**DRAFT5/12/05**

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-Q**

 

**Mark One**

**ý**** Quarterly Report Pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934 for the Quarterly Period Ended March 31,2005.**

 

**or**

 

**o**** Transition Report Pursuant to Section 13 or 15(d) ofthe Securities Exchange Act of 1934 for the Transition Period From                  To                  .**

 

**Commission file number:  000-25755**

 

**WORLDGATECOMMUNICATIONS, INC.**

(Exact Name of Registrant as Specified in ItsCharter)

 
| **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, IncludingArea Code)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing 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 May 9, 2005, there were 33,756,436 shares of common stock,par value $.01 per share, outstanding.

 

 

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WORLDGATE COMMUNICATIONS, INC.

 

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED MARCH 31,2005

 

TABLE OF CONTENTS

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

 

2

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PART I.FINANCIAL INFORMATION

 

# ITEM1.  FINANCIAL STATEMENTS

#  

WORLDGATE COMMUNICATIONS, INC.

CONSOLIDATED BALANCE SHEETS

(DOLLARS IN THOUSANDS)

 
| ** **                                                                                                                                                                                           | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **(Unaudited)**          | ** ** | **(Audited)**               | ** ** |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| ASSETS                                                                                                                                                                                               |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                                      |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                            |       | $                        | 9,929      |                        | $          | 11,840 |   |
| Other receivables                                                                                                                                                                                    |       | 12                       |       | 28                          |       |
| Inventory, net                                                                                                                                                                                       |       | 99                       |       | 46                          |       |
| Prepaid and other assets                                                                                                                                                                             |       | 355                      |       | 184                         |       |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Total current  assets                                                                                                                                                                                |       | 10,395                   |       | 12,098                      |       |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Property and equipment                                                                                                                                                                               |       | 3,609                    |       | 3,530                       |       |
| Less: accumulated depreciation and  amortization                                                                                                                                                     |       | (1,985                   | )          | (1,815                      | )          |
| Property and equipment, net                                                                                                                                                                          |       | 1,624                    |       | 1,715                       |       |
| Deposits and other assets                                                                                                                                                                            |       | 9                        |       | 9                           |       |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Total assets                                                                                                                                                                                         |       | $                        | 12,028     |                        | $          | 13,822 |   |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| LIABILITIES  AND STOCKHOLDERS’ DEFICIENCY                                                                                                                                                       |       |                     |       |                        |       |
| Current  liabilities:                                                                                                                                                                                |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                     |       | $                        | 258        |                        | $          | 222 |   |
| Accrued expenses                                                                                                                                                                                     |       | 841                      |       | 951                         |       |
| Accrued compensation and benefits                                                                                                                                                                    |       | 241                      |       | 540                         |       |
| Dividend payable on Preferred Stock                                                                                                                                                                  |       | 82                       |       | 85                          |       |
| Detachable Warrants                                                                                                                                                                                  |       | 3,527                    |       | 5,583                       |       |
| Notes payable                                                                                                                                                                                        |       | 0                        |       | 37                          |       |
| Conversion option on Preferred Stock                                                                                                                                                                 |       | 5,417                    |       | 8,612                       |       |
| Deferred revenues                                                                                                                                                                                    |       | 190                      |       | 369                         |       |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Total liabilities                                                                                                                                                                                    |       | $                        | 10,556     |                        | $          | 16,399 |   |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Commitments                                                                                                                                                                                          |       | $                        | 0          |                        | $          | 0 |   |
| Redeemable Preferred Stock; 6,675 shares  outstanding at March 31, 2005, and 6,775 outstanding at  December 31, 2004                                                                       |       | $                        | 3,382      |                        | $          | 2,995 |   |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Stockholders’ deficiency:                                                                                                                                                                       |       |                     |       |                        |       |
| Preferred Stock, $.01 par value, 13,500,000  shares authorized; shares issued 7,550 at March 31, 2005 and  December 31, 2004                                                               |       | $                        | 0          |                        | $          | 0 |   |
| Common Stock, $.01 par value; 80,000,000  shares authorized, 31,716,189 shares issued and outstanding at March 31,  2005 and 30,865,777 shares issued and outstanding at December 31, 2004 |       | 317                      |       | 308                         |       |
| Additional paid-in capital                                                                                                                                                                           |       | 215,418                  |       | 213,863                     |       |
| Accumulated deficit                                                                                                                                                                                  |       | $                        | (217,645   | )                           | (219,743   | ) |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Total stockholders’ deficiency                                                                                                                                                                  |       | $                        | (1,910     | )                           | $          | (5,572 | ) |
|                                                                                                                                                                                                 |       |                     |       |                        |       |
| Total liabilities and stockholders’  deficiency                                                                                                                                                 |       | $                        | 12,028     |                        | $          | 13,822 |   |

 

The accompanying notes are an integral partof these financial statements.

 

3

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**WORLDGATE COMMUNICATIONS, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Dollars in Thousands, Except per ShareAmounts)**

 
| ** **                                                                                                  | ** ** | **Three Months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Revenues                                                                                                    |       | $                                     | 179        |   | $ | 0 |   |
| Cost of revenues                                                                                            |       | 125                                   |       | 0 |   |
| Gross margins                                                                                               |       | 54                                    |       | 0 |   |
|                                                                                                        |       |                                  |       |   |   |
| Engineering and development (excluding  depreciation and amortization amounts of $66, and $0, respectively) |       | 1,305                                 |       | 800 |   |
| Sales and marketing (excluding depreciation  and amortization amounts of $8 and $0, respectively)           |       | 379                                   |       | 191 |   |
| General and administrative (excluding  depreciation and amortization amounts of $97 and $102, respectively) |       | 847                                   |       | 1,674 |   |
| Depreciation and amortization                                                                               |       | 171                                   |       | 102 |   |
|                                                                                                        |       |                                  |       |   |   |
| Total expenses from continuing operations                                                                   |       | 2,702                                 |       | 2,767 |   |
|                                                                                                        |       |                                  |       |   |   |
| Loss from operating activities of  continuing operations                                                    |       | (2,648                                | )          | (2,767 | ) |
| Interest and other income                                                                                   |       | 66                                    |       | 7 |   |
| Change in fair value of warrants and  conversion options                                                    |       | 5,176                                 |       | 0 |   |
| Interest and other expense                                                                                  |       | 0                                     |       | (1 | ) |
| Income (loss) from continuing operations                                                                    |       | 2,594                                 |       | (2,761 | ) |
| Income from discontinued operations                                                                         |       | 0                                     |       | 23 |   |
| Net income (loss)                                                                                           |       | 2,594                                 |       | (2,738 | ) |
| Accretion on preferred stock and dividends                                                                  |       | (495                                  | )          | 0 |   |
| Net income (loss) available to common  stockholders                                                         |       | $                                     | 2,099      |   | $ | (2,738 | ) |
|                                                                                                        |       |                                  |       |   |   |
| Income (loss) from continuing operations  per common share:                                                 |       |                                  |       |   |   |
| Basic                                                                                                       |       | $                                     | 0.08       |   | $ | (0.10 | ) |
| Fully Diluted                                                                                               |       | $                                     | 0.07       |   | $ | (0.10 | ) |
| Income from discontinued operations per  common share:                                                      |       |                                  |       |   |   |
| Basic                                                                                                       |       | $                                     | 0.00       |   | $ | 0.00 |   |
| Fully Diluted                                                                                               |       | $                                     | 0.00       |   | $ | 0.00 |   |
| Net income (loss) per common share:                                                                         |       |                                  |       |   |   |
| Basic                                                                                                       |       | $                                     | 0.08       |   | $ | (0.10 | ) |
| Fully Diluted                                                                                               |       | $                                     | 0.07       |   | $ | (0.10 | ) |
| Net income (loss) available to common  shareholders per common share:                                       |       |                                  |       |   |   |
| Basic                                                                                                       |       | $                                     | 0.07       |   | $ | (0.10 | ) |
| Fully Diluted                                                                                               |       | $                                     | 0.07       |   | $ | (0.10 | ) |
| Weighted average common shares outstanding:                                                                 |       |                                  |       |   |   |
| Basic                                                                                                       |       | 31,582,115                            |       | 27,236,662 |   |
| Fully Diluted                                                                                               |       | 38,334,855                            |       | 27,236,662 |   |

 

The accompanying notes are an integral partof these financial statements.

 

4

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

 
| ** **                                                                                                                    | ** ** | **Three Months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2005**                               | ** ** | **2004** | ** ** |
|                                                                                                                          |       |                                   |       |   |   |
| Cash flows from operating activities:                                                                                         |       |                                   |       |   |   |
| Net income (loss)                                                                                                             |       | $                                      | 2,594      |   | $ | (2,738 | ) |
| Income from discontinued operations                                                                                           |       | 0                                      |       | (23 | ) |
| Adjustments to reconcile net income (loss)  to net operating cash flow from operating activities from continuing  operations: |       |                                   |       |   |   |
| Depreciation and amortization                                                                                                 |       | 171                                    |       | 102 |   |
| Change in fair value of warrants and  conversion options                                                                      |       | (5,176                                 | )          | 0 |   |
| Non-cash stock based compensation                                                                                             |       | 1                                      |       | 631 |   |
| Changes in operating assets and  liabilities:                                                                                 |       |                                   |       |   |   |
| Other receivable                                                                                                              |       | 16                                     |       | 0 |   |
| Inventory                                                                                                                     |       | (53                                    | )          | 0 |   |
| Prepaid and other assets                                                                                                      |       | (209                                   | )          | 261 |   |
| Accounts payable                                                                                                              |       | 36                                     |       | (95 | ) |
| Accrued expenses                                                                                                              |       | (110                                   | )          | 111 |   |
| Accrued compensation and benefits                                                                                             |       | (299                                   | )          | (39 | ) |
| Other                                                                                                                         |       | (179                                   | )          | (7 | ) |
| Net operating cash flow from continuing  operations                                                                           |       | (3,208                                 | )          | (1,797 | ) |
| Net operating cash flow from discontinued  operations                                                                         |       | 0                                      |       | 57 |   |
| Net cash used in operating activities                                                                                         |       | (3,208                                 | )          | (1,740 | ) |
|                                                                                                                          |       |                                   |       |   |   |
| Cash flows from investing activities of  continuing operations:                                                               |       |                                   |       |   |   |
| Capital expenditures                                                                                                          |       | (80                                    | )          | (8 | ) |
| Net cash used in investing activities                                                                                         |       | (80                                    | )          | (8 | ) |
|                                                                                                                          |       |                                   |       |   |   |
| Cash flows from financing activities of  continuing operations:                                                               |       |                                   |       |   |   |
| Proceeds from issuance of common stock                                                                                        |       | 12                                     |       | 1,406 |   |
| Proceeds from the exercise of stock options                                                                                   |       | 204                                    |       | 105 |   |
| Proceeds from the exercise of stock rights  and warrants                                                                      |       | 1,161                                  |       | 320 |   |
| Net cash provided by financing activities                                                                                     |       | 1,377                                  |       | 1,831 |   |
| **Net (decrease) increase in cash and  equivalents**                                                                          |       | (1,911                                 | )          | 83 |   |
| **Cash and cash equivalents, beginning of  period**                                                                           |       | 11,840                                 |       | 3,365 |   |
| **Cash and cash equivalents, end of period**                                                                                  |       | $                                      | 9,929      |   | $ | 3,448 |   |
| Non-cash financing activities:                                                                                                |       |                                   |       |   |   |
| Conversion of preferred stock to common  stock                                                                                |       | $                                      | 100        |   | $ | 0 |   |

 

The accompanying notes are an integral partof these financial statements.

 

5

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WORLDGATE COMMUNICATIONS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS

 

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

(Unaudited)

 

1.                                       Basisof Presentation.

 

The unauditedfinancial statements of WorldGate Communications, Inc. (“WorldGate” or the“Company”) for the three months ended March 31, 2005 and March 31,2004 presented herein have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission for quarterly reports on Form 10-Q.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to such rules andregulations.  These financial statementsshould be read in conjunction with the financial statements for the year ended December 31,2004 and the notes thereto included in the Company’s Annual Report on Form 10-K.

 

The financial information in this Report reflects, in the opinion ofmanagement, all adjustments of a normal recurring nature necessary to presentfairly the results for the interim period. Quarterly operating results are notnecessarily indicative of the results that may be expected for the year ending December 31,2005.

 

2.                                       Liquidityand Going Concern Considerations.

 

As of March 31,2005 the Company had cash and cash equivalents of $9,929. The operating cashusage from continuing operations for the three months ended March 31, 2005was $3,208. The funds we received as a result of private placements of oursecurities on December 1, 2003, December 4, 2003, January 21,2004, April 22, 2004, June 23, 2004 and December 15, 2004, havepermitted us to fund the development of our new business.

 

In December 2003and January 2004, WorldGate received proceeds from investments aggregating$3,100 by certain institutional investors. These investors purchased anaggregate of 3,000,000 shares of newly issued common stock. The investors alsoreceived a right, for a limited period of time, to purchase additional sharesof up to 20% of the common stock purchased by the investors in their investment,at the same price as their investment, and five-year warrants to purchase up to30% of the common stock purchased by the investors in their investment, at anexercise price equal to a twenty-five percent premium to their purchase pricefor the investment. The purchase price for the 2 million shares purchased inthe December 2003 transactions were $0.80 per share, with the warrantshaving a $1.00 per share exercise price. The purchase price for the 1 millionshares purchased in the January 2004 transaction was $1.50 per share, withthe warrants having a $1.875 per share exercise price. All additionalinvestment rights associated with the December 2003 transaction wereexercised during January and February of 2004, resulting in anincremental investment of $320. All additional investment rights associatedwith the January 2004 transaction were exercised in May 2004,resulting in an incremental investment of $300. A portion of the warrants andadditional investment right warrants associated with the December 2003 andJanuary 2004 transactions were exercised in December 2004 and January 2005,resulting in an incremental investment of $925.

 

In June 2004,WorldGate completed a private placement of 7,550 shares of its Series APreferred Stock at a stated value of $1000 per share, which preferred stock isconvertible into the Company’s common stock at a conversion price of $2.35 pershare; five-year warrants to purchase up to 803,190 shares of our common stockat an exercise price of $2.69 per share; and five-year warrants to purchase upto 803,190 shares of our common stock at an exercise price of $3.14 per share.The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,606,383 additional shares of common stock at $3.14a share. In November and December 2004 and January 2005, 875preferred shares were converted to common stock. In April 2005, anadditional 4,250 preferred shares were converted to common stock. In December 2004and January 2005, 1,606,383 additional investment rights were exercised,resulting in an incremental investment of $5,044.

 

The Companyhas $10,556 of liabilities and its assets are not pledged as collateral as of March 31,2005. These liabilities include $9,026 related to the Company’s private placementof Series A Preferred Stock and $190 of advanced funds received fromMotorola for future shipments of video phones in accordance with the Agreementsigned in April 2004.

 

6

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The Company continues to evaluate possibilities to obtain additionalfinancing through public or private equity or debt offerings, bank debtfinancing, asset securitizations, or from other sources.  Such additional financing would be subject tothe risk of availability, may be dilutive to our shareholders, or could imposerestrictions on operating activities. There can be no assurance that thisadditional financing will be available on terms acceptable to the Company, ifat all. The Company has limited capacity to further reduce its workforce andscale back on capital and operational expenditures to decrease its cash usagegiven the measures it has already taken to reduce staff and expenses.

 

Theconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities and commitments in the normal course of business.  Therefore, the financial statements do notinclude any adjustments relating to the Company’s ability to operate as a goingconcern.  The appropriateness of usingthe going concern basis in the future, however, will be dependent upon theCompany’s ability to address its liquidity needs as described above.  There is no assurance that the Company willbe able to address its liquidity needs through the measures described above onacceptable terms and conditions, or at all, and accordingly, there issubstantial doubt about the Company’s ability to continue as a goingconcern.  The independent auditors’report for the year ended December 31, 2004 includes an explanatoryparagraph stating that because the Company has suffered recurring losses fromoperations and had a net accumulated deficiency of $220 million, those issuesraise substantial doubt about the Company’s ability to continue as a goingconcern.

 

3.                                       RecentAccounting Pronouncement.

 

In November 2004, the FASB issued SFAS no. 151 “Inventory Costs”which amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,” toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that under somecircumstances, items such as idle facility expense, excessive spoilage, doublefreight and rehandling costs may be so abnormal as to require treatment ascurrent period charges.”  SFAS No. 151requires that those items be recognized as current-period charges regardless ofwhether they meet the criterion of “so abnormal.”  In addition, SFAS No. 151 requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  SFAS No. 151 shall be effective forinventory costs incurred during fiscal years beginning after June 15,2005.  Earlier application is permittedfor inventory costs incurred during fiscal years beginning after the date SFAS No. 151was issued.  SFAS No. 151 shall beapplied prospectively.  The Company doesnot expect the adoption of SFAS No. 151 to have a material effect on itsconsolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 153 “Exchanges ofNonmonetary Assets” which amends APB Opinion No. 29, “Accounting forNonmonetary Transactions.”  APB No. 29is based on the principle that exchanges of nonmonetary assets should bemeasured based on the fair value of the assets exchanged.  The guidance in that Opinion, however,included certain exceptions to that principle. SFAS No. 153 amends APB No. 29 to eliminate the exception fornonmonetary exchanges of similar productive assets and replaces it with ageneral exception for exchanges of nonmonetary assets that do not havecommercial substance.  A nonmonetaryexchange has commercial substance if the future cash flows of the entity are expectedto change significantly as a result of the exchange.  SFAS No. 153 shall be effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005.  Earlier application is permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after thedate SFAS No. 153 was issued.  SFAS No. 153shall be applied prospectively.  TheCompany does not expect the adoption of SFAS No. 153 to have a materialeffect on its consolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123 (R), “Share-BasedPayment” that focuses primarily on accounting for transactions in which anentity obtains employee services in share-based payment transactions. Thisstatement replaces SFAS No. 123, “Accounting for Stock-Based Compensation”,and supersedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.” Beginning with our quarterly period that begins after June 15,2005, we will be required to expense the fair value of employee stock optionsand similar awards. As a public company, we are allowed to select from twoalternative transition methods, each having different reporting implications.The impact of SFAS No. 123R has not been determined at this time.

 

In March 2005, the Financial Accounting Standards Board (FASB)issued Interpretation No. 47 (FIN 47) to clarify the guidance included inSFAS No. 143, “Accounting for Asset Retirement Obligations”.  FIN 47 requires companies to recognize aliability for the fair value of a legal obligation to perform asset retirementactivities that

 

7

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are conditional on a future event if the amount can be reasonablyestimated.  If amounts cannot bereasonably estimated, certain disclosures will be required about theunrecognized asset retirement obligations. The interpretation is required to be adopted in the first quarter of2006.  We are currently evaluating theinterpretation to determine the effect on our financial statements and relateddisclosures.

 

4.                                       Inventories.

 

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

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

 

5.                                       Stock-BasedCompensation.

 

The Companyaccounts for stock-based compensation in accordance with Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees,” asamended by SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure”.

 

The Company appliesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” and related interpretations in accounting for its plans, andaccordingly, no compensation cost has been recognized for the Company’s fixedstock based compensation.  Hadcompensation cost been determined consistent with SFAS No. 123, as amendedby SFAS No. 148, the Company’s net loss would have been increased to thefollowing pro forma amounts:

 
| ** **                                                                                                                          | ** ** | **For the Three Month Period  Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**                                             | ** ** | **2004** | ** ** |
|                                                                                                                                |       |                                                 |       |   |   |
| Income (loss) from continuing operations                                                                                            |       | $                                                    | 2,594      |   | $ | (2,761 | ) |
| Income from discontinued operations                                                                                                 |       | 0                                                    |       | 23 |   |
| Net income (loss)                                                                                                                   |       | 2,594                                                |       | (2,738 | ) |
| Accretion on preferred stock and dividends                                                                                          |       | (495                                                 | )          | 0 |   |
| Net income (loss) available to common  shareholders, as reported                                                                    |       | 2,099                                                |       | (2,738 | ) |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects                  |       | 0                                                    |       | 0 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of tax of $0 |       | (194                                                 | )          | (2,249 | ) |
| Pro forma net income (loss)                                                                                                         |       | $                                                    | 1,905      |   | $ | (4,987 | ) |
|                                                                                                                                |       |                                                 |       |   |   |
| Net income (loss) per share:                                                                                                        |       |                                                 |       |   |   |
| Income (loss) from continuing operations:                                                                                           |       |                                                 |       |   |   |
| Basic                                                                                                                               |       | $                                                    | 0.08       |   | $ | (0.10 | ) |
| Fully Diluted                                                                                                                       |       | $                                                    | 0.07       |   | $ | (0.10 | ) |
| Income from discontinued operations:                                                                                                |       |                                                 |       |   |   |
| Basic                                                                                                                               |       | $                                                    | 0.00       |   | $ | 0.00 |   |
| Fully Diluted                                                                                                                       |       | $                                                    | 0.00       |   | $ | 0.00 |   |
| Net income (loss):                                                                                                                  |       |                                                 |       |   |   |
| Basic                                                                                                                               |       | $                                                    | 0.08       |   | $ | (0.10 | ) |
| Fully Diluted                                                                                                                       |       | $                                                    | 0.07       |   | $ | (0.10 | ) |
| Net income (loss) available to common  shareholders:                                                                                |       |                                                 |       |   |   |
| Basic                                                                                                                               |       | $                                                    | 0.07       |   | $ | (0.10 | ) |
| Fully Diluted                                                                                                                       |       | $                                                    | 0.07       |   | $ | (0.10 | ) |
| Net income (loss) available to common  shareholders – pro forma:                                                               |       |                                                 |       |   |   |
| Basic                                                                                                                               |       | $                                                    | 0.06       |   | $ | (0.18 | ) |
| Fully Diluted                                                                                                                       |       | $                                                    | 0.06       |   | $ | (0.18 | ) |

 

8

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Such pro forma disclosures may not be representative of futurecompensation expense because options vest over several years and additionalgrants are made each year.

 

6.                                       Commitmentsand Contingencies.

 

*Leases*

 

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

 

* Significant Agreements and Transactions*

 

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

 

Revenues, included in discontinuedoperations, were recognized from such investors of approximately $0 and $1,respectively, for the three months ended March 31, 2005 and 2004. Accountsreceivable from such investors were $0 as of March 31, 2005 and December 31,2004.

 

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

 

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7.                                       NetLoss per Share.

 

Basic and diluted net income (loss) per common share is computed bydividing the net income (loss) available to common stockholders for the periodby the weighted average number of shares of common stock outstanding during theperiod.  The calculation of diluted netincome (loss) per common share excludes potential common shares if the effectis antidilutive.  Potential common sharescomprise shares of common stock issuable upon the exercise of stock options andwarrants.  The number of potential commonshares which would have been assumed to be converted in the periods ended March 31,2005 and 2004 and have a dilutive effect if the Company had income fromcontinuing operations, or if the options’ exercise price was less than theaverage market price of the common shares, is 862,250 and 8,065,111,respectively.

 

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

#  

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

 

We may from time to time make written or oral forward-lookingstatements, including those contained in the following Management’s Discussionand Analysis of Financial Condition and Results of Operations.  The words “estimate,” “project,” “believe,” “intend,”“expect,” and similar expressions are intended to identify forward-lookingstatements, although not all forward-looking statements contain theseidentifying words.  In order to takeadvantage of the “safe harbor” provisions of the Private Securities LitigationReform Act of 1995, we are hereby identifying certain important factors thatcould cause our actual results, performance or achievement to differ materiallyfrom those that may be contained in or implied by any forward-looking statementmade by or on our behalf.  The factors,individually or in the aggregate, that could cause such forward-lookingstatements not to be realized include, without limitation, the following: (1) difficultyin developing and implementing marketing and business plans, (2) industrycompetition factors and other uncertainty that a market for our products willdevelop, (3) challenges associated with HSD operators (including,uncertainty that they will offer our products, inability to predict the mannerin which they will market and price our products and existence of potential conflictsof interests and contractual limitations impeding their ability to offer ourproducts), (4) continued losses, (5) difficulty or inability to raiseadditional financing on terms acceptable to us, (6) departure of one ormore key persons, (7) delisting of our Common Stock from the NASDAQ SmallCap Market, (8) changes in regulatory requirements, and (9) otherrisks identified in our filings with the Securities and ExchangeCommission.  We caution you that theforegoing list of important factors is not intended to be, and is not,exhaustive.  We do not undertake toupdate any forward-looking statement that may be made from time to time by oron our behalf.

 

Results of Operations:

 

Critical Accounting Policies and Estimates.

 

The consolidated financial statements are prepared in conformity withaccounting principles generally accepted in the United States.  The preparation of these financial statementsrequired management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

The significant accounting policies of the Company are described in thenotes to the consolidated financial statements included in the annual report onForm 10-K.  Judgments and estimatesof uncertainties are required in applying the Company’s accounting policies inmany areas.  Following are some of theareas requiring significant judgments and estimates:  revenue recognition, accounts receivable,inventories, and cash flow and valuation assumptions in performing assetimpairment tests of long-lived assets.

 

Discontinued Operations

 

During the first quarter of 2004, we transitioned from the business ofdeveloping and selling interactive television, or ITV, technology, products andservices for use in conjunction with cable TV broadband networks (the “ITVbusiness”) to the development of our video phone products as our primarybusiness focus. During the three months ended March 31, 2004, the Companyhad revenues from discontinued operations of $82. Cost of

 

10

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revenues for the three months ended March 31, 2004 were $43.Concurrently, operating expenses from discontinued operations were $16 for thethree months ended March 31, 2004. For the three months ended March 31,2004, other income and other expense relating to discontinued operations were$13. There were no revenues, cost of revenues, operating expenses, and otherincome and other expenses from discontinued operations during the three monthsended March 31, 2005.

 

The information in our quarter-to-quarter comparisons below representsonly our results from continuing operations.

 

Three Months Ended March 31, 2005 and March 31, 2004

 

Revenues.

 

Revenues.Revenues from continuing operations for the three months ended March 31,2005 were $179. These revenues represent initial deliveries of video phones forpre-market testing. There were no revenues from continuing operations duringthe three months ended March 31, 2004.

 

Costs and Expenses.

 

Cost ofRevenues. The cost of revenues from continuing operations consisted of productand delivery costs relating to the initial deliveries of video phones was $125for the three months ended March 31, 2005. There were no costs of revenuesfrom continuing operations during the three months ended March 31, 2004.

 

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

 

Sales andMarketing.  Sales and marketing expensesconsist primarily of compensation, attendance at conferences and trade shows,travel costs, promotions and other marketing programs related to theintroduction of the Company’s video phone product.  Sales and marketing costs were $379 for thethree months ended March 31, 2005, compared with $191 for the three monthsended March 31, 2004.  This increaseof $188, or 98%, reflects the increased effort of staff, and related marketingand promotional expenditures associated with the launch of the Company’s videophone product.

 

General andAdministrative.  General andadministrative expenses consist primarily of expenditures for administration,office and facility operations, finance and general management activities,including legal, accounting and professional fees.  General and administrative expenses were $847for the three months ended March 31, 2005, compared with $1,674 for thethree months ended March 31, 2004. This decrease of $827, or 49%, is primarilyattributable to certain non-recurring expenses incurred during the three monthsended March 31, 2004 that were not incurred during the three months ended March 31,2005. These expenses consisted of a non cash charge of $631 reflecting a BlackScholes estimate of the value of the warrants issued as part of the privateplacement of the Company’s stock to certain institutional investors in January 2004,an expense for sales taxes of $125, and a $242 reduction in rent expense fromthe $303 recorded during the three months ended March 31, 2004 to $61recorded for the three months ended March 31, 2005.

 

Interest andOther Income and Interest Expense. Interest and other income and interestexpense consist of interest earned on cash and cash equivalents, and interestexpense on short-term debt. Interest and other income increased from $7 for thethree months ended March 31, 2004 to $66 for the three months ended March 31,2005, primarily due to additional interest income earned on a higher level ofinvested funds. During the three months ended March 31, 2005, the Companyearned interest on average cash balances of approximately $11,026 and incurredinterest expense related to its insurance financing. In comparison, during thethree months ended March 31, 2004 the Company earned interest on averagecash balances of approximately $3,878 and incurred interest expense related toits insurance financing.

 

Income Taxes.  The Company has incurred net operating lossessince inception and accordingly had no income taxes and has not recorded anyincome tax benefit for those losses.

 

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Liquidity and Capital Resources.

 

As of March 31,2005, our primary source of liquidity consisted of cash and cash equivalentsthat are highly liquid, are of high quality investment grade and havematurities of less than 90 days.

 

At March 31,2005, we had cash and cash equivalents of $9,929 (and no short-terminvestments) as compared to cash and equivalents of $11,840 (and no short-terminvestments) at December 31, 2004. Net cash used in continuing operations was $3,208 for the three monthsended March 31, 2005, as compared to $1,797 used for the same period in2004. This increase in net cash used for continuing operations was primarilyattributable to the Company’s increase in expenditures related to the videophone business.  The Company recorded baddebt expense in the amount of $16 from discontinued operations during the threemonths ended March 31, 2004 to reflect its current assessment of thecollectability of certain receivables.

 

Cash providedby financing activities from continuing operations during the three monthsended March 31, 2005, totaled $1,377 compared to $1,831 provided duringthe same period in 2004. Capital expenditures were $80 and $8 for the threemonths ended March 31, 2005 and 2004, respectively.

 

Operations andLiquidity.

 

To date, the Company hasfunded operations primarily through private sales of equity securities andthrough an initial public offering of common stock in April 1999.  As of March 31, 2005 the Company hadcash, and cash equivalents of $9,929. The operating cash usage from continuing operations for the three monthsended March 31, 2005 and 2004 was $3,208 and $1,797, respectively. As of March 31,2005 we have no outstanding debt and our assets are not pledged as collateral.From time to time opportunities arise for us to obtain additional financingthrough public or private equity or debt offerings, bank debt financing, assetsecuritizations, or from other sources. Such additional financing, if obtained, could provide additional cashfor working capital, accelerated engineering and development activities andpotential acquisitions. While we continue to evaluate such opportunities, itshould be noted that any additional financing may be dilutive to ourshareholders, or could impose restrictions on operating activities.Furthermore, there can be no assurance that any additional financing willremain available to us on terms acceptable, if at all.

 

With the private placement ofour common stock, together with additional rights and warrants, aggregate grossproceeds received of $1.5 million in January 2004, the private placementof our common stock in April 2004 providing proceeds of $1.0 million, the June 2004private placement of our redeemable preferred stock providing proceeds of $7.55million, the December 2004 private placement of common stock of $500, theexercise of additional investment rights and warrants of $6.8 million inJanuary, February, May and December 2004 and January and February 2005,and the exercise by employees and former employees of options throughout 2004and January and February 2005 providing aggregate proceeds of $900;we project we will have sufficient funding to continue operations through 2005,without additional financing, and assuming no impact from sales. We do howeverhave an obligation to pay dividends on, as well as to redeem, our outstanding Series APreferred Stock upon maturity, or at the earlier option of a holder of thesesecurities. Under certain limited circumstances we may be forced to make suchpayments and redemptions with cash instead of shares of our common stock. Insuch event our ability to fund continuing operations would be negativelyimpacted. The report of the registered independent public accounting firm forthe year ended December 31, 2004 included an explanatory paragraph statingthat because the Company had suffered recurring losses from operations and hada net accumulated deficiency of $220 million, these issues raised substantialdoubt about the Company’s ability to continue as a going concern. No assurancescan be given that sufficient sales, if any, will materialize, or that, ifpursued, a financing transaction can be consummated. We however remain hopefulthat sales will materialize and/or that sufficient funding can be developedthrough ongoing operations or additional financings to continue our operations.

 

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#  

# ITEM3.     QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Interest RateRisk.  Our exposure to market riskrelated to changes in interest rates relates primarily to our investmentportfolio.  We invest in instruments thatmeet high credit quality standards, and we limit the amount of credit exposurewith respect to any one issue, issuer and type of investment.

 

As of March 31,2005, the Company’s cash and cash equivalents were $9,929, having a maturity ofless than 90 days, 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 the portfolio.Management estimates that had the average yield of our investments decreased by100 basis points, our interest income for the three months ended March 31,2005 would have decreased by approximately $24. This estimate assumes that thedecrease occurred on the first day of 2005 and reduced the yield of eachinvestment instrument by 100 basis points. The impact on our future interest income of future changes in investmentyields will depend largely on our total investments.

 

ForeignCurrency Exchange Risk.  Although wetransact business in various foreign countries, the principal portion of ourbusiness is in the United States and substantially all of our revenues andcosts to date have been denominated in U.S. dollars.  Although our agreement with Mototech, ourcontract manufacturer in Taiwan, is denominated in U.S. dollars, their materialacquisition costs are subject to exchange rate changes that could impact ourproduct costs.

 

# ITEM 4.     CONTROLS ANDPROCEDURES.

#  

As of the endof the period covered by this Form 10-Q, the Company’s principal executiveand principal financial officers, including its chief executive officer andchief financial officer, conducted an evaluation of the effectiveness of theCompany’s disclosure controls and procedures. Based on that evaluation, thechief executive officer and chief financial officer concluded that a “significantdeficiency”, that is considered to be a “material weakness,” (as defined underthe standards established by the American Institute of Certified PublicAccountants) existed with respect to the Company’s reporting of complextransactions. To address this material weakness, we have engaged outsideexperts to provide counsel and guidance in areas where we cannot economicallymaintain the required expertise internally (e.g., with the appropriateclassifications and treatments of complex and non-routine transactions).

 

With theexception of this condition, the chief executive officer and chief financialofficer concluded that our disclosure controls and procedures are reasonablydesigned and effective to alert them on a timely basis to material informationrelating to us required to be included in our reports filed or submitted underthe Exchange Act. Except as identified above, there have been no changes to ourinternal control over financial reporting that occurred during the quarterended March 31, 2005, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

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PART II.OTHER INFORMATION

 

(Dollar Amounts are in Thousands, Except perShare Amounts)

 

# ITEM 1.     LEGAL PROCEEDINGS.

#  

None

 

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

#  

On June 24,2004, we completed a private placement that resulted in the issuance of 7,550shares of Series A preferred stock at a sale price of $1000 per share(which preferred stock is convertible into our common stock at a conversionprice of $2.35 per share), five-year warrants to purchase up to 803,190 sharesof our common stock at an exercise price of $2.69 per share, and five-yearwarrants to purchase up to 803,190 shares of our common stock at an exerciseprice of $3.14 per share. The investors also received an additional investmentright, for a limited period of time, to purchase 1,606,383 additional shares ofcommon stock shares at $3.14 a share. The June 2004 private placementresulted in gross proceeds to our Company of $7,550,000. From November 2004through April 15, 2005, holders of the Series A preferred stock fromthe June 24, 2004 private placement have converted 5,125 of their shares,resulting in the issuance of 2,180,851 shares of our common stock based uponthe $2.35 conversion price. Furthermore, between January 2004 and April 18,2005, the investors from the 2003 and 2004 private placements have exercisedwarrants and additional investment rights resulting in additional grossproceeds of approximately $7,089,000 and the issuance of 3,134,048 shares.

 

# ITEM3.     DEFAULTSUPON SENIOR SECURITIES.

#  

None.

 

# ITEM4.     SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.

#  

None.

 

# ITEM 5.     OTHER INFORMATION.

#  

None.

#  

14

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# ITEM6.  EXHIBITS AND REPORTS ON FORM 8-K.

 

(a)          Exhibits.

 

The following is a list of exhibits filed as part of this report on Form 10-Q.  Where so indicated by footnote, exhibits thatwere previously filed are incorporated by reference.  For exhibits incorporated by reference, thelocation of the exhibit in the previous filing is indicated parentheticallyexcept in those situations where the exhibit number was the same as set forthbelow.

** **
| **Exhibit** | ** ** | **Description**                                                                                                                                       |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Amended and Restated Certificate of  Incorporation (3)                                                                                                |
| 3.2         |       | Amended and Restated Bylaws (1)                                                                                                                       |
| 3.3         |       | Certificate of Amendment to Certificate of  Incorporation, dated October 18, 2004 (3)                                                            |
| 3.4         |       | Certificate of Designations, Preferences  and Rights of the Series A Convertible Preferred Stock of the Company  dated June 23, 2004 (2)    |
| 24          |       | Power of Attorney (included in signature  page)                                                                                                       |
| 31.1        |       | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(a)*                                                                            |
| 31.2        |       | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(a)*                                                                            |
| 32.1        |       | Certification of Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of  the Sarbanes-Oxley Act of 2002* |
| 32.2        |       | Certification of Chief Financial Officer Pursuant  to 18 U.S.C. Section 1350, as adopted by Section 906 of the  Sarbanes-Oxley Act of 2002* |

 

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* Filed herewith

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

(2) Incorporated by reference to the exhibits to the Company’sProxy Statement to shareholders filed September 30, 2004.

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

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of1934,  the registrant has duly causedthis report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |              | WORLDGATE COMMUNICATIONS, INC.                                                           |
|--------|-------------------|------------------------------------------------------------------------------------------|
|   |              |                                                                                     |
|   |              |                                                                                     |
| Date:  | May 16, 2005 | /s/ Hal M. Krisbergh                                                                     |   |
|   |              | Hal M. Krisbergh                                                                         |
|   |              | Chairman and Chief Executive Officer  (Principal Executive Officer)                      |
|   |              |                                                                                     |
|   |              |                                                                                     |
| Date:  | May 16, 2005 | /s/ Joel Boyarski                                                                        |   |
|   |              | Joel Boyarski                                                                            |
|   |              | Vice President and Chief Financial Officer  (Principal Financial and Accounting Officer) |
|        |                   |                                                                                          |  |  |

 

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