** **

**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-Q**

 

**Mark One**

 

**ý**** Quarterly Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

**for theQuarterly Period Ended March 31, 2006.**

 

**or**

** **

**o**** Transition Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

**for theTransition Period From                         To                         .**

 

**Commission file number:  000-25755**

 

**WORLDGATECOMMUNICATIONS, INC.**(Exact Name of Registrant as Specified in Its Charter)

 

| **Delaware**             | ** ** | **23-2866697**                       |
|--------------------------|------------|--------------------------------------|
| (State of Incorporation) |       | (I.R.S. Employer Identification No.) |

 

**3190 Tremont AvenueTrevose, Pennsylvania 19053**(Address of Principal Executive Offices)        (ZipCode)

 

**(215) 354-5100**(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes ý  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer , or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o            Acceleratedfiler ý            Non-acceleratedfiler o

 

Indicate by a check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

Yes o  No ý

 

As of May 3, 2006, there were 39,607,975 shares of common stock, parvalue $.01 per share, outstanding.

 

** **

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WORLDGATE COMMUNICATIONS, INC.

 

QUARTERLY REPORT ON FORM 10-QFOR THE THREE MONTHS ENDED MARCH 31, 2006

 

TABLE OF CONTENTS

 
| PART I.                          | FINANCIAL INFORMATION                                                                       |   |
|----------------------------------|---------------------------------------------------------------------------------------------|--------|
|                             |                                                                                        |
| Item 1.                          | Financial Statements                                                                        |   |
| Item 2.                          | Management’s Discussion And Analysis Of Financial Condition And  Results Of Operations |   |
| Item 3.                          | Quantitative And Qualitative Disclosures About Market Risk                                  |   |
| Item 4.                          | Controls And Procedures                                                                     |   |
|                             |                                                                                        |
| PART II. OTHER  INFORMATION |                                                                                        |
|                             |                                                                                        |
| Item  1.                         | Legal  Proceedings                                                                          |   |
| Item 1A                          | Risk Factors                                                                                |   |
| Item 2.                          | Unregistered Sales of Equity Securities And Use Of Proceeds                                 |   |
| Item 3.                          | Defaults Upon Senior Securities                                                             |   |
| Item 4.                          | Submission Of Matters To A Vote Of Security Holders                                         |   |
| Item  5.                         | Other  Information                                                                          |   |
| Item 6.                          | Exhibits                                                                                    |   |

 

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PART I. FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTS

 

WORLDGATE COMMUNICATIONS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

 
| ** **                                                                                                                                                                                 | ** ** | **March 31,  2006 ** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                       |       | **(Unaudited)**                |       | **(Audited)**               |       |
| ASSETS                                                                                                                                                                                     |       |                           |       |                        |       |
| Current assets:                                                                                                                                                                            |       |                           |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                              | 10,493     |                        | $          | 16,277 |   |
| Trade accounts receivables                                                                                                                                                                 |       | 450                            |       | 133                         |       |
| Other receivables                                                                                                                                                                          |       | 49                             |       | 26                          |       |
| Inventory, net                                                                                                                                                                             |       | 2,225                          |       | 2,878                       |       |
| Prepaid and other assets                                                                                                                                                                   |       | 186                            |       | 209                         |       |
| Total current  assets                                                                                                                                                                      |       | 13,403                         |       | 19,523                      |       |
| Property and equipment                                                                                                                                                                     |       | 4,275                          |       | 4,084                       |       |
| Less: accumulated depreciation and  amortization                                                                                                                                           |       | (2,687                         | )          | (2,508                      | )          |
| Property and equipment, net                                                                                                                                                                |       | 1,588                          |       | 1,576                       |       |
| Deposits and other assets                                                                                                                                                                  |       | 130                            |       | 130                         |       |
| Total assets                                                                                                                                                                               |       | $                              | 15,121     |                        | $          | 21,229 |   |
|                                                                                                                                                                                       |       |                           |       |                        |       |
| LIABILITIES  AND STOCKHOLDERS’ DEFICIENCY                                                                                                                                             |       |                           |       |                        |       |
| Current  liabilities:                                                                                                                                                                      |       |                           |       |                        |       |
| Accounts payable                                                                                                                                                                           |       | $                              | 415        |                        | $          | 1,695 |   |
| Accrued expenses                                                                                                                                                                           |       | 1,553                          |       | 1,333                       |       |
| Accrued compensation and benefits                                                                                                                                                          |       | 167                            |       | 36                          |       |
| Dividend payable on Preferred Stock                                                                                                                                                        |       | 4                              |       | 6                           |       |
| Detachable Warrants                                                                                                                                                                        |       | 859                            |       | 1,038                       |       |
| Conversion option on Preferred Stock                                                                                                                                                       |       | 35                             |       | 57                          |       |
| Incentive sales claims liability                                                                                                                                                           |       | 58                             |       | 278                         |       |
| Warranty reserve                                                                                                                                                                           |       | 98                             |       | 336                         |       |
| Deferred revenues                                                                                                                                                                          |       | 64                             |       | 44                          |       |
| Returns reserve                                                                                                                                                                            |       | 0                              |       | 2,310                       |       |
| Total current liabilities                                                                                                                                                                  |       | 3,253                          |       | 7,133                       |       |
| Commitments                                                                                                                                                                                |       |                           |       |                        |       |
| Redeemable Preferred Stock; 7,550 shares  authorized; 333 shares issued and outstanding at March 31, 2006, and 500  shares issued and outstanding at December 31, 2005                     |       | 278                            |       | 379                         |       |
|                                                                                                                                                                                       |       |                           |       |                        |       |
| Stockholders’ deficiency:                                                                                                                                                             |       |                           |       |                        |       |
| Preferred Stock, $.01 par value, 13,492,450  shares authorized; 0 shares issued at March 31, 2006 and December 31, 2005                                                                    |       | 0                              |       | 0                           |       |
| Common Stock, $.01 par value; 80,000,000  shares authorized; 39,605,720 shares issued and outstanding at March 31, 2006  and 39,511,519 shares issued and outstanding at December 31, 2005 |       | 396                            |       | 395                         |       |
| Additional paid-in capital                                                                                                                                                                 |       | 244,735                        |       | 242,414                     |       |
| Deferred stock based compensation                                                                                                                                                          |       | (1,745                         | )          | 0                           |       |
| Accumulated deficit                                                                                                                                                                        |       | (231,796                       | )          | (229,092                    | )          |
| Total stockholders’ deficiency                                                                                                                                                        |       | 11,590                         |       | 13,717                      |       |
| Total liabilities and stockholders’  deficiency                                                                                                                                       |       | $                              | 15,121     |                        | $          | 21,229 |   |

 

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

 

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**WORLDGATE COMMUNICATIONS, INC.****CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS****(Unaudited)**

**(Dollars in Thousands, Except Share and perShare Amounts)**

 
| ** **                                                                                                  | ** ** | **Three Months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Revenues                                                                                                    |       | $                                                    | 509        |   | $ | 179 |   |
| Cost of revenues                                                                                            |       | 442                                                  |       | 125 |   |
| Gross margins                                                                                               |       | 67                                                   |       | 54 |   |
|                                                                                                        |       |                                                 |       |   |   |
| Engineering and development (excluding  depreciation and amortization amounts of $88 and $66, respectively) |       | 1,454                                                |       | 1,305 |   |
| Sales and marketing (excluding depreciation  and amortization amounts of $14 and $8, respectively)          |       | 653                                                  |       | 379 |   |
| General and administrative (excluding  depreciation and amortization amounts of $77 and $97, respectively)  |       | 2,523                                                |       | 847 |   |
| Depreciation and amortization                                                                               |       | 179                                                  |       | 171 |   |
| Total expenses from operations                                                                              |       | 4,809                                                |       | 2,702 |   |
| Loss from operating activities                                                                              |       | (4,742                                               | )          | (2,648 | ) |
| Interest and other income                                                                                   |       | 134                                                  |       | 66 |   |
| Change in fair value of warrants and  conversion options                                                    |       | 182                                                  |       | 5,176 |   |
| Gain on contract termination                                                                                |       | 1,792                                                |       | 0 |   |
| Interest and other expense                                                                                  |       | 0                                                    |       | 0 |   |
| Net (loss) income                                                                                           |       | (2,634                                               | )          | 2,594 |   |
| Accretion on preferred stock, dividends and  deemed dividends                                               |       | (69                                                  | )          | (495 | ) |
| Net(loss) income available to common  stockholders                                                          |       | $                                                    | (2,703     | ) | $ | 2,099 |   |
| Net (loss) income per common share:                                                                         |       |                                                 |       |   |   |
| Basic                                                                                                       |       | $                                                    | (0.07      | ) | $ | 0.08 |   |
| Fully Diluted                                                                                               |       | $                                                    | (0.07      | ) | $ | 0.07 |   |
| Net (loss) income available to common  shareholders per common share:                                       |       |                                                 |       |   |   |
| Basic                                                                                                       |       | $                                                    | (0.07      | ) | $ | 0.07 |   |
| Fully Diluted                                                                                               |       | $                                                    | (0.07      | ) | $ | 0.05 |   |
| Weighted average common shares outstanding:                                                                 |       |                                                 |       |   |   |
| Basic                                                                                                       |       | 39,595,917                                           |       | 31,582,115 |   |
| Fully Diluted                                                                                               |       | 39,595,917                                           |       | 38,334,855 |   |

 

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

 

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**WORLDGATE COMMUNICATIONS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in Thousands)**

 
| ** **                                                                                           | ** ** | **Three Months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                                                                 |       |                                             |       |   |   |
| Cash flows from operating activities:                                                                |       |                                             |       |   |   |
| Net (loss) income                                                                                    |       | $                                                | (2,634     | ) | $ | 2,594 |   |
| Adjustments to reconcile net (loss) income  to net operating cash flow used in operating activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                                        |       | 179                                              |       | 171 |   |
| Change in fair value of warrants and  conversion options                                             |       | (182                                             | )          | (5176 | ) |
| Gain on contract termination                                                                         |       | (1,792                                           | )          | — |   |
| Non-cash stock based compensation                                                                    |       | 208                                              |       | 1 |   |
| Changes in operating assets and  liabilities:                                                        |       |                                             |       |   |   |
| Trade accounts receivable                                                                            |       | (316                                             | )          | — |   |
| Other receivables                                                                                    |       | (23                                              | )          | 16 |   |
| Inventory                                                                                            |       | (433                                             | )          | (53 | ) |
| Prepaid and other assets                                                                             |       | 23                                               |       | (209 | ) |
| Accounts payable                                                                                     |       | (1,280                                           | )          | 36 |   |
| Accrued expenses                                                                                     |       | 506                                              |       | (110 | ) |
| Accrued compensation and benefits                                                                    |       | 131                                              |       | (299 | ) |
| Warranty reserve                                                                                     |       | (5                                               | )          | — |   |
| Deferred revenue                                                                                     |       | 20                                               |       | (179 | ) |
| Net cash used in operating activities                                                                |       | (5,598                                           | )          | (3,208 | ) |
|                                                                                                 |       |                                             |       |   |   |
| Cash flows from investing activities:                                                                |       |                                             |       |   |   |
| Capital expenditures                                                                                 |       | (192                                             | )          | (80 | ) |
| Net cash used in investing activities                                                                |       | (192                                             | )          | (80 | ) |
|                                                                                                 |       |                                             |       |   |   |
| Cash flows from financing activities:                                                                |       |                                             |       |   |   |
| Proceeds from issuance of common stock                                                               |       | 6                                                |       | 12 |   |
| Proceeds from the exercise of stock options                                                          |       | —                                           |       | 204 |   |
| Proceeds from the exercise of stock rights  and warrants                                             |       | —                                           |       | 1,161 |   |
| Net cash provided by financing activities                                                            |       | 6                                                |       | 1,377 |   |
| **Net decrease in cash and equivalents**                                                             |       | (5,784                                           | )          | (1,911 | ) |
| **Cash and cash equivalents, beginning of  period**                                                  |       | 16,277                                           |       | 11,840 |   |
| **Cash and cash equivalents, end of period**                                                         |       | $                                                | 10,493     |   | $ | 9,929 |   |
| ** **                                                                                           |       |                                             |       |   |   |
| Cash paid for interest                                                                               |       | $                                                | —     |   | $ | — |   |
|  Non-cash financing activities:                                                                 |       |                                             |       |   |   |
| Conversion of preferred stock to common  stock                                                       |       | $                                                | 167        |   | $ | 100 |   |
| Accretion on preferred stock                                                                         |       | 25                                               |       | 413 |   |
| Dividends payable on preferred stock                                                                 |       | 4                                                |       | 82 |   |
| Deemed dividend on conversion of preferred  stock                                                    |       | 40                                               |       | — |   |
| Common stock issued for accrued dividends                                                            |       | 6                                                |       | 85 |   |

 

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

 

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WORLDGATE COMMUNICATIONS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(Dollar Amounts are in Thousands, Except forper Share and Share Amounts)

(Unaudited)

 

1.                                       Basis ofPresentation.

 

The unaudited condensed consolidated financial statements of WorldGateCommunications, Inc. (“WorldGate” or the “Company”) for the three months endedMarch 31, 2006 and March 31, 2005 presented herein have been prepared by theCompany pursuant to the rules and regulations of the Securities and ExchangeCommission for quarterly reports on Form 10-Q. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith United States generally accepted accounting principles have been condensedor omitted pursuant to such rules and regulations. These financial statementsshould be read in conjunction with the financial statements for the year endedDecember 31, 2005 and the notes thereto included in the Company’s Annual Reporton Form 10-K.

 

The financial information in this Report reflects, in the opinion ofmanagement, all adjustments of a normal recurring nature necessary to presentfairly the results for the interim period. Quarterly operating results are notnecessarily indicative of the results that may be expected for the year endingDecember 31, 2006.

 

2.                                       Liquidity andGoing Concern Considerations.

 

As of March 31, 2006the Company had cash and cash equivalents of $10,493.  The operating cashused in continuing operations for the three months ended March 31, 2006was $5,598. During the third quarter of 2003, we completed a sale of certainassets, including our interactive television (“ITV”) intellectual propertyrights and our membership interest in TVGateway, LLC, for $3,000 in cash toTVGateway, LLC. The transaction with TVGateway, LLC marked a shift in ourbusiness away from the ITV business and toward a new video phone product andassociated business. The funds we received from the sale of assets toTVGateway, LLC, as well as the funds we received as a result of privateplacements of our securities on December 1, 2003 and December 4,2003, January 21, 2004, April 22, 2004, June 24, 2004,December 15, 2004 and August 3, 2005, have permitted us to fund thedevelopment of our new business.

 

In December 2003 andJanuary 2004, WorldGate received investments aggregating $3,100 from certaininstitutional investors. These investors purchased an aggregate of 3,000,000shares of newly issued common stock. The investors also received a right, for alimited period of time, to purchase additional shares of up to 20% of thecommon stock purchased by the investors in their investment, at the same priceas their investment, and five-year warrants to purchase up to 30% of the commonstock purchased by the investors in their investment, at an exercise priceequal to a twenty-five percent premium to their purchase price for theinvestment. The purchase price for the 2,000,000 shares purchased in theDecember 2003 transactions were $0.80 per share, with the warrants havinga $1.00 per share exercise price. The purchase price for the 1,000,000 sharespurchased in the January 2004 transaction was $1.50 per share, with thewarrants having a $1.875 per share exercise price. All additional investmentrights associated with the December 2003 transaction were exercised duringJanuary and February of 2004, resulting in an incremental investmentof $320. All additional investment rights associated with the January 2004transaction were exercised in May 2004, resulting in an incrementalinvestment of $300. A portion of the warrants and additional investment right warrantsassociated with the December 2003 and January 2004 transactions wereexercised in December 2004 and January 2005, resulting in an incrementalinvestment of $925.

 

In December 2003,WorldGate reached agreement with Mototech, Inc. (“Mototech” is not anaffiliate of General Instruments or Motorola) for the purchase of 625,000shares of newly issued common stock at $0.80 per share, in return for futuredesign and engineering services by Mototech. WorldGate had previouslycontracted with Mototech to assist the Company with the design and volumemanufacture of WorldGate’s Ojo personal video phone. The purchase price forthese shares has been fully paid as of December 31, 2004 by an equivalentreduction in the development and initial procurement payments that wouldotherwise be due to Mototech. The value of this transaction was $600 (based onthe closing stock price of $0.96 on the date of the transaction) of which $200was recorded as an expense for the year ended December 31, 2003 and $400 wasexpensed for the year ended December 31, 2004. In addition, in April 2004,Mototech invested $1,000 to purchase 666,666 shares of newly issued commonstock at $1.50 per share.

 

In June 2004 we completed a private placement of 7,550 shares (the“June 2004 Shares”) of Series A Convertible Preferred stock tocertain institutional investors.  The shares were sold for $1,000 pershare, resulting in gross proceeds from the offering of $7,550. The preferredstock issued pursuant to this placement is convertible into WorldGate commonstock at a conversion price of $2.35 per share. WorldGate has the right torequire conversion of the preferred stock into common stock

 

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upon achieving certain pricetargets with respect to its common stock and the satisfaction of certain otherconditions. Of the 7,550 convertible preferred issued, 500 shares remainedoutstanding as of December 31, 2005 and 333 shares remain outstanding as ofMarch 31, 2006. Between November 2004 and March 2006 all but one ofthe investors have fully converted their preferred shares resulting in theissuance of 3,071,064 of our common shares. The preferred stock has a dividendrate of 5% per annum, payable quarterly, which may be paid either by cash orthrough the issuance of common stock at WorldGate’s option (with stock paymentsbeing made at a 10% discount to the then current market price). Through March31, 2006, for all quarterly dividend payments due, WorldGate exercised itsright to make these dividend payments in stock, resulting in the issuance of anadditional 136,623 shares of our common stock. The preferred stock has a stagedmaturity over three years with scheduled payments of one third due after 18months, one half of the remainder due after 24 months and the balance due after36 months. The preferred stock may be redeemed at maturity in cash or throughthe issuance of an indeterminate number of shares of common stock, at WorldGate’soption (subject to certain conditions). All dividend and maturity payments madein stock are subject to the satisfaction of certain conditions including thelisting and availability of an effective registration statement. As part of thetransaction, WorldGate issued five-year warrants to purchase a total of1,606,380 shares of WorldGate common stock, with one-half of the warrantshaving an exercise price of $2.69 per share and the remaining half having anexercise price of $3.14 per share. Through December 2005, 125,000 of the$2.69 warrants have been exercised resulting in the issuance of an addition125,000 of our common shares and an additional $336 in gross proceeds and51,915 of the $3.14 warrants have been exercised resulting in the issuance ofan additional 51,915 of our common shares and an additional $163 in grossproceeds. The investors also received an additional investment right, for alimited period of time, to purchase 1,606,380 additional common stock shares at$3.14 a share. During December 2004, all but one of the investorsexercised their additional investment rights resulting in the issuance of anadditional 1,500,000 shares and an additional $4,710 in gross proceeds. Duringthe first quarter of 2005, the remaining investor exercised its additionalinvestment right resulting in the issuance of an additional 106,383 shares andan additional $334 in gross proceeds. The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.0% per month for unredeemed preferred shares onceregistration of the shares lapse and until the registration again becomeseffective.

 

In December 2004, WorldGate completed a privateplacement of 208,333 shares of its common stock to K. Y. Chou, President andGeneral Manager of Mototech, at a sales price of $2.40 per share, whichresulted in additional gross proceeds to the Company of $500.  Inconnection with this placement the Company granted warrants to Mr. Chou topurchase up to 62,500 shares of common stock at an exercise price of $2.88 pershare.

 

In August 2005, the Company completed a privateplacement of $17,500 of its common stock and warrants with severalinstitutional investors. The Company issued 4,666,664 shares of its commonstock at $3.75 per share to the participating investors. The Company alsoissued five-year warrants to purchase a total of 1,671,947 shares of its commonstock: 1,633,333 shares to the investors at an exercise price of $5.00 pershare, and 38,614 shares to the placement agent at an exercise price of $4.53per share. The investors also received an additional investment right, fora period of 60 days from the time the shares become registered, to purchase1,554,000 additional shares of common stock at $4.12 per share. The accountingfor these warrants and investment rights is established by analogy toAccounting Principle Board Opinion (“APB”) No. 14 “Accounting forConvertible Debt and Debt Issued with Stock Purchase Warrants,” which addressesdetachable stock purchase warrants issued in conjunction with convertible debtand prescribes that such warrants be accounted for as additional paid incapital measured at fair value. The private placement includes numerousprovisions intended to protect these institutional investors including a cashpayment penalty of 1.5% per month for the period above 120 days from theeffective date of the Agreement that the shares in the transaction fail to beregistered. On March 31, 2006 the shares under this private placement hadnot been registered and until such time as the shares become registered the Companyis subject to the penalty provision under this private placement. For the threemonths ended March 31, 2006 and 2005 the Company recorded and expensed relatedpenalties of $787 and $0, respectively. The related unpaid penalties accrued asof March 31, 2006 and December 31, 2005 were $780 and $525, respectively.

 

Registration statements for the securities sold pursuant to the June2004, December 2004 and August 2005 private placements were originally filedcontaining financial statements that were current at the time of the filing.Subsequently, the Company initiated a process to amend, restate and re-filecertain of its 2003, 2004 and 2005 financial statements to correct an error inthe accounting treatment for various security components of our private placements.As a result the registration statements then on file also needed to be amendedto reflect these changes in our financial statements. Amended registrationstatements were subsequently filed with the SEC to reflect the amended andrestated financial statements, and these amended registration statements arecurrently awaiting SEC review.

 

On April 28, 2004, the Company entered into a multi-year agreementwith General Instrument Corporation d/b/a the Connected Home Solutions Businessof Motorola, Inc. (“General Instrument”) for the worldwide development anddistribution of the Ojo personal video phone. This agreement provided forGeneral Instrument to be WorldGate’s exclusive distributor of its broadbandvideo

 

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phone products and forWorldGate to be General Instrument’s exclusive supplier of its broadband videophone products. On February 17, 2006, we mutually agreed with GeneralInstrument to end this agreement. The ending of this agreement immediately terminatesexclusivity for both parties. In addition to its current role for developmentand manufacture of Ojo, WorldGate will now have direct responsibility andcontrol for the advertising, marketing, and distribution of itsproducts.  Under its agreement with General Instrument, WorldGate hadbeen active in marketing and promoting its products, and working with GeneralInstrument to distribute Ojo. WorldGate intends to continue the rollout of Ojousing many of the same distributors, retailers and service providers, and plansto expand distribution to service providers and retailers around theworld.  The two companies will work together to ensure a smooth transitionfor customer accounts. As part of ending its agreement with General Instrument,and in anticipation of WorldGate inventory requirements as a result of takingfull responsibility for product distribution, WorldGate negotiated the right tobuy back about two-thirds of the units sold to General Instrument, valued atapproximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturing sources.As a result, the Company recorded a reserve for returns and reduced revenue inthe amount of approximately $2,310 during the fourth quarter of 2005. Inaddition, the Company has recorded no revenue for units shipped to GeneralInstrument in the first quarter 2006 and has recorded a gain on termination ofthis agreement of approximately $1,792 during the first quarter 2006 as aresult of the lower purchase price of the inventory repurchased from GeneralInstrument ($1,342, net of the cost of rework for rebranding the product andthe adjustment of the inventory to its current replacement value) and reversalof the product refund program reserve ($212) as well as an adjustment of thewarranty reserve for products repurchased ($233), both of which resulted fromthe termination of the Company’s agreement with General Instrument.

 

The Company had $3,253 of liabilities and its assets are not pledged ascollateral as of March 31, 2006. These liabilities include $898 ofdividends, detachable warrants and conversion options related to the Company’sprivate placement of Preferred Stock.

 

Our Company has suffered recurring losses fromoperations and had an accumulated deficit of $231,796 as of March 31, 2006 andthese issues raise substantial doubt about the Company’s ability to continue asa going concern. Our short term cash requirements and obligations include,inventory, accounts payable and capital expenditures from continuingoperations, operating expenses, and the redemption of preferred stock, of which$167 is required to be redeemed in June 2006, although this redemption canbe made in common stock if certain conditions are met. In addition, the August2005 private placement includes cash payment penalties of 1.5% per month forthe period that the shares in the transaction fail to be registered. OnMarch 31, 2006, the shares under this private placement had not beenregistered and until such time as the shares become registered the Company issubject to the penalty provision under this private placement. For the threemonths ended March 31, 2006 and 2005 the Company recorded and expensed relatedpenalties of $787 and $0, respectively. The related unpaid penalties accrued asof March 31, 2006 and December 31, 2005 were $780 and $525, respectively. Theending of the General Instrument agreement places additional cash burdens onthe Company and this could impact our cash requirements and usage.

 

Management expects, based onour internal forecasts and assumptions relating to our operations (includingamong others, assumptions regarding our short term cash requirements and ourprojected revenue growth) that we have sufficient cash on hand to meet itsobligations into the fourth quarter of 2006.

 

The Company’s ability to generate cash is dependentupon the sale of Ojo products and on obtaining cash through capitalmarkets. The Company began generating revenue from commercial shipment ofthe Ojo product in April 2005 and expect revenues to increase as the productcontinues to roll out to the marketplace. Depending on the ramp up of sales andthe achievable margin, the increased level of sales activity should have apositive impact on our cash flows from operations, which will support ourability to meet our cash requirements in the long term. Given that the videophone business involves the development of a new product line with no marketpenetration, in an underdeveloped market sector, no assurances can be giventhat sufficient sales, if any, will materialize.

 

Additionally, as needed, theCompany plans to generate cash by turning to the capital markets forfunding.  No assurances can be given that, if pursued, additionalfinancing transactions can be consummated.  The Company continues toevaluate possibilities to obtain additional financing through public or privateequity or debt offerings, bank debt financing, asset securitizations, or fromother sources, should the Company need to obtain such financing.  Suchadditional financing would be subject to the risk of availability, may bedilutive to our stockholders, or could impose restrictions on operatingactivities. There can be no assurance that this additional financing will beavailable on terms acceptable to the Company, if at all.

 

Long term cash requirementobligations are primarily comprised of the items noted above. The Company has nolong term debt and our contractual cash requirements and obligations existingbeyond the next twelve months are comprised solely of

 

8

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operating lease commitments and redemption of preferred stock, whichare not considered material.  The Company has limited capacity to reduceits workforce and scale back on capital and operational expenditures todecrease our cash usage.

 

3.                                       RecentAccounting Pronouncement.

 

In November 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 151 “Inventory Costs” which amends theguidance in ARB No. 43, Chapter 4 “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). ARB 43 previously stated that under somecircumstances, items such as idle facility expense, excessive spoilage, doublefreight, and rehandling costs may be so abnormal as to require treatment ascurrent period charges.” SFAS No. 151 requires that those items berecognized as current period charges regardless of whether they meet thecriterion of “so abnormal.” In addition, SFAS No. 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. SFAS No. 151 shall beeffective for inventory costs incurred during fiscal years beginning afterJune 15, 2005. Earlier application is permitted for inventory costsincurred during fiscal years beginning after the date SFAS No. 151 wasissued. SFAS No. 151 shall be applied prospectively. The Company does notexpect the adoption of SFAS No. 151 to have a material effect on itsconsolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123 (R), “Share-BasedPayment” that focuses primarily on accounting for transactions in which anentity obtains employee services in share-based payment transactions. Thisstatement replaces SFAS No. 123, “Accounting for Stock-Based Compensation,”and supersedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.”  In March 2005, theSecurities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB107”) relating to the adoption of SFAS 123R. SAB 107 primarily interprets howthe implementation of SFAS 123R is to be applied under SEC rules andregulations. Beginning January 1, 2006, the Company will be required toexpense the fair value of employee stock options and similar awards. TheCompany has elected to utilize the modified prospective transitional method inaccounting for share-based employee payment transactions. Based upon theemployee options outstanding as of March 31, 2006, and the transitionalprovisions of SFAS No. 123R and SAB 107, there are approximately $1,745 offuture costs, utilizing the fair value method that will be expensed over a fouryear period from 2006 through 2010. Additionally, the Company will utilize thefair value method for any future instruments issued after January 1, 2006 (formore details, refer to Note 5).

 

In March 2005, the FASB issued InterpretationNo. 47 (FIN 47) to clarify the guidance included in SFAS No. 143, “Accountingfor Asset Retirement Obligations.” FIN 47 requires companies to recognize aliability for the fair value of a legal obligation to perform asset retirementactivities that are conditional on a future event if the amount can bereasonably estimated.  If amounts cannot be reasonably estimated, certaindisclosures will be required about the unrecognized asset retirementobligations.  The adoption of FIN 47 in the first quarter of 2006 didnot have a material effect on the Company’s consolidated financial statements.

 

In May 2005, SFAS No. 154, “AccountingChanges and Error Corrections – replacement of APB Opinion No. 20 and FASBStatement No. 3,” was issued. SFAS No. 154 changes the accounting forand reporting of a change in accounting principle by requiring retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple unless impracticable. SFAS No. 154 is effective for accountingchanges made in fiscal years beginning after December 15, 2005. Theadoption of SFAS No. 154 did not have a material impact on the Company’sresults of operations, financial position or cash flows.

 

In June 2005, the EITF reached consensus on IssueNo. 05-2, “The Meaning of ‘Conventional Convertible Debt Instrument’ in EITFIssue No. 00-19, ‘Accounting for Derivative Financial Instruments Indexed to,and Potentially Settled in, a Company’s Own Stock.’“ Issue 00-19 is used toevaluate whether embedded derivatives should be bifurcated under SFAS No. 133, “AccountingFor Derivative Instruments and Hedging Activities,” as amended. Specifically,SFAS No.133 provides guidance as to when an issuer is required to bifurcate aconversion option that is embedded in convertible debt. However, Issue 00-19does not define “conventional convertible debt instrument.” Given thedevelopment of numerous contractual terms that may be included in a convertibledebt instrument, it is not clear when a convertible debt instrument is “conventional.”  We do not believe that our redeemablepreferred stock and related warrants meet the definition of conventionalconvertible debt and as a result Issue No. 00-19 applies to the liabilitytreatment of these instruments. The adoption of the Issue may have an effect onthe Company’s financial position or results of operations in future periods.

 

9

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In September 2005, the EITF reached consensus onIssue No. 04-13, “*Accounting for Purchasesand Sales of Inventory with the Same Counterparty,”* that inventorypurchases and sales transactions with the same counterparty that are enteredinto in contemplation of one another should be combined for purposes ofapplying APB Opinion No. 29, “*Accountingfor Nonmonetary Transactions.”* The effect reduces reported revenues and costof sales for affected transactions. The consensus on this issue would apply tosuch transactions beginning in the first quarter 2006. The adoption of IssueNo. 04-13 did not have a material effect on the Company’s consolidatedfinancial statements in the first quarter of 2006.

 

In September 2005, the FASB ratified the EITF IssueNo. 05-7, “Accounting for Modifications to Conversion Options Embedded in DebtInstruments and Related Issues,” which addresses whether a modification to aconversion option that changes its fair value effects the recognition ofinterest expense for the associated debt instrument after the modification, andwhether a borrower should recognize a beneficial conversion feature, not a debtextinguishment, if a debt modification increases the intrinsic value of thedebt (for example, the modification reduces the conversion price of the debt).The adoption of the Issue may have a material effect on our consolidatedfinancial position or results of operations in future periods.

 

In September 2005, the FASB also ratified the EITF’sIssue No. 05-8, “Income Tax Consequences of Issuing Convertible Debt with aBeneficial Conversion Feature,” which discusses whether the issuance ofconvertible debt with a beneficial conversion feature results in a basisdifference arising from the intrinsic value of the beneficial conversionfeature on the commitment date (which is recorded in the stockholder’s equityfor book purposes, but as a liability for income tax purposes) and, if so,whether that basis difference is a temporary difference under SFAS No. 109, “Accountingfor Income Taxes.”  The adoption of theIssue is not expected to have a material effect on the Company’s consolidatedfinancial position or results of operations in future periods.

 

                InFebruary 2006, the FASB issued SFAS No. 155 “Accounting for Certain HybridFinancial Instruments, an amendment of FASB Statements No. 133 and 140” (“SFAS155”). SFAS 155 clarifies certain issues relating to embedded derivatives andbeneficial interests in securitized financial assets. The provisions of SFAS155 are effective for all financial instruments acquired or issued after fiscalyears beginning after September 15, 2006. The Company is currently assessingthe impact that the adoption of SFAS 155 will have on its results of operationsand financial position.

 

In March 2006, the FASB issued SFAS No. 156, “Accounting forServicing of Financial Assets” (“SFAS156”), which amends SFAS 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities,” with respect to the accounting for separately recognizedservicing assets and servicing liabilities. SFAS 156 permitsthe choice of the amortization method or the fair value measurement method,with changes in fair value recorded in income, for the subsequent measurementfor each class of separately recognized servicing assets and servicingliabilities. The statement is effective for years beginning afterSeptember 15, 2006, with earlier adoption permitted. The Company iscurrently evaluating the effect that adopting this statement willhave on the Company’s financial position and results of operations.

 

4.                                       Inventories.

 

The Company’s inventory as carried in its financial statements is allfinished goods inventory. The Company orders, purchases and receives finished,completed, boxed and ready for sale video phone products directly from itssupplier. The Company makes no subsequent changes to the products. The Companydoes not maintain work in process inventory, component raw materials orsupplies, except for very minimal quantities for repair work. The Company doesnot include tooling, deferred start-up or general and administrative costs inits inventory costs. The Company also does not maintain specific inventory forany specific long-term contracts or programs. The Company tracks and removesinventory only under the “first-in, first-out method” and prices it based uponthe Company’s actual cost.

 

Inventories as of March 31, 2006 and December 31, 2005 aresummarized as follows:

 
| ** **        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------|------------|--------------------------|------------|-----------------------------|------------|
| Raw material      |       | $                        | —     |                        | $          | — |   |
| Finished goods    |       | 2,225                    |       | 2,878                       |       |
| Total Inventory   |       | 2,225                    |       | 2,878                       |       |
|              |       |                     |       |                        |       |
| Inventory Reserve |       | —                   |       | —                      |       |
|              |       |                     |       |                        |       |
| Inventory, net    |       | $                        | 2,225      |                        | $          | 2,878 |   |

 

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5.                                       Stock Based Compensation

 

Effective January 1, 2006, the Company adopted the fair valuerecognition provisions of SFAS No. 123(Revised 2004), “Share-Based Payment,”using the modified-prospective-transition method. As a result, the Company’snet loss before taxes for the three months ended March 31, 2006 isapproximately $191 greater than if it had continued to account for share-basedcompensation under Accounting Principles Board (“APB”) opinion No. 25 “Accountingfor Stock Issued to Employees.”

 

Prior to January 1, 2006 the Company’s stock-based employeecompensation plans were accounted for under the recognition and measurementprovisions of  APB No. 25, and relatedInterpretations, as permitted by FASB Statement No. 123, “Accounting forStock-Based Compensation.” The Company did not recognize stock-basedcompensation cost in its statement of operations for periods prior to January1, 2006 as all options granted had an exercise price equal to the market valueof the underlying common stock on the date of grant. However, compensationexpense was recognized under APB No. 25 for certain options granted to nonemployees of the Company based upon the intrinsic value (the difference betweenthe exercise price at the date of grant and the deemed fair value of the commonstock).

 

As was permitted under SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure,” which amended SFAS No. 123, theCompany elected to continue to follow the intrinsic value method in accountingfor its stock-based employee compensation arrangements as defined by APB No.25, and related interpretations including FASB Interpretation No. 44, “Accountingfor Certain Transactions Involving Stock Compensation,” an interpretation ofAPB No. 25. No stock-based employee compensation cost is reflected inoperations, as all options granted under those plans had an exercise priceequal to the market value of the underlying common stock on the date of grant.The following table illustrates the effect on net income and net income pershare as if the Company had applied the fair value recognition provisions ofSFAS No. 123 to stock-based employee compensation: (in thousands).

 
| ** **                                                                                                                   | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Net income, as reported                                                                                                      |       | $                                                      | 2,594      |   |
|                                                                                                                         |       |                                                   |       |
| Less: Stock-based employee compensation  expense determined under fair value-based method for all awards, net of  income tax |       | 194                                                    |       |
| Pro forma net income                                                                                                         |       | $                                                      | 2,400      |   |
|                                                                                                                         |       |                                                   |       |
| Net income per share:                                                                                                        |       |                                                   |       |
|                                                                                                                         |       |                                                   |       |
| Net Income - as reported:                                                                                                    |       |                                                   |       |
| Basic                                                                                                                        |       | $                                                      | 0.08       |   |
|                                                                                                                         |       |                                                   |       |
| Fully Diluted                                                                                                                |       | $                                                      | 0.07       |   |
|                                                                                                                         |       |                                                   |       |
| Net income – pro forma:                                                                                                 |       |                                                   |       |
| Basic                                                                                                                        |       | $                                                      | 0.08       |   |
|                                                                                                                         |       |                                                   |       |
| Fully Diluted                                                                                                                |       | $                                                      | 0.06       |   |

 

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6.                                       Accounting forPreferred Shares and Derivative Shares

 

In June 2004, WorldGate completed a privateplacement of preferred stock. The Preferred Stock has a dividend rate of 5% perannum, payable quarterly, either by cash or through the issuance of commonstock at the Company’s option. The preferred stock has a staged maturity overthree years with scheduled payments of one third due after 18 months, one halfof the remainder due after 24 months and the balance due after 36 months, andmay be redeemed at maturity in cash or, at the Company’s option, subject tocertain conditions that may not be solely under the control of the Company,through the issuance of the number of shares of common stock determined bydividing the liquidation preference of the preferred shares by the then averagemarket price over the ten consecutive trading days prior to the date ofconversion.  If the effectiveness of the registration statement lapses,the Company ceases to be listed on certain specified exchanges and trading inthe Company’s stock is suspended or a change in control occurs with respect tothe Company, the Company may be required to settle redemption of the preferredstock with cash instead of its common shares.  Furthermore, since themarket price of the Company’s common stock cannot be predicted, the actualnumber of shares of the Company’s common stock that will be required if aredemption is made through the issuance of common stock, can also not bepredicted. The private placement includes numerous provisions intended toprotect these institutional investors including a cash payment penalty of 1.0%per month for unredeemed preferred shares once registration of the shares lapseand until the registration again becomes effective. Similarly the amount of thecash penalties may not be determinable until such time as the event triggeringthe cash payment is cured or removed.

 

 The Preferred Stock has embedded conversionoptions. Specifically, the holders of the Preferred Stock may convert theirshares into the Company’s common stock at a conversion price of $2.35 pershare. In addition the Company may force conversion of the Preferred Stock intocommon stock if the Company achieves certain price targets for its common stockand satisfaction of certain other conditions, such as the existence of an effectiveregistration statement. In either event the conversion price is subject toadjustment if, at any time after the date the preferred shares were issued, theCompany issues or sells, or is deemed to have issued or sold, any shares of theCompany’s common stock for per share consideration less than the conversionprice of the preferred shares on the date of such issuance or sale. Accordingly, the number of common shares issuable upon the conversion of thepreferred shares cannot be predicted.  Furthermore, net-cash settlementmay be required in the event of conversion default under certain circumstancesthat may not be solely under the control of the Company.  If theeffectiveness of the registration statement lapses, the Company ceases to belisted on certain specified exchanges and trading in the Company’s stock issuspended or a change in control occurs with respect to the Company, theCompany may be required to settle a conversion of the preferred stock with cashinstead of its common shares.

 

Also, as part of the private placement the Companyissued five-year warrants to purchase up to 803,190 shares of our common stockat an exercise price of $2.69 per share and five-year warrants to purchase upto 803,190 shares of our common stock at an exercise price of $3.14 per share.The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,606,383 additional shares of common stock sharesat $3.14 a share. This exercise price of the warrants is subject to adjustmentif, at any time after the date the warrants were issued, the Company issues orsells, or is deemed to have issued or sold, any shares of the Company’s commonstock for per share consideration less than the exercise price of the warrantson the date of such issuance or sale.  Accordingly, the number of commonshares that will be issued upon the exercise of the warrants cannot bepredicted.  As of March 31, 2006, 125,000 warrants exercisable at$2.69 had been exercised and 51,915 warrants exercisable at $3.14 had beenexercised.  All of the additional investment rights had been exercised asof March 31, 2006.

 

Of the 7,550 preferred shares issuedunder this private placement, 7,217 shares have been redeemed as ofMarch 31, 2006.

 

With respect to the Company’s accounting for thepreferred stock, Emerging Issues Task Force (“EITF”) Topic D-98, paragraph 4,states that Rule 5-02.28 of Regulation S-X requires securities withredemption features that are not solely within the control of the issuer to berecorded outside of permanent equity. As described above, the terms of thePreferred Stock include certain redemption features that may be triggered byevents that are not solely within the control of the Company, such as apotential failure in the Company’s ability to maintain an effectiveregistration statement. Furthermore, the actual number of shares of commonstock required to satisfy redemption is based upon the market value of thecommon stock at the time of the redemption, which cannot be predicted. Accordingly,the Company has classified the preferred stock as temporary equity and thevalue ascribed to the redeemable preferred stock upon initial issuance, i.e. atJune 24, 2004, was the amount received in the transaction minus the fairvalue ascribed to the conversion options and warrants. The initial value of theredeemable preferred stock is accreted up to the redemption value (the amountreceived in the transaction) over the future relevant periods using theinterest method.Thevalue of the redeemable preferred stock at March 31, 2006 was $278.

 

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The terms of the preferred stock include certainconversion options that represent derivative financial instruments underparagraph 12 of SFAS No. 133 and thus were separated from the PreferredStock and valued using the Black-Scholes option pricing model.  Theconversion options include certain provisions that could result in a variablenumber of shares to be issued upon conversion, adjustment to the strike priceat which conversion shares will be determined, or the requirement for theCompany to settle the conversion options in cash. EITF 00-19, “Accounting forDerivative Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock,” states that if the conversion options require net cash settlement inthe event of circumstances that are not solely within the Company’s controlthey should be classified as a liability measured at fair value on the balancesheet.

 

The terms of the five-year warrants include cashpenalty provisions in the event that the Company fails to meet its obligationsto deliver registered shares to the warrant holder upon exercise and ananti-dilution provision that could result in a variable number of shares to beissued upon warrant exercise. Additionally, the terms and conditions of thewarrants provide for net settlement through cashless exercise whereby theshares delivered to the warrant holder would be readily convertible to cash. Inaccordance with EITF 00-19 and given the terms and conditions of the warrantsas outlined above, the Company has classified the warrants as a liability onits balance sheet measured at fair value using the Black-Scholes option pricingmodel.

 

The Company accounts for both the conversion optionsand warrants using the fair value method at the end of each quarter, with theresultant gain or loss recognition recorded against earnings. Both the warrantsand conversion options are valued using the Black-Scholes valuation model.Actual period close common stock prices, applicable volatility rates, and theperiod close risk-free interest rate for the instrument’s expected remaininglife (continuously compounded), are the key assumptions used in the valuationcalculation. The WorldGate share price changed from $2.06 per share as ofDecember 31, 2005 to $2.00 per share at March 31, 2006, making thewarrants and preferred stock conversion elements less valuable, and thereforeless costly, relative to their strike price. The result was a $182 non cash gainfor the three months ended March 31, 2006.

 

7.                                       Warranty Reserve

 

We provide a warrantycovering defects arising from the sales of our video phone product. Thiswarranty is limited to a specific time period. As of March 31, 2006, theCompany has a reserve of $98 that is based on a percentage of product sales. Asof March 31, 2006, the Company has not incurred any material warrantycosts related to our product. Warranty costs are charged to cost of revenueswhen they are probable and reasonably estimable. While we believe our estimateat March 31, 2006 is reasonable and adequate, it is subject to changebased on our future sales and experience, which may require an increase ordecrease in our reserve.

 

During the three monthsended March 31, 2006, the Company reduced its warranty reserve of $336 atDecember 31, 2005 by $233. This adjustment, recorded as an increase to the gainrecorded from the termination on February 17, 2006 of the Company’s agreementwith General Instrument, is a result of the elimination of the warrantyexposure for products previously sold and then repurchased from GeneralInstrument under this termination.

 

8.                                       Commitments andContingencies.

 

*Leases*

 

In 1998, the Company enteredinto a leasing arrangement for a building with an entity formed by non-employeeinvestors. The Company stopped paying rent on this lease in May 2003, andin lieu of rent payments the Company’s landlord, 3190 T General, Inc. ,began drawing down the security deposit for the facility. Prior to stoppingrent payments, the Company had commenced negotiations with its landlord for anamendment of its lease to reduce the space commitment and the rent payable.These negotiations were not successful, and in September 2003, the Company’slandlord filed an action in the Court of Common Pleas, Bucks County,Pennsylvania to perfect its interest to take possession of the Company’sfacility, and to establish damages for past rent and expenses. Although ajudgment was granted allowing the Company’s landlord to regain possession ofthe facility, the Company remained in the facility and continued negotiationswith its landlord. During 2004, the landlord deeded the facility to itsmortgage holders and negotiations commenced with GMAC as representative for themortgage holders. These negotiations were successful and in November 2004the Company’s lease was amended with an effective date of June 2004 toreduce the lease obligation in line with the Company’s then current spacerequirements, and to bring the Company current with respect to all outstandingback rent.  Subsequently, GMAC sold the building and the Company hasnegotiated a new lease with the new owner on September 1, 2005. Thecurrent lease covers 42,500 square feet at an annual rate of $11.40 per squarefoot with a 3% increase annually, cancelable by either party with 8 monthsnotice, with a termination

 

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by tenant also including six months termination fee. Total rent expenseresulting from this lease for the three months ended March 31, 2006 and 2005amounted to approximately $159 and $90, respectively.

 

In November 2003, theCompany entered into a 60 month lease for office equipment. As ofMarch 31, 2006, there remains a total of $14 to be paid over the remainingperiod of this lease. In October 2005, the Company entered into a 36 monthlease for office equipment. As of March 31, 2006 there remains a total of$20 to be paid over the remaining period of this lease.

 

The future minimumcommitments under non-cancelable leases for the balance of each of the fiscalyears ending December 31 are as follows:

 
| ** **                                     | ** ** | **(Dollars in  Thousands)** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | ** **                       | ** ** |
| 2006 (April 1, 2006 through December  31,2006) |       | $                                | 378        |   |
| 2007                                           |       | 517                              |       |
| 2008                                           |       | 530                              |       |
| 2009                                           |       | 535                              |       |
| 2010                                           |       | 363                              |       |
| Total                                          |       | $                                | 2,323      |   |

 

*Significant Agreements and Transactions*

 

Net revenues from continuingoperations recognized from General Instrument, an investor, were approximately$0 and $179, respectively, for the three months ended March 31, 2006 and2005 respectively. This investor accounted for approximately 100% of therevenues for the three months ended March 31, 2005. This investorpreviously provided a cash advance against product shipments. The balance ofthis advance received from this investor was $0 and $190 as of March 31,2006 and 2005, respectively. Accounts receivable from this investor was $0 and$123 as of March 31, 2006 and December 31, 2005, respectively. InApril and September 2004, we issued warrants to this investor topurchase shares of our common stock, with the April warrants having anexercise price of $1.4375 per share and the September warrants having anexercise price of $1.75 per share. Included in General and Administrativeexpenses in September 2004 were $606 of expenses relating to the valuationof these warrants. This valuation was determined by using the Black-Scholesfair value option model. The following assumptions were used: expectedvolatility of 65%; average risk-free interest rate of 3.43 percent; dividendyield of 0%; and an expected life of 5.0 years.

 

 On April 28,2004, the Company entered into a six-year distribution agreement with GeneralInstrument for the marketing and distribution of the Ojo video phone. Thisagreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phone products.After a period of eighteen months following the commercial availability of theOjo video phone, this mutual exclusivity would terminate unless GeneralInstrument elected to continue the mutual exclusivity after having achievedcertain minimum sales targets for the Ojo video phone. General Instrument couldhave, however, at its option, elected to terminate this mutual exclusivity atany time. In the event mutual exclusivity terminates or is terminated, then fora twelve month period thereafter, WorldGate was to continue to be GeneralInstrument’s exclusive supplier of broadband video phones, but would be free tosell video phone products to customers other than certain defined GeneralInstrument accounts. During this twelve month period, General Instrument had aright of first refusal to accept and fill any orders for video phone productsthat WorldGate obtained from non- General Instrument accounts, and wasobligated to use good faith efforts to solicit and accept product orders fromGeneral Instrument accounts in a commercially reasonable manner. During anyperiod of exclusivity under this agreement the Company was reliant upon GeneralInstrument and its distribution partners, including, for example, wholesalers,retailers and service providers, to provide the worldwide sales anddistribution of the Ojo video phone. Although the agreement required GeneralInstrument to provide for certain marketing and promotional activities for theOjo video phone, there were no required sales quotas for the agreement toremain in effect, and General Instrument controlled the volume of productsbeing distributed by our Company. Neither party was permitted to terminate theagreement except in cases of uncured breaches of the agreement or as a resultof insolvency events suffered by the other party. If General Instrument and itspartners were not successful, or if their activities did not lead tosignificant sales of our product, our operating results could have beenadversely affected, our revenue could be significantly reduced and the Companycould lose potential customers. In connection with the Development andDistribution Agreement with General Instrument, the Company issued warrants toGeneral Instrument to purchase 600,000 shares of our common stock, 300,000 atan exercise price of $1.4375 per share with

 

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the execution of the agreement in April 2004, and 300,000 at an exerciseprice of $1.75 upon the delivery to General Instrument of acceptable prototypesfor the product. Additionally, the Company agreed to issue warrants to purchaseup to an additional 1,650,000 shares of our common stock, upon the achievementof certain sales milestones, at an exercise price based upon the averageclosing sales price of our common stock during the 20 day period preceding theissuance of each warrant.

 

On February 17, 2006, the Company mutually agreed with GeneralInstrument to end their mutually exclusive distribution agreement. The endingof this agreement immediately terminated this exclusivity for both parties, andaccordingly enabled WorldGate to expand its focus in bringing Ojo to themarketplace. In addition to its current role for development and manufacture ofOjo, WorldGate became directly responsible for the advertising, marketing, anddistribution of its products.

 

The Company does not plan to establish a reserve for retailer returnsto General Instrument. In the Company’s discussions with the retailers eligiblefor such returns, the retailers have indicated their intention to continue tosell the Company’s video phone products and, to date, the Company has notreceived any returned products.

 

As part of ending the development and distribution agreement, GeneralInstrument has agreed to certain restrictions on its development of astand-alone video phone product which has as a primary function the making orreceipt of video phone calls over a broadband network.  Such restrictionswill end in January 2007.

 

The Company has a currenttwo year agreement with Mototech , an investor, to provide the Company withengineering and development support. As a result of this agreement, the Companyhas expensed approximately $19 and $102, respectively for the three monthsended March 31, 2006 and 2005. Accounts payable to this investor amounted to$68 and $1,173 at March 31, 2006 and December 31, 2005, respectively. Thisagreement provided for contracted services, including hardware and softwaredevelopment, and the creation and development of tools to facilitate theCompany’s engineering efforts. This agreement does not provide for ongoingroyalties, purchase provisions, or for any requirement to provide additionalfunding to the Company. Net revenues from continuing operations recognized fromMototech were approximately $393 and $0 for the three months endedMarch 31, 2006 and 2005, respectively. This investor accounted forapproximately 77% and 0% of the revenues for the three months ended March 31,2006 and 2005, respectively. Accounts receivable from this investor were $393and $0, respectively, as of March 31, 2006 and December 31, 2005.

 

In June 2004, WorldGatecompleted a private placement of 7,550 shares of Preferred Stock at a statedvalue of $1,000 per share. The Preferred Stock has attached warrants andconversion options. Specifically, the holders of the Preferred Stock mayconvert their shares into our common stock at a conversion price of $2.35 pershare. The private placement includes numerous provisions intended to protectthese institutional investors including a cash payment penalty of 1.0% permonth for unredeemed preferred shares once registration of the shares lapse anduntil the registration again becomes effective. A registration statement forthese securities was originally filed containing fiscal 2003 financialstatements, and an amendment to this registration statement which would includefiscal 2005 financial statements has not been registered and until such time asthe shares become registered the Company is subject to the penalty provisionunder this private placement.

 

In August 2005, the Company completed a privateplacement for $17,500 of its common stock and warrants with severalinstitutional investors. The Company issued 4,666,664 shares of its commonstock at $3.75 per share to the participating investors. The Company alsoissued five-year warrants to purchase a total of 1,671,947 shares of its commonstock: 1,633,333 shares to the investors at an exercise price of $5.00 pershare, and 38,614 shares to the placement agent at an exercise price of $4.53per share.  The investors also received an additional investment right,for a limited period of time, to purchase 1,554,000 additional shares of commonstock at $4.12 per share. The private placement includes numerous provisionsintended to protect these institutional investors including a cash paymentpenalty of 1.5% per month for the period above 120 days fromthe effective date of the Agreement that the shares in the transactionfail to be registered. On March 31, 2006 the shares under this privateplacement had not been registered and until such time as the shares becomeregistered the Company is subject to the penalty provision under this privateplacement. For the three months ended March 31, 2006 and 2005 the Companyrecorded and expensed related penalties of $787 and $0, respectively. Therelated unpaid penalties accrued as of March 31, 2006 and December 31, 2005were $780 and $525, respectively.

 

9.                                       Net Loss per Share.

 

Basic and diluted net income (loss) per common share is computed bydividing the net income (loss) available to common stockholders for the periodby the weighted average number of shares of common stock outstanding during theperiod. The calculation of diluted net income (loss) per common share excludespotential common shares if the effect is antidilutive. Potential common sharescomprise shares of common stock issuable upon the exercise of stock options andwarrants. The number of potential common shares which would have been assumedto be converted in the periods ended

 

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March 31, 2006 and 2005 andhave a dilutive effect if the Company had income from continuing operations, orif the options’ exercise price was less than the average market price of thecommon shares, is 10,965,140 and 862,250, respectively.

 

10.                                 Stock Options andWarrants.

 

In October 2004, theCompany’s stockholders approved the 2003 Equity Incentive Plan (“2003 Plan”).This plan is intended to replace the 1996 Plan for new grants. No additionalshares were reserved for the new plan but rather all available shares under the1996 Plan were made available for the new plan. As with the 1996 Plan, the 2003Plan includes the same automatic annual increase in the number of sharesreserved for use with the plan equal to the greater of 4% of the thenoutstanding shares of the Company’s common stock or 1,000,000 shares. Inaddition to ISOs and NQSOs, the new plan also provides for performance basedawards and restricted stock. At March 31, 2006, there were 8,085,730 sharesreserved under these plans, and 4,526,273 options outstanding. During the threemonths ended March 31, 2006, there were 58,000 options granted to employees.

 

At March 31, 2006 there were a total of 6,297,165 warrants outstanding(for more details, refer to Note 2).

 

11.                                 RevenueRecognition

 

Revenue is recognized when persuasive evidence of anarrangement exists, the price is fixed or determinable, the collectibility isreasonably assured, and the delivery and acceptance of the equipment hasoccurred or services have been rendered.  Management exercises judgment inevaluating these factors in light of the terms and conditions of its customercontracts and other existing facts and circumstances to determine appropriaterevenue recognition. Due to our limited commercial sales history, our abilityto evaluate the collectibility of customer accounts requires significantjudgment. The Company evaluates its equipment customer and service customers’ accountsfor collectibility at the date of sale and on an ongoing basis.

 

For the years ended December 31, 2004 and 2005, and through midFebruary 2006, the Company had only one customer for the purchase of itsproduct and the agreement with this customer included several elements relevantto revenue recognition including: (a) the customer had no general right toreturn the product; (b) the customer earned warrants upon thepurchase of significant video telephony units and the value of these warrantswould result in a reduction of recognized revenue (the value of these warrantshas been routinely monitored by the Company and is currently deemed to beinsignificant, however, should the value of these warrants become material anoffset would be made against revenues); (c) penalties are payable to thecustomer if certain excessive field failure rates areexceeded; (d) the Company and the customer share in the benefitachieved by product cost reductions; (e) penalties are payable to thecustomer if the Company fails to deliver shipments on a timely basis;(f) the Company extends to the customer a limited product warranty for aterm not to exceed three years (the Company maintains a warranty reserve basedupon the percentage of product sales consistent with industry comparablefailure rates and the warranty period provided by the agreement). Beginning inmid February 2006, as a result of the termination of the General Instrumentmarketing and distribution agreement, the Company began selling its products tomultiple customers and now evaluates its revenue recognition policy on acustomer by customer basis.

 

Revenues are also offset by a reserve for any pricerefunds and consumer rebates consistent with the EITF Issue 01-9, “Accountingfor Consideration Given by a Vendor to a Customer.”

 

As an incentive to promote delivery of the units, aspecial product launch discount was provided by the Company to a distributor asa quantity restricted reduction to the unit contract based price in effect. Forthe year ended December 31, 2005, this discount was $398. In addition, theCompany has offered a forward pricing program to our distributor and a rebateprogram to consumers, as further incentives for the holiday season. Theseincentive programs began in the fourth quarter of 2005 and terminated duringthe first quarter of 2006. Consistent with the EITF Issue 01-9, Accounting forConsideration Given by a Vendor to a Customer, the Company has offset itsrevenues for the year ended December 31, 2005 by $212 for a reserve forthe total estimated liability for the forward pricing program, and $91 as anestimated liability associated with the rebate program.  The total of theproduct launch discount, refunds and rebates for the year endedDecember 31, 2005 was $701. There were no product launch discounts,refunds or rebates for the years ended December 31, 2003 and 2004 and for thethree months ended March 31, 2005. The forward pricing program was terminatedwith the termination on February 17, 2006 of the distribution agreement withGeneral Instruments, and this liability was reversed and recorded as a $212increase to the gain

 

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realized from termination ofthis agreement. On March 13, 2006, the Company announced that it was going tooffer a new consumer rebate program effective April 1, 2006 and terminatingJune 30, 2006. An estimated liability of $44 associated with this rebateprogram was recorded at March 31, 2006. Also, on March 13, 2006 the Companyannounced a price protection program for certain retailers holding Ojo VideoPhone inventory as of April 1, 2006. An estimated liability of $12 associatedwith this price protection program was recorded at March 31, 2006. These rebateand price protection programs were recorded as offsets against revenues in thethree months ended March 31, 2006.

 

As part of ending its agreement with General Instrument, and inanticipation of WorldGate inventory requirements as a result of taking fullresponsibility for product distribution, WorldGate negotiated the right to buyback about two-thirds of the units sold to General Instrument, valued atapproximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturing sources.As a result the Company recorded a reserve for returns and reduced revenue inthe amount of approximately $2,310, during the fourth quarter of 2005. Inaddition, the Company has recorded no revenue for units shipped to GeneralInstrument in the first quarter 2006 and has recorded a gain on termination ofthis agreement of approximately $1,792 during the first quarter 2006 as aresult of the lower purchase price of the inventory repurchased from GeneralInstrument ($1,342, net of the cost of rework for rebranding the product andthe adjustment of the inventory to its current replacement value) and reversalof the product refund program reserve ($212) as well as an adjustment of thewarranty reserve for products repurchased ($233), both of which resulted fromtermination of the Company’s agreement with General Instrument.

 

12.                                 Risks anduncertainties

 

Our primary line of businessis the development of video phone products and technology. We are still in theprocess of launching our first product based on this technology and, althoughwe have realized some revenues for the commercial sale of our product, therevenues to date have not been substantial. Given the early stage of ourproduct and the lack of operating history in the video phone business, it isdifficult to predict our future results.

 

On April 28, 2004, weentered into a multi-year agreement with General Instrument Corporation d/b/athe Broadband Communication Sector of Motorola, Inc. (“General Instrument”)for the worldwide development and distribution of the Ojo personal video phone.This agreement provided for General Instrument to be WorldGate’s exclusivedistributor of its broadband video phone products and for WorldGate to beGeneral Instrument’s exclusive supplier of its broadband video phone products. OnFebruary 17, 2006, we mutually agreed with General Instrument to end thisagreement. The ending of this agreement immediately terminated this exclusivityfor both parties, and accordingly enabled WorldGate to expand its focus inbringing Ojo to the marketplace. In addition to its current role fordevelopment and manufacture of Ojo, WorldGate became directly responsible forthe advertising, marketing, and distribution of its products. Subsequent to theending of the agreement with General Instrument we will depend upondistribution partners, including, for example, wholesalers, retailers andservice providers, to provide the worldwide sales and distribution of the Ojovideo phone. If our partners are not successful, or if their activities do notlead to significant sales of our product, our operating results will beadversely affected, our revenue could be significantly reduced and we couldlose potential customers.

 

###### **Wealso depend on relationships with third parties such as contract manufacturingcompanies, chip design companies and others who may be sole source providers ofkey components and services critical for the product we are developing in ourvideo phone business. A formal relationship with Mototech has been establishedfor the volume manufacture of Ojo. Mototech is currently the sole volumemanufacturer of Ojo. Our agreement with Mototech allows either party toterminate the agreement with 90 days prior notice. If Mototech or otherproviders of components and/or manufacturing services do not produce thesecomponents or provide their services on a timely basis, if the components orservices do not meet our specifications and quality control standards, or if thecomponents or services are otherwise flawed, we may have to delay productdelivery, or recall or replace unacceptable products. In addition, suchfailures could damage our reputation and could adversely affect our operatingresults. As a result, we could lose potential customers and any revenues thatwe may have at that time may decline dramatically.**

 

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# ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS.

 

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

 

We may from time to time make written or oral forward-lookingstatements, including those contained in the following Management’s Discussionand Analysis of Financial Condition and Results of Operations. The words “estimate,”“project,” “believe,” “intend,” “expect,” and similar expressions are intendedto identify forward-looking statements, although not all forward-lookingstatements contain these identifying words. In order to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, weare hereby identifying certain important factors that could cause our actualresults, performance or achievement to differ materially from those that may becontained in or implied by any forward-looking statement made by or on ourbehalf. The factors, individually or in the aggregate, that could cause suchforward-looking statements not to be realized include, without limitation, thefollowing: (1) difficulty in developing and implementing marketing and businessplans, (2) industry competition factors and other uncertainty that a market forour products will develop, (3) challenges associated with distributionchannels, including both the retail distribution channel and HSD operators(e.g., uncertainty that they will offer our products, inability to predict themanner in which they will market and price our products and existence ofpotential conflicts of interests and contractual limitations impeding theirability to offer our products), (4) continued losses, (5) difficulty orinability to raise additional financing on terms acceptable to us, (6)departure of one or more key persons, (7) delisting of our Common Stock fromthe NASDAQ Small Cap Market, (8) changes in regulatory requirements, and (9)other risks identified in our filings with the Securities and ExchangeCommission. We caution you that the foregoing list of important factors is notintended to be, and is not, exhaustive. We do not undertake to update anyforward-looking statement that may be made from time to time by or on ourbehalf.

 

**Results of Operations:**

 

**General**

 

Our ITV business has historically accounted for substantially all ofour revenue.  In the third quarter of 2003, we completed a sale ofsignificant assets, including our ITV intellectual property rights and ourmembership interest in TVGateway, LLC.  This transaction marked a shift inour business away from the ITV business and toward a new video phone productand related business.  Although we continued to support our remaining ITVbusiness into the first quarter of 2004, the development of our video phoneproduct became a primary business focus.

 

Our video phone business has not produced significant revenues todate.  The extent and timing of future revenues for our business dependson several factors, including the rate of market acceptance of our products andthe degree of competition from similar products.  We cannot predict towhat extent our video phone product will produce revenues, or when, or if, wewill reach profitability.

 

On April 28, 2004, we entered into a multi-year agreement withGeneral Instrument Corporation d/b/a the Connected Home Solutions Business ofMotorola, Inc. (“General Instrument”) for the worldwide development anddistribution of the Ojo personal video phone. This agreement provided forGeneral Instrument to be WorldGate’s exclusive distributor of its broadbandvideo phone products and for WorldGate to be General Instrument’s exclusivesupplier of its broadband video phone products. On February 17, 2006, wemutually agreed with General Instrument to end this agreement. The ending ofthis agreement immediately terminates exclusivity for both parties. In additionto its current role for development and manufacture of Ojo, WorldGate will nowhave direct responsibility and control for the advertising, marketing, anddistribution of its products.

 

Under our development and distribution agreement with GeneralInstrument, General Instrument was responsible for the distribution of ourproducts and for the direct relationship with the distributors, dealers, andother resellers ultimately used to sell the products. In addition, GeneralInstrument marketed our products and maintained an inventory of our products. Inperforming these functions General Instrument carried the associated risks,costs and expenses. As a result of ending our agreement with GeneralInstrument, we are now directly assuming these responsibilities and theassociated risks, costs and expenses, and this places increased demands on thecash which we have available. Although General Instrument’s price of ourproduct to its reseller customers included a mark-up from its cost of theproduct from us that was intended to reflect its risks, cost and expenses, plusits profit, we will be charging these reseller customers a lower price and wecannot be assured that the new price will include a sufficient mark-up to coverthe risks, costs and expenses that is now our responsibility going forward.

 

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Under its agreement with General Instrument, WorldGate had been activein marketing and promoting its products, and working with General Instrument todistribute Ojo. WorldGate intends to continue the rollout of Ojo using many ofthe same distributors, retailers and service providers and plans to expanddistribution to service providers and retailers around the world.  Inaddition to direct sales on our web site, we will continue to rely upon adistribution organization of dealers, distributors, original equipmentmanufacturers, value added resellers, service providers and other resellers tomarket and sell our video phone products, many of which will be the same asthose used by General Instrument. To enable our own retail distribution effortswe have hired an experienced retail consumer electronics executive to directour efforts in this area. To create retail and consumer interest and builddemand for the product, the Company plans to lower the wholesale and suggestedmanufacturer suggested retail prices. In addition, the Company will offer timelimited rebates to further spur interest and sales. Under its agreement withGeneral Instrument, WorldGate’s video phone products were required to beco-branded with the Ojo brand (which WorldGate continued to own) and theMotorola brand. As the result of ending our agreement with General Instrument,we will now be dropping the Motorola brand.

 

General Instrument also maintained the necessary infrastructure tohandle distribution logistics, including customer ordering, inventorywarehousing, billing, customer service, credit and accounts receivablefunctions multiple customers. Until February 17, 2006 all of our revenue forthe sale of our video phones was derived from General Instrument, a singlecustomer, and there were minimal administrative costs associated with billingand collecting this revenue. The Company will now have multiple customers andbear the associated increased administrative costs and risks of collection.WorldGate will also need to develop the necessary infrastructure to handlemultiple customers and these other logistical functions.

 

As part of ending our agreement with General Instrument, and inanticipation of WorldGate inventory requirements as a result of taking fullresponsibility for product distribution, WorldGate negotiated the right to buyback about two-thirds of the units sold to General Instrument, valued atapproximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturing sources.For more details, refer to Note 11 to our condensed consolidated financialstatements for the three months ended March 31, 2006.

 

The Company does not plan to establish a reserve for retailer returnsto General Instrument. In the Company’s discussions with the retailers eligiblefor such returns, the retailers have indicated their intention to continue tosell the Company’s video phone products and, to date, the Company has notreceived any returned products.

 

As part of ending the development and distribution agreement, GeneralInstrument has agreed to certain restrictions on its development of astand-alone video phone product which has as a primary function of the makingor receipt of video phone calls over a broadband network.  Suchrestrictions will end in January 2007.

 

Critical Accounting Policies and Estimates.

 

Our condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United States. Thesegenerally accepted accounting principles require management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

 

Our significant accounting policies are described in the notes to theconsolidated financial statements included in our annual report on Form 10-K. Judgmentsand estimates of uncertainties are required in applying our accounting policiesin many areas. Following are some of the areas requiring significant judgmentsand estimates: revenue recognition, accounts receivable, inventories, cash flowand valuation assumptions in performing asset impairment tests of long-livedassets, value of redeemable preferred stock, related warrants and conversionoptions.

 

Three Months Ended March 31, 2006 and March 31, 2005

 

Revenues.

 

Revenues for the three months ended March 31, 2006 were $509. Theserevenues represent deliveries of video phones and related service fees.Revenues during the three months ended March 31, 2005 were $179.

 

On March 13, 2006, as an incentive to promotedelivery of the units, the Company announced a special price protection programto certain retailers and a rebate program to consumers. These incentiveprograms will begin on April 1, 2006 and will

 

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terminate at the end of thesecond quarter of 2006. Consistent with the EITF Issue 01-9, Accounting forConsideration Given by a Vendor to a Customer, we offset our March 31, 2006revenues by $12 for the price protection program and $44 for the consumerrebate program. For more details, refer to Note 11 to our condensedconsolidated financial statements for the three months ended March 31, 2006.

 

Costs and Expenses.

 

Cost of Revenues. The cost of revenues consisted of product anddelivery costs relating to the initial deliveries of video phones was $442 forthe three months ended March 31, 2006. Costs of revenues during the threemonths ended March 31, 2005 were $125.

 

Engineering and Development. Engineering and development expensesprimarily consist of compensation, and the cost of design, programming,testing, documentation and support of the Company’s video phone product. Engineeringand development costs were $1,454 for the three months ended March 31, 2006,compared with $1,305 for the three months ended March 31, 2005. This increaseof $149, or 11%, reflects the Company’s increased concentration of itsengineering staff, and related costs, for the further and continuingdevelopment of its video phone product.

 

Sales and Marketing. Sales and marketing expenses consist primarily ofcompensation, attendance at conferences and trade shows, travel costs,advertising, promotions and other marketing programs related to the continuedintroduction of the Company’s video phone product. Sales and marketing costswere $653 for the three months ended March 31, 2006, compared with $379 for thethree months ended March 31, 2005. This increase of $274, or 72%, reflects theincreased effort of staff, advertising and related marketing and promotionalexpenditures associated with the Company’s video phone product.

 

General and Administrative. General and administrative expenses consistprimarily of expenditures for administration, office and facility operations,finance and general management activities, including legal, accounting andprofessional fees. General and administrative expenses were $2,523 for thethree months ended March 31, 2006, compared with $847 for the three monthsended March 31, 2005. This increase of $1,676, or 198%, is primarilyattributable to certain expenses incurred during the three months ended March31, 2006 that were not incurred during the three months ended March 31, 2005.These expenses included non cash charges of $191 from the Company’s adoption ofthe fair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS 123(R)”),using the modified-prospective-transition method. Prior to January 1, 2006, theCompany’s stock-based employee compensation plans were accounted for under therecognition and measurement provisions of Accounting Principles Board Opinion “APBNo.” No. 25, “Accounting for Stock Issued to Employees” “APB No. 25”, andrelated Interpretations, as permitted by Financial Accounting Standards Board (“FASB”)Statement No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”). TheCompany did not recognize stock-based compensation cost in its statement ofoperations for periods prior to January 1, 2006 as all options granted had anexercise price equal to the market value of the underlying common stock on thedate of grant (for more details, refer to Note 5 to our condensed consolidatedfinancial statements for the three months ended March 31, 2006.) In addition,this increase reflects $800 of accrued penalties related to private placementsin June 2004 and August 2005 (for more details, refer to Note 2 to ourcondensed consolidated financial statements for the three months ended March31, 2006). Furthermore, the increase for the three months ended March 31, 2006,includes legal, accounting and auditing fees of $400 in excess of fees incurredin the same period of 2005. These increased fees are associated with itsSarbanes- Oxley internal control compliance implementation for 2005 andrestatements of prior filings with the Securities and Exchange Commission.

 

Interest and Other Income and Interest Expense. Interest and otherincome and interest expense consist of interest earned on cash and cashequivalents. Interest and other income increased from $66 for the three monthsended March 31, 2005 to $134 for the three months ended March 31, 2006,primarily due to additional interest income earned on a higher level ofinvested funds. During the three months ended March 31, 2006, the Companyearned interest on average cash balances of approximately $13,355. Incomparison, during the three months ended March 31, 2005 the Company earnedinterest on average cash balances of approximately $11,026.

 

Income Taxes. The Company has incurred net operating losses sinceinception and accordingly had no income taxes and has not recorded any incometax benefit for those losses.

 

Non Cash Change in Fair Value of Warrants andConversion Options*.*For the three months ended March 31, 2006 and 2005, the non cash change infair value of warrants and conversion option was income of $182 and $5,176,respectively. This income was the result of a marked to market adjustmentprimarily related to our common stock price decline as of March 31, 2006compared to December 31, 2005 and March 31, 2005 compared to December 31,2004 , respectively, as it related to our June 24, 2004 private placementof our Series A Convertible Preferred Stock and Warrants.

 

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Liquidity and Capital Resources.

 

As ofMarch 31, 2006, our primary source of liquidity consisted of cash and cashequivalents that are highly liquid, are of high quality investment grade andhave original maturities of less than three months.

 

AtMarch 31, 2006, we had cash and cash equivalents of $10,493 as compared tocash and equivalents of $16,277 at December 31, 2005. Net cash used inoperating activities was $5,598 for the three months ended March 31, 2006,as compared to $3,208 used for the same period in 2005. This increase in netcash used in operating activities was primarily attributable to our increase inexpenditures during the three months ended March 31, 2006, relatedprimarily to an increase in staffing of approximately $400, increased expendituresof approximately $533 paid to certain investors in penalties, a $480expenditure for repurchased products previously sold to General Instrument andincreased expenditures for inventory of approximately $1,000 over suchpurchases in 2005. No bad debt expense was recorded for the three months endedMarch 31, 2006 and 2005.

 

Cash used forinvesting activities were primarily a result of investments in equipment forproduct development and manufacture as well as for general administrativepurposes. For the three month periods ending March 31, 2006 and 2005, suchinvestments were $192 and $80, respectively.

 

Cash providedby financing activities primarily through various private placements of ourCompany’s securities, through the exercise of warrants and through the exerciseof non-executive employees’ and prior employees’ stock options during the threemonths ended March 31, 2006, totaled $6 compared to $1,377 provided duringthe same period in 2005.

 

Operations and Liquidity.

 

To date, wehave funded operations primarily through multiple private sales of equitysecurities and through an initial public offering of common stock inApril 1999. As of March 31, 2006 we have no outstanding debt and ourassets are not pledged as collateral. We continue to evaluate the possibilitiesto obtain additional financing through public or private equity or debtofferings, bank debt financing, asset securitizations, or from other sources.Such additional financing would be subject to the risk of availability, may bedilutive to our shareholders, or could impose restrictions on operatingactivities. There can be no assurance that this additional financing will beavailable on terms acceptable to us, if at all.

 

The report of the independent registered publicaccounting firm for the year ended December 31, 2005 includes anexplanatory paragraph stating that our Company had suffered recurring lossesfrom operations and had an accumulated deficit of $229,092, and that theseissues raised substantial doubt about our Company’s ability to continue as agoing concern. Our short term cash requirements and obligations includeinventory, accounts payable and capital expenditures from continuingoperations, operating expenses, and the redemption of preferred stock, of which$167 is required to be redeemed in June 2006, although this redemption canbe made in common stock if certain conditions are met. In addition, the August2005 private placement includes cash payment penalties of 1.5% per month forthe period that the shares in the transaction fail to be registered. OnMarch 31, 2006 the shares under this private placement had not beenregistered and until such time as the shares become registered the Company issubject to the penalty provision under this private placement. For the three monthsended March 31, 2006 and 2005 the Company recorded and expensed relatedpenalties of $787 and $0, respectively. The related unpaid penalties accrued asof March 31, 2006 and December 31, 2005 were $780 and $525, respectively. Theending of the General Instrument agreement on February 17, 2006 placesadditional cash burdens on the Company and this could impact our cashrequirements and usage. As part of ending its agreement with GeneralInstrument, and in anticipation of WorldGate inventory requirements as a resultof taking full responsibility for product distribution, WorldGate negotiatedthe right to buy back about two-thirds of the units sold to General Instrument,valued at approximately $2,765 (based upon the original sales price to GeneralInstrument), for approximately $1,064. This is less than half of what it wouldcost the Company to purchase the same inventory from its manufacturing sources.For more details, refer to Note 11 to our condensed consolidated financialstatements for the three months ended March 31, 2006.

 

We believe, based on our internal forecasts and assumptions relating toour operations (including among others, assumptions regarding our short termcash requirements and our projected revenue growth) that we have sufficientcash on hand to meet our obligations into the fourth quarter of 2006.

 

Our ability to generate cashis dependent upon the sale of our Ojo product and on obtaining cash throughcapital markets.  We began generating revenue from commercial shipment ofour Ojo product in April 2005 and we expect revenues to increase as the productcontinues to roll out to the marketplace. Depending on the ramp up of sales andthe achievable margins, the increased level of sales activity should have apositive impact on our cash flows from operations, which will support ourability to meet our cash requirements in the long term. Given that our videophone business involves the development of a new

 

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product line with nomarket penetration, in an underdeveloped market sector, no assurances can begiven that sufficient sales, if any, will materialize.

 

We, however, remain hopeful that sufficient sales will materializeand/or that sufficient funding can be developed through ongoing operations oradditional financings to continue our operations beyond 2006.

 

Our long term cash requirement obligations are primarily comprised ofthe items noted above. We have no long term debt and our contractual cashrequirements and obligations existing beyond the next twelve months arecomprised solely of operating lease commitments and redemption of preferredstock, which are not considered material.  We have limited capacity toreduce our workforce and scale back on capital and operational expenditures todecrease our cash usage.

 

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ITEM 3.     QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK.

 

Interest Rate Risk. Our exposure to market risk related to changes ininterest rates relates primarily to our investment portfolio. We invest ininstruments that meet high credit quality standards, and we limit the amount ofcredit exposure with respect to any one issue, issuer and type of investment.

 

As of March 31, 2006, the Company’s cash and cash equivalents were$10,493, which were comprised of securities having a maturity of less thanthree months. Due to the average maturity and conservative nature of ourinvestment portfolio, management believes a sudden change in interest rateswould not have a material effect on the value of the portfolio. Managementestimates that had the average yield of our investments decreased by 100 basispoints, our interest income for the three months ended March 31, 2006 wouldhave decreased by approximately $41. This estimate assumes that the decreaseoccurred on the first day of 2006 and reduced the yield of each investmentinstrument by 100 basis points. The impact on our future interest income offuture changes in investment yields will depend largely on our totalinvestments.

 

Foreign Currency Exchange Risk. Although we transact business invarious foreign countries, the principal portion of our business is in theUnited States and substantially all of our revenues and costs to date have beendenominated in U.S. dollars. Although our agreement with Mototech, Inc. (not anaffiliate of General Instruments or Motorola), our contract manufacturer inTaiwan, is denominated in U.S. dollars, their material acquisition costs aresubject to exchange rate changes that could impact our product costs.

 

ITEM 4.     CONTROLS AND PROCEDURES.

#  

Disclosure Controls and Procedures. We maintaindisclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)and 15d-15(e)) that are designed to ensure that information required to bedisclosed in reports that we file or submit under the Securities Exchange Actof 1934 is recorded, processed, summarized, and reported within the timeperiods specified in the Securities and Exchange Commission’s rules and forms,and that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding the required disclosures. Indesigning and evaluating the disclosure controls and procedures, we recognizethat any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives.

 

Wecarried out an evaluation, under the supervision and with the participation ofmanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures as of March 31, 2006. Our Chief Executive Officer and ChiefFinancial Officer determined that we have a material weakness (as defined underthe standards established by the Public Company Accounting Oversight Board)that exists with respect to our control procedure for the accounting andreporting of complex financial transactions.

 

Aspreviously reported in our Form 10-K for the year ended December 31, 2005, we identified material weaknessesin our control procedure for the accounting and reporting of complex financialtransactions. These material weaknesses contributed to restatements of our financialstatements in our annual and quarterly reports from the quarter ended March 31,2004 through September 30, 2005.

 

Toaddress this material weakness, we have engaged outside experts to providecounsel and guidance in areas where we cannot economically maintain therequired expertise internally (e.g., with the appropriate classifications andtreatments of complex and non-routine transactions.)

 

Asa result of the material weakness identified with respect to our controlprocedures for the accounting and reporting of complex transactions, the ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are not designed and are not effective in ensuring thatthe information required to be disclosed by our Company in the reports that wefile and submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the Commission’s rules andforms.  Except as identified above, there have been no changes in ourinternal control over financial reporting that occurred during the quarterended March 31, 2006, that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

 

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PART II. OTHERINFORMATION

 

ITEM 1.     LEGAL PROCEEDINGS.

#  

None.

 

ITEM 1A RISKFACTORS

 

There are no material changes from the risk factors previouslydisclosed in our annual report on Form 10-K for the fiscal year ended December31, 2005 in response to Item 1A of Form 10-K.

 

# ITEM2.  UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

#  

# None.

#  

# ITEM3. DEFAULTS UPON SENIOR SECURITIES.

#  

None.

 

ITEM 4.     SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS.

#  

None.

 

ITEM 5.     OTHER INFORMATION.

#  

None.

 

ITEM 6.     EXHIBITS.

 

The following is a list of exhibits filed as part of this report onForm 10-Q. Where so indicated by footnote, exhibits that were previously filedare incorporated by reference. For exhibits incorporated by reference, thelocation of the exhibit in the previous filing is indicated parentheticallyexcept in those situations where the exhibit number was the same as set forth below.

 
| **Exhibit** | ** ** | **Description**                                                                                                                            |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Amended and Restated Certificate of Incorporation (3)                                                                                      |
| 3.2         |       | Amended and Restated Bylaws (1)                                                                                                            |
| 3.3         |       | Certificate of Amendment to Certificate of Incorporation, dated  October 18, 2004 (3)                                                      |
| 3.4         |       | Certificate of Designations, Preferences and Rights of the Series A  Convertible Preferred Stock of the Company dated June 23, 2004 (2)    |
| 31.1        |       | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)*                                                                       |
| 31.2        |       | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)*                                                                       |
| 32.1        |       | Certification of Chief Executive Officer Pursuant to 18 U.S.C.  Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002* |
| 32.2        |       | Certification of Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002* |

 

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* Filed herewith

(1) Incorporated by reference to the exhibits to our Form 10-QReport for the quarter ended March 31, 1999.

(2) Incorporated by reference to the exhibits to our Form 8-K CurrentReport filed on June 25, 2004 (Exhibit 3.1).

(3)Incorporated by reference to the exhibits to our Form 10-QReport for the quarter ended September 30, 2004, as filed on November 17, 2004.

 

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SIGNATURES

 

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

 

 
|   | WORLDGATE COMMUNICATIONS, INC. |
|--------|--------------------------------|
|   |                           |
|   |                           |
| Date:  |                           | May 10, 2006 |   | /s/ Hal M. Krisbergh |   |
|   |                           |   |   | Hal M. Krisbergh |
|   |                           |   |   | Chairman and Chief Executive Officer |
|   |                           |   |   | (Principal Executive Officer) |
|   |                           |   |   |   |
|   |                           |   |   |   |
| Date:  |                           | May 10, 2006 |   | /s/ Joel Boyarski |   |
|   |                           |   |   | Joel Boyarski |
|   |                           |   |   | Vice President and Chief Financial Officer |
|   |                           |   |   | (Principal Financial and Accounting Officer) |

 

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