<PAGE>

===============================================================================
             UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                       WASHINGTON, D.C. 20549

-------------------------------------------------------------------------------

                              FORM 10-Q

(Mark One)

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

                   FOR THE QUARTERLY PERIOD ENDED March 31, 2002

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

-------------------------------------------------------------------------------

                         Commission file number 0-23634

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

           Delaware                                        84-1079971
(State or other jurisdiction of                         (I.R.S. employer
incorporation or organization)                        Identification number)

        3300 EAST FIRST AVENUE, SUITE 290, DENVER, COLORADO USA 80206
                    (Address of principal executive offices)

                              (303) 293-2992
               (Registrant's telephone number including area code)

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

On May 13, 2002 there were 35,115,879 shares of the Registrant's common stock,
$.001 par value, outstanding.

===============================================================================
<PAGE>

                                KFX INC.
                       FORM 10-Q QUARTERLY REPORT
              FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002

                                TABLE OF CONTENTS

                                                                        PAGE NO.
PART I.  FINANCIAL INFORMATION

     ITEM 1.  FINANCIAL STATEMENTS:

         Consolidated Balance Sheets - March 31, 2002
               and December 31, 2001 (Unaudited)....................        3

         Consolidated Statements of Operations - Three Months Ended
               March 31, 2002 and 2001 (Unaudited)..................        4

         Consolidated Statements of Cash Flows - Three Months Ended
               March 31, 2002 and 2001 (Unaudited)..................        5

         Notes to Consolidated Financial Statements (Unaudited).....        7

     ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
              FINANCIAL CONDITION AND RESULTS OF
              OPERATIONS............................................       17

     ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES
              ABOUT MARKET RISK.....................................       23

PART II.  OTHER INFORMATION

     ITEM 1.  LEGAL PROCEEDINGS.....................................       24

     ITEM 2.  CHANGES IN SECURITIES AND USE OF PROCEEDS.............       24

     ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K......................       24

SIGNATURES..........................................................       25
<PAGE>

<TABLE>
<CAPTION>
                                    KFX INC.
                           CONSOLIDATED BALANCE SHEETS
                                                                              UNAUDITED
                                                                      MARCH 31,        DECEMBER 31,
                                                                        2002              2001
                                                                   ------------      -------------
<S>                                                                <C>               <C>
ASSETS
Current assets
     Cash and cash equivalents .............................       $    926,003      $     604,252
     Trade accounts receivable..............................            770,026            738,442
     Unbilled revenue.......................................            652,334            359,079
     Other receivables......................................            113,330             93,522
     Prepaid expenses.......................................            181,572            253,983
     Debt issue costs, net of accumulated amortization......             66,800            145,954
     Deferred job costs.....................................            347,377            352,714
                                                                   ------------      -------------
         Total current assets...............................          3,057,442          2,547,946
Property, plant and equipment, net of accumulated
     depreciation...........................................            317,973            309,510
Patents, net of accumulated amortization....................          1,698,717          1,712,095
Investment in K-Fuel, LLC...................................            333,385            351,454
Goodwill, net of accumulated amortization...................          7,256,355          7,370,355
Intangibles, net of accumulated amortization................          1,137,936          1,261,083
Debt issue costs, net of accumulated amortization...........             98,081            108,503
Prepaid royalty.............................................            498,000            498,000
Other assets................................................            203,232            157,857
                                                                   ------------      -------------
TOTAL ASSETS................................................       $ 14,601,121        $14,316,803
                                                                   ============      =============

LIABILITIES, REDEEMABLE COMMON STOCK AND STOCKHOLDERS' DEFICIT
Current liabilities
     Accounts payable ......................................       $  2,363,232      $   2,312,526
     Accrued expenses ......................................            751,454            579,892
     Interest payable.......................................            394,532            472,049
     Deferred revenue.......................................          1,453,252          1,028,750
     Deferred income........................................            128,405            152,684
     Short-term notes payable to directors..................            450,000            450,000
     Obligations to repurchase Pegasus preferred stock, net           3,144,839          2,508,788
     Convertible debentures, net............................          3,345,330          7,195,326
     Liability for warrants.................................          4,484,992                 --
     Current maturities of long-term debt...................          1,187,096          5,250,329
                                                                   ------------      -------------
         Total current liabilities..........................         17,703,132         19,950,344
Deferred revenue, less current portion......................            418,961            423,673
Convertible long-term debt, less current maturities.........          3,008,938          2,957,005
Long-term debt, less current maturities.....................            120,000            130,000
                                                                   ------------      -------------
         Total liabilities..................................         21,251,031         23,461,022
                                                                   ------------      -------------
Commitments and Contingencies (Note 10)
Minority interest...........................................          5,085,826          4,534,045
                                                                   ------------      -------------
Redeemable common stock, 2,141,450 and 141,450
     shares issued and outstanding..........................            970,320            424,350
                                                                   ------------      -------------
Stockholders' deficit
    Preferred stock, $.001 par value, 20,000,000 shares
        authorized; none issued.............................                 --                 --
     Common stock, $.001 par value, 80,000,000 shares
        authorized; and 30,134,429 and 28,956,104 shares
        issued and outstanding..............................            30,134              28,956
Additional paid-in capital..................................        77,153,068          72,136,810
Accumulated deficit.........................................       (89,889,258)        (86,268,380)
                                                                   ------------      -------------
         Total stockholders' deficit........................       (12,706,056)        (14,102,614)
                                                                   ------------      -------------
TOTAL LIABILITIES, REDEEMABLE COMMON
STOCK AND STOCKHOLDERS' DEFICIT.............................       $ 14,601,121      $  14,316,803
                                                                   ============      =============
</TABLE>

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

                                       3
<PAGE>

<TABLE>
<CAPTION>
                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

                                                                          UNAUDITED
                                                                  THREE MONTHS ENDED MARCH 31,

                                                                   2002            2001
                                                                   ----            ----
<S>                                                             <C>             <C>
OPERATING REVENUES
Pegasus software licenses and services.....................     $  1,250,961    $   247,950

OPERATING COSTS & EXPENSES
Cost of Pegasus software licenses and services,
  excluding depreciation and amortization..................          767,126        229,520
Marketing, general and administrative expenses.............        1,366,245      1,153,840
Pegasus software research and development..................          136,551        140,736
K-Fuel demonstration plant and laboratory .................           62,915         53,402
Depreciation and amortization..............................          325,226        714,525
                                                                ------------    -----------
  Total operating costs and expenses.......................        2,658,063      2,292,023
                                                                ------------    -----------

OPERATING LOSS.............................................       (1,407,102)    (2,044,073)

Other expense..............................................          (35,697)       (25,734)
Interest expense...........................................       (2,178,071)      (749,485)
Equity in income (loss) of unconsolidated affiliates.......               (8)         2,571
                                                                ------------    -----------
NET LOSS...................................................       (3,620,878)    (2,816,721)

Accretion of redeemable common stock.......................         (113,315)            --
                                                                ------------    -----------

NET LOSS AVAILABLE TO COMMON STOCKHOLDERS..................     $ (3,734,193)   $(2,816,721)
                                                                ============    ===========

NET LOSS PER COMMON SHARE (BASIC AND DILUTED)..............     $      (0.12)   $     (0.11)
                                                                ============    ===========

Weighted-average common shares outstanding.................       30,140,000     25,284,000
                                                                ============    ===========
</TABLE>

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

                                       4
<PAGE>

                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                          UNAUDITED
                                                                  THREE MONTHS ENDED MARCH 31,
                                                                   2002           2001
                                                               ------------    --------------
<S>                                                            <C>            <C>
OPERATING ACTIVITIES
  Net loss.................................................    $ (3,620,878)  $  (2,816,721)
  Adjustments to reconcile net loss to cash
    used in operating activities
      Depreciation and amortization........................         325,226         714,525
      Equity in loss (income) of unconsolidated
        affiliates.........................................               8          (2,571)
      Amortization of debt discount........................       1,445,915         214,449
      Accretion of maturity premiums.......................         234,965         204,699
      Common stock and warrants issued for services........          75,204         107,435
      Minority interest preferred dividends................          51,779          30,986
  Changes in operating assets and liabilities, net of
      business acquired:
      Accounts receivable, unbilled revenue and deferred
        job costs..........................................        (339,310)       (213,262)
      Prepaid and other assets.............................          (5,567)          6,540
      Deferred revenue.....................................         419,790          87,287
      Accounts payable and accrued expenses................          36,244         (28,538)
      Interest payable.....................................         (77,517)       (208,245)
                                                               ------------   -------------
Cash used in operating activities..........................      (1,454,141)     (1,903,416)
                                                               ------------   -------------
INVESTING ACTIVITIES
  Purchases of property and equipment......................         (49,388)         (3,671)
  Patent acquisition and pending patent applications.......         (14,322)        (30,723)
  Cash paid on obligation for acquisition of business......      (4,654,179)             --
  Investments in equity based investees....................          (6,219)             --
                                                               ------------   -------------
Cash used in investing activities..........................      (4,724,108)        (34,394)
                                                               ------------   -------------
FINANCING ACTIVITIES
  Issuance of redeemable common stock and warrants, net....       5,000,000              --
  Issuance of preferred stock in subsidiary................         500,000         500,000
  Proceeds from sale of Pegasus preferred stock............              --       1,850,000
  Proceeds from short-term notes payable...................       1,000,000              --
  Repayment of short-term notes payable to directors.......              --        (100,000)
  Payments on notes payable................................              --        (155,387)
                                                               ------------   -------------
Cash provided by financing activities......................       6,500,000       2,094,613
                                                               ------------   -------------

Increase in cash and cash equivalents......................         321,751         156,803
Cash and cash equivalents, beginning of period.............         604,252         348,955
                                                               ------------   -------------
Cash and cash equivalents, end of period...................    $    926,003   $     505,758
                                                               ============   =============

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
  Cash paid for interest...................................    $    574,709   $     561,031
                                                               ============   =============
</TABLE>
              The accompanying notes are an integral part
              of these consolidated financial statements.

                                       5
<PAGE>

                                    KFX INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (CONTINUED)

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

Three Months Ended March 31, 2002:

KFx Inc. ("KFx" or the "Company") issued 15,000 shares of the Company's common
stock, of which 10,000 of these shares were issued to a related party of the
Chairman and CEO, in exchange for consulting services during the three months.
Accordingly, $42,600 was charged to general and administrative expense.

Convertible Debentures with a principal value of $3,490,000 were converted,
based on a conversion price of $3.00 per share, into 1,163,325 shares of the
Company's common stock, which resulted in an addition to stockholders' equity of
$3,839,886, including a pro rata portion of accreted maturity premium and net
of a pro rata portion of unamortized debt issue costs (see Note 6).

During the first quarter of 2002, the Company sold common stock in a private
placement transaction, which reduced the conversion price of the Convertible
Debentures to $2.50 per share. The reduction of the conversion price resulted
in a beneficial conversion feature of $802,000, which was recorded as debt
discount and an addition to stockholders' equity. The debt discount is being
amortized to interest expense over the remaining life of the Convertible
Debentures (see Note 6).

The Company issued warrants to purchase 500,000 shares of KFx common stock in
conjunction with the notes payable issued during the first quarter of 2002,
resulting in debt discount of $446,265, which is being amortized to interest
expense through the maturity of the notes on June 30, 2002.

The Company issued a warrant to purchase 2,250,000 shares of KFx common stock
in conjunction with a private placement of the Company's common stock during
the first quarter, resulting in accretion expense of $113,315 (see Note 8).

Three Months Ended March 31, 2001:

The Company issued 106,250 shares of common stock, of which 50,000 of these
shares were issued a related party of the Chairman and CEO, in exchange for
consulting services during the three months and to satisfy an obligation that
existed at December 31, 2000. Accordingly, approximately $107,000 was charged
to general and administrative expense and $89,000 reduced a liability
outstanding at December 31, 2001.

In connection with the sales of Pegasus preferred stock, subject to KFx's
obligation to repurchase, a debt discount of $1,740,000 was recorded, which is
being amortized to interest expense over the one-year term of the repurchase
obligation.

On March 3, 2001, Kennecott Energy's put option relative to its Pegasus common
stock expired; accordingly, the $1,000,000 sales price has been included in
minority interest as of March 31, 2001.

                                       6
<PAGE>

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

NOTE 1.  BASIS OF PRESENTATION

    The accompanying unaudited consolidated financial statements include the
accounts of KFX Inc. ("KFx" or the "Company"), its wholly owned subsidiary, KFX
Wyoming Inc., and its majority-owned subsidiaries, Pegasus Technologies, Inc.
("Pegasus"), KFX Technology, Inc. ("KFxT"), and Heartland Fuels Corporation.
The Company's 51% interest in K-Fuel, L.L.C. ("K-Fuel, LLC") is accounted for
as an equity investment since the 49% partner, Kennecott Energy Company
("Kennecott Energy"), has certain participative rights; accordingly, the
Company does not control K-Fuel, LLC.

    The consolidated financial statements at March 31, 2002 and for the
three-month periods ended March 31, 2002 and 2001 are unaudited. In the opinion
of the Company's management, all adjustments, consisting of only normal
recurring adjustments, necessary for a fair statement of the results for the
interim periods have been made. Certain reclassifications have been made to the
2001 financial statements to conform to the current year presentation.

    Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. These financial statements should be read in
conjunction with the audited financial statements and notes to financial
statements for the year ended December 31, 2001 included in the Company's Form
10-K/A. The accounting policies used in the preparation of these unaudited
quarterly financial statements are the same as those policies used in the
preparation of the audited annual financial statements. The results of
operations for the three months ended March 31, 2002 are not necessarily
indicative of the results of operations expected for the year ended December
31, 2002.

    The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has incurred net
losses of approximately $15,177,000, $12,290,000 and $12,730,000 and negative
cash flow from operations of approximately $6,738,000, $5,151,000 and $3,458,000
in the years ended December 31, 2001, 2000 and 1999, respectively, and an
additional net loss of $3,620,878 and negative cash flow from operations of
$1,454,141 in the three months ended March 31, 2002 and had an accumulated
deficit of approximately $89,889,258 as of March 31, 2002. These factors,
coupled with the need for additional financing to fund operations and planned
growth in the business, raise substantial doubt about whether the Company can
continue as a going concern. The Report of Independent Accountants, dated April
12, 2002, covering the Company's consolidated financial statements for the year
ended December 31, 2001 included an explanatory paragraph discussing this going
concern uncertainty.

    In order to mitigate this uncertainty, the Company intends to seek further
capital through various means which may include the sale of all or a portion of
its interest in Pegasus, additional sales of debt or equity securities, a
business combination or other means and to further reduce expenditures as
necessary. Should the Company not be successful in achieving one or more of
these actions, it is possible that the Company may not be able to continue as a
going concern. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

    Net loss per common share for the three month periods ended March 31, 2002
and 2001 are based on the weighted-average number of shares of common stock
outstanding during the period, and excludes approximately 11,902,000 and
10,642,000 of potentially issuable common shares from common stock options,
warrants and convertible debt, as the effect on the Company's net loss would be
anti-dilutive.

NOTE 2.  ISSUANCES AND SALES OF PEGASUS PREFERRED STOCK

    On March 3, 2000, KFx and Pegasus closed a transaction with Kennecott Energy
that included, among various other elements, (a) the sale of 4% of the common
stock of Pegasus, held by KFx ("Pegasus Common Stock"), to Kennecott Energy for
$1,000,000, (b) the issuance by Pegasus to Kennecott Energy, in exchange for
$500,000, of newly authorized 6% cumulative convertible preferred stock
("Pegasus Preferred Stock") equivalent to an additional 2% interest in Pegasus
on an as converted basis, and (c) the joint development by KFx, Pegasus and
Kennecott Energy of a work plan for enhancements to NeuSIGHT, new product
development and the completion of

                                       7
<PAGE>

other tasks designed to improve the performance of Pegasus and trigger
additional purchases of Pegasus Preferred Stock by Kennecott Energy at its
discretion of up to $3,500,000, for an additional interest in Pegasus up to
14%, on an as converted basis, by December 31, 2004 or earlier. Through March
31, 2002, Kennecott Energy has purchased $3,000,000 of additional Pegasus
Preferred Stock, $500,000 of which was purchased during the three months ended
March 31, 2002. The entire Kennecott Energy investment in Pegasus is included
in minority interest as of March 31, 2002.

    During 2001, KFx closed transactions with various parties pursuant to which
KFx sold all of its preferred stock investment in Pegasus for $2,722,330, which
represents an approximate 16% interest in Pegasus on an as converted basis.
Included in these sales of Pegasus preferred stock were sales to Evergreen
Resources, Inc. ("Evergreen"), whose Chairman is a director of KFx, for
$1,500,000, two directors of KFx and KFx's Chairman, Theodore Venners, for
$300,000, and a related party of KFx's Chairman for $100,000. These sales to
related parties represent an as converted interest in Pegasus of approximately
11.2%.

    KFx is obligated to repurchase this preferred stock, or any other security
issued with respect to this preferred stock, at a premium of 33% over the
original purchase price, plus interest at an annual rate of 6% on the accreted
repurchase price, at dates varying from January 31, 2002 to November 20, 2002,
or earlier upon the occurrence of certain events, such as a change in control.
In certain circumstances, the parties can individually elect to exchange their
interest in Pegasus, with an aggregate maturity value of $3,847,562, for common
stock of KFx at $3.65 per share, subject to certain adjustments, including a
reduction to the then current market value upon the conversion or redemption of
the Company's 6% Convertible Debentures due July 31, 2002 ("Debentures"). In
addition, the parties were provided with warrants, expiring five years after
their issue, to purchase an aggregate amount of 1,814,887 shares of KFx common
stock at an exercise price of $3.65 per share, subject to certain adjustments
including a reduction to a weighted-average price of $2.52 per share upon the
conversion or redemption of the Company's Debentures. The terms of these
agreements are substantially the same except that Evergreen can elect to defer
the repurchase date to January 31, 2003, in which case it will receive the right
to purchase from KFx an additional interest in Pegasus on similar terms,
excluding additional warrants to purchase KFx common stock.

    Based on the terms and characteristics of the preferred stock sales as
discussed above, the instruments have been classified as debt in the March 31,
2002 balance sheet. Accordingly, the Company estimated the fair value of the
related warrants and recorded an aggregate debt discount of $1,179,037. The
Company calculated the debt discount amount based upon an allocation of the
initial sales proceeds to the relative fair value of the debt and warrants in
accordance with Accounting Principles Board Opinion No. 14, "Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants" ("APB 14"). The
estimated fair value of the warrants was determined using a Black-Scholes
option-pricing model using an expected life of 5 years, expected volatility
ranging from 73% to 76%, a risk free interest rate ranging from 4.1% to 5.0%,
and an expected dividend yield of zero. In addition, the difference between the
effective conversion price of the preferred stock and the fair value of KFx's
common stock on the respective dates of the transactions resulted in a
beneficial conversion feature in an aggregate amount of $1,351,217, which was
calculated in accordance with EITF 98-5, "Accounting for Convertible Securities
with Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios" and EITF 00-27, "Application of Issue No. 98-5 to Certain Convertible
Instruments." The unamortized portion of the debt discount associated with the
warrants and the beneficial conversion feature, is $509,363 at March 31, 2002.
During the three months ended March 31, 2002, the Company recorded $428,076 in
interest expense related to the amortization of the debt discount associated
with the warrants and beneficial conversion feature, and recorded $207,975 of
interest expense related to the accretion of these instruments to their
respective redemption values.

    At March 31, 2002, as a result of the additional investments by Kennecott
Energy in Pegasus Series B Preferred Stock and KFx's sale of a portion of its
Pegasus Preferred Stock, the ownership, on an as converted basis, of Pegasus is
approximately as follows: KFx--52.0%, Pegasus founders---14.4%, Kennecott
Energy--18.2%, Evergreen--8.5% and other private investors--6.9%.

    On April 30, 2002, the Company satisfied its obligation to repurchase the
Pegasus preferred stock for $3,846,049 (see Note 12).

                                       8
<PAGE>

NOTE 3.  NOTES PAYABLE TO DIRECTORS

    During 2000, the Company borrowed a total of $650,000 consisting of (a) a
$100,000 note payable to the Chairman, due on demand and bearing interest at the
prime rate plus 2% and (b) a $550,000 note payable to another director, bearing
interest at 11.5%, due April 30, 2001 and personally guaranteed by the Company's
Chairman. The Company repaid $400,000 of the notes during 2000 and repaid the
remaining $250,000 during 2001.

    During 2001, Pegasus borrowed $300,000 under an unsecured note payable to
the Company's Chairman and CEO bearing interest at prime plus 2% (6.75% at March
31, 2002), due on demand. The terms of the agreement include a warrant to
purchase 285,000 shares of common stock of Pegasus at an exercise price of $1.07
per share. The Company estimated the fair value of the warrant and recorded
$102,348 as debt discount, which was immediately amortized to interest expense
on the issuance date. The Company calculated the debt discount amount based upon
an allocation of the proceeds to the relative fair value of the debt and
warrants in accordance with APB 14. The estimated fair value of the warrants was
determined using a Black-Scholes option-pricing model using an expected life of
3 years, expected volatility of 73%, a risk free interest rate of 4.65% and a
dividend yield of zero. At March 31, 2002, the unpaid balance of this note was
$150,000 and the warrant was outstanding and fully exercisable.

    During 2000, Pegasus borrowed $900,000 under three unsecured notes from a
KFx director and one of his affiliates. Under a $400,000 note, which bears
interest at the prime rate plus 2% (6.75% at March 31, 2002) and was initially
due January 21, 2001 (subsequently amended to be due on demand), a fully
exercisable warrant was issued to purchase 350,000 shares of common stock of
Pegasus at an exercise price of $1.07 per share. The Company estimated the fair
value of the warrant and recorded $213,500 as debt discount, which was amortized
to interest expense over the initial six-month term of the note. The Company
calculated the debt discount amount based upon an allocation of the proceeds to
the relative fair value of the debt and warrants in accordance with APB 14. The
estimated fair value of the warrants was determined using a Black-Scholes
option-pricing model with an expected life of 3 years, expected volatility of
83%, a risk free interest rate of 6.4% and a dividend yield of zero. The warrant
expires in July 2003. At March 31, 2002, the warrant was outstanding and fully
exercisable. An additional $200,000 was borrowed under a separate note issued to
this director, which bears interest at the prime rate plus 2% (6.75% at March
31, 2002), is due on demand, and is personally guaranteed by KFx's Chairman. At
March 31, 2002, the unpaid balance of the three unsecured notes was $300,000.

NOTE 4.  NOTES PAYABLE

    In January 2002, the Company borrowed $500,000 under an unsecured note
payable bearing interest at 10% per annum, due on June 30, 2002. The terms of
the agreement include a warrant to purchase 250,000 shares of common stock of
KFx at an exercise price of $3.00 a share. The Company estimated the fair value
of the warrant and recorded a debt discount of $223,817, which is being
amortized to interest expense over the term of the note. The Company calculated
the debt discount amount based upon an allocation of the proceeds to the
relative fair value of the debt and warrants in accordance with APB 14. The
estimated fair value of the warrants was determined using a Black-Scholes
option-pricing model using an expected life of 3 years, expected volatility of
83%, a risk free interest rate of 3.46% and a dividend yield of zero. At March
31, 2002, the entire balance of this note was outstanding and the warrant was
outstanding and fully exercisable.

    In February 2002, the Company borrowed $500,000 under four unsecured notes
payable bearing interest at 10% per annum, due on June 30, 2002. The terms of
the agreements include warrants to purchase a total of 250,000 shares of common
stock of KFx at an exercise price of $3.00 a share. The Company estimated the
fair value of the warrant and recorded a debt discount of $222,448, which is
being amortized to interest expense over the term of the notes. The Company
calculated the debt discount amount based upon an allocation of the proceeds to
the relative fair value of the debt and warrants in accordance with APB 14. The
estimated fair value of the warrants was determined using a Black-Scholes
option-pricing model using an expected life of 3 years, expected volatility of
82%, a risk free interest rate of 3.50% and a dividend yield of zero. At March
31, 2002, the entire balance of these notes was outstanding and the warrant was
outstanding and fully exercisable.

                                       9
<PAGE>

NOTE 5.  CONVERTIBLE LONG-TERM DEBT

    On July 25, 2001, Cinergy Corp. ("Cinergy") advanced $3.5 million to Pegasus
against the existing contract between Pegasus and Cinergy, which was signed on
May 1, 2001. The advance bears interest at 7% per annum, payable monthly.
Cinergy may elect to apply future Pegasus invoices against the advance or may
choose to convert the balance of the advance into KFx common stock, at a price
of $3.65 per share, or into Pegasus common stock, at a price of $2.10 per share,
subject to certain adjustments. The note is also putable by Cinergy upon (i) a
change in control of KFx or Pegasus, (ii) the sale of substantially all of
Pegasus' or KFx's assets, (iii) the completion of third party financing for
Pegasus of $12.5 million or for Pegasus and KFx combined of $30 million, or (iv)
termination for cause as set forth in the original contract. Cinergy also
received a warrant, expiring three years after the date of issue, exercisable
for 200,000 shares of KFx common stock, at $3.65 per share. The exercise price
of the warrant resets to $2.75 per share upon conversion, maturity or redemption
of all of the Company's 6% convertible debentures due July 31, 2002. The Company
estimated the fair value of the warrant and recorded a debt discount of
$391,522, which is being amortized to interest expense over the estimated
three-year term of the note. The Company calculated the debt discount amount
based upon an allocation of the proceeds to the relative fair value of the debt
and warrants in accordance with APB 14. The estimated fair value of the warrant
was determined using a Black-Scholes option-pricing model with an expected life
of 3 years, expected volatility of 86%, a risk free interest rate of 4.3% and a
dividend yield of zero. At March 31, 2002, the original balance of this note was
outstanding, the unamortized portion of debt discount was $301,169 and the
warrant was outstanding and fully exercisable.

    In addition, the difference between the effective conversion price of the
note into KFx common stock and the fair value of KFx's common stock on date of
issuance of the note resulted in a beneficial conversion feature in an amount of
$247,687, which was calculated in accordance with EITF 98-5, "Accounting for
Convertible Securities with Beneficial Conversion Features or Contingently
Adjustable Conversion Ratios" and EITF 00-27, "Application of Issue No. 98-5 to
Certain Convertible Instruments." The unamortized portion of the beneficial
conversion feature, which is $189,893 at March 31, 2002, is reflected as
additional debt discount in the balance sheet. During the three months ended
March 31, 2002, the Company recorded $51,933 in interest expense related to the
amortization of the debt discount associated with the warrant and beneficial
conversion feature.

    In relation to the above transaction the Company authorized the granting of
a warrant for professional services rendered to purchase 68,507 shares of the
Company's common stock at an exercise price of $3.00 per share. The estimated
fair value of the warrant of approximately $127,000 was recorded as debt issue
costs and is being amortized over the expected term of the related note. The
fair value of the warrant was determined using a Black-Scholes option-pricing
model using an expected life of 5 years, expected volatility of 76%, a risk free
interest rate of 4.04% and a dividend yield of zero. The warrant expires 5
years from the date of grant.  During the three months ended March 31, 2002,
the Company recorded $10,422 in amortization expense related to the debt issue
costs.

NOTE 6.  CONVERTIBLE DEBENTURES

    On December 3, 2001, the Company sold common stock for $3.00 per share to a
private investor, which reduced the conversion price of the unsecured
convertible debentures (the "Debentures") to $3.00 per share in accordance with
provisions of the Debentures. As a result of the reduction of the conversion
price, the difference between the new conversion price and the fair value of the
Company's common stock on the original issuance date

                                       10
<PAGE>

of the debentures resulted in a beneficial conversion feature of approximately
$2,283,000, calculated in accordance with EITF 98-5 and EITF 00-27. The
unamortized portion of the beneficial conversion feature, which is $331,481 at
March 31, 2002, is reflected as debt discount on the balance sheet and is being
amortized over the remaining life of the debentures. During the three months
ended March 31, 2002, the Company recorded $768,304 in interest expense related
to the amortization of the debt discount.

    On March 28, 2002, the Company sold common stock in a private placement
transaction for $2.50 per share, which reduced the conversion price to $2.50 per
share in accordance with provisions of the Debentures. As a result of the
reduction of the conversion price, the difference between the new conversion
price and the previously adjusted conversion price resulted in a beneficial
conversion feature of $802,000, calculated in accordance with EITF 98-5 and EITF
00-27. The beneficial conversion feature is reflected as debt discount on the
balance sheet and is being amortized over the remaining life of the debentures.
During the three months ended March 31, 2002, the Company recorded $20,390 in
interest expense related to the amortization of the debt discount.

    During the three months ended March 31, 2002, holders of Debentures with a
face value of $3,490,000 exercised their right to convert their Debentures into
common stock of the Company at a conversion price of $3.00 per share.
Accordingly, 1,163,325 shares of common stock were issued, and $3,839,886,
including a pro rata portion of accreted maturity premium, net of a pro rata
portion of deferred debt issue costs, was credited to common stock and
additional paid in capital.

NOTE 7. PURCHASE OF POWER OPTIMIZATION SEGMENT OF PAVILION TECHNOLOGIES, INC.

    Pursuant to an Asset Purchase and License Agreement (the "Purchase
Agreement") between Pavilion, Pegasus and KFx, dated July 31, 2001, certain
assets and liabilities relating to the Pavilion Power Optimization Division were
acquired by Pegasus. These purchased assets and acquired liabilities were
primarily accounts receivable, unbilled revenue, deposits, customer list,
exclusive rights to license Pavilion's software, other intangibles and deferred
revenue. Pavilion has retained certain liabilities of the Power Optimization
Division, including but not limited to Pavilion indemnifying Pegasus regarding
the intellectual property of Pavilion's software being licensed. The Purchase
Agreement initially provided for a base price of $9.5 million in cash, payable
to Pavilion in installments through July 31, 2003, adjusted for the net of
assets and liabilities assumed. Additionally, Pegasus was to initially pay
Pavilion royalties of up to $5.5 million between August 1, 2001 and October 31,
2005, based on Pavilion and Pegasus software licenses sold by Pegasus. During
2001, Pegasus made payments to Pavilion totaling $2,447,740 against the base
purchase price. KFx guarantees the duties and obligations of Pegasus under the
Purchase Agreement. On March 28, 2002, the Purchase Agreement between Pavilion,
Pegasus and KFx was amended to decrease the base cash payment to $7.5 million,
from $9.5 million, subject to certain adjustments for the value of assets and
liabilities acquired and transaction costs. This reduction resulted in a net
purchase price adjustment, based upon the present value of the payments, of
approximately $1.5 million, which was recorded as a reduction of goodwill as of
December 31, 2001. The amendment also increased the future royalty payments on
licenses sold to a total of $9 million with no expiration date on the royalty
payment period. Future royalty payments are considered contingent purchase price
and will result in additions to goodwill as the royalties become due. As of
March 31, 2002, the Company had incurred $142,000 in royalty obligations as a
result of the sales of software licenses subsequent to the consummation of the
acquisition, $36,000 of which were incurred during the three months ended
March 31, 2002. Per the terms of this amendment, Pegasus paid Pavilion $4.35
million on March 28, 2002 as the final base purchase price payment for the
acquisition.

                                       11
<PAGE>

    This acquisition expands the software product offerings, customer installed
base, and technical expertise as well as effectively dismissing the Pavilion
Lawsuit, which allows management to concentrate on the growth of Pegasus. The
acquisition has been accounted for by the purchase method and the results of
operations are included in the Company's financial statements beginning in the
third quarter of 2001. The assets acquired and liabilities assumed were recorded
at estimated fair values. The allocation of the purchase price to net assets
acquired, liabilities assumed and intangible assets was based on an independent
valuation of those assets as follows:

(dollars in thousands):

Purchase price (including royalty obligations incurred)     $   7,006
Fair value of identifiable intangible assets acquired           1,426
Deferred revenue                                                 (269)
                                                            ---------
Excess cost over net assets acquired                            5,849
Acquisition costs                                                 269
                                                            ---------
Goodwill                                                    $   6,118
                                                            =========

    The purchase price was reduced by $150,000 during the quarter based on the
transaction costs incurred relating to the March 28, 2002 amendment to the
Purchase Agreement. Goodwill recognized as a result of the transaction is
attributable to Pegasus and all activity relating to the goodwill was assigned
to the Pegasus segment.

     The intangible assets acquired consist of the following:

                                                         March 31, 2002
                                                         --------------
     Order backlog, 18 month useful life                   $  319,000
     Customer lead list, 18 month useful life              $  117,000
     Maintenance contract, 7 year useful life              $  990,000
                                                           ----------
     Total                                                 $1,426,000
     Less accumulated amortization                        ($  288,064)
                                                           ----------
     Net book value                                        $1,137,936
                                                           ==========

     Amortization expense for the above intangible assets for the three months
ended March 31, 2002 was approximately $123,000. Estimated future amortization
expense is as follows (including amortization expense charged through March 31,
2002):

     For the year ended December 31, 2002                  $  447,219
     For the year ended December 31, 2003                  $  165,650
     For the year ended December 31, 2004                  $  141,429
     For the year ended December 31, 2005                  $  141,429
     For the year ended December 31, 2006                  $  141,429
     Thereafter                                            $  223,927

NOTE 8. REDEEMABLE COMMON STOCK

    On March 28, 2002, the Company issued 2 million shares of KFx common stock
at a price of $2.50 per share and warrants to purchase 2.25 million shares of
KFx common stock, which resulted in cash proceeds to the Company of $5 million.
The warrants have an exercise price of $2.75 per share, and are subject to
adjustment through March 27, 2003, in the event that the Company issues options,
warrants or other securities convertible to KFx common stock at a price of less
than $2.75 per share. The common stock issued is subject to redemption pursuant
to a put option, in whole or in part, at the option of the investors. The put
option is exercisable upon the earlier of July 31, 2002 or upon the redemption
or conversion of all of the Convertible Debentures. At the time the investors
notify KFx of their intent to exercise the put option, KFx must repurchase the
common stock at a price of $2.50 per share plus accrued interest ("Redemption
Value") within 100 days of notification. Interest for purposes of redemption
accrues at the rate of 9% per annum, beginning upon the original issuance date
and ceases on the date which the common stock is repurchased. If two-thirds or
more of the investors exercise their put option and KFx is unable to secure the
necessary funding to satisfy these exercised put options, KFx must transfer its
entire interest in Pegasus to the investors. The put option expires on December
23, 2002. Until the put option expires, the Company is precluded from issuing,
selling, transferring or pledging any of its interest in Pegasus and Pegasus is
precluded from transferring any rights with respect to its equity and assets
without approval of at least two-thirds of the investors.

     As a result of the put option, the common stock issued to the investors is
classified as redeemable common stock in the mezzanine level of the consolidated
balance sheet as of March 31, 2002, and is being accreted to its redemption
value of $5,154,110, which includes 9% interest, through July 31, 2002, the date
upon which the put option first becomes exercisable. During the three months
ended March 31, 2002, the Company recorded approximately $113,000 of expense
related to the accretion of the redeemable common stock to its redemption value.

                                       12
<PAGE>

    In addition, the investors have the right to select two persons to serve on
the board of directors of KFx and, upon election to the board, KFx has agreed to
appoint these two persons to serve on the board's executive committee. This
agreement will remain in force until the investors hold less than 400,000 shares
of KFx's common stock. In accordance with the terms of the investment agreement,
approximately $4.4 million of the proceeds were required to be applied against
the outstanding amount on the Pavilion Power Optimization Division acquisition
obligation.

    As part of the agreement the Company is required to register the shares
issued, including the potential shares of common stock underlying the warrants,
in a qualifying registration statement. In the event that a registration
statement has not been declared effective by June 21, 2002, the Company shall
issue additional warrants to purchase shares of common stock equal to 10 percent
of the warrants currently held by the investor for each 30-day period for which
the registration statement has not been declared effective. These new warrants
will have the same terms and conditions as the original warrants issued to the
investors.

     In March 2000, the Emerging Issues Task Force ("EITF") reached a consensus
on the application of Issue No. 96-13, "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" with
Issue No. 00-7, "Application of Issue No. 96-13 to Equity Derivative Instruments
That Contain Certain Provisions That Require Net Cash Settlement if Certain
Events Outside the Control of the Issuer Occur" ("EITF 00-7"). Equity
derivatives that contain any provision that could require net cash settlement
must be marked to fair value through earnings under EITF 00-7. The EITF reached
a consensus on Issue No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock" ("EITF 00-19") in
September 2000.

     In accordance with EITF 00-19, as the Company is required to issue
additional warrants in the event that the registration statement is not declared
effective and, as there is no cap on the number of warrants that could be
issued, the warrants have been recorded at their estimated fair value of
$4,484,992 on the issuance date as a liability on the consolidated balance
sheet. The estimated fair value of the warrants was determined using a Black-
Scholes option-pricing model using an expected life of 8 years, expected
volatility of 67%, a risk free interest rate of 5.7% and a dividend yield of
zero. The difference between the estimated fair value of the warrants and the
proceeds received from the transaction was recorded as redeemable common stock
of $432,655, net of related issuance costs of $82,353. Until the registration
statement for the warrants and redeemable common stock is declared effective,
the warrants will be marked to their estimated fair value using a Black-Scholes
option-pricing model with any difference recorded to interest expense. Upon the
registration statement being declared effective, the related outstanding
warrants will be reclassified to equity at their then current estimated fair
value.

    During 2001, the Company issued 141,450 shares of common stock, which is
presented as redeemable common stock on the balance sheet at a redemption value
of $424,350 as of March 31, 2002, to an investment banker in return for services
rendered. The common stock is redeemable for cash at the option of the holder at
the greater of $3.00 per share or the weighted-average fair market value of the
Company's common stock for the preceding fifteen days. The stock is only
redeemable after the Company consummates a qualifying equity transaction, which
occurred on March 28, 2002 (see above), and upon the retirement or conversion of
all of the outstanding Debentures.

NOTE 9. SEGMENT INFORMATION

    KFx's reportable segments are based on its principal products and services,
which are optimization software and related services, through its Pegasus
subsidiary ("Pegasus" segment), and clean fuels technology, through certain
activities of KFx and certain of its subsidiaries ("K-Fuel" segment). The
accounting policies of these segments are the same as described in the Company's
Annual Report on Form 10-K/A for the year ended December 31, 2001. In addition,
the goodwill and intangibles and related amortization resulting from the
acquisitions of Pegasus and Pavilion are included in the Pegasus segment. KFx
evaluates the performance of its segments and allocates resources to them
primarily based on its view of the potential for net income and operating cash
flow. There are no intersegment revenues; however, KFx's corporate office
charges management and related fees to the Pegasus segment, based on actual
costs and estimated time and other resources devoted to assist with and support
the activities of Pegasus.

                                       13
<PAGE>

    The following table presents information about revenues, net loss, cash used
in operating activities, segment assets and certain other information used by
KFx's Chairman and CEO, its chief operating decision maker, as of March 31, 2002
and 2001 and for the three month periods then ended:

<TABLE>
<CAPTION>
                                                                 RECONCILING
        THREE MONTHS ENDED          PEGASUS           K-FUEL      ITEMS (a)       CONSOLIDATED
        ------------------          -------           ------     -----------      ------------
<S>                                <C>             <C>          <C>             <C>
          March 31, 2002
          --------------
Operating Revenues..............   $   1,250,961   $       --   $        --     $    1,250,961

Net Loss........................   $    (836,788)     (94,203)  $ (2,689,887)   $   (3,620,878)

Cash Used in
Operating Activities............   $    (678,494)  $   (2,573)  $   (773,074)   $   (1,454,141)

Total Assets                       $  10,746,924   $2,305,325   $  1,548,872    $   14,601,121

          March 31, 2001
          --------------
Operating Revenues..............   $     247,950   $       --   $         --    $      247,950

Net Loss........................   $  (1,018,249)  $ (457,448)  $ (1,341,024)   $   (2,816,721)

Cash Provided by (Used in)
Operating Activities               $    (559,764)  $    6,187   $ (1,349,839)   $   (1,903,416)

Total Assets                       $   3,177,893   $2,884,462   $  2,016,609    $    8,078,964
</TABLE>

(a) Consists primarily of KFx corporate office activities and consolidating
    entries.

NOTE 10. CONTINGENCIES

    On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden ("Sanden")
filed a complaint against the Company in US District Court for the District of
Colorado. The complaint alleged that KFx, Link, Kobel and Sanden had entered
into an agreement requiring KFx to acquire Link and that KFx breached such
agreement. The complaint sought damages in excess of $5.3 million. This
litigation was settled in February 2002 with the costs of the settlement borne
by the Company's insurance carrier.

    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 (other than the
current facility owned by BKH) located in the United States in which the
feedstock is coal and which uses the Company's proprietary 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 March 31, 2002 under
these agreements.

    The Company is contingently liable to the State of Wyoming for a 12% royalty
on a license fee for patents and other intellectual properties sold and
transferred by the Company to Kennecott Energy. This amount is only payable to
the State of Wyoming if Kennecott Energy builds a K-Fuel commercial production
facility in the United States.

    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 agreement,
Mr. Koppelman's royalty is now 25% of the Company's worldwide royalty and
license fee revenue, computed after a State of Wyoming royalty. The royalty to
Mr. Koppelman will cease when the cumulative payments to him reach the sum of
approximately $75,222,000. Mr. Koppelman is now deceased and his estate holds
all royalty rights. The total amount paid under this agreement through March 31,
2002 was $250,000.

                                       14
<PAGE>

    Pegasus is contingently liable to certain of its founding stockholders for a
royalty equivalent to 2% of the license fee revenues derived from the sale its
NeuSIGHT product through November 30, 2004. This obligation is limited to the
extent of pretax income without regard to such royalty, subject to a maximum of
$2.5 million and certain other limitations. Through March 31, 2002, Pegasus has
made no payments or accruals under this agreement.

    Under terms of an amendment to the Purchase Agreement, Pegasus is
contingently liable to Pavilion for $9 million in royalty payments based on all
software licenses sold starting with the date of the agreement. These royalty
payments are considered contingent purchase price and will be added to goodwill
as such royalties become due. Through March 31, 2002, $142,000 in royalties was
payable, and added to goodwill, under the amended Purchase Agreement.

NOTE 11. RECENT ACCOUNTING PRONOUNCEMENTS

    In July 2001, the Financial Accounting Standard Board ("FASB") issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("FAS 142"). FAS 142 requires that after a company allocates
the purchase price in accordance with FAS 141, the assets acquired, liabilities
assumed and goodwill must be assigned to one or more reporting units based on
certain criteria outlined in FAS 142. In addition, goodwill will no longer be
amortized. FAS 142 is effective for the Company for any goodwill acquired in a
business combination entered into after June 30, 2001, including the acquisition
of certain assets of Pavilion, see Note 7. The remaining provisions of the
Statement are effective beginning in the first six months of 2002. As of March
31, 2002, the net carrying value of the goodwill relating to KFx's acquisition
of Pegasus was $1,138,017. There has been no amortization expense recorded for
this goodwill during 2002 and this goodwill will no longer be amortized.

    FAS 142 requires that goodwill be tested annually for impairment using a
two-step process. The first step is to identify a potential impairment and, in
transition, this step must be measured as of the beginning of the fiscal year.
However, a company has six months from the date of adoption to complete the
first step. The Company expects to complete that first step of the goodwill
impairment test during the first six months of 2002. The second step of the
goodwill impairment test measures the amount of the impairment loss (measured as
of the beginning of the year of adoption), if any, and must be completed by the
end of the Company's fiscal year. Any impairment loss resulting from the
transitional impairment tests will be reflected as the cumulative effect of a
change in accounting principle in the first six months of 2002. The Company
anticipates that these impairment tests will not have a material impact upon the
Company's financial position, results of operations or cash flows.

    The unaudited pro forma results of operations for the three months ended
March 31, 2002 and 2001, assuming the adoption of FAS 142 as of January 1, 2001
are as follows:

<TABLE>
<CAPTION>
                                                                          Unaudited Pro Forma
(in thousands, except per share amounts)                              Three Months Ended March 31,
                                                                          2002            2001
                                                                          ----            ----
<S>                                                                    <C>             <C>
Net loss as reported                                                   $  (3,621)      $  (2,817)
Adjustments for goodwill amortization                                  $      --       $     170
                                                                       ----------      ----------
Adjusted net loss                                                      $  (3,621)      $  (2,647)
                                                                       ==========      ==========
Adjusted net loss per common share (basic and diluted)                 $   (0.12)      $   (0.10)
                                                                       ==========      ==========
</TABLE>

    On October 3, 2001, the FASB issued Statement of Accounting Standards No.
144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS
144"). FAS 144 supercedes FAS 121 "Accounting for the

                                       15
<PAGE>

Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
FAS 144 applies to all long-lived assets (including discontinued operations)
and consequently amends Accounting Principles Board Opinion No. 30, "Reporting
Results of Operations - Reporting the Effects of Disposal of a Division of a
Business" ("APB 30"). FAS 144 develops one accounting model for long-lived
assets that are to be disposed of by sale. FAS 144 requires that long-lived
assets that are to be disposed of by sale be measured at the lower of book
value or fair value less cost to sell.  Additionally, FAS 144 expands the scope
of discontinued operations to include all components of an entity with
operations that (1) can be distinguished from the rest of the entity and (2)
will be eliminated from the ongoing operations of the entity in a disposal
transaction. FAS 144 is effective for the Company's financial statements issued
in fiscal 2002. The Company has not yet determined the impact of FAS 144 on the
Company's financial position, results of operations or cash flows.

NOTE 12. SUBSEQUENT EVENTS

Sale of Common Stock
--------------------

    On April 30, 2002, the Company issued 2.4 million shares of KFx common
stock at a price of $2.50 per share and warrants to purchase 2.7 million shares
of KFx common stock, which resulted in cash proceeds to the Company of $6
million. The warrants have an exercise price of $2.75 per share, and are subject
to adjustment through April 30, 2003, in the event that the Company issues
options, warrants or other securities convertible to KFx common stock at a price
of less than $2.75 per share. The sale of the common stock was to the same
investment group that purchased the KFx common stock and warrants on March 28,
2002 for $5 million. The purchase was completed pursuant to an Addendum to the
original Common Stock and Warrant Purchase Agreement ("Addendum"), on
substantially equivalent terms, including a put option on the common stock with
the same terms.

    As a result of the put option, the common stock issued to the investors will
be classified as redeemable common stock in the mezzanine level of the
consolidated balance sheet as of June 30, 2002, and will be accreted to its
redemption value of approximately $6,136,000, which includes 9% interest,
through July 31, 2002, the date upon which the put option first becomes
exercisable.

    The Addendum allows, at the option of the investors and anytime prior to
July 31, 2002, on the same terms, the investors to have the right to purchase up
to an additional $9 million of common stock and to receive an equivalent amount
of warrants on a pro rata basis.

    As part of the agreement the Company is required to register the shares
issued, including the potential shares of common stock underlying the warrants,
in a qualifying registration statement. In the event that a registration
statement has not been declared effective by June 21, 2002, the Company shall
issue additional warrants to purchase shares of common stock equal to 10 percent
of the warrants currently held by the investor for each 30-day period for which
the registration statement has not been declared effective.

    In the event that the registration statement has not been declared effective
as of June 30, 2002, the warrants will be recorded at their estimated fair value
of approximately $5,000,000 on the issuance date as a liability on the
consolidated balance sheet. The estimated fair value of the warrants was
determined using a Black-Scholes option-pricing model using an expected life of
8 years, expected volatility of 67%, a risk free interest rate of 5% and a
dividend yield of zero. The difference between the estimated fair value of the
warrants and the proceeds received from the transaction will be recorded as
redeemable common stock of approximately $1,000,000, net of related issuance
costs. Until the registration statement for the warrants and redeemable common
stock is declared effective, the warrants will be marked to their estimated fair
value using a Black-Scholes option-pricing model with any difference recorded to
interest expense. Upon the registration statement being declared effective, the
related outstanding warrants will be reclassified to equity at their then
current estimated fair value.

    Pursuant to the Addendum, a portion of the proceeds of this investment was
used to satisfy the entire outstanding obligation to repurchase the Pegasus
preferred stock for $3,846,049. In addition, $450,000 of the proceeds shall be
used to fund the development of the K-Fuel demonstration plant and the remaining
proceeds are to be used for general corporate purposes.

Conversion of Debentures
------------------------

    In April 2002, Convertible Debentures with a principal value of $850,000
were converted, based on a conversion price of $2.50 per share, into 340,000
shares of the Company's common stock.

                                       16
<PAGE>

                                    KFX INC.

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

    This quarterly report includes forward-looking statements. We have based
these forward-looking statements on our current expectations and projections
about future events based on our knowledge of facts as of the date of this
quarterly report and our assumptions about future events. These forward-looking
statements are subject to various risks and uncertainties that may be outside of
our control, including, but not limited to:

     .   the ability of the Company to continue as a going concern;
     .   adverse market and various other conditions that could impair the
         Company's ability to obtain needed financing;
     .   actions or the inaction of the Company's strategic partners;
     .   the breadth or degree of protection available to the Company's
         intellectual property;
     .   availability of key management and skilled personnel;
     .   competition and technological developments by competitors;
     .   lack of market interest in the Company's existing products and any new
         products or services;
     .   changes in environmental, electric utility and other governmental
         regulations;
     .   unanticipated problems that could arise in research and development
         activities;
     .   cost overruns, delays and other problems that may occur in developing,
         permitting, financing or constructing K-Fuel production facilities;
     .   the availability of Section 29 or similar tax credits related to any
         future K-Fuel production facilities;
         and
     .   domestic and international economic and political developments.

    We use words like "believe," "expect," "anticipate," "will," "estimate,"
"project," "plan," and similar expressions to help identify forward-looking
statements in this quarterly report.

    For additional factors that could affect the validity of our forward-looking
statements, you should read "Risk Factors" contained in Part I, Item 1 of our
Annual Report on Form 10-K/A for the year ended December 31, 2001, "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
contained in Part II, Item 7 of our Annual Report on Form 10-K/A for the year
ended December 31, 2001 and "Notes to Consolidated Financial Statements"
contained in Part II, Item 8 of our Annual Report on Form 10-K/A for the year
ended December 31, 2001. 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.

    The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. KFx Inc. ("KFx" or the "Company")
has incurred net losses of approximately $15,177,000, $12,290,000 and
$12,730,000 and negative cash flow from operations of approximately $6,738,000,
$5,151,000 and $3,458,000 in the years ended December 31, 2001, 2000 and 1999,
respectively, and an additional net loss of $3,620,878 and negative cash flow
from operations of $1,454,141 in the three months ended March 31, 2002 and had
an accumulated deficit of approximately $89,889,258 as of March 31, 2002. These
factors, coupled with the need for additional financing to fund operations and
planned growth in the business, raise substantial doubt about whether the
Company can continue as a going concern. The Report of Independent Accountants,
dated April 12, 2002, covering the Company's consolidated financial statements
for the year ended December 31, 2001 included an explanatory paragraph
discussing this going concern uncertainty.

    In order to mitigate this uncertainty, the Company intends to seek further
capital through various means which may include the sale of all or a portion of
its interest in Pegasus Technologies, Inc. ("Pegasus"), additional sales of debt
or equity securities, a business combination or other means and to further
reduce expenditures as necessary. Should the Company not be successful in
achieving one or more of these actions, it is possible that the Company

                                       17
<PAGE>

may not be able to continue as a going concern. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.

OVERVIEW

    A 16-month project of its K-Fuel LLC joint venture with Kennecott Energy
culminated in the demonstration of an improved design for a K-Fuel plant that
was announced in February 2001. K-Fuel LLC is conducting studies concerning
appropriate means to further test the new process and design facilities for
production.

    On March 28, 2002, the Asset Purchase and License Agreement ("Purchase
Agreement") between Pavilion Technologies, Inc. ("Pavilion"), Pegasus and KFx
was amended to decrease the total base cash payment to $7.5 million, from $9.5
million, subject to certain adjustments for the value of assets and liabilities
acquired and transaction costs. The amendment also increased the future royalty
payments on licenses sold to a total of $9 million with no expiration date on
the royalty payment period. Future royalty payments are considered contingent
purchase price and will result in additions to goodwill as the royalties become
due. Per the terms of this amendment, Pegasus paid Pavilion $4.35 million on
March 28, 2002 as the final base purchase price payment for the acquisition.

    The renegotiation of the Purchase Agreement and subsequent payment of the
remaining base purchase price was made possible by a private equity investment
in KFx common stock on March 28, 2002. As a result of this investment, the
Company issued 2 million shares of KFx common stock at a price of $2.50 per
share and warrants to purchase 2.25 million shares of KFx common stock, which
resulted in cash proceeds to the Company of $5 million. The common stock issued
is subject to redemption pursuant to a put option, in whole or in part, at the
option of the investors. The put option is exercisable upon the earlier of July
31, 2002 or upon the redemption or conversion of all of the Convertible
Debentures. If two-thirds or more of the investors exercise their put option and
KFx is unable to secure the necessary funding to satisfy these exercised put
options, KFx must transfer its entire interest in Pegasus to the investors. The
put option expires on December 23, 2002. As a result of the put option, the
common stock issued to the investors is classified as redeemable common stock in
the mezzanine level of the consolidated balance sheet as of March 31, 2002, and
is being accreted to its redemption value of $5,154,110, which includes 9%
interest, through July 31, 2002, the date upon which the put option first
becomes exercisable. Until the put option expires, the Company is precluded from
issuing, selling, transferring or pledging any of its interest in Pegasus and
Pegasus is precluded from transferring any rights with respect to its equity and
assets without approval of at least two-thirds of the investors.

    On April 30, 2002, another private equity investment was made by the same
investment group that purchased the KFx common stock and warrants on March 28,
2002. As a result of this investment, the Company issued 2.4 million shares of
KFx common stock at a price of $2.50 per share and warrants to purchase 2.7
million shares of KFx common stock, on substantially similar terms to the March
28, 2002 investment, which resulted in cash proceeds to the Company of $6
million. As a result of the put option, the common stock issued to the investors
will be classified as redeemable common stock in the mezzanine level of the
consolidated balance sheet. The amended agreement allows, at the option of the
investors and anytime prior to July 31, 2002, on the same terms, the investors
to have the right to purchase up to an additional $9 million of common stock and
to receive an equivalent amount of warrants on a pro rata basis.

    As part of the agreement the Company is required to register all of the
shares issued in both transactions, including the potential shares of common
stock underlying the warrants, in a qualifying registration statement. In the
event that a registration statement has not been declared effective by June 21,
2002, the Company shall issue additional warrants to purchase shares of common
stock equal to 10 percent of the warrants currently held by the investors for
each 30-day period for which the registration statement has not been declared
effective. Based upon the number of warrants currently held by investors, if a
qualifying registrations statement is not declared effective by June 21, 2002,
the Company will be required to issue warrants to purchase 495,000 shares of KFx
common stock.

    On April 30, 2002, pursuant to the private placement agreement described
above, a portion of the proceeds of this investment was used to satisfy the
entire outstanding obligation to repurchase the Pegasus preferred stock for
approximately $3.8 million.

    Pegasus' firm backlog of software license and installation contracts as of
May 13, 2002 was approximately $8,382,000, compared to approximately $6,800,000
at May 11, 2001, an increase of 23.3%.

                                       18
<PAGE>

RESULTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2002 VS. THREE MONTHS ENDED MARCH 31, 2001

    Consolidated revenues in the first quarter of 2002 increased as compared to
the first quarter of 2001 by $1,003,011 (405%) due entirely to an increase in
Pegasus revenues. The increase in Pegasus revenues resulted from a significant
increase in revenue-generating projects caused by the receipt of the Cinergy
fleet wide order in May 2001, the acquisition of the Pavilion power optimization
division in July 2001, which contributed approximately $271,000 in revenue
during the first quarter of 2002, an increase in engineers hired to complete
software installations and increased utilization of software installers. Due to
the increase in the Pegasus backlog, mainly due to the Cinergy fleet wide order
and the Pavilion power optimization division acquisition, we expect the trend of
increasing revenue to continue in future quarters.

    Consolidated operating costs and expenses in the first quarter of 2002
increased as compared to the first quarter of 2001 by $366,040 (16%) due
primarily to the net effect of (a) an increase of $537,606 (234%) in Pegasus'
cost of software licenses and services triggered by the increase in the number
of software installation contracts, the increase in the engineer headcount and
increased utilization of these software installers, (b) an increase in
marketing, general and administrative expense of $212,405 (18%) caused by an
increase in the sales staff and the installation engineering staff at Pegasus
and an increase in costs relating to international market expansion offset by
headcount reductions at the corporate level, and (c) an increase of $9,513 (18%)
in the costs at the K-Fuel demonstration plant due to an increase in research
activities, offset by a decrease of $389,299 (54%) in depreciation and
amortization expense. The decrease in depreciation and amortization expense was
due to (a) fully depreciating the demonstration plant and fully amortizing the
demonstration module during 2001 with no depreciation recognized during 2002,
(b) fully amortizing a majority of the Series A and Series B technology patents
during 2001, and (c) per FAS 142, beginning after December 31, 2001, no
amortization was recognized on the remaining goodwill balance of $1,138,018
related to the Company's acquisition of Pegasus. In the first quarter of 2001,
amortization of this goodwill balance totaled approximately $170,000.

    The factors discussed above combined in the first quarter of 2002 to produce
an operating loss of $1,407,102 which was $636,971 (31%) less than for the
first quarter of 2001. Pegasus' portion of the operating loss for the first
quarter of 2002 was $590,652, which was $387,092 (40%) less than the first
quarter of 2001 and was mainly due to an overall improvement in margins on
installation projects from 7.2% in 2001 to 38.7% in 2002. This improvement in
margin is due to efficiencies achieved in the installation process, improved
utilization of installation staff and the completion, during 2001, of
installation projects that had an unfavorable impact on margins because of
problems or delays. The combined K-Fuel segment and corporate cost portion of
the operating loss for the first quarter of 2002 was $816,450 compared to
$1,066,329 in 2001 with the decrease in operating loss resulting mainly from the
decrease in depreciation and amortization noted above.

    Non-operating items added $2,213,776 of net expense in the first quarter of
2002, compared to $772,648 in the first quarter of 2001, for an increase of
$1,441,128 (187%), due to an increase in interest expense of $1,428,586 (191%).
The increase in interest expense is due to the recognition of $788,694 for the
beneficial conversion charges relating to the reduction of the conversion price
of the convertible debentures from $3.65 per share to $3.00 and again to $2.50
per share, an increase of $328,662 in the expense recognized for the accretion
to maturity premium, amortization of debt discount and beneficial conversion
charges related to the 2001 sales to third parties of Pegasus Preferred Stock
and KFx's related obligation to repurchase those shares, an increase of $206,696
due to the amortization to interest expense of debt discount relating to the
issuance of warrants for the Company's common stock, $200,000 of additional
interest relating to notes payable entered into in the first quarter of 2002 and
interest expense relating to the Pavilion purchase obligation of $142,767 offset
by a reduction in the interest expense relating to the outstanding Convertible
Debentures of $179,350.

    As a result of the above factors, the consolidated net loss of $3,620,878
($0.12 per share) for the first quarter of 2002 was $804,157 more than the net
loss for the first quarter of 2001. Included in the first quarter 2002 and 2001
net losses were non-cash charges approximating $2,133,000 and $1,268,000,
respectively.

LIQUIDITY AND CAPITAL RESOURCES

    During the first quarter of 2002, the Company used $1,454,141 of cash for
its operating activities, compared to $1,903,416 in the first quarter of 2001, a
decrease of $449,275 (24%). Included in the 2002 amount is $574,709 of

                                       19
<PAGE>

interest payments ($261,609 by Pegasus and $313,100 by KFx), $416,885 for other
Pegasus operations and $462,547 for the K-Fuel segment and other KFx corporate
activities. Included in the 2001 amount is $561,031 of interest payments,
$560,000 for Pegasus' operations, $781,969 of cash used by the K-Fuel segment
and KFx's corporate activities.

    Sources of cash during the first three months of 2002 included the
following:
     .   In January 2002, the Company borrowed $500,000 under an unsecured
         note payable bearing interest at 10% per annum, due on June 30,
         2002. The terms of the agreement include a warrant, expiring three
         years after the date of issue, to purchase 250,000 shares of common
         stock of KFx at an exercise price of $3.00 per share.
     .   In February 2002, the Company borrowed $500,000 under four
         unsecured notes payable bearing interest at 10% per annum, due on
         June 30, 2002. The terms of the agreements include warrants,
         expiring three years after the date of issue, to purchase a total
         of 250,000 shares of common stock of KFx at an exercise price of
         $3.00 per share.
     .   In March 2002, the Company issued 2 million shares of redeemable
         common stock at a price of $2.50 per share and warrants, expiring
         eight years after the date of issue, exercisable for 2.25 million
         shares of KFx common stock, at a price of $2.75 per share, subject
         to certain adjustments, to an institutional investor, resulting in
         net proceeds to the Company of $5 million.
     .   Pegasus issued $500,000 of Pegasus preferred stock to Kennecott Energy
         during the first three months of 2002.

    Cash raised during the first three months of 2002 was used for funding of
current operations and for making the renegotiated final base purchase price
payment of $4.35 million for the acquisition of the Pavilion power optimization
segment.

    On March 28, 2002, the Purchase Agreement between Pavilion, Pegasus and KFx
was amended to decrease the total base cash payment to $7.5 million, from $9.5
million, subject to certain adjustments for the value of assets and liabilities
acquired and transaction costs. The amendment also increased the future royalty
payments on licenses sold to a total of $9 million with no expiration date on
the royalty payment period. Future royalty payments are considered contingent
purchase price and will result in additions to goodwill as the royalties become
due. Per the terms of this amendment, Pegasus paid Pavilion $4.35 million on
March 28, 2002 as the final base purchase price payment for the acquisition. See
Note 7 to the accompanying financial statements.

    The Company has refocused its efforts to strengthen its balance sheet to
position the Company to take advantage of the rapidly growing energy market
opportunities. The Company is in discussions with industry and private investors
for additional equity to fund the Company's capital needs for the future. At
this time, all discussions are preliminary; however, the Company intends to
continue such discussions and negotiate definitive agreements only under
acceptable terms.

    The Company is continuing to work toward its goal of licensing a large
commercial K-Fuel plant. Upon granting a license to construct a commercial scale
K-Fuel production facility, KFx expects to generate significant K-Fuel license
fees and net cash flows. Through March 31, 2002, there were no commitments to
build a K-Fuel plant. Pursuant to the April 30, 2002 investment in KFx common
stock, $450,000 of the proceeds of the investment shall be used to fund the
development of the K-Fuel demonstration plant. It is estimated that construction
of a K-Fuel production facility will take approximately nine months, thus no
royalty payment would begin until at least nine months after a license agreement
is signed.

    From time to time, directors of the Company have provided to the Company
short term unsecured financing and the Company expects that such financing, on
at least a short-term basis, will continue to be available if needed. Such
short-term financing will not, however, cover the cash needs of the Company on
an ongoing basis.

    The Company will seek to meet its cash requirements over the next fiscal
year with respect to day-to-day operations and debt service requirements through
(a) cash on hand, which as of May 13, 2002 approximated $2,442,000; (b) an
additional discretionary investment by Kennecott of $500,000 during the year;
(c) potential

                                       20
<PAGE>

additional investment pursuant to the option in the Addendum to the Common Stock
and Warrant Purchase Agreement dated April 30, 2002, whereby the investment
group has an option to invest an additional $9 million in KFx common stock; (d)
potential additional investments in Pegasus and/or KFx from interested
participants in the power generation industry; (e) potential debt and/or equity
offerings of the Company; (f) potential fees from licensing new K-Fuel
facilities; (g) potential partners in connection with opportunities to expand
the Company's product and service offerings to the power industry; and (h)
unsecured short-term borrowings for the Company and/or Pegasus from one or more
of its directors and/or other parties. Efforts by the Company to raise
additional funding may be hampered by the put option and additional financing
restrictions as a result of the financing transactions that have occurred during
2002.

    On April 30, 2002, the Company issued 2.4 million shares of KFx common stock
at a price of $2.50 per share and warrants to purchase 2.7 million shares of KFx
common stock, which resulted in cash proceeds to the Company of $6 million. The
warrants have an exercise price of $2.75 per share, and are subject to
adjustment through April 30, 2003, in the event that the Company issues options,
warrants or other securities convertible to KFx common stock at a price of less
than $2.75 per share. The sale of the common stock was with the same investment
group that purchased the KFx common stock and warrants on March 28, 2002 for $5
million. The purchase was completed pursuant to an Addendum to the original
Common Stock and Warrant Purchase Agreement, on substantially equivalent terms.

    The common stock issued is subject to redemption pursuant to a put option,
in whole or in part, at the option of the investors. The put option is
exercisable upon the earlier of July 31, 2002 or upon the redemption or
conversion of all of the Convertible Debentures. At the time the investors
notify KFx of their intent to exercise the put option, KFx must repurchase the
common stock at a price of $2.50 per share plus accrued interest ("Redemption
Value") within 100 days of notification. Interest for purposes of redemption
accrues at the rate of 9% per annum, beginning upon the original issuance date
and ceases on the date in which the common stock is repurchased. If two-thirds
or more of the investors exercise their put option and KFx is unable to secure
the necessary funding to satisfy these exercised put options, KFx must transfer
its entire interest in Pegasus to the investors. The put option expires on
December 23, 2002. As a result of the put option, the common stock issued to the
investors will be classified as redeemable common stock in the mezzanine level
of the consolidated balance sheet. Until the put option expires, the Company is
precluded from issuing, selling, transferring or pledging any of its interest in
Pegasus and Pegasus is precluded from transferring any rights with respect to
its equity and assets without approval of at least two-thirds of the investors.

     As a result of the put option, the common stock issued to the investors
will be classified as redeemable common stock in the mezzanine level of the
consolidated balance sheet as of June 30, 2002, and will be accreted to its
redemption value of approximately $6,136,000, which includes 9% interest,
through July 31, 2002, the date upon which the put option first becomes
exercisable.

    The Addendum allows, at the option of the investors and anytime prior to
July 31, 2002, on the same terms, the investors to have the right to purchase up
to an additional $9 million of common stock and to receive an equivalent amount
of warrants on a pro rata basis.

    As part of the agreement the Company is required to register the shares
issued, including the potential shares of common stock underlying the warrants,
in a qualifying registration statement. In the event that a registration
statement has not been declared effective by June 21, 2002, the Company shall
issue additional warrants to purchase shares of common stock equal to 10 percent
of the warrants currently held by the investor for each 30-day period for which
the registration statement has not been declared effective.

     In the event that the registration statement has not been declared
effective as of June 30, 2002, the warrants will be recorded at their estimated
fair value of approximately $5,000,000 on the issuance date as a liability on
the consolidated balance sheet. The estimated fair value of the warrants was
determined using a Black-Scholes option-pricing model using an expected life of
8 years, expected volatility of 67%, a risk free interest rate of 5% and a
dividend yield of zero. The difference between the estimated fair value of the
warrants and the proceeds received from the transaction will be recorded as
redeemable common stock of approximately $1,000,000, net of related issuance
costs. Until the registration statement for the warrants and redeemable common
stock is declared effective, the warrants will be marked to their estimated fair
value using a Black-Scholes option-pricing model with any difference recorded to
interest expense. Upon the registration statement being declared effective, the
related outstanding warrants will be reclassified to equity at their then
current estimated fair value.

    Pursuant to the agreement, a portion of the proceeds of this investment was
used to satisfy the entire outstanding obligation to repurchase the Pegasus
preferred stock for $3,846,049. In addition, $450,000 of the proceeds shall be
used to fund the development of the K-Fuel demonstration plant and the remaining
proceeds are to be used for general corporate purposes.

    Depending on the outcome of various uncertainties, including those discussed
herein, the Company may be required to seek additional debt and/or equity
financing for general operating purposes and/or to meet debt service
requirements. The timing of collection of accounts receivable and payment of
accounts payable could significantly alter the Company's need for at least
temporary financing. Should the Company be required to seek any additional debt
and/or equity financing, its ability to do so will be affected by the terms of
the Debentures, which contain a number of restrictions including (a) limitations
on the Company's ability to incur secured and unsecured debt, (b) limitations on
the Company's ability to sell assets or enter into merger agreements, and (c)
provisions that would reduce the Debenture conversion price from $2.50 per share
if the Company sells KFx common stock at a price below $2.50 per share. In
addition, included in the agreements among KFx and the other shareholders of
Pegasus are provisions governing the terms of investments from any new investors
in Pegasus, limiting the borrowings of Pegasus, limiting the payment of
dividends by Pegasus, and precluding the Company from issuing, selling,
transferring or pledging any of its interest in Pegasus and precluding Pegasus
from transferring any rights with

                                       21
<PAGE>

respect to its equity and assets without approval of at least two-thirds of the
investors (see Note 8).

    There are no assurances that any of these potential funding sources will
materialize, the Company currently does not have the means to satisfy certain
indebtedness, including, but not limited to the Debentures due July 2002 (see
Note 6), and the Company does not currently have any commitments with respect to
any such funding sources. If the overall outcome of the various uncertainties
affecting the Company is not favorable, the Company may be forced to seek debt
and/or equity financing on terms and conditions that may be unfavorable to the
Company, if available at all. If the Company requires additional financing and
cannot obtain it when needed, the Company may default on payments when due.
Should the Company not be successful in achieving one or more of the financing
alternatives discussed above, the Company may not be able to continue as a going
concern.

RECENT ACCOUNTING PRONOUNCEMENTS

    In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets" ("FAS 142"). FAS 142 requires that after a company allocates
the purchase price in accordance with FAS 141, the assets acquired, liabilities
assumed and goodwill must be assigned to one or more reporting units based on
certain criteria outlined in FAS 142. In addition, goodwill will no longer be
amortized. FAS 142 is effective for the Company for any goodwill acquired in a
business combination entered into after June 30, 2001, including the acquisition
of certain assets of Pavilion, see Note 7. The remaining provisions of the
Statement are effective beginning in the first six months of 2002. As of March
31, 2002, the net carrying value of the goodwill relating to KFx's acquisition
of Pegasus was $1,138,017. There has been no amortization expense recorded for
this goodwill during 2002 and this goodwill will no longer be amortized.

    FAS 142 requires that goodwill be tested annually for impairment using a
two-step process. The first step is to identify a potential impairment and, in
transition, this step must be measured as of the beginning of the fiscal year.
However, a company has six months from the date of adoption to complete the
first step. The Company expects to complete that first step of the goodwill
impairment test during the first six months of 2002. The second step of the
goodwill impairment test measures the amount of the impairment loss (measured as
of the beginning of the year of adoption), if any, and must be completed by the
end of the Company's fiscal year. Intangible assets deemed to have an indefinite
life will be tested for impairment using a one-step process, which compares the
fair value to the carrying amount of the asset as of the beginning of the fiscal
year, and pursuant to the requirements of FAS 142 will be completed during the
first six months of 2002. Any impairment loss resulting from the transitional
impairment tests will be reflected as the cumulative effect of a change in
accounting principle in the first six months of 2002. The Company anticipates
that these impairment tests will not have a material impact upon the Company's
financial position, results of operations or cash flows.

    On October 3, 2001, the FASB issued Statement of Accounting Standards No.
144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS
144"). FAS 144 supercedes FAS 121 "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of." FAS 144 applies to all
long-lived assets (including discontinued operations) and consequently amends
Accounting Principles Board Opinion No. 30, "Reporting Results of Operations -
Reporting the Effects of Disposal of a Division of a Business" ("APB 30"). FAS
144 develops one accounting model for long-lived assets that are to be disposed
of by sale. FAS 144 requires that long-lived assets that are to be disposed of
by sale be measured at the lower of book value or fair value less cost to sell.
Additionally, FAS 144 expands the scope of discontinued operations to include
all components of an entity with operations that (1) can be distinguished from
the rest of the entity and (2) will be eliminated from the ongoing operations of
the entity in a disposal transaction. FAS 144 is effective for the Company's
financial

                                       22
<PAGE>

statements issued in fiscal 2002. The Company has not yet determined the impact
of FAS 144 on the Company's financial position, results of operations or cash
flows.

                      ITEM 3. QUANTITATIVE AND QUALITATIVE
                          DISCLOSURES ABOUT MARKET RISK

    The Company is not currently subject to a significant level of direct market
risk related to interest rates, foreign currency exchange rates and commodity
prices. The Company has only $450,000 of floating rate debt and does not expect
to derive a material amount of its revenues from interest bearing securities.
Currently the Company has no foreign operations. To the extent that the Company
establishes significant foreign operations in the future, it will attempt to
mitigate risks associated with foreign currency exchange rates contractually and
through the use of hedging activities and other means considered appropriate.
The Company is indirectly exposed to fluctuations in fuel commodity prices. To
the extent that fuel prices rise, there may be a tendency for greater demand for
certain of the Company's products and services, since K-Fuel and Pegasus'
combustion optimization products have been shown to result in lower usage of
coal and coal beneficiated fuel products when used to generate electric power.
The Company's fuel-related products provide various environmental benefits that
management believes significantly mitigate the fuel commodity risk associated
with the Company's business. The Company holds no equity market securities, but
does face equity market risk relative to its own equity securities.

     On March 28, 2002, the Company issued 2 million shares of KFx common stock
at a price of $2.50 per share and warrants to purchase 2.25 million shares of
KFx common stock, which resulted in cash proceeds to the Company of $5 million.
As part of the agreement the Company is required to register the shares issued,
including the potential shares of common stock underlying the warrants, in a
qualifying registration statement. In the event that a registration statement
has not been declared effective by June 21, 2002, the Company shall issue
additional warrants to purchase shares of common stock equal to 10 percent of
the warrants currently held by the investor for each 30-day period for which the
registration statement has not been declared effective. These new warrants will
have the same terms and conditions as the original warrants issued to the
investors. In accordance with EITF 00-19, as the Company is required to issue
additional warrants in the event that the registration statement is not declared
effective and, as there is no cap on the number of warrants that could be
issued, the warrants have been recorded at their estimated fair value of
$4,484,992 on the issuance date as a liability on the consolidated balance
sheet. Also, as clarified in EITF 00-19, the warrants are considered a
derivative instrument as defined in SFAS 133. Until the registration statement
is declared effective, the warrants will be marked to their estimated fair value
using a Black-Scholes option-pricing model with any difference recorded to
interest expense.

     We prepared a sensitivity analysis of our exposure to fluctuations in our
stock price to assess the impact of a hypothetical change in the price of our
stock. Based on the results of this analysis, we estimate that a hypothetical
10% increase in the price of our stock from the March 31, 2002 stock price could
have an impact of approximately $550,000 on our results of operations. This risk
could have a material effect on our results of operations and financial
condition until the registration statement is declared effective.

                                       23
<PAGE>

                           PART II - OTHER INFORMATION
                            ITEM 1. LEGAL PROCEEDINGS

    On November 4, 1999, Link Resources, Inc., a Georgia corporation, ("Link")
and its two shareholders, Linda E. Kobel ("Kobel") and Gary A. Sanden ("Sanden")
filed a complaint against the Company in US District Court for the District of
Colorado. The complaint alleged that KFx, Link, Kobel and Sanden had entered
into an agreement requiring KFx to acquire Link and that KFx breached such
agreement. The complaint sought damages in excess of $5.3 million. This
litigation was settled in February 2002 with the costs of the settlement borne
by the Company's insurance carrier.

                ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

    During the three months ended March 31, 2002, KFx issued the following
securities in private transactions pursuant to an exemption from the
registration requirements of the Securities Act of 1933, as amended ("Securities
Act") under Section 4(2) of the Securities Act:

<TABLE>
<CAPTION>
 Purchaser/                                                                   Number
Recipient of                    Terms of Exercise, if                        Sold or      Consideration
 Securities         Date             Convertible         Title of Security   Granted         Received
 ----------         ----             -----------         -----------------    -------        --------
<S>             <C>                      <C>               <C>                <C>       <C>
John Venners    January 2002             N/A               Common Stock       10,000      Professional
                                                                                        services valued at
                                                                                              $30,000

Richard Witner  January 2002             N/A                Common Stock       5,000      Professional
                                                                                        services valued at
                                                                                              $15,000
</TABLE>

                  ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(A) EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER         DESCRIPTION
------         -----------
<S>            <C>
4.1            Warrant to Purchase  250,000  Shares of KFx Inc.  Common Stock issued to Frank  Cilluffo dated
               January 10, 2002
4.2            Warrant to Purchase  50,000  Shares of KFx Inc.  Common Stock issued to Paul  Archinard  dated
               February 12, 2002
4.3            Warrant to Purchase  50,000  Shares of KFx Inc.  Common  Stock issued to William A. Boyd dated
               February 15, 2002
4.4            Warrant to Purchase  100,000  Shares of KFx Inc.  Common Stock  issued to Daniel  Marino dated
               February 12, 2002
4.5            Warrant to Purchase  50,000 Shares of KFx Inc.  Common Stock issued to Mariella  Marquez dated
               February 15, 2002
10.1*          Common Stock and Warrant Purchase Agreement between KFx Inc. and the Investors dated March
               28, 2002
</TABLE>

*    Document previously filed with the U.S. Securities and Exchange
     Commission with the Company's Current Report on Form 8-K dated
     March 28, 2002 and incorporated herein by reference.

(B) REPORTS ON FORM 8-K

    During the quarter ended March 31, 2002, the Company filed a Current Report
on Form 8-K dated March 28, 2002, under Item 5, Other Events.

                                       24
<PAGE>

                                   SIGNATURES

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

                                   KFX INC.

                                   /s/ PATRICK S. FLAHERTY
                                   -----------------------------------

                                   PATRICK S. FLAHERTY
                                   VICE PRESIDENT & CHIEF FINANCIAL OFFICER
                                   (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER)

                                   DATE: MAY 20, 2002

                                       25