**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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**AMENDMENT NO. 2**

**FORM 10-Q**

 

**Mark One**

 
| **ý**                                          | ** **                                                                                                                                                                                                           | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|-----------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
| ** **                                          | ** **                                                                                                                                                                                                           | ** **                                                                                    |
| **for the  Quarterly Period Ended March 31, 2005.** |
|                                                |                                                                                                                                                                                                                 |                                                                                          |
| **or**                                              |
|                                                |                                                                                                                                                                                                                 |                                                                                          |
| **o**                                               | ** **                                                                                                                                                                                                           | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|                                                |                                                                                                                                                                                                                 |                                                                                          |
| ** **                                          | **for the  Transition Period From                 To                 .** |

 

**Commissionfile number: 000-25755**

 

**WORLDGATE COMMUNICATIONS, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 
| **Delaware**                                    | ** ** | **23-2866697**                        |
|-------------------------------------------------|------------|---------------------------------------|
| (State of Incorporation)                        |       | (I.R.S. Employer  Identification No.) |
|                                            |       |                                  |
| **3190  Tremont Avenue  Trevose, Pennsylvania** |       | **19053**                             |
| (Address of Principal  Executive Offices)       |       | (Zip Code)                            |

 

**(215)354-5100**

(Registrant’s TelephoneNumber, 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.

Yesý No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

Yeso No ý

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yeso No ý

 

Asof May 9, 2005, there were 33,756,436 shares of common stock, par value $.01per share, outstanding.

 

 

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**EXPLANATORY NOTE**

.

WorldGate Communications,Inc. (the “Company”) is filing this Amendment No. 2 on Form 10-Q/A to amend itsQuarterly Report on Form 10-Q for the quarter ended March 31, 2005, as filedwith the Securities and Exchange Commission (the “SEC”) on May 16, 2005 (the“Original Filing”) and as first amended on August 30, 2005 (the “AmendedFiling”).  The purpose of this AmendmentNo. 2 is to amend and restate Part I, Item 1 and Item 2 which set forth theaccounting for the warrants and additional investments rights issued in privateplacements of the Company’s common stock during the fourth quarter of 2003 andthe first and fourth quarters of 2004. These security components were originally treated as non-cash expensesand with this amendment are being restated as equity transactions. Accordingly,changes have been made to the applicable line items associated with additionalpaid-in capital, accumulated deficit, general and administrative costs, netincome (loss) and net income (loss) per common share.  In addition, Part I, Item 1 and Item 2 hasbeen amended and restated to reflect certain clarifications made in response tothe SEC’s comments as raised in its review of the Company’s registrationstatement on Form SB-2/A, as filed with the SEC on August 30, 2005, and annualreport on Form 10-K/A for the year ended December 31, 2004, as filed with theSEC on August 30, 2005. Finally the certifications attached as Exhibits 31.1,31.2, 32.1 and 32.2 have been updated to reflect the filing date of thisamendment and interim changes in the regulations applicable to thesecertifications.  Except as describedabove, no additions or modifications have been made to this Amendment No. 2 toreflect facts or events occurring subsequent to the date of the Original Filingor the Amended Filing.

 

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**WORLDGATECOMMUNICATIONS, INC.**

 

**QUARTERLYREPORT ON FORM 10-Q**

**FOR THETHREE MONTHS ENDED MARCH 31, 2005**

 

**TABLE OFCONTENTS**

 
| PART I. FINANCIAL INFORMATION                                                                        | 3      |
|------------------------------------------------------------------------------------------------------|--------|
|                                                                                                 |   |
| Item 1. Financial Statements                                                                         | 3      |
| Item 2. Management’s  Discussion And Analysis Of Financial Condition And Results Of Operations. | 13     |
| Item 3. Quantitative And  Qualitative Disclosures About Market Risk.                                 | 17     |
| Item 4. Controls And Procedures.                                                                     | 18     |
|                                                                                                 |   |
| PART II. OTHER INFORMATION                                                                           | 19     |
|                                                                                                 |   |
| Item 1. Legal Proceedings.                                                                           | 19     |
| Item 2. Unregistered Sales  of Equity Securities And Use Of Proceeds.                                | 19     |
| Item 3. Defaults Upon Senior  Securities.                                                            | 19     |
| Item 4. Submission Of  Matters To A Vote Of Security Holders.                                        | 19     |
| Item 5. Other Information.                                                                           | 19     |
| Item 6. Exhibits And Reports  On Form 8-K.                                                           | 19     |

 

2

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**PART I. FINANCIAL INFORMATION**

# **ITEM 1.  FINANCIAL STATEMENTS**

 

**WORLDGATECOMMUNICATIONS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(DOLLARS INTHOUSANDS)**

 
| ** **                                                                                                                                                                                           | ** ** | **As of  March 31,** | ** ** | **As of  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2005**             | ** ** | **2004**                | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **(Unaudited)**      | ** ** | **(Audited)**           | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **As restated**      | ** ** | **As restated**         | ** ** |
| ASSETS                                                                                                                                                                                               |       |                 |       |                    |       |
| Current assets:                                                                                                                                                                                      |       |                 |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                            |       | $                    | 9,929      |                    | $          | 11,840 |   |
| Other receivables                                                                                                                                                                                    |       | 12                   |       | 28                      |       |
| Inventory, net                                                                                                                                                                                       |       | 99                   |       | 46                      |       |
| Prepaid and other assets                                                                                                                                                                             |       | 355                  |       | 184                     |       |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Total current assets                                                                                                                                                                                 |       | 10,395               |       | 12,098                  |       |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Property and equipment                                                                                                                                                                               |       | 3,609                |       | 3,530                   |       |
| Less: accumulated depreciation and  amortization                                                                                                                                                     |       | (1,985               | )          | (1,815                  | )          |
| Property and equipment, net                                                                                                                                                                          |       | 1,624                |       | 1,715                   |       |
| Deposits and other assets                                                                                                                                                                            |       | 9                    |       | 9                       |       |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Total assets                                                                                                                                                                                         |       | $                    | 12,028     |                    | $          | 13,822 |   |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIENCY                                                                                                                                                        |       |                 |       |                    |       |
| Current liabilities:                                                                                                                                                                                 |       |                 |       |                    |       |
| Accounts payable                                                                                                                                                                                     |       | $                    | 258        |                    | $          | 222 |   |
| Accrued expenses                                                                                                                                                                                     |       | 841                  |       | 951                     |       |
| Accrued compensation and benefits                                                                                                                                                                    |       | 241                  |       | 540                     |       |
| Dividend payable on Preferred Stock                                                                                                                                                                  |       | 82                   |       | 85                      |       |
| Detachable Warrants                                                                                                                                                                                  |       | 3,527                |       | 5,583                   |       |
| Notes payable                                                                                                                                                                                        |       | 0                    |       | 37                      |       |
| Conversion option on Preferred Stock                                                                                                                                                                 |       | 5,417                |       | 8,612                   |       |
| Deferred revenues                                                                                                                                                                                    |       | 190                  |       | 369                     |       |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Total liabilities                                                                                                                                                                                    |       | 10,556               |       | 16,399                  |       |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Commitments                                                                                                                                                                                          |       | 0                    |       | 0                       |       |
| Redeemable Preferred Stock; 6,675 shares  outstanding at March 31, 2005, and 6,775 outstanding at  December 31, 2004                                                                       |       | 3,382                |       | 2,995                   |       |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Stockholders’ deficiency:                                                                                                                                                                       |       |                 |       |                    |       |
| Preferred Stock, $.01 par value, 13,500,000  shares authorized; shares issued 7,550 at March 31, 2005 and  December 31, 2004                                                               |       | 0                    |       | 0                       |       |
| Common Stock, $.01 par value; 80,000,000  shares authorized, 31,716,189 shares issued and outstanding at March 31,  2005 and 30,865,777 shares issued and outstanding at December 31, 2004 |       | 317                  |       | 308                     |       |
| Additional paid-in capital                                                                                                                                                                           |       | 213,994              |       | 212,439                 |       |
| Accumulated deficit                                                                                                                                                                                  |       | (216,221             | )          | (218,319                | )          |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Total stockholders’ deficiency                                                                                                                                                                  |       | (1,910               | )          | (5,572                  | )          |
|                                                                                                                                                                                                 |       |                 |       |                    |       |
| Total liabilities and stockholders’  deficiency                                                                                                                                                 |       | $                    | 12,028     |                    | $          | 13,822 |   |

 

The accompanying notes arean integral part of these financial statements.

 

3

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**WORLDGATECOMMUNICATIONS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Dollars inThousands, Except per Share Amounts)**

 
| ** **                                                                                                   | ** ** | **Three Months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                                                                                   | ** ** | ** **                             | ** ** | **(As restated)** | ** ** |
| Revenues                                                                                                     |       | $                                      | 179        |   | $ | 0 |   |
| Cost of revenues                                                                                             |       | 125                                    |       | 0 |   |
| Gross margins                                                                                                |       | 54                                     |       | 0 |   |
|                                                                                                         |       |                                   |       |   |   |
| Engineering and development (excluding  depreciation and amortization amounts of $66, and $0, respectively). |       | 1,305                                  |       | 800 |   |
| Sales and marketing (excluding depreciation  and amortization amounts of $8 and $0, respectively).           |       | 379                                    |       | 191 |   |
| General and administrative (excluding  depreciation and amortization amounts of $97 and $102, respectively). |       | 847                                    |       | 1,044 |   |
| Depreciation and amortization                                                                                |       | 171                                    |       | 102 |   |
|                                                                                                         |       |                                   |       |   |   |
| Total expenses from continuing operations                                                                    |       | 2,702                                  |       | 2,137 |   |
|                                                                                                         |       |                                   |       |   |   |
| Loss from operating activities of continuing operations                                                      |       | (2,648                                 | )          | (2,137 | ) |
| Interest and other income                                                                                    |       | 66                                     |       | 7 |   |
| Change in fair value of warrants and conversion options                                                      |       | 5,176                                  |       | 0 |   |
| Interest and other expense                                                                                   |       | 0                                      |       | (1 | ) |
| Income (loss) from continuing operations                                                                     |       | 2,594                                  |       | (2,131 | ) |
|                                                                                                         |       |                                   |       |   |   |
| Income from discontinued operations                                                                          |       | 0                                      |       | 23 |   |
| Net income (loss)                                                                                            |       | 2,594                                  |       | (2,108 | ) |
| Accretion on preferred stock and dividends                                                                   |       | (495                                   | )          | 0 |   |
| Net income (loss) available to common stockholders                                                           |       | $                                      | 2,099      |   | $ | (2,108 | ) |
|                                                                                                         |       |                                   |       |   |   |
| Income (loss) from continuing operations per common share:                                                   |       |                                   |       |   |   |
| Basic                                                                                                        |       | $                                      | 0.08       |   | $ | (0.08 | ) |
| Fully Diluted                                                                                                |       | $                                      | 0.07       |   | $ | (0.08 | ) |
| Income from discontinued operations per common share:                                                        |       |                                   |       |   |   |
| Basic                                                                                                        |       | $                                      | 0.00       |   | $ | 0.00 |   |
| Fully Diluted                                                                                                |       | $                                      | 0.00       |   | $ | 0.00 |   |
| Net income (loss) per common share:                                                                          |       |                                   |       |   |   |
| Basic                                                                                                        |       | $                                      | 0.08       |   | $ | (0.08 | ) |
| Fully Diluted                                                                                                |       | $                                      | 0.07       |   | $ | (0.08 | ) |
| Net income (loss) available to common shareholders per common share:                                         |       |                                   |       |   |   |
| Basic                                                                                                        |       | $                                      | 0.07       |   | $ | (0.08 | ) |
| Fully Diluted                                                                                                |       | $                                      | 0.05       |   | $ | (0.08 | ) |
| Weighted average common shares outstanding:                                                                  |       |                                   |       |   |   |
| Basic                                                                                                        |       | 31,582,115                             |       | 27,236,662 |   |
| Fully Diluted                                                                                                |       | 38,334,855                             |       | 27,236,662 |   |

 

The accompanying notes arean integral part of these financial statements.

 

4

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**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in Thousands)**

 
| ** **                                                                                                                    | ** ** | **Three Months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                                                                                                    | ** ** | ** **                             | ** ** | **(As restated)** | ** ** |
| Cash flows from operating activities:                                                                                         |       |                                   |       |   |   |
| Net income (loss)                                                                                                             |       | $                                      | 2,594      |   | $ | (2,108 | ) |
| Income from discontinued operations                                                                                           |       | 0                                      |       | (23 | ) |
| Adjustments to reconcile net income (loss)  to net operating cash flow from operating activities from continuing  operations: |       |                                   |       |   |   |
| Depreciation and amortization                                                                                                 |       | 171                                    |       | 102 |   |
| Change in fair value of warrants and  conversion options                                                                      |       | (5,176                                 | )          | 0 |   |
| Non-cash stock based compensation                                                                                             |       | 1                                      |       | 1 |   |
| Changes in operating assets and  liabilities:                                                                                 |       |                                   |       |   |   |
| Other receivable                                                                                                              |       | 16                                     |       | 0 |   |
| Inventory                                                                                                                     |       | (53                                    | )          | 0 |   |
| Prepaid and other assets                                                                                                      |       | (209                                   | )          | 261 |   |
| Accounts payable                                                                                                              |       | 36                                     |       | (95 | ) |
| Accrued expenses                                                                                                              |       | (110                                   | )          | 111 |   |
| Accrued compensation and benefits                                                                                             |       | (299                                   | )          | (39 | ) |
| Other                                                                                                                         |       | (179                                   | )          | (7 | ) |
| Net operating cash flow from continuing  operations                                                                           |       | (3,208                                 | )          | (1,797 | ) |
| Net operating cash flow from discontinued  operations                                                                         |       | 0                                      |       | 57 |   |
| Net cash used in operating activities                                                                                         |       | (3,208                                 | )          | (1,740 | ) |
|                                                                                                                          |       |                                   |       |   |   |
| Cash flows from investing activities of continuing operations:                                                                |       |                                   |       |   |   |
| Capital expenditures                                                                                                          |       | (80                                    | )          | (8 | ) |
| Net cash used in investing activities                                                                                         |       | (80                                    | )          | (8 | ) |
|                                                                                                                          |       |                                   |       |   |   |
| Cash flows from financing activities of continuing operations:                                                                |       |                                   |       |   |   |
| Proceeds from issuance of common stock                                                                                        |       | 12                                     |       | 1,406 |   |
| Proceeds from the exercise of stock options                                                                                   |       | 204                                    |       | 105 |   |
| Proceeds from the exercise of stock rights  and warrants                                                                      |       | 1,161                                  |       | 320 |   |
| Net cash provided by financing activities                                                                                     |       | 1,377                                  |       | 1,831 |   |
| **Net (decrease) increase in cash and equivalents**                                                                           |       | (1,911                                 | )          | 83 |   |
| **Cash and cash equivalents, beginning of period**                                                                            |       | 11,840                                 |       | 3,365 |   |
| **Cash and cash equivalents, end of period**                                                                                  |       | $                                      | 9,929      |   | $ | 3,448 |   |
|                                                                                                                          |       |                                   |       |   |   |
| Non-cash financing activities                                                                                                 |       |                                   |       |   |   |
| Conversion of preferred stock to common  stock                                                                                |       | $                                      | 100        |   | $ | 0 |   |

 

The accompanying notes arean integral part of these financial statements.

 

5

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**WORLDGATECOMMUNICATIONS, INC.**

**NOTES TOCONDENSED FINANCIAL STATEMENTS**

 

**(DollarAmounts are in Thousands, Except for per Share and Share Amounts)**

**(Unaudited)**

 

1.                                       Basis of Presentation.

 

The unaudited financial statements of WorldGateCommunications, Inc. (“WorldGate” or the “Company”) for the three months endedMarch 31, 2005 and March 31, 2004 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 andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations.  These financialstatements should be read in conjunction with the financial statements for theyear ended December 31, 2004 and the notes thereto included in the Company’sAnnual Report on Form 10-K.

 

The financial information in this Report reflects,in the opinion of management, all adjustments of a normal recurring naturenecessary to present fairly the results for the interim period. Quarterlyoperating results are not necessarily indicative of the results that may beexpected for the year ending December 31, 2005.

 

2.                                       Restatement

 

The Company has restated its financialstatements for the three months ended March 31, 2005 to amend and restate theaccounting for the warrants and additional investments rights issued in aprivate placement of the Company’s common stock during the fourth quarter of2003, and the first and fourth quarters of 2004.  These security components were originallytreated as non-cash expenses and with this restatement are being restated asequity transactions. There is no cash impact associated with theserestatements. There were also related adjustments to the Company’s consolidatedstatement of cash flows and consolidated statement of stockholders’ equity.

 

The effect of the restatement on specificamounts provided in the consolidated financial statements is as follows:

 
| ** **                          | ** ** | **As of March 31, 2005**   | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| **Consolidated Balance Sheet**      | ** ** | **As previously reported** | ** ** | **As restated** | ** ** |
|                                |       |                       |       |   |   |
| Accumulated deficit                 |       | $                          | (217,645   | ) | $ | (216,221 | ) |
| Additional-paid-in capital          |       | 215,418                    |       | 213,994 |   |
| Total stockholders’ deficiency |       | (1,910                     | )          | (1,910 | ) |
|                                     |            |                            |            |  |  |  |  |

 

6

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| ** **                               | ** ** | **For the three months ended March 31, 2005** | ** ** |
|------------------------------------------|------------|-----------------------------------------------|------------|
| **Consolidated Statement of Operations** | ** ** | **As previously reported**                    | ** ** | **As restated** | ** ** |
| ** **                               | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net income per common share              |       |                                          |       |   |   |
| Basic                                    |       | $                                             | 0.07       |   | $ | 0.08 |   |
| Diluted                                  |       | 0.07                                          |       | 0.07 |   |
|                                          |            |                                               |            |  |  |  |  |

 

In addition, the Company has includedrestatements to reflect certain clarifications made in response to the SEC’scomments as raised in its review of the Company’s registration statement onForm SB-2 as filed with the SEC on May 24, 2005, on Form SB-2/A as filed withthe SEC on August 30, 2005 and on Form 10KA as filed with the SEC on August 30,2005. These restatements include expanded clarifications on the preferred stocktransaction the Company completed in June of 2004, liquidity and going concernconsiderations and changes to the Notes to Consolidated Financial Statements.

 

3.                                       Liquidity and Going Concern ConsiderationsRestated

 

As of March 31, 2005 the Company had cash and cashequivalents of $9,929. The operating cash usage from continuing operations forthe three months ended March 31, 2005 was $3,208. The funds we received as aresult of private placements of our securities on December 1, 2003, December 4,2003, January 21, 2004, April 22, 2004, June 24, 2004 and December 15, 2004,have permitted us to fund the development of our new business.

 

In December 2003 and January 2004, WorldGatereceived proceeds from investments aggregating $3,100 by certain institutionalinvestors. These investors purchased an aggregate of 3,000,000 shares of newlyissued common stock. The investors also received a right, for a limited periodof time, to purchase additional shares of up to 20% of the common stockpurchased by the investors in their investment, at the same price as theirinvestment, and five-year warrants to purchase up to 30% of the common stockpurchased by the investors in their investment, at an exercise price equal to atwenty-five percent premium to their purchase price for the investment. Thepurchase price for the 2,000,000 shares purchased in the December 2003transactions were $0.80 per share, with the warrants having a $1.00 per shareexercise price. The purchase price for the 1,000,000 shares purchased in theJanuary 2004 transaction was $1.50 per share, with the warrants having a $1.875per share exercise price. All additional investment rights associated with theDecember 2003 transaction were exercised during January and February of 2004,resulting in an incremental investment of $320. All additional investmentrights associated with the January 2004 transaction were exercised in May 2004,resulting in an incremental investment of $300. A portion of the warrants andadditional investment right warrants associated with the December 2003 andJanuary 2004 transactions were exercised in December 2004 and January 2005,resulting in an incremental investment of $925.

 

In December 2003, WorldGate announced that itreached agreement with Mototech, Inc. (not an affiliate of Motorola) for thepurchase of 625,000 shares of newly issued common stock at $0.80 per share, inreturn for future design and engineering services by Mototech.  WorldGate previously announced in November2003, that it had contracted with Mototech to assist the Company with thedesign and volume manufacture of WorldGate’s Ojo personal video phone. Thepurchase price for these shares will be paid by an equivalent reduction in thedevelopment and initial procurement payments that would otherwise be due toMototech.  The value of this transactionwas $600 (based on the closing stock price of $0.96 on the date of thetransaction) of which $200 was recorded as an expense for the year endedDecember 31, 2003 and $400 was expensed for the year ended December 31,2004.  Mototech is an affiliate of AcctonTechnology Group, a group of Taiwanese manufacturers that we believe arewell-known in the electronics industry. They currently manufacture and distribute a full range of high performancehigh speed data and computer networking products, including cable set topboxes, home gateways, wireless LANs, hubs, switches, routers, and other relatedproducts.  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, WorldGate completed a privateplacement of 7,550 shares of its Preferred Stock at a stated value of $1,000per share, which preferred stock is convertible into the Company’s common stockat a conversion price of $2.35 per share; five-year warrants to purchase up to803,190 shares of our common stock at an exercise price of $2.69 per share; andfive-year warrants to purchase up to 803,190 shares of our common stock at anexercise price of $3.14 per share. The investors also received an additionalinvestment right, for a limited period of time, to purchase 1,606,383additional shares of common stock at $3.14 a share. In November and December2004 and January 2005, 875 preferred shares were converted to commonstock.  In April 2005, an additional 4,250 preferred shares were convertedinto common stock.  In December 2004 and January 2005, 1,606,383additional investment rights were exercised, resulting in an incrementalinvestment of $5,044.

 

7

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In December 2004, WorldGate completed a privateplacement of 208,333 shares of our common stock to K. Y. Chou, President andGeneral Manager of Mototech, at a sales price of $2.40 per shares, 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 our common stock at an exercise price of $2.88per share.

 

The Company has $10,556 of liabilities and itsassets are not pledged as collateral as of March 31, 2005. These liabilitiesinclude $9,026 related to the Company’s private placement of Preferred Stock,and $190 of advanced funds received from Motorola for future shipments of videophones in accordance with the Agreement signed in April 2004.

 

OurCompany has suffered recurring losses from operations and had a net accumulateddeficiency of $218,000 as of December 31, 2004, and these issues raisesubstantial doubt about our Company’s ability to continue as a going concern.Our short term cash requirements and obligations include inventory, accountspayable and capital expenditures from continuing operations, operatingexpenses, and the redemption of preferred stock, of which $2,225 is required tobe redeemed in December 2005, although this redemption can be made in commonstock if certain conditions are met. We expect, based on our internal forecastsand assumptions relating to our operations (including among others, assumptionsregarding our short term cash requirements and our projected revenue growth)that we have sufficient cash on hand to meet our obligations for at least thenext twelve months.

 

Ourability to generate cash is dependant upon the sale of our Ojo product and onobtaining cash through capital markets. We expect to begin generating revenue from commercial shipment of ourOjo product in the second quarter of 2005 and we expect revenues to increase asthe product continues to roll out to the marketplace. This increased level ofsales activity is projected to have a positive impact on our cash flows fromoperations, which will support our ability to meet our obligations beyond thenext twelve months. Given that our video phone business involves thedevelopment of a new product line with no market penetration, in an undevelopedmarket sector, no assurances can be given that sufficient sales, if any, willmaterialize.

 

Additionally,as needed, we plan to generate cash by turning to the capital markets forfunding. No assurances can be given that, if pursued, additional financingtransactions can be consummated.  Wecontinue to evaluate possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources, should we need to obtain suchfinancing.  Such additional financingwould be subject to the risk of availability, may be dilutive to ourshareholders, or could impose restrictions on operating activities. There canbe no assurance that this additional financing will be available on termsacceptable to us, if at all.

 

We,however, remain hopeful that sufficient sales will materialize and/or thatsufficient funding can be developed through ongoing operations or additionalfinancings to continue our operations beyond the next twelve months.

 

Ourlong term cash requirement obligations are primarily comprised of the itemsnoted above. We have no long term debt and our contractual cash requirementsand obligations existing beyond the next twelve months are comprised solely ofoperating lease commitments and redemption of preferred stock, which are notconsidered material.  We have limitedcapacity to further reduce our workforce and scale back on capital andoperational expenditures to decrease our cash usage.

 

*Accounting for Preferred Shares and Derivative Shares[Restated]*

 

The following information has been restated toprovide a more complete description of the accounting method and policy relatedto redeemable preferred shares and derivative shares.

 

InJune 2004, WorldGate completed a private placement of Preferred Stock. ThePreferred Stock has a dividend rate of 5% per annum, payable quarterly, eitherby cash or through the

 

8

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issuance of common stock at the Company’s option. The Preferred Stockhas a staged maturity over three years with one-third of the Preferred Stock tobe redeemed after 18 months, one-third after 24 months and one-third after 36months, and may be redeemed at maturity in cash or, at the Company’s option,subject to certain conditions that may not be solely under the control of theCompany, through the issuance of the number of shares of common stockdetermined by dividing the liquidation preference of the preferred shares bythe then current market price.  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, the Companymay be required to settle redemption of the preferred stock with cash insteadof its common shares.  Furthermore, sincethe market 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.

 

ThePreferred Stock has embedded conversion options. Specifically, the holders ofthe Preferred Stock may convert their shares into the Company’s common stock ata conversion price of $2.35 per share. In addition the Company may forceconversion of the Preferred Stock into common stock if the Company achievescertain price targets for its common stock and satisfaction of certain otherconditions, such as the existence of an effective registration statement. Ineither event the conversion price is subject to adjustment if, at any timeafter the date the preferred shares were issued, the Company issues or sells,or is deemed to have issued or sold, any shares of the Company’s common stockfor per share consideration less than the conversion price of the preferredshares on the date of such issuance or sale. Accordingly, the number of common shares issuable upon the conversion ofthe preferred shares cannot be predicted. Furthermore, net-cash settlement may be required in the event ofconversion default under certain circumstances that may not be solely under thecontrol 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.

 

Alsoas part of the private placement the Company issued five-year warrants topurchase up to 803,190 shares of our common stock at an exercise price of $2.69per share and five-year warrants to purchase up to 803,190 shares of our commonstock at an exercise price of $3.14 per share. The investors also received anadditional investment right, for a limited period of time, to purchase1,606,383 additional shares of common stock shares at $3.14 a share. Thisexercise price of the warrants is subject to adjustment if, at any time afterthe date the warrants were issued, the Company issues or sells, or is deemed tohave issued or sold, any shares of the Company’s common stock for per shareconsideration less than the exercise price of the warrants on the date of suchissuance or sale.  Accordingly, thenumber of common shares that will be issued upon the exercise of the warrantscannot be predicted.  As of March 31,2005, 31,915 warrants exercisable at $2.69 had been exercised and 31,915 warrantsexercisable at $3.14 had been exercised, all in the quarter ending March 31,2005.  All of the additional investmentrights had been exercised as of March 31, 2005 with 106,383  being exercised in the quarter.

 

In first quarter 2005, 100 preferred shares wereconverted to common stock. Of the 7,550 preferred shares issued under thisprivate placement, 6,675 shares remain outstanding as of March 31, 2005.

 

Withrespect to the Company’s accounting for the Preferred Stock, EITF Topic D-98,paragraph 4, states that Rule 5-02.28 of Regulation S-X requires securitieswith redemption features that are not solely within the control of the issuerto be recorded outside of permanent equity. As described above, the terms ofthe Preferred Stock include certain redemption features that may be triggeredby events 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 equityand the value ascribed to the redeemable preferred stock upon initial issuance,

 

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i.e., at June 23, 2004, was the amount received in the transactionminus the fair value ascribed to the conversion options and warrants. Theinitial value of the redeemable preferred stock is accreted up to theredemption value (the amount received in the transaction) over the futurerelevant periods using the interest method. The value of the redeemable preferred stock at March 31, 2005 was$3,382.

 

Theterms of the Preferred Stock include certain conversion options that representderivative financial instruments under paragraph 12 of SFAS No. 133 and thuswere separated from the Preferred Stock and valued using the Black-Scholesoption pricing model.  The conversionoptions include certain provisions that could result in a variable number ofshares to be issued upon conversion, adjustment to the strike price at whichconversion shares will be determined, or the requirement for the Company tosettle the conversion options in cash. EITF 00-19, “Accounting for Derivative Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, state that if the conversionoptions require net cash settlement in the event of circumstances that are notsolely within the Company’s control they should be classified as a liabilitymeasured at fair value on the balance sheet.

 

Theterms of the five-year warrants include cash penalty provisions in the eventthat the Company fails to meet its obligations to deliver registered shares tothe warrant holder upon exercise and an anti-dilution provision that couldresult in a variable number of shares to be issued upon warrant exercise.Additionally, the terms and conditions of the warrants provide for netsettlement via cashless exercise whereby the shares delivered to the warrantholder would be readily convertible to cash. In accordance with EITF 00-19 andgiven the terms and conditions of the warrants as outlined above, the Companyhas classified the warrants as a liability on its balance sheet measured atfair value using the Black-Scholes option pricing model.

 

TheCompany accounts for both the conversion options and warrants using the fairvalue method at the end of each quarter, with the resultant gain or loss recognitionrecorded against earnings. Both the warrants and conversion options are valuedusing the Black-Scholes valuation model. Actual period close common stockprices, applicable volatility rates, and the period close risk-free interestrate for the instrument’s expected remaining life (continuously compounded),are the key assumptions used in the valuation calculation. The WorldGate shareprice changed from $4.99 per share as of December 31, 2004 to $3.90 per shareat March 31, 2005 making the warrants and preferred stock conversion elementsless valuable, and therefore less costly, relative to their strike price. Theresult was a $5,200 non cash gain for the quarter ended March 31, 2005.

 

4.                                       Recent Accounting Pronouncement.

 

In November 2004, the FASB issued SFAS no. 151 “InventoryCosts” which amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,”to clarify the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage).  Paragraph 5 ofARB 43, Chapter 4, previously stated that under some circumstances, items suchas idle facility expense, excessive spoilage, double freight and rehandlingcosts may be so abnormal as to require treatment as current period charges.” SFAS No. 151 requires that those items be recognized as current-period chargesregardless of whether they meet the criterion of “so abnormal.”  Inaddition, SFAS No. 151 requires that allocation of fixed production overheadsto the costs of conversion be based on the normal capacity of the productionfacilities.  SFAS No. 151 shall be effective for inventory costs incurredduring fiscal years beginning after June 15, 2005.  Earlier application ispermitted for inventory costs incurred during fiscal years beginning after thedate SFAS No. 151 was issued.  SFAS No. 151 shall be appliedprospectively.  The Company does not expect the adoption of SFAS No. 151to have a material effect on its consolidated financial statements.

 

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In December 2004, the FASB issued SFAS No. 153 “Exchangesof Nonmonetary Assets” which amends APB Opinion No. 29, “Accounting forNonmonetary Transactions.”  APB No. 29 is based on the principle thatexchanges of nonmonetary assets should be measured based on the fair value ofthe assets exchanged.  The guidance in that Opinion, however, includedcertain exceptions to that principle.  SFAS No. 153 amends APB No. 29 toeliminate the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance.  A nonmonetary exchange hascommercial substance if the future cash flows of the entity are expected tochange significantly as a result of the exchange.  SFAS No. 153 iseffective for nonmonetary asset exchanges occurring in fiscal periods beginningafter June 15, 2005.  Earlier application is permitted for nonmonetaryasset exchanges occurring in fiscal periods beginning after the date SFAS No.153 was issued.  SFAS No. 153 is to be applied prospectively.  TheCompany does not expect the adoption of SFAS No. 153 to have a material effecton its consolidated 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”, andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”Beginning with our annual periods that begin after June 15, 2005, we will berequired to expense the fair value of employee stock options and similarawards. As a public company, we are allowed to select from two alternative transitionmethods, each having different reporting implications.  The impact of SFASNo. 123 (R) has not been determined at this time.

 

In March 2005, the Financial Accounting StandardsBoard (FASB) issued Interpretation No. 47 (FIN 47) to clarify the guidanceincluded in SFAS No. 143, “Accounting for Asset Retirement Obligations”. FIN 47 requires companies to recognize a liability for the fair value of alegal obligation to perform asset retirement activities that are conditional ona future event if the amount can be reasonably estimated.  If amountscannot be reasonably estimated, certain disclosures will be required about theunrecognized asset retirement obligations.  The interpretation is requiredto be adopted in the first quarter of 2006.  We are currently evaluatingthe interpretation to determine the effect on our financial statements andrelated disclosures.

 

5.                                       Inventories.

 

Inventories as of March 31, 2005 and December31, 2004 are summarized as follows:

 
| ** **                                  | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| Raw material (from discontinued operations) |       | $                  | 1,622      |                  | $          | 1,622 |   |
| Finished goods (from continuing operations) |       | 99                 |       | 46                    |       |
| Total Inventory                             |       | 1,721              |       | 1,668                 |       |
| Inventory Reserve                           |       | (1,622             | )          | (1,622                | )          |
| Inventory, net                              |       | $                  | 99         |                  | $          | 46 |   |

 

6.                                       Stock-Based Compensation (Restated).

 

The Company accounts for stock-based compensation inaccordance with Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure”.

 

The Company applies Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” and relatedinterpretations in accounting for its plans, and accordingly, no compensationcost has been recognized for the Company’s fixed stock basedcompensation.  Had compensation cost been determined consistent with SFASNo. 123, as amended by SFAS No. 148, the Company’s net loss would have beenincreased to the following pro forma amounts:

 

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| ** **                                                                                                                          | ** ** | **For the Three Month Period  Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**                                        | ** ** | **2004** | ** ** |
| ** **                                                                                                                          | ** ** | ** **                                      | ** ** | **(As restated)** | ** ** |
| Net income (loss)                                                                                                                   |       | 2,594                                           |       | (2,108 | ) |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects                  |       | 0                                               |       | 0 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of tax of $0 |       | (194                                            | )          | (2,249 | ) |
| Pro forma net income (loss)                                                                                                         |       | $                                               | 2,400      |   | $ | (4,357 | ) |
| Net income (loss) per share:                                                                                                        |       |                                            |       |   |   |
|                                                                                                                                |       |                                            |       |   |   |
| Net income (loss):                                                                                                                  |       |                                            |       |   |   |
| Basic                                                                                                                               |       | $                                               | 0.08       |   | $ | (0.08 | ) |
| Fully Diluted                                                                                                                       |       | $                                               | 0.07       |   | $ | (0.08 | ) |
| Net income (loss)— pro forma:                                                                                                  |       |                                            |       |   |   |
| Basic                                                                                                                               |       | $                                               | 0.08       |   | $ | (0.16 | ) |
| Fully Diluted                                                                                                                       |       | $                                               | 0.06       |   | $ | (0.16 | ) |

 

Such pro forma disclosures may not be representativeof future compensation expense because optionsvest over several years and additional grantsare made each year.

 

7.                                       Commitments and Contingencies.

 

*Leases*

 

In 1998 the Company entered into a leasingarrangement for a building with an entity formed by non-employee investors. TheCompany stopped paying rent on this lease in May 2003, and in lieu of rentpayments the Company’s landlord, 3190 T General, Inc. (an entity formed bynon-employee investors in the Company), began drawing down the security depositfor the facility. Prior to stopping rent payments, the Company had commencednegotiations with its landlord for an amendment of its lease to reduce thespace commitment and the rent payable. These negotiations were not successful,and in September 2003, the Company’s landlord filed an action in the Court ofCommon Pleas, Bucks County Pennsylvania to perfect its interest to takepossession of the Company’s facility, and to establish damages for past rentand expenses. Although a judgment was granted allowing the Company’s landlordto regain possession of the facility, the Company remained in the facility andcontinued negotiations with its landlord. During 2004, the landlord deeded thefacility to its mortgage holders and negotiations commenced with GMAC asrepresentative for the mortgage holders. These negotiations were successful andin June 2004 the Company’s lease was amended to reduce the lease obligation inline with the Company’s current space requirements, and to bring the Companycurrent with respect to all outstanding back rent. In November 2003, theCompany entered into a 60 month lease for office equipment. As of March 31,2005 there remains a total of $21 to be paid over the remaining period of thelease.

 

*Significant Agreements and Transactions*

 

In 1997, the Company entered into agreements withcertain customers who are investors. Revenues from continuing operationsrecognized from such investors were approximately $179 and $0, respectively,for the three months ended March 31, 2005 and 2004. One of these investorsaccounted for 100% of the revenues for the three months ended March 31, 2005.Advances received from this investor were $190 as of March 31, 2005 and areincluded in deferred revenue in the accompanying balance sheet.

 

Revenues, included in discontinued operations, were recognizedfrom such investors of approximately $0 and $1, respectively, for the threemonths ended March 31, 2005 and 2004. Accounts receivable from such investorswere $0 as of March 31, 2005 and December 31, 2004.

 

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The Company has a current two year agreement with aninvestor, and previously had agreements with certain other investors, toprovide the Company with engineering and development support. As a result ofthose agreements, the Company has expensed approximately $102 (included incontinuing operations) and $0 (included in discontinued operations), for thethree months ended March 31, 2005 and March 31, 2004, respectively. Accountspayable to these investors amounted to $180 and $117 at March 31, 2005 andDecember 31, 2004, respectively. Some of these stockholders were suppliers oftechnology and components for the Company’s discontinued ITV products andservices. These agreements provided for licensing of technology, as well ascontracted services, including hardware and software development, producttesting and certification, and the creation and development of tools andsystems to facilitate the Company’s engineering efforts. These agreements didnot provide for ongoing royalties, purchase provisions, or for any requirementto provide additional funding to the Company.

 

OnApril 28, 2004, we entered into a Development and Distribution Agreementwith General Instrument Corporation d/b/a the Broadband Communication Sector ofMotorola, Inc., or Motorola. In connection with the Development andDistribution Agreement with Motorola, we issued warrants to Motorola topurchase 600,000 shares of our common stock, 300,000 at an exercise price of$1.4375 per share and 300,000 at an exercise price of $1.75, and agreed toissue additional warrants to purchase up to an additional 1,650,000 shares ofour common stock, upon the achievement of certain product and sales milestones,at an exercise price based upon the average closing sales price of our commonstock during the 20 day period preceding the issuance of each warrant.

 

8.                                       Net Income (Loss) per Share.

 

Basic and diluted net income (loss) per common shareis computed by dividing the net income (loss) available to common stockholdersfor the period by the weighted average number of shares of common stockoutstanding during the period.  The calculation of diluted net income(loss) per common share excludes potential common shares if the effect isantidilutive.  Potential common shares comprise shares of common stockissuable upon the exercise of stock options and warrants.  The number ofpotential common shares which would have been assumed to be converted in theperiods ended March 31, 2005 and 2004 and have a dilutive effect if the Companyhad income from continuing operations, or if the options’ exercise price wasless than the average market price of the common shares, is 862,250 and8,065,111, respectively.

 

9.             Revenue recognition

 

Revenueis recognized when persuasive evidence of an arrangement exists, the price isfixed or determinable, the collectibility is reasonably assured, and thedelivery and acceptance of the equipment has occurred or services have beenrendered.  Management exercises judgmentin evaluating these factors in light of the terms and conditions of itscustomer contracts and other existing facts and circumstances to determineappropriate revenue recognition. Due to our limited commercial sales history,our ability to evaluate the collectibility of customer accounts requiressignificant judgment. The Company evaluates its equipment customer, and servicecustomers’, accounts for collectibility at the date of sale and on an ongoingbasis.

 

Presentlythe Company has only one customer for the purchase of its equipment and theagreement with this customer includes several elements relevant to revenuerecognition including: (a) The customer has no general right to return theproduct.  (b) The customer can earnwarrants upon the purchase of significant video telephony units and the valueof these warrants would result in a reduction of recognized revenue (the valueof these warrants is routinely monitored by the Company and is currently deemedto be insignificant, however, should the value of these warrants becomematerial an offset would be made against revenues). (c) Penalties arepayable to the customer if certain excessive field failure rates areexceeded.  (d) The Company and thecustomer share in the benefit achieved by product cost reductions. (e) Penaltiesare payable to the customer if the Company fails to deliver shipments on atimely basis. (f) The Company extends to the customer a limited productwarranty for a term not to exceed three years (the Company maintains a warrantyreserve based upon the percentage of product sales consistent with industrycomparable failure rates and the warranty period provided by the agreement.)

 

Revenuesare also offset with a reserve for any price refunds and consumer rebatesconsistent with the Emerging Task Force (“EITF”) Issue 01-9, Accounting forConsideration Given by a vendor to a Customer.

 

10.           Risks and uncertainties

 

Ourprimary line of business is the development of video phone products andtechnology. We are still in the process of launching our first product based onthis technology and, although we have realized some revenues for the commercialsale of our product, the revenues to date have not been substantial. Given theearly stage of our product and the lack of operating history in the video phonebusiness, it is difficult to predict our future results.

 

Wehave entered into a six year distribution agreement with Motorola, Inc.for the marketing and distribution of our Ojo video phone. This agreementprovides for Motorola to be WorldGate’s exclusive distributor of its broadbandvideo phone products and for WorldGate to be Motorola’s exclusive supplier ofits broadband video phone products.  Although the agreement requiresMotorola to provide for certain marketing and promotional activities for theOjo video phone, there are no required sales quotas for the agreement to remainin effect, and Motorola controls the volume of the Company’s products beingdistributed.  Neither party can terminate the agreement except in cases ofuncured breaches of the agreement or as a result of insolvency events sufferedby the other party. After a period of 18 months following the commercialavailability of the Ojo video phone the mutual exclusivity will terminateunless Motorola elects to continue the mutual exclusivity after having achievedcertain minimum sales targets for the Ojo video phone. Motorola may, however,at its option, elect to terminate the exclusivity at any time.

 

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In the event mutual exclusivity terminates or is terminated, then for aperiod of twelve months thereafter, WorldGate will continue to be Motorola’sexclusive supplier of broadband video phones but will be free to sell videophones to customers other than certain defined Motorola accounts. During thistwelve month period, Motorola has a right of first refusal to accept and fillany orders for video phone products that WorldGate obtains from non-Motorolaaccounts, and is obligated to use good faith efforts to solicit and acceptproduct orders from Motorola accounts in a commercially reasonable manner.During any period of exclusivity under this agreement we are reliant uponMotorola and its distribution partners, including, for example, wholesalers,retailers and service providers, to provide the worldwide sales anddistribution of the Ojo video phone. If Motorola and its partners are notsuccessful, or if their activities do not lead to significant sales of ourproduct, our operating results will be adversely affected, our revenue could besignificantly reduced and we could lose potential customers.

 

We also depend onrelationships with third parties such as contract manufacturing companies, chipdesign companies and others who may be sole source providers of key componentsand services critical for the product we are developing in our video phone business.A formal relationship with Mototech, Inc. (not an affiliate of Motorola)has been established for the volume manufacture of Ojo. Mototech iscurrently the sole volume manufacturer of Ojo. Our agreement with Mototechallows either party to terminate the agreement with 90 days prior notice. If Mototech, Inc. or other providers of components and/or manufacturingservices do not produce these components or provide their services on a timelybasis, if the components or services do not meet our specifications and qualitycontrol standards, or if the components or services are otherwise flawed, wemay have to delay product delivery, or recall or replace unacceptable products.In addition, such failures could damage our reputation and could adversely affectour operating results. As a result, we could lose potential customers and anyrevenues that we may have at that time may decline dramatically.

 

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

 

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

 

Wemay from time to time make written or oral forward-looking statements,including those contained in the following Management’s Discussion and Analysisof Financial Condition and Results of Operations.  The words “estimate,” “project,”“believe,” “intend,” “expect,” and similar expressions are intended to identifyforward-looking statements, although not all forward-looking statements containthese identifying words.  In order to take advantage of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995, we arehereby 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 causesuch forward-looking statements not to be realized include, without limitation,the following: (1) difficulty in developing and implementing marketing andbusiness plans, (2) industry competition factors and other uncertainty that amarket for our products will develop, (3) challenges associated with HSDoperators (including, uncertainty that they will offer our products, inabilityto predict the manner in which they will market and price our products andexistence of potential conflicts of interests and contractual limitationsimpeding their ability to offer our products), (4) continued losses, (5)difficulty or inability to raise additional financing on terms acceptable tous, (6) departure of one or more key persons, (7) delisting of our Common Stockfrom the NASDAQ Small Cap Market, (8) changes in regulatory

 

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requirements, and (9) other risks identified in our filings with theSecurities and Exchange Commission.  We caution you that the foregoinglist of important factors is not intended to be, and is not, exhaustive. We do not undertake to update any forward-looking statement that may be made fromtime to time by or on our behalf.

 

Resultsof Operations:

 

General

 

Our ITV business has historically accounted forsubstantially all of our revenue.  In the third quarter of 2003, wecompleted a sale of significant assets, including our ITV intellectual propertyrights and our membership interest in TVGateway, LLC.  This transactionmarked a shift in our business away from the ITV business and toward a newvideo phone product and related business.  Although we continued tosupport our remaining ITV business into the first quarter of 2004, thedevelopment of our video phone product became a primary business focus.

 

Our video phone business has not producedsignificant revenues to date.  The extent and timing of future revenuesfor our business depends on several factors, including the rate of marketacceptance of our products and the degree of competition from similarproducts.  We cannot predict to what extent our video phone product willproduce revenues, or when, or if, we will reach profitability.

 

CriticalAccounting Policies and Estimates.

 

The consolidated financial statements are preparedin conformity with accounting principles generally accepted in the UnitedStates.  The preparation of these financial statements required managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting period.  Actual results could differ from thoseestimates.

 

The significant accounting policies of the Companyare described in the notes to the consolidated financial statements included inthe annual report on Form 10-K.  Judgments and estimates of uncertaintiesare required in applying the Company’s accounting policies in many areas. Following are some of the areas requiring significant judgments andestimates:  revenue recognition, accounts receivable, inventories, andcash flow and valuation assumptions in performing asset impairment tests oflong-lived assets.

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities, at the date the financial statements and the reported amount ofrevenues and expenses during the reporting period.  Actual results coulddiffer from those estimates.

 

The information in our quarter-to-quartercomparisons below represents only our results from continuing operations.

 

ThreeMonths Ended March 31, 2005 and March 31, 2004 (Restated)

 

Revenues.

 

Revenues. Revenues from continuing operations forthe three months ended March 31, 2005 were $179. These revenues representinitial deliveries of video phones for pre-market testing. There were norevenues from continuing operations during the three months ended March 31,2004.

 

Costs and Expenses.

 

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Cost of Revenues. The cost of revenues fromcontinuing operations consisted of product and delivery costs relating to theinitial deliveries of video phones was $125 for the three months ended March31, 2005. There were no costs of revenues from continuing operations during thethree months ended March 31, 2004.

 

Engineering and Development.  Engineering anddevelopment expenses primarily consist of compensation, and the cost of design,programming, testing, documentation and support of the Company’s video phoneproduct.  Engineering and development costs were $1,305 for the threemonths ended March 31, 2005, compared with $800 for the three months endedMarch 31, 2004.  This increase of $505, or 63%, reflects the Company’sincreased concentration of its engineering staff, and related costs, for thefurther and continuing development of its video phone product.

 

Sales and Marketing.  Sales and marketingexpenses consist primarily of compensation, attendance at conferences and tradeshows, travel costs, promotions and other marketing programs related to theintroduction of the Company’s video phone product.  Sales and marketingcosts were $379 for the three months ended March 31, 2005, compared with $191for the three months ended March 31, 2004.  This increase of $188, or 98%,reflects the increased effort of staff, and related marketing and promotionalexpenditures associated with the launch of the Company’s video phone product.

 

General and Administrative — as restated. General and administrative expenses consist primarily of expenditures foradministration, office and facility operations, finance and general managementactivities, including legal, accounting and professional fees.  Generaland administrative expenses were $847 for the three months ended March 31,2005, compared with $1,044 for the three months ended March 31, 2004. Thisdecrease of $197, or 19%, is primarily attributable to certain non-recurringexpenses incurred during the three months ended March 31, 2004 that were notincurred during the three months ended March 31, 2005. These expenses consistedof an expense for sales taxes of $125, and a $242 reduction in rent expensefrom the $303 recorded during the three months ended March 31, 2004 to $61recorded for the three months ended March 31, 2005.  These decreases were offset by increases inprofessional fees of $125 and compensation costs of $50 for the three monthsended March 31, 2005 when compared to the three months ended March 31, 2004.

 

Interest and Other Income and Interest Expense.Interest and other income and interest expense consist of interest earned oncash and cash equivalents, and interest expense on short-term debt. Interestand other income increased from $7 for the three months ended March 31, 2004 to$66 for the three months ended March 31, 2005, primarily due to additionalinterest income earned on a higher level of invested funds. During the threemonths ended March 31, 2005, the Company earned interest on average cashbalances of approximately $11,026 and incurred interest expense related to itsinsurance financing. In comparison, during the three months ended March 31,2004 the Company earned interest on average cash balances of approximately$3,878 and incurred interest expense related to its insurance financing.

 

Change in the Fair Value of Warrants and ConversionOptions.  The warrants and conversion options are considered embeddedderivative instruments under SFAS No. 133, paragraph 11a, and are classified asliabilities.  The company identifies and measures these derivatives underthe fair value method at the end of each quarter, and their value is marked tomarket at the end of each reporting period with the gain or loss recognitionrecorded against earnings.  We continue to revalue these instruments eachquarter to reflect their current value in light of the current market price ofour common stock.  The warrants and conversion options are valued usingthe Black-Scholes valuation model.  Actual period close common stockprices, applicable volatility rates, and the period close risk-free interestrate for the instrument’s expected remaining life (continuously compounded),are the key assumptions used in the valuation calculation.  The WorldGateshare price changed from $4.99 per share at December 31, 2004 to $3.90 as ofMarch 31, 2005, making the embedded warrants and preferred stock conversionelements less valuable, and therefore less costly, relative to their strikeprice. The result was the $5,176 non cash gain for the quarter ended March 31,2005.  Also, it is important to note that these periodic marked to marketaddition to or deduction from earnings has no cash

 

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effect over the life of the instruments, with the cumulative non-cashmark-to-market adjustments of gains and losses offsetting and netting to $0.

 

Income Taxes.  The Company has incurred netoperating losses since inception and accordingly had no income taxes and hasnot recorded any income tax benefit for those losses.

 

Liquidity and Capital Resources.

 

As of March 31, 2005, our primary source ofliquidity consisted of cash and cash equivalents that are highly liquid, are ofhigh quality investment grade and have maturities of less than 90 days.

 

At March 31, 2005, we had cash and cash equivalentsof $9,929 (and no short-term investments) as compared to cash and equivalentsof $11,840 (and no short-term investments) at December 31, 2004.  Net cashused in continuing operations was $3,208 for the three months ended March 31,2005, as compared to $1,797 used for the same period in 2004. This increase innet cash used for continuing operations was primarily attributable to theCompany’s increase in expenditures related to the video phone business. The Company recorded bad debt expense in the amount of $16 from discontinuedoperations during the three months ended March 31, 2004 to reflect its currentassessment of the collectability of certain receivables.

 

Cash provided by financing activities fromcontinuing operations during the three months ended March 31, 2005, totaled$1,377 compared to $1,831 provided during the same period in 2004. Capitalexpenditures were $80 and $8 for the three months ended March 31, 2005 and2004, respectively.  During the thirdquarter of 2003, we completed a sale of certain assets, including our ITVintellectual property rights and our membership interest in TVGateway, LLC, for$3,000 in cash to TVGateway, LLC, a company we were instrumental in forming.

 

Operations and Liquidity.

 

To date, the Company has funded operations primarilythrough private sales of equity securities and through an initial publicoffering of common stock in April 1999.  As of March 31, 2005 theCompany had cash, and cash equivalents of $9,929.  The operating cash usagefrom continuing operations for the three months ended March 31, 2005 and 2004was $3,208 and $1,797, respectively. As of March 31, 2005 we have nooutstanding debt and our assets are not pledged as collateral. From time totime opportunities arise for us to obtain additional financing through publicor private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources.  Such additional financing, ifobtained, could provide additional cash for working capital, acceleratedengineering and development activities and potential acquisitions. While wecontinue to evaluate such opportunities, it should be noted that any additionalfinancing may be dilutive to our shareholders, or could impose restrictions onoperating activities. Furthermore, there can be no assurance that anyadditional financing will remain available to us on terms acceptable, if atall.

 

With the private placement of our common stock inJanuary 2004, which provided proceeds of $1,500, the private placement of ourcommon stock in April 2004 providing proceeds of $1,000, the June 2004 privateplacement of our redeemable preferred stock providing proceeds of $7,550, theDecember 2004 private placement of common stock of $500, the exercise ofadditional investment rights and warrants of $6,800 in January, February, Mayand December 2004 and January, February and April 2005, and the exercise byemployees and former employees of options throughout 2004 and January andFebruary 2005 providing aggregate proceeds of $900; we project we will havesufficient funding to continue operations through 2005, without additionalfinancing, and assuming no impact from sales. We do however have an obligationto pay dividends on, as well as to redeem, our outstanding Preferred Stockupon maturity, or at the earlier option of a holder of these securities.Under certain limited circumstances we may be forced to make such payments andredemptions with cash instead of shares of our common stock. In such event ourability to fund continuing operations would be negatively impacted.

 

Thereport of the independent registered public accounting firm for the year endedDecember 31, 2004 included an explanatory paragraph stating that our Companyhad suffered recurring losses from operations and had a net accumulateddeficiency of $218,000, and that these issues raised substantial doubt aboutour Company’s ability to continue as a going concern. Our short term cashrequirements and obligations include inventory, accounts payable and capitalexpenditures from continuing operations, operating expenses, and the redemptionof preferred stock, of which $2,225 is required to be redeemed in December2005, although

 

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this redemption can be made in common stock if certain conditions aremet. We expect, based on our internal forecasts and assumptions relating to ouroperations (including among others, assumptions regarding our short term cashrequirements and our projected revenue growth) that we have sufficient cash onhand to meet our obligations for at least the next twelve months.

 

Ourability to generate cash is dependant upon the sale of our Ojo product and onobtaining cash through capital markets. We expect to begin generating revenue from commercial shipment of ourOjo product in the second quarter of 2005 and we expect revenues to increase asthe product continues to roll out to the marketplace. This increased level ofsales activity is projected to have a positive impact on our cash flows fromoperations, which will support our ability to meet our obligations beyond thenext twelve months. Given that our video phone business involves thedevelopment of a new product line with no market penetration, in an undevelopedmarket sector, no assurances can be given that sufficient sales, if any, willmaterialize.

 

Additionally,as needed, we plan to generate cash by turning to the capital markets forfunding. No assurances can be given that, if pursued, additional financingtransactions can be consummated.  Wecontinue to evaluate possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources, should we need to obtain suchfinancing.  Such additional financingwould be subject to the risk of availability, may be dilutive to ourshareholders, or could impose restrictions on operating activities. There canbe no assurance that this additional financing will be available on termsacceptable to us, if at all.

 

We,however, remain hopeful that sufficient sales will materialize and/or thatsufficient funding can be developed through ongoing operations or additionalfinancings to continue our operations beyond the next twelve months.

 

Ourlong term cash requirement obligations are primarily comprised of the itemsnoted above. We have no long term debt and our contractual cash requirementsand obligations existing beyond the next twelve months are comprised solely ofoperating lease commitments and redemption of preferred stock, which are notconsidered material.  We have limitedcapacity to further reduce our workforce and scale back on capital andoperational expenditures to decrease our cash usage.

 

In December 2003, WorldGate reached agreement withMototech, Inc. (not an affiliate of 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 volume manufactureof WorldGate’s Ojo personal video phone. The purchase price for these shareshas been fully paid as of December 31, 2004 by an equivalent reduction in thedevelopment and initial procurement payments that would otherwise be due toMototech.The value ofthis transaction was $600 (based on the closing stock price of $0.96 on thedate of the transaction) of which $200 was recorded as an expense for the yearended December 31, 2003 and $400 was expensed for the year ended December 31,2004. Mototech is an affiliate of Accton Technology Group, a group of Taiwanese manufacturers that webelieve are well-known in the electronics industry. Mototech currentlymanufactures and distributes a full range of high performance high speed dataand computer networking products, including cable set top boxes, home gateways,wireless LANs, hubs, switches, routers, and other related products. Inaddition, in April 2004, Mototech invested $1,000 to purchase 666,666 shares ofnewly issued common stock at $1.50 per share.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK.

 

Interest Rate Risk.  Our exposure to marketrisk related to changes in interest rates relates primarily to our investmentportfolio.  We invest in instruments that meet high credit qualitystandards, and we limit the amount of credit exposure with respect to any oneissue, issuer and type of investment.

 

As of March 31, 2005, the Company’s cash and cashequivalents were $9,929, having a maturity of less than 90 days, and it had noshort-term investments.  Due to the average maturity and conservativenature of our investment portfolio, management believes a sudden change ininterest rates would not have a material effect on the value of the portfolio.Management estimates that had the average yield of our investments decreased by100 basis points, our interest income for the three months ended March 31, 2005would have decreased by approximately $24. This estimate assumes that thedecrease occurred on the first

 

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day of 2005 and reduced the yield of each investment instrument by 100basis points.  The impact on our future interest income of future changesin investment yields will depend largely on our total investments.

 

Foreign Currency Exchange Risk.  Although wetransact business in various foreign countries, the principal portion of ourbusiness is in the United States and substantially all of our revenues andcosts to date have been denominated in U.S. dollars.  Although ouragreement with Mototech (not an affiliate of Motorola), our contractmanufacturer in Taiwan, is denominated in U.S. dollars, their materialacquisition costs are subject to exchange rate changes that could impact ourproduct costs.

 

ITEM 4.    CONTROLS AND PROCEDURES.

 

As of the end of the period covered by this Form10-Q/A, our management, with the participation of our chief executive officerand chief financial officer, conducted an evaluation of the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)).

 

Based on that evaluation, our chief executiveofficer and chief financial officer determined that we have a material weakness(as defined under the standards established by the American Institute ofCertified Public Accountants) that exists with respect to our reporting ofcomplex transactions. As a result of this material weakness, on November 14,2004 we restated our financial statements in our annual and quarterly reportsfrom our Form 10-Q for the quarter ended March 31, 2004 through this report.

 

To address this material weakness, we have engagedoutside experts to provide counsel and guidance in areas where we cannoteconomically maintain the required expertise internally (e.g., with theappropriate classifications and treatments of complex and non-routinetransactions).

 

As a result of the material weakness identified withrespect to our reporting of complex transactions, the chief executive officerand chief financial officer concluded that our disclosure controls andprocedures are not designed and effective in ensuring that the informationrequired to be disclosed by our company in the reports that we file and submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the Commission’s rules and forms.  Except asidentified above, there have been no changes in our internal control overfinancial reporting that occurred during the quarter ended March 31, 2005, thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

(Dollar Amounts are in Thousands,Except per Share Amounts)

 

ITEM 1. LEGAL PROCEEDINGS.

 

None

 

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS.

 

On June 24, 2004, we completed a private placementthat resulted in the issuance of 7,550 shares of preferred stock at a saleprice of $1000 per share (which preferred stock is convertible into our commonstock at a conversion price of $2.35 per share), five-year warrants to purchaseup to 803,190 shares of our common stock at an exercise price of $2.69 pershare, and five-year warrants to purchase up to 803,190 shares of our commonstock at an exercise price of $3.14 per share. The investors also received anadditional investment right, for a limited period of time, to purchase1,606,383 additional shares of common stock shares at $3.14 a share. The June2004 private placement resulted in gross proceeds to our Company of $7,550.From November 2004 through April 15, 2005, holders of the preferred stock fromthe June 24, 2004 private placement have converted 5,125 of their shares,resulting in the issuance of 2,180,851 shares of our common stock based uponthe $2.35 conversion price. Furthermore, between January 2004 and April 18,2005, the investors from the 2003 and 2004 private placements have exercisedwarrants and additional investment rights resulting in additional grossproceeds of approximately $7,089,000 and the issuance of 3,134,048 shares.

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

 

None.

 

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

 

None.

 

ITEM 5. OTHER INFORMATION.

 

None.

 

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

 

(a)  Exhibits.

 

The following is a list of exhibits filed as part ofthis report on Form 10-Q.  Where so indicated by footnote, exhibits thatwere previously filed are incorporated by reference.  For exhibitsincorporated by reference, the location of the exhibit in the previous filingis indicated parenthetically except in those situations where the exhibitnumber 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* |

 

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| 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-Q Report for thequarter ended March 31, 1999.

(2)Incorporated by reference to the exhibits to the Company’s Proxy Statement toshareholders filed September 30, 2004.

(3)Incorporatedby reference to the exhibits to our Form 10-Q Report for the quarter endedSeptember 30, 2004, as filed on November 17, 2004.

 

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SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to besigned on its behalf by the undersigned thereunto duly authorized.

 

 
|   | WORLDGATE  COMMUNICATIONS, INC.               |
|--------|-----------------------------------------------|
|   |                                          |
| Date:  | January  23, 2006                             | /s/  Hal M. Krisbergh |   |
|   |                                          | Hal  M. Krisbergh |   |
|   |                                          | Chairman  and Chief Executive Officer |   |
|   |                                          | (Principal  Executive Officer) |   |
|   |                                          |   |   |
| Date:  | January  23, 2006                             | /s/  Joel Boyarski |   |
|   | Joel  Boyarski                                |   |
|   | Vice  President and Chief Financial Officer   |   |
|   | (Principal  Financial and Accounting Officer) |   |

 

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