**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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**FORM 10-Q**

 

**Mark One**

**ý****                                ****QuarterlyReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of1934 for the Quarterly Period Ended September 30, 2004.**

 

**or**

 

**o****                                ****TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of1934 for the Transition Period From               To               .**

 

**Commissionfile number:  000-25755**

 

**WORLDGATE COMMUNICATIONS, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

 
| **Delaware**                                                    | ** ** | **23-2866697**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State of  Incorporation)                                       |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **3190  Tremont Avenue**                                        |
| **Trevose,  Pennsylvania 19053**                                |
| (Address of  Principal Executive Offices)  (Zip Code) |
|                                                            |       |                                  |
| **(215)  354-5100**                                             |
| (Registrant’s  Telephone Number, Including Area Code)      |

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.

Yes    ý    No    o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

Yes    o    No    ý

 

As of November 8,2004, there were 28,310,475 shares of common stock, par value $.01 per share,outstanding.

 

 

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WORLDGATECOMMUNICATIONS, INC.

 

QUARTERLY REPORTON FORM 10-Q

FOR THE THREEMONTHS ENDED SEPTEMBER 30, 2004

 

TABLE OF CONTENTS

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

 

2

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PARTI. FINANCIAL INFORMATION

# ITEM1.  FINANCIAL STATEMENTS

 

**WORLDGATECOMMUNICATIONS, INC.CONSOLIDATED BALANCE SHEETS**

**(Dollarsin Thousands)**

 
| ** **                                                                                                                                                                                                | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **(Unaudited)**              | ** ** | **(Audited)**               | ** ** |
| ASSETS                                                                                                                                                                                                    |       |                         |       |                        |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Current  assets:                                                                                                                                                                                          |       |                         |       |                        |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Cash  and cash equivalents                                                                                                                                                                                |       | $                            | 8,290      |                        | $          | 3,365 |   |
| Accounts  receivable, less allowance for doubtful accounts of $0 at September 30,  2004 and $381 at December 31, 2003                                                                           |       | 82                           |       | 146                         |       |
| Prepaid  and other assets                                                                                                                                                                                 |       | 285                          |       | 199                         |       |
| Total  current assets                                                                                                                                                                                     |       | 8,657                        |       | 3,710                       |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Property  and equipment                                                                                                                                                                                   |       | 2,802                        |       | 2,605                       |       |
| Less:  accumulated depreciation and amortization                                                                                                                                                          |       | (1,648                       | )          | (1,338                      | )          |
| Property  and equipment, net                                                                                                                                                                              |       | 1,154                        |       | 1,267                       |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Deposits  and other assets                                                                                                                                                                                |       | 0                            |       | 140                         |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
|  Total  assets                                                                                                                                                                                       |       | $                            | 9,811      |                        | $          | 5,117 |   |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| LIABILITIES  AND STOCKHOLDERS’ (DEFICIENCY) EQUITY                                                                                                                                                   |       |                         |       |                        |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Current  Liabilities:                                                                                                                                                                                     |       |                         |       |                        |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Accounts  payable                                                                                                                                                                                         |       | $                            | 110        |                        | $          | 440 |   |
| Accrued  expenses                                                                                                                                                                                         |       | 1,557                        |       | 594                         |       |
| Accrued  compensation and benefits                                                                                                                                                                        |       | 228                          |       | 238                         |       |
| Dividend  payable on Preferred Stock                                                                                                                                                                      |       | 103                          |       | 0                           |       |
| Detachable  warrants                                                                                                                                                                                      |       | 1,223                        |       | 0                           |       |
| Notes  payable                                                                                                                                                                                            |       | 147                          |       | 0                           |       |
| Conversion  option on Preferred Stock                                                                                                                                                                     |       | 1,124                        |       | 0                           |       |
| Deferred  revenues                                                                                                                                                                                        |       | 494                          |       | 0                           |       |
| Deferred  rent credit                                                                                                                                                                                     |       | 143                          |       | 30                          |       |
| Total  current liabilities                                                                                                                                                                                |       | 5,129                        |       | 1,302                       |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Deferred  rent credit                                                                                                                                                                                     |       | 0                            |       | 135                         |       |
| Total  liabilities                                                                                                                                                                                        |       | $                            | 5,129      |                        | $          | 1,437 |   |
|                                                                                                                                                                                                      |       |                         |       |                        |       |   |   |
| Redeemable  Preferred Stock                                                                                                                                                                               |       | $                            | 3,121      |                        | $          | 0 |   |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Total  stockholders’ (deficiency) equity:                                                                                                                                                            |       |                         |       |                        |       |
|                                                                                                                                                                                                      |       |                         |       |                        |       |
| Preferred  Stock, $.01 par value, 13,500,000 shares authorized                                                                                                                                            |       | $                            | 0          |                        | $          | 0 |   |
| Redeemable  Preferred Stock, $.01 par value, shares authorized, 7,550 shares issued and  outstanding at September 30, 2004, and 0 outstanding at December 31,  2003                             |       | 0                            |       | 0                           |       |
| Common  stock, $.01 par value, 50,000,000 shares authorized, 28,235,456 shares issued  and outstanding at September 30, 2004 and 25,706,843 shares issued and  outstanding at December 31, 2003 |       | 282                          |       | 262                         |       |
| Additional  paid-in capital                                                                                                                                                                               |       | 206,546                      |       | 202,466                     |       |
| Unearned  compensation                                                                                                                                                                                    |       | (400                         | )          | (400                        | )          |
| Accumulated  deficit                                                                                                                                                                                      |       | (205,267                     | )          | (198,643                    | )          |
| Less  Treasury Stock, at cost – 500,000 shares as of December 31, 2003                                                                                                                          |       | 0                            |       | (5                          | )          |
| Total  stockholders’ (deficiency) equity                                                                                                                                                             |       | 1,561                        |       | 3,680                       |       |
| Total  liabilities and stockholders’ (deficiency) equity                                                                                                                                             |       | $                            | 9,811      |                        | $          | 5,117 |   |

 

The accompanying notesare an integral part of these financial statements.

 

3

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**WORLDGATECOMMUNICATIONS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                                                                                                          | ** **    | **Three Months ended September 30,** | ** ** | **Nine Months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                          | ** **    | **2004**                                  | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                                                                                                                                                |          |                                      |       |                                     |       |   |   |   |   |
| Revenues                                                                                                                                                                                                                                                            |          | $                                         | 106        |                                     | $          | 0 |   | $ | 106 |   | $ | 0 |   |
| Cost  of revenues                                                                                                                                                                                                                                                   |          | 50                                        |       | 0                                        |       | 50 |   | 0 |   |
| Gross  Margins                                                                                                                                                                                                                                                      |          | 56                                        |       | 0                                        |       | 56 |   | 0 |   |
| Engineering  and development (excluding depreciation and amortization amounts of $2 and $0  for the three months ended September 30, 2004 and 2003, respectively,  and $2 and $0 for the nine months ended September 30, 2004 and 2003,  respectively).   |          | 1,038                                     |       | 660                                      |       | 2,637 |   | 1,922 |   |
| Sales  and marketing (excluding depreciation and amortization amounts of $6 and $0  for the three months ended September 30, 2004 and 2003, respectively,  and $6 and $0 for the nine months ended September 30, 2004 and 2003,  respectively).           |          | 324                                       |       | 130                                      |       | 924 |   | 354 |   |
| General  and administrative (excluding depreciation and amortization amounts of $99  and $0 for the three months ended September 30, 2004 and 2003,  respectively, and $302 and $0 for the nine months ended September 30,  2004 and 2003, respectively). |          | 1,762                                     |       | 862                                      |       | 4,435 |   | 1,562 |   |
| Depreciation  and amortization                                                                                                                                                                                                                                      |          | 107                                       |       | 0                                        |       | 310 |   | 0 |   |
| Total  costs and expenses from continuing operations                                                                                                                                                                                                                |          | 3,231                                     |       | 1,652                                    |       | 8,306 |   | 3,838 |   |
| Loss  from operating activities of continuing operations                                                                                                                                                                                                            |          | (3,175                                    | )          | (1,652                                   | )          | (8,250 | ) | (3,838 | ) |
| Interest  and other income                                                                                                                                                                                                                                          |          | 37                                        |       | 0                                        |       | 56 |   | 0 |   |
| Change  in fair value of warrants and conversion options                                                                                                                                                                                                            |          | 1,623                                     |       | 0                                        |       | 1,971 |   | 0 |   |
| Interest  and other expense                                                                                                                                                                                                                                         |          | (2                                        | )          | 0                                        |       | (5 | ) | 0 |   |
| Loss  from continuing operations                                                                                                                                                                                                                                    |          | (1,517                                    | )          | (1,652                                   | )          | (6,228 | ) | (3,838 | ) |
| Income  (loss) from discontinued operations                                                                                                                                                                                                                         |          | 7                                         |       | 1,755                                    |       | 36 |   | (943 | ) |
|                                                                                                                                                                                                                                                                |          |                                      |       |                                     |       |   |   |   |   |
| Net  (loss) income                                                                                                                                                                                                                                                  |          | (1,510                                    | )          | 103                                      |       | (6,192 | ) | (4,781 | ) |
| Accretion  on preferred stock and dividends                                                                                                                                                                                                                         |          | (400                                      | )          | 0                                        |       | (431 | ) | 0 |   |
| Net  (loss) income applicable to common stockholders                                                                                                                                                                                                                |          | $                                         | (1,910     | )                                        | $          | 103 |   | $ | (6,623 | ) | $ | (4,781 | ) |
|                                                                                                                                                                                                                                                                |          |                                      |       |                                     |       |   |   |   |   |
| Net  loss per common share (basic and diluted)                                                                                                                                                                                                                      |          | $                                         | (0.07      | )                                        | $          | 0.00 |   | $ | (0.24 | ) | $ | (0.20 | ) |
| Weighted  average common shares outstanding:                                                                                                                                                                                                                        |          |                                      |       |                                     |       |   |   |   |   |
| •                                                                                                                                                                                                                                                              | Basic         |                                      | 28,235,349 |                                     | 23,580,543 |   | 27,662,870 |   | 23,579,690 |   |
| •                                                                                                                                                                                                                                                              | Fully Diluted |                                      | 28,235,349 |                                     | 23,662,115 |   | 27,662,870 |   | 23,579,690 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

4

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**WORLDGATECOMMUNICATIONS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(Dollarsin Thousands)**

 
| ** **                                                                                        | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **Cash flows from operating activities of  continuing operations:**                               |       |                                      |       |   |   |
| Net  loss                                                                                         |       | $                                         | (6,228     | ) | $ | (3,838 | ) |
| Adjustments  to reconcile net loss to cash used in operating activities of continuing  operations |       |                                      |       |   |   |
| Depreciation  and amortization                                                                    |       | 310                                       |       | 0 |   |
| Change  in fair value of warrants and conversion options                                          |       | (1,971                                    | )          | 0 |   |
| Non-cash  stock based compensation                                                                |       | 1,238                                     |       | 43 |   |
| Changes  in operating assets and liabilities from continuing operations:                          |       |                                      |       |   |   |
| Accounts  receivable                                                                              |       | 48                                        |       | 0 |   |
| Prepaid  and other assets                                                                         |       | 201                                       |       | 432 |   |
| Accounts  payable                                                                                 |       | (330                                      | )          | 503 |   |
| Accrued  expenses                                                                                 |       | 962                                       |       | 348 |   |
| Accrued  compensation and benefits                                                                |       | (10                                       | )          | 478 |   |
| Other                                                                                             |       | 472                                       |       | 0 |   |
| Net  cash used in operating activities of continuing operations                                   |       | (5,308                                    | )          | (2,034 | ) |
| **Cash flows from investing activities of  continuing operations:**                               |       |                                      |       |   |   |
| Capital  expenditures                                                                             |       | (197                                      | )          | 0 |   |
| Net  cash used by investing activities of continuing operations                                   |       | (197                                      | )          | 0 |   |
| **Cash flows from financing activities of  continuing operations:**                               |       |                                      |       |   |   |
| Proceeds  from the issuance of common stock                                                       |       | 2,521                                     |       | 0 |   |
| Proceeds  from the issuance of redeemable preferred stock                                         |       | 7,111                                     |       | 0 |   |
| Proceeds  from the exercise of stock options                                                      |       | 126                                       |       | 1 |   |
| Proceeds  from the exercise of stock rights and warrants                                          |       | 620                                       |       | 0 |   |
| Net  cash provided by financing activities of continuing operations                               |       | 10,378                                    |       | 1 |   |
| **Net cash contributed to continuing operations  from discontinued operations**                   |       | 52                                        |       | 1,772 |   |
| **Net increase in cash and equivalents**                                                          |       | 4,925                                     |       | 261 |   |
| **Cash and cash equivalents, beginning of period**                                                |       | 3,365                                     |       | 589 |   |
| **Cash and cash equivalents, end of period**                                                      |       | $                                         | 8,290      |   | $ | 850 |   |
|                                                                                              |       |                                      |       |   |   |
| **Cash paid for interest**                                                                        |       | $                                         | 5          |   | $ | 15 |   |
| **Non-cash financing activity:**                                                                  |       |                                      |       |   |   |
| Issuance  of note payable to finance D&O insurance                                            |       | 256                                       |       | 560 |   |
| Termination  of contractual obligation related to equity financing                                |       | 0                                         |       | 3,283 |   |

 

The accompanying notesare an integral part of these financial statements.

 

5

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WORLDGATECOMMUNICATIONS, INC.

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

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

(Unaudited)

 

1.                                       Basisof Presentation.

 

The unaudited financialstatements of WorldGate Communications, Inc. (“WorldGate” or the “Company”) forthe three and nine months ended September 30, 2004 presented herein havebeen prepared by the Company pursuant to the rules and regulations of theSecurities and Exchange Commission for quarterly reports on Form 10-Q.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to suchrules and regulations.  These financialstatements should be read in conjunction with the financial statements for theyear ended December 31, 2003 and the notes thereto included in the Company’sAnnual Report on Form 10-K.       

 

The financial informationin this Report reflects, in the opinion of management, all adjustments of anormal recurring nature necessary to present fairly the results for the interimperiod. Quarterly operating results are not necessarily indicative of theresults that may be expected for the year ending December 31, 2004.

 

Certain prior yearamounts have been reclassified in the accompanying financial statements forconsistent presentation to current period amounts.

 

2.                                       Liquidityand Going Concern Considerations.

 

As of September 30,2004 the Company had cash and cash equivalents of $8,290. The operating cashusage from continuing operations for the three and nine months ended September 30,2004 was $1,867 and $5,308, respectively. During the third quarter of 2003, we completed a sale of certain assets,including our ITV intellectual property rights and our membership interest inTVGateway, LLC, for $3,000 in cash to TVGateway, LLC, a company we wereinstrumental in forming. Our transaction with TVGateway, LLC, marked a shift inour business away from the ITV business and toward a new video phone productand associated business.  The funds wereceived from the sale of assets to TVGateway, LLC, as well as the funds wereceived as a result of private placements of our securities on December 1,2003, December 4, 2003, January 21, 2004, April 22, 2004, and June 23,2004, have permitted us to fund the development of our new business.

 

In December 2003 andJanuary 2004, WorldGate received investments aggregating $3,100 by certaininstitutional investors.  These investorspurchased an aggregate of 3,000,000 shares of newly issued common stock. Theinvestors also received a right, for a limited period of time, to purchaseadditional shares of up to 20% of the common stock purchased by the investorsin their investment, at the same price as their investment, and five-yearwarrants to purchase up to 30% of the common stock purchased by the investors intheir investment, at an exercise price equal to a twenty-five percent premiumto their purchase price for the investment. The purchase price for the 2 million shares purchased in December 2003transactions was $0.80 per share, with the warrants having a $1.00 per shareexercise price.  The purchase price forthe 1 million shares purchased in the January 2004 transaction was $1.50per share, with the warrants having a $1.875 per share exercise price.  All additional investment rights associatedwith the December 2003 transaction were exercised during January and February of2004, resulting in an incremental investment of $320.  All additional investment rights associatedwith the January 2004 transaction were exercised in May 2004, resulting inan incremental investment of $300.

 

In December 2003,WorldGate reached agreement with Mototech, Inc. for the purchase of 625,000shares of newly issued common stock at $0.80 per share, in return for futuredesign and engineering services by Mototech. WorldGate had previously contracted with Mototech to assist the Companywith the design and volume manufacture of WorldGate’s Ojo personal video phone.The purchase price for these shares has been partially paid as of September 30,2004 by an equivalent reduction in the development and initial procurementpayments that would otherwise be due to Mototech.  As of September 30, 2004, that paymentwas $200,000. Mototech is an affiliate of Accton Technology Group.  Mototech currently manufactures anddistributes a full range of high performance high speed data and computernetworking products, including cable set top boxes, home gateways, wirelessLANs, hubs, switches, routers, and other related products.  In addition, in April 2004, Mototechinvested $1 million to purchase 666,666 shares of newly issued common stock at$1.50 per share.

 

6

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In June 2004,WorldGate completed a private placement of 7,550 shares of its Series APreferred Stock at a stated value of $1000 per share, which preferred stock isconvertible into the Company’s common stock at a conversion price of $2.35 pershare; five-year warrants to purchase up to 803,190 shares of our common stockat an exercise price of $2.69 per share; and five-year warrants to purchase upto 803,190 shares of our common stock at an exercise price of $3.14 per share.The investors also received an additional investment right, for a limitedperiod of time, to purchase 1,606,383 additional shares of common stock sharesat $3.14 a share.

 

The Company has $5,129 of liabilities andits assets are not pledged as collateral as of September 30, 2004. Theseliabilities include $2,450 related to the Company’s private placement of SeriesA Preferred Stock (refer to Footnote 5), building rent obligation of $785 as ofSeptember 30, 2004 (refer to Footnote 7) and $494 of advanced funds fromMotorola for future shipments of video phones in conformity with the Agreementsigned in April 2004.

 

The Company continues to evaluatepossibilities to obtain additional financing through public or private equityor debt offerings, bank debt financing, asset securitizations,or from other sources.  Such additionalfinancing would be subject to the risk of availability, may be dilutive to ourshareholders, or could impose restrictions on operating activities. There canbe no assurance that this additional financing will be available on termsacceptable to the Company, if at all. The Company has limited capacity tofurther reduce its workforce and scale back on capital and operationalexpenditures to decrease its cash usage given the measures it has already takento reduce staff and expenses.

 

The consolidated financial statementshave been prepared on a going concern basis, which contemplates the realizationof assets and the satisfaction of liabilities and commitments in the normalcourse of business.  Therefore, thefinancial statements do not include any adjustments relating tothe Company’s ability to operate as a going concern.  The appropriateness of using the going concernbasis in the future, however, will be dependent upon the Company’s ability toaddress its liquidity needs as described above. There is no assurance that the Company will be able to address itsliquidity needs through the measures described above on acceptable terms andconditions, or at all, and accordingly, there is substantial doubt about theCompany’s ability to continue as a going concern.  The independent auditors’ report for the yearended December 31, 2003 includes an explanatory paragraph stating thatbecause the Company has suffered recurring losses from operations and has a netaccumulated deficiency of $199 million, those issues raise substantial doubtabout the Company’s ability to continue as a going concern.

 

3.                                       RecentAccounting Pronouncement.

 

In January 2003, the FASB issuedInterpretation No. 46, *Consolidation ofVariable Interest Entities*. Interpretation No. 46 addressesconsolidation by business enterprises of variable interest entities, which areentities that either (a) do not have equity investors with vesting rights or(b) have equity investors that do not provide sufficient financial resourcesfor the entity to support its activities. The interpretation is effectiveimmediately for variable interest entities created after February 1, 2003.In December 2003, the FASB published FASB Interpretation No. 46 (revised December 2003),*Consolidation of Variable Interest Entities*(FIN 46(R)). FIN 46(R), among other things, defers the effective date ofimplementation for certain entities. The revised interpretation is effectivefor the first interim or annual reporting period ending after March 15,2004, with the exception of structures that are commonly referred to asspecial-purpose entities, for which the statement is effective for periodsending after December 15, 2003. The adoption of Interpretation No. 46 didnot have a material impact on WorldGate’s results of operations or financialposition.

 

7

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4.                                       Inventories.

 

Inventories are summarizedas follows:

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

 

5.                                       RedeemablePreferred Stock

 

In June 2004,WorldGate completed a private placement of 7,550 shares of its Series APreferred Stock at a stated value of $1,000 per share, which preferred stock isconvertible into the Company’s common stock at a conversion price of $2.35 pershare.  The Company has the right torequire conversion of the preferred stock into common stock upon achievingcertain price targets with respect to its common stock and the satisfaction ofcertain other conditions.  As part of the transaction, the Company issuedfive-year warrants to purchase a total of 1.6 million shares of the Company’scommon stock, with one-half of the warrants having an exercise price of $2.69per share and the remaining half having an exercise price of $3.14 pershare.  The preferred stock has a dividend rate of 5% per annum, payablequarterly, which may be paid either by cash or through the issuance of commonstock at the Company’s option (with stock payments being made at a 10% discountto the then current market price).  The preferred stock has a stagedmaturity over three years with scheduled payments of one third due after 18months, one half of the remainder due after 24 months and the balance due after36 months.  The preferred stock may be redeemed at maturity in cash orthrough the issuance of common stock, at the Company’s option (with stockpayments being made at the then current market price).  All dividend andmaturity payments made in stock are subject to the satisfaction of certainconditions including the listing of the stock and availability of an effectiveregistration statement. The investors also received an additionalinvestment right, for a limited period of time, to purchase 1.6 millionadditional shares of common stock shares at $3.14 a share.

 

In accordance with EITFtopic D-98 “Classification and Measurement of Redeemable Securities”, theRedeemable Preferred Stock was recorded in the financial statements astemporary equity.  At September 30,2004, that amount was $3,121. Additionally, the fair value of warrants and preferred stock conversionoptions were recorded into the financial statements as liabilities as a resultof their features that require accounting under FAS 133 "Accounting forderivative instruments and hedging activities."  At September 30, 2004, these amountstotaled $2,450. At each reporting balance sheet date an evaluation is made ofthese valuations and marked to market. During the three and nine months ended September 30,2004, the Company recorded $400 and $431 against Retained Earnings resultingfrom $96 and $103, for the three and nine months ended September 30, 2004,respectively, for dividends on redeemable preferred stock, and $304 and $328,for the three and nine months, respectively, for the accretion of the warrantvalue to redeemable preferred stock.

 

6.                                       Stock-BasedCompensation.

 

The Company accounts forstock-based compensation in accordance with Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations. 

 

The Company appliesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees” and related interpretations in accounting for its plans, andaccordingly, no compensation cost has been recognized for the Company’s fixedstock based compensation. Had compensation cost been determined consistent withSFAS No. 123, as amended by SFAS No. 148, the Company’s net loss would havebeen increased or decreased to the following pro forma amounts:

 

8

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| ** **                                                                                                                           | ** ** | **For the Three Month Period  Ended September 30,** | ** ** | **For the Nine Month Period  Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                                                 | ** ** | **2003**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Net  (loss) income:                                                                                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| As  reported                                                                                                                         |       | $                                                        | (1,510     | )                                                       | $          | 103 |   | $ | (6,192 | ) | $ | (4,781 | ) |
| Add: Stock-based compensation expense included in  reported net loss, net of related tax effects of $0                               |       | 0                                                        |       | 43                                                      |       | 0 |   | 83 |   |
| Deduct:  Total stock-based employee expense determined under the fair value based  method for all awards, net of related tax effects |       | (544                                                     | )          | (1,359                                                  | )          | (1,627 | ) | (4,129 | ) |
| Pro  forma net loss                                                                                                                  |       | $                                                        | (2,054     | )                                                       | $          | (1,213 | ) | $ | (7,819 | ) | $ | (8,827 | ) |
|                                                                                                                                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Net Loss per share:                                                                                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic and diluted – as reported                                                                                                 |       | $                                                        | (0.07      | )                                                       | $          | (0.00 | ) | $ | (0.24 | ) | $ | (0.20 | ) |
| Basic and diluted - pro forma                                                                                                        |       | $                                                        | (0.07      | )                                                       | $          | (0.51 | ) | $ | (0.28 | ) | $ | (0.37 | ) |

 

Suchpro forma disclosures may not be representative of future compensation expensebecause options

vestover several years and additional grants are made each year.

 

7.               SignificantAgreements and Transactions.

 

In 1997, the Companyentered into agreements with certain customers who are investors. Revenues fromcontinuing operations recognized from such investors were approximately $106and $0, respectively, for the three months ended September 30, 2004 and2003, and approximately $106 and $0, respectively, for the nine months ended September 30,2004 and 2003. This customer accounted for 100% of the revenues for the threeand nine months ended September 30, 2004. Amounts received in advance asof September 30, 2004 of $494 is included in deferred revenue in theaccompanying balance sheet.

 

Revenues fromdiscontinued operations recognized from such investors were approximately $0and $65 (included in discontinued operations), respectively, for the three monthsended September 30, 2004 and 2003, and approximately $0 and $2,068(included in discontinued operations), respectively for the nine months ended September 30,2004 and 2003. Accounts receivable from such investors amounted toapproximately $81 at September 30, 2004 and $153 at December 31,2003.

 

The Company has a currentagreement with an investor, and previously had agreements with certain otherinvestors, to provide the Company with engineering and development support. Asa result of those agreements, the Company has expensed approximately $0 and$394 (included in discontinued operations), respectively, for the three monthsended September 30, 2004 and 2003, and approximately $0 and $950 (includedin discontinued operations), respectively, for the nine months ended September 30,2004 and 2003. Accounts payable to these investors amounted to $5 and $170 at September 30,2004 and December 31, 2003, respectively. Some of these stockholders weresuppliers of technology and components for the Company’s discontinued ITVproducts and services. These agreements provided for licensing of technology,as well as contracted services, including hardware and software development,product testing and certification, and the creation and development of toolsand systems to facilitate the Company’s engineering efforts. These agreementsdid not provide for ongoing royalties, purchase provisions, or for anyrequirement to provide additional funding to the Company.

 

In 1998 the Companyentered into a leasing arrangement for a building with an entity formed bynon-employee investors. Included in deposits and other assets at September 30,2004 and December 31, 2003 is $0 and $388, respectively, related to this lease.We have not paid our rent on our current facility since May 2003. As a result,our landlord, 3190 T General, Inc. in September 2003, filed an action inthe Court of Common Pleas, Bucks County Pennsylvania to perfect its interest totake possession of our facility at any time, and to establish damages for pastrent and expenses. In lieu of rent payments our landlord has drawn from oursecurity deposit to satisfy the unpaid rent and such deposit has now been fullydepleted. A judgment was also granted allowing our landlord to regainpossession of the facility, although we remain in the facility, albeit insubstantially reduced space. During

 

9

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this process we attemptedto negotiate a settlement of our lease obligation with the landlord in aneffort to reduce our outstanding liability and secure the continued right tooccupy the facility with a reduced ongoing lease obligation. We also workedwith the landlord to secure other tenants for the unused space. However, thelandlord informed us that this process was complicated by the requirement forthe landlord’s mortgage holder to approve any such amendments to our lease aswell as any arrangements with other prospective tenants. The landlord was notable to obtain such approvals from the mortgage holder and ultimately the landlordand the landlord’s mortgage holder reached an agreement for the landlord’smortgage holder to become a successor to the landlord’s interest in theproperty. We have already commenced negotiations directly with the mortgageholder’s representatives to secure the continued right to occupy the facilitywith a reduced ongoing lease obligation, and are currently awaiting a proposalfrom the mortgage holder, although there can be no assurance that an agreementcan be reached with the mortgage holder. Concurrently we are exploring otherfacility opportunities in the event an agreement cannot be reached. In lieu ofmonthly rent payments of $104 (offset by monthly sublease payments by TVGatewayof $19 during the period February 1, 2003 through January 31, 2004),the Company’s landlord has drawn down from its security deposit to satisfy $388of the unpaid rent of $1,173 as of September 30, 2004. As of September 30,2004, the amount of the deposit remaining after deduction for the unpaid rentis $0.  The Company has continued toaccrue the full rent expense through September 30, 2004.

 

8.               TVGateway JointVenture and related Cable Operator Agreements.

 

On July 24, 2000,the Company formed a separate joint venture, TVGateway, LLC, with four cableoperators.  As part of this ventureWorldGate entered into a management agreement with TVGateway to provideengineering, operations and administrative support services. In addition toproviding for the terms and conditions under which such services were to beprovided, the management agreement provided for WorldGate and TVGateway tocooperate to transition to TVGateway some or all of the support services beingprovided by WorldGate and/or the employees providing these services. Inaddition, this provision required WorldGate to remain available to providesupport services until July 24, 2005. During 2002 WorldGate and TVGatewayagreed to commence the transition of services pursuant to this provision. Inaddition, the parties agreed that the management agreement would be of no furtherforce and effect with respect to the services that are transferred as of thedate of completion of the specific transfers. The companies completed thistransition in the first quarter 2003, and accordingly, WorldGate has now beenrelieved of any continuing obligation to provide such transitionedservices.   WorldGate no longer receivesrevenues from the management agreement with TVGateway.

 

Revenues for suchservices, which are included in service fee revenue, totaled $0, and $0,respectively for the three months ended September 30, 2004 and 2003, and$0 and $794 (included in discontinued operations), respectively, for the ninemonths ended September 30, 2004 and 2003. In addition, product sales toTVGateway totaled $0 and $0 for the three months ended September 30, 2004and 2003, respectively, and $0 and $1,074 (included in discontinued operations),respectively, for the nine months ended September 30, 2004 and 2003.Accounts Receivable from TVGateway amounted to $0 at September 30, 2004and $0 at December 31, 2003. WorldGate was accounting for its 18%investment in the TVGateway joint venture, which was previously reduced to acarrying value of $0 due to prior losses, under the equity method.

 

On September 30,2003 the Company announced that it had sold to TVGateway, LLC certain ITVintellectual property rights and certain software and equipment related to theITV business, which TVGateway was currently using, for $2,400.  In addition, on August 7, 2003,WorldGate and TVGateway entered into a redemption agreement pursuant to whichTVGateway redeemed WorldGate’s equity interest in TVGateway for $600 incash.  The purchase price for theseassets in the aggregate was $3,000 and was used by the Company to fundcontinuing operations, as well as to develop and distribute its new Ojo videotelephony product. As part of this transaction WorldGate retained aroyalty-free license to certain of the transferred intellectual property rightsand software. At this time the Company has completely exited from the interactivetelevision (ITV) business.

 

In connection with theAsset Purchase Agreement we entered into with TVGateway for the sale of certainITV Business assets, we have an obligation to indemnify TVGateway for anylosses from breaches of our representations or warranties in the Asset PurchaseAgreement that occur within twelve months after the closing date of theTVGateway transaction or within the applicable statute of limitations periodfor claims relating to our ownership of our assets, payment of our taxes, andour compliance with applicable laws, if longer. Our indemnification obligationsare limited by an overall cap of $500 on the amount of the indemnification.Although we know of no breaches of our representations or warranties and theinitial twelve-month period has expired, the payment of any suchindemnification obligations would adversely impact our cash resources and ourability to

 

10

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pursue our video phonebusiness.

 

 

9.               Net Loss per Share.

 

Basic and diluted netloss per common share is computed by dividing the net loss available to commonstockholders for the period by the weighted average number of shares of commonstock outstanding during the period.  Thecalculation of diluted net loss per common share excludes potential commonshares if the effect is antidilutive. Potential common shares comprise shares of common stock issuable uponthe exercise of stock options and warrants. The number of potential common shares which would have been assumed tobe converted in the periods ended September 30, 2004 and 2003 and have adilutive effect if the Company had income from continuing operations, or if theoptions’ exercise price was less than the average market price of the commonshares, is 13,590,347 and 5,861,201, respectively.

 

10            DiscontinuedOperations

 

During the first quarterof 2004, the Company decided to transition from the business of developing andselling interactive television, or ITV, technology, products and services foruse in conjunction with cable TV broadband networks (the “ITV business”) to thedevelopment of videophone products. In accordance with Statement of FinancialAccounting Standards 144, Accounting for the Impairment or Disposal ofLong-Lived Assets, all assets related to the ITV business have been writtendown to their net realizable value. Related operating results of the ITVbusiness have been reported as discontinued operations for all years presented.

 

Revenue and net incomebefore income taxes from discontinued operations were as follows:

 
| ** **                             | ** ** | **For the Three Month Period  Ended September 30,** | ** ** | **For the Nine Month Period  Ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                                 | ** ** | **2003**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Revenues                               |       | $                                                        | 0          |                                                    | $          | 941 |   | $ | 82 |   | $ | 3,497 |   |
| Net  income (loss) before income taxes |       | 7                                                        |       | (1,755                                                  | )          | 36 |   | (943 | ) |
|                                        |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

Assets and liabilities ofdiscontinued operations include the following:

 
| ** **                                                                                                | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Assets                                                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Inventory,  net reserve of $1,622 as of September 30, 2004 and December 31,  2003, respectively |       | $          | 0          |       | $          | 0 |   |
|                                                                                                           |            |            |            |            |            |  |  |

#  

# ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

(Dollar Amountsare in Thousands, Except per Share Amounts)

 

FORWARD-LOOKINGAND CAUTIONARY STATEMENTS.

 

The Company may from timeto time make written or oral forward-looking statements, including thosecontained in the following Management’s Discussion and Analysis of FinancialCondition and Results of Operations. The words “estimate,” “project,” “believe,”“intend,” “expect,” and similar expressions are intended to identifyforward-looking statements, although not all forward-looking statements containthese identifying words. In order to take advantage of the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995, we arehereby identifying certain important factors, which could cause our actualresults, performance or achievement to differ materially from those that may becontained in or implied by any forward-looking statement made by or on behalfof WorldGate.  The factors, individuallyor in the aggregate, that could cause such forward-

 

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looking statements not tobe realized include, without limitation, the following: (1) difficulty orinability to raise additional financing on terms acceptable to us, (2)difficulty in developing and implementing marketing and business plans, (3)continued losses, (4) industry competition factors and other uncertainty that amarket for our products will develop, (5) challenges associated with broadbandoperators (including, uncertainty that they will offer our products, inabilityto predict the manner in which they will market and price our products andexistence of potential conflicts of interests and contractual limitationsimpeding their ability to offer our products), (6) departure of one or more keypersons,  (7) delisting of our CommonStock from the NASDAQ Small Cap Market, (8) changes in regulatory requirements,and (9) other risks identified in our filings with the Securities and ExchangeCommission.  We caution you that the foregoinglist of important factors is not intended to be, and is not, exhaustive.  We do not undertake to update anyforward-looking statement that may be made from time to time by or on behalf ofWorldGate.  

 

Results of Operations:

 

Critical Accounting Policiesand Estimates.

 

The consolidatedfinancial statements are prepared in conformity with accounting principlesgenerally accepted in the United States. The preparation of these financial statements required management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Actualresults could differ from those estimates.

 

The significantaccounting policies of the Company are described in the notes to theconsolidated financial statements included in the annual report on Form10-K.  Judgments and estimates ofuncertainties are required in applying the Company’s accounting policies inmany areas.  Following are some of theareas requiring significant judgments and estimates:  revenue recognition, accounts receivable,inventories, and cash flow and valuation assumptions on equity relatedtransaction and in performing asset impairment tests of long-lived assets.

 

Discontinued Operations

 

During the first quarterof 2004 the Company transitioned from the business of developing and sellinginteractive television, or ITV, technology, products and services for use inconjunction with cable TV broadband networks (the “ITV business”) to thedevelopment of our video phone products as our primary business focus. Duringthe three months ended September 30, 2004 the Company had revenues fromdiscontinued operations of $0, compared to revenues of $941 for the threemonths ended September 30, 2003. For the nine months ended September 30,2004 and 2003, respectively, revenues were $82 and $3,497 respectively. Thisreduction reflects service revenues of $0 and $253, respectively, for the threemonths ended September 30, 2004 and 2003. For the nine months ended September 30,2004 and 2003, service revenues were $0 and $1,573 respectively. Equipmentrevenues were $0 and $688 for the three months ended September 30, 2004and 2003, respectively, and $82 and $1,924, respectively, for the nine monthsended September 30, 2004 and 2003. Cost of revenues for the three monthsended September 30, 2004 and 2003, were $0 and $1,524, respectively. Forthe nine months ended September 30, 2004 and 2003, cost of revenues were$0 and $4,218, respectively. Concurrently, operating expenses, consisting ofResearch and Development, Marketing, General and Administration, andDepreciation and Amortization costs were also reduced as a result of thetransition from the ITV business. These expenses were $0 for the three monthsended September 30, 2004, compared to $563 for the three months ended September 30,2003, and $16 and $3,122, respectively, for the nine months ended September 30,2004 and 2003.

 

The information in ourquarter-to-quarter comparisons below represents only our results fromcontinuing operations.

 

Three and Nine MonthsEnded September 30, 2004 and September 30, 2003

 

Revenues.

 

Revenues.  Revenues from continuing operations of $106were realized during the three and nine months ended September 30, 2004.These revenues represent the initial deliveries of video phones for pre-market

 

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testing. There were norevenues from continuing operations for the three and nine months ended September 30,2003.

 

Costs and Expenses.

 

Cost of revenues. Thecost of revenues from continuing operations relating to the initial deliveriesof video phones was $50 for the three and nine months ended September 30,2004. There were no cost of revenues from continuing operations for the threeand nine months ended September 30, 2003.

 

Engineering andDevelopment.  Engineering and developmentexpenses primarily consist of compensation, and the cost of design,programming, testing, documentation and support of the Company’s video phoneproduct.  Engineering and developmentcosts were $1,038 for the three months ended September 30, 2004, comparedwith $660 for the three months ended September 30, 2003. For the ninemonths ended September 30, 2004 and September 30, 2003, engineeringand development expenses were $2,637 and $1,922, respectively. These increasesin 2004 over 2003 of $378, or 57%, for the three months ended September 30,2004, and $715, or 37%, for the nine months ended September 30, 2004,reflect the Company’s increased concentration of its engineering staff, andrelated costs, for the continuing development of its video phone product. 

 

Sales and Marketing.  Sales and marketing expenses consist primarilyof compensation, attendance at conferences and trade shows, travel costs,promotions and other marketing programs related to the introduction of theCompany’s video phone product.  Sales andmarketing costs were $324 for the three months ended September 30, 2004,compared with $130 for the three months ended September 30, 2003. For thenine months ended September 30, 2004 and 2003, sales and marketingexpenses were $924 and $354, respectively. These increases of $194 and $570,respectively, or 149% and 161%, respectively, for the three and nine monthsended September 30, 2004, reflect the increased marketing and promotionalexpenditures, primarily related to trade shows attendance, for the Company’svideo phone product. 

 

General andAdministrative.  General andadministrative expenses consist primarily of expenditures for administration,office and facility operations, finance and general management activities,including legal, accounting and professional fees.  General and administrative expenses were$1,762 for the three months ended September 30, 2004, compared with $862for the three months ended September 30, 2003. For the nine months ended September 30,2004 and 2003, general and administrative expenses were $4,435 and $1,562,respectively. The increases of $900 and $2,873, respectively, or 104% and 184%,respectively, for the three and nine months ended September 30, 2004, areattributable primarily to the Company’s transition of nearly all of itsadministrative management compensation, facility, legal, finance andprofessional consulting fees toward the further development of the video phonebusiness, and a non cash charge of $606 and $1,238, for the three and ninemonths ended September 30, 2004, reflecting a Black Scholes estimate ofthe value of the warrants issued as part of the private placement of theCompany’s stock to certain investors in January and June 2004, andwarrants issued to Motorola in September 2004 in conformity with terms ofthe Agreement signed in April 2004. For the three and nine months ended September 30, 2003, video phonerelated costs were 63% and 54%, respectively, of total General andAdministrative expense of $1,150 and $2,957, respectively.

 

Interest and Other Incomeand Interest Expense.  Interest and otherincome and interest expense from continuing operations consisted of interestearned on cash and cash equivalents, interest expense on short-term debt andchange in fair value of warrants and conversion options.  Total interest and other income increased to$1,651 for the three months ended September 30, 2004 from $0 for the threemonths ended September 30, 2003, and increased to $2,016 for the ninemonths ended September 30, 2004 from $0 for the nine months ended September 30,2003. Included in Other Income for the three and nine months ended September 30,2004 were non cash change in fair value of warrants and conversion optionsreported of $1,616 and $1,965, respectively, for marked to market adjustmentsas of September 30, 2004 related to the Company’s June 23, 2004private placement of its Series A Convertible Preferred Stock and Warrants.During the three and nine months ended September 30, 2003, the Companyearned interest on average cash balances of approximately $800 and $2,077,respectively, and incurred interest expense related to its insurancefinancing.  In comparison, during thethree and nine months ended September 30, 2004 the Company earned intereston average cash balances of approximately $6,693 and $6,049, respectively, andincurred interest expense related to its insurance financing.

 

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

 

13

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Liquidity and CapitalResources.

 

As of September 30,2004, our primary source of liquidity consisted of cash and cash equivalentsthat are highly liquid, are of high quality investment grade and havematurities of less than one year.

 

At September 30,2004, we had cash and cash equivalents of $8,290 (and no short-terminvestments) as compared to cash and equivalents of $3,365 (and no short-terminvestments) at December 31, 2003. Net cash used in continuing operations was $5,308 for the nine monthsended September 30, 2004, as compared to $2,034 (included in discontinuedoperations) used for the same period in 2003. This increase in net cash usedfor continuing operations was primarily attributable to the Company’s increasein expenditures related to the video phone business.  The Company recorded bad debt expense in theamount of $16 from discontinued operations during the nine months ended September 30,2004 to reflect its current assessment of the collectability of certainreceivables. 

 

Cash provided byfinancing activities from continuing operations during the nine months ended September 30,2004, totaled $10,378 compared to $1 provided during the same period in2003.  During the nine months ended September 30,2004, net proceeds from our maturing short-term investments were $0 compared to$3,423 (included in discontinued operations) for the nine months ended September 30,2003.  Capital expenditures were $197 and$0 for the nine months ended September 30, 2004 and 2003,respectively.  

 

Operations and Liquidity.

 

To date, the Company has funded operations primarilythrough private sales of equity securities and through an initial publicoffering of common stock in April 1999. As of September 30, 2004 the Company had cash, and cash equivalentsof $8,290. The operating cash usage from continuing operations for the ninemonths ended September 30, 2004 was $5,308. As of September 30, 2004we have $147 of outstanding debt and our assets are not pledged ascollateral.  However, we have not paidour monthly rent of $104 (offset by monthly sublease payments by TVGateway of$19 during the period February 1, 2003 through January 31, 2004) onour current facility since May 2003.  Asa result, our landlord, a non-employee investor, has perfected its interest totake possession of our facility at any time and has drawn down from our rentdeposit to satisfy $388 of the unpaid rent of $1,173 as of September 30,2004.  As of September 30, 2004 theamount of the deposit remaining is $0 after deduction for the unpaid rent.  The Company has continued to accrue the fullrent expense through September 30, 2004. Although we are presently not earning additional funding we continue toexplore and negotiate to resolve this matter (refer to Part II, Item I LegalProceedings).  We also continue toevaluate possibilities to obtain additional financing through public or privateequity or debt offerings, bank debt financing, asset securitizations, or fromother sources.  Such additional financingwould be subject to the risk of availability, may be dilutive to ourshareholders, or could impose restrictions on operating activities.  There can be no assurance that thisadditional financing will be available on terms acceptable to us, if at all.  The Company has limited capacity to furtherreduce its workforce and scale back on capital and operational expenditures todecrease cash burn given the measures it has already taken to reduce staff andexpenses. 

 

With the private placement of the Company’s common stock,together with additional rights and warrants, resulting in the aggregate grossproceeds received of $1.5 million in January 2004, the private placementof the Company’s common stock in April 2004 providing proceeds of $1,000,and the June 2004 private placement of Company’s redeemable preferredstock aggregating proceeds to the Company of $7.55 million, the Companyprojects it will have sufficient funding to continue operations into the thirdquarter of 2005, assuming no additional funding is received and assuming noimpact from sales. Depending on the timing and magnitude of the ramp up ofvideo phone sales, it is possible that our current cash may be sufficient toget the company to a cash breakeven position. No assurances can be given that sufficient sales, if any, will materialize,or that a funding transaction can be consummated prior to the depletion of ouravailable cash.  We however remainhopeful that sufficient funding can be developed through funding or ongoingoperations to continue the Company’s operations.  The independent auditors’ report for the yearended December 31, 2003 included an explanatory paragraph stating thatbecause the Company has suffered recurring losses from operations and has a netaccumulated deficiency of $199 million, those issues raise substantial doubtabout the Company’s ability to continue as a going concern.

 

14

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# ITEM 3.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Interest Rate Risk.  Our exposure to market risk related to changesin interest rates relates primarily to our investment portfolio.  We invest in instruments that meet highcredit quality standards, and we limit the amount of credit exposure withrespect to any one issue, issuer and type of investment.

 

As of September 30,2004, the Company’s cash and cash equivalents were $8,290, most of which weresecurities having a maturity of less than one year, and it had no short-terminvestments.  Due to the average maturityand conservative nature of our investment portfolio, management believes asudden change in interest rates would not have a material effect on the valueof the portfolio. Management estimates that had the average yield of ourinvestments decreased by 100 basis points, our interest income for the nine monthsended September 30, 2004 would have decreased by approximately $69. Thisestimate assumes that the decrease occurred on the first day of 2004 andreduced the yield of each investment instrument by 100 basis points.  The impact on our future interest income offuture changes in investment yields will depend largely on our totalinvestments.

 

Foreign Currency ExchangeRisk.  The principal portion of ourcurrent business is in the United States and substantially all of our costs todate have been denominated in U.S. dollars. As a result, adverse movements in foreign currency exchange rates wouldnot have a material adverse effect on us.

 

# ITEM 4.  CONTROLSAND PROCEDURES.

 

As of the end of theperiod covered by this Form 10-Q, the Company’s principal executive andprincipal financial officers, including its chief executive officer and chieffinancial officer, conducted an evaluation of the effectiveness of the Company’sdisclosure controls and procedures. Based on that evaluation, the chiefexecutive officer and chief financial officer concluded that a"significant deficiency", that is considered to be a "materialweakness," (as defined under the standards established by the AmericanInstitute of Certified Public Accountants) existed with respect to the Company'sreporting of the various components of the June 2004 private placement ofSeries A preferred stock and warrants. As a result the Company has restated itsfinancial statements in its June 30, 2004 10-QA. The Company will evaluate theneed to enhance its internal resources, including obtaining or engaging outsideexperts to address the accounting for complex transactions. The Company willevaluate the findings of such experts in addressing these matters. With theexception of this condition, the Company’s disclosure controls and procedureswere found to be effective. There have been no other changes in the Company’sinternal control over financial reporting that occurred during the period endedSeptember 30, 2004, that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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PARTII. OTHER INFORMATION

 

(Dollar Amountsare in Thousands, Except per Share Amounts)

 

# ITEM 1. LEGAL PROCEEDINGS.   

 

The Company has not paidits rent on its current facility since May 2003. As a result, our landlord,3190 T General, Inc. in September 2003, filed an action in the Court ofCommon Pleas, Bucks County Pennsylvania to perfect its interest to take possessionof our facility at any time, and to establish damages for past rent andexpenses. In lieu of rent payments our landlord has drawn from our securitydeposit to satisfy the unpaid rent and such deposit has now been fullydepleted. A judgment was also granted allowing our landlord to regainpossession of the facility, although we remain in the facility, albeit insubstantially reduced space. During this process we attempted to negotiate asettlement of our lease obligation with the landlord in an effort to reduce ouroutstanding liability and secure the continued right to occupy the facilitywith a reduced ongoing lease obligation. We also worked with the landlord tosecure other tenants for the unused space. However, the landlord informed usthat this process was complicated by the requirement for the landlord’smortgage holder to approve any such amendments to our lease as well as anyarrangements with other prospective tenants. The landlord was not able toobtain such approvals from the mortgage holder and ultimately the landlord andthe landlord’s mortgage holder reached an agreement for the landlord’s mortgageholder to become a successor to the landlord’s interest in the property. Wehave already commenced negotiations directly with the mortgage holder’srepresentatives to secure the continued right to occupy the facility with areduced ongoing lease obligation, and are currently awaiting a proposal fromthe mortgage holder, although there can be no assurance that an agreement canbe reached with the mortgage holder. Concurrently we are exploring otherfacility opportunities in the event an agreement cannot be reached.

 

# ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS.    

 

None.

#  

# ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

 

None.

 

16

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

 

TheCompany held its annual meeting of stockholders on October 13, 2004. Thefollowing items reflect the matters that were voted upon at the annual meetingand the results of each vote.

 

(1)               Election of Directors:

 

| **Nominee**             | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-------------------------|------------|------------|------------|--------------|------------|
|                    |       |       |       |         |       |
| Hal M. Krisbergh        |       | 26,183,611 |       | 90,771       |       |
| Steven C. Davidson      |       | 26,198,630 |       | 75,752       |       |
| Clarence L. Irving, Jr. |       | 26,040,254 |       | 234,128      |       |
| Martin Jaffe            |       | 26,201,996 |       | 72,386       |       |
| Jeff Morris             |       | 26,185,945 |       | 88,437       |       |
| Lemuel Tarshis          |       | 26,199,580 |       | 74,802       |       |

 

(2)               Ratification and approval of the Company’sissuance of common stock in accordance with the terms of the June 2004private placement to certain institutional investors of $7.55 million insecurities.

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 10,809,490 |       | 267,947     |       | 31,362      |       |

 

(3)               Approval of the amendment of the Company’sCertificate of Incorporation to increase the number of authorized shares of theCompany’s common stock from 50 million to 80.

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 25,855,524 |       | 382,056     |       | 36,802      |       |

 

(4)               Ratification and approval of the Company’s 2003Equity Incentive Plan.

 

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 10,405,028 |       | 623,248     |       | 77,413      |       |

 

# ITEM 5.     OTHER INFORMATION.

 

None.

 

17

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# ITEM 6.  EXHIBITSAND REPORTS ON FORM 8-K.

 
| (a) Exhibits. |
|--------------------|
|               |
| 3.1                |   | Amended  and Restated Certificate of Incorporation * |
|               |   |   |
| 3.2                |   | Certificate  of Designations, Preferences and Rights of the Series A Convertible Preferred  Stock of the Company * |
|               |   |   |
| 3.3                |   | Certificate  of Amendment to Certificate of Incorporation * |
|               |   |   |
| 3.4                |   | Amended  and Restated Bylaws (incorporated by reference to Exhibit 3.2 to our Form  10-Q Report for the quarter ended March 31, 1999) |
|               |   |   |
| 4.1                |   | Amendment  to Securities Purchase Agreement and Warrants dated as of September 2,  2004 by and among WorldGate and certain investors. * |
|               |   |   |
| 31.1               |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |
|               |   |   |
| 31.2               |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.* |
|               |   |   |
| 32.1               |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |
|               |   |   |
| 32.2               |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |

 

----

*Filed herewith.

 

18

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(b)                                 Reportson Form 8-K.

 

During the fiscal quarterended September 30, 2004, the Company filed the following Current Reportson Form 8-K:

 

On July 13, 2004, aCurrent Report on Form 8-K was filed, reporting under Items 5 and 7 that, on April 28,2004, the Company had entered into an exclusive multi-year Development andDistribution Agreement with General Instrument Corporation d/b/a the BroadbandCommunications Sector of Motorola, Inc. for the worldwide development anddistribution of our OjoTM personal video phone.

 

SIGNATURES

 

 

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

 

 

WORLDGATE COMMUNICATIONS,INC.

 

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

 

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