**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,DC 20549**

 

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**Amendmentno. 1 to FORM10-Q**

 

**Mark One**

** **

**ý****         Quarterly Report Pursuantto Section 13 or 15(d) of the Securities Exchange Act of 1934 for the QuarterlyPeriod Ended June 30, 2004.**

 

**or**

 

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

 

 

**Commissionfile number:  000-25755**

 

 

 

**WORLDGATE COMMUNICATIONS, INC.**

(ExactName of Registrant as 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’sTelephone Number, Including Area Code)

 

Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes ý No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).   Yes o No ý

 

As of August 6, 2004, there were 28,225,590shares of common stock, par value $.01 per share, outstanding.

 

 

 

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WORLDGATECOMMUNICATIONS, INC.

 

QUARTERLYREPORT ON FORM 10-QAFOR THE THREE MONTHS ENDED JUNE 30, 2004

 

TABLE OF CONTENTS
| PART II. 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. Changes In 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. FINANCIALINFORMATION

# ITEM1.  FINANCIAL STATEMENTS

 

**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED BALANCE SHEETS**

**(Dollars in Thousands)**

 
| ** **                                                                                                                                                                                | ** ** | **June 30,**                    | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                | ** ** | **2004**                        | ** ** | **2003**         | ** ** |
| ** **                                                                                                                                                                                | ** ** | **(Unaudited and as restated)** | ** ** | **(Audited)**    | ** ** |
| ASSETS                                                                                                                                                                                    |       |                            |       |             |       |
| Current assets:                                                                                                                                                                           |       |                            |       |             |       |
| Cash and cash equivalents                                                                                                                                                                 |       | $                               | 10,306     |             | $          | 3,365 |   |
| Accounts receivable, less allowance for doubtful accounts of $0 at  June 30, 2004 and $381 at December 31, 2003                                                                           |       | 102                             |       | 146              |       |
| Prepaid and other assets                                                                                                                                                                  |       | 348                             |       | 199              |       |
| Total current assets                                                                                                                                                                      |       | 10,756                          |       | 3,710            |       |
|                                                                                                                                                                                      |       |                            |       |             |       |
| Property and equipment                                                                                                                                                                    |       | 2,635                           |       | 2,605            |       |
| Less: accumulated depreciation and amortization                                                                                                                                           |       | (1,541                          | )          | (1,338           | )          |
| Property and equipment, net                                                                                                                                                               |       | 1,094                           |       | 1,267            |       |
| Deposits and other assets                                                                                                                                                                 |       | 0                               |       | 140              |       |
| Total assets                                                                                                                                                                              |       | $                               | 11,850     |             | $          | 5,117 |   |
|                                                                                                                                                                                      |       |                            |       |             |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                 |       |                            |       |             |       |
| Current Liabilities:                                                                                                                                                                      |       |                            |       |             |       |
| Accounts payable                                                                                                                                                                          |       | $                               | 146        |             | $          | 440 |   |
| Accrued expenses                                                                                                                                                                          |       | 1,072                           |       | 594              |       |
| Accrued compensation and benefits                                                                                                                                                         |       | 278                             |       | 238              |       |
| Dividend payable on Preferred Stock                                                                                                                                                       |       | 7                               |       | 0                |       |
| Detachable warrants                                                                                                                                                                       |       | 1,723                           |       | 0                |       |
| Notes payable                                                                                                                                                                             |       | 256                             |       | 0                |       |
| Conversion option on Preferred Stock                                                                                                                                                      |       | 2,247                           |       | 0                |       |
| Deferred revenues                                                                                                                                                                         |       | 300                             |       | 0                |       |
| Deferred rent credit                                                                                                                                                                      |       | 150                             |       | 30               |       |
| Total current liabilities                                                                                                                                                                 |       | 6,179                           |       | 1,302            |       |
|                                                                                                                                                                                      |       |                            |       |             |       |
| Deferred rent credit                                                                                                                                                                      |       | 0                               |       | 135              |       |
| Total liabilities                                                                                                                                                                         |       | $                               | 6,179      |             | $          | 1,437 |   |
| Redeemable Preferred Stock                                                                                                                                                                |       | $                               | 2,816      |             | $          | 0 |   |
|                                                                                                                                                                                      |       |                            |       |             |       |
| Stockholders’ equity:                                                                                                                                                                |       |                            |       |             |       |
| Preferred Stock, $.01 par value, 13,500,000 shares authorized                                                                                                                             |       | $                               | 0          |             | $          | 0 |   |
| Redeemable Preferred Stock, $.01 par value, shares authorized, 7,550  shares issued and outstanding at June 30, 2004, and 0 outstanding at December  31, 2003                             |       | 0                               |       | 0                |       |
| Common stock, $.01 par value, 50,000,000 shares authorized,  28,225,590 shares issued and outstanding at June 30, 2004 and 25,706,843  shares issued and outstanding at December 31, 2003 |       | 282                             |       | 262              |       |
| Additional paid-in capital                                                                                                                                                                |       | 206,329                         |       | 202,466          |       |
| Unearned compensation                                                                                                                                                                     |       | (400                            | )          | (400             | )          |
| Accumulated deficit                                                                                                                                                                       |       | (203,356                        | )          | (198,643         | )          |
| Less Treasury Stock, at cost — 500,000 shares as of December 31, 2003                                                                                                                |       | 0                               |       | (5               | )          |
| Total stockholders’ equity                                                                                                                                                           |       | 2,855                           |       | 3,680            |       |
| Total liabilities and stockholders’ equity                                                                                                                            |       | $                               | 11,850     |             | $          | 5,117 |   |
|                                                                                                                                                                                           |            |                                 |            |                  |            |  |  |  |

 

 

Theaccompanying notes are an integral part of these financial statements.

 

 

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**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(Dollarsin Thousands, Except per Share Amounts)**

 
| ** **                                                                                                                                                                                                                                         | ** ** | **Three  Months ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                                                                                                                         | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                                                                                                                               |       | **(As restated)**                     |       |                               |       | **(As restated)** |   |   |   |
| Revenues from operating activities of continuing operations                                                                                                                                                                                        |       | $                                     | 0          |                               | $          | 0 |   | $ | 0 |   | $ | 0 |   |
| Engineering and development (excluding depreciation and amortization  amounts of $102 and $76 for the three months ended June 30, 2004 and 2003,  respectively, and $204 and $220 for the six months ended June 30, 2004 and  2003, respectively). |       | 799                                   |       | 727                                |       | 1,599 |   | 1,263 |   |
| Sales and marketing (excluding depreciation and amortization amounts  of $0 and $24 for the three months ended June 30, 2004 and 2003,  respectively, and $0 and $50 for the six months ended June 30, 2004 and 2003,  respectively).              |       | 408                                   |       | 139                                |       | 599 |   | 225 |   |
| General and administrative (excluding depreciation and amortization  amounts of $0 and $83 for the three months ended June 30, 2004 and 2003,  respectively, and $0 and $167 for the six months ended June 30, 2004 and  2003, respectively).      |       | 1,001                                 |       | 506                                |       | 2,674 |   | 697 |   |
| Depreciation and amortization                                                                                                                                                                                                                      |       | 102                                   |       | 0                                  |       | 204 |   | 0 |   |
| Total costs and expenses from operating activities from continuing  operations                                                                                                                                                                     |       | 2,310                                 |       | 1,372                              |       | 5,076 |   | 2,185 |   |
| Loss from operating activities of continuing operations                                                                                                                                                                                            |       | (2,310                                | )          | (1,372                             | )          | (5,076 | ) | (2,185 | ) |
| Interest and other income                                                                                                                                                                                                                          |       | 13                                    |       | 0                                  |       | 20 |   | 0 |   |
| Change  in fair value of warrants and conversion options                                                                                                                                                                                           |       | 348                                   |       | 0                                  |       | 348 |   | 0 |   |
| Interest and other expense                                                                                                                                                                                                                         |       | (2                                    | )          | 0                                  |       | (3 | ) | 0 |   |
| Loss from continuing operations                                                                                                                                                                                                                    |       | (1,951                                | )          | (1,372                             | )          | (4,711 | ) | (2,185 | ) |
| Income (loss) from discontinued operations                                                                                                                                                                                                         |       | 7                                     |       | (1,627                             | )          | 29 |   | (2,699 | ) |
|                                                                                                                                                                                                                                               |       |                                  |       |                               |       |   |   |   |   |
| Net loss                                                                                                                                                                                                                                           |       | (1,944                                | )          | (2,999                             | )          | (4,682 | ) | (4,884 | ) |
| Accretion  on preferred stock and dividends                                                                                                                                                                                                        |       | (31                                   | )          | 0                                  |       | (31 | ) | 0 |   |
| Net loss applicable to common shareholders                                                                                                                                                                                                         |       | $                                     | (1,975     | )                                  | $          | (2,999 | ) | $ | (4,713 | ) | $ | (4,884 | ) |
|                                                                                                                                                                                                                                               |       |                                  |       |                               |       |   |   |   |   |
| Net loss per common share (basic and diluted)                                                                                                                                                                                                      |       | $                                     | (0.07      | )                                  | $          | (0.13 | ) | $ | (0.17 | ) | $ | (0.21 | ) |
| Weighted average common shares outstanding - basic and diluted                                                                                                                                                                                     |       | 27,898,268                            |       | 23,579,861                         |       | 27,380,133 |   | 23,579,256 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

 

4

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**WORLDGATE COMMUNICATIONS,INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(Dollarsin Thousands)**

 
| ** **                                                                                       | ** ** | **Six months ended**

**June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| ** **                                                                                       | ** ** | **(As restated)**                       | ** ** | ** ** | ** ** |
| **Cash flows from operating activities of  continuing operations:**                              |       |                                    |       |   |   |
| Net loss                                                                                         |       | $                                       | (4,711     | ) | $ | (2,185 | ) |
| Adjustments to reconcile net loss to cash used in operating  activities of continuing operations |       |                                    |       |   |   |
| Depreciation and amortization                                                                    |       | 204                                     |       | 0 |   |
| Change in fair value of warrants and conversion  options                                         |       | (348                                    | )          | 0 |   |
| Non-cash stock based compensation                                                                |       | 631                                     |       | 0 |   |
| Changes in operating assets and liabilities from continuing  operations:                         |       |                                    |       |   |   |
| Accounts receivable                                                                              |       | 28                                      |       | 0 |   |
| Prepaid and other assets                                                                         |       | 247                                     |       | 0 |   |
| Accounts payable                                                                                 |       | (294                                    | )          | 357 |   |
| Accrued expenses                                                                                 |       | 477                                     |       | 359 |   |
| Accrued compensation and benefits                                                                |       | 40                                      |       | 521 |   |
| Other                                                                                            |       | 285                                     |       | 0 |   |
| Net cash used in operating activities of continuing operations                                   |       | (3,441                                  | )          | (948 | ) |
| **Cash flows from investing activities of  continuing operations:**                              |       |                                    |       |   |   |
| Capital expenditures                                                                             |       | (30                                     | )          | 0 |   |
| Net cash provided by investing activities of continuing operations                               |       | (30                                     | )          | 0 |   |
| **Cash flows from financing activities of  continuing operations:**                              |       |                                    |       |   |   |
| Proceeds from the issuance of common stock                                                       |       | 2,509                                   |       | 0 |   |
| Proceeds from the issuance of redeemable preferred stock                                         |       | 7,111                                   |       | 0 |   |
| Proceeds from the exercise of stock options                                                      |       | 126                                     |       | 0 |   |
| Proceeds from the exercise of stock rights and warrants                                          |       | 620                                     |       | 0 |   |
| Net cash provided by financing activities of continuing operations                               |       | 10,366                                  |       | 0 |   |
| **Net cash contributed to continuing operations  from discontinued operations**                  |       | 46                                      |       | 1,122 |   |
| **Net increase (decrease) in cash**                                                              |       | 6,941                                   |       | 174 |   |
| **Cash and cash equivalents, beginning of period**                                               |       | 3,365                                   |       | 589 |   |
| **Cash and cash equivalents, end of period**                                                     |       | $                                       | 10,306     |   | $ | 763 |   |
|                                                                                             |       |                                    |       |   |   |
| **Cash paid for interest**                                                                       |       | $                                       | 2          |   | $ | 9 |   |
| **Non-cash financing activity:**                                                                 |       |                                    |       |   |   |
| Issuance of note payable to finance D&O insurance                             |       | 256                                     |       | 560 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

 

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WORLDGATE COMMUNICATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(Dollar Amounts are in Thousands, Except for per Share and ShareAmounts)

(Unaudited)

 

1.                        Basis ofPresentation.

 

The unaudited financial statements of WorldGate Communications, Inc. (“WorldGate”or the “Company”) for the three and six months ended June 30, 2004 presentedherein have been prepared by the Company pursuant to the rules and regulationsof 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 suchrules and regulations.  These financialstatements should be read in conjunction with the financial statements for theyear ended December 31, 2003 and the notes thereto included in the Company’sAnnual 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 endingDecember 31, 2004.

 

2.                        Restatement

 

The Company has restated its financial statementsfor the three and six months ended June 30, 2004.  In the second quarter of 2004, the Companyincorrectly made accounting entries to record theCompany’s June 23, 2004 private placement of Series A Convertible PreferredStock and Warrants using a “relative fair value” basis of accounting.  On November 10, 2004, the Company determined that the proceeds of the private placementtransaction should be allocated using a “fair value” basis of accounting for the warrants and conversion options, with theresidual amount to preferred stock instead of the “relative fair value” basis and should also be marked to market as of June 30, 2004.  The net effect of these adjustments at June30, 2004 increases the Company’s current liabilities and redeemable preferred stock, and reduces its losses.

 

On the balance sheet at June 30, 2004, weincorrectly reported and valued warrants of $1,390 and the preferred stockconversion option at $1,840under the “relative fair value” basis. The restatement to the “fair value” basis, and marked to market at June30, 2004, resulted in the warrants increasing by $333, to a restatedbalance of $1,723, and the preferred stock conversion option balance increasingby $407, to a restated balance of $2,247. Additionally, at June 30, 2004, we incorrectly classified as liabilities the beneficial conversion options on preferred stock balance at $1,714, under the “relative fair value” basis.  The restatement increased the value from$1,714 to $2,182, and reclassified this balance from current liabilities to redeemablepreferred stock.  As a result of the above restatements, theCompany’s accumulated deficit balance was reduced by $346, from a deficit of$203,701 to a deficit of $203,356 atJune 30, 2004.  This reduction resulted from the followingadjustments to the Company’s net loss applicable to common stockholders of$2,319, as originally reported for the three months ended June 30, 2004, to a restated $1,975. For the six months ended June 30, 2004, Netloss applicable to common shareholders was reduced from $5,059 to $4,713.Accordingly, the loss per share for the three months ended June 30, 2004 wasdecreased from $.08 per share to $.07 per share, and for the six months endedJune 30, 2004, the loss per share also decreased from $.18 pershare to $.17 pershare. Beneficial conversion option interest of $11 was eliminated from generaland administrative expenses with this liability reclassification to redeemablepreferred stock.  Additionally, with the change in valuation from“relative fair value” to “fair value” of the warrants and preferred stockconversion option, together with the marked to market adjustment as of June 30,2004, a change in fair value increase was recorded of $348, and the resulting accretionadjustment to the temporary equity account, redeemable preferred stock, was increasedby $15, from$16 to $31, resulting from $7 for dividends on preferredstock, and $24 for the accretion to redeemable preferred stock of the conversionoption, for the three and six months ended June 30, 2004. Redeemable preferredstock increased from $2,187 to $2,816 primarily asa result of the change from the relative fair value to fair value basis ofaccounting.  Certain information provided in Management’sDiscussion and Analysis of Financial Condition and Results of Operations hasbeen revised to reflect these restatements.

 

3.                  Liquidity and Going Concern Considerations.

 

Asof June 30, 2004 the Company had cash and cash equivalents of $10,306. Theoperating cash usage from continuing operations for the three and six monthsended June 30, 2004 was $1,662 and $3,441, respectively.  During the third quarter of 2003, wecompleted a sale of certain assets, including our ITV intellectual property rightsand our membership interest in TVGateway, LLC, for $3,000 in cash to TVGateway,LLC, a company we were instrumental in forming. Our transaction with TVGateway,LLC, marked a shift in our business away from the ITV business and toward a newvideo phone product and associated business. The funds we received from the sale of assets to TVGateway, LLC, as wellas the funds we received as a result of private 

 

 

6

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placements of our securitieson December 1, 2003, December 4, 2003, January 21, 2004, April 22, 2004, andJune 23, 2004, have permitted us to fund the development of our new business.

 

InDecember 2003 and January 2004, WorldGate received investments aggregating to atotal of $3,100 by certain institutional investors.  These investors purchased an aggregate of3,000,000 shares of newly issued common stock. The investors also received aright, for a limited period of time, to purchase additional shares of up to 20%of the common stock purchased by the investors in their investment, at the sameprice as their investment, and five-year warrants to purchase up to 30% of thecommon stock purchased by the investors in their investment, at an exerciseprice equal to a twenty-five percent premium to their purchase price for theinvestment.  The purchase price for the 2million shares purchased in December 2003 transactions was $0.80 per share,with the warrants having a $1.00 per share exercise price.  The purchase price for the 1 million sharespurchased in the January 2004 transaction was $1.50 per share, with thewarrants having a $1.875 per share exercise price.  All additional investment rights associatedwith the December 2003 transaction were exercised during January and Februaryof 2004, resulting in an incremental investment of $320.  All additional investment rights associatedwith the January 2004 transaction were exercised in May 2004, resulting in anincremental investment of $300.

 

InDecember 2003, WorldGate announced that it reached agreement with Mototech,Inc. for the purchase of 625,000 shares of newly issued common stock at $0.80per share, in return for future design and engineering services byMototech.  WorldGate previously announcedin November 2003, that it had contracted with Mototech to assist the Companywith the design and volume manufacture of WorldGate’s Ojo personal video phone.The purchase price for these shares will be paid by an equivalent reduction inthe development and initial procurement payments that would otherwise be due toMototech.  Mototech is an affiliate ofAccton Technology Group.  They currentlymanufacture and distribute a full range of high performance high speed data andcomputer networking products, including cable set top boxes, home gateways,wireless LANs, hubs, switches, routers, and other related products.  In addition, in April 2004, Mototech invested$1 million to purchase 666,666 shares of newly issued common stock at $1.50 pershare.

 

In June 2004, WorldGatecompleted a private placement of 7,550 shares of its Series A Preferred Stockat a stated value of $1000 per share, which preferred stock is convertible intothe Company’s common stock at a conversion price of $2.35 per share; five-yearwarrants to purchase up to 803,190 shares of our common stock at an exerciseprice of $2.69 per share; and five-year warrants to purchase up to 803,190shares of our common stock at an exercise price of $3.14 per share. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1,606,383 additional shares of common stock shares at $3.14 ashare.

 

TheCompany has $6,179 of liabilities and itsassets are not pledged as collateral as of June 30, 2004. The Company continuesto evaluate possibilities to obtain additional financing through public orprivate equity or debt offerings, bank debt financing, asset securitizations,or from other sources.  Such additionalfinancing would be subject to the risk of availability, may be dilutive to ourshareholders, or could impose restrictions on operating activities. There canbe no assurance that this additional financing will be available on termsacceptable to the Company, if at all. The Company has limited capacity tofurther reduce its workforce and scale back on capital and operationalexpenditures to decrease its cash usage given the measures it has already takento 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, 2003 includes an explanatory paragraphstating that because the Company has suffered recurring losses from operationsand has a net accumulated deficiency of $199 million, those issues raisesubstantial doubt about the Company’s ability to continue as a going concern.

 

 

7

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4.                  RecentAccounting Pronouncement.

 

InJanuary 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Entities*. InterpretationNo. 46 addresses consolidation by business enterprises of variable interestentities, which are entities that either (a) do not have equity investors withvesting rights or (b) have equity investors that do not provide sufficientfinancial resources for the entity to support its activities. Theinterpretation is effective immediately for variable interest entities createdafter February 1, 2003. In December 2003, the FASB published FASBInterpretation No. 46 (revised December 2003), *Consolidationof Variable Interest Entities* (FIN 46(R)). FIN 46(R), among otherthings, defers the effective date of implementation for certain entities. Therevised interpretation is effective for the first interim or annual reportingperiod ending after March 15, 2004, with the exception of structures that arecommonly referred to as special-purpose entities, for which the statement iseffective for periods ending after December 15, 2003. The adoption ofInterpretation No. 46 did not have a material impact on WorldGate’s results ofoperations or financial position.

 

 

InMay 2003, the FASB issued SFAS No. 150, *Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity*. SFAS No. 150 establishes standards for classification andmeasurement by an issuer of certain financial instruments with characteristicsof both liabilities and equity. The statement requires that an issuer classifya financial instrument that is within the scope as a liability (or asset insome circumstances). This statement is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003, except asit relates to consolidated limited-life subsidiaries. The FASB indefinitelydeferred the effective date of this statement as it relates to certain mandatorilyredeemable non-controlling interests in consolidated limited-life subsidiaries.WorldGate does not have any interest in limited-life entities as of June 30, 2004. The adoption of theeffective provisions of SFAS No. 150 did not have an impact on WorldGate’sresults of operations or financial position.

 

5.      Inventories.

 

Inventories are summarized as follows:

 
| ** **                              | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------|------------|-------------------|------------|-----------------------|------------|
|                                    |       |              |       |                  |       |
| Raw material                            |       | $                 | 1,622      |                  | $          | 1,622 |   |
| Work in progress                        |       | -                 |       | -                     |       |
| Finished goods                          |       | -                 |       | -                     |       |
| Inventory held by customers and vendors |       | -                 |       | -                     |       |
| Total inventory                         |       | 1,622             |       | 1,622                 |       |
| Inventory reserve                       |       | (1,622            | )          | (1,622                | )          |
| Net inventory                           |       | $                 | —     |                  | $          | — |   |

 

6.      RedeemablePreferred Stock

 

In June 2004, WorldGate completed a privateplacement of 7,550 shares of its Series A Preferred Stock at a stated value of$1,000 per share, which preferred stock is convertible into the Company’scommon stock at a conversion price of $2.35 per share. The Company has theright to require conversion of the preferred stock into common stock uponachieving certain price targets with respect to its common stock and thesatisfaction of certain other conditions. As part of the transaction, theCompany issued five-year warrants to purchase a total of 

 

 

8

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1.6 million shares of theCompany’s common stock, with one-half of the warrants having an exercise priceof $2.69 per share and the remaining half having an exercise price of $3.14 pershare. The preferred stock has a dividend rate of 5% per annum, payablequarterly, which may be paid either by cash or through the issuance of commonstock at the Company’s option (with stock payments being made at a 10% discountto the then current market price). The preferred stock has a staged maturityover three years with scheduled payments of one third due after 18 months, onehalf of the remainder due after 24 months and the balance due after 36 months.The preferred stock may be redeemed at maturity in cash or through the issuanceof common stock, at the Company’s option (with stock payments being made at thethen current market price). All dividend and maturity payments made in stockare subject to the satisfaction of certain conditions including the listing ofthe stock and availability of an effective registration statement. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1.6 million additional shares of common stock shares at $3.14a share.

 

In accordance with EITFtopic D-98 “Classification and Measurement of Redeemable Securities”, theRedeemable Preferred Stock was recorded in the financial statements astemporary equity. At June 30, 2004, that amount was $2,816.Additionally, the fair values of thewarrants and preferred stock conversion options were recorded into the financial statements asliabilities as aresult of their features that require accounting under FAS 133 "Accounting for derivative instruments and hedging activities".  At June 30, 2004, these amounts totaled $3,977. Ateach reporting balance sheet date an evaluation is made of these valuations andmarked to market.  Duringthe three and six months ended June 30, 2004, the Company recorded $31 againstRetained Earningsresulting from $7 for dividends on preferred stock, and $24for the accretion to redeemable preferred stock of the conversion option, for  the threeand six months ended June 30, 2004.

 

7.      Stock-BasedCompensation.

 

The Company accounts for stock-based compensation in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations.

 

The Company applies Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” and related interpretations in accounting forits plans, and accordingly, no compensation cost has been recognized for theCompany’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 June 30,** | ** ** | **For the Six Month Period**

**Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2004**                                                | ** ** | **2003**                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                          | ** ** | **(As restated)**                                       | ** ** | ** **                                            | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| Net loss:                                                                                                                           |       |                                                    |       |                                                  |       |   |   |   |   |
| As reported                                                                                                                         |       | $                                                       | (1,944     | )                                                     | $          | (2,999 | ) | $ | (4,682 | ) | $ | (4,884 | ) |
| Add: Stock-based compensation expense included in reported net loss,  net of related tax effects of $0                              |       | 0                                                       |       | 0                                                     |       | 0 |   | 40 |   |
| Deduct: Total stock-based employee expense determined under the fair  value based method for all awards, net of related tax effects |       | (520                                                    | )          | (1,350                                                | )          | (1,083 | ) | (2,770 | ) |
| Pro forma net loss                                                                                                                  |       | $                                                       | (2,464     | )                                                     | $          | (4,349 | ) | $ | (5,765 | ) | $ | (7,614 | ) |
|                                                                                                                                |       |                                                    |       |                                                  |       |   |   |   |   |
| Net Loss per share:                                                                                                                 |       |                                                    |       |                                                  |       |   |   |   |   |
| Basic and diluted — as reported                                                                                                |       | $                                                       | (0.07      | )                                                     | $          | (0.13 | ) | $ | (0.17 | ) | $ | (0.21 | ) |
| Basic and diluted - pro forma                                                                                                       |       | $                                                       | (0.09      | )                                                     | $          | (0.18 | ) | $ | (0.21 | ) | $ | (0.32 | ) |
|                                                                                                                                     |            |                                                         |            |                                                       |            |  |  |  |  |  |  |  |  |  |  |

 

 

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Such pro forma disclosures may not berepresentative of future compensation expense because options vest over several years and additional grantsare made each year.

 

8.   Significant Agreements andTransactions.

 

In 1997, the Company entered into agreements with certain cableoperators who are investors.  Revenuesrecognized from such investors were approximately $0 and $65, respectively, forthe three months ended June 30, 2004 and 2003, and approximately $0 and $136,respectively, for the six months ended June 30, 2004 and 2003. Accountsreceivable from such investors amounted to approximately $0 at June 30, 2004and $2 at December 31, 2003.

 

The Company has a current agreement with an investor, and previously had agreements withcertain other investors, to provide engineering anddevelopment support. As a result of those agreements, the Company has expensedapproximately $0 and $165, respectively, for the three months ended June 30,2004 and 2003, and approximately $0 and $556, respectively, for the six monthsended June 30, 2004 and 2003. Accounts payable to these stockholders amountedto $528 and $170 at June 30, 2004 and December 31, 2003, respectively. Some ofthese stockholders were suppliers of technology and components for the Company’sdiscontinued ITV products and services. These agreements provided for licensingof technology, as well as contracted services, including hardware and softwaredevelopment, product testing and certification, and the creation anddevelopment of tools and systems to facilitate the Company’s engineeringefforts. These agreements did not provide for ongoing royalties, purchaseprovisions, or for any requirement to provide additional funding to theCompany.

 

In1998 the Company entered into a leasing arrangement for a building with anentity formed by non-employee investors. Included in deposits and other assetsat June 30, 2004 and December 31, 2003is $0 and $388, respectively, related to thislease. We have not paid our rent on our current facility since May 2003. As aresult, our landlord, 3190 T General, Inc. in September 2003, filed an actionin the Court of Common Pleas, Bucks County Pennsylvania to perfect its interestto take possession of our facility at any time, and to establish damages forpast rent and expenses. In lieu of rent payments our landlord has drawn fromour security deposit to satisfy the unpaid rent and such deposit has now beenfully depleted. A judgment was also granted allowing our landlord to regainpossession of the facility, although we remain in the facility, albeit insubstantially reduced space. During this process we attempted to negotiate asettlement of our lease obligation with the landlord in an effort to reduce ouroutstanding liability and secure the continued right to occupy the facilitywith a reduced ongoing lease obligation. We also worked with the landlord tosecure other tenants for the unused space. However, we were informed by thelandlord that this process was complicated by the requirement for the landlord’smortgage holder to approve any such amendments to our lease as well as anyarrangements with other prospective tenants. The landlord was not able toobtain such approvals from the mortgage holder and ultimately the landlord andthe landlord’s mortgage holder reached an agreement for the landlord’s mortgageholder to become a successor to the landlord’s interest in the property. Wehave already commenced negotiations directly with the mortgage holder’srepresentatives to secure the continued right to occupy the facility with areduced ongoing lease obligation, and are currently awaiting a proposal fromthe mortgage holder, although there can be no assurance that an agreement canbe reached with the mortgage holder. Concurrently we are exploring otherfacility opportunities in the event an agreement cannot be reached. In lieu ofmonthly rent payments of $104 (offset by monthly sublease payments by TVGatewayof $19 during the period February 1, 2003 through January 31, 2004), theCompany’s landlord has drawn down from its security deposit to satisfy $750 ofthe unpaid rent of $1,223 as of June 30, 2004. As of June 30, 2004, the amountof the deposit remaining after deduction for the unpaid rent is $0.  The Company has continued to accrue the fullrent expense through June 30, 2004.

 

9.   TVGatewayJoint Venture and related Cable Operator Agreements.

 

On July 24, 2000, the Company formed a separate jointventure, TVGateway, LLC, with four cable operators.  As part of this venture WorldGate enteredinto a management agreement with TVGateway to provide engineering, operationsand administrative support services. In addition to providing for the terms andconditions under which such services were to be provided, the managementagreement provided for WorldGate and TVGateway to cooperate to transition toTVGateway some or all of the support services being provided by WorldGateand/or the employees providing these services. In addition, this provisionrequired WorldGate to remain available to provide support services until July24, 2005. During 2002 WorldGate and TVGateway agreed to

 

 

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commence the transition of services pursuant to thisprovision. In addition, the parties agreed that the management agreement wouldbe of no further force and effect with respect to the services that aretransferred as of the date of completion of the specific transfers. The companiescompleted this transition in the first quarter 2003, and accordingly, WorldGatehas now been relieved of any continuing obligation to provide such transitionedservices.  Further, WorldGate will nolonger receive future revenues from the management agreement with TVGateway.

 

Revenues for such services, which are included inservice fee revenue, totaled $0, and $732(included in discontinued operations), respectively for thethree months ended June 30, 2004 and 2003, and $0 and $788 (included in discontinued operations),respectively, for the six months ended June 30, 2004 and 2003. In addition,product sales to TVGateway totaled $0 and $0 for the three months ended June30, 2004 and 2003, respectively, and $0 and $1,079 (included in discontinued operations),respectively, for the six months ended June 30, 2004 and 2003. AccountsReceivable from TVGateway amounted to $0 at June 30, 2004 and $0 atDecember 31, 2003. WorldGate was accounting for its 18% investment in theTVGateway joint venture, which was previously reduced to a carrying value of $0due to prior losses, under the equity method.

 

On September 30, 2003 the Company announcedthat it had sold to TVGateway, LLC certain ITV intellectual property rights andcertain software and equipment related to the ITV business, which TVGateway wascurrently using, for $2,400.  Inaddition, on August 7, 2003, WorldGate and TVGateway entered into a redemptionagreement pursuant to which TVGateway redeemed WorldGate’s equity interest inTVGateway for $600 in cash.  The purchaseprice for these assets in the aggregate was $3,000 and was used by the Companyto fund continuing operations, as well as to develop and distribute its new Ojovideo telephony product. As part of this transaction WorldGate retained a royalty-freelicense to certain of the transferred intellectual property rights andsoftware. At this time the Company has completely exited from the interactivetelevision (ITV) business.

 

In connection with the Asset PurchaseAgreement we entered into with TVGateway for the sale of certain ITV Businessassets, we have an obligation to indemnify TVGateway for any losses frombreaches of our representations or warranties in the Asset Purchase Agreementthat occur within twelve months after the closing date of the TVGatewaytransaction or within the applicable statute of limitations period for claimsrelating to our ownership of our assets, payment of our taxes, and ourcompliance with applicable laws, if longer. Our indemnification obligations arelimited by an overall cap of $500 on the amount of the indemnification.Although we know of no breaches of our representations or warranties, thepayment of any such indemnification obligations would adversely impact our cashresources and our ability to pursue our video phone business.

 

 

10.       Net Loss per Share.

 

Basic and diluted net loss per common share is computed by dividing thenet loss available to common stockholders for the period by the weightedaverage number of shares of common stock outstanding during the period.  The calculation of diluted net loss percommon share excludes potential common shares if the effect isantidilutive.  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 June30, 2004 and 2003 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 12,968,818 and 5,932,513,respectively.

 

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

 

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

 

FORWARD-LOOKING AND CAUTIONARY STATEMENTS.

 

The Company may from time to time make written or oral forward-lookingstatements, including those contained in the following Management’s Discussionand Analysis of Financial Condition and Results of Operations. The words “estimate,”“project,” “believe,” “intend,” “expect,” and similar expressions are intendedto identify forward-looking statements, although not all forward-lookingstatements contain these identifying words. In order to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, weare hereby identifying certain important factors, which could cause our actualresults, performance or achievement to differ materially from those that may becontained in or implied by any forward-looking statement

 

 

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made by or on behalf of WorldGate. The factors, individually or in the aggregate, that could cause suchforward-looking statements not to be realized include, without limitation, thefollowing: (1) difficulty or inability to raise additional financing on termsacceptable to us, (2) difficulty in developing and implementing marketing andbusiness plans, (3) continued losses, (4) industry competition factors andother uncertainty that a market for our products will develop, (5) challengesassociated with broadband operators (including, uncertainty that they willoffer our products, inability to predict the manner in which they will marketand price our products and existence of potential conflicts of interests andcontractual limitations impeding their ability to offer our products), (6)departure of one or more key persons, (7) delisting of our Common Stock from the NASDAQ Small Cap Market, (8) changesin regulatory requirements, and (9) other risks identified in our filings withthe Securities and Exchange Commission. We caution you that the foregoing list of important factors is notintended to be, and is not, exhaustive. We do not undertake to update any forward-looking statement that may bemade from time to time by or on behalf of WorldGate.

 

 

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 and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ from those estimates.

 

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 estimates ofuncertainties 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 the Company transitioned from thebusiness of developing and selling interactive television, or ITV, technology,products and services for use in conjunction with cable TV broadband networks(the “ITV business”) to the development of our video phone products as ourprimary business focus. During the three months ended June 30, 2004 the Companyhad revenues from discontinued operations of $7, compared to revenues of $391for the three months ended June 30, 2003. For the six months ended June 30,2004 and 2003, respectively, revenues were $89 and $2,556 respectively. Thisreduction reflects service revenues of $7 and $342, respectively, for the threemonths ended June 30, 2004 and 2003, and for the six months ended June 30, 2004and 2003, service revenues were $7 and $1,320 respectively. Equipment revenueswere $0 and $49 for the three months ended June 30, 2004 and 2003,respectively, and $82 and $1,236, respectively, for the six months ended June30, 2004 and 2003. Concurrently, operating expenses, consisting of Research andDevelopment, Marketing and General and Administration costs were also reducedas a result of the transition from the ITV business.  These expenses were $0 for the three monthsended June 30, 2004, compared to $755 for the three months ended June 30, 2003,and $16 and $2,561, respectively, for the six months ended June 30, 2004 and2003.

 

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

 

Three and Six Months Ended June 30, 2004 and June 30, 2003

 

Revenues.

 

Revenues.  There were no revenuesfrom continuing operations during the three and six months ended June 30, 2004and June 30, 2003. We expect that revenues from video phones will not berealized until, at the earliest, the fourth quarter of 2004.

 

 

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Costs and Expenses.

 

Cost of Revenues.  There were nocosts of revenues from continuing operations during the three and six monthsended June 30, 2004 and June 30, 2003. We expect that costs of revenues fromvideo phones will not be incurred until, at the earliest, the fourth quarter of2004.

 

Engineering and Development. Engineering and development expenses primarily consist of compensation,and the cost of design, programming, testing, documentation and support of theCompany’s video phone product. Engineering and development costs were $799 for the three months endedJune 30, 2004, compared with $727 for the three months ended June 30, 2003. Forthe six months ended June 30, 2004 and June 30, 2003, engineering anddevelopment expenses were $1,599 and $1,263, respectively. These increases of$72 and $336, respectively, or 10% and 27%, respectively, for the three and sixmonths ended June 30, 2004, reflect the Company’s increased concentration ofits engineering staff, and related costs, for the further and continuingdevelopment of its video phone product.

 

Sales and Marketing.  Sales andmarketing expenses consist primarily of compensation, attendance at conferencesand trade shows, travel costs, promotions and other marketing programs relatedto the introduction of the Company’s video phone product.  Sales and marketing costs were $408 for thethree months ended June 30, 2004, compared with $139 for the three months endedJune 30, 2003. For the six months ended June 30, 2004 and 2003, sales andmarketing expenses were $599 and $225, respectively. These increases of $269and $374, respectively, or 193% and 166%, respectively, for the three and sixmonths ended June 30, 2004, reflect the increased marketing and promotionalexpenditures, primarily related to trade shows attendance, for the Company’svideo phone product.

 

General and Administrative. General and administrative expenses consist primarily of expendituresfor administration, office and facility operations, finance and generalmanagement activities, including legal, accounting and professional fees.  General and administrative expenses were $1,001for the three months ended June 30, 2004, compared with $506 for the threemonths ended June 30, 2003. For the six months ended June 30, 2004 and 2003,general and administrative expenses were $2,674 and $697, respectively. Theincreases of $495 and $1,977, respectively, or 98%and 284%, respectively, for the threeand six months ended June 30, 2004, are attributable primarily to the Company’stransition of nearly all ofits administrative management compensation, facility, legal, finance andprofessional consulting fees toward the further development of the video phonebusiness, and a noncash charge of $631 reflecting a Black Scholes estimate of the value of thewarrants issued as part of the private placement of the Company’s stock tocertain institutional investors in January 2004.  For the three and six months ended June 30,2003, video phone related costs were 60% and 39%, respectively, of totalGeneral and Administrative expense of $845 and $1,807, respectively.

 

Interest and Other Income and Interest Expense.  Interest and other income and interestexpense consist of interest earned on cash and cash equivalents, interest expense onshort-term debt and change in fair value of warrants and conversion options.  Interest and other income increased from $12for the three months ended June 30, 2003 to $361 for the three months ended June30, 2004, and increased from $39 for the sixmonths ended June 30, 2003 to $368 for the six months ended June30, 2004. Primarily, theseincreases reflect for the three and six months ended June 30, 2004 a reportednon-cash change in fair value ofwarrants and conversion optionsof $348 that resulted from a marked to market adjustment as of June 30, 2004related to the Company’s June 23, 2004 private placement of its Series AConvertible Preferred Stock and Warrants.  During the three and six months ended June30, 2003, the Company earned interest on average cash balances of approximately$8,963 and $10,913, respectively, and incurred interest expense related to itsinsurance financing.  In comparison,during the three and six months ended June 30, 2004 the Company earned intereston average cash balances of approximately $3,878 and $4,817, respectively, andincurred interest expense related to its insurance financing.

 

Income Taxes.  TheCompany has incurred net operating losses since inception and accordingly hadno income taxes and has not recorded any income tax benefit for those losses.

 

Liquidity and Capital Resources.

 

As of June 30, 2004, our primary source of liquidity consisted of cashand cash equivalents that are highly liquid, are of high quality investmentgrade and have maturities of less than one year.

 

At June 30, 2004, we had cash and cash equivalents of $10,306 (and noshort-term investments) as compared to cash and equivalents of $3,365 (and noshort-term investments) at December 31, 2003. Net cash 

 

 

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used in continuing operations was $3,441 for the six months ended June30, 2004, as compared to $2,813 (includedin discontinued operations) used for the same period in 2003.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 sixmonths ended June 30, 2004 to reflect its current assessment of thecollectability of certain receivables.

 

Cash provided by investing activities from continuing operations duringthe three months ended June 30, 2004, totaled $10,366 compared to $0 providedduring the same period in 2003.  Duringthe six months ended June 30, 2004 net proceeds from our maturing short-terminvestments were $0 compared to $3,218 (includedin discontinued operations) for the six months ended June 30,2003.  Capital expenditures were $30 and$0 for the six months ended June 30, 2004 and 2003, respectively.

 

Operations and Liquidity.

 

Todate, the Company has funded operations primarily through private sales ofequity securities and through an initial public offering of common stock inApril 1999.  As of June 30, 2004 theCompany had cash, and cash equivalents of $10,306. The operating cash usagefrom continuing operations for the six months ended June 30, 2004 was $3,441.As of June 30, 2004 we have $256 of outstanding debt and our assets are notpledged as collateral.  However, we havenot paid our monthly rent of $104 (offset by monthly sublease payments byTVGateway of $19 during the period February 1, 2003 through January 31, 2004)on our current facility since May 2003. As a result, our landlord, a non-employee investor, has perfected itsinterest to take possession of our facility at any time and has drawn down fromour rent deposit to satisfy $750 of the unpaid rent of $1,223 as of June 30,2004.  As of June 30, 2004 the amount ofthe deposit remaining is $0 after deduction for the unpaid rent.  The Company has continued to accrue the fullrent expense through June 30, 2004.  Wecontinue to negotiate to resolve this matter (refer to Part II, Item I LegalProceedings).  Although we are presently not seeking additionalfunding we continue to explore and evaluate possibilities toobtain additional financing through public or private equity or debt offerings,bank debt financing, 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 this additional financing will beavailable on terms acceptable to us, if at all. The Company has limited capacity to further reduce its workforce andscale back on capital and operational expenditures to decrease cash burn giventhe measures it has already taken to reduce staff and expenses.

 

Withthe private placement of the Company’s common stock, together with additionalrights and warrants, resulting in the aggregate gross proceeds received of $1.5million in January 2004, the private placement of the Company’s common stock inApril 2004 providing proceeds of $1,000, and the June 2004 private placement ofCompany’s redeemable preferred stock aggregating proceeds to the Company of$7.55 million, the Company projects it will have sufficient funding to continueoperations into the third quarter of 2005, assuming no additional funding isreceived and assuming no impact from sales. Depending on the timing andmagnitude of the ramp up of video phone sales, we expect that our current cashmay be sufficient to get the company to a cash breakeven position.  No assurances can be given that sufficientsales, if any, will materialize, or that a funding transaction can beconsummated prior to the depletion of our available cash.  We however remain hopeful that sufficientfunding can be developed through funding or ongoing operations to continue theCompany’s operations.  The independentauditors’ report for the year ended December 31, 2003 included an explanatoryparagraph stating that because the Company has suffered recurring losses fromoperations and has a net accumulated deficiency of $199 million, those issuesraise substantial doubt about the Company’s ability to continue as a goingconcern.

 

 

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# ITEM3.   QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.

 

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

 

As of June 30, 2004, the Company’s cash and cash equivalents were$10,306, most of which were securities having a maturity of less than one year,and it had no short-term investments. Due to the average maturity and conservative nature of our investmentportfolio, management believes a sudden change in interest rates would not havea material effect on the value of the portfolio. Manage­ment estimates that hadthe average yield of our investments decreased by 100 basis points, ourinterest income for the six months ended June 30, 2004 would have decreased byapproximately $30. This estimate assumes that the decrease occurred on thefirst day of 2004 and reduced the yield of each investment instrument by 100basis points.  The impact on our futureinterest income of future changes in investment yields will depend largely onour total investments.

 

Foreign Currency Exchange Risk. The principal portion of our current business is in the United Statesand substantially all of our costs to date have been denominated in U.S.dollars.  As a result, adverse movementsin foreign currency exchange rates would not have a material adverse effect onus.

 

 

# ITEM 4.   CONTROLS AND PROCEDURES.

 

In connection with Company's preparation of thethird quarter 2004 10-Q, the Company’s principal executive andprincipal financial officers, 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 chiefexecutive officer and chief financial officer concluded that a “significantdeficiency,” that is considered to be a “materialweakness,”  (asdefined under the standards established by the American Institute of CertifiedPublic Accountants) existed with respect to the Company’s reporting of the various components of the June 2004 privateplacement of Series Apreferred stock and warrants.  As aresult the Company has restated its financial statements in its June 30, 200410-QA.  The Company will evaluate theneed to enhance its internal resources, including obtaining or engaging outsideexperts to address the accounting for complex transactions.  The Company will evaluate the findings ofsuch experts in addressing these matters. With the exception of this condition, the Company’sdisclosure controlsand procedures were found to be effective. There have been no other changes in the Company’sinternal control over financial reporting that occurred during the period endedJune 30, 2004, that have materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

 

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PARTII. OTHER INFORMATION

 

(Dollar Amounts are in Thousands, Exceptper Share Amounts)

 

# ITEM 1.   LEGAL PROCEEDINGS.

 

The Company has not paid itsrent on its current facility since May 2003. As a result, our landlord, 3190 TGeneral, Inc. in September 2003, filed an action in the Court of Common Pleas,Bucks County Pennsylvania to perfect its interest to take possession of ourfacility at any time, and to establish damages for past rent and expenses. Inlieu of rent payments our landlord has drawn from our security deposit tosatisfy the unpaid rent and such deposit has now been fully depleted. Ajudgment was also granted allowing our landlord to regain possession of thefacility, although we remain in the facility, albeit in substantially reducedspace. During this process we attempted to negotiate 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. We also worked with the landlord to secure other tenants forthe unused space. However, we were informed by the landlord that this processwas complicated by the requirement for the landlord’s mortgage holder toapprove any such amendments to our lease as well as any arrangements with otherprospective tenants. The landlord was not able to obtain such approvals fromthe mortgage holder and ultimately the landlord and the landlord’s mortgageholder reached an agreement for the landlord’s mortgage holder to become asuccessor to the landlord’s interest in the property. We have already commencednegotiations directly with the mortgage holder’s representatives to secure thecontinued right to occupy the facility with a reduced ongoing lease obligation,and are currently awaiting a proposal from the mortgage holder, although therecan be no assurance that an agreement can be reached with the mortgage holder.Concurrently we are exploring other facility opportunities in the event anagreement cannot be reached.

 

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

Instruments Defining theRights of Holders of Our Registered Securities

 

On June 17, 2004, ourboard of directors authorized 7,550 shares of Series A ConvertiblePreferred Stock.  The rights, preferencesand privileges of holders of the outstanding preferred stock are subject to,and may be adversely affected by, the rights of holders of shares of anyadditional preferred stock which we may designate and issue in the future.

 

The holders of the preferredstock may convert their shares into our common stock at an initial conversionprice of $2.35 per share. The conversion price adjusts in the event of stockdividends and splits and certain distributions to stockholders, fundamentaltransactions, and future equity transactions. The number of shares of commonstock issuable upon conversion of the preferred stock increases with anyaccrued but unpaid dividends on the preferred stock, and changes in inverseproportion to the conversion price. We have the right to require conversion ofthe preferred stock into common stock upon achieving certain price targets withrespect to our common stock and the satisfaction of certain other conditions.

 

The preferred stock has adividend rate of 5% per annum, payable quarterly and in preference to thepayment of any dividend on our common stock. The dividends may be paid eitherby cash or, subject to certain conditions, through the issuance of common stockat our option (with stock payments being made at a 10% discount to the thencurrent market price). The preferred stock has a staged maturity over threeyears with scheduled payments of one third due after 18 months, one half ofthe remainder due after 24 months and the balance due after36 months. The preferred stock may be redeemed at maturity in cash or,subject to certain conditions, through the issuance of common stock, at ouroption (with stock payments being made at the then current market price).

 

Upon any liquidation,dissolution or winding up of our company, after payment of all debts andliabilities of our company, but prior to any payment to the holders of commonstock, the holders of the preferred stock will be entitled to receive thestated value of their preferred shares plus accrued but unpaid dividends.Holders of the preferred stock generally have no voting rights, but areentitled to veto certain actions which would have the effect of changing,altering, or diluting their shares. In connection with the issuance of thepreferred stock, the Company agreed to indemnify the purchasers in connectionwith actions that may be instituted against them by our shareholders, exceptfor actions based upon a breach by such purchaser, violation by them of stateor federal securities laws or fraud, gross negligence, willful misconduct ormalfeasance. We do not believe such

 

 

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indemnification obligations are material toour Company.

 

 

Sales of UnregisteredSecurities

 

(1)                                  OnApril 23, 2004, we completed a private placement of 666,666 shares of ourcommon stock with Mototech Inc., at a sale price of $1.50 per share. Theprivate placement resulted in gross proceeds to us of $1 million.

 

The common stock was issuedin reliance upon the exemption from the registration requirements of theSecurities Act afforded to transactions not involving a public offering bySection 4(2) of that Act and Rule 506 thereunder.

 

(2)                                  OnApril 28, 2004, we entered into a Development and Distribution Agreementwith General Instrument Corporation d/b/a the Broadband Communication Sector ofMotorola, Inc., or Motorola. In connection with the Development andDistribution Agreement with Motorola, we issued a warrant to Motorola topurchase 300,000 shares of our common stock at an exercise price of $1.4375 pershare, and agreed to issue additional warrants to purchase up to an additional1,950,000 shares of our common stock, upon the achievement of certain productand sales milestones, at an exercise price based upon the average closing salesprice of the our common stock during the 20 day period preceding theissuance of each warrant.

 

The warrants were issued inreliance upon the exemption from the registration requirements of theSecurities Act afforded to transactions not involving a public offering bySection 4(2) of that Act and Rule 506 thereunder.

 

(3)                                  OnJune 11, 2004, we entered into an agreement with Sejin America to settle adispute with respect to certain inventory alleged to have been purchased by theCompany. In connection with the agreement, we issued 39,035 shares of ourcommon stock to Sejin America in full settlement of the dispute. The commonstock was issued in reliance upon the exemption from the registrationrequirements of the Securities Act afforded to transactions not involving apublic offering by Section 4(2) of that Act and Rule 506 thereunder.

 

(4)                                  OnJune 24, 2004, we completed a private placement of 7,550 shares of ourpreferred stock at a sale price of $1000 per share, which preferred stock isconvertible into our common stock at a conversion price of $2.35 per share;five-year warrants to purchase up to 803,190 shares of our common stock at anexercise price of $2.69 per share; and five-year warrants to purchase up to803,190 shares of our common stock at an exercise price of $3.14 per share. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1,606,383 additional shares of common stock shares at $3.14 ashare.

 

The private placementresulted in gross proceeds to the Company of $7,550,000. The Company paid feesto Janney Montgomery Scott LLC, Ashenden Finance & Cie SA and SloanSecurities LLC, based upon the proceeds received by the Company from certain ofthe Investors participating in this financing. The aggregate fees payable tothese entities was less than six percent of the gross proceeds.

 

The preferred shares,warrants, and additional investment rights were issued in reliance upon theexemption from the registration requirements of the Securities Act afforded totransactions not involving a public offering by Section 4(2) of that Actand Rule 506 thereunder.

 

 

# ITEM3.  DEFAULTS UPON SENIOR SECURITIES.

 

None.

 

# ITEM4.   SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.

 

None.

 

 

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# ITEM 5.  OTHER INFORMATION.

 

None.

 

 

18

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

#  

# (a)   Exhibits.

 
| 3.1  |   | Amended and Restated  Certificate of Incorporation(1)                                                                                                                                                                                                                                                                                       |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  |   | Amended  and Restated Bylaws(1)                                                                                                                                                                                                                                                                                                             |
| 3.3  |   | Form  of Certificate of Designations, Preferences and Rights of the Series A  Convertible Preferred Stock of the Company (2) (filed as Exhibit 3.1 to the  June 8-K)                                                                                                                                                                        |
| 4.1  |   | Form  of Series A Warrant dated as of June 24, 2004 issued by the Company to the  Investors (as defined in the Securities Purchase Agreement dated as of June  24, 2004 between the Company and the Investors)(2)                                                                                                                           |
| 4.2  |   | Form  of Series B Warrant dated as of June 24, 2004 issued by the Company to the  Investors (as defined in the Securities Purchase Agreement dated as of June  24, 2004 between the Company and the Investors)(2)                                                                                                                           |
| 4.3  |   | Form  of Series C Warrant dated as of June 24, 2004 issued by the Company to the  Investors (as defined in the Securities Purchase Agreement dated as of June  24, 2004 between the Company and the Investors)(2)                                                                                                                           |
| 10.1 |   | Development  and Distribution Agreement dated as of April 28, 2004 between the Company,  WorldGate Services, Inc. and General Instrument Corporation d/b/a the  Broadband Communication Sector of Motorola, Inc.(3) (filed as Exhibit 99.1 to  the July 8-K) (Portions of this agreement are subject to a confidential  treatment request.) |
| 10.2 |   | Securities  Purchase Agreement dated as of June 24, 2004 by and between the Company and  the Investors (as defined therein)(2) (filed as Exhibit 99.1 to the June 8-K)                                                                                                                                                                      |
| 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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*      Filedherewith.

 

(1)                                  Incorporated byreference to the exhibits to our Form 10-Q Report for the quarter endedMarch 31, 1999.

 

(2)                                  Incorporated byreference to the exhibits to our Current Report on Form 8-K datedJune 25, 2004 (the “June 8-K”).

 

(3)                               Incorporated byreference to the exhibits to our Current Report on Form 8-K filedJuly 13, 2004 (the “July 8-K”).

 

 

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(b)   Reports on Form 8-K.

 

Duringthe fiscal quarter ended June 30, 2004, the Company filed the following CurrentReports on Form 8-K:

 

On June 25, 2004, a CurrentReport on Form 8-K was filed, reporting under items 5 and 7 that the Companyhad completed a private placement of $7.55 million of its Series A ConvertiblePreferred Stock and Warrants with several institutional investors.

 

SIGNATURES

 

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

 
|   |   |              | WORLDGATE COMMUNICATIONS,  INC.                       |
|--------|--------|-------------------|-------------------------------------------------------|
| Date:  |   | November 17, 2004 |                                                  | /s/ Hal M. Krisbergh |
|   |   |              | Hal M. Krisbergh                                      |
|   |   |              | Chairman and Chief  Executive Officer                 |
|   |   |              | (Principal Executive  Officer)                        |
| Date:  |   | November 17, 2004 |                                                  | /s/ Joel Boyarski |
|   |   |              | Joel Boyarski                                         |
|   |   |              | Executive Vice President and  Chief Financial Officer |
|   |   |              | (Principal Financial and  Accounting Officer)         |

 

 

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