UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549




FORM 10-Q




x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934For the quarterly period ended June 30, 2011OR ̈

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934For the transition period from ________________ to ________________





Commission file number:  000-25755





WORLDGATE COMMUNICATIONS, INC.


(Exact name of registrant as specified in its charter)





Delaware

23-2866697(State or other jurisdiction of

(I.R.S. Employerincorporation or organization)

Identification No.)3800 Horizon Blvd, Suite 103

Trevose, Pennsylvania

19053(Address of principal executive offices)

(Zip Code)





(215) 354-5100


(Registrant’s telephone number, including area code)





[None]


(Former name, former address and former fiscal year, if changed since last report)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 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 such reports), and (2) has been subject to such filing requirements for the past 90 days.


Yes x                             No   ̈





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Yes x                             No   ̈





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Securities Exchange Act of 1934.


Large accelerated filer ̈
Accelerated filer xNon-accelerated filer  ̈

(Do not check if a smaller reporting company)
Smaller reporting company  ̈





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the SecuritiesExchange Act of 1934).


Yes  ̈                             No  x





Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.





Class

Outstanding at August 5, 2011Common Stock, par value $0.01 per share

339,733,363 shares







WORLDGATE COMMUNICATIONS, INC.





QUARTERLY REPORT ON FORM 10-Q


FOR THE THREE MONTHS ENDED JUNE 30, 2011





TABLE OF CONTENTS





PART I. FINANCIAL INFORMATION

2ITEM 1.  FINANCIAL STATEMENTS

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

17ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

24ITEM 4.  CONTROLS AND PROCEDURES.

25PART II. OTHER INFORMATION

26ITEM 1.  LEGAL PROCEEDINGS.

26ITEM 1A.  RISK FACTORS.

26ITEM 6.  EXHIBITS.

26




1


PART I. FINANCIAL INFORMATION


ITEM 1.  FINANCIAL STATEMENTS




WORLDGATE COMMUNICATIONS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(Dollars in thousands except share amounts)





June 30,


December 31,2011

(Unaudited)


2010*ASSETSCurrent assets:Cash and cash equivalents

$
43


$
878Trade accounts receivable less allowance for doubtful accounts of $4 at June 30, 2011 and $110 at December 31, 2010


74



1Accounts receivable – related party


-



96Inventory,  net


250



296Prepaid and other current assets


180



117Assets related to discontinued operations


-



10Total current assets


547



1,398Property and equipment, net


539



719Deposits


187



193Deferred debt issuance costs, net


5,016



5,769Total assets

$
6,289


$
8,079LIABILITIES AND STOCKHOLDERS’ DEFICIENCYCurrent liabilities:Accounts payable

$
5,005


$
1,995Account payable due to related parties


466



415Accrued expenses


2,304



578Accrued compensation and benefits


6



182Warranty reserve


343



343Deferred rent


208



150Deferred revenues


-



2,206Revolving Loan, with related party


2,700



4,400Notes payable


113



49Total liabilities


11,145



10,318Commitments and contingenciesStockholders’ deficiency:Preferred Stock, $.01 par value, 13,500,000 shares authorized, and 0 shares issued at June 30, 2011 and December 31, 2010Common Stock, $.01 par value; 700,000,000 shares authorized at June 30, 2011 and December 31, 2010; and 339,733,363 and 339,475,805 shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively


3,397



3,395Additional paid-in capital


283,894



282,833Accumulated deficit


(292,147
)


(288,467
)Total stockholders’ deficiency


(4,856
)


(2,239
)Total liabilities and stockholders’ deficiency

$
6,289


$
8,079





* Condensed from audited financial statement





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


2


WORLDGATE COMMUNICATIONS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)


(Dollars in thousands except share and per share amounts)





Three Months Ended June 30,


Six Months Ended June 30,2011


2010


2011


2010Revenues (includes $5,005 and $0, respectively, with related parties for the three months ended June 30, 2011 and 2010 and $10,400 and $0 , respectively, with related parties for the six months ended June 30, 2011).

$
5,080


$
97


$
10,507


$
307Revenue discount  with related party


(27
)


-



(194
)


-Net revenues


5,053



97



10,313



307Cost of revenues


2,635



32



9,220



210Gross profit


2,418



65



1,093



97Expenses from operations:Engineering and development


251



926



1,005



1,847Operations


89



217



348



432Sales and marketing


(198
)


363



353



675General and administrative


923



1,176



2,147



2,472Depreciation and amortization


92



99



186



187Total expenses from operations


1,157



2,781



4,039



5,613Income (Loss) from operations


1,261



(2,716
)


(2,946
)


(5,516
)Other income (expense):Interest and other income


46



-



74



-Bad debt expense


-



-



(18
)


-Amortization of debt issuance costs


(377
)


(179
)


(754
)


(224
)Interest and other expense , related party


(58
)


(91
)


(137
)


(170
)Total other income (expense)


(389
)


(270
)


(835
)


(394
)Net Income (loss) from continuing operations


872



(2,986
)


(3,781
)


(5,910
)Discontinued operations:Net income from discontinued operations


74



27



101



104Net Income (loss)

$
946


$
(2,959
)

$
(3,680
)

$
(5,806
)Net Income (loss) per common share – Basic and Diluted:Continuing operations

$
0.00


$
(0.01
)

$
(0.01
)

$
(0.02
)Discontinuing operations


0.00



0.00



0.00



0.00Total

$
0.00


$
(0.01
)

$
(0.01
)

$
(0.02
)Weighted average common shares outstanding:Basic and Diluted


367,327,614



364,433,587



367,138,865



362,948,583





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


3




WORLDGATE COMMUNICATIONS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIENCY


(Unaudited)


(Dollars and shares in thousands)





Common Stock


Additional


Accumulated


Total Stockholders’Shares


Amount


Paid-In Capital


Deficit


DeficiencyBalance at January 1, 2011


339,476


$
3,395


$
282,833


$
(288,467
)

$
(2,239
)Issuance of common stock upon exercise of stock options


257



2



26



-



28Stock based compensation


-



-



841



-



841Issuance of warrants to ACN


-



-



194



-



194Net loss


-



-



-



(3,680



(3,680
)Balance at June 30, 2011


339,733


$
3,397


$
283,894


$
(292,147
)

$
(4,856
)





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


4





WORLDGATE COMMUNICATIONS, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


(Dollars in thousands)





Six Months Ended June 30,2011


2010Cash flows from operating activities:Net loss

$
(3,680
)

$
(5,806
)Adjustments to reconcile net loss to cash provided by (used in) operating activities:Depreciation and amortization


186



187Amortization of debt issuance costs


753



224Fair value of warrants recorded as a sales discount


194



-Inventory reserve


-



(86
)Stock based compensation


841



749Bad debt expense, net of recoveries


18



2Changes in operating assets and liabilities:Accounts receivable – trade, other  and related party


15



(1,125
)Inventory


46



(7,387
)Prepaid and other current assets


(63
)


(171
)Accounts payable


3,010



5,458Accounts payable - related parties


51



90Accrued expenses


1,726



(124
)Accrued compensation and benefits


(176
)


(255
)Warranty reserve


-



(6
)Deferred revenue


(2,206
)


7,518Deferred rent


58



119Net cash provided by (used in) operating activities


773



(613
)Cash flows from investing activities:Capital expenditures


-



(168
)Net cash  used in investing activities


-



(168
)Cash flows from financing activities:Proceeds from issuance of common stock


28



153Net payments/proceeds from revolving loan with related party


(1,700
)


600Net proceeds from notes


64



84Net cash (used in) provided by financing activities


(1,608
)


837Net (decrease) increase in cash and cash equivalents


(835
)


56Cash and cash equivalents, beginning of period


878



578Cash and cash equivalents, end of period

$
43


$
634Supplemental disclosures of non-cash financing activities:Issuance of warrants to WGI (see Note 4)

$
-


$
3,330Cash paid for:Interest

$
38


$
-





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


5





WORLDGATE COMMUNICATIONS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)


(Dollars in thousands except per share and per unit amounts)





1.
Business and Basis of presentation





WorldGate Communications, Inc. and its subsidiaries (collectively, “WorldGate” or the “Company”) design and develop innovative digital video phones featuring high quality, real-time, two-way video.  During fiscal year 2010, the Company provided a turn-key digital voice and video communication services platform supplying complete back-end support services.  In connection with cost reduction measures in March 2011, the Company discontinued offering digital voice and video communication services to customers.





The Company’s condensed financial statements have been prepared on a “going concern” basis, which contemplates realization of assets and liquidation of liabilities in the normal course of business. As discussed in more detail below in Footnote 3, due to the Company’s inability to generate sufficient cash flow from operations, the lack of availability of additional loan advances under the Company’s revolving loan with WGI Investor LLC (“WGI”) and the reduction of video phone orders in the near term by ACN Digital Phone Service, LLC (“ACN DPS”), a subsidiary of ACN, Inc. (“ACN”), a direct seller of telecommunications services and a distributor of video phones, the Company does not believe its current cash and cash equivalents will satisfy its projected cash requirements in the near term and through June 30, 2012 and there exists substantial doubt about its ability to continue as a going concern.  As a result, the Company’s auditors have included a going concern modification in their audit report on the consolidated financial statements at December 31, 2010 and for the fiscal year then ended.  The Company is in the process of reducing its operating costs and other expenditures, including reductions of personnel and capital expenditures.  The condensed consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.





The unaudited condensed consolidated financial statements of the Company for the three and six months ended June 30, 2011 and 2010 presented herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission for quarterly reports on Form 10-Q.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with United States generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations.  In addition, the December 31, 2010 condensed consolidated balance sheet was derived from the audited financial statements, but does not include all disclosures required by GAAP.  These financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2010 and the notes thereto included in the Company’s Annual Report on Form 10-K.  The accounting policies used in preparing these unaudited condensed consolidated financial statements are materially consistent with those described in the audited December 31, 2010 consolidated financial statements.





The financial information in these financial statements reflects, in the opinion of management, all adjustments of a normal recurring nature necessary to present fairly the results for the interim periods. Quarterly operating results are not necessarily indicative of the results that may be expected for other interim periods or the year ending December 31, 2011.  All significant intercompany accounts have been eliminated in consolidation.





The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, as of the date of the financial statements, and the reported amount of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Judgments and estimates of uncertainties are required in applying the Company’s accounting policies in many areas.  Some of the areas requiring significant judgments and estimates are as follows:  revenue recognition, inventory valuation, stock-based compensation, valuation of warrants and deferred tax asset valuation allowance.




In accordance with ASC 360, Property, Plant, and Equipment, the Company reviews its long-lived assets, including property and equipment and intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amounts of the assets may not be fully recoverable. If the total of the expected undiscounted future net cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between the fair value and carrying amount of the asset. There were no impairment charges for the three or six months ended June 30, 2011 or 2010.




6


2.
Discontinued Operations





The Company does not have multiple business segments.  During fiscal year 2010, the Company had two reportable business segments: Services and Equipment. The Services segment marketed and distributed products and related recurring services to end users.  The Services segment was previously known as the Consumer Services segment.  The Equipment segment sells digital video phones directly to telecommunications service providers who already have a digital voice and video management and network infrastructure.  The Equipment segment was previously known as the Original Equipment Manufacturer or OEM segment.  In connection with cost reduction measures in March 2011, the Company discontinued offering its digital voice and video phone services to customers.





In March 2011, the Company’s Board of Directors approved the discontinuation of the Services segment of the business. Based on this approval, the Company determined that this segment substantially met the criteria to report the segment as "Discontinued Operations" in accordance with ASC 360, “Property, Plant and Equipment”  Accordingly, assets classified as discontinued have been measured at the lower of the carrying amount or fair value less cost to sell. The Company expects to complete the discontinuation of the operations of the Services segment of the business during fiscal year 2011.  At that time, the Company will cease to report that segment’s results.





In accordance with ASC 360, depreciation and amortization expense were suspended on assets in the Services segment of the business in March 2011.  Operating results of our discontinued operations for the three and six months ended June 30, 2011 and 2010 are as follows:





For the three months ended

June 30


For the six months ended

June 302011


2010


2011


2010(unaudited)


(unaudited)


(unaudited)


(unaudited)Revenue from discontinued operations

$
74


$
81


$
101


$
154Net Income

$
74


$
27


$
101


$
104





The major class of assets of our discontinued operations at June 31, 2011 and December 31, 2010 are as follows:





For the Period endedJune 30, 2011


December 31,

2010(unaudited)


(unaudited)Current Assets:Accounts Receivable

$
-


$
10





3.
Liquidity Considerations





The Company has incurred recurring net losses and has an accumulated deficit of $(292,147), stockholder’s deficiency of $(4,856) and a working capital deficiency of $(10,598) as of June 30, 2011.





The Company’s ability to generate cash is dependent upon the sale of the Company’s products and on obtaining cash through the private or public issuance of debt or equity securities. Given that the Company’s video phone business involves a newly developed video phone with no market penetration in an underdeveloped market sector, no assurances can be given that sufficient sales, if any, will materialize. The lack of success of the Company’s sales efforts could also have an adverse impact on our ability to raise additional financing.





ACN Video Phone Purchases.  On March 8, 2011, ACN DPS informed the Company that, although it intends to abide by its obligations under the Master Purchase Agreement, as amended, ACN DPS expected to revise its purchase forecast downward for video phones.  On March 22, 2011, the Company received a significantly reduced ordering forecast from ACN DPS for the remainder of 2011, based in part on a significant build up in inventory of unsold video phones held by ACN DPS.  The Master Purchase Agreement requires ACN DPS to purchase 300,000 video phones over a two year period (through August 2012), but does not specify the timing of such purchases during the two year commitment period.  Accordingly, the Company expects that revenues from sales to ACN DPS in fiscal year 2011 will be significantly lower than in fiscal year 2010, which the Company expects will have a material impact on its ability to generate cash from product sales


7


Advances Under the Revolving Loan.  In October 2009, the Company entered into a Revolving Loan and Security Agreement with WGI pursuant to which WGI agreed to provide to the Company a line of credit in the principal amount of $3,000. In March 2010, the principal amount of the line of credit was increased to $5,000, and in August 2010 the principal amount of the line of credit was increased to $7,000. Each loan advance under the Revolving Loan and Security Agreement requires the satisfaction of certain conditions, including a condition that there shall not have occurred, in WGI’s sole discretion, any material adverse change in the Company’s business, operations or condition (financial or otherwise) or a material impairment in the prospect of repayment of any portion of the Company’s obligations under the Revolving Loan and Security Agreement.  On March 8, 2011, following the Company’s request for funds from the Revolving Loan and Security Agreement pursuant to a notice of borrowing, WGI informed the Company that it believes the Company has not satisfied the condition relating to the absence of a material adverse change or material impairment in the prospect of repayment of the Company’s obligations under the Revolving Loan and Security Agreement and, therefore, no loan advance under the Revolving Loan and Security Agreement was to be made at that time.    The outstanding principal balance under the Revolving Loan and Security Agreement was $2,700 and $2,839 as of June 30, 2011 and August 15, 2011, respectively.





On March 30, 2011, the Company entered into a Waiver and Conditional Advance Agreement (the “Advance Agreement”) with WGI.  Pursuant to the Advance Agreement, WGI agreed to provide the Company up to $1,200 in funds under the Revolving Loan and Security Agreement to fund specific expenses pursuant to a proposed operating budget. The Advance Agreement also provided that the obligation of the Company to make periodic interest payments on outstanding amounts under the Revolving Loan and Security Agreement was deferred until July 1, 2011, which subsequently extended to September 1, 2011, at which time (i) all accrued but unpaid interest is due and payable, and (ii) the obligation of the Company to make periodic interest payments under the Revolving Loan and Security Agreement resumes.  The Company acknowledged its failure to meet certain borrowing conditions under the Revolving Loan and Security Agreement and that WGI is not obligated to make further loan advances under the Revolving Loan and Security Agreement.  The Company also provided WGI and its related parties with a release of all claims relating to the Advance Agreement and the Revolving Loan and Security Agreement.  As of June 30, 2011, the Company had borrowed $400 of the available $1,200 in funds under the WGI Revolving Loan and Security Agreement in accordance with the Advance Agreement and has borrowed an additional $139 thereunder between July 1, 2011 and August 15, 2011.





Due to the Company’s inability to generate sufficient cash flow from operations, the lack of availability of additional loan advances under the Revolving Loan and Security Agreement beyond (the remaining funds that may be available pursuant to the Advance Agreement),  and the reduction of video phone orders in the near term by ACN DPS, the Company does not believe its current cash and cash equivalents will satisfy its projected cash requirements in the near term and through June 30, 2012 and there exists substantial doubt about the Company’s ability to continue as a going concern.





Given the Company’s current liquidity, the Company terminated its office lease obligation in Pittsford, New York, discontinued offering digital voice and video communication services to customers and substantially reduced research and development activities.  The Company has continued to reduce its expenses, including substantial reductions in its workforce, as it continues to explore strategic alternatives.  The Company’s workforce has been reduced to 2 employees and one consultant.





The Company believes that, based on currently projected cash inflows generated from operations, the Company will be unable to pay future scheduled interest and/or principal payments under the Revolving Loan and Security Agreement as these obligations become due.  If WGI is not willing to waive compliance or otherwise modify the Company’s obligations such that the Company is able to avoid defaulting on such obligations, WGI could accelerate the maturity of the Company’s debts due to it.  Further, because WGI has a lien on all of the Company’s assets to secure the Company’s obligations under the Revolving Loan and Security Agreement, WGI could take actions under the loan agreement and seek to sell the Company’s assets to satisfy the Company’s obligations thereunder. All of these actions would likely have an immediate material adverse effect on the Company’s business, financial condition or results of operations.





In view of the Company’s current cash resources, nondiscretionary expenses, debt and near term debt service obligations, the Company intends to explore all strategic alternatives available to it, including, but not limited to, a sale or merger of the Company or certain of its assets, recapitalization, partnership, debt or equity financing, financial reorganization, liquidation and/or ceasing operations.  The Company may determine that it is in its best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code.  Seeking relief under the U.S. Bankruptcy Code, even if the Company is able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between the Company and its existing and potential customers, employees, and others. Further, if the Company was unable to implement a successful plan of reorganization, the Company might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code.




8


The Company’s board of directors has established a special committee of directors that are independent and disinterested from WGI and ACN to guide the Company through the evaluation of strategic alternatives.  There can be no assurance that exploration of strategic alternatives will result in the Company pursuing any particular transaction or, if the Company pursues any such transaction, that it will be completed.  The Company retained a financial advisor to assist the Company in the exploration of strategic alternatives, including preparation of marketing materials and the solicitation of potential acquirers for the Company and/or its assets and persons interested in providing financing to the Company.  The Company does not expect to make further public comment regarding its consideration of strategic alternatives until the Company’s board of directors has approved a specific course of action, the Company’s board of directors deems disclosure of significant developments is appropriate, or the Company is legally required to do so.





Because of the Company’s significant losses to date and the Company’s limited tangible assets, the Company does not fit traditional credit lending criteria, which, in particular, could make it difficult for the Company to obtain loans or to access the capital markets.  If the Company issues additional equity or convertible debt securities to raise funds, the ownership percentage of the Company’s existing stockholders would be reduced and they may experience significant dilution.  New investors may demand rights, preferences or privileges senior to those of existing holders of the Company’s common stock.





The Company currently does not have any employees that have software or manufacturing engineering expertise, resulting in the Company not being able to provide service to customers, not being able to make substantives changes to the software on the Company’s video phones and not being able to manufacture, sell or provision additional video phones.  The Company is continuing to negotiate with its vendors and counterparties regarding settling outstanding payables and eliminating future contractual obligations.





4.
Summary of Significant Accounting Policies





Fair value of financial instruments


The Company’s financial instruments consist primarily of cash and cash equivalents, accounts receivable and accounts payable. The book value of cash and cash equivalents, accounts receivable and accounts payable is considered to be representative of their values because of their short term maturities. Due to the Company’s relationship, the carrying value of the revolving loan with a related party approximates fair value, as determined by comparison of rates currently available for obligations with similar terms and maturities.





Revenue Recognition


Revenue is recognized when persuasive evidence of an arrangement exists, the price is fixed or determinable, the collectability is reasonably assured, and the delivery and acceptance of the equipment has occurred or services have been rendered. Management exercises judgment in evaluating these factors in light of the terms and conditions of its customer contracts and other existing facts and circumstances to determine appropriate revenue recognition. Due to the Company’s limited commercial sales history, its ability to evaluate the collectability of customer accounts requires significant judgment. The Company periodically evaluates its customers for collectability at the date of sale and periodically thereafter.





The Company’s revenue is net of any collections of state or municipal taxes, fees or surcharges on the charges to customers for the products that they purchase. Revenues are also offset by a reserve for any price refunds and consumer rebates consistent with Accounting Standards Codification (“ASC”) Topic 605-50. In addition, revenues are also offset to reflect any consideration given by a vendor to a customer for whom an otherwise identifiable benefit has not been received. This consideration includes warrants given to a customer (See Note 7).





During the three months ended June 30, 2011 the Company shipped $3,668 of units previously recorded as deferred revenue as of March 31, 2011 and as such recorded this as revenue in the three months ended June 30, 2011. Prior to the shipment of these units, these units were held and revenue deferred by the Company pending shipment to the ultimate customer.





During the three months ended March 31, 2011 the Company shipped $2,356 of units previously recorded as deferred revenue as of December 31, 2010 and as such recorded this as revenue in the six months ended June 30, 2011. Prior to the shipment of these units, these units were held and revenue deferred by the Company pending shipment to the ultimate customer.





Reclassification


Certain accounts in the prior year condensed consolidated financial statements have been reclassified for comparative purpose to confirm to the presentation in the current year condensed consolidated financial statements. The reclassifications have no effect on the previously reported net loss.




9


Recent Accounting Pronouncements


There were various other updates recently issued, most of which represented technical corrections of accounting literature or application to specific industries and are not expected to have a material impact on the Company’s condensed consolidated financial position, results of operations or cash flows.





5.
WGI / ACN DPS transactions





Securities Purchase. In April 2009, the Company issued to WGI an aggregate of 202,462,155 shares of its common stock in a private placement transaction representing approximately 63% of the total number of the issued and outstanding shares of the Company’s common stock, as well as a warrant to purchase up to 140,009,750 shares of the Company’s common stock in certain circumstances (the “Anti-Dilution Warrant”) in exchange for (a) cash consideration of $1,450, (b) the cancellation of convertible debentures held by WGI under which approximately $5,100 in principal and accrued interest was outstanding, and (c) the cancellation of certain outstanding warrants held by WGI to purchase shares of the Company’s common stock. WGI is a private investment fund whose ownership includes owners of ACN, a direct seller of telecommunications services and a distributor of video phones.





Anti-Dilution Warrant. The Anti-Dilution Warrant entitles WGI to purchase up to 140,009,750 shares of the Company’s common stock at an exercise price of $0.01 per share to the extent the Company issues any capital stock upon the exercise or conversion of (i) any warrants, options and other purchase rights that were outstanding as of April 6, 2009 (“Existing Contingent Equity”), (ii) up to approximately 19.7 million shares underlying future options, warrants or other purchase rights issued after April 6, 2009 (“Future Contingent Equity”), or (iii) the warrant issued to ACN DPS, a subsidiary of ACN, to purchase up to approximately 38.2 million shares of the Company’s common stock at an exercise price of $0.0425 per share (the “ACN 2009 Warrant”). The Anti-Dilution Warrant is designed to ensure that WGI may maintain ownership of 63% of the Company’s issued and outstanding shares of capital stock in the event that any of the Company’s capital stock is issued in respect to the Existing Contingent Equity, the Future Contingent Equity or the ACN 2009 Warrant – upon each issuance of a share pursuant to Existing Contingent Equity, Future Contingent Equity or the ACN 2009 Warrant, the Anti-Dilution Warrant may be exercised for 1.7027027 shares. The term of the Anti-Dilution Warrant is ten years from the date of issuance, and the shares subject to the Anti-Dilution Warrant will be decreased proportionally upon the expiration of Existing Contingent Equity, Future Contingent Equity and the ACN 2009 Warrant. As of June 30, 2011, the full amount of Future Contingent Equity (approximately 19.7 million shares) had been fully allocated to options and warrants issued by the Company after April 6, 2009, and therefore, any future options, warrants or other purchase rights issued by the Company will not be considered Future Contingent Equity.





Commercial Relationship with ACN DPS. In April 2009, the Company entered into a commercial relationship with ACN DPS pursuant to which the Company agreed to design and sell video phones to ACN DPS (the “Commercial Relationship”). As part of the Commercial Relationship, the Company entered into two agreements with ACN DPS:  a Master Purchase Agreement pursuant to which ACN DPS committed to purchase 300,000 videophones over a two-year period (the “Master Purchase Agreement”) and a Software Development and Integration and Manufacturing Assistance Agreement pursuant to which ACN DPS committed to provide the Company with $1,200 to fund associated software development costs. In connection with the Commercial Relationship, the Company granted ACN DPS the ACN 2009 Warrant, which vests incrementally based on ACN DPS’s purchases of video phones under the Commercial Relationship.





In March 2010, the Company entered into the First Amendment (the “MPA Amendment”) to the Master Purchase Agreement with ACN DPS to require ACN DPS to pay 50% of the purchase price for video phones pursuant to a purchase order upon the later of (a) acceptance of the purchase order by the Company and (b) five (5) weeks prior to the delivery of video phones to ACN DPS at the Company’s manufacturing facility. ACN DPS will pay the remaining 50% of the purchase price upon delivery of the video phones to ACN DPS at the Company’s manufacturing facility. In connection with the MPA Amendment, the Company granted ACN DPS a warrant to purchase up to 3,000,000 shares of the Company’s common stock at an exercise price of $0.0425 per share (the “ACN 2010 Warrant”). The ACN 2010 Warrant will vest incrementally based on ACN DPS’s purchases of video phones under the Master Purchase Agreement. The Company refers to the ACN 2009 Warrant and the ACN 2010 Warrant collectively as the “ACN Warrants.”





In January 2011 and effective as of December 31, 2010, the vesting schedule of the ACN Warrants was amended to provide that the first 1/6 of the ACN Warrants would vest upon reaching 99,440 units shipped to ACN DPS and the remaining 5/6 of the ACN Warrants will vest upon reaching an additional 200,560 units shipped to ACN DPS.





On March 8, 2011, ACN DPS informed the Company that, although it intends to abide by its obligations under the Master Purchase Agreement, as amended by the MPA Amendment, ACN DPS expected to revise its purchase forecast downward for video phones.  On March 22, 2011, the Company received a significantly reduced ordering forecast from ACN DPS for the remainder of 2011, based in part on a significant build up in inventory of unsold video phones held by ACN DPS.  The Master Purchase Agreement requires ACN DPS to purchase 300,000 video phones over a two year period (through August 2012), but does not specify the timing of such purchases during the two year commitment period.




10


Revolving Loan and Security Agreement with WGI. In October 2009, the Company entered into a Revolving Loan and Security Agreement with WGI pursuant to which WGI provided the Company a line of credit in a principal amount of $3,000. In March 2010, the principal amount of the line of credit was increased to $5,000. In August 2010, the principal amount of the line of credit was increased to $7,000. Interest accrues on any loan advances at the rate of 10% per annum. Interest payments commenced June 1, 2010 and are payable monthly after such date, and any principal amount repaid is available for re-borrowing. All outstanding principal and interest outstanding are required to be repaid on October 28, 2014. The Company granted WGI a security interest in substantially all of the Company’s assets and the Company made customary representations and covenants to WGI. Any loan advance requires the satisfaction of customary borrowing conditions. Upon the occurrence of an event of default, (1) WGI may require repayment of all outstanding amounts under the Revolving Loan and Security Agreement, may terminate its commitment to make additional loans, and may exercise its rights with respect to the security interest in substantially all of the Company’s assets and (2) all outstanding amounts under the Revolving Loan and Security Agreement will bear interest at the rate of 15% per annum.  The outstanding principal balance under the Revolving Loan and Security Agreement was $2,700 and $2,839 as of June 30, 2011 and August 15, 2011, respectively.  During the six months ended June 30, 2011 and 2010, interest expenses on outstanding balance of loans are $149 and $145, respectively.  During the three months ended June 30, 2011 and 2010, interest expenses on outstanding balance of loans is $70 and $84, respectively.





In connection with the increase of the principal amount of the Revolving Loan and Security Agreement to $5,000, in March 2010, the Company granted WGI a warrant to purchase up to 6.0 million shares of the Company’s common stock at an exercise price of $0.574 per share. The warrant was fully vested on issuance and has a term of 10 years. The warrant has a value of $3,330 utilizing the Black-Scholes option pricing model with the following assumptions: term of 10 years, volatility of 162%, dividends of $0 and a risk free interest rate of 3.71%.





In connection with the increase of the principal amount of the Revolving Loan and Security Agreement to $7,000, in August 2010, the Company granted WGI a warrant to purchase up to 8.0 million shares of the Company’s common stock at an exercise price of $0.432 per share. The warrant was fully vested on issuance and has a term of 10 years. The warrant has a value of $3,327 utilizing the Black-Scholes option pricing model with the following assumptions: term of 10 years, volatility of 161%, dividends of $0 and a risk free interest rate of 2.72%.





Each loan advance under the Revolving Loan and Security Agreement with WGI requires the satisfaction of certain conditions, including a condition that there shall not have occurred, in WGI’s sole discretion, any material adverse change in the Company’s business, operations or condition (financial or otherwise) or a material impairment in the prospect of repayment of any portion of the Company’s obligations under the Revolving Loan and Security Agreement.  On March 8, 2011, following the Company’s request for funds from the Revolving Loan and Security Agreement pursuant to a notice of borrowing, WGI informed the Company that it believes the Company has not satisfied the condition relating to the absence of a material adverse change or material impairment in the prospect of repayment of the Company’s obligations under the Revolving Loan and Security Agreement and, therefore, no loan advance under the Revolving Loan and Security Agreement was to be made at that time.





On March 30, 2011, the Company entered into the Advance Agreement with WGI.  Pursuant to the Advance Agreement, WGI agreed to provide the Company up to $1,200 in funds under the Revolving Loan and Security Agreement to fund specific expenses pursuant to a proposed operating budget.  The Advance Agreement also provided that the obligation of the Company to make periodic interest payments on outstanding amounts under the Revolving Loan and Security Agreement was deferred until July 1, 2011, which subsequently extended to September 1, 2011, at which time (i) all accrued but unpaid interest is due and payable, and (ii) the obligation of the Company to make periodic interest payments under the Revolving Loan and Security Agreement resumes.  The Company acknowledged its failure to meet certain borrowing conditions under the Revolving Loan and Security Agreement and that WGI is not obligated to make further loan advances under the Revolving Loan and Security Agreement.  The Company also provided WGI and its related parties with a release of all claims relating to the Advance Agreement and the Revolving Loan and Security Agreement.





6.
Inventory





The Company’s inventory consists primarily of finished goods equipment to be sold to customers. The cost is determined at the lower of cost or market on a first-in, first-out cost basis. During the quarter, the Company shipped $1,447 of units that were previously recorded as deferred revenue at March 31, 2011.  At June 30, 2011, all inventory consisted of saleable inventory.   As of June 30, 2011, the Company’s inventory balance was $250 net of a reserve of $-0- for excess and obsolete inventory.  As of December 31, 2010, the Company’s inventory balance was $296 net of a reserve of $405 for excess and obsolete inventory.  During 2010, the Company adjusted its reserve for excess and obsolete inventory by $352.




11


7.
Deferred Debt Issuance Costs





In connection with the increase of the principal amount of the Revolving Loan and Security Agreement to $5,000, in March 2010, the Company granted WGI a warrant to purchase up to 6.0 million shares of the Company’s common stock. The warrant had a value of $3,330 utilizing the Black-Scholes option pricing model which was recorded as a deferred debt issuance cost and will be amortized on a straight-line basis, which approximates the interest rate method, over the remaining term of the Revolving Loan and Security Agreement.  For the three month periods ended June 30, 2011 and 2010, the Company has amortized deferred debt discount for $179 and $179, respectively.  For the six month periods ended June 30, 2011 and 2010, the Company has amortized deferred debt discount for $358 and $224, respectively.  As of June 30, 2011, $940 of this warrant had been amortized and the balance of the deferred debt issuance cost was recorded as a long term asset.





In connection with the increase of the principal amount of the Revolving Loan and Security Agreement to $7,000, in August 2010, the Company granted WGI a warrant to purchase up to 8.0 million shares of the Company’s common stock.  The warrant had a value of $3,327 utilizing the Black-Scholes option pricing model which was recorded as a deferred debt issuance cost and will be amortized on a straight-line basis, which approximates the interest rate method, over the remaining term of the Revolving Loan and Security Agreement.  For the three month periods ended June 30, 2011 and 2010, the Company has amortized deferred debt discount for $197 and $-0-, respectively.  For the six month periods ended June 30, 2011 and 2010, the Company has amortized deferred debt discount for $395 and $-0-, respectively.  As of June 30, 2011, $701 of this warrant had been amortized and the balance of the deferred debt issuance cost was recorded as a long term asset.





8.
Accrued Expenses





The Company’s accrued expenses consisted of the following as of June 30, 2011 and December 31, 2010:





June 30, 2011


December 31, 2010D3 network fees

$
-


$
37License fees


117



88Contingent penalties


157



157Kentec long lead inventory items


1,995



-Inventory purchased by vendor


-



132Taxes


35



2Other


-



162Totals

$
2,304



578





The Kentec long lead inventory items consists of an estimate ofamounts incurred by Kentec pursuant to the manufacturing agreement between Kentec and the Company for parts which require long lead times to purchase and which were necessary to have ordered in advance to meet the Company’s prior production forecasts.  The Company does not expect to be able to utilize the long lead items purchased by Kentec, which could result in the Company being responsible for the costs of such items.





9.
Warranty Reserve





The Company provides a warranty covering defects arising from the sales of its video phone product. This warranty is limited to a specific time period. Warranty costs are charged to cost of revenues when they are probable and reasonably estimable. While the Company believes its estimate at June 30, 2011 is reasonable and adequate, it is subject to change based on its future sales and experience, which may require an increase or decrease in its reserve. The outstanding balance of warranty reserve at June 30, 2011 and December 31, 2010 is $343 and $343, respectively.





10.
Deferred Revenue and Income





Deferred revenue and income consists primarily of advance payments received from ACN DPS for units that have not been shipped.  There were no deferred revenues as of June 30, 2011 as all deferred revenues were earned during the six months ended June 30, 2011.




12




11.
Stockholders’ Equity





Anti-Dilution Warrant





The following table summarizes, as of June 30, 2011, each contingent equity category under the Anti-Dilution Warrant and the exercisability of the Anti-Dilution Warrant.





Shares Under Contingent Equity CategoriesAs of June 30, 2011Contingent Equity Categories

Issuable as of

April 6, 2009


Terminated

or Expired

Shares


Shares Not

Exercisable


Shares

Exercisable


Total Shares

Issuable

(Exercisable

and Non-
Exercisable)Existing Contingent Equity


24,318,869



8,816,892



1,285,967



14,216,010



15,501,977Future Contingent Equity


19,689,182



14,345,433



4,295,000



1,048,750



5,343,750CAN 2009 Warrant


38,219,897



-



38,219,897



-



38,219,897Total Contingent Equity


82,227,948



23,162,325



43,800,864



15,264,760



59,065,624Anti-Dilution Warrant (Total Contingent Equity*1.7027027)


140,009,750



39,438,551



74,579,848



25,991,345



100,571,193





ACN Warrants





In connection with the commercial relationship with ACN DPS, the Company granted ACN DPS the ACN 2009 Warrant to purchase up to approximately 38.2 million shares of common stock at an exercise price of $0.0425 per share. The ACN 2009 Warrant granted to ACN DPS will vest incrementally based on ACN DPS’s purchases of video phones under the Master Purchase Agreement.





In March 2010, the Company amended the Master Purchase Agreement with ACN DPS. In connection with this amendment, the Company granted ACN DPS the ACN 2010 Warrant to purchase up to 3 million shares of common stock at an exercise price of $0.0425 per share. The ACN 2010 Warrant will vest incrementally based on ACN DPS’s purchases of video phones under the Master Purchase Agreement, as amended by the MPA Amendment.





In January 2011 and effective as of December 31, 2010, the vesting schedule of the ACN Warrants was amended to provide that the first 1/6 of the ACN Warrants would vest upon reaching 99,440 units shipped to ACN DPS and the remaining 5/6 of the ACN Warrants will vest upon reaching 200,560 additional units shipped to ACN DPS. .





The Black Scholes economic model calculations of these fair values were based on the following assumptions:





At December 31, 2010

Vested warrant for

6,869,982 shares


At June 30, 2011

Unvested warrant for

34,349,915 sharesMarket Price

$
0.38


$
0.04Exercise Price

$
0.0425


$
0.0425Term

8.53 yrs


7.77 yrsVolatility Rate


165.12
%


178.45
%Interest Rate


2.200
%


3.45
%




A summary of the Company warrant activity for the six months ended June 30, 2011 is as follows:





Warrants


Weighted Average

Exercise Price


Weighted Average

Remaining Contract

LifeOutstanding, January 1, 2011


181,092,464


$
0.05



8.38Granted


-



-Exercised


-



-Cancelled / Forfeited/ Expired


(25,301,374
)


(0.01
)Outstanding, June 30, 2011


155,791,090


$
0.06



8.60Exercisable, June 30, 2011


46,861,327


$
0.16



8.83




13


Stock Option Plan





In December 1996, the Company adopted the 1996 Stock Option Plan (“1996 Plan”). In October 2004, the Company’s stockholders approved the 2003 Equity Incentive Plan (“2003 Plan”). The 2003 Plan replaced the 1996 Plan for new grants. No additional shares were reserved for the new plan with all available shares under the 1996 Plan made available for the new plan. In May 2009, the board of directors of the Company approved the terms of Amendment No. 1 (the “Amendment”) to the 2003 Plan, subject to stockholder approval. The Amendment, among other things, increased the maximum number of shares of common stock that may be issued or transferred under the 2003 Plan to 26,500,000 and increased the maximum amount of shares that may be issued in any fiscal year to any single participant in the 2003 Plan underlying an option award to 2,000,000 shares. In May 2010, the Company’s stockholders approved the Amendment and, immediately thereafter, the 2003 Plan was terminated (except for outstanding awards) upon the approval of the adoption of the 2010 Plan (as described below) by the stockholders.





In May 2010, the Company’s stockholders approved the adoption of the 2010 Stock Incentive Plan (the “2010 Plan”). The 2010 Plan authorizes the granting of equity-based compensation in the form of stock options and restricted stock awards to the Company’s directors, officers, other employees and consultants. Total awards under the 2010 Plan are limited to 12,000,000 shares of common stock plus any shares relating to awards that expire or are forfeited or cancelled under the 2010 Plan.





Each of the 1996 Plan, the 2003 Plan and 2010 Plan are administered by the compensation committee of the board of directors of the Company. The compensation committee determines the term of each award, provided, however, that the exercise period may not exceed ten years from the date of grant, and for incentive stock options, in certain instances, may not exceed five years. As of June 30, 2011, there were 12,000,000 shares available for grant under the 2010 Plan and 5,580,967 options outstanding.





The weighted-average fair values of the options granted were $0.21 and $0.54 per option during the six months ended June 30, 2011 and 2010, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes fair value option valuation model. The following weighted-average assumptions were used for grants during the six months ended June 30, 2011 and 2010, respectively: expected volatility of 142.68% and 151.3%; average risk-free interest rates of 2.56% and 2.70%; dividend yield of 0%; and expected lives of 6.25 and 6.25 years.





The Company accounts for all stock based compensation as an expense in the financial statements and associated costs are measured at the fair value of the award. As a result, the Company’s net loss before taxes for the six months ended June 30, 2011 and 2010 included approximately $841 and $749, respectively, of stock based compensation. The stock based compensation expense is included in general and administrative expense in the consolidated statements of operations. The Company has selected a “with-and-without” approach regarding the accounting for the tax effects of share-based compensation awards.





A summary of the Company’s stock plans is presented below:





Stock Options


Weighted-Average

Exercise Price

Weighted

Average

Remaining

Contractual

Term

Aggregate

Intrinsic ValueOutstanding, January 1, 2011


22,699,426


$
0.40

8.19 years

$
331,154Granted


537,000


$
0.21Exercised


(257,557
)

$
0.83Cancelled/Forfeited


(17,397,902
)

$
0.42Outstanding, June 30, 2011


5,580,967


$
0.27

7.02 years

$
-Exercisable, June 30, 2011


3,545,967


$
0.26

6.51 years

$
-





As of June 30, 2011, there was $2,680 of total unrecognized compensation arrangements granted under the Company’s equity compensation plans.  The cost is expected to be recognized through 2014.




14


The aggregate intrinsic value of outstanding and exercisable stock options at June 30, 2011 represents (i) the difference between the Company’s closing stock price of $0.04 on June 30, 2011 and the weighted average option exercise price per share on that date of $0.27 for outstanding options and $0.26 for exercisable options, multiplied by (ii) the number of shares underlying outstanding options on that date.





Restricted Stock Grants





The 2003 Plan provided for performance share grants of restricted shares of common stock representing the right to receive a payment in cash, shares of common stock, or a combination thereof as determined by the compensation committee equal to the value of the shares of common stock on achievement of performance criteria. An aggregate of 1,151,000 restricted shares were granted in October 2007 and December 2007 to certain executives that vest upon the achievement of certain performance criteria.  During the three months ended June 30, 2011, no restricted shares were outstanding.





12.
Net (Loss) Per Share (Basic and Diluted)





The Company displays dual presentation of earnings per share as both basic and diluted earnings per share (“EPS”). Basic EPS includes no dilution and is computed by dividing net profit (loss) attributable to common stockholders by the weighted average number of common shares outstanding for the period.  Basic weighted average shares outstanding for the three months ended June 30, 2011, includes 27,594,251weighted average shares issuable in the future under the terms of the WGI Anti-Dilution Warrant, as these warrants are exercisable at a nominal amount.  Basic weighted average shares outstanding for the six months ended June 30, 2011, includes 27,475,228, weighted average shares issuable in the future under the terms of the WGI Anti-Dilution Warrant for the six months ended June 30, 2011, as these warrants are exercisable at a nominal amount.  Diluted EPS includes, under the “treasury stock” and “if converted” methods, the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Outstanding stock options, warrants and other potential stock issuances are not included in the computation when they are not in the money or their effect would be anti-dilutive.





Potential common shares excluded from net income per share for the three months ended June 30, 2011 were 128,510,729 because their effect would be anti-dilutive as they are not in the money at June 30, 2011. Potential common shares excluded from net loss per share for the six months ended June 30, 2011 were 128,510,729 and for the three and six months ended June 30, 2010 were 173,557,581 because their effect would be anti-dilutive due to the Company's net loss.  Excluded shares of common stock include shares issuable upon the exercise of stock options, unvested restricted stock and warrants, irrespective of whether such securities are in the money.





13.
Commitments and Contingencies





Leases





The Company leases approximately 18,702 square feet of office space at 3800 Horizon Boulevard, Trevose, Pennsylvania.





As of June 30, 2011, the future minimum contractual lease commitments under leases for each of the fiscal years ending December 31 are as follows:





2011

$
2242012


4572013


4672014


4762015


485Thereafter


1,041Total

$
3,150





Other Commitments





During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company entered into an agreement with its contract manufacturer to allow it to procure component inventory based upon criteria as defined by the Company. If the component inventory procured by the contract manufacturer is not used in production of products for the Company and is not returnable, usable or saleable to other parties, then the Company may be responsible for purchasing the component inventory. At June 30, 2011, the Company has accrued $1,995 related to such obligation.


15


Legal Proceedings





From time to time, the Company becomes involved in various legal proceedings, claims, investigations and proceedings that arise in the normal course of operations. While the results of such claims and litigation cannot be predicted with certainty, the Company is not currently aware of any such matters that it believes would have a material adverse effect on its financial position, results of operations or cash flows. In accordance with generally accepted accounting principles, the Company makes a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss or range of loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case.





14.
Subsequent Events.





The Company evaluated subsequent events through the date the financialstatements were issued and filed with the Securities and Exchange Commission. There were no subsequent events that required recognition or disclosure.


16


ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollar amounts contained in this Item 2 are in thousands, except for share and per share amounts)




FORWARD-LOOKING AND CAUTIONARY STATEMENTS




From time to time, we may provide information, whether orally or in writing, including those contained in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, which are deemed to be “forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995.  Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements.  These forward-looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.  The words  “if,” “will,” “predicts,” “may,” “should,” “believe,” “anticipate,” “future,” “forward,” “potential,” “estimate,” “reinstate,” “opportunity,” “goal,” “objective,” “continue,” “exchange,” “growth,” “outcome,” “could,” “expect,” “intend,” “plan,” “strategy,” “provide,” “commitment,” “result,” “seek,” “pursue,” “ongoing,” “include” or in the negative of such terms or comparable terminology and similar expressions, as they relate to us, are intended to identify forward-looking statements.  In accordance with the provisions of the Private Securities Litigation Reform Act of 1995, we are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements.  Factors and risks that could cause actual results to differ materially from those set forth or contemplated in forward looking statements include the risks identified in our filings with the Securities and Exchange Commission, including the risks identified in “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.  Forward-looking statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from such forward looking statements or expectations.  Readers are also cautioned not to place undue reliance on these forward looking statements which speak only as of the date these statements were made.  Except as required by law, we do not intend to update or revise any forward looking statements, whether as a result of new information, future events or otherwise.




General




WorldGate Communications, Inc. designs and develops innovative digital video phones featuring high quality, real-time, two-way video. The unique combination of functional design, advanced technology and use of IP broadband networks provides true-to-life video communication.




We currently do not have multiple business segments.  During fiscal year 2010, we had two reportable business segments: Services and Equipment. The Services segment marketed and distributed products and related recurring services to end users.  The Equipment segment sells digital video phones directly to telecommunications service providers who already have a digital voice and video management and network infrastructure.  In connection with our cost reduction measures in March 2011, we discontinued offering digital voice and video communication services to customers.  The Services business segment is now included in discontinued operations.




Recent Developments and Going Concern Uncertainty





Our condensed consolidated financial statements have been prepared on a “going concern” basis, which contemplates realization of assets and liquidation of liabilities in the normal course of business.





ACN Video Phone Purchases.  On March 8, 2011, ACN DPS informed us that, although it intends to abide by its obligations under the Master Purchase Agreement, as amended, ACN DPS expected to revise its purchase forecast downward for video phones.  On March 22, 2011, we received a significantly reduced ordering forecast from ACN DPS for the remainder of 2011, based in part on a significant build up in inventory of unsold video phones held by ACN DPS.  The Master Purchase Agreement requires ACN DPS to purchase 300,000 video phones over a two year period (through August 2012), but does not specify the timing of such purchases during the two year commitment period.  Accordingly, we expect that revenues from sales to ACN DPS in fiscal year 2011 will be significantly lower than in fiscal year 2010, which we expect will have a material impact on our ability to generate cash from product sales.





Advances Under the Revolving Loan.  Each loan advance under the Revolving Loan and Security Agreement requires the satisfaction of certain conditions, including a condition that there shall not have occurred, in WGI’s sole discretion, any material adverse change in our business, operations or condition (financial or otherwise) or a material impairment in the prospect of repayment of any portion of our obligations under the Revolving Loan and Security Agreement.  On March 8, 2011, following our request for funds from the Revolving Loan and Security Agreement pursuant to a notice of borrowing, WGI informed us that it believes we have not satisfied the condition relating to the absence of a material adverse change or material impairment in the prospect of repayment of our obligations under the Revolving Loan and Security Agreement and, therefore, no loan advance under the Revolving Loan and Security Agreement was to be made at that time.




17


On March 30, 2011, we entered into the Advance Agreement with WGI.  Pursuant to the Advance Agreement, WGI agreed to provide us up to $1,200 in funds under the Revolving Loan and Security Agreement to fund specific expenses pursuant to a proposed operating budget.  The Advance Agreement also provided that our obligation to make periodic interest payments on outstanding amounts under the Revolving Loan and Security Agreement was deferred until July 1, 2011, subsequently to September 1, 2011, at which time (i) all accrued but unpaid interest is due and payable, and (ii) our obligation to make periodic interest payments under the Revolving Loan and Security Agreement resumes.  We acknowledged our failure to meet certain borrowing conditions under the Revolving Loan and Security Agreement and that WGI is not obligated to make further loan advances under the Revolving Loan and Security Agreement.  We also provided WGI and its related parties with a release of all claims relating to the Advance Agreement and the Revolving Loan and Security Agreement.  As of June 30, 2011, we had borrowed $400 of the available $1,200 in funds under the Revolving Loan and Security Agreement in accordance with the Advance Agreement and have borrowed an additional $139 thereunder between July 1, 2011 and August 15, 2011.





Due to our inability to generate sufficient cash flow from operations, the lack of availability of additional loan advances under the Revolving Loan and Security Agreement (beyond the remaining funds that may be available pursuant to the Advance Agreement), and the reduction of video phone orders in the near term by ACN DPS, we do not believe our current cash and cash equivalents will satisfy our projected cash requirements in the near term and through June 30, 2012 and there exists substantial doubt about our ability to continue as a going concern.  As a result, our auditors have included a going concern modification in their audit report on our financial statements at December 31, 2010 and for the fiscal year then ended, and we have disclosed this going concern uncertainty and management’s plans to deal with this uncertainty in the footnotes to our consolidated financial statements.





Given our current liquidity, we terminated our office lease obligation in Pittsford, New York, discontinued offering digital voice and video communication services to customers and substantially reduced research and development activities.  We have continued to reduce our expenses, including substantial reductions in our workforce, as we continue to explore strategic alternatives.  Our workforce has been reduced to 2 employees and one consultant.





We also believe that, based on currently projected cash inflows generated from operations, we may be unable to pay future scheduled interest and/or principal payments under the Revolving Loan and Security Agreement as these obligations become due.  If WGI is not willing to waive compliance or otherwise modify our obligations such that we are able to avoid defaulting on such obligations, WGI could accelerate the maturity of our debts due to it.  Further, because WGI has a lien on all of our assets to secure our obligations under the Revolving Loan and Security Agreement, WGI could take actions under the loan agreement and seek to sell our assets to satisfy our obligations thereunder. All of these actions would likely have an immediate material adverse effect on our business, financial condition or results of operations.





In view of our current cash resources, nondiscretionary expenses, debt and near term debt service obligations, we intend to explore all strategic alternatives available to us, including, but not limited to, a sale or merger of the Company or certain of our assets, recapitalization, partnership, debt or equity financing, financial reorganization, liquidation and/or ceasing operations.  We may determine that it is in our best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code.  Seeking relief under the U.S. Bankruptcy Code, even if we are able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between us and our existing and potential customers, employees, and others. Further, if we were unable to implement a successful plan of reorganization, we might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code.





Our board of directors has established a special committee of directors that are independent and disinterested from WGI and ACN to guide us through the evaluation of strategic alternatives.  There can be no assurance that exploration of strategic alternatives will result in us pursuing any particular transaction or, if we pursue any such transaction, that it will be completed. We retained a financial advisor to assist us in the exploration of strategic alternatives, including preparation of marketing materials and the solicitation of potential acquirers for our company and/or its assets and persons interested in providing financing to us.  We do not expect to make further public comment regarding our consideration of strategic alternatives until our board of directors has approved a specific course of action, our board of directors deems disclosure of significant developments is appropriate, or we are legally required to do so.





Because of our significant losses to date and our limited tangible assets, we do not fit traditional credit lending criteria, which, in particular, could make it difficult for us to obtain loans or to access the capital markets. If we issue additional equity or convertible debt securities to raise funds, the ownership percentage of our existing stockholders would be reduced and they may experience significant dilution. New investors may demand rights, preferences or privileges senior to those of existing holders of our common stock.




18


In addition, we currently do not have any employees that have software or manufacturing engineering expertise, resulting in WorldGate not being able to provide service to customers, not being able to make substantives changes to the software on the our video phones and not being able to manufacture, sell or provision additional video phones.  We are continuing to negotiate with our vendors and counterparties regarding settling outstanding payables and eliminating future contractual obligations.





These factors raise substantial doubt about our ability to continue as a going concern, and our auditors have included a going concern modification in their audit report on our financial statements at December 31, 2010 and for the fiscal year then ended as a result of these uncertainties, and we have discussed this going concern uncertainty and management’s plans to deal with this uncertainty in the footnotes to our consolidated financial statements.  The condensed consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.





Critical Accounting Policies and Estimates





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




Our significant accounting policies are described in the Management’s Discussion and Analysis section and the notes to the consolidated financial statements included in our annual report on Form 10-K for the fiscal year ended December 31, 2010.  Judgments and estimates of uncertainties are required in applying our accounting policies in many areas.  Following are some of the areas requiring significant judgments and estimates:  revenue recognition, customer inducement and valuation of warrants, inventory, long-lived assets, income taxes and stock based compensation.  Management has discussed the development and selection of these policies with the Audit Committee of our Board of Directors, and the Audit Committee of the Board of Directors has reviewed our disclosures of these policies.  There have been no material changes to the critical accounting policies or estimates reported in the Management’s Discussion and Analysis section or the audited financial statements for the year ended December 31, 2010 as filed with the Securities and Exchange Commission.




Results of Continuing Operations for the Three and Six Months Ended June 30, 2011 and 2010.




Revenues.




For the three months ended June 30,


For the six months ended June 30,2011


2010


Change


2011


2010


ChangeGross revenues

$
5,080


$
124


$
4,956


$
10,507


$
411


$
10,096Revenue discount


(27
)


-



(27
)


(194
)


-



(194
)Net revenues

$
5,053


$
124


$
4,929


$
10,313


$
411


$
9,902





Revenues consist of digital video phones and engineering services sold directly to telecommunications service providers. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the increase in revenues reflects shipments of our Ojo Vision video phones to ACN DPS pursuant to our Master Purchase Agreement. Sales to ACN DPS accounted for substantially all of our total net revenues for the three months ended June 30, 2011 and 2010, respectively.





For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the increase in revenues reflects shipments of our Ojo Vision video phones to ACN DPS pursuant to our Master Purchase Agreement. Sales to ACN DPS accounted for substantially all of our total net revenues for the six months ended June 30, 2011 and 2010, respectively.





Applicable accounting guidance requires that revenue generated from sales to ACN DPS be reduced to reflect the extent that the ACN 2009 Warrant and ACN 2010 Warrant are determined to be consideration given by a vendor to a customer for which an otherwise identifiable benefit has not been received. We recorded a non-cash revenue discount of $27 and $194 during the three and six months ended June 30, 2011, respectively, to reflect the fair value of the portion of the ACN 2009 Warrant and ACN 2010 Warrant earned based on the number of units shipped through June 30, 2011.  Revenue discounts are reflected as non-cash charges that are deducted from gross revenues.




19


On March 8, 2011, ACN DPS informed us that, although it intends to abide by its obligations under the Master Purchase Agreement, as amended, ACN DPS expected to revise its purchase forecast downward for video phones.  On March 22, 2011, we received a significantly reduced ordering forecast from ACN DPS for the remainder of 2011, based in part on a significant build up in inventory of unsold video phones held by ACN DPS.  The Master Purchase Agreement requires ACN DPS to purchase 300,000 video phones over a two year period (through August 2012), but does not specify the timing of such purchases during the two year commitment period.  Accordingly, we expect that revenues from sales to ACN DPS in fiscal year 2011 will be significantly lower than in fiscal year 2010.




Cost of Revenues and Gross Profit




For the three months ended June 30,


For the six months ended June 30,2011


2010


Change


2011


2010


ChangeCost of Revenues

$
2,635


$
32


$
2,603


$
9,220


$
210


$
9,010Gross Profit

$
2,418


$
92


$
2,326


$
1,093


$
201


$
892





Cost of Revenues. The cost of revenues consists primarily of direct costs related to product and delivery costs. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the $2,603 increase in cost of revenues was the result of shipments of video phones to ACN DPS.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the $9,010 increase in cost of revenues was the result of shipments of video phones to ACN DPS and the recording of a liability of approximately $1,995 that may be owed to our contract manufacturer with respect to excess and obsolete component parts and long lead component parts purchased made by our contract manufacturer for which we do not expect to be able to utilize in production.





Gross Profit.  For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the $2,326 increase in gross profit was primarily the result of the gross profit on the shipments of video phones to ACN DPS.    For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the $892 increase in gross profit was primarily the result of the gross profit on the shipments less the recording of the liability for excess and obsolete component parts and long lead component parts described above.





Expenses From Continuing Operations




For the three months ended June 30,


For the six months ended June 30,2011


2010


Change


2011


2010


ChangeEngineering and development

$
251


$
926


$
(675
)


(73
)%

$
1,005


$
1,847


$
(842
)


(46
)%Operations


89



217



(128
)


(59
)%


348



432



(84
)


(19
)%Sales and marketing


(198
)


363



(561
)


(155
)%


353



675



(322
)


(48
)%General and administrative


923



1,176



(253
)


(22
%


2,147



2,472



(325
)


(13
)%Depreciation and amortization


92



99



(7
)


(7
)%


186



187



(1
)


(1
)%Total Expenses from Operations

$
1,157


$
2,781


$
(1,624
)


(58
)%

$
4,039


$
5,613


$
(1,574
)


(28
)%





Engineering and Development. Engineering and development expenses primarily consist of compensation, and the cost of design, programming, testing, manufacture, documentation and support of our video phone product. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the $675 decrease in engineering and development expenses primarily reflects the decrease in staff compensation costs and product development expenditures.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the $842 decrease in engineering and development expenses primarily reflects the decrease in staff compensation costs and product development expenditures.





Operations. Operating expenses consist primarily of facility operations, including information technology infrastructure and related support services. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the $128 decrease in operations expenses primarily reflects decreased staff compensation costs and reduced consulting fees offset by increases in facilities operations.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the $84 decrease in operations expenses primarily reflects decreased staff compensation and reduced consulting fees offset by increases in facilities operations.




20


Sales and Marketing. Sales and marketing expenses consist primarily of compensation, attendance at conferences and trade shows, travel costs, advertising, promotions and other marketing programs. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the $561 decrease in sales and marketing expenses primarily reflects decreased compensation expenses and the reversal of a first quarter severance accrual.  All sales and marketing severance packages were settled during the second quarter.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the $322 decrease in sales and marketing expenses primarily reflects decreased compensation and benefits expenses and the reversal of a first quarter severance accrual.





General and Administrative. General and administrative expenses consist primarily of expenditures for administration, office and facility operations, as well as finance and general management activities, including legal, accounting and professional fees. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the $253 decrease in general and administrative expenses primarily reflect decreased staff compensation.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the $325 decrease in general and administrative expenses primarily reflects decreased staff compensation costs , partially offset by an increase of stock based compensation costs related to employee stock options.





Other Income and  Expenses




For the three months ended June 30,


For the six months ended June 30,2011


2010


Change


2011


2010


ChangeInterest and other income

$
46


$
-


$
(46
)


-
%

$
74


$
-


$
(74
)


-
%Bad debt expense


-



-



-



-
%


(18
)


-



18



-
%Related party interest


(58
)


(91
)


(33
)


(36
)%


(137
)


(170
)


(33
)


(19
)%Amortization of debt issuance costs


(377
)


(179
)


198



110
%


(754
)


(224
)


530



236
%Total Other Income (Expense)

$
(389
)

$
(270
)

$
119



44
%

$
(835
)

$
(394
)

$
441



112
%





Interest and Other Income.  Interest and other income consisted of interest earned on cash and cash equivalents and payments received through negotiated settlements with a certain customer. For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the increase in interest and other income was primarily related to negotiated settlement payments of $40 received from a customer.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the increase in interest and other income was primarily related to $60 received from a customer.




Bad debt expense.  Bad debt expense primarily relates to the costs associated with accounts receivable balances which are deemed uncollectible by management.    For the three months ended June 30, 2011 compared with June 30, 2010, there was no change.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the increase reflects the additional amounts reserved for uncollectible service revenue accounts.




Related party interest.  Interest and other expense primarily reflect the accrued interest under our Revolving Loan and Security Agreement with WGI and the carrying costs under our ACN Service Agreement.  For the three and six months ended June 30, 2011 compared with the three and six months ended June 30, 2010, the decrease in related party interest was primarily related to the reduction in outstanding balance under revolving loan during the three and six months period ended June 30, 2011.




Amortization of Debt Issuance Costs. Amortization of debt issuance costs relates to warrants issued to WGI in March 2010 and August 2010.  For the three months ended June 30, 2011 compared with the three months ended June 30, 2010, the increase in amortization of $198 of debt issuance costs was due to amortization of additional debt issuance costs.  For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the increase in amortization of $530 of debt issuance costs was due to amortization of additional debt issuance costs.




Income Taxes.  We have incurred net operating losses since inception and accordingly had no current income tax provision and have not recorded any income tax benefit for those losses, since realization of such benefit is currently uncertain.




21


Net Income from Discontinued Operations




Pursuant to the board of directors’ approved discontinuation of the Services segment of business, all operating results related to this segment have been reclassified and included in discontinued operations.  For the three months ended June 30, 2011 and 2010, net income from discontinued operations of the Service segment were $74 and $27, respectively.  For the six months ended June 30, 2011 and 2010, net income from discontinued operations of the Service segment were $101 and $104, respectively.





Liquidity and Capital Resources




As of June 30, 2011, our primary sources of liquidity consisted of proceeds from the sale of video phones and video services and borrowings from WGI under our Revolving Loan and Security Agreement.




The following table sets forth a summary of our cash flows for the dates and periods indicated:





As of and for the Six Months Ended

June 30,2011


2010Cash provided by (used in) operating activities

$
773


$
(613
)Cash (used in) investing activities


-



(168
)Cash (used in) provided by financing activities


(1,608
)


837Net (decrease) increase in cash and cash equivalents


(835
)


56Cash and cash equivalents at beginning of period


878



578Cash and cash equivalents at end of period

$
43


$
634





Operating Activities. For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the increase in cash provided by operating activities primarily reflects an increase in accounts payable, an increase in accrued expenses and gross profit, offset by a decrease in deferred revenues.





Investing Activities. For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, there was no significant change in investing activities. During the six months ended June 30, 2011, the Company acquired fixed assets of $168.





Financing Activities. For the six months ended June 30, 2011 compared with the six months ended June 30, 2010, the increase in cash used in financing activities primarily reflects net repayments under our Revolving Loan and Security Agreement with WGI.





Cash and Cash Equivalents. Cash and cash equivalents at June 30, 2011 were held for working capital purposes.





Indebtedness. Our outstanding debt as of June 30, 2011 and 2010 is summarized below:





As of June 30,2011


2010Note Payable

$
113


$
106Revolving loan, with related party


2,700



2,000Total debt

$
2,813


$
2,106





The weighted average annual interest rate on total debt at June 30, 2011 and 2010 was 10.0%.





As of June 30, 2011, the Company had severance arrangements with two employees.  Under these contracts, each individual is entitled to six months’ salary and benefits continuation following termination of their employment by us without cause or good reason.  The estimated future obligation under these severance arrangements, if all of them were to be terminated as of June 30, 2011, was $216 payable in installments for six months after the termination date.  As of July 29, 2011, one of these individuals resigned from the Company.


22


Operations and Liquidity. We have incurred recurring net losses and have an accumulated deficit of $(292,147), stockholder’s deficiency of $(4,856) and a working capital deficiency of $(10,598) as of June 30, 2011.  As of June 30, 2011, we had $11,145 of liabilities. These liabilities primarily included $2,700 under the Revolving Loan and Security Agreement, $5,005 of accounts payable, $2,304 of accrued expenses, $466 payable to related parties and $670 of other current liabilities. Substantially all of our assets are pledged pursuant to WGI under the Revolving Loan and Security Agreement.





Our ability to generate cash is dependent upon the sale of our product and on obtaining cash through the private or public issuance of debt or equity securities. Given that our video phone business involves a newly developed video phone with no market penetration in an underdeveloped market sector, no assurances can be given that sufficient sales, if any, will materialize. The lack of success of our sales efforts could also have an adverse impact on our ability to raise additional financing.





ACN Video Phone Purchases.  On March 8, 2011, ACN DPS informed us that, although it intends to abide by its obligations under the Master Purchase Agreement, as amended, ACN DPS expected to revise its purchase forecast downward for video phones.  On March 22, 2011, we received a significantly reduced ordering forecast from ACN DPS for the remainder of 2011, based in part on a significant build up in inventory of unsold video phones held by ACN DPS.  The Master Purchase Agreement requires ACN DPS to purchase 300,000 video phones over a two year period (through August 2012), but does not specify the timing of such purchases during the two year commitment period.  Accordingly, we expect that revenues from sales to ACN DPS in fiscal year 2011 will be significantly lower than in fiscal year 2010, which we expect will have a material impact on our ability to generate cash from product sales.





Advances Under the Revolving Loan.   In October 2009, we entered into a Revolving Loan and Security Agreement with WGI pursuant to which WGI agreed to provide to us a line of credit in the principal amount of $3,000. In March 2010, the principal amount of the line of credit was increased to $5,000, and in August 2010 the principal amount of the line of credit was increased to $7,000.  Each loan advance under the Revolving Loan and Security Agreement requires the satisfaction of certain conditions, including a condition that there shall not have occurred, in WGI’s sole discretion, any material adverse change in our business, operations or condition (financial or otherwise) or a material impairment in the prospect of repayment of any portion of our obligations under the Revolving Loan and Security Agreement.  On March 8, 2011, following our request for funds from the Revolving Loan and Security Agreement pursuant to a notice of borrowing, WGI informed us that it believes we have not satisfied the condition relating to the absence of a material adverse change or material impairment in the prospect of repayment of our obligations under the Revolving Loan and Security Agreement and, therefore, no loan advance under the Revolving Loan and Security Agreement was to be made at that time.





On March 30, 2011, we entered into the Advance Agreement with WGI.  Pursuant to the Advance Agreement, WGI agreed to provide us up to $1,200 in funds under the Revolving Loan and Security Agreement to fund specific expenses pursuant to a proposed operating budget.  The Advance Agreement also provided that our obligation to make periodic interest payments on outstanding amounts under the Revolving Loan and Security Agreement was deferred until July 1, 2011, subsequently to September 1, 2011, at which time (i) all accrued but unpaid interest is due and payable, and (ii) our obligation to make periodic interest payments under the Revolving Loan and Security Agreement resumes.  We acknowledged our failure to meet certain borrowing conditions under the Revolving Loan and Security Agreement and that WGI is not obligated to make further loan advances under the Revolving Loan and Security Agreement.  We also provided WGI and its related parties with a release of all claims relating to the Advance Agreement and the Revolving Loan and Security Agreement.  The outstanding principal balance under the Revolving Loan and Security Agreement was $2,700 and $2,839 as of July 1, 2011 and August 15, 2011, respectively.





Due to our inability to generate sufficient cash flow from operations, the lack of availability of additional loan advances under the Revolving Loan and Security Agreement (beyond the remaining funds that may be available pursuant to the Advance Agreement), and the reduction of video phone orders in the near term by ACN DPS, we do not believe our current cash and cash equivalents will satisfy our projected cash requirements in the near term and through June 30, 2012 and there exists substantial doubt about our ability to continue as a going concern.  As a result, our auditors have included a going concern modification in their audit report on our financial statements at December 31, 2010 and for the fiscal year then ended, and we have disclosed this going concern uncertainty and management’s plans to deal with this uncertainty in the footnotes to our consolidated financial statements.





Given our current liquidity, we terminated our office lease obligation in Pittsford, New York, discontinued offering digital voice and video communication services to customers and substantially reduced research and development activities.  We have continued to reduce our expenses, including substantial reductions in our workforce, as we continue to explore strategic alternatives.  Our workforce has been reduced to 2 employees and one consultant.


23


We also believe that, based on currently projected cash inflows generated from operations, we may be unable to pay future scheduled interest and/or principal payments under the Revolving Loan and Security Agreement as these obligations become due.  If WGI is not willing to waive compliance or otherwise modify our obligations such that we are able to avoid defaulting on such obligations, WGI could accelerate the maturity of our debts due to it.  Further, because WGI has a lien on all of our assets to secure our obligations under the Revolving Loan and Security Agreement, WGI could take actions under the loan agreement and seek to sell our assets to satisfy our obligations thereunder. All of these actions would likely have an immediate material adverse effect on our business, financial condition or results of operations.





In view of our current cash resources, nondiscretionary expenses, debt and near term debt service obligations, we intend to explore all strategic alternatives available to us, including, but not limited to, a sale or merger of the Company or certain of our assets, recapitalization, partnership, debt or equity financing, financial reorganization, liquidation and/or ceasing operations.  We may determine that it is in our best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code.  Seeking relief under the U.S. Bankruptcy Code, even if we are able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between us and our existing and potential customers, employees, and others. Further, if we were unable to implement a successful plan of reorganization, we might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code.





Our board of directors has established a special committee of directors that are independent and disinterested from WGI and ACN to guide us through the evaluation of strategic alternatives.  There can be no assurance that exploration of strategic alternatives will result in us pursuing any particular transaction or, if we pursue any such transaction, that it will be completed. We retained a financial advisor to assist us in the exploration of strategic alternatives, including preparation of marketing materials and the solicitation of potential acquirers for our company and/or its assets and persons interested in providing financing to us.  We do not expect to make further public comment regarding our consideration of strategic alternatives until our board of directors has approved a specific course of action, our board of directors deems disclosure of significant developments is appropriate, or we are legally required to do so.





Because of our significant losses to date and our limited tangible assets, we do not fit traditional credit lending criteria, which, in particular, could make it difficult for us to obtain loans or to access the capital markets. If we issue additional equity or convertible debt securities to raise funds, the ownership percentage of our existing stockholders would be reduced and they may experience significant dilution. New investors may demand rights, preferences or privileges senior to those of existing holders of our common stock.





In addition, we currently do not have any employees that have software or manufacturing engineering expertise, resulting in our inability to provide service to customers, make substantives changes to the software on our video phones or to manufacture, sell or provision additional video phones.  We are continuing to negotiate with our vendors and counterparties regarding settling outstanding payables and eliminating future contractual obligations.





Off-Balance Sheet Arrangements





As of June 30, 2011, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.





Indemnification Provisions





In the ordinary course of business, we have included limited indemnification provisions in certain of our agreements with parties with whom we have commercial relations, related to intellectual property and contract breaches. It is not possible to determine the maximum potential loss under these indemnification provisions due to our limited history of prior indemnification claims and the unique facts and circumstances involved in each particular provision. To date, no significant costs have been incurred, either individually or collectively, in connection with our indemnification provisions.




ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. (Dollar amounts contained in this Item 3 are in thousands)




Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign currency. We do not hold financial instruments for trading purposes.




24


Interest Rate Sensitivity




We had cash and cash equivalents of $43 at June 30, 2011.  We held these amounts primarily in cash or money market funds.  We hold cash and cash equivalents for working capital purposes.  We do not have material exposure to market risk with respect to investments, as our investments consist primarily of highly liquid investments purchased with original maturities of three months or less.  We do not use derivative financial instruments for speculative or trading purposes; however, we may adopt specific hedging strategies in the future.  Any declines in interest rates, however, will reduce future interest income.  We had total outstanding debt of $2,813 at June 30, 2011.  The debt outstanding as of June 30, 2011 is subject to a fixed interest rate.




Inflation Risk




We do not believe that inflation has had a material effect on our business, financial condition or results of operations.  If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases.  Our inability or failure to do so could harm our business, financial condition and results of operations.




ITEM 4.  CONTROLS AND PROCEDURES.





Evaluation of Disclosure Controls and Procedures.





The Company maintains disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934)  that are designed to ensure that information required to be disclosed in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to its management, including its Principal Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding the required disclosures. In designing and evaluating the disclosure controls and procedures, the Company recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.





The Company carried out an evaluation, under the supervision and with the participation of management, including its Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of June 30, 2011.  The Company’s Principal Executive Officer and Principal Financial Officer concluded that as of June 30, 2011, its disclosure controls and procedures were designed properly and were effective in ensuring that the information required to be disclosed by the Company in the reports that we file and submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to its management, including its Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.





There is no assurance that the necessary resources will be available going forward to ensure that our reporting systems will continue to be appropriately designed or effective, or that a future material weakness will not be found in our internal controls over financial reporting or disclosure controls and procedures, which could result in material misstatement in future financial statements.





Change in Internal Control over Financial Reporting.





There have been no changes to the Company’s internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.





Effective as of June 24, 2011, Joseph Calarco resigned as Controller and Vice President, Finance of the Company.  Effective as of July 29, 2011, Christopher V. Vitale resigned as Chief Administrative Officer.  Effective as of June 16, 2011, Edward L. Cummings was appointed Principal Financial Officer of the Company.  Effective August 5, 2011, Allan Van Buhler was appointed as our Chief Administrative Officer.





The Company has continued to reduce its expenses, including voluntary and involuntary reductions in its workforce, as it continues to explore strategic alternatives.  The Company’s workforce has been reduced to 2 employees and one consultant.





The changes to our principal financial officer and principal executive officer and the reduction in the Company’s workforce did not materially affect the Company’s internal control over financial reporting for the three months ended June 30, 2011.


25




PART II. OTHER INFORMATION




ITEM 1.  LEGAL PROCEEDINGS.




We are not currently a party to any material legal proceedings, other than ordinary routine litigation incidental to our business.  From time to time, we receive claims of and become subject to employment, intellectual property and other litigation related to the conduct of our business.  Given our financial position, we may also become subject to claims of nonpayment of certain of our obligations.  Any such litigation could be costly and time consuming and could divert our management from out business operations.  In connection with any such litigation, we may be subject to significant damages or equitable remedies relating to the operation of our business.  Any such litigation may materially harm our business, results of operations and financial condition.





ITEM 1A.  RISK FACTORS




There have been no material changes to our risk factors as described in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as filed with the SEC, except to the extent additional factual information disclosed in this Quarterly Report on Form 10-Q related to such risk factors and except as described below.




We depend on Kentec, our contract manufacturer, to manufacture substantially all of our video phone products, and any delay or interruption in manufacturing by Kentec, any refusal to continue to supply our products, or shortage or lack of availability of components would substantially harm our business.




We do not have long-term purchase agreements with Kentec and we depend on Kentec to manufacture our video phone products. There can be no assurance that Kentec will be able or willing to reliably manufacture our video phone products, in volumes, on a cost-effective basis, in a timely manner, or at all. If we cannot compete effectively for the business of Kentec, if Kentec experiences financial or other difficulties in their business, or if Kentec refuses to fulfill orders for video phones, our revenue and our business could be adversely affected.




Our recent liquidity issues have prevented us from paying Kentec outstanding payables of approximately $7.9 million for previously shipped video phones, component inventory and obsolete inventory.  Kentec has demanded payment for these amounts and has ceased manufacturing our video phone products until payment issues are resolved.  We are currently seeking to resolve these payment issues with Kentec but can give no assurance that Kentec will accept a resolution or settlement.  As a result of these issues, Kentec may refuse to resume manufacturing our video phone products or may in the future demand less favorable payment terms if it remains concerned about our ability to meet our obligations under the Manufacturing Agreement.  The failure to negotiate a settlement of our outstanding payables to Kentec and Kentec deciding not to manufacture additional video phones or demanding less favorable payment terms could materially and adversely affect our operating results and our business.


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ITEM 6.  EXHIBITS




The following is a list of exhibits filed as part of this report on Form 10-Q.  Where so indicated, exhibits that were previously filed are incorporated by reference.  For exhibits incorporated by reference, the location of the exhibit in the previous filing is indicated parenthetically.




31.1

Certification of Principal Executive Officer Pursuant to Rule 13a-14(a)*31.2

Certification of Principal Financial Officer Pursuant to Rule 13a-14(a)*32.1

Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002**32.2

Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002**


* Filed herewith


** Furnished herewith


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SIGNATURES





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





WORLDGATE COMMUNICATIONS, INC.Dated:
August 15, 2011
/s/ Allan Van BuhlerAllan Van BuhlerChief Administrative Officer(Principal Executive Officer)Dated:
August 15, 2011
/s/ Edward L. CummingsEdward L. CummingsPrincipal Financial Officer and Principal Accounting Officer




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EXHIBIT INDEX





10.1

[  ]31.1

Certification of Principal Executive Officer Pursuant to Rule 13a-14(a)*31.2

Certification of Principal Financial Officer Pursuant to Rule 13a-14(a)*32.1

Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002**32.2

Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002**





* Filed herewith


** Furnished herewith




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