** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

----

 

**FORM 10-Q**

 

**Mark One**

**ý****Quarterly Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934**

**for the Quarterly Period Ended June 30,2005.**

 

**or**

 

**o****Transition Report Pursuant to Section 13 or 15(d) of the SecuritiesExchange Act of 1934**

**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’sTelephone 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 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes ýNo o

 

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

Yes oNo ý

 

As of August 4, 2005,there were 38,579,857 shares of common stock, par value $.01 per share,outstanding.

 

 

----

 

WORLDGATECOMMUNICATIONS, INC.

 

QUARTERLY REPORTON FORM 10-Q

FOR THE THREEMONTHS ENDED JUNE 30, 2005

 

TABLE OF CONTENTS

 
| PART I.  FINANCIAL INFORMATION                                                                       |   |
|------------------------------------------------------------------------------------------------------|--------|
|                                                                                                 |   |
| Item 1.  Financial Statements                                                                        | 3      |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 11     |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                  | 15     |
| Item  4. Controls and Procedures                                                                     | 15     |
|                                                                                                 |   |
| PART II.  OTHER INFORMATION                                                                          |   |
|                                                                                                 |   |
| Item 1.  Legal Proceedings                                                                           | 16     |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                 | 16     |
| Item  3. Defaults Upon Senior Securities                                                             | 16     |
| Item  4. Submission of Matters to a Vote of Security Holders                                         | 16     |
| Item 5.  Other Information                                                                           | 16     |
| Item 6. Exhibits                                                                                     | 17     |

 

2

----

 

PART I. FINANCIALINFORMATION

 

# ITEM1.  FINANCIAL STATEMENTS

#  

**WORLDGATECOMMUNICATIONS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(DOLLARSIN THOUSANDS)**
| ** **                                                                                                                                                                                           | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **(Unaudited)**         | ** ** | **(Audited)**               | ** ** |
|                                                                                                                                                                                                 |       |                    |       |                        |       |
| ASSETS                                                                                                                                                                                               |       |                    |       |                        |       |
| Current  assets:                                                                                                                                                                                     |       |                    |       |                        |       |
| Cash  and cash equivalents                                                                                                                                                                           |       | $                       | 7,520      |                        | $          | 11,840 |   |
| Accounts  Receivable                                                                                                                                                                                 |       | 1,075                   |       | 0                           |       |
| Other  receivables                                                                                                                                                                                   |       | 40                      |       | 28                          |       |
| Inventory,  net                                                                                                                                                                                      |       | 1,004                   |       | 46                          |       |
| Prepaid  and other assets                                                                                                                                                                            |       | 354                     |       | 184                         |       |
| Total current assets                                                                                                                                                                                 |       | 9,993                   |       | 12,098                      |       |
|                                                                                                                                                                                                 |       |                    |       |                        |       |
| Property  and equipment                                                                                                                                                                              |       | 3,852                   |       | 3,530                       |       |
| Less:  accumulated depreciation and amortization                                                                                                                                                     |       | (2,157                  | )          | (1,815                      | )          |
| Property  and equipment, net                                                                                                                                                                         |       | 1,695                   |       | 1,715                       |       |
| Deposits  and other assets                                                                                                                                                                           |       | 9                       |       | 9                           |       |
| Total  assets                                                                                                                                                                                        |       | $                       | 11,697     |                        | $          | 13,822 |   |
|                                                                                                                                                                                                 |       |                    |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIENCY)                                                                                                                                              |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                                 |       |                    |       |                        |       |
| Accounts  payable                                                                                                                                                                                    |       | $                       | 1,971      |                        | $          | 222 |   |
| Accrued  expenses                                                                                                                                                                                    |       | 879                     |       | 951                         |       |
| Accrued  compensation and benefits                                                                                                                                                                   |       | 357                     |       | 540                         |       |
| Dividend  payable on Preferred Stock                                                                                                                                                                 |       | 30                      |       | 85                          |       |
| Detachable  Warrants                                                                                                                                                                                 |       | 2,514                   |       | 5,583                       |       |
| Notes  payable                                                                                                                                                                                       |       | 230                     |       | 37                          |       |
| Conversion  option on Preferred Stock                                                                                                                                                                |       | 1,348                   |       | 8,612                       |       |
| Deferred  revenues                                                                                                                                                                                   |       | 10                      |       | 369                         |       |
| Total  liabilities                                                                                                                                                                                   |       | 7,339                   |       | 16,399                      |       |
| Commitments                                                                                                                                                                                          |       | 0                       |       | 0                           |       |
| Redeemable  Preferred Stock; 2,425 shares outstanding at June 30, 2005, and 6,775  outstanding at December 31, 2004                                                                        |       | 1,858                   |       | 2,995                       |       |
|                                                                                                                                                                                                 |       |                    |       |                        |       |
| Stockholders’  equity (deficiency):                                                                                                                                                             |       |                    |       |                        |       |
| Preferred  Stock, $.01 par value, 13,500,000 shares authorized; redeemable shares issued  7,550 at June 30, 2005 and December 31, 2004                                                     |       | 0                       |       | 0                           |       |
| Common  Stock, $.01 par value; 80,000,000 shares authorized, 33,840,802 shares issued  and outstanding at June 30, 2005 and 30,865,777 shares issued and  outstanding at December 31, 2004 |       | 338                     |       | 308                         |       |
| Additional  paid-in capital                                                                                                                                                                          |       | 220,312                 |       | 213,863                     |       |
| Accumulated  deficit                                                                                                                                                                                 |       | (218,150                | )          | (219,743                    | )          |
| Total  stockholders’ equity (deficiency)                                                                                                                                                        |       | 2,500                   |       | (5,572                      | )          |
| Total  liabilities and stockholders’ equity (deficiency)                                                                                                                                        |       | $                       | 11,697     |                        | $          | 13,822 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

3

----

 

**WORLDGATECOMMUNICATIONS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                                                                                                   | ** ** | **Three Months ended June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                   | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total  Revenues                                                                                                                                                                                                                                              |       | $                                    | 1,789      |                               | $          | 0 |   | $ | 1,967 |   | $ | 0 |   |
| Less:  Product Launch Discount                                                                                                                                                                                                                               |       | (390                                 | )          | 0                                  |       | (390 | ) | 0 |   |
| Net  Revenue                                                                                                                                                                                                                                                 |       | 1,399                                |       | 0                                  |       | 1,577 |   | 0 |   |
| Cost  of revenues                                                                                                                                                                                                                                            |       | 1,266                                |       | 0                                  |       | 1,390 |   | 0 |   |
| Gross  margins                                                                                                                                                                                                                                               |       | 133                                  |       | 0                                  |       | 187 |   | 0 |   |
|                                                                                                                                                                                                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Engineering  and development (excluding depreciation and amortization amounts of $73 and  $102 for the three months ended June 30, 2005 and 2004, respectively,  and $139 and $204 for the six months ended June 30, 2005 and 2004,  respectively) |       | 1,373                                |       | 799                                |       | 2,679 |   | 1,599 |   |
| Sales  and marketing (excluding depreciation and amortization amounts of $10 and $0  for the three months ended June 30, 2005 and 2004, respectively, and $18  and $0 for the six months ended June 30, 2005 and 2004, respectively)               |       | 640                                  |       | 408                                |       | 1,018 |   | 599 |   |
| General  and administrative (excluding depreciation and amortization amounts of $88  and $0 for the three months ended June 30, 2005 and 2004, respectively,  and $185 and $0 for the six months ended June 30, 2005 and 2004,  respectively)      |       | 887                                  |       | 1,001                              |       | 1,734 |   | 2,674 |   |
| Depreciation  and amortization                                                                                                                                                                                                                               |       | 171                                  |       | 102                                |       | 342 |   | 204 |   |
| Total  expenses from continuing operations before interest, other income (expense),  change in fair value of warrants and conversion options                                                                                                                 |       | 3,071                                |       | 2,310                              |       | 5,773 |   | 5,076 |   |
| Loss  from continuing operations                                                                                                                                                                                                                             |       | (2,938                               | )          | (2,310                             | )          | (5,586 | ) | (5,076 | ) |
| Interest  and other income                                                                                                                                                                                                                                   |       | 109                                  |       | 13                                 |       | 175 |   | 20 |   |
| Change  in fair value of warrants and conversion options                                                                                                                                                                                                     |       | 2,466                                |       | 348                                |       | 7,642 |   | 348 |   |
| Interest  and other expense                                                                                                                                                                                                                                  |       | (3                                   | )          | (2                                 | )          | (3 | ) | (3 | ) |
| (Loss)  income from continuing operations                                                                                                                                                                                                                    |       | (366                                 | )          | (1,951                             | )          | 2,228 |   | (4,711 | ) |
| Income  from discontinued operations                                                                                                                                                                                                                         |       | 0                                    |       | 7                                  |       | 0 |   | 29 |   |
| Net  (loss) income                                                                                                                                                                                                                                           |       | (366                                 | )          | (1,944                             | )          | 2,228 |   | (4,682 | ) |
| Accretion  on preferred stock and dividends                                                                                                                                                                                                                  |       | (139                                 | )          | (31                                | )          | (635 | ) | (31 | ) |
| Net  (loss) income available to common stockholders                                                                                                                                                                                                          |       | $                                    | (505       | )                                  | $          | (1,975 | ) | $ | 1,593 |   | $ | (4,713 | ) |
| (Loss)  income from continuing operations per common share:                                                                                                                                                                                                  |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | $                                    | (0.01      | )                                  | $          | (0.07 | ) | $ | 0.07 |   | $ | (0.17 | ) |
| Fully  Diluted                                                                                                                                                                                                                                               |       | $                                    | (0.01      | )                                  | $          | (0.07 | ) | $ | 0.06 |   | $ | (0.17 | ) |
| Income  from discontinued operations per common share:                                                                                                                                                                                                       |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | $                                    | 0.00       |                               | $          | 0.00 |   | $ | 0.00 |   | $ | 0.00 |   |
| Fully  Diluted                                                                                                                                                                                                                                               |       | $                                    | 0.00       |                               | $          | 0.00 |   | $ | 0.00 |   | $ | 0.00 |   |
| Net  (loss) income per common share:                                                                                                                                                                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | $                                    | (0.01      | )                                  | $          | (0.07 | ) | $ | 0.07 |   | $ | (0.17 | ) |
| Fully  Diluted                                                                                                                                                                                                                                               |       | $                                    | (0.01      | )                                  | $          | (0.07 | ) | $ | 0.06 |   | $ | (0.17 | ) |
| Net  (loss) income available to common shareholders per common share:                                                                                                                                                                                        |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | $                                    | (0.02      | )                                  | $          | (0.07 | ) | $ | 0.05 |   | $ | (0.17 | ) |
| Fully  Diluted                                                                                                                                                                                                                                               |       | $                                    | (0.02      | )                                  | $          | (0.07 | ) | $ | 0.06 |   | $ | (0.17 | ) |
| Weighted  average common shares outstanding:                                                                                                                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                        |       | 33,546,229                           |       | 27,898,268                         |       | 32,569,598 |   | 27,380,133 |   |
| Fully  Diluted                                                                                                                                                                                                                                               |       | 33,546,229                           |       | 27,898,268                         |       | 38,432,028 |   | 27,380,133 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

4

----

 

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

 
| ** **                                                                                                                    | ** ** | **Six Months ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2005**                           | ** ** | **2004** | ** ** |
|                                                                                                                          |       |                               |       |   |   |
| Cash  flows from operating activities:                                                                                        |       |                               |       |   |   |
| Net  income (loss)                                                                                                            |       | $                                  | 2,228      |   | $ | (4,682 | ) |
| Income  from discontinued operations                                                                                          |       | 0                                  |       | (29 | ) |
| Adjustments  to reconcile net income (loss) to net operating cash flow from operating  activities from continuing operations: |       |                               |       |   |   |
| Depreciation  and amortization                                                                                                |       | 342                                |       | 204 |   |
| Change  in fair value of warrants and conversion options                                                                      |       | (7,642                             | )          | (348 | ) |
| Non-cash  stock based compensation                                                                                            |       | 0                                  |       | 631 |   |
| Changes  in operating assets and liabilities:                                                                                 |       |                               |       |   |   |
| Accounts  receivable                                                                                                          |       | (1,075                             | )          | 0 |   |
| Other  receivables                                                                                                            |       | (12                                | )          | 28 |   |
| Inventory                                                                                                                     |       | (958                               | )          | 0 |   |
| Prepaid  and other assets                                                                                                     |       | 60                                 |       | 247 |   |
| Accounts  payable                                                                                                             |       | 1,749                              |       | (294 | ) |
| Accrued  expenses                                                                                                             |       | (72                                | )          | 477 |   |
| Accrued  compensation and benefits                                                                                            |       | (183                               | )          | 40 |   |
| Other                                                                                                                         |       | (359                               | )          | 285 |   |
| Net  cash used in continuing operations                                                                                       |       | (5,922                             | )          | (3,441 | ) |
| Net  cash provided by discontinued operations                                                                                 |       | 0                                  |       | 46 |   |
| Net  cash used in operating activities                                                                                        |       | (5,922                             | )          | (3,395 | ) |
|                                                                                                                          |       |                               |       |   |   |
| Cash  flows from investing activities of continuing operations:                                                               |       |                               |       |   |   |
| Capital  expenditures                                                                                                         |       | (322                               | )          | (30 | ) |
| Net  cash used in investing activities                                                                                        |       | (322                               | )          | (30 | ) |
|                                                                                                                          |       |                               |       |   |   |
| Cash  flows from financing activities of continuing operations:                                                               |       |                               |       |   |   |
| Payment  of Note Payable                                                                                                      |       | (37                                | )          | 0 |   |
| Proceeds  from issuance of common stock                                                                                       |       | 21                                 |       | 2,509 |   |
| Proceeds  from issuance of redeemable preferred stock                                                                         |       | 0                                  |       | 7,111 |   |
| Proceeds  from the exercise of stock options                                                                                  |       | 465                                |       | 126 |   |
| Proceeds  from the exercise of stock rights and warrants                                                                      |       | 1,475                              |       | 620 |   |
| Net  cash provided by financing activities                                                                                    |       | 1,924                              |       | 10,366 |   |
| **Net (decrease) increase in cash and equivalents**                                                                           |       | (4,320                             | )          | 6,941 |   |
| **Cash and cash equivalents, beginning of period**                                                                            |       | 11,840                             |       | 3,365 |   |
| **Cash and cash equivalents, end of period**                                                                                  |       | $                                  | 7,520      |   | $ | 10,306 |   |
|                                                                                                                          |       |                               |       |   |   |
| Cash  paid for interest                                                                                                       |       | $                                  | 1          |   | $ | 2 |   |
| Non-cash  financing activities:                                                                                               |       |                               |       |   |   |
| Conversion  of preferred stock to common stock                                                                                |       | $                                  | 4,350      |   | $ | 0 |   |
| Issuance  of common stock for payment of dividend                                                                             |       | $                                  | 168        |   | $ | 0 |   |
| Issuance  of note payable to finance D & O insurance                                                                 |       | $                                  | 230        |   | $ | 256 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

5

----

 

WORLDGATECOMMUNICATIONS, INC.

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

 

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

(Unaudited)

 

1.                                       Basisof Presentation.

 

The unaudited financial statementsof WorldGate Communications, Inc. (“WorldGate” or the “Company”) for thethree and six months ended June 30, 2005 and June 30, 2004 presentedherein have been prepared by the Company pursuant to the rules andregulations of the Securities and Exchange Commission for quarterly reports on Form 10-Q.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and regulations.  These financial statements should be read inconjunction with the consolidated financial statements for the year ended December 31,2004 and the notes thereto included in the Company’s Annual Report on Form 10-K.

 

The financial 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, 2005.

 

2.                                       Liquidityand Going Concern Considerations.

 

As of June 30, 2005 theCompany had cash and cash equivalents of $7,520. The operating cash usage fromcontinuing operations for the three and six months ended June 30, 2005 was$2,714 and $5,922, respectively. The funds we received as a result of privateplacements of our securities on December 1, 2003, December 4, 2003, January 21,2004, April 22, 2004, June 23, 2004 and December 15, 2004, havepermitted us to fund the development of our new business.

 

In December 2003 andJanuary 2004, WorldGate received proceeds from investments aggregating$3,100 by certain institutional investors. These investors purchased anaggregate of 3,000,000 shares of newly issued common stock. The investors alsoreceived a right, for a limited period of time, to purchase additional sharesof up to 20% of the common stock purchased by the investors in theirinvestment, at the same price as their investment, and five-year warrants topurchase up to 30% of the common stock purchased by the investors in theirinvestment, at an exercise price equal to a twenty-five percent premium totheir purchase price for the investment. The purchase price for the 2 millionshares purchased in the December 2003 transactions were $0.80 per share,with the warrants having a $1.00 per share exercise price. The purchase pricefor the 1 million shares purchased in the January 2004 transaction was$1.50 per share, with the warrants having a $1.875 per share exercise price.All additional investment rights associated with the December 2003transaction were exercised during January and February of 2004,resulting in an incremental investment of $320. All additional investment rightsassociated with the January 2004 transaction were exercised in May 2004,resulting in an incremental investment of $300. A portion of the warrants andadditional investment right warrants associated with the December 2003 andJanuary 2004 transactions were exercised in December 2004 and January 2005,resulting in an incremental investment of $925.

 

In June 2004,WorldGate completed a private placement of redeemable preferred stock. The Series AConvertible Preferred Stock has attached warrants and conversion options.Specifically, the holders of the Preferred Stock may convert their shares intoour common stock at a conversion price of $2.35 per share. In addition, theCompany may force conversion of the Preferred Stock into common stock if theCompany achieves certain price targets for its common stock and satisfaction ofcertain other conditions. In either event the conversion price is subject toadjustment in the event the Company enters into another transaction which isdilutive to the subject transaction. As part of this transaction, the Companyhas also issued five-year warrants to purchase 1,606,383 shares of the Company’scommon stock, one-half of the warrants at an exercise price of $2.69 per shareand the remaining half at an exercise price of $3.14 per share. The preferredstock has a dividend rate of 5% per annum, payable quarterly, either by cash orthrough the issuance of common stock at the Company’s option. The PreferredStock has a staged maturity over three years with one-third of the preferredstock to be redeemed after 18 months, one-third after 24 months and one-thirdafter 36 months, and may be redeemed at maturity in cash or, subject to certainconditions, through the issuance of common stock, at the

 

6

----

 

Company’s option (withstock payments being made at the then current market price). Of the 7,550preferred shares issued under this private placement, all but 2,425 shares havebeen redeemed as of June 30, 2005.

 

EITF Issue D-98, paragraph4, states that Rule 5.02.28 of Regulation S-X requires securities withredemption features that are not solely within the control of the issuer to berecorded as a liability outside of permanent equity. The value ascribed to theredeemable preferred stock upon initial issuance, i.e. at June 23, 2004,was the amount received in the transaction minus the value ascribed to theconversion option and warrants. This initial value of the redeemable preferredstock is accreted up to the redemption value (the amount received in thetransaction) over the future relevant periods using the interest method.

 

The conversion optionsand warrants are considered embedded derivative instruments under SFAS No. 133,paragraph 11a. In accordance with EITF Issue 00-19, paragraph 8, and EITF IssueNo. 00-27, Issue Summary Number 1, paragraph 5, these conversion optionsand warrants do not meet the paragraph 11(a) exclusion of SFAS No. 133and are therefore classified as liabilities. In accordance with EITF Issue D-98,the Company identifies and measures these derivatives under the fair valuemethod at the end of each quarter, and their value is marked to market at theend of each reporting period with the gain or loss recognition recorded againstearnings in accordance with paragraph 16 of SFAS No. 133. We continue torevalue these instruments each quarter to reflect their current value in lightof the current market price of our common stock. The warrants and conversionoptions are valued using the Black-Scholes valuation model. Actual period closecommon stock prices, volatility rate of 64%, and the period close risk-freeinterest rate for the instrument’s expected remaining life (continuouslycompounded), are the key assumptions used in the valuation calculation. TheWorldGate share price changed from $4.99 per share at the end of December 31,2004 to $3.90 as of March 31, 2005, and to $3.24 as of June 30, 2005,making the embedded warrants and preferred stock conversion elements lessvaluable, and therefore less costly, relative to their strike price. The resultwas $2,466 and $7,642 in non-cash gains, respectively, recorded for the threeand six months ended June 30, 2005.

 

It is important to notethat this periodic marked to market addition to, or deduction from, earningshas no cash effect over the life of the instruments, with the cumulativenon-cash mark-to-market adjustments of gains and losses offsetting and nettingto $0. These instruments are conventional elements of financing transactionsand were not intended to be, nor are they, hedging instruments. The preferredstock and warrants are convertible or exercisable at fixed prices and thereforethere is no market risk associated with these instruments.

 

The Company had $7,339 ofliabilities and its assets are not pledged as collateral as of June 30,2005. These liabilities include $3,892 of dividends, detachable warrants andconversion options related to the Company’s private placement of Series APreferred Stock.

 

The consolidatedfinancial statements have been prepared on a going concern basis, whichcontemplates the realization of assets and the satisfaction of liabilities andcommitments in the normal course of business. Therefore, the consolidated financial statements do not include anyadjustments relating to the Company’s ability to operate as a goingconcern.  The appropriateness of usingthe going concern basis in the future, however, will be dependent upon theCompany’s ability to address its ongoing liquidity needs. There is no assurancethat the Company will be able to address its liquidity needs, and accordingly,there is substantial doubt about the Company’s ability to continue as a goingconcern.  The independent auditors’report for the year ended December 31, 2004 included an explanatoryparagraph stating that because the Company has suffered recurring losses fromoperations and had a net accumulated deficiency of $220,000, those issues raisedsubstantial doubt about the Company’s ability to continue as a going concern.

 

3.                                       RecentAccounting Pronouncement.

 

In November 2004,the FASB issued SFAS no. 151 “Inventory Costs” which amends the guidance in ARBNo. 43, Chapter 4 “Inventory Pricing,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage).  Paragraph 5 of ARB43, Chapter 4, previously stated that under some circumstances, items such asidle facility expense, excessive spoilage, double freight and rehandling costsmay be so abnormal as to require treatment as current period charges.”  SFAS No. 151 requires that those itemsbe recognized as current-period charges regardless of whether they meet thecriterion of “so abnormal.”  In addition,SFAS No. 151 requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities.  SFAS No. 151 iseffective for inventory costs incurred during fiscal years beginning after June 15,2005.  Earlier application is permittedfor inventory costs incurred during fiscal years beginning after the date SFAS No. 151was issued.  SFAS No. 151 is to beapplied prospectively.

 

7

----

 

The Company does notexpect the adoption of SFAS No. 151 to have a material effect on itsconsolidated financial statements.

 

In December 2004,the FASB issued SFAS No. 153 “Exchanges of Nonmonetary Assets” whichamends APB Opinion No. 29, “Accounting for Nonmonetary Transactions.”  APB No. 29 is based on the principlethat exchanges of nonmonetary assets should be measured based on the fair valueof the assets exchanged.  The guidance inthat Opinion, however, included certain exceptions to that principle.  SFAS No. 153 amends APB No. 29 toeliminate the exception for nonmonetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of nonmonetary assetsthat do not have commercial substance.  Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange.  SFAS No. 153 is effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005.  Earlier application is permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after thedate SFAS No. 153 was issued.  SFAS No. 153is to be applied prospectively.  TheCompany does not expect the adoption of SFAS No. 153 to have a materialeffect on its consolidated financial statements.

 

In December 2004,the FASB issued SFAS No. 123 (R), “Share-Based Payment” that focusesprimarily on accounting for transactions in which an entity obtains employeeservices in share-based payment transactions. This statement replaces SFAS No. 123,“Accounting for Stock-Based Compensation”, and supersedes APB Opinion No. 25,“Accounting for Stock Issued to Employees.” Beginning with our annual periodsthat begin after June 15, 2005, we will be required to expense the fairvalue of employee stock options and similar awards. As a public company, we areallowed to select from two alternative transition methods, each havingdifferent reporting implications.

 

Subsequently, in April 2005,the SEC issued release 2005-57 which allows companies to implement StatementNo. 123 (R) at the beginning of their next fiscal year, instead of the nextreporting period that begins after June 15, 2005 as disclosed in the originalStatement No 123 (R) release in December 2004.  We are currently evaluating the impact of thisstandard and its transitional alternatives.

 

In March 2005, theFinancial Accounting Standards Board (FASB) issued Interpretation No. 47(FIN 47) to clarify the guidance included in SFAS No. 143, “Accounting forAsset Retirement Obligations”.  FIN 47requires companies to recognize a liability for the fair value of a legal obligationto perform asset retirement activities that are conditional on a future eventif the amount can be reasonably estimated. If amounts cannot be reasonably estimated, certain disclosures will berequired about the unrecognized asset retirement obligations.  The interpretation is required to be adoptedin the first quarter of 2006.  We arecurrently evaluating the interpretation to determine the effect on ourfinancial statements and related disclosures.

 

In May 2005, SFAS No. 154,“Accounting Changes and Error Corrections – replacement of APB Opinion No. 20and FASB Statement No. 3,” (SFAS No. 154) was issued. SFAS No. 154changes the accounting for and reporting of a change in accounting principle byrequiring retrospective application to prior periods’ financial statements ofchanges in accounting principle unless impracticable. SFAS No. 154 iseffective for accounting changes made in fiscal years beginning after December 15,2005. The Company does not expect the adoption of SFAS No. 154 to have a materialimpact on its results of operations, financial position or cash flows.

 

4.                                       Inventories.

 

Inventories as of June 30,2005 and December 31, 2004 are summarized as follows:

 
| ** **                                   | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| Raw  material (from discontinued operations) |       | $                      | 0          |                       | $          | 1,622 |   |
| Finished  goods (from continuing operations) |       | 1,004                  |       | 46                         |       |
| Total  Inventory                             |       | 1,004                  |       | 1,668                      |       |
| Inventory  Reserve                           |       | 0                      |       | (1,622                     | )          |
| Inventory,  net                              |       | $                      | 1,004      |                       | $          | 46 |   |

 

8

----

 

5.                                       Stock-BasedCompensation.

 

The Company accounts forstock-based compensation in accordance with Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees,” as amended by SFAS No. 148,“Accounting for Stock-Based Compensation—Transition and Disclosure”.

 

TheCompany applies Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” and related interpretations in accounting forits plans, and accordingly, no compensation cost has been recognized for theCompany’s fixed stock based compensation. Had compensation cost been determined consistent with SFAS No. 123,as amended by SFAS No. 148, the Company’s net loss would have beenincreased to the following pro forma amounts:

 

 
| ** **                                                                                                                          | ** ** | **For the Three Month Period  Ended June 30,** | ** ** | **For the Six Month Period  Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**                                            | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| (Loss)  income from continuing operations                                                                                           |       | $                                                   | (366       | )                                                 | $          | (1,951 | ) | $ | 2,228 |   | $ | (4,711 | ) |
| Income  from discontinued operations                                                                                                |       | 0                                                   |       | 7                                                 |       | 0 |   | 29 |   |
| Net  (loss) income                                                                                                                  |       | (366                                                | )          | (1,944                                            | )          | 2,228 |   | (4,682 | ) |
| Accretion  on preferred stock and dividends                                                                                         |       | (139                                                | )          | (31                                               | )          | (635 | ) | (31 | ) |
| Net  income (loss) available to common shareholders, as reported                                                                    |       | (505                                                | )          | (1,975                                            | )          | 1,593 |   | (4,713 | ) |
| Add:  Stock-based employee compensation expense included in reported net (loss)  income, net of related tax effects                 |       | 0                                                   |       | 0                                                 |       | 0 |   | 631 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of tax of $0 |       | (206                                                | )          | (520                                              | )          | (400 | ) | (1,083 | ) |
| Pro  forma net (loss) income                                                                                                        |       | $                                                   | (711       | )                                                 | $          | (2,495 | ) | $ | 1,193 |   | $ | (5,165 | ) |
|                                                                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Net  (loss) income per share:                                                                                                       |       |                                                |       |                                              |       |   |   |   |   |
| Income  (loss) from continuing operations:                                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                               |       | $                                                   | (0.01      | )                                                 | $          | (0.07 | ) | $ | 0.07 |   | $ | (0.17 | ) |
| Fully  Diluted                                                                                                                      |       | $                                                   | (0.01      | )                                                 | $          | (0.07 | ) | $ | 0.06 |   | $ | (0.17 | ) |
| Income  from discontinued operations:                                                                                               |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                               |       | $                                                   | 0.00       |                                              | $          | 0.00 |   | $ | 0.00 |   | $ | 0.00 |   |
| Fully  Diluted                                                                                                                      |       | $                                                   | 0.00       |                                              | $          | 0.00 |   | $ | 0.00 |   | $ | 0.00 |   |
| Net  (loss) income:                                                                                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                               |       | $                                                   | (0.01      | )                                                 | $          | (0.07 | ) | $ | 0.07 |   | $ | (0.17 | ) |
| Fully  Diluted                                                                                                                      |       | $                                                   | (0.01      | )                                                 | $          | (0.07 | ) | $ | 0.06 |   | $ | (0.17 | ) |
| Net  (loss) income available to common shareholders:                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                               |       | $                                                   | (0.02      | )                                                 | $          | (0.07 | ) | $ | 0.05 |   | $ | (0.17 | ) |
| Fully  Diluted                                                                                                                      |       | $                                                   | (0.02      | )                                                 | $          | (0.07 | ) | $ | 0.06 |   | $ | (0.17 | ) |
| Net  (loss) income available to common shareholders – pro forma:                                                               |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                                                                               |       | $                                                   | (0.02      | )                                                 | $          | (0.09 | ) | $ | 0.04 |   | $ | (0.19 | ) |
| Fully  Diluted                                                                                                                      |       | $                                                   | (0.02      | )                                                 | $          | (0.09 | ) | $ | 0.05 |   | $ | (0.19 | ) |

 

Suchpro forma disclosures may not be representative of future compensation expensebecause options vest over several years and additional grants are made eachyear.

 

9

----

 

6.                                       Commitmentsand Contingencies.

 

*Leases*

 

In 1998 the Companyentered into a leasing arrangement for a building with an entity formed bynon-employee investors. The Company stopped paying rent on this lease in May 2003,and in lieu of rent payments the Company’s landlord, 3190 T General, Inc.(an entity formed by non-employee investors in the Company), began drawing downthe security deposit for the facility. Prior to stopping rent payments, theCompany had commenced negotiations with its landlord for an amendment of itslease to reduce the space commitment and the rent payable. These negotiationswere not successful, and in September 2003, the Company’s landlord filedan action in the Court of Common Pleas, Bucks County, Pennsylvania to perfectits interest to take possession of the Company’s facility, and to establishdamages for past rent and expenses. Although a judgment was granted allowingthe Company’s landlord to regain possession of the facility, the Companyremained in the facility and continued negotiations with its landlord. During2004, the landlord deeded the facility to its mortgage holders and negotiationscommenced with GMAC as representative for the mortgage holders. Thesenegotiations were successful and in November 2004 the Company’s lease wasamended with an effective date of June 2004 to reduce the lease obligationin line with the Company’s then current space requirements, and to bring theCompany current with respect to all outstanding back rent.  Subsequently, GMAC sold the building and weare now in negotiations with the new owner to further amend the lease to securea lower rental rate and additional square footage. The current lease covers22,176 square feet at an annual rate of $15 per square foot, cancelable byeither party with 90 days notice.

 

In November 2003,the Company entered into a 60 month lease for office equipment. As of June 30,2005 there remains a total of $20 to be paid over the remaining period of thelease.

 

* Significant Agreements and Transactions*

 

Net revenues fromcontinuing operations recognized from an investor were approximately $1,399 and$0, respectively, for the three months ended June 30, 2005 and 2004, andapproximately $1,577 and $0, respectively, for the six months ended June 30,2005 and 2004. This investor accounted for approximately 100% of the revenuesfor the three and six months ended June 30, 2005. This investor previouslyprovided a cash advance against product shipments. The balance of this advancereceived from this investor was $0 as of June 30, 2005. Accountsreceivable from this investor were $1,072 as of June 30, 2005 and $0 at December 31,2004.

 

The Company has a currentagreement with an investor to provide the Company with engineering anddevelopment support. As a result of this agreement, the Company has expensedapproximately $92 (included in continuing operations) and $0 (included indiscontinued operations), for the three months ended June 30, 2005 and June 30,2004, respectively, and approximately $158 (included in continuing operations)and $0 (included in discontinued operations), for the six months ended June 30,2005 and 2004, respectively. Accounts payable to this investor amounted to $1,803and $117 at June 30, 2005 and December 31, 2004, respectively. Thisagreement provided for contracted services, including hardware and softwaredevelopment, and the creation and development of tools to facilitate theCompany’s engineering efforts. This agreement does not provide for ongoingroyalties, purchase provisions, or for any requirement to provide additionalfunding to the Company.

 

7.                                       Net(Loss) Income per Share.

 

Basic and diluted net (loss)income per common share is computed by dividing the net (loss) income availableto common stockholders for the period by the weighted average number of sharesof common stock outstanding during the period. The calculation of diluted net (loss) income per common share excludespotential common shares if the effect is antidilutive.  Potential common shares comprise shares ofcommon stock issuable upon the exercise of stock options and warrants and theconversion of preferred stock.  For thesix month periods ended June 30, 2005 and 2004, there would have been apotential additional 1,272,256 and 12,968,818, respectively, shares assumed tobe converted, that would have a dilutive effect, if the Company had income fromcontinuing operations, or if the options’ exercise price was less than theaverage market price of the common shares.

 

10

----

 

8.                                       SubsequentEvent.

 

On August 3, 2005,the Company completed a private placement of $17.5 million of its common stockand warrants with several institutional investors. The Company issued 4,666,664shares of its common stock at $3.75 per share to the participating investors.The Company also issued five-year warrants to purchase a total of 1,633,333shares of its common stock, with an exercise price of $5.00 per share. Theinvestors also received an additional investment right, for a limited period oftime, to purchase 1,554,000 additional shares of common stock at $4.12 a share.

 

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

#  

**FORWARD-LOOKINGAND CAUTIONARY STATEMENTS**

 

We may from time to timemake written or oral forward-looking statements, including those contained inthe following Management’s Discussion and Analysis of Financial Condition andResults of Operations.  The words “estimate,”“project,” “believe,” “intend,” “expect,” and similar expressions are intendedto identify forward-looking statements, although not all forward-lookingstatements contain these identifying words. In order to take advantage of the “safe harbor” provisions of thePrivate Securities Litigation Reform Act of 1995, we are hereby identifyingcertain important factors that could cause our actual results, performance orachievement to differ materially from those that may be contained in or impliedby any forward-looking statement made by or on our behalf.  The factors, individually or in theaggregate, that could cause such forward-looking statements not to be realizedinclude, without limitation, the following: (1) difficulty in developingand implementing marketing and business plans, (2) industry competitionfactors and other uncertainty that a market for our products will develop, (3) challengesassociated with broadband service operators (including, uncertainty that theywill offer our products, inability to predict the manner in which they willmarket and price our products and existence of potential conflicts of interestsand contractual limitations impeding their ability to offer our products), (4) continuedlosses, (5) difficulty or inability to raise additional financing on termsacceptable to us, (6) departure of one or more key persons, (7) delistingof our Common Stock from the NASDAQ Small Cap Market, (8) changes inregulatory requirements, and (9) other risks identified in our filingswith the Securities and Exchange Commission. We caution you that the foregoing list of important factors is notintended to be, and is not, exhaustive. We do not undertake to update any forward-looking statement that may bemade from time to time by or on our behalf.

 

Results of Operations:

 

Critical AccountingPolicies and Estimates.

 

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

 

The significantaccounting policies of the Company are described in the notes to theconsolidated financial statements included in the annual report on Form 10-K.  Judgments and estimates of uncertainties arerequired in applying the Company’s accounting policies in many areas.  Following are some of the areas requiringsignificant judgments and estimates: revenue recognition, accounts receivable, inventories, cash flow and valuationassumptions in performing asset impairment tests of long-lived assets, value ofredeemable preferred stock, related warrants and conversion options.

 

Discontinued Operations

 

During the first quarterof 2004, we 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

 

11

----

 

three and six monthsended June 30, 2004, the Company had revenues from our discontinued ITVbusiness operations of $82. Cost of revenues for the three and six months endedJune 30, 2004 was $43. Concurrently, operating expenses from discontinuedoperations were $16 for the three and six months ended June 30, 2004. Forthe three and six months ended June 30, 2004, other income, net of otherexpenses, relating to our discontinued ITV business operations were $6. Therewere no revenues, cost of revenues, operating expenses, and other income andother expenses from discontinued operations during the three and six monthsended June 30, 2005.

 

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

 

Three and six MonthsEnded June 30, 2005 and June 30, 2004

 

Revenues.

 

Revenues. Total gross revenuesfrom continuing operations for the three and six months ended June 30,2005 were $1,789 and $1,967, respectively. Net revenues for the three and sixmonths ended June 30, 2005 were $1,399 and $1,577, respectively. Theserevenues represent deliveries of video phones for pre-market testing and for theinitial launch of video phones for the consumer market. As an incentive topromote delivery of the units, a special “Product Launch Discount” was providedby the Company to our distributor as a quantity restricted reduction to theunit contract based price in effect. For the three and six months ended June 30,2005, this “Discount” was $390. There were no revenues from continuingoperations during the three and six months ended June 30, 2004.

 

Costs and Expenses.

 

Cost of Revenues. Thecost of revenues from continuing operations, which consisted of product anddelivery costs relating to the delivery of video phones, was $1,266 and $1,390,respectively, for the three and six months ended June 30, 2005. There wereno costs of revenues from continuing operations during the three and six monthsended June 30, 2004.

 

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 $1,373 for the three months ended June 30, 2005, compared with$799 for the three months ended June 30, 2004, and $2,679 and $1,599,respectively, for the six months ended June 30, 2005 and 2004. Thisincrease of $574, or 72%, and $1,080 , or 68%, respectively, for the three andsix months ended June 30, 2005 over 2004, reflects the Company’s increasedconcentration of its engineering staff, and related costs, for the further andcontinuing development of its video phone product.

 

Sales and Marketing.  Sales and marketing expenses consistprimarily of compensation, attendance at conferences and trade shows, travelcosts, promotions and other marketing programs related to the marketing of theCompany’s video phone product.  Sales andmarketing costs were $640 for the three months ended June 30, 2005,compared with $408 for the three months ended June 30, 2004, and $1,018and $599, respectively, for the six months ended June 30, 2005 and 2004.  This increase of $232, or 57%, and $419, or70%, respectively, for the three and six months ended June 30, 2005 over2004, reflects the increased effort of staff, and related marketing, serviceand promotional expenditures associated with the launch and growth of theCompany’s video phone business.

 

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 $887for the three months ended June 30, 2005, compared with $1,001 for thethree months ended June 30, 2004, and $1,734 and $2,674, respectively, forthe six months ended June 30, 2005 and 2004.  This decrease of $114, or 11%, and $940, or35%, respectively, for the three and six months ended June 30, 2005 over2004, is attributable to certain expenses incurred during the three and six monthsended June 30, 2004 that were not incurred during the three and six monthsended June 30, 2005. These expenses consisted of a non cash charge of $631reflecting a Black Scholes estimate of the value of the warrants issued as partof the private placement of the Company’s stock to certain institutionalinvestors in January 2004, an expense for sales taxes of $125, and a reductionin rent

 

12

----

 

expense of $241 and $437,respectively, for the three and six months ended June 30, 2005 compared tothe three and six months ended June 30, 2004.

 

Interest, Other Incomeand Interest Expense. Interest, other income and interest expense consist ofinterest earned on cash and cash equivalents, and interest expense onshort-term debt. Interest and other income increased from $13 for the threemonths ended June 30, 2004 to $109 for the three months ended June 30,2005, and increased from $20 for the six months ended June 30, 2004 to $175for the six months ended June 30, 2005, primarily due to additionalinterest income earned on a higher level of invested funds and an insurancerefund settlement of $36. During the three months ended June 30, 2005, theCompany earned interest on average cash balances of approximately $6,362 andincurred interest expense related to its insurance financing. In comparison,during the three months ended June 30, 2004 the Company earned interest onaverage cash balances of approximately $4,552 and incurred interest expenserelated to its insurance financing.  Forthe six months ended June 30, 2005, the Company earned interest on averagecash balances of approximately $9,936 compared to $4,817 for the six monthsended June 30, 2004.

 

IncomeTaxes.  The Company has incurred netoperating losses since inception and accordingly had no income taxes and hasnot recorded any income tax benefit for those losses.

 

Liquidity and CapitalResources.

 

As of June 30, 2005,our primary source of liquidity consisted of cash and cash equivalents that arehighly liquid, are of high quality investment grade and have original maturitiesof less than 90 days.

 

At June 30, 2005, wehad cash and cash equivalents of $7,520 (and no short-term investments) ascompared to cash and equivalents of $11,840 (and no short-term investments) at December 31,2004.  Net cash used in continuingoperations was $2,714 for the three months ended June 30, 2005, ascompared to $1,644 used for the same period in 2004. The net cash used incontinuing operations was $5,922 for the six months ended June 30, 2005 ascompared to $3,441 used for the same period in 2004.  This increase in net cash used for continuingoperations was primarily attributable to the Company’s increase in expendituresrelated to the video phone business.  TheCompany recorded bad debt expense in the amount of $16 from discontinuedoperations during the three and six months ended June 30, 2004 to reflectits current assessment of the collectability of certain receivables.

 

Cash provided by financingactivities from continuing operations during the three months ended June 30,2005, totaled $583 compared to $8,535 provided during the same period in 2004. Cashprovided by financing activities from continuing operations during the sixmonths ended June 30, 2005 was $1,924 as compared to $10,366 providedduring the same period in 2004.  Capitalexpenditures were $242 and $22 for the three months ended June 30, 2005and 2004, respectively.  For the sixmonths ended June 30, 2005 and 2004 capital expenditures were $322 and $30,respectively.

 

Operations and Liquidity.

 

Todate, the Company has funded operations primarily through private sales ofequity securities and through an initial public offering of common stock in April 1999.  As of June 30, 2005 the Company hadcash, and cash equivalents of $7,520. The operating cash usage from continuing operations for the three monthsended June 30, 2005 and 2004 was $2,714 and $1,644, respectively. Operatingcash usage from continuing operations for the six months ended June 30,2005 and 2004 was $5,922 and $3,441, respectively.  As of June 30, 2005 we have nooutstanding debt and our assets are not pledged as collateral.

 

TheCompany has funded operations through the private placement of our common stockin January 2004, which provided proceeds of $1,500, the private placementof our common stock in April 2004 providing proceeds of $1,000, the June 2004private placement of our redeemable preferred stock providing proceeds of $7,550,the private placement of common stock in December 2004 providing $500, theexercise of additional investment rights and warrants providing $6,800 in January,February, May and December 2004 and January, February, and April 2005,the exercise by employees and former employees of options throughout 2004 and January throughJune 2005 providing aggregate proceeds of $1,171, and the August 2005private placement of common stock, together with additional rights andwarrants, providing $17,500. We do however have an obligation to pay dividends on,as well as to redeem, our outstanding Series A Preferred Stock uponmaturity, or at the earlier option of a holder of these

 

13

----

 

securities.Under certain limited circumstances we may be forced to make such payments andredemptions with cash instead of shares of our common stock. In such event ourability to fund continuing operations would be negatively impacted. The reportof the independent registered public accounting firm for the year ended December 31,2004 included an explanatory paragraph stating that the Company had sufferedrecurring losses from operations and had a net accumulated deficiency of $220,000,and that these issues raised substantial doubt about the Company’s ability tocontinue as a going concern.

 

14

----

 

ITEM 3.               QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Interest Rate Risk.  Our exposure to market risk related tochanges in 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 June 30, 2005,the Company’s cash and cash equivalents were $7,520, having an originalmaturity of less than 90 days, and it had no short-term investments.  Due to the average maturity and conservativenature of our investment portfolio, management believes a sudden change ininterest rates would not have a material effect on the value of the portfolio.Management estimates that had the average yield of our investments decreased by100 basis points, our interest income for the six months ended June 30,2005 would have decreased by approximately $43. This estimate assumes that thedecrease occurred on the first day of 2005 and reduced the yield of eachinvestment instrument by 100 basis points. The impact on our future interest income of future changes in investmentyields will depend largely on our total investments.

 

Foreign Currency ExchangeRisk.  Although we transact business invarious foreign countries, the principal portion of our business is in theUnited States and substantially all of our revenues and costs to date have beendenominated in U.S. dollars.  Althoughour agreement with Mototech, our contract manufacturer in Taiwan, isdenominated in U.S. dollars, their material acquisition costs are subject to exchangerate changes that could impact our product costs.

 

# ITEM4.               CONTROLS ANDPROCEDURES.

#  

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 our disclosurecontrols and procedures are reasonably designed and effective to alert them ona timely basis to material information relating to the Company and that are requiredto be included in our reports filed or submitted under the Exchange Act. Therehave been no changes to our internal control over financial reporting thatoccurred during the quarter ended June 30, 2005, that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

15

----

 

PART II.OTHER INFORMATION

 

(Dollar Amountsare in Thousands, Except per Share Amounts)

 

# ITEM 1.  LEGAL PROCEEDINGS.

#  

None

 

# ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS.

#  

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

 

# ITEM3.  DEFAULTS UPON SENIOR SECURITIES.

#  

None.

 

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

#  

None.

 

# ITEM 5.  OTHER INFORMATION.

#  

None.

 

16

----

 

# ITEM 6.  EXHIBITS.

#  

(a)                                  Exhibits.

 

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

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

 

----

* Filed herewith

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

(2) Incorporated byreference to the exhibits to our Form 8-K Current Report filed on June 25,2004 (Exhibit 3.1).

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

 

17

----

 

SIGNATURES

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   | WORLDGATE  COMMUNICATIONS, INC. |
|--------|---------------------------------|
|   |                            |
|   |                            |
| Date:  | August 15, 2005            | /s/ Hal M. Krisbergh |   |
|   |                            | Hal M. Krisbergh |
|   |                            | Chairman and Chief  Executive Officer |
|   |                            | (Principal Executive  Officer) |
|   |                            |   |
|   |                            |   |
| Date:  | August 15, 2005            | /s/ Joel Boyarski |   |
|   |                            | Joel Boyarski |
|   |                            | Vice President and  Chief Financial Officer |
|   |                            | (Principal Financial  and Accounting Officer) |
|        |                                 |  |  |  |  |

 

18

----