**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

** **

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** **

**FORM 10-Q**

 

**Mark One**

**ý****Quarterly Report Pursuantto Section 13 or 15(d) of the Securities Exchange Act of 1934**

 

**for the Quarterly Period EndedSeptember 30, 2003.**

** **

**or**

** **

**o****Transition Report Pursuantto 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 Registrantas Specified 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 Telephone  Number, Including Area Code)                        |

 

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

Yes ý No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act.

Yes o No ý

 

As of November 7, 2003, there were 23,580,876 shares of common stock,par value $.01 per share, outstanding.

 

 

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WORLDGATE COMMUNICATIONS,INC.

 

QUARTERLY REPORT ON FORM10-Q

FOR THE THREE MONTHSENDED SEPTEMBER 30, 2003

 

TABLE OF CONTENTS

 
| PART  I  FINANCIAL INFORMATION |                                                                                        |
|-------------------------------------|---------------------------------------------------------------------------------------------|
|                                |                                                                                        |
| Item  1.                            | Financial  Statements                                                                       | 3 |
| Item  2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 10 |
| Item  3.                            | Quantitative  and Qualitative Disclosures about Market Risk                                 | 15 |
| Item  4.                            | Controls  and Procedures                                                                    | 15 |
|                                |                                                                                        |   |
| PART  II  OTHER INFORMATION    |                                                                                        |
|                                |                                                                                        |   |
| Item 1.                             | Legal Proceedings                                                                           | 16 |
| Item 2.                             | Changes in Securities and Use  of Proceeds                                                  | 16 |
| Item 3.                             | Defaults upon Senior Securities                                                             | 16 |
| Item 4.                             | Submission of Matters to a  Vote of Security Holders                                        | 16 |
| Item 5.                             | Other Information                                                                           | 16 |
| Item 6.                             | Exhibits and Reports on Form 8-K                                                            | 18 |

 

2

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**PART I****. FINANCIALINFORMATION**

 

**ITEM 1****.  FINANCIAL STATEMENTS**

 

**WORLDGATE COMMUNICATIONS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

** **

**(Dollarsin Thousands)**

 
|                                                                                                                                                                                            |   | **September  30,  2003** |       | **December  31,  2002** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-------------------------|------------|
|                                                                                                                                                                                            |   | **(Unaudited)**          | ** ** | **(Audited)**           | ** ** |
| ASSETS                                                                                                                                                                                          |   |                     |       |                    |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Current assets:                                                                                                                                                                                 |   |                     |       |                    |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                                      |   | $                        | 850        |                    | $          | 589 |   |
| Short - term  investments                                                                                                                                                                       |   | —                   |       | 3,218                   |       |
| Accounts  receivable, less allowance for doubtful accounts of $343 at September 30,  2003 and $1,596 at December 31, 2002                                                                       |   | 2,674                    |       | 1,407                   |       |
| Accounts  receivable due from related parties                                                                                                                                                   |   | 138                      |       | 1,186                   |       |
| Inventory                                                                                                                                                                                       |   | 1,423                    |       | 3,962                   |       |
| Prepaid and  other assets                                                                                                                                                                       |   | 380                      |       | 281                     |       |
| Total current  assets                                                                                                                                                                           |   | 5,465                    |       | 10,643                  |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Property and  equipment                                                                                                                                                                         |   | 4,503                    |       | 5,109                   |       |
| Less:  accumulated depreciation and amortization                                                                                                                                                |   | (2,732                   | )          | (2,605                  | )          |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Property and  equipment, net                                                                                                                                                                    |   | 1,771                    |       | 2,504                   |       |
| Deposits and  other assets                                                                                                                                                                      |   | 397                      |       | 872                     |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Total assets                                                                                                                                                                                    |   | $                        | 7,633      |                    | $          | 14,019 |   |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                      |   |                     |       |                    |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Current  Liabilities:                                                                                                                                                                           |   |                     |       |                    |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Notes Payable                                                                                                                                                                                   |   | $                        | —     |                    | $          | 50 |   |
| Accounts payable                                                                                                                                                                                |   | 740                      |       | 775                     |       |
| Accounts payable  due to related party                                                                                                                                                          |   | 65                       |       | 453                     |       |
| Accrued expenses                                                                                                                                                                                |   | 564                      |       | 779                     |       |
| Accrued  compensation and benefits                                                                                                                                                              |   | 212                      |       | 1,132                   |       |
| Contractual  obligations related to equity financing                                                                                                                                            |   | 0                        |       | 3,283                   |       |
| Deferred rent  credit, current and other                                                                                                                                                        |   | 30                       |       | 87                      |       |
| Total current  liabilities                                                                                                                                                                      |   | 1,611                    |       | 6,559                   |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Deferred rent  credit                                                                                                                                                                           |   | 142                      |       | 165                     |       |
| Total  liabilities                                                                                                                                                                              |   | 1,753                    |       | 6,724                   |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Stockholders’  equity:                                                                                                                                                                     |   |                     |       |                    |       |
|                                                                                                                                                                                            |   |                     |       |                    |       |
| Preferred Stock,  $.01 par value, 13,500,000 shares authorized                                                                                                                                  |   | —                   |       | —                  |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized, 23,580,876 shares issued and  outstanding at September 30, 2003 and 23,577,963 shares issued and outstanding  at December 31, 2002 |   | 236                      |       | 236                     |       |
| Additional  paid-in capital                                                                                                                                                                     |   | 197,758                  |       | 193,391                 |       |
| Warrant for  Common Stock                                                                                                                                                                       |   | 1,911                    |       | 1,911                   |       |
| Accumulated  deficit                                                                                                                                                                            |   | (194,020                 | )          | (189,238                | )          |
| Less Treasury  Stock, at cost – 500,000 shares as of September 30, 2003 and December 31,  2002                                                                                             |   | (5                       | )          | (5                      | )          |
| Total  stockholders’ equity                                                                                                                                                                |   | 6,180                    |       | 7,295                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                |   | $                        | 7,633      |                    | $          | 14,019 |   |

 

The accompanying notesare an integral part of these financial statements.

 

3

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**WORLDGATE COMMUNICATIONS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Dollars in Thousands, Except per Share Amounts)**

 
|                                                                                                                                                                                                                                                                                     |   | **Three  Months ended September 30,** |   | **Nine  Months ended September 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                                                                                                                                                                                     |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                                                                                                                                                                                                                                     |   |                                  |   |                                 |   |   |   |   |   |
| Revenues                                                                                                                                                                                                                                                                                 |   |                                  |   |                                 |   |   |   |   |   |
| Equipment  product revenues earned from third parties                                                                                                                                                                                                                                    |   | $                                     | 674    |                                 | $      | 445 |   | $ | 805 |   | 481 |   |
| Equipment  product revenues earned from related parties                                                                                                                                                                                                                                  |   | 14                                    |   | 87                                   |   | 1,119 |   | 263 |   |
| Service fee  revenues earned from third parties                                                                                                                                                                                                                                          |   | 201                                   |   | 207                                  |   | 623 |   | 963 |   |
| Service fee  revenues earned from related parties                                                                                                                                                                                                                                        |   | 52                                    |   | 3,557                                |   | 950 |   | 9,682 |   |
| Total revenues                                                                                                                                                                                                                                                                           |   | 941                                   |   | 4,296                                |   | 3,497 |   | 11,389 |   |
| Costs and  expenses                                                                                                                                                                                                                                                                      |   |                                  |   |                                 |   |   |   |   |   |
|                                                                                                                                                                                                                                                                                     |   |                                  |   |                                 |   |   |   |   |   |
| Cost of  equipment product revenues                                                                                                                                                                                                                                                      |   | 1,523                                 |   | 685                                  |   | 3,414 |   | 4,354 |   |
| Cost of service  fee revenues                                                                                                                                                                                                                                                            |   | 1                                     |   | 3,291                                |   | 804 |   | 9,120 |   |
| Engineering and  development (excluding depreciation and amortization amounts of $69 and $151  for the three months ended September 30, 2003 and 2002, respectively, and  $289 and $450 for the nine months ended September 30, 2003 and September 30,  2002, respectively).             |   | 723                                   |   | 1,920                                |   | 2,667 |   | 6,711 |   |
| Sales and  marketing (excluding depreciation and amortization amounts of $17 and $80 for  the three months ended September 30, 2003 and 2002, respectively, and $52 and  $243 for the nine months ended September 30, 2003 and September 30, 2002,  respectively).                       |   | 173                                   |   | 561                                  |   | 745 |   | 2,069 |   |
| General and  administrative (excluding depreciation and amortization amounts of $84 and  $88 for the three months ended September 30, 2003 and September 30, 2002,  respectively, and $251 and $261 for the nine months ended September 30, 2003  and September 30, 2002, respectively). |   | 1,150                                 |   | 680                                  |   | 2,956 |   | 2,038 |   |
| Depreciation and  amortization                                                                                                                                                                                                                                                           |   | 169                                   |   | 319                                  |   | 592 |   | 954 |   |
| Goodwill  impairment                                                                                                                                                                                                                                                                     |   | 0                                     |   | 0                                    |   | 0 |   | 3,006 |   |
| Total costs and  expenses                                                                                                                                                                                                                                                                |   | 3,739                                 |   | 7,456                                |   | 11,178 |   | 28,252 |   |
| Loss from  operations                                                                                                                                                                                                                                                                    |   | (2,798                                | )      | (3,160                               | )      | (7,681 | ) | (16,863 | ) |
| Interest and  other income                                                                                                                                                                                                                                                               |   | 28                                    |   | 35                                   |   | 67 |   | 140 |   |
| Interest and  other expense                                                                                                                                                                                                                                                              |   | (127                                  | )      | (38                                  | )      | (167 | ) | (74 | ) |
| Gain on the sale  of Investment in TVGateway, LLC                                                                                                                                                                                                                                        |   | 600                                   |   | 0                                    |   | 600 |   | 0 |   |
| Gain on the sale  of intellectual property                                                                                                                                                                                                                                               |   | 2,400                                 |   | 0                                    |   | 2,400 |   | 0 |   |
|                                                                                                                                                                                                                                                                                     |   |                                  |   |                                 |   |   |   |   |   |
| Net Income  (Loss)                                                                                                                                                                                                                                                                       |   | $                                     | 103    |                                 | $      | (3,163 | ) | $ | (4,781 | ) | $ | (16,797 | ) |
|                                                                                                                                                                                                                                                                                     |   |                                  |   |                                 |   |   |   |   |   |
| Net Income  (Loss)  per common share (basic and diluted)                                                                                                                                                                                                                            |   | $                                     | 0.00   |                                 | $      | (0.13 | ) | $ | (0.20 | ) | $ | (0.71 | ) |
| Weighted average  common shares outstanding - basic and diluted:                                                                                                                                                                                                                         |   |                                  |   |                                 |   |   |   |   |   |
| Basic                                                                                                                                                                                                                                                                                    |   | 23,580,543                            |   | 23,576,243                           |   | 23,579,690 |   | 23,572,577 |   |
| Fully Diluted                                                                                                                                                                                                                                                                            |   | 23,662,115                            |   | 23,576,243                           |   | 23,579,690 |   | 23,572,577 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

4

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**WORLDGATE COMMUNICATIONS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(Dollars in Thousands)**

 
|                                                                    |   | **Nine  months ended  September 30,** |   |
|-------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                    |   | **2003**                              |   | **2002** |   |
| **Cash flows from operating  activities:**                              |   |                                  |   |   |   |
| Net loss                                                                |   | $                                     | (4,781 | ) | $ | (16,797 | ) |
| Adjustments to  reconcile net loss to cash used in operating activities |   |                                  |   |   |   |
| Depreciation and  amortization                                          |   | 592                                   |   | 954 |   |
| Bad debt expense                                                        |   | 551                                   |   | 402 |   |
| Amortization of  deferred compensation                                  |   | 0                                     |   | 171 |   |
| Non-cash stock  based compensation                                      |   | 83                                    |   | 0 |   |
| Impairment of  goodwill                                                 |   | 0                                     |   | 3,006 |   |
| Provision for  inventory                                                |   | 1,377                                 |   | 1,601 |   |
| Loss on the  disposition of fixed assets                                |   | 127                                   |   | 0 |   |
| Gain on sale of  fixed assets                                           |   | (2,400                                | )      | 0 |   |
| Gain on sale of  investment in TVGateway, LLC                           |   | (600                                  | )      | 0 |   |
| Changes in  operating assets and liabilities:                           |   |                                  |   |   |   |
| Accounts  receivable                                                    |   | 1,630                                 |   | 1,296 |   |
| Inventories                                                             |   | 1,162                                 |   | 871 |   |
| Prepaid and  other assets                                               |   | 376                                   |   | (76 | ) |
| Accounts payable                                                        |   | (423                                  | )      | 820 |   |
| Accrued expenses                                                        |   | (215                                  | )      | (501 | ) |
| Accrued  compensation and benefits                                      |   | (920                                  | )      | (531 | ) |
| Other                                                                   |   | (80                                   | )      | (43 | ) |
| Net cash used in  operating activities                                  |   | (3,521                                | )      | (8,827 | ) |
| **Cash flows from investing  activities:**                              |   |                                  |   |   |   |
| Capital  expenditures                                                   |   | 0                                     |   | (62 | ) |
| Proceeds from  maturities of short-term investments, net                |   | 3,423                                 |   | 6,794 |   |
| Proceeds from  sale of equipment                                        |   | 368                                   |   | 0 |   |
| Proceeds from  the sale of investment in TVGateway, LLC                 |   | 600                                   |   | 0 |   |
| Net cash  provided by investing activities                              |   | 4,391                                 |   | 6,732 |   |
| **Cash flows from financing  activities:**                              |   |                                  |   |   |   |
| Proceeds from  issuance of common stock                                 |   | 1                                     |   | 13 |   |
| Proceeds from  notes payable                                            |   | 0                                     |   | 443 |   |
| Repayments of  capital leases and notes payable                         |   | (610                                  | )      | (245 | ) |
| Net cash  provided by (used in) financing activities                    |   | (609                                  | )      | 211 |   |
| Net increase  (decrease) in cash                                        |   | 261                                   |   | (1,884 | ) |
| Cash and cash  equivalents, beginning of period                         |   | 589                                   |   | 3,356 |   |
| Cash and cash  equivalents, end of period                               |   | $                                     | 850    |   | $ | 1,472 |   |
|                                                                    |   |                                  |   |   |   |
| Cash paid for  interest                                                 |   | $                                     | 15     |   | $ | 7 |   |
|                                                                    |   |                                  |   |   |   |
| **Non-cash  financing activity:**                                       |   |                                  |   |   |   |
|                                                                    |   |                                  |   |   |   |
| Issuance of note payable to finance D&O insurance                   |   | 560                                   |   | 0 |   |
| Utilization of contractual obligation related to equity financing       |   | 0                                     |   | 25 |   |
| Termination of contractual obligation related to equity financing       |   | 3,283                                 |   | 0 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

5

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WORLDGATE COMMUNICATIONS,INC.

NOTES TO CONDENSEDFINANCIAL STATEMENTS

 

(Dollar Amounts are inThousands, Except for per Share Amounts)

(Unaudited)

 

1.                                       Basisof Presentation.

 

The unaudited financial statements of WorldGateCommunications, Inc. (“WorldGate” or the “Company”) for the three months endedSeptember 30, 2003 presented herein have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission forquarterly reports on Form 10-Q.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations.  These financial statements should be read inconjunction with the financial statements for the year ended December 31, 2002and the notes thereto included in the Company’s Annual Report on Form 10-K.

 

The financial information in this Report reflects, inthe 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, 2003.

 

2.                                       Liquidityand Going Concern Considerations.

 

Asof September 30, 2003 the Company had cash and cash equivalents of $850.  The operating cash usage for the three andnine months ended September 30, 2003 was $1,072 and $3,521, respectively.  On September 30, 2003, the Company sold toTVGateway, LLC certain interactive television (“ITV”) intellectual propertyrights and certain software and furniture also related to the ITV business thatwere being used by TVGateway, for $2.4 million pursuant to an Asset PurchaseAgreement (the “Agreement”).  Inaddition, on August 7, 2003, TVGateway redeemed WorldGate’s equity interest inTVGateway for $600,000 in cash pursuant to a redemption agreement.  The purchase price for these assets in theaggregate was $3 million and will be used by the Company to fund continuingoperations, as well as to develop and distribute its new Ojo video phonetelephony product.  With the September30, 2003 closing of the TVGateway transaction and receipt of the $2.4 millionfrom TVGateway (less associated costs of $300) on October 1, 2003, the Companyprojects that it will have sufficient funding to continue operations into thefirst quarter of 2004, assuming no additional funding is received.  As part of this transaction the Companyretained a royalty-free license to certain of the transferred intellectualproperty rights and software, and with such license the Company is able tocontinue to support its current interactive television customers.  Accordingly, at this time the Companyexpects to continue to receive revenues from the operation of this business,although given the Company’s going concern considerations, no assurances can beprovided as to the amount and collectability of such revenues, or to the periodsuch revenues will continue to be received. However, the Company continues to evaluate the merits of staying in theITV business versus exiting and putting all its focus behind videotelephony.  If it were to exit the ITVbusiness it would lose the revenue from this business and could potentially befaced with write-offs on inventory and equipment that would no longer beneeded.

 

The Company has no outstanding debt and its assets arenot pledged as collateral.  The Companycontinues to evaluate possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations or from other sources. Such additional financing would be subject to the risk of availability,may be dilutive to our shareholders, or could impose restrictions on operatingactivities.  There can be no assurancethat this additional financing will be available on terms acceptable to theCompany, if at all.  The Company haslimited capacity to further reduce its workforce and scale back on capital andoperational expenditures to decrease cash burn given the measures it hasalready taken to reduce staff and expenses.

 

6

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The unaudited consolidated financial statements havebeen prepared on a going concern basis, which contemplates the realization ofassets and the satisfaction of liabilities and commitments in the normal courseof business.  Therefore, the financialstatements do not include any adjustments relating to the Company’s ability tooperate as a going concern.  Theappropriateness of using the going concern basis in the future, however, willbe dependent upon the Company’s ability to address its liquidity needs asdescribed above.  There is no assurancethat the Company will be able to address its liquidity needs through themeasures described above on acceptable terms and conditions, or at all, and,accordingly, there is substantial doubt about the Company’s ability to continueas a going concern beyond the first quarter of 2004.

 

3.                                       RecentAccounting Pronouncement.

 

In January 2003, the FASB issued Interpretation No.46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No.51”.  This Interpretation addresses theconsolidation by business enterprises of variable interest entities as definedin the Interpretation.  TheInterpretation applies immediately to variable interests in variable interestentities created after January 31, 2003 and to variable interests in variableinterest entities obtained after January 31, 2003.  A company with a variable interest or a variable interest entitycreated before February 1, 2003 shall apply the provisions of FIN 46 effectiveDecember 31, 2003.  Management does notbelieve the adoption of this Interpretation will have an impact on theCompany’s consolidated financial position or results of operations.

 

The FASB recently issued SFAS No. 149, “Amendment ofStatement 133 on Derivative Instruments and Hedging Activities”.  In addition, the Emerging Issues Task Forcerecently issued EITF Issue 00-21, “Revenue Arrangements with MultipleDeliverables”.  The adoption of theseaccounting pronouncements did not have a material impact on the Company’s consolidatedfinancial position or results of operations.

 

In November 2002, the FASB issued Interpretation No.45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”).  This interpretation expands the disclosure requirementsof guarantee obligations and requires the guarantor to recognize a liabilityfor the fair value of the obligation assumed under a guarantee.  In general, FIN 45 applies to contracts orindemnification agreements that contingently require the guarantor to makepayments to the guaranteed party based on changes in an underlying instrumentthat is related to an asset, liability, or equity security of the guaranteedparty.  Other guarantees are subject tothe disclosure requirements of FIN 45 but not to the recognition provisions andinclude, among others, a guarantee accounted for as a derivative instrumentunder SFAS No. 133, “Accounting for Derivatives and Hedging” (“SFAS No. 133”),a parent’s guarantee of debt owed to a third party by its subsidiary or viceversa, and a guarantee which is based on performance.  The disclosure requirements of FIN 45 were effective as ofDecember 31, 2002.  The recognitionrequirements of FIN 45 are to be applied prospectively to guarantees issued ormodified after December 31, 2002.  Therequirements of FIN 45 did not have a material impact on our results ofoperations, financial position or liquidity.

 

In May 2003, the FASB issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity.”  SFAS 150 establishes standardsfor how an issuer of financial statements classifies and measures certainfinancial instruments that have characteristics of both liabilities and equity.  This statement is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003.  The adoption of this statementdid not have any impact on the Company’s financial statements.

 

4.                                       AccountsReceivable

 

Included in Account Receivables is $2.4 million fromTVGateway, LLC related to the sale of intellectual property (see footnote 2).

 

5.                                       Agreementwith Argentine Customer.

 

In 2001, the Company sold $742 worth of deploymentequipment, keyboards and other items to a cable

 

7

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operator in Argentina whoat the time, was not experiencing economic difficulties. Shortly after thesale, the country of Argentina encountered economic difficulties that adverselyaffected our Argentine customer’s financial position. Our Argentine customermade a $400 payment on the equipment purchased but was having difficultiessatisfying the remaining unpaid portion of their invoice of $342. During thesecond quarter of 2002, after further negotiations with our Argentine customer,the Company believed that the best course of action to salvage value from theremaining $342 unpaid balance was to agree to a cash payment of $55, take backa portion of the keyboards previously sold worth $150 (which was recorded as areduction in revenues), and write off the remaining unsatisfied portion oftheir invoice of $137 as general and administrative expense. The keyboardstaken back from our customer can be resold to other cable operators in Spanishspeaking countries. It is not a normal policy or practice of the Company totake back inventory previously sold; it was done only due to the extenuatingcircumstances. Our Argentine customer has made the cash payment stipulated in theagreement.

 

6.                                       Inventories.

 

Inventories are summarized as follows:

 
|                                     |   | **September  30, 2003** |   | **December  31, 2002** |   |
|------------------------------------------|--------|-------------------------|--------|------------------------|--------|
|                                     |   |                    |   |                   |   |
| Raw Material                             |   | $                       | 1,423  |                   | $      | 2,479 |   |
| Work in Progress                         |   | —                  |   | 2                      |   |
| Finished Goods                           |   | —                  |   | 865                    |   |
| Inventory held  by customers and vendors |   | —                  |   | 616                    |   |
|                                     |   | $                       | 1,423  |                   | $      | 3,962 |   |

 

7.                                       Stock-BasedCompensation.

 

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 compensation costhas been recognized for the Company’s fixed stock based compensation.  Had compensation cost been determinedconsistent with SFAS No. 123, as amended by SFAS No. 148, the Company’s netloss would have been increased to the following pro forma amounts:

 
|                                                                                                                                 |   | **For the  Three Month Period  Ended September 30,** |   | **For the  Nine Month Period  Ended September 30,** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                                                                                 |   | **2003**                                             |   | **2002**                                            |   | **2003** |   | **2002** |   |
|                                                                                                                                 |   |                                                 |   |                                                |   |   |   |   |   |
| Net Income  (Loss):                                                                                                                  |   |                                                 |   |                                                |   |   |   |   |   |
| As reported                                                                                                                          |   | $                                                    | 103    |                                                | $      | (3,163 | ) | $ | (4,781 | ) | $ | (16,797 | ) |
| Add: Stock-based compensation expense included in reported net loss,  net of related tax effects of $0                               |   | 43                                                   |   | 44                                                  |   | 83 |   | 171 |   |
| Deduct: Total  stock-based employee expense determined under the fair value based method for  all awards, net of related tax effects |   | (1,359                                               | )      | (1,060                                              | )      | (4,129 | ) | (3,797 | ) |
| Pro forma net  loss                                                                                                                  |   | (1,213                                               | )      | (4,179                                              | )      | (8,827 | ) | (20,433 | ) |
|                                                                                                                                 |   |                                                 |   |                                                |   |   |   |   |   |
| Net Loss per share:                                                                                                                  |   |                                                 |   |                                                |   |   |   |   |   |
| Basic and diluted – as reported                                                                                                 |   | 0.00                                                 |   | (0.13                                               | )      | (0.20 | ) | (0.71 | ) |
| Basic and diluted - pro forma                                                                                                        |   | (0.51                                                | )      | (0.18                                               | )      | (0.37 | ) | (0.87 | ) |
|                                                                                                                                      |        |                                                      |        |                                                     |        |  |  |  |  |  |  |  |  |

 

Such pro forma disclosures may not be representative of futurecompensation expense because options

 

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vestover several years and additional grants are made each year.

 

8.               Related PartyTransactions.

 

In 1997, the Company entered into agreements withcertain cable operators who are investors. Revenues recognized from such investors were approximately $64 and $119,for the three months ended September 30, 2003 and September 30, 2002 andapproximately $200 and $299, respectively, for the nine months ended September30, 2003 and September 30, 2002. Accounts receivable from such investorsamounted to approximately $138 at September 30, 2003 and $97 at December 31,2002. 

 

The Company has agreements with some investors toprovide engineering and development support. As a result of these agreements, the Company has expensed approximately$394 and $355, respectively, for the three months ended September 30, 2003 andSeptember 30, 2002 and approximately $950 and $1,508, respectively, for thenine months ended September 30, 2003 and September 30, 2002.  Accounts payable to these stockholdersamounted to $65 and $468 at September 30, 2003 and December 31, 2002,respectively.  These stockholders aresuppliers of technology and components for the Company’s products andservices.  These agreements provide forlicensing of technology, as well as contracted services, including hardware andsoftware development, product testing and certification, and the creation anddevelopment of tools and systems to facilitate the Company’s engineeringefforts.  These agreements do notprovide for ongoing royalties, purchase provisions, nor for any requirement toprovide additional funding to the Company.

 

In 1998 the Company entered into a leasing arrangementfor a building with an entity formed by non-employee investors.  Included in deposits and other assets atSeptember 30, 2003 and 2002 is $388 and $864, respectively, related to thislease.  The Company has not paid itsrent on its current facility since May 2003, totaling approximately $425.  Subsequent to June 30, 2003, thecorresponding monthly and operating amounts which approximate $85 per month,have been deducted by our landlord from the deposit referenced above which isthe security deposit the Company maintains with respect to the building.  Although the Company and the non-employeeinvestor are in the process of trying to negotiate a settlement, thenon-employee investor has perfected its interest to enable it to takepossession of the facility.

 

9.               TVGateway JointVenture and related Cable Operator Agreements.

 

On July 24, 2000, theCompany formed a separate joint venture, TVGateway, LLC, with four cableoperators.  As part of this ventureWorldGate entered into a management agreement with TVGateway to provideengineering, operations and administrative support services. In addition toproviding for the terms and conditions under which such services were to beprovided, the management agreement provided for WorldGate and TVGateway to cooperateto transition to TVGateway some or all of the support services being providedby WorldGate and/or the employees providing these services. In addition, thisprovision required WorldGate to remain available to provide support servicesuntil July 24, 2005. During 2002 WorldGate and TVGateway agreed to commence thetransition of services pursuant to this provision. In addition, the partiesagreed that the management agreement would be of no further force and effectwith respect to the services that are transferred as of the date of completionof the specific transfers. The companies completed this transition in firstquarter 2003, and accordingly, WorldGate has now been relieved of anycontinuing obligation to provide such transitioned services.  Further, WorldGate will no longer receivefuture revenues from the management agreement with TVGateway.

 

Revenues for such services,which are included in service fee revenue, totaled $0, and $3,438, respectivelyfor the three months ended September 30, 2003 and 2002, and $794 and $9,464,respectively, for the nine months ended September 30, 2003 and 2002.  In addition, product sales to TVGatewaytotaled $0 and $86 for the three months ended September 30, 2003 and 2002, and$1,074 and $182, respectively, for the nine months ended September 30, 2003 and2002.  Accounts Receivable fromTVGateway amounted to $1 at September 30, 2003 and $1,089 at December 31,2002. WorldGate was accounting for its 18% investment in the TVGateway jointventure, which was previously reduced to a carrying value of $0 due to priorlosses, under the equity method.

 

OnSeptember 30, 2003 the Company announced that it had sold to TVGateway, LLCcertain ITV intellectual property rights and certain software and equipmentrelated to the ITV business, which TVGateway was currently using, for $2.4million.  In addition, on August 7,2003, WorldGate and TVGateway entered into a

 

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redemptionagreement pursuant to which TVGateway redeemed WorldGate’s equity interest inTVGateway for $600 thousand in cash. The purchase price for these assets in the aggregate was $3 million andwill be used by the Company to fund continuing operations, as well as todevelop and distribute its new Ojo video telephony product. As part of thistransaction WorldGate retained a royalty-free license to certain of thetransferred intellectual property rights and software, and with such license,at this time the Company plans to continue to support its current interactivetelevision (“ITV”) customers.  However,the Company continues to evaluate the merits of staying in the ITV businessversus exiting and putting all its focus behind video telephony.  If it were to exit the ITV business it wouldlose the revenue from this business and could potentially be faced withwrite-offs on inventory and equipment that would no longer be needed.

 

*Related Cable Operator Agreements.*

 

In 2000, and concurrentlywith the formation of the TVGateway joint venture, the Company entered intomulti-year agreements with four cable operators for the digital deployment ofthe Company’s ITV service to a predetermined number of households. In additionto the deployment agreements, the cable providers purchased an aggregate of1,531,211 shares of the Company’s Common Stock yielding proceeds to the Companyof $24,530. These same cable operators were issued warrants to purchaseadditional shares of Common Stock which were to vest at varying rates based onthe deployment of the Company’s ITV service on the cable operator’s digitalcable system.  As part of the asset saleto TVGateway, two of the cable operators have returned their warrants toWorldGate, in the aggregate amount of 1 million shares and the same have beencancelled.

 

Furthermore, the Company entered into a supplyagreement with the cable operators whereby the Company agreed to supply thesecable operators, on a pro rata basis, products that pertain to the developmentand deployment of the WorldGate service. The Company initially recorded aliability in the amount of $5,110 related to this obligation. The recordedamount was based on the Company’s best estimate of what it would cost tosatisfy the contractual obligation to the various cable operators. TheCompany’s policy has been to not adjust the liability after it has beenestablished. Any future change in the contractual obligation liability would bea reclassification to additional paid in capital. When equipment credits areutilized by the cable operators, the value of the equipment is reflected in itsentirety in the cost of revenues. The equipment credit balance of $3,283expired on August 24, 2003, consequentially, the Company reduced this liabilityof $3,283 and increased its paid in capital.

 

10.         Net Loss per Share.

 

Basic and diluted net loss per common share iscomputed by dividing the net loss available to common stockholders for theperiod by the weighted average number of shares of common stock outstandingduring the period.  The calculation ofdiluted net loss per common share excludes potential common shares if theeffect is antidilutive.  Potentialcommon shares comprise shares of common stock issuable upon the exercise ofstock options and warrants.  The numberof potential common shares which would have been assumed to be converted in theperiods ended September 30, 2003 and 2002 and have a dilutive effect if theCompany had income from continuing operations, or if the options’ exerciseprice was less than the average market price of the common shares, is 5,861,201and 6,333,582, respectively.

 

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

 

(Dollar Amounts are inThousands, Except per Share Amounts)

 

FORWARD-LOOKING ANDCAUTIONARY STATEMENTS.

 

We may from time to time make written or oralforward-looking statements, including those contained in the followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.  The words “estimate,”“project,” “believe,” “intend,” “expect,” and similar expressions are intendedto identify forward-looking statements, although not all forward-lookingstatements contain these identifying words. In order to take advantage of the “safe harbor” provisions of thePrivate Securities Litigation Reform Act of 1995, we are hereby identifyingcertain important factors which could cause our actual results, performance orachievement to differ materially from those that may be contained in or impliedby any forward-looking statement made by or on behalf of WorldGate.  The factors, individually or in theaggregate, that could cause such forward-looking statements not

 

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to be realized include,without limitation, the following: (1) difficulty or inability to raiseadditional financing on terms acceptable to us, (2) difficulty in developingand implementing marketing and business plans, (3) continued losses, (4)industry competition factors and other uncertainty that a market for ourproducts will develop, (5) challenges associated with broadband operators(including, uncertainty that they will offer our products, inability to predictthe manner in which they will market and price our products and existence ofpotential conflicts of interests and contractual limitations impeding theirability to offer our products), (6) departure of one or more key persons,  (7) delisting of our Common Stock from theNASDAQ Small Cap Market, (8) changes in regulatory requirements, and (9) otherrisks identified in our filings with the Securities and Exchange Commission.  We caution you that the foregoing list ofimportant factors is not intended to be, and is not, exhaustive.  We do not undertake to update anyforward-looking statement that may be made from time to time by or on behalf ofWorldGate.

 

Results of Operations:

 

Critical Accounting Policies and Estimates.

 

The consolidated financial statements are prepared inconformity with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements required management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

The significant accounting policies of the Company aredescribed in the notes to the consolidated financial statements included in theannual report on Form 10-K.  Judgmentsand estimates of uncertainties are required in applying the Company’saccounting policies in many areas. Following are some of the areas requiring significant judgments andestimates:  revenue recognition,accounts receivable, inventories, and cash flow and valuation assumptions inperforming asset impairment tests of long-lived assets.

 

Three and Nine Months Ended September 30, 2003 and September 30, 2002

 

Revenues.

 

Revenues. Revenues decreased to $941 for the three months ended September 30,2003, or 78%, from $4,296 for the three months ended September 30, 2002.  Revenues also decreased 69% from $11,389 forthe nine months ended September 30, 2002 to $3,497 for the nine months endedSeptember 30, 2003.    A substantialportion of the revenue decrease for the three months ended September 30, 2003,as compared to the three months ended September 30, 2002, is attributable toreduced consulting fees from TVGateway. For the nine months ended September 30, 2003, a substantial portion ofthe revenue decrease, when compared to the nine months ended September 30,2002, is also attributable to reduced consulting fees with TVGateway, partiallyoffset by increased equipment sales from TVGateway during the first quarter of2003.  As a result of the transition ofservices formerly provided by the Company to TVGateway, we do not expect toreceive any significant revenues from consulting fees or equipment sales fromTVGateway in the future.  For the threemonths ended September 30, 2003 there were no consulting fee revenues fromTVGateway compared to consulting fees of $3,469 for the three months endedSeptember 30, 2002.  For the nine monthsended September 30, 2003 consulting fee revenues from TVGateway were $794, or92% below such consulting fees of $9,554 for the nine months ended September30, 2002.  For the three months endedSeptember 30, 2003, equipment sold to TVGateway was $1, compared to $55 for thethree months ended September 30, 2002. For the nine months ended September 30, 2003, equipment sold toTVGateway was $1,079, compared to $182 for the nine months ended September 30,2002.  At September 30, 2002 we haddeployed our services in 66 cable systems with approximately 600,000 RevenueGenerating Units.  As of September 30,2003 we had deployed our services in 30 cable systems, representingapproximately 219,000 Revenue Generating Units.  For the three months ended September 30, 2003, we derivedrevenues of $253, or 27%, from service fees consisting of consulting fees,subscriber fees and advertising fees, and $688, or 73%, from the delivery ofheadends, keyboards, and related equipment products.  For the three months ended September 30, 2002, we derivedrevenues of $3,764, or 88%, and $532, or 12%, from the delivery of headends,keyboards, and related equipment products. For the nine months ended September 30, 2003, we derived revenues of$1,573, or 45%, from service fee revenues and $1,924, or 55%, from the deliveryof equipment.  For the nine months endedSeptember 30, 2002, we derived revenues of $10,645, or 93%, from service feesand $744, or 7%, from the delivery of equipment.  Included in

 

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equipment revenues forthe three months ended September 30, 2003 and 2002, were sales of excessinventory of $688 and $0, respectively. For the nine months ended September 30, 2003 and 2002, the sale ofexcess inventory included in equipment revenues were $730 and $0, respectively.  TheCompany currently continues to provide the WorldGate service to its customers,and accordingly expects to continue to receive revenues from the operation ofthis business, although given the Company’s going concern considerations noassurances can be provided as to amount and collectability of such revenues orto the period such revenues will continue to be received.  However, the Company continues to evaluatethe merits of staying in the ITV business versus exiting and putting all itsfocus behind video telephony.  If itwere to exit the ITV business it would lose the revenue from this business andcould potentially be faced with write-offs on inventory and equipment thatwould no longer be needed.  WorldGatedoes not expect to generate any significant revenues from its videophoneproduct for the remainder of this year and during 2004.

 

Costs and Expenses.

 

Cost of Revenues. Cost of revenues consists primarily of equipment product costs andservice fee revenue costs, related primarily to the provision of engineeringand administrative services.  Costs ofequipment product revenues for the three and nine months ended September 30,2003, were $1,523 and $3,414, respectively, or approximately 2,214% and 177%,respectively, of equipment product revenues, compared to the product costs ofrevenues of $685 and $4,354, respectively, or approximately 129% and 585%,respectively, of equipment product revenues, for the three and nine monthsended September 30, 2002.  The increasein the cost of equipment product revenues for the three months ended September30, 2003, as compared to the three months ended September 30, 2002, wereprimarily the result of approximately $156 increase in inventory equipmentsales.  The decrease in the cost ofequipment product revenues for the nine months ended September 30, 2003, ascompared to the nine months ended September 30 2002, were primarily the resultof approximately $760 of equipment sales to TVGateway, which primarilyconsisted of equipment previously expensed or written-off, and reducedmanufacturing overhead costs for the nine months ended September 30, 2003 of$1,109.  The Company recorded $338 and$1,378, respectively, in inventory reserves in the three and nine months endedSeptember 30, 2003.  For the three andnine months ended September 30, 2002, inventory reserves were $170 and $1,601,respectively.  Service fee costs ofrevenues for the three and nine months ended September 30, 2003, were $1 and$804, respectively, or approximately 0% and 51%, respectively, of service feerevenues.  Service fee costs of revenueswere $3,271 and $9,120, respectively, or approximately 87% and 86%,respectively, of service fee revenues for the three and nine months endedSeptember 30, 2002.  These decreases inservice fee cost of revenues for the three and nine months ended September 30,2003 of $3,270 and $8,316, respectively, when compared to the same period in2002, are primarily attributable to decreased staffing levels required as aresult of the TVGateway transfer.

 

Engineering and Development.  Engineering and development expenses primarily consist of thecost of design, programming, testing, documentation and support of theCompany’s hardware, software and services. Engineering and development costs were $723 for the three months endedSeptember 30, 2003, a decrease of approximately 62% when compared to $1,920 forthe three months ended September 30, 2002. For the nine months ended September 30, 2003, engineering anddevelopment costs were $2,667, a decrease of approximately 60%, when comparedto $6,711 for the nine months ended September 30, 2002.  These decreases in expenses are primarilyattributable to declines in staffing over the last two years which resulted ina significant payroll cost reduction, a significant portion of which is theresult of termination of all of the personnel of the former DVA (“Digital VideoArt, Inc.”, a wholly owned subsidiary of the Company) and of the engineeringdevelopment consultants for TVGateway, partially offset by the issuance of189,000 stock options to a manufacturer with a fair value of $43 inconsideration for engineering and development work.  Employee compensation costs declined for the three and ninemonths ended September 30, 2003 by $2,016 and $6,794, respectively, or 80% and73%, respectively, when compared to the same periods in 2002.  These reductions were partially offset byengineering and development overhead costs no longer allocable to TVGateway.

 

Sales and Marketing. Sales and marketing costs consist primarily of compensation, attendanceat conferences and trade shows, travel costs necessary to cover a domestic andinternational customer market base, promotions and other marketing programssubstantially related to initial trial installations and commercialdeployments.  For the three months endedSeptember 30, 2003, sales and marketing expenses were $173.  This represents a decrease of approximately69%, when compared to sales and marketing expenses of $561 for the three monthsended September 30, 2002.  For the ninemonths ended September 30, 2003, sales and marketing expenses were $745, a decreaseof approximately 64%, when compared to $2,069 for the nine months endedSeptember 30, 2002.  These decreases inexpenses are primarily attributable to declines in staffing over the last

 

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two years.  These actions resulted in employee compensationcosts declining in the three and nine months ended September 30, 2003 by $351and $826, respectively, or approximately 73% and 55%, respectively, whencompared to the same periods in 2002. Advertising, conferences and trade show costs also declined for thethree and nine months ended September 30, 2003 by $11 and $297, respectively,or approximately 23% and 83%, respectively, when compared to the same periodsin 2002, as a result of reduced participation by the Company.

 

General and Administrative.  General and administrative expenses consist primarily ofexpenditures for administration, office and facility operations, finance andgeneral management activities, including legal, accounting and other professionalfees.  General and administrative expenseswere $1,150 and $2,956, respectively, for the three and nine months endedSeptember 30, 2003, an increase of approximately 69% and 45%, respectively,when compared to expenses of $680 and $2,038, respectively, for the sameperiods in 2002.  These increases inexpenses are primarily attributable to facility overhead costs that are nolonger allocable to TVGateway, partially offset by declines in staffing, andthe issuance of 150,000 stock options to an investment financial advisor with afair value of $40 to assist us in evaluating various strategic and financialalternatives available to the Company. Employee compensation costs declined in the three and nine months endedSeptember 30, 2003 by $198 and $583, respectively, or approximately 15% and 16%,when compared to the same periods in 2002, as a result of decreases instaffing.  External professionalconsulting fee expenditures were also reduced for the three and nine monthsended September 30, 2003 by $316 and $657, respectively, or approximately 22%and 15%, respectively, when compared to the same periods in 2002.  Facility expenses increased for the threeand nine months ended September 30, 2003 by $548 and $962, respectively, orapproximately 91% and 46%, respectively, when compared to the same periods in2002, also as a result of the facility overhead costs no longer being allocatedto TVGateway.

 

Goodwill Impairment. During the second quarter of 2002, in an effort to cut costs and achieveoperational efficiencies, the Company commenced the termination of allpersonnel of the former DVA which performed engineering development services.In conjunction with this action, it was determined that the carrying amount ofthe Company’s remaining goodwill, which was originally recorded with theCompany’s acquisition of DVA, exceeded its fair value. As such, the Companymeasured the impairment loss by the amount the carrying value exceeded theimplied fair value of the goodwill. The amount of the non-cash impairment losswas $3,006. The fair value of goodwill was estimated using the expected presentvalue of future cash flows.

 

Interest and Other Income and Interest Expense.  Interest and other income and interestexpense consist of interest earned on cash and cash equivalents and short-terminvestments, and interest expense on equipment financing and short-termdebt.  Interest and other incomedecreased from $35 for the three months ended September 30, 2002 to $28 for thethree months ended September 30, 2003, and decreased from $140 for the ninemonths ended September 30, 2002 to $67 for the nine months ended September 30,2003, primarily due to declining average cash balances and to declininginterest rates.  During the three andnine months ended September 30, 2002, the Company earned interest on average cashbalances of approximately $6,696 and $9,554, respectively, and incurredinterest expense related to its $1,100 equipment financing facility.  In comparison, during the three and ninemonths ended September 30, 2003 the Company earned interest on average cashbalances of approximately $800 and $2,077, respectively, and incurred interestexpense related to its insurance financing.

 

Income Taxes.  The Company has incurred net operatinglosses since inception and accordingly had no income taxes and has not recordedany income tax benefit for those losses.

 

Liquidity and Capital Resources.

 

As of September 30, 2003, 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 one year.

 

At September 30, 2003, we had cash and cashequivalents of $850 (and no short-term investments) as compared to cash andequivalents of $589 (in addition to $3,218 in short-term investments) atDecember 31, 2002.  Net cash used inoperations was $3,521 for the nine months ended September 30, 2003, as comparedto $8,827 used for the same period in 2002. The decrease in net cash used for operations was primarily attributableto the Company’s decrease in expenditures, including its reduction in workforceprograms.  Accounts receivable andinventory reductions were partially offset by other changes in working capitalduring the quarter.  The Company recordedbad debt expense in the amount of $551 during the nine months ended September30, 2003 to reflect its current assessment of the collectability of certainreceivables, primarily Latin and South America.

 

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The Company hasinstituted tighter credit procedures to minimize its collection exposure withparticular emphasis on international customers.

 

Cash provided by investing activities during the ninemonths ended September 30, 2003, totaled $4,391 compared to $6,732 providedduring the same period in 2002.  Duringthe nine months ended September 30, 2003, we utilized the net proceeds from ourmaturing short-term investments of $3,423 compared to $6,794 for the ninemonths ended September 30, 2002. Capital expenditures were $0 and $62 for the nine months ended September30, 2003 and 2002, respectively.

 

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 September 30, 2003 theCompany had cash, and cash equivalents of $850. The operating cash usage forthe nine months ended September 30, 2003 was $3,521. In October 2002, theCompany announced multiple actions that it believed would further reduceoperating expenses and increase operating efficiencies. These actions includeda reduction in work force as well as the implementation of an agreement withTVGateway to transfer to TVGateway certain WorldGate employees and functionsthat WorldGate was currently providing for TVGateway. During the first quarterof 2003, the Company substantially finalized the transition settlement andother matters with TVGateway and in January 2003 received $2,428 in cash aspart of this settlement. This amount largely comprises payment of ourreceivable balance as of December 31, 2002 in the amount of $1,000, payment ofJanuary 2003 service fees in the amount of $300 and other payments largelyrelated to our January 2003 sale of certain equipment and inventory in theapproximate amount of $1,055. This transition of services removed both theobligation of WorldGate to provide the service as well as TVGateway’sobligation to pay WorldGate for rendering the service. As such, WorldGate wasnegatively impacted in that it will no longer receive any significant revenuesfrom providing these services.  AlthoughWorldGate’s revenue attributable to the transitioned service was reduced, sowas the corresponding expense of providing the service. Also, there wasoverhead which was reduced or otherwise allocated and which was previouslypassed on to TVGateway.

 

Asof September 30, 2003, we have no outstanding debt and our assets are notpledged as collateral.  However,we have not paid our rent on our current facility since May 2003. As a result,our landlord, a non-employee investor, has perfected its interest to takepossession of our facility at any time and is drawing down from our rentdeposit to satisfy the unpaid rent.  As of September 30, 2003, theamount of the deposit remaining is $388. We continue to negotiate with our landlordto resolve this matter.  We alsocontinue to evaluate possibilities to obtain additional financing throughpublic or private equity or debt offerings, bank debt financing, assetsecuritizations or from other sources. Such additional financing would besubject to the risk of availability, may be dilutive to our shareholders, orcould impose restrictions on operating activities. There can be no assurancethat this additional financing will be available on terms acceptable to us, ifat all.  The Company has limitedcapacity to further reduce its workforce and scale back on capital andoperational expenditures to decrease cash burn given the measures it hasalready taken to reduce staff and expenses.

 

Withthe closing of the TVGateway transaction on September 30, 2003, and the receiptin the aggregate of $3 million from TVGateway (less the associated costs forsoliciting shareholder approval and fees for our investment advisors of $300),the Company projects it will have sufficient funding to continue operationsinto the first quarter of 2004, assuming no additional funding is received. Tothis end, we have been discussing, and continue to discuss, possible financingtransactions with several parties. No assurances can be given that atransaction can be consummated prior to the depletion of our availablecash.  We however remain hopeful thatsufficient funding can be obtained to continue the Company’s operations.

 

The Company received aletter dated October 8, 2002, from the NASDAQ, which notified it that the bidprice for its common stock had been below $1.00 per share for a period ofthirty consecutive days.  Subsequentlythe Company sought and received NASDAQ approval to transfer its listing to theNASDAQ Small Cap Market, and on January 9, 2003 the Company’s common stockcommenced trading on this market.  Wehave recently been given an extension by NASDAQ on the time allowed to regaincompliance with its minimum bid price requirement and currently have untilJanuary 3, 2004 to regain compliance. WorldGate cannot offer any assurance that other NASDAQ requirements forcontinued listing will be satisfied.  Ifthe Company’s common stock is delisted, this may have a negative impact on theliquidity and price of its common stock and investors may find it more difficultto purchase or dispose of, or to obtain accurate quotations as to the marketvalue of, its common stock. Furthermore,

 

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thelisting of the Company’s common stock on the NASDAQ Small Cap Market, makes itineligible for certain exemptions from the various state securities or “bluesky” laws, which makes it more difficult for the Company to raise capitalthrough issuances of securities.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.

 

Interest Rate Risk. Our exposure to market risk related to changes in interest rates relatesprimarily to our investment portfolio. We invest in instruments that meet high credit quality standards, and welimit the amount of credit exposure with respect to any one issue, issuer andtype of investment.

 

As of September 30, 2003, the Company’s cash and cashequivalents were $850, most of which were debt securities having a maturity ofless than one year, and it had no short-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 theportfolio.  Management estimates thathad the average yield of our investments decreased by 100 basis points, ourinterest income for the nine months ended September 30, 2003 would havedecreased by approximately $17.  Thisestimate assumes that the decrease occurred on the first day of 2003 andreduced the yield of each investment instrument by 100 basis points.  The impact on our future interest income offuture changes in investment yields will depend largely on our totalinvestments.

 

Foreign Currency Exchange Risk.  Although we transact business in variousforeign countries, the principal portion of our business is in the UnitedStates and substantially all of our revenues and costs to date have beendenominated in U.S. dollars.  As aresult, adverse movements in foreign currency exchange rates would not have amaterial adverse effect on us.

 

ITEM 4.  CONTROLS AND PROCEDURES.

 

As of the end of the period covered by this Form 10-Q,the Company’s management, including its chief executive officer and chieffinancial officer conducted an evaluation of the effectiveness of the Company’sdisclosure controls and procedures. Based on that evaluation, the chief executive officer and chieffinancial officer, concluded that the Company’s disclosure controls andprocedures were effective.  There havebeen no changes in the Company’s internal control over financial reporting thatoccurred during the period ended September 30, 2003, that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

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PART II. OTHER INFORMATION

 

(Dollar Amounts are inThousands, Except per Share Amounts)

 

ITEM 1.  LEGAL PROCEEDINGS.

 

We have not paid our rent on our current facilitysince May 2003.  As a result, ourlandlord, 3190 T General, Inc. has filed an action in the Court of CommonPleas, Bucks County Pennsylvania to perfect its interest to take possession ofour facility at any time, and to establish damages for past rent andexpenses.  Although a judgment has beengranted allowing our landlord to regain possession of the facility, we remainin the facility and in the process of negotiating a settlement of our leaseobligation with the landlord in an effort to reduce our outstanding liabilityand secure the continued right to occupy the facility with a reduced ongoinglease obligation, although there can be no assurance that a settlement can beobtained.  In lieu of rent payments ourlandlord is drawing down from our security deposit to satisfy the unpaidrent.  As of September 30, 2003, theamount of the deposit remaining is $388.

 

ITEM 2.  CHANGES INSECURITIES AND USE OF PROCEEDS.

 

On January 21, 2003 WorldGate issued an option topurchase 150,000 shares of common stock, with an exercise price of $0.70 pershare to an investment advisor in consideration for financial services.  Also, on September 11, 2003, the Companyissued options to purchase 189,000 shares of common stock, with an exerciseprice of $0.59 per share to a manufacturer in consideration for engineering anddevelopment work.  These options wereissued pursuant to an exemption under Section 4(2) of the Securities Act of1933, as amended.

 

ITEM 3.  DEFAULTS UPONSENIOR SECURITIES.

 

None.

 

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

 

The Company held its annual meeting (the “AnnualMeeting”) of stockholders on September 22, 2003.  At this meeting, the stockholders voted in favor of the followingitems listed in the Proxy Statement:

 

(1)   Election ofDirectors:

 

| **Nominee**              |   | **For**    |   | **Withheld** |
|--------------------------|--------|------------|--------|--------------|
|                     |   |       |   |         |
| Hal M. Krisbergh         |   | 21,028,563 |   | 529,659      |
| Steven C.  Davidson      |   | 21,314,793 |   | 243,429      |
| Clarence L.  Irving, Jr. |   | 21,193,865 |   | 364,357      |
| Martin Jaffe             |   | 21,335,707 |   | 222,515      |
| Jeff Morris              |   | 21,193,865 |   | 364,357      |
| Lemuel Tarshis           |   | 21,335,707 |   | 222,515      |

 

(2)   Approvedthe plan of recapitalization and authorized the board of directors to implementor abandon, in the board’s discretion, a twenty-for-one reverse stock split ofthe Company’s common stock.  The Companyhas, however, decided not to implement the plan of recapitalization at thistime.

 

| **For**    |   | **Against** |   | **Abstain** |
|------------|--------|-------------|--------|-------------|
| 20,960,778 |   | 544,644     |   | 52,780      |

 

(3)   After thestockholders took the foregoing actions, the Annual Meeting was adjourned toallow continued voting on the sale of assets (described below) to TVGateway,which was approved by the stockholders when the Annual Meeting was reconvenedon September 30, 2003.

 

| **For**    |   | **Against** |   | **Abstain** |
|------------|--------|-------------|--------|-------------|
| 12,885,791 |   | 359,720     |   | 69,155      |

 

ITEM 5.  OTHER INFORMATION.

 

The Company has announcedthat on September 30, 2003 it completed a definitive agreement to sell to TVGateway,LLC certain ITV intellectual property rights and certain software and equipmentrelated to the ITV business which TVGateway was currently using, for $2.4million in cash. In addition, WorldGate and TVGateway completed a redemptionagreement pursuant to which TVGateway redeemed WorldGate’s equity interest inTVGateway for $600 thousand in cash, paid concurrently with the execution ofthe redemption agreement.  The purchaseprice for these assets, in the aggregate, was $3 million which WorldGate will useto fund continuing operations, as well as to develop and its new Ojo videotelephony product.  The WorldGate Boardof Directors, in evaluating its options, has concluded that investing theproceeds from the TVGateway transaction in the continued development anddistribution of products and services for the broadband market, including ournew videophone business, will create the best value for shareholders.

 

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Inconnection with this transaction the Company incurred certain costs associatedwith soliciting shareholder approval for the transaction as well as certainadvisor fees for the transaction.  Inlight of the transaction, the Company has also continued to implement measures,including significant personnel reorganizations, intended to reduce itsoperating costs and improve efficiencies. The Company therefore projects it will have sufficient funding tocontinue operations into the first quarter 2004, assuming no additional fundingis received.

 

Forthe past several months, WorldGate has been developing, and will continue todevelop, a videophone with high quality, full motion video.  Since this product is designed to work withexisting broadband infrastructures, the Company plans to leverage its longstandingrelationships and business partnerships within the broadband marketplace aswell as its expertise in video and broadband technology.  The Company believes that it has overcomemany of the historical obstacles to consumer acceptance of video telephoneproducts by producing a unique combination of superior technology andconsumer-friendly style.

 

We believe WorldGate’svideo phone, which will be marketed under the trademark Ojo, revolutionizes thetechnology approach and will advance video telephony to economic reality.  Ojo employs proprietary image processing andsystem designs to deliver “true to life” synchronized images and sound at anaffordable price to consumers.  We alsobelieve that Ojo is differentiated, both from competitors and from previousefforts at personal video telephony by providing: true to life communication,interoperability with the PSTN (public switched telephone network), wirelessimplementation, easy deployment by cable and DSL operators as well asbusinesses, and all packaged in a highly styled ergonomic design.  In addition, Ojo is further differentiatedversus competition and past video telephony efforts by the development of astate of the art connectivity infrastructure, which leverages the convergenceof latest compression technology, processing power and increased bandwidthavailability to help ensure, enable and maintain dedicated high qualityend-to-end connections.

 

The initial market forvideophones is expected to be comprised of existing high-speed data customers,including both existing DSL and cable modem subscribers.  According to Kagan Worldwide Media (KaganBroadband Technology, May 13, 2003,) by the end of 2008 there will be almost 45million modem subscribers in the United States while the international market isprojected to approach 170 million DSL and DOCSIS modems by 2008.  We believe that these modem users provide afertile and large target market for a quality, low cost videophone offering.  Additional videophone growth is expected tobe derived from new technology adopters and regular long distance communicatorssuch as families and close friends.

 

We also find thebusiness-to-business opportunity attractive as a means to improve interpersonalcommunication and multi-location productivity. According to AMI Partners (Cable and Telecommunications Association forMarketing, Commercial Services Seminar, May 15, 2003,) a leader in Global SMBMarket Intelligence and Business Consulting, there are 7.5 million smallbusinesses in the US, representing 67.5 million employees and 100,000 mediumbusinesses representing 25 million employees who, the Company believes, willfind that videophone offers a more intimate customer experience while reducingtravel costs.  Furthermore AMI Partnersestimate that the number of small and medium businesses in markets outside theUS is approaching 65 million.  US smalland medium companies spent $214 billion on data transmission in 2002, $80billion on PC and networking hardware and peripherals and $78 billion onwireless and paging communication and local and long distance.  This is an area where we expect the cableand DSL industries to concentrate sizable resources to capture incrementalrevenue from this untapped market.  Ourmarketing objective is to have videophones, and Ojo in particular, supplementand hopefully replace ordinary home and business phones worldwide.

 

Ojo“productization” and manufacturing is being undertaken in Asia, to takeadvantage of the base of lower labor, tooling and component costing.  A formal relationship with Mototech, Inc.has already been established for the volume manufacture of Ojo.  Mototech, along with U.S. Robotics and SMCNetworks, are affiliates of the Accton Technology Corporation.  Mototech has earned an enviable reputationfor the design and manufacture of broadband/networking components under severalOEM brands, including those of multiple Fortune 500 companies.  We are currently in the process ofmanufacturing prototype units to demonstrate the functionality and expectedease of use of our Ojo videophone, with customer trials expected to commence inthe first quarter of 2004.  Weanticipate the formal commercial launch of Ojo sometime in the fall of 2004.

 

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WorldGate intends to partner with experienceddistribution partners to market and distribute the Ojo video phone.  We are well along in the process ofnegotiating contracts with these partners to market and distribute the Ojovideo phone. Although we hope to finalize the negotiations with our partnerswithin the next few months, we cannot assure you that we will be able tofinalize these agreements on terms acceptable to us, if at all.  These partners already have skilledorganizations in place as well as extensive established customer relationships.  Such partnerships are intendedto reduce our working capital requirements by minimizing our sales andinventory costs, and provide an entrée to more extensive and acceleratedcoverage than would be permitted by an internal organization.  The name recognition, “shelf-space”potential and technology/product validation provided by such partners are alsoexpected to provide a significant advantage. Through our distribution partners, Ojo will be marketed domestically andinternationally to both the residential and to the business sectors, throughthe standard consumer and business electronics channels as well as throughbroadband providers such as cable and DSL service operators, in a mannersimilar to broadband modems.

 

ITEM 6.  EXHIBITS ANDREPORTS ON FORM 8-K.

 

(a)          Exhibits.

 

The following is alist of exhibits filed as part of this report on Form 10-Q.  Where so indicated by footnote, exhibitswhich were previously filed are incorporated by reference.  For exhibits incorporated by reference, the locationof the exhibit in the previous filing is indicated parenthetically except inthose situations where the exhibit number was the same as set forth below.

 
| **Exhibit No.** |   | **Description**                                                                                                    |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                               |
| 2.1             |   | Asset Purchase Agreement dated as of August 6, 2003  between WorldGate Communications, Inc. and TVGateway, LLC (1) |
| 3.1             |   | Amended and Restated Certificate of Incorporation  (2)                                                             |
| 3.2             |   | Amended and Restated Bylaws (2)                                                                                    |
| 31.1            |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002*                                          |
| 31.2            |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002*                                          |
| 32.1            |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002**                                         |
| 32.2            |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002**                                         |

 

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(1)          Incorporated byreference to Exhibit A to the Company’s Proxy Statement filed on August 26,2003.

(2)          Incorporated byreference to the exhibits to the Company’s Form 10-Q Report for the quarterended March 31, 1999.

*                                         Filedherewith.

**                                  Furnishedherewith

 

(b)         Reportson Form 8-K.

 

During the fiscalquarter ended September 30, 2003, the Company filed the following CurrentReport on Form 8-K:

 

On August 11,2003, a Current Report on Form 8-K was filed, reporting under items 5, 7 and 12that the Company announced its earnings for the fiscal quarter ended June 30,2003 and that the Company announced the sale of its equity interest inTVGateway, LLC back to TVGateway and the signing of a definitive agreement tosell to TVGateway certain interactive television intellectual property rights andrelated assets.

 

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SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934,  the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 

 
|   | WORLDGATE COMMUNICATIONS, INC. |
|--------|--------------------------------|
|   |
| Date:  | November 14, 2003              | /s/ Hal M. Krisbergh |   |
|   |                           | Hal M. Krisbergh |
|   |                           | Chairman and Chief Executive Officer |
|   |                           |   |
| Date:  | November 14, 2003              | /s/ Joel Boyarski |   |
|   |                           | Joel Boyarski |
|   |                           | Vice President and Chief Financial Officer |
|        |                                |  |  |  |

 

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##### **Exhibit Index**

 
| **Exhibit** |   | **Description**                                                                                                    |
|-------------|--------|--------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                               |
| 2.1         |   | Asset Purchase Agreement dated as of August 6, 2003  between WorldGate Communications, Inc. and TVGateway, LLC (1) |
| 3.1         |   | Amended and Restated Certificate of Incorporation  (2)                                                             |
| 3.2         |   | Amended and Restated Bylaws (2)                                                                                    |
| 31.1        |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002*                                          |
| 31.2        |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002*                                          |
| 32.1        |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002**                                         |
| 32.2        |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002**                                         |

 

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(1)                                  Incorporated byreference to Exhibit A to the Company’s Proxy Statement filed on August 26,2003.

 

(2)                                  Incorporated byreference to the exhibits to the Company’s Form 10-Q Report for the quarterended March 31, 1999.

 

*                                         Filed herewith.

 

**                                  Furnishedherewith.

 

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