
cured.

5. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2001, the FASB issued Financial Accounting Standard 141  Business
Combinations (FAS 141). FAS 141, effective for all business combinations
initiated after July 1, 2001, requires that all business combinations be
accounted for using the purchase method of accounting. Further, FAS 141
requires certain intangible assets to be recognized as assets apart from
goodwill if they meet certain criteria. FAS 141 also requires expanded
disclosures regarding the primary reason for consummation of the combination
and the allocation of the purchase price to the assets acquired and liabilities
assumed by major balance sheet caption. The Company does not expect the
standard to have a material effect on its results of operations or financial
position.

In July 2001, the FASB issued Financial Accounting Standard 142  Goodwill
and Intangible Assets (FAS 142). FAS 142, effective for fiscal years beginning
after December 15, 2001, defines accounting requirements for the treatment of
goodwill. Under FAS 142, goodwill is considered to have an indefinite life and
is therefore subject to impairment accounting rather than amortization. As the
Company does not have any recorded goodwill as of September 30, 2001, the
standard is not expected to have a material effect on the Companys results of
operations or financial position.

In July 2001, the FASB issued Financial Accounting Standard 143 
Accounting for Asset Retirement Obligations (FAS 143). FAS 143, effective for
fiscal years beginning after June 15, 2002, addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. It applies to legal
obligations associated with the retirement of long-lived assets that result
from acquisition, construction, development, and (or) the normal operation of a
long-lived asset, except for certain obligations of lessees. The Company does
not expect the standard to have a material effect on its results of operations
or financial position.

In August 2001, the FASB issued Financial Accounting Standard 144 
Accounting for the Impairment or Disposal of Long-Lived Assets (FAS 144). FAS
144, effective for fiscal years beginning after December 15, 2001, addresses
financial accounting and reporting for the impairment or disposal of long-lived
assets. The Company does not expect the standard to have a material effect on
its results of operations or financial position.

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

FORWARD LOOKING INFORMATION

Statements made in this filing that are not historical facts are
forward-looking statements. Forward-looking statements include, but are not
limited to, statements containing the words will, should, expect, plan, intend,
anticipate, believe, estimate, predict, potential, believes or continue, the
negative of such terms or other comparable terminology. Actual results may
differ materially from those projected in any forward-looking statements. Such
forward-looking statements are subject to various known and unknown risks and
uncertainties and are therefore not a guarantee of future performance. The
potential risks and uncertainties which could cause actual results to differ
materially include, but are not limited to, the competitive nature of the
Internet filtering industry, changes in domestic market conditions, the success
of our brand and systems development efforts, the absence of patent protection
for our technology, the fact that others have patented various filtering
technologies, customer acceptance of our services, products and fee structures,
and the potential delisting of our stock from the Nasdaq National Market
System. Further information on the factors and risks that could affect our
business, financial condition and results of operations are included in Part I,
Item 1 to the Companys Form 10-K for the year ended September 30, 2001, which
has been filed with the Securities and Exchange Commission and is available at
http://www.sec.gov.

OVERVIEW

N2H2 is an Internet access management company, providing fast and scalable
filtering solutions that conserve bandwidth, increase user productivity, and
seek to limit potential legal liability. Our internet filtering is designed to
enable organizations (enterprises, Internet Service Providers (ISPs), and
schools) to control costs through customizable filtering levels that are
designed to allow access to only the Web content most relevant to their
specific environment.

On January 18, 2002, the Company received a Nasdaq Staff Determination
indicating that N2H2 did not comply with the minimum stockholders equity
requirements for continued listing on the Nasdaq National Market as set forth
in Marketplace Rule 4450(a)(3), and that our securities are, therefore, subject
to delisting from the Nasdaq National Market. We have requested a hearing to
appeal the determination before the Nasdaq Listing Qualifications Panel, in
which we will propose that N2H2s stock listing be moved to the Nasdaq Small
Cap Market. The appeal, scheduled for February 21, 2002, will stay the
delisting of N2H2 stock pending a decision by the Qualifications Panel. There
is no assurance the Panel will grant our request for continued listing.

In addition, a minimum bid price of $1.00 is required for continued
listing on the Nasdaq National Market System. After the events of September 11,
2001, Nasdaq placed a moratorium on the $1.00 listing requirement, and Nasdaqs
previous delisting action with the Company was dropped. On January 1, 2002,
Nasdaq began again the process of enforcement of its listing requirements. At
the time of this filing, the Companys common stock bid price had closed below
$1.00 per share for a period of thirty consecutive business days from January
1, 2002. The Nasdaq National Market System grants a 90 day grace period,
during which time the Companys stock bid price must trade at or above $1.00
per share for a minimum of ten consecutive business days in order to regain
compliance. In the event N2H2s stock price does not rise above $1.00 for the
required ten consecutive business days, Nasdaq would have the right to delist
the stock and then the Company would have the right to request a hearing to
appeal a determination that the stock should be delisted. There is no guarantee
that the Company would prevail in such a hearing.

If the Companys stock were delisted, the delisting would most likely have
a material adverse affect on the price of its common stock, would adversely
affect the liquidity of the shares held by its shareholders, and would severely
restrict any ability the Company may have to raise additional capital.

RESULTS OF OPERATIONS  THREE MONTHS ENDED DECEMBER 31, 2001

Revenues

We generate our revenues from installation, subscription and maintenance
fees charged for our Internet filtering services, consulting fees, and through
June 30, 2001, advertising fees.

Internet filtering and consulting services revenues increased by 33% to
$2.9 million for the quarter, compared to $2.2 million for the comparable
period in the prior fiscal year. Due to our strategic move away from the
advertising model, sales efforts during the second half of fiscal 2001 were
largely focused on converting school customers from the advertising-based
filtering model to our

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subscription fee-based filtering model. These conversions have resulted
in a significant increase in our subscription contracts with education
customers. In addition, our new software plug-in filtering solutions have
added to our revenue base for fiscal 2002.

During fiscal 2001, we terminated our advertising-based fee structure
previously offered to schools and converted over 70% of those customers to a
fee-paying subscription model. Accordingly, advertising revenue has been
eliminated.

Internet filtering services and customer support costs

Internet filtering services and customer support costs consist of the
costs of Website review, technical installation and support, system development
and network operations, search engine services, collocation, bandwidth, and an
allocation of corporate facilities costs. Internet filtering services and
customer support costs decreased by 43% to $0.8 million for the quarter,
compared to $1.5 million for the comparable period in the prior fiscal year.
The decrease is primarily due to reduced level of staffing and
personnel-related expenses. In addition, we renegotiated key vendor contracts
to obtain more favorable terms. We anticipate that internet filtering services
and customer support costs will remain materially consistent with first quarter
levels through the remainder of the fiscal year.

Educational content and advertising costs

Educational content and advertising costs previously consisted of product
license fees and advertiser commissions. Educational content and advertising
costs have been eliminated due to the conclusion of the advertising-based
filtering model.

Sales and marketing

Sales and marketing expenses consist primarily of salaries, commissions,
stock compensation expense, marketing brochures, trade shows, market research,
corporate brand identification, public relations, advertising and travel.
Sales and marketing also includes an allocation of corporate facilities costs.

Sales and marketing expenses decreased by 56% to $1.8 million for the
quarter, from $4.1 million for the comparable period in the prior fiscal year.
The decrease is due in part to our reduced direct sales staffing and related
expenses, as we have shifted a large portion of our sales efforts to an
indirect sales channel in which we will leverage resellers to increase our
customer base. In addition, deferred stock compensation expense related to the
employment of two executives of N2H2 Pty Limited, our Australian sales office,
has declined as a result of an accelerated method of amortization.
Renegotiations of various marketing contracts and the elimination of sales and
marketing expenditures related to the advertising-based filtering program have
also contributed to the decrease in total sales and marketing expense. We
expect that sales and marketing costs will increase in the upcoming
quarters as we launch new products and expand our reseller channel.

General and administrative

General and administrative expenses consist primarily of salaries,
benefits and related costs for executive, finance, human resources and
administrative personnel, third party professional service fees and an
allocation of corporate facilities costs.

General and administrative expenses decreased by 33% to $1.0 million for
the quarter, from $1.5 million for the comparable period in the prior fiscal
year. This decrease is primarily due to reductions in administrative staffing
and related personnel costs. In addition, amortization of deferred stock
compensation has declined due to the cancellation of certain stock options for
employees who are no longer with the Company. Further, we have reduced our
spending on professional services and other support functions in a continued
effort to operate within a more disciplined cost structure. We anticipate that
general and administrative expenses will remain materially consistent with
first quarter levels through the remainder of the fiscal year.

Research and development

Research and development costs consist primarily of salaries and benefits
for software developers, consulting fees and an allocation of corporate
facilities costs. Research and development activities consist primarily of
developing new products and enhancing existing products. Product costs related
to internal research and development have been expensed as incurred.

Research and development expenses decreased by 57% to $0.4 million for the
quarter, from $1.0 million for the comparable period in the prior fiscal year.
This decrease is primarily the result of our reduced level of staffing and our
reduced usage of contractors and

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third party service providers in the development of our products, as we
have focused our development efforts on our core filtering products. Research
and development costs are expected to increase slightly in the upcoming
quarters as we prepare to launch new products.

Depreciation and amortization

Depreciation consists of depreciation on all fixed assets and leasehold
improvements. Amortization previously consisted of amortization of technology
licenses and acquired intangible assets. Depreciation and amortization expenses
decreased by 58% to $0.5 million for the quarter, from $1.3 million for the
comparable period in the prior fiscal year. In fiscal 2001, based upon changes
in the Companys service model, the Company wrote off remaining field servers,
acquired intangible assets and technology licenses as their estimated fair
values were less than their recorded amounts and therefore no depreciation or
amortization associated with those assets was recorded in fiscal 2002.

Interest income and expense

Interest income consists primarily of interest earned on our cash
equivalents and held-to-maturity investments, if any. Interest expense
consists of interest paid on our note payable. Net interest income has
decreased by 82% to $43,000, from $243,000 for the comparable period in the
prior fiscal year. The decrease is due to our reduced cash and investment
balance. Interest expense has been substantially eliminated due to the
repayment of all of our outstanding bank debt during fiscal 2001.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were $6.0 million (including restricted cash of
$675,000) or 58% of total assets at December 31, 2001, compared to $6.7
(including restricted cash of $675,000) million or 52% of total assets at
September 30, 2001. The decrease in cash and cash equivalents is primarily due
to cash used to fund operations, combined with minor purchases of computer
equipment and payments under capital lease and note payable obligations.
Operating activities consumed $0.5 million for the period, compared to $4.4
million for the comparable period of the prior fiscal year. We had working
capital of $0.4 million at December 31, 2001, compared to $1.2 million at
September 30, 2001. The decline in working capital is primarily due to our
operating loss for the period and our seasonally low billings during the
quarter.

Investing activities consumed net cash flows of $107,000 during the
period, primarily as a result of additions to property and equipment.
Additions to property and equipment totaled $116,000 during the period,
compared to $711,000 during the comparable period of the prior fiscal year. The
additions to property and equipment during the period primarily consisted of
computer equipment purchased to provide additional backup and storage capacity
for electronic data. We anticipate that only minimal purchases of equipment
will be required to support our customers, internal operations and
administrative infrastructure throughout the remainder of fiscal 2002.

Financing activities consumed $72,000 during the period, due to payments
under capital lease and note payable obligations. We also have a revolving line
of credit facility with Comerica (formerly Imperial Bank), which allows for
draws up to a maximum short-term borrowing of $2.5 million if specified
conditions are met. Current commitments against the line of credit consist of
an irrevocable standby letter of credit for our leased office space in the
amount of $665,000, which expires on July 31, 2005, and a $10,000 deposit held
by Comerica for the issuance of corporate credit cards. The total of these
commitments is in excess of our borrowing base as of December 31, 2001. As a
result, the Company is unable to draw upon the credit facility at this time.
To cover the over-advance against the line of credit, we established a
$675,000, 30-day, automatically renewing certificate of deposit, which is
pledged as collateral to Imperial Bank. The cash restriction will remain in
effect until such time as our over-advance is cured.

Operating expenses will continue to consume our cash resources. However,
at recent rates of net cash consumption, our current cash and cash equivalent
balance is anticipated to be sufficient to sustain our operations for the next
twelve months. Assuming our new software plug-in filtering solutions are
accepted by customers and that we are able to effectively leverage the reseller
distribution channel to expand our customer base, we believe that our cash on
hand, together with cash from operations, will be sufficient to meet our
anticipated cash needs beyond the next 12 months. If cash generated from
operations is insufficient to satisfy our longer-term liquidity requirements,
we may seek to sell additional equity or debt securities or to obtain an
additional credit facility. The incurring of indebtedness would result in
increased fixed obligations and could result in covenants that would restrict
our operations. We have not made arrangements to obtain additional financing
and we cannot assure you that financing will be available in amounts or on
terms acceptable to us, if at all. If we are unable to raise additional funds
on acceptable terms when needed, our business, financial position and results
of operations would be seriously harmed.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in foreign currency
exchange rates and interest rates relating to debt and investment instruments.
We have assets and liabilities denominated in certain foreign currencies
related to our international subsidiaries. We have not hedged our translation
risk on these assets and liabilities as we have the ability to hold them for an
indefinite period. We do not expect that a sudden or significant change in
foreign exchange rates would have a material impact on results of operations,
financial position or cash flows. We believe the reported amounts of cash
equivalents and capital lease obligations at December 31, 2001 are reasonable
approximations of their fair values. As a result, we believe that the market
risk arising from our holdings of financial instruments is minimal.




PART II OTHER INFORMATION




ITEM 1. LEGAL PROCEEDINGS

See discussion of Nasdaq proceedings in the Overview section of
Managements Discussion and Analysis.




ITEM 2(d). CHANGES IN SECURITIES AND USE OF PROCEEDS

At September 30, 2001 the Company had remaining net proceeds from its
initial public offering of $6.2 million. During the three-months ended December
31, 2001, the Company used $0.5 million to fund its operating loss, leaving
remaining net proceeds of $5.7 million.




ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable.




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

Not Applicable.




ITEM 5. OTHER INFORMATION

Not Applicable.




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | a) | Exhibits:
| | -- | ---------



| |  | Not Applicable.
| |  | ---------------



| | b) | Reports on Form 8-K.
| | -- | --------------------



| |  | There were no reports on Form 8-K filed during the quarter ended December 31, 2001.
| |  | -----------------------------------------------------------------------------------

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SIGNATURES

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

|                         |  |            |  |                                                                                
|------------------------ |  | ---------- |  | -------------------------------------------------------------------------------
|                         |  | N2H2, INC.
|                        
|Dated: February 12, 2002 |  | By:        |  | /s/ Philip Welt                                                                
|                         |  |            |  |                                                                                
|                         |  |            |  | Philip Welt
President and Chief Executive Officer
(principal executive officer)

|                         |  |     |  |                                                                                                                             
|------------------------ |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------
|Dated: February 12, 2002 |  | By: |  | /s/ J. Paul Quinn                                                                                                           
|                         |  |     |  |                                                                                                                             
|                         |  |     |  | J. Paul Quinn
Vice President  Chief Financial Officer,
Secretary and Treasurer
(principal financial and accounting officer)

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