UNITED STATES
 SECURITIES AND EXCHANGE
COMMISSION
 Washington,
DC 20549
   
  FORM 10-Q
 
  
 (MARK
      ONE)x
              QUARTERLY REPORT UNDER
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For the quarterly
      period ended December 31, 2007ORo
              TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
  ACTFor the transition period from
       ______________ to
______________
   Commission
File No. 000-50888
  AEROGROW
INTERNATIONAL, INC.
 (Exact
Name of Registrant as specified in its charter)
  NEVADA
              46-0510685(State
      or other jurisdiction
                of
      incorporation or organization)
              (IRS
      Employer
                Identification
      Number)
    6075
      Longbow Drive, Suite 200, Boulder, Colorado
              80301(Address
      of principal executive offices)
              (Zip
      Code)
  (303)
444-7755
 (Registrant's
telephone number, including area code)
   Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
file such reports), and (2) has been subject to such filing requirements for the
past 90 days.   Yes  x     
No  o
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer.
 
 Large
accelerated filer  o Accelerated
filer o  Non-accelerated
filer x
  Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).   Yes o  
  No x
  Number
of shares of issuer's common stock outstanding as of January 31,
2008:  12,050,162
  Table of Contents
  AeroGrow
International, Inc.
 TABLE OF CONTENTS
 FORM
10-Q REPORT
 December
31, 2007
  PART
      I   Financial InformationItem
      1.
              Condensed Financial Statements
              3Condensed Balance Sheets as of December 31, 2007 (Unaudited)
      and March 31, 2007
              3Condensed Statements of Operations for the Three and Nine
      Months Ended December 31, 2007 and December 31, 2006
      (Unaudited)
              4Condensed Statements of Cash Flows for the Nine Months Ended
      December 31, 2007 and December 31, 2006
    (Unaudited)
              5Notes to the Condensed Financial Statements
      (Unaudited)
              6Item
      2.
              Management's Discussion and Analysis of Financial Condition
      and Results of Operations
              12Item
      3.
              Quantitative and Qualitative Disclosures about Market
      Risk
              19Item
      4.
              Controls and Procedures
              19PART
      II  Other InformationItem
      1.
              Legal Proceedings
              20Item
      1A.
              Risk Factors
              20Item
      2.
              Unregistered Sales of Equity Securities and Use of
      Proceeds
              20Item
      3.
              Defaults Upon Senior Securities
              20Item
      4.
              Submission of Matters to Vote of Security
      Holders
              20Item
      5.
              Other Information
              20Item
      6.
              Exhibits
              20Signatures
              21


2
 Table of Contents




Item 1.Condensed Financial Statements





AEROGROW INTERNATIONAL, INC.


CONDENSED
BALANCE SHEETS





December
      31,
            
            
            March
      31,2007
            
            
            2007(Unaudited)ASSETSCurrent
      assetsCash
      and cash equivalents
            
            $
            3,729,822
            
            
            $
            5,495,501Restricted
      cash
            
            
            86,256
            
            
            
            84,363Accounts
      receivable, net of allowance for doubtful accounts of $182,231
              and $80,695 at December 31, 2007 and March 31, 2007,
      respectively
            
            
            6,705,924
            
            
            
            1,884,743Other
      receivables
            
            
            286,342
            
            
            
            182,221Inventory
            
            
            5,791,752
            
            
            
            3,940,614Prepaid
      expenses and other
            
            
            947,135
            
            
            
            480,990Total
      current assets
            
            
            17,547,231
            
            
            
            12,068,432Property
      and equipment, net of accumulated depreciation of $636,133
              and $322,405 at December 31, 2007 and March 31, 2007,
      respectively
            
            
            1,367,314
            
            
            
            909,496Other
      assetsIntangible
      assets, net of $14,157and
      $6,659 of accumulated amortization
              at December 31, 2007 and March 31, 2007, respectively
            
            
            54,948
            
            
            
            28,723Deposits
            
            
            102,659
            
            
            
            35,155157,607
            
            
            
            63,878Total
      Assets
            
            $
            19,072,152
            
            
            $
            13,041,806LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilitiesCurrent
      portion  -  capital lease obligations
            
            $
            124,331
            
            
            $
            -Due
      to factor
            
            
            4,450,538
            
            
            
            645,151Accounts
      payable
            
            
            3,656,668
            
            
            
            3,192,734Accrued
      expenses
            
            
            2,336,154
            
            
            
            1,166,485Customer
      deposits
            
            
            490,397
            
            
            
            -Deferred
      rent
            
            
            64,787
            
            
            
            53,531Total
      current liabilities
            
            
            11,122,875
            
            
            
            5,057,901Capital
      lease obligations, net of current
            
            
            163,489
            
            
            
            -Stockholders'
      equityPreferred
      stock, $.001 par value, 20,000,000 shares authorized, none issued or
      outstanding
            
            
            -
            
            
            
            -Common
      stock, $.001 par value, 75,000,000 shares authorized, 12,050,162
              and 11,065,609 shares issued and outstanding at December 31, 2007 and
      March 31, 2007, respectively
            
            
            12,032
            
            
            
            11,065Additional
      paid-in capital
            
            
            43,583,798
            
            
            
            37,765,003Accumulated
      (deficit)
            
            
            (35,810,042
            )
            
            
            (29,792,163
            )Total
      Stockholders' Equity
            
            
            7,785,788
            
            
            
            7,983,905Total
      Liabilities and Stockholders' Equity
            
            $
            19,072,152
            
            
            $
            13,041,806





See
accompanying notes to the condensed financial statements.





3
 Table of Contents






AEROGROW INTERNATIONAL, INC.


CONDENSED
STATEMENTS OF OPERATIONS


(Unaudited)








Three Months Ended December
    31,
            
            
            Nine Months Ended December
    31,2007
            
            
            2006
            
            
            2007
            
            
            2006RevenueProduct
      sales, net
            
            $
            14,637,742
            
            
            $
            4,857,604
            
            
            $
            27,199,821
            
            
            $
            6,709,858Operating
      expensesCost
      of revenue
            
            
            8,938,857
            
            
            
            3,282,291
            
            
            
            16,286,651
            
            
            
            4,785,151Research
      and development
            
            
            682,453
            
            
            
            700,111
            
            
            
            1,840,441
            
            
            
            1,544,495Sales
      and marketing
            
            
            4,997,801
            
            
            
            1,965,578
            
            
            
            11,089,338
            
            
            
            4,285,849General
      and administrative
            
            
            1,471,364
            
            
            
            1,042,537
            
            
            
            3,679,397
            
            
            
            2,671,939Total
      operating expenses
            
            
            16,090,475
            
            
            
            6,990,517
            
            
            
            32,895,827
            
            
            
            13,287,434Loss
      from operations
            
            
            (1,452,733
            )
            
            
            (2,132,913
            )
            
            
            (5,696,006
            )
            
            
            (6,577,576
            )Other
      (income) expense, netInterest
      (income)
            
            
            (31,679
            )
            
            
            (12,646
            )
            
            
            (101,879
            )
            
            
            (157,508
            )Interest
      expense
            
            
            234,833
            
            
            
            101,841
            
            
            
            426,681
            
            
            
            305,445Other
      income
            
            
            -
            
            
            
            -
            
            
            
            (2,929
            )
            
            
            -Registration
      rights penalty
            
            
            -
            
            
            
            636,130
            
            
            
            -
            
            
            
            1,664,380Total
      other (income) expense, net
            
            
            203,154
            
            
            
            725,325
            
            
            
            321,873
            
            
            
            1,812,317Net
      loss
            
            $
            (1,655,887
            )
            
            $
            (2,858,238
            )
            
            $
            (6,017,879
            )
            
            $
            (8,389,893
            )Net
      loss per share, basic and diluted
            
            $
            (0.13
            )
            
            $
            (0.30
            )
            
            $
            (0.52
            )
            
            $
            (0.90
            )Weighted
      average number of commonshares
      outstanding, basic and diluted
            
            
            12,371,517
            
            
            
            9,501,095
            
            
            
            11,529,472
            
            
            
            9,304,380





See
accompanying notes to the condensed financial statements.




4
 Table of Contents






AEROGROW INTERNATIONAL, INC.


CONDENSED
STATEMENTS OF CASH FLOWS


(Unaudited)





Nine Months Ended December
    31,2007
            
            
            2006Cash
      flows from operating activities:Net
      (loss)
            
            $
            (6,017,879
            )
            
            $
            (8,389,893
            )Adjustments
      to reconcile net (loss) to cash provided(used)
      by operations:Common
      stock issued for registration rights penalty
            
            
            -
            
            
            
            1,664,380Issuance
      of common stock and options under equity compensation
plans
            
            
            370,441
            
            
            
            730,935Issuance
      of common stock not under equity compensation plan
            
            
            -
            
            
            
            44,360Issuance
      of warrants for services
            
            
            57,558
            
            
            
            -Depreciation
      and amortization expense
            
            
            321,226
            
            
            
            136,935Allowance
      for bad debt
            
            
            101,536
            
            
            
            14,627Amortization
      of debt issuance costs
            
            
            -
            
            
            
            45,618Amortization
      of convertible debentures, beneficial conversion feature
            
            
            -
            
            
            
            81,563Interest
      expense from warrants issued with convertible debentures
            
            
            -
            
            
            
            115,218Change
      in assets and liabilities:(Increase)
      in accounts receivable
            
            
            (4,922,717
            )
            
            
            (1,608,193
            )(Increase)
      in other receivables
            
            
            (104,121
            )
            
            
            -(Increase)
      in inventory
            
            
            (1,851,138
            )
            
            
            (1,141,180
            )(Increase)
      in other current assets
            
            
            (466,145
            )
            
            
            (144,308
            )(Increase)
      decrease in deposits
            
            
            (67,504
            )
            
            
            (31,885
            )Increase
      in accounts payable
            
            
            463,934
            
            
            
            1,046,936Increase
      in accrued expenses
            
            
            1,169,669
            
            
            
            921,364Increase
      in customer deposits
            
            
            490,397
            
            
            
            -Increase
      in deferred rent
            
            
            11,256
            
            
            
            22,039Net
      cash (used) by operating activities
            
            
            (10,443,487
            )
            
            
            (6,491,484
            )Cash
      flows from investing activities:Increase
      in restricted cash
            
            
            (1,893
            )
            
            
            (161,609
            )Purchases
      of equipment
            
            
            (460,531
            )
            
            
            (525,729
            )Patent
      expenses
            
            
            (33,722
            )
            
            
            (4,649
            )Net
      cash (used) by investing activities
            
            
            (496,146
            )
            
            
            (691,987
            )Cash
      flows from financing activities:Increase
      in amount due to factor
            
            
            3,805,387
            
            
            
            -Stock
      repurchase
            
            
            -
            
            
            
            (15,000
            )Proceeds
      from issuance of common stock, net
            
            
            4,433,372
            
            
            
            -Proceeds
      from exercise and issuance of warrants
            
            
            940,875
            
            
            
            116,250Proceeds
      from the exercise of stock options
            
            
            17,515
            
            
            
            -Principal
      payments on capital leases
            
            
            (23,195
            )
            
            
            -Repayment
      of convertible debentures
            
            
            -
            
            
            
            (30,000
            )Net
      cash provided (used) by financing activities
            
            
            9,173,954
            
            
            
            71,250Net
      increase (decrease) in cash
            
            
            (1,765,679
            )
            
            
            (7,112,221
            )Cash,
      beginning of period
            
            
            5,495,501
            
            
            
            8,852,548Cash,
      end of period
            
            $
            3,729,822
            
            
            $
            1,740,327Supplemental
      disclosure of non-cash investing and financing activities:Interest
      paid
            
            $
            426,681
            
            
            $
            63,500Income
      taxes paid
            
            $
            -
            
            
            $
            -Equipment
      financed by capital lease
            
            $
            311,015
            
            
            $
            -Accretion
      of debt modification
            
            $
            -
            
            
            $
            119,319Conversion
      of manditorily redeemable common stock
            
            $
            -
            
            
            $
            310,000








See
accompanying notes to the condensed financial statements.




5
 Table of Contents




AEROGROW
INTERNATIONAL INC.


NOTESTO THE CONDENSED FINANCIAL STATEMENTS


(Unaudited)







1.
            Description
      of the Business





AeroGrow
International, Inc. ("the Company") was incorporated in the State of Nevada on
March 25, 2002.  The Company’s principal business is developing,
marketing, and distributing advanced indoor aeroponic garden systems designed
and priced to appeal to the gardening, cooking and small kitchen appliance
markets worldwide.  The Company’s principal activities since its
formation through March 2006 consisted of product research and development,
market research, business planning, and raising the capital necessary to fund
these activities. In December 2005, the Company commenced pilot production of
its AeroGardenTM system and, in March 2006, began shipping these systems to
retail and catalogue customers.  Today the Company manufactures,
distributes and markets over six different models of its AeroGarden systems, as
well as over 30 varieties of seed kits and a full line of accessory products
through multiple channels including retail, catalogue and direct to consumer
sales.





2.
            Basis
      of Presentation





Interim Financial
Information


The
unaudited interim financial statements of the Company included herein have been
prepared in accordance with the rules and regulations of the Securities and
Exchange Commission (“SEC”) for interim reporting including the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. These condensed statements
do not include all disclosures required by accounting principles generally
accepted in the United States of America (“U.S. GAAP”) for annual audited
financial statements and should be read in conjunction with the Company’s
audited consolidated financial statements and related notes included in the
Company’s Annual Report on Form 10-KSB for the year ended March 31, 2007 as
filed with the SEC.





In the
opinion of management, the accompanying unaudited interim financial statements
reflect all adjustments, including normal recurring accruals, necessary to
present fairly the financial position of the Company at December 31, 2007, the
results of operations for the three and nine months ended December 31, 2007 and
2006, and the cash flows for the nine months ended December 31, 2007 and 2006.
The results of operations for the three and nine months ended December 31, 2007
are not necessarily indicative of the expected results of operations for the
full year or any future period. The balance sheet as of March 31, 2007 is
derived from the Company’s audited financial statements.





Use of
Estimates


The
preparation of financial statements in conformity with U.S. GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period.  Actual results could differ
from those estimates.





Net Income (Loss) per Share
of Common Stock


The
Company computes net income (loss) per share of common stock in accordance with
Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per
Share,” and SEC Staff Accounting Bulletin No. 98 (“SAB 98”).  SFAS No.
128 requires companies with complex capital structures to present basic and
diluted earnings per share (“EPS”).  Basic EPS is measured as the
income or loss available to common stock shareholders divided by the weighted
average shares of common stock outstanding for the period. Diluted EPS is
similar to basic EPS but presents the dilutive effect on a per share basis of
potential common stock (e.g., convertible securities, options and warrants) as
if they had been converted at the beginning of the periods presented. Potential
shares of common stock that have an anti-dilutive effect (i.e., those that
increase income per share or decrease loss per share) are excluded from the
calculation of diluted EPS.





Reclassifications


Certain
prior period amounts have been reclassified to conform to the current period’s
presentation.




Segments of an Enterprise
and Related Information


SFAS No.
131, "Disclosures about Segments of an Enterprise and Related Information"
replaces the industry segment approach under previously issued pronouncements
with the management approach.  The management approach designates the
internal organization that is used by management for allocating resources and
assessing performance as the source of the Company's reportable
segments.  SFAS No. 131 also requires disclosures about products and
services, geographic areas and major customers.  At present, the
Company only operates in one segment.




6
 Table of Contents




Concentration of Credit
Risk


SFAS No.
105, "Disclosure of Information About Financial Instruments with Off-Balance
Sheet Risk and Financial Instruments with Concentrations of Credit Risk,"
requires disclosure of significant concentrations of credit risk regardless of
the degree of such risk.  Financial instruments with significant
credit risk include cash.  The amount of cash the Company has on
deposit with a financial institution exceeded the $100,000 federally insured
limit as of December 31, 2007 and March 31, 2007.  However, management
believes that the financial institution is financially sound and the risk of
loss is minimal.





Financial
instruments consist of cash and cash equivalents, accounts receivable and
accounts payable. The carrying values of all financial instruments approximate
their fair value.





Customers:


For the
three months ended December 31, 2007, the Company had one customer who
represented 14.1% of net product sales. For the three months
ended December 31, 2006, the Company had one customer who represented 10.8%
of net product sales. For the nine months ended December 31, 2007, the Company
had one customer who represented 13.1% of net product sales. For the nine
months ended December 31, 2006, the Company had two customers who
represented 19.4% and 15.2% of net product sales.





At
December 31, 2007, the Company had three customers which accounted for in excess
of 10% of total accounts receivable consisting of 16.4%, 16.9% and 29.2%,
respectively, of the total outstanding accounts receivable. As of March 31,
2007, the Company had four customers each of which accounted for in excess of
10% of total accounts receivable consisting of 14.7%, 13.4%, 11.3% and 11.3%,
respectively, of total outstanding accounts receivable.





Suppliers:


As of
December 31, 2007, the Company had two suppliers that accounted for in excess of
10% of total accounts payable consisting of $455,080 and $399,748, or 12.4% and
10.9% respectively, of total outstanding accounts payable.  As of
March 31, 2007, the Company had two suppliers each of which accounted for in
excess of 10% of total accounts payable consisting of $942,758 and $383,976, or
29.5% and 12.0% respectively, of total outstanding accounts
payable.





During
the three months ended December 31, 2007, the Company purchased inventories and
other inventory related items from two manufacturers totaling $1,691,625 and
$2,991,821, representing 18.9% and 33.5%, respectively, of the cost of revenues.
During the nine months ended December 31, 2007, the Company purchased
inventories and other inventory related items from two manufacturers totaling
$4,137,401 and $5,232,799 representing 25.4% and 32.1% respectively of the cost
of revenues for the nine months ended December 31, 2007.





During
the nine months ended December 31, 2006, the Company utilized one manufacturer
for 100% of its manufacturing of its aeroponic garden systems which accounted
for $2,573,464, or 53.8%, of cost of revenues. As of December 31, 2006, the
Company had paid cash deposits to this manufacturer for goods not yet shipped
totaling $214,196 which are included in prepaid expenses, and had outstanding
accounts payable to this manufacturer as of December 31, 2006 of $280,881 or
18.3% of the accounts payable balance.





Inventory


Inventories
are valued at the lower of cost, determined by the first-in, first-out method,
or market. Included in inventory costs where the Company is the manufacturer are
raw materials, labor and manufacturing overhead. The Company records the raw
materials at delivered cost. Standard labor and manufacturing overhead costs are
applied to the finished goods based on normal production capacity as prescribed
under ARB No. 43, Chapter 4, “Inventory Pricing.”  A majority of the
Company’s products are manufactured overseas and are recorded at
cost.




December
      31, 2007
              
              
              March
      31, 2007Finished
      goods
              
              $
              4,755,957
              
              
              $
              3,626,671Raw
      materials
              
              
              1,035,795
              
              
              
              313,943$
              5,791,752
              
              
              $
              3,940,614





The
Company will determine inventory obsolescence reserve based on management’s
historical experience and establishes reserves against inventory according to
the age of the product. As of December 31, 2007 and March 31, 2007, the Company
had determined that no inventory obsolescence reserve was required.




7
 Table of Contents




Revenue
Recognition


The
Company recognizes revenue from product sales, net of estimated returns, when
persuasive evidence of a sale exists; that is, a product is shipped under an
agreement with a customer; risk of loss and title has passed to the customer;
the fee is fixed or determinable; and collection of the resulting receivable is
reasonably assured. Beginning with the quarter ended December 31, 2006, the
Company began to offer promotions to its direct sales consumers allowing thirty
or thirty-six days for product evaluation, where the customer pays only the
shipping and handling costs for such products before making the required
installment payments after the expiration of the thirty or thirty-six day trial
period.  During the nine months ended December 31, 2007, the Company
offered a thirty-six day trial period and accordingly, the Company did not
record as of December 31, 2007 $782,624 related to the unpaid balance due for
orders shipped in conjunction with this evaluation program.  The Company
also deferred, as of December 31, 2007, recognition of $237,083 of product costs
associated with the foregoing revenue in as much as the customer is required to
return the product and the Company is therefore able to recover these costs
through resale of the goods. The media, telemarketing and fulfillment costs
related to these orders are expensed as incurred.





Additionally,
the Company did not record $551,420 of revenue as of December 31, 2007 related
to the wholesale sales value of inventory held by its retail shopping channel
customers as these sales are contingent upon the shopping channel selling the
goods. Payments for these goods so deferred are charged to Customer Deposits.
The Company has also deferred, as of December 31, 2007, recognition of $300,153
of product and freight costs associated with these sales, which have been
included in inventory.





The
Company records estimated reductions to revenues for customer and distributor
sales programs and incentive offerings, including, promotions, general
advertising, merchandising and other volume-based incentives. Future market
conditions and product transitions may require the Company to take actions to
increase customer incentive offerings, possibly resulting in an incremental
reduction of revenue at the time the incentive is offered. Additionally, certain
incentive programs require the Company to estimate based on industry experience
the number of customers who will actually redeem the incentive. At December 31,
2007 and March 31, 2007, the Company had accrued $684,511 and $65,385,
respectively, as its estimate for the foregoing deductions and
allowances.





Direct Response Advertising
Costs


The
Company records media costs related to its direct to consumer advertisements,
inclusive of postage and printing costs incurred in conjunction with mailings of
direct response catalogues, and related direct response advertising costs, in
accordance with the statement of position, SOP 93-7, “Reporting on Advertising
Costs.” In accordance with SOP 93-7, advertising costs incurred should be
reported as assets and should be amortized over the estimated period of the
benefits, based on the proportion of current period revenue from the
advertisement to probable future revenue. As of December 31, 2007, the Company
had deferred $493,086 in media related costs, primarily for television time for
direct response advertisements which generated orders that did not ship to
customers and therefore revenue was not recognized, until after December 31,
2007.





Warranty and Return
Reserves


The
Company records warranty liabilities at the time of sale for the estimated costs
that may be incurred under its basic warranty program. The specific warranty
terms and conditions vary depending upon the product sold but generally include
technical support, repair parts and labor for periods up to one year. Factors
that affect the Company’s warranty liability include the number of installed
units currently under warranty, historical and anticipated rates of warranty
claims on those units, and cost per claim to satisfy the Company’s warranty
obligation.   Both manufacturers of the Company’s products
provide replacement parts for components free of charge up to 2% of the total
units purchased.  Based upon the foregoing, the Company has recorded a
provision for potential future warranty costs of $58,981 and $15,593 at December
31, 2007 and March 31, 2007, respectively.





The
Company reserves for potential returns from customers and associated refunds or
credits related to such returns based upon historical experience. The Company
has recorded reserves for customer returns of units purchased by consumers
$424,036 and $238,569 at December 31, 2007 and March 31, 2007,
respectively.





New Accounting
Pronouncements


In
December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” and
SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements –
an amendment of ARB No. 51.” These statements will require more assets acquired
and liabilities assumed to be measured at fair value as of the acquisition date,
liabilities related to contingent consideration to be remeasured at fair value
in each subsequent reporting period, an acquirer to expense all
acquisition-related costs in preacquisition periods, and noncontrolling
interests in subsidiaries initially to be measured at fair value and classified
as a separate component of equity. SFAS Nos. 141(R) and 160 are effective for
fiscal years beginning after December 15, 2008. We are currently evaluating the
impact of adopting SFAS Nos. 141(R) and 160, if any, on our results of
operations and financial condition.




8
 Table of Contents




3.
            Capital
      Lease Obligations





The
Company has capitalized lease obligations for computer equipment, licensed
software, and factory equipment due on various dates through November2010 of which $287,820
was outstanding as of December 31, 2007. The interest rates range from 12% to
15% per annum. These lease obligations are collateralized by the related assets
with a net book value of $292,132 as of December 31, 2007. In addition, recorded
as deposits, is a security deposit of $48,180 which will be released upon
theCompany achieving
certain financial requirements. The leases also required $21,465 in prepaid
rents.





4.
            Due
      to Factor





On
February 9, 2007, the Company entered into an agreement with Benefactor Group
Inc. (“Benefactor”) whereby Benefactor agreed to factor the company’s retail
accounts receivable invoices. The term of the agreement is for one year with
automatic one year renewal but can be terminated by the Company with 60 days
written notice. In accordance with the terms of the agreement, Benefactor will
purchase the invoices that it approves for an initial payment of 85% of the
amount of the invoice with the remaining 15% paid upon collection less any
deductions from the customer. Benefactor charges a commission of 11⁄4% of the
gross amount of the invoice and a maintenance fee equal to an annual rate of
prime plus 3%, prime being determined by Benefactor based upon either the prime
rate published by Benefactor’s bank or the Wall Street Journal, (10.25% at
December 31, 2007 and 11.25% at March 31, 2007), charged on a daily basis for
the unpaid invoice amounts outstanding. The Company has agreed, beginning May
2007, to factor with Benefactor a minimum of $800,000 of invoices monthly. The
Company is responsible for any invoices that are unpaid after 91 days or are
subject to other defaults by the customer and this obligation is secured by the
Company with a security interest granted to Benefactor on all assets. As of
December 31, 2007, Benefactor had advanced the Company $4,450,538 against
invoices totaling $5,430,694.  Fees paid to Benefactor for interest,
discounts and other services for the three and nine months ended December 31,
2007 totaled $213,720 and $378,601, respectively.  The receivables are
considered recourse and are shown at their gross value on the balance
sheet.





5.
            Stock
      Based Compensation





Prior to
January 1, 2006, the Company accounted for employee stock options using the
intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25,
“Accounting for Stock Issued to Employees” and related interpretations, which
generally results in no employee stock option expense. The Company adopted SFAS
No. 123R, “Share-Based Payment” on January 1, 2006, and does not plan to restate
financial statements for prior periods.





For the
nine months ended December 31, 2007 and December 31, 2006, respectively, the
Company granted 5,000 and 142,500 options to purchase the Company’s common stock
at an exercise price of $5.15 and $5.00 per share, respectively, under the 2005
Equity Compensation Plan (“2005 Plan”).





For the
option grants issued from January 1, 2006 through December 31, 2006, inclusive
of the nine months ended December 31, 2006, the Company used the following
weighted average assumptions: no dividend yield; expected volatility rate of
129.67%; risk free interest rate of 5%; and average lives of four years
resulting in a value of $4.12 per option granted. In March 2007, because the
Company’s stock had begun trading in the public market but trading history was
limited, the Company reviewed the assumptions utilized for the volatility
rate.  This review included researching companies within the consumer
products category with comparable market capitalizations, comparable per share
prices and with a minimum of five years of trading history, five years
representing the length of time the options are exercisable. Accordingly, for
the options granted subsequent to December 31, 2006, the Company used the
following weighted average assumptions: no dividend yield; expected volatility
rate of 50.3%; risk free interest rate of 5%; and average lives of three years.
As a result of recognizing compensation expense for stock options pursuant to
the provisions of SFAS No. 123R, the net loss for the nine months ended December
31, 2007 and the nine months ended December 31, 2006 was $370,441 and $404,965
greater, respectively, than if the Company had continued to account for stock
options under APB Opinion No. 25. In addition, both basic and diluted loss per
share for the nine months ended December 31, 2007 and the nine months ended
December 31, 2006 was $0.03 and $0.04 greater, respectively, than if the Company
had continued to account for stock options under APB Opinion No.
25.




Options
to purchase 5,000 shares of the Company’s common stock at an exercise price of
$5.15 per share were granted during the nine months ended December 31, 2007
under the 2005 Plan. These options will vest pro rata over a two year period.
During the same period, there were 11,433 options to purchase common stock
forfeited and 10,573 shares issued upon exercise of outstanding stock options
under the Company’s equity compensation plans. As of December 31, 2007, the
Company had granted options for 58,128 shares of the Company’s common stock that
are unvested that will result in $202,350 of compensation expense in future
periods if fully vested.




9
 Table of Contents




Information
regarding all stock options outstanding under the 2005 Plan as of December 31,
2007 is as follows:








OPTIONS
      OUTSTANDING
            
            OPTIONS
      EXERCISABLEWeighted
            
            
            
            
            
            
            
            
            
            WeightedAverage
            
            
            Weighted
            
            
            
            
            
            
            Average
            
            
            WeightedRemaining
            
            
            Average
            
            Aggregate
            
            
            
            
            Remaining
            
            
            Average
            
            AggregateExercise
            
            
            
            
            Contractual
            
            
            Exercise
            
            Intrinsic
            
            
            
            
            Contractual
            
            
            Exercise
            
            IntrinsicPrice Range
            
            Options
            
            
            Life (years)
            
            
            Price
            
            Value
            
            Options
            
            
            Life (years)
            
            
            Price
            
            ValueOver
      $0.00 to $0.50
            
            
            21,169
            
            
            
            0.85
            
            
            $
            0.06
            
            
            
            
            21,169
            
            
            
            2.58
            
            
            $
            0.06Over
      $0.50 to $2.50
            
            
            130,558
            
            
            
            1.00
            
            
            $
            1.57
            
            
            
            
            130,558
            
            
            
            2.58
            
            
            $
            1.57Over
      $5.00 to $5.50
            
            
            1,108,327
            
            
            
            3.25
            
            
            $
            5.00
            
            
            
            
            1,060,115
            
            
            
            3.22
            
            
            $
            5.00Over
      $5.50
            
            
            60,300
            
            
            
            4.22
            
            
            $
            5.90
            
            
            
            
            50,383
            
            
            
            5.00
            
            
            $
            5.901,320,354
            
            
            
            3.03
            
            
            $
            4.36
            
            $ 1,621,164
            
            
            1,262,226
            
            
            
            2.96
            
            
            $
            4.36
            
            $
1,579,405








6.
            Income
      Taxes





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes.” FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise’s financial statements in accordance with SFAS No. 109, Accounting
for Income Taxes. This Interpretation defines the minimum recognition threshold
a tax position is required to meet before being recognized in the financial
statements. The Company adopted FIN 48 on April 1, 2007. As a result of the
implementation, the Company recognized no material adjustment in the liability
of unrecognized income tax benefits. At the adoption date of April 1, 2007, the
Company had $4.0 million of unrecognized tax benefits, all of which would affect
the Company’s effective tax rate if recognized. It is reasonably possible that
the Company’s unrecognized tax benefit could change; however, the Company does
not expect any such change to be material.





The
Company is subject to U.S. federal income tax as well as income tax of several
state jurisdictions including primarily Colorado and California. The Company has
concluded all U.S. federal income tax matters for the year ended December 31,
2002. Substantially all material state and local income tax matters have been
concluded through December 31, 2002, depending on the statute of limitations for
a given jurisdiction. Federal and state income tax returns for 2003 through 2006
have not yet been examined by the applicable jurisdictions.





7.
            Related
      Party Transactions





During
the nine months ended December 31, 2007 and December 31, 2006, the Company paid
fees totaling $2,000 per month, a total of $18,000, to one director as a
retainer for general legal services.





During
the nine months ended December 31, 2007, the Company paid $10,000 to a director
for various services in connection with the hiring and company integration of a
new executive.





Also
during the nine months ended December 31, 2007 and December 31, 2006, the
Company incurred fees totaling $740,552 and $600,094, respectively to MedEd
Architects LLC, a video production company owned 33% by Randy Seffren, the
Company’s Chief Marketing Officer.





8.
            Stockholders’
      Equity





In
September 2007, the Company completed a private offering in which it sold an
aggregate of 800,000 shares of common stock and warrants to purchase 800,000
shares of common stock at an exercise price of $8.00 per share in the form of
units consisting of one share of common stock and one warrant per unit. The
units were sold at a per unit price of $6.25. Upon closing of offering, the
Company received gross proceeds of $5,000,000, less a placement agent fee in the
amount of $400,000 and approximately $170,000 in other expenses related to the
offering. In addition, the Company issued warrants to purchase 80,000 shares of
common stock at an exercise price of $8.25 per share to the placement agent of
this offering.




10
 Table of Contents




During
the nine months ended December 2007, the Company received proceeds, net of
$5,000 in expenses, of $940,875 from the exercise of warrants to purchase
156,100 shares of the Company’s common stock at prices ranging from $2.50 to
$6.25 per share.





On August
1, 2007, the Company entered into an agreement with an investor relations firm
that included a grant of a five year warrant to purchase 50,000 shares of the
Company’s common stock at an exercise price of $6.96, the closing market price
as of the date of the agreement. The warrants will vest monthly over a one year
period unless the agreement is terminated. The Company used the following
weighted average assumptions for valuation of the warrants issued: no dividend
yield; expected volatility rate of 50.3%; risk free interest rate of 6%; and
average lives of three years, resulting in a total value of $138,023 to be
recognized monthly over the twelve month period.




A summary
of the Company’s warrant activity for the period from April 1, 2007 through
December 31, 2007 is presented below:




Weighted
            
            AggregateWarrants
            
            
            Average
            
            IntrinsicOutstanding
            
            
            Exercise Price
            
            ValueOutstanding,
      March 31, 2007
            
            
            5,724,094
            
            
            $
            7.21Granted
            
            
            930,000
            
            
            $
            7.97Exercised
            
            
            (156,100
            )
            
            $
            6.06Expired
            
            
            -
            
            
            $
            -Outstanding,
      December 31, 2007
            
            
            6,497,994
            
            
            $
            7.35
            
            $    605,468





As
of December 31, 2007, the Company had the following outstanding warrants to
purchase its common stock:




Weighted
            
            
            WeightedWarrants
            
            
            Average
            
            
            AverageOutstanding
            
            
            Exercise Price
            
            
            Remaining Life31,498
            
            
            $
            2.50
            
            
            
            0.1515,000
            
            
            $
            5.00
            
            
            
            0.15580,000
            
            
            $
            5.01
            
            
            
            2.70644,000
            
            
            $
            6.00
            
            
            
            3.622,232,300
            
            
            $
            6.25
            
            
            
            3.1550,000
            
            
            $
            6.96
            
            
            
            4.581,283,436
            
            
            $
            7.57
            
            
            
            4.24800,000
            
            
            $
            8.00
            
            
            
            6.6780,000
            
            
            $
            8.25
            
            
            
            6.67390,880
            
            
            $
            10.00
            
            
            
            -390,880
            
            
            $
            15.00
            
            
            
            -6,497,994
            
            
            $
            7.35
            
            
            
            3.46







11
 Table of Contents








Item 2.Management’s Discussion and Analysis of Financial Condition and Results of
Operations





The
discussion contained herein is for the three and nine months ended December 31,
2007 and December 31, 2006. The following discussion should be read in
conjunction with the financial statements of AeroGrow International, Inc. (the
“Company, ” “we,” or “our”) and the notes to the financial statements included
elsewhere in this Quarterly Report on Form 10-Q for the quarterly period ended
December 31, 2007 (this “Quarterly Report”). The following discussion contains
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended (the “Securities Act”), and Section 21E of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”), including
statements that include words such as “anticipates,” “expects,” “intends,”
“plans,” “believes,” “may,” “will,” or similar expressions that are intended to
identify forward-looking statements. In addition, any statements that refer to
expectations, projections, or other characterizations of future events or
circumstances, including any underlying assumptions, are forward-looking
statements. Such statements include, but are not limited to, statements
regarding our intent, belief, or current expectations regarding our strategies,
plans, and objectives, our product release schedules, our ability to design,
develop, manufacture, and market products, our intentions with respect to
strategic acquisitions, the ability of our products to achieve or maintain
commercial acceptance, and our ability to obtain financing for our obligations.
Such statements are not guarantees of future performance and are subject to
risks, uncertainties, and assumptions that are difficult to predict. Therefore,
the Company’s actual results could differ materially and adversely from those
expressed in any forward-looking statements as a result of various factors.
Factors that could cause or contribute to the differences are discussed in “Risk
Factors” and elsewhere in the Company’s annual report on Form 10-KSB for the
period ended March 31, 2007, and filed on June 29, 2007 with the Securities and
Exchange Commission (the “SEC”) and the Form S-3/A filed with the SEC September
28, 2007. Except as required by applicable law or regulation, the Company
undertakes no obligation to revise or update any forward-looking statements
contained in this Quarterly Report. The information contained in this Quarterly
Report is not a complete description of the Company’s business or the risks
associated with an investment in the Company’s common stock. Each reader should
carefully review and consider the various disclosures made by the Company in
this Quarterly Report and in the Company’s other filings with the
SEC.





Overview





We are in
the business of developing, marketing, distributing, and selling advanced indoor
aeroponic garden systems and related products. Since formation and through our
development stage, which ended in February 2006, our principal activities
consisted of product research and development, market research, business
planning, and raising the capital necessary to fund these activities. We have
completed development of our initial kitchen garden systems and related
“bio-grow” seed pods and have contracted with two third-party manufacturers who
have commenced production activities. In March 2006, we began sales activities.
Today, we manufacture, distribute, and market over six different models of our
AeroGarden systems, as well as over 30 varieties of seed kits and a full line of
accessory products through multiple channels including retail, catalogue, and
direct to consumer sales. As of December 31, 2007, we had shipped over 358,000
units of our AeroGardens and over 900,000 seed kits.





Our
Critical Accounting Policies





Inventory


Inventories
are valued at the lower of cost, determined by the first-in, first-out method,
or market. When we are the manufacturer, we include in inventory costs raw
materials, labor, and manufacturing overhead. We record the raw materials at
delivered cost. Standard labor and manufacturing overhead costs are applied to
the finished goods based on normal production capacity as prescribed under
Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing.” A majority
of our products are manufactured overseas and are recorded at cost.





As
required, we will determine an inventory obsolescence reserve based on
historical experience and will establish reserves against inventory according to
the age of the product. As of December 31, 2007 and March 31, 2007, we had
determined that no inventory obsolescence reserve was required.





Revenue
Recognition


We
recognize revenue from product sales, net of estimated returns, when persuasive
evidence of a sale exists, that is, a product is shipped under an agreement with
a customer; risk of loss and title has passed to the customer; the fee is fixed
or determinable; and collection of the resulting receivable is reasonably
assured. During the quarter ended December 31, 2006, we began to offer
promotions to our direct sales consumers where we allow customers  36
days to evaluate the product (such sales, “Trial Sales”), requiring the customer
to pay only the shipping and handling costs for such products before making the
required installment payments after the expiration of the 36- day trial
period.  We do not recognize the revenue from Trial Sales until the
expiration of the trial period.  Accordingly, we did not record
$782,624 of revenue from these Trial Sales as of December 31,
2007.  We also deferred, as of December 31, 2007, recognition of
$237,083 of product costs associated with the Trial Sales because the customers
are required to return the product at the end of the trial period if they choose
not to purchase the product, and we are therefore able to recover these costs
through resale of the goods.




12
 Table of Contents




Additionally,
we did not record $551,420 of revenue as of December 31, 2007 related to the
wholesale sales value of inventory held by our retail shopping channel
customers.  Payments for the goods deferred are charged to customer
deposits. We also deferred, as of December 31, 2007, recognition of $300,153 of
product and freight costs associated with these transactions, which have been
included in inventory.





We record
estimated reductions to revenues for customer and distributor sales programs and
incentive offerings, including, promotions, general advertising, merchandising,
and other volume-based incentives. Future market conditions and product
transitions may require that we take actions to increase customer incentive
offerings, possibly resulting in an incremental reduction of revenue at the time
the incentive is offered. Additionally, certain incentive programs require us to
estimate, based on industry experience, the number of customers who will
actually redeem the incentive. At December 31, 2007 and March 31, 2007, we had
accrued $684,511 and $65,385, respectively, as our estimate for the foregoing
deductions and allowances.





Direct
Response Advertising Costs


We record
media costs related to our direct to consumer advertisements, inclusive of
postage and printing costs incurred in conjunction with mailings of our direct
response catalogues and other related direct response advertising costs, in
accordance with the American Institute of Certified Public Accountants’
Accounting Standards Executive Committee Statement of Position, SOP 93-7,
“Reporting on Advertising Costs.” In accordance with SOP 93-7, advertising costs
we incur are reported as assets and amortized over the estimated period of the
benefits, based on the proportion of current period revenue from the
advertisement to probable future revenue. As of December 31, 2007, we had
deferred $493,086 in media related costs, primarily for television time, for
direct response advertisements which generated orders which did not ship to
customers and for which revenue was therefore not recognized until after
December 31, 2007.





Warranty
and Return Reserves


We record
warranty liabilities at the time of sale for the estimated costs that may be
incurred under our basic warranty program. The specific warranty terms and
conditions vary depending upon the product sold but generally include technical
support, repair parts, and labor for periods up to one year. Factors that affect
our warranty liability include the number of installed units currently under
warranty, historical and anticipated rates of warranty claims on those units,
and cost per claim to satisfy our warranty obligation.   Both
manufacturers of our products provide replacement parts for any defective
components free of charge up to 2% of the total units
purchased.  Based upon the foregoing, we have recorded a provision for
potential future warranty costs of $58,981 and $15,593 at December 31, 2007 and
March 31, 2007, respectively.   The liability for sales returns
of units purchased by consumers is estimated based upon historical experience of
return levels and, as of December 31, 2007, we had recorded a liability of
$424,036 representing the estimated sales value of such future
returns.




Shipping
and Handling Costs


Shipping
and handling costs associated with inbound freight are recorded in cost of
revenue. Shipping and handling costs associated with freight out to customers
are also included in cost of revenue. Shipping and handling charges to be paid
by customers are included in sales.





Stock
Based Compensation


In
December 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment.”
Subsequently, the SEC provided for a phased-in implementation process for SFAS
No. 123R, which required adoption of the new accounting standard no later than
January 1, 2006. SFAS No. 123R requires accounting for stock options using a
fair-value-based method as described in such statement and recognition of the
resulting compensation expense in our financial statements. Prior to January 1,
2006, we accounted for employee stock options using the intrinsic value method
under Accounting Principles Board (“APB”) No. 25, “Accounting for Stock Issued
to Employees” and related interpretations, which generally results in no
employee stock option expense. We adopted SFAS No. 123R on January 1, 2006, and
do not plan to restate financial statements for prior periods. We plan to
continue to use the Black-Scholes option valuation model in estimating the fair
value of the stock option awards issued under SFAS No. 123R. The adoption of
SFAS No. 123R has increased net loss by $370,441 and $404,965 for the nine
months ended December 31, 2007 and the nine months ended December 31, 2006,
respectively, as compared to our prior method under APB No. 25.




13
 Table of Contents




Results
of Operations





The
following table sets forth, as a percentage of sales, our financial results for
the three and nine months ended December 31, 2007 and the three and nine months
ended December 31, 2006:





Three Months Ended December
    31,
            
            
            Nine Months Ended December
    31,2007
            
            
            2006
            
            
            2007
            
            
            2006RevenueProduct
      sales- retail, net
            
            
            65.1
            %
            
            
            67.2
            %
            
            
            68.0
            %
            
            
            70.9
            %Product
      sales- direct to consumer, net
            
            
            34.9
            %
            
            
            32.8
            %
            
            
            32.0
            %
            
            
            29.1
            %Total
      sales
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %Operating
      expensesCost
      of revenue
            
            
            61.1
            %
            
            
            67.6
            %
            
            
            59.9
            %
            
            
            71.3
            %Research
      and development
            
            
            4.7
            %
            
            
            14.4
            %
            
            
            6.8
            %
            
            
            23.0
            %Sales
      and marketing
            
            
            34.1
            %
            
            
            40.5
            %
            
            
            40.8
            %
            
            
            63.9
            %General
      and administrative
            
            
            10.1
            %
            
            
            21.5
            %
            
            
            13.5
            %
            
            
            39.8
            %Total
      operating expenses
            
            
            110.0
            %
            
            
            144.0
            %
            
            
            121.0
            %
            
            
            198.0
            %Loss
      from operations
            
            
            -10.0
            %
            
            
            -44.0
            %
            
            
            -21.0
            %
            
            
            -98.0
            %





For the
three months ended December 31, 2007 and December 31, 2006, product sales
totaled $14,637,742 and $4,857,604, respectively, an increase of $9,780,138 or
201.3%. For the nine months ended December 31, 2007 and December 31, 2006,
product sales totaled $27,199,821 and $6,709,858, respectively, an increase of
$20,489,963 or 305.4%. Our AeroGarden products are primarily sold through two
sales methods. Direct to consumer sales are generated as a result of airings of
our infomercial, our websites, our own catalogues, and other direct to consumer
advertisements. Retail sales are generated through sales to “brick and mortar”
retailers, catalogues, and home shopping companies who in turn sell to
consumers. For the three and nine months ended December 31, 2007, the increase
in sales is attributable to growing acceptance and distribution of our
AeroGarden products, reaching approximately 4,300 storefronts as of December 31,
2007, as compared to 750 storefronts as of December 31, 2006. The resulted in an
increase in our sales to retailers of $6,262,111, or 191.7% for the three months
ended December 31, 2007 as compared to the three months ended December 31, 2006.
Also netted against sales for the three and nine months ended December 31, 2007
were $730,354 and $1,353,255 of promotional and merchandising allowances granted
to retail customers for ad placements, in store merchandising and other
promotional activities representing 7.1% and 6.8% of retail sales before
granting these allowances.





In
addition, we significantly increased our media spending for our infomercials,
developed an affiliate and search engine marketing program for our web sales,
and launched our own mail order catalogue program, all of which enabled us to
grow our direct to consumer sales by $3,518,027, or 221.1%, as compared to the
three months ended December 31, 2006.  Included in retail sales are
$360,000 in revenues for sales to international distributors in Japan and
Europe.  We anticipate this will become a significant component of our
aggregate sales volume in future periods. A summary of our sales for the three
and nine months ended December 31, 2007 and 2006 is as follows:





Three Months Ended December
    31,
            
            
            Nine Months Ended December
    31,Product
      Revenues
            
            2007
            
            
            2006
            
            
            2007
            
            
            2006Product
      sales- retail, net
            
            $
            9,528,337
            
            
            $
            3,266,226
            
            
            $
            18,508,237
            
            
            $
            4,759,171Product
      sales- direct to consumer, net
            
            
            5,109,405
            
            
            
            1,591,378
            
            
            
            8,691,584
            
            
            
            1,950,687Total
            
            $
            14,637,742
            
            
            $
            4,857,604
            
            
            $
            27,199,821
            
            
            $
            6,709,858





In regard
to our direct sales, we offer our direct customers Trial Sales, requiring
them to pay only the shipping and handling costs for such products before making
the required installment payments after the expiration of the 36-day trial
period. We do not recognize the revenue from Trial Sales until the expiration of
the trial period. Accordingly, we did not record $782,624 of revenue from these
Trial Sales as of December 31, 2007. We also deferred, as of December 31, 2007,
recognition of $237,083 of product costs associated with the foregoing Trial
Sales because the customers are required to return the product at the end of the
trial period if they choose not to purchase the product, and we are therefore
able to recover these costs through resale of the goods. All costs associated
with acquisition of Trial Sales, including media, telemarketing, order
processing, fulfillment, and outbound freight were expensed as
incurred.





14
 Table of Contents




Sales
were also impacted for the three and nine months ended December 31, 2007 by a
higher than anticipated demand for our black AeroGarden units, resulting in an
out-of-stock allocation situation the last ten days of December for this item.
The result was a backlog of unshipped direct to consumer orders as of December
31, 2007 of approximately $982,000 and unshipped retail orders of $471,000, for
a total of $1,453,000. Media and telemarketing costs related to these orders
totaling $315,000 was deferred as of December 31, 2007.





Also, we
did not record $551,420 of revenue as of December 31, 2007 related to the
wholesale sales value of inventory held by our retail shopping channel customers
as these sales are contingent upon the shopping channel selling the goods.
Payments for the goods deferred in the foregoing were charged to customer
deposits. We have also deferred, as of December 31, 2007, recognition of
$300,153 of product and freight costs associated with this sale, which have been
included in inventory.





Our products consist of our AeroGardens
as well as seed kits and accessories, which represent recurring revenue
opportunity for each AeroGarden sold. A summary of the sales of these two
product categories is as follows:





Three Months Ended December
    31,
            
            
            Nine Months Ended December
    31,2007
            
            
            2006
            
            
            2007
            
            
            2006Product
      RevenuesAeroGardens
            
            $
            12,145,733
            
            
            $
            4,438,916
            
            
            $
            22,605,871
            
            
            $
            5,931,861Seed
      kits and accessories
            
            
            2,492,009
            
            
            
            418,688
            
            
            
            4,593,950
            
            
            
            777,997Total
            
            $
            14,637,742
            
            
            $
            4,857,604
            
            
            $
            27,199,821
            
            
            $
            6,709,858%
      of RevenuesAeroGardens
            
            
            82.98
            %
            
            
            91.38
            %
            
            
            83.11
            %
            
            
            88.41
            %Seed
      kits and accessories
            
            
            17.02
            %
            
            
            8.62
            %
            
            
            16.89
            %
            
            
            11.59
            %Total
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %





Cost of
revenues for the three months ended December 31, 2007 and December 31, 2006
totaled $8,938,857 and $3,282,291 respectively, representing 61.1% and 67.6% of
revenues for the respective periods, an increase of $5,656,566 or 172.3%. Cost
of revenues include product costs for purchased and manufactured products,
freight costs for inbound freight from manufacturers and outbound freight to
customers, costs related to warehousing and the shipping of products to
customers, credit card processing fees for direct sales, and duties and customs
applicable to products imported. Costs of revenues increased primarily as a
direct result of the increase of 201.3% in revenues discussed above. Costs of
revenues improved as a percentage of sales over the prior period primarily due
to the elimination of air freight costs incurred during the three months ended
December 31, 2006, as well efficiencies gained in the manufacturing of our
products. Included in cost of revenues for the three months ended December 31,
2006, was approximately $260,000, or 5.4% of sales, in incremental airfreight
costs related to higher than expected demand for our products during the holiday
season.





Cost of
revenues for the nine months ended December 31, 2007 and December 31, 2006
totaled $16,286,651 and $4,785,151, respectively, representing 59.9% and 71.3%
of revenues for the respective periods, an increase of $11,501,500 or 240.4%.
The increase in cost of revenues was primarily a direct result of the increase
in revenues of 305.4% discussed above.  In addition to the above
airfreight costs, included in cost of revenue for the nine months ended December
31, 2006 are costs associated with expedited shipping of 5,000 of our AeroGarden
units from our factory in China by air rather than by sea in order to expedite
our initial deliveries in April 2006, at an incremental airfreight cost of $27
per unit, a total of $135,000 in additional freight costs. We also experienced
higher than anticipated costs in the startup of our seed kit manufacturing
operations during the three months ended December 31, 2006. Also impacting cost
of revenues during the three and nine months ended December 31, 2007 were
increases in freight costs associated with outbound freight to retail customers
as a result of 15% to 20% fuel surcharges imposed by freight providers resulting
in approximately a 10% increase in outbound freight costs. For the nine months
ended December 31, 2007 and December 31, 2006, outbound freight, fulfillment,
and order processing costs were approximately 12.3% and 13.0% of net sales,
respectively.





Gross
margins vary based upon the factors impacting cost of revenue discussed above as
well as the ratio of direct sales versus retail sales. In a direct to consumer
sale, we recognize as revenue the full purchase price for the product as opposed
to retail sales, where we recognize as revenue the wholesale price for the
product charged to the retailer less allowances granted for merchandising and
promotion. Media costs associated with direct sales are included in sales and
marketing costs. Gross margins for the three and nine months ended December 31,
2007 were $5,698,885 and $10,913,170, representing 38.9% and 40.1% of revenues,
respectively, as compared to $1,575,313 and $1,924,707 for the three and nine
months ended December 31, 2006, representing 32.4% and 28.7% of revenues,
respectively.  Impacting gross margins for the three and nine months
ended December 31, 2007 were two primary factors. First, as a result of the
deferrals related to the Trial Sales discussed above, gross margins deferred for
the three and nine months ended December 31, 2007 were $349,721 and $229,102,
effectively reducing margins for these periods by 1.0% and 0.5% , respectively.
For the three and nine months ended December 31, 2006, Trial Sales deferrals
reduced gross margins by $251,570 for each period. Further impacting gross
margins for the three and nine months ended December 31, 2007 were approximately
$400,000 in free shipping allowances for our catalogue and web promotions
granted during the 2007 holiday period, effectively reducing margins for these
periods by 1.6% and 0.9% , respectively. Together, these two factors reduced
gross margins for the three and nine months ended December 31, 2007 by $749,721
and $629,102, effectively reducing gross margins for these periods by 2.6% and
1.4%, respectively.




15
 Table of Contents




Sales and
marketing costs for the three months ended December 31, 2007 totaled $4,997,801,
as compared to $1,965,578 for the three months ended December 31, 2006, an
increase of $3,032,223 or 154.3%. For the nine months ended December 31, 2007
and December 31, 2006, sales and marketing costs were $11,089,338 and
$4,285,849, respectively, representing an increase of $6,803,489or
158.7%.





Sales and
marketing costs include all costs associated with the marketing, sales, customer
support, and sales order processing for our products and consist of the
following:





Three Months Ended December
    31,
            
            
            Nine Months Ended December
    31,2007
            
            
            2006
            
            
            2007
            
            
            2006Advertising
            
            $
            2,535,704
            
            
            $
            755,689
            
            
            $
            4,446,080
            
            
            $
            837,477Salaries
      and related expenses
            
            
            1,011,499
            
            
            
            569,032
            
            
            
            2,462,428
            
            
            
            1,211,345Infomercial
      production costs
            
            
            253,130
            
            
            
            96,351
            
            
            
            1,082,478
            
            
            
            687,241Sales
      commissions
            
            
            455,758
            
            
            
            177,863
            
            
            
            876,215
            
            
            
            311,592Sales
      displays
            
            
            134,462
            
            
            
            9,156
            
            
            
            285,230
            
            
            
            9,156Supplies
      & printing
            
            
            99,213
            
            
            
            25,623
            
            
            
            335,730
            
            
            
            85,060Consulting
      fees
            
            
            134,462
            
            
            
            106,643
            
            
            
            394,509
            
            
            
            341,547Public
      relations
            
            
            45,727
            
            
            
            37,450
            
            
            
            144,462
            
            
            
            161,699Trade
      Shows
            
            
            88,095
            
            
            
            8,250
            
            
            
            286,691
            
            
            
            61,771Telemarketing
            
            
            192,906
            
            
            
            42,452
            
            
            
            396,156
            
            
            
            47,663Other
            
            
            46,845
            
            
            
            137,069
            
            
            
            379,359
            
            
            
            531,296$
            4,997,801
            
            
            $
            1,965,578
            
            
            $
            11,089,338
            
            
            $
            4,285,849





Advertising
is primarily comprised of media costs for airing our infomercial which we
consider a key component of our marketing strategy because it helps build
awareness, and therefore consumer demand, for all channels of distribution, as
well as generating revenues from direct to consumer sales.





During
the nine months ended December 31, 2007, we substantially completed at a cost to
date of approximately $800,000 in infomercial production costs focused on our
next generation of product, a three pod AeroGarden utilizing a new aeroponic
technology. Infomercial production costs represent costs related to the
development, production, editing, and revision of our 30-minute infomercials and
short form (0:60 and 1:20 second) television commercials. We continue to test
variations of these infomercials and short form commercials to determine the
best offer and content configuration for airing in calendar 2008. All
infomercial production costs are expensed as incurred.  During the
three months ended December 31, 2006, we had incurred similar costs for the
production of our current infomercial featuring our original AeroGarden product.
Since September 2006 to date, we have spent $6.2 million in media airing our
infomercials and short form commercials.





Sales and
marketing salaries and related costs shown above consist of salaries, payroll
taxes, employee benefits, and other payroll costs for our sales, customer
service operations, graphics, and marketing departments. Stock based
compensation represents charges related to granting stock options and grants to
employees and consultants who service the foregoing departments.  For
the three months ended December 31, 2007, salaries and wage related costs for
sales and marketing were $1,011,499 as compared to $569,032 for the three months
ended December 31, 2006, an increase of $442,467 or 78%. As compared to the
three months ended September 30, 2007, salaries and wage related costs for sales
and marketing increased during the three months ended December 31, 2007 by
$224,697, or 28.5%. These salary increases reflect ramp-up in order processing,
customer service and telemarketing sales personnel for the holiday season. Sales
commissions reflect commissions equal to 4% to 7% of collections from net retail
sales to retailers, which were paid to sales representative organizations that
assisted us in opening and maintaining our relationships with retail customers.
We have recently renegotiated the agreements with our sales representative
organizations to sliding scales based upon the size of the customers and, as a
result, anticipate the aggregate percentage rate of these commissions to decline
in the next 12 months.





General
and administrative costs for the three months ended December 31, 2007 totaled
$1,471,364 as compared to $1,042,537 for the three months ended December 31,
2006, an increase of $428,827, or 41.1%. General and administrative costs have
increased in most areas as we have positioned our organization to manage our
sales growth and diversification of products and distribution channels.
Increases in general and administrative costs or the three months ended December
31, 2007 over the three months ended December 31, 2006 include primarily
$319,000 increases in salary and wage related costs, $123,000 in facilities
costs, and $134,000 in bad debt expenses, offset by $151,000 in reductions in
legal and accounting costs. As compared to the three months ended September 30,
2007, general and administrative costs increased $489,000, or 50%, primarily due
to an increase of $142,000 in salaries and wage related costs, $140,000 in bad
debt allowances associated with our increased sales, $56,000 in increased
facilities costs, and $40,000 in increased depreciation and
amortization.




16
 Table of Contents




For the
nine months ended December 31, 2007, general and administrative costs totaled
$3,679,397 as compared to $2,671,939 for the nine months ended December 31,
2006, an increase of $1,007,458, or 37.7%. Increases in general and
administrative costs for the nine months ended December 31, 2007 over the nine
months ended December 31, 2006 include $255,000 in salary related costs,
$184,000 in depreciation expense, $229,000 in facilities costs, $130,000 in
corporate governance costs, and $304,000 in bad debt expense
allowances.





During
the three months ended December 31, 2007, we incurred $682,453 in research and
development costs, as compared to $700,111 for the three months ended December
31, 2006, a decrease of $17,658 or 2.5%.





For the
nine months ended December 31, 2007, research and development costs totaled
$1,840,441 as compared to $1,544,495 for the nine months ended December 31,
2006, an increase of $295,946 or 19.2%. The principal components of this
increase are $143,000 in salaries and wage related costs and $120,000 in
supplies related to our expanded research labs.





We have
completed development of multiple new models of our AeroGarden systems including
(1) our Pro series, which feature stainless steel trim and more
sophisticated electronics for managing light and nutrient delivery during the
plant’s life cycle; (2) our deluxe series, which feature a higher
adjustable light hood and a new light bulb technology that delivers more light
enabling  higher height for the light hood and therefore the ability
to grow full size tomatoes, peppers etc.; and (3) our new six pod and three
pod systems which will feature lower retail price points combined with a new,
more efficient seed pod technology and nutrient delivery system. In the next 12
months we intend to continue researching and developing new product designs and
product extensions including, but not limited to, nutrient delivery systems and
additional seed varieties for our seed kits.  We have also begun
development of a methodology to cultivate and ship live “starter” plants in the
grow pod mediums that will be able to grow in our kitchen garden systems. We
started market testing this process with strawberries during the first quarter
of calendar 2007 and continue to refine and develop this process.





Our loss
from operations for the three months ended December 31, 2007 was $1,452,733 as
compared to $2,132,913 for the three months ended December 31, 2006, a decrease
of $680,180, or 31.9%. For the nine months ended December 31, 2007, the loss
from operations was $5,696,006 as compared to $6,577,576 for the nine months
ended December 31, 2006, a decrease of $881,570, or 13.4%.





Other
income and expense for the three months ended December 31, 2007 totaled $203,154
as compared to $725,325 for the three months ended December 31, 2006, a decrease
of $522,171. In the three months ended December 31, 2006 we incurred $636,130 in
penalties payable in our common stock related to delays we encountered in
registering common stock issued in various private offerings. Current interest
expense is the result of our factoring arrangement for our accounts receivable
as discussed below. For the nine months ended December 31, 2007, other income
and expense totaled $321,873 as compared to $1,812,317 for the nine months ended
December 31, 2006, a decrease of $1,490,444.





Liquidity
and Capital Resources




In
September 2007, we completed a private offering in which we sold an aggregate of
800,000 shares of common stock and warrants to purchase 800,000 shares of common
stock at an exercise price of $8.00 per share in the form of units consisting of
one share of common stock and one warrant per unit. The units were sold at a per
unit price of $6.25. Upon the close of the offering, we received gross proceeds
of $5,000,000, less a placement agent fee in the amount of $400,000 and
approximately $200,000 in other expenses related to the offering. In addition,
we issued warrants to purchase 80,000 shares of common stock at an exercise
price of $8.25 per share to the placement agent of this offering.





During
the nine months ended December 2007, we received proceeds, net of $5,000 in
expenses, of $940,875 from the exercise of warrants to purchase 156,100 shares
of our common stock at prices ranging from $2.50 to $6.25 per
share.





17
 Table of Contents




On
February 9, 2007, we entered into an agreement with Benefactor Group Inc.
(“Benefactor”) whereby Benefactor agreed to factor our retail accounts
receivable invoices. The term of the agreement is for one year with automatic
one year renewals but can be terminated by us with 60 days written notice. In
accordance with the terms of the agreement, Benefactor will purchase the
invoices that it approves for an initial payment of 85% of the amount of the
invoice with the remaining 15% paid upon collection less any deductions from the
customer. Benefactor charges a commission of 11⁄4% of the gross amount of the
invoice and a maintenance fee equal to an annual rate of prime plus 3%, prime
being determined by Benefactor based upon either the prime rate published by
Benefactor’s bank or the Wall Street Journal (10.25% at December 31, 2007 and
11.25% at March 31, 2007), charged on a daily basis for the unpaid invoice
amounts outstanding. We have agreed, beginning May 2007, to factor with
Benefactor a minimum of $800,000 of invoices monthly. We are responsible for any
invoices that are unpaid after 91 days or are subject to other defaults by the
customer and this obligation is secured by a security interest granted to
Benefactor on all assets. As of December 31, 2007, Benefactor had advanced us
$4,450,538 against invoices totaling $5,430,694.  Fees paid to
Benefactor for interest, discounts, and other services for the three and nine
months ended December 31, 2007 totaled $213,720 and $378,601,
respectively.  The receivables are considered recourse and are shown
at their gross value on the balance sheet.




As of
December 31, 2007, we had a cash balance of $3,729,822. We anticipate our
principal sources of liquidity during the next 12 months will be proceeds from
sales of our products. We intend to use our working capital principally to
purchase inventory, fund media advertising, fund product promotion and trade
show costs, as well as support ongoing product development, overhead, and
operational costs. Accordingly, we anticipate that existing cash resources will
be sufficient for the next 12 months. However, in the event retail and/or direct
response sales accelerate more rapidly than currently anticipated, we would need
to support this growth through additional asset-based or other debt financing or
the raising of additional equity. There is no assurance that such financing will
be available on attractive terms or at all.





For the
nine months ended December 31, 2007, cash used in operations was $10,443,487 as
compared to cash used in operations for the nine months ended December 31, 2006
of $6,491,484, an increase of $3,952,003. The principal use of cash in
operations was the net loss, which, after add back of non cash items, equaled
$5,167,000,  increases in accounts receivable of $4,922,000 related to
expansion of our retail distribution, and increases in inventory of $1,851,000
acquired to support our expanded distribution and product line. Offsetting the
foregoing are increases in customer deposits for goods under guaranteed sale
arrangements of $490,000 and increase in accrued expenses and accounts payable
of $1,634,000, consisting of increases in accrued allowances for advertising of
$619,000, reserves for returns and warranty of $229,000, and accrued media costs
of $231,000.





Cash used
by investing activities totaled $496,146 for the nine months ended December 31,
2007, as compared to $691,987 used in investing activities for the nine months
ended December 31, 2006. The principal use of cash in investing activities was
the addition of $243,000 in tooling for our new products, $141,000 in new
computers and office equipment, and $70,000 in manufacturing equipment. In
addition, we purchased $105,000 in manufacturing and $206,000 in computer
equipment and software related to installation of a new computer network and ERP
accounting and purchasing system through a capitalized lease program that did
not require the outlay of cash.





Cash
provided by financing activities was $9,173,954 for the nine months ended
December 31, 2007, as compared to cash provided by financing activities of
$71,250 for the nine months ended December 31, 2006. Cash provided by financing
activities included $4,433,272 from the issuance of common stock in our
September 2007 offering discussed above, $940,875 of proceeds from exercise of
warrants, and $3,805,387 from our accounts receivable factoring
facility.




Off-Balance
Sheet Arrangements





We
have certain current commitments under operating leases and capital leases and
have not entered into any contracts for financial derivative instruments such as
futures, swaps, and options.




18
 Table of Contents




Item 3.
Quantitativeand Qualitative Disclosures About Market
Risk





We do not
have any assets or liabilities which, in our view, impose upon us significant
market risk except for our credit facility from our accounts receivable factor
which has a variable rate of interest generally consisting of stated premiums
above prime. At December 31, 2007, we had $4,450,538 in outstanding borrowings
under this credit facility as compared to $645,151 at March 31, 2007. As
short-term interest rates fluctuate, the interest expense we incur on our credit
facility will change resulting in either a positive or negative effect on our
financial position, results of operations, and cash flows. At this borrowing
level for our credit facility, a one percentage point increase in interest rates
would have an unfavorable impact on our net loss of $44,505 on an annual basis;
however, because our excess cash is generally invested in short-term, high
quality interest bearing investments, a comparable increase in interest income
would offset much of the unfavorable impact.





We
purchase the majority of our inventory from vendors in China in transactions
that are U.S. dollar denominated transactions. Because the percentage of our
international purchases denominated in currencies other than the U.S. dollar is
small, any currency risks related to these transactions are immaterial to us.
However, a decline in the relative value of the U.S. dollar to other foreign
currencies, particularly the Chinese ren min bi, could lead to increased
purchasing costs. In order to mitigate this exposure, we make virtually all of
our purchase commitments in U.S. dollars.








Item 4.
Controlsand Procedures





(a)
Evaluation of Disclosure Controls and Procedures





Disclosure
controls and procedures are designed to ensure that information required to be
disclosed in the reports filed or submitted by the Company under the Exchange
Act is recorded, processed, summarized, and reported, within the time periods
specified in the rules and forms of the SEC. Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed in the reports filed under the Exchange Act
is accumulated and communicated to the Company’s management, including its
principal executive and financial officer, as appropriate, to allow timely
decisions regarding required disclosure.





The
Company carried out an evaluation, under the supervision and with the
participation of its management, including its principal executive officer and
principal financial officer, of the effectiveness of the design and operation of
the Company’s disclosure controls and procedures as of the end of the period
covered by this report. Based upon and as of the date of that evaluation, the
Company’s principal executive officer and financial officers concluded that the
Company’s disclosure controls and procedures are effective to ensure that
information required to be disclosed in the reports the Company files and
submits under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms.





(b)
Changes in Internal Controls




There
were no changes in the Company’s internal controls or in other factors that
could have significantly affected those controls during the three months ended
December 31, 2007.




19
 Table of Contents





PART
II - OTHER INFORMATION





Item 1. LegalProceedings





None.





Item 1A. Risk Factors





During
the three months ended December 31, 2007, there has not been any material
changes in risk factors previously disclosed.





Item 2.Unregistered Sales of Equity Securities and Use of
Proceeds





None.





Item 3. DefaultsUpon Senior Securities





None.





Item 4. Submissionof Matters to a Vote of Security
Holders





During
the three months ended December 31, 2007, there were no matters brought to a
vote of the security holders.





Item 5. OtherInformation





None





Item 6. Exhibits





3.1
            Articles
      of Incorporation of the Company (incorporated by reference to Exhibit 3.1
      of our Current Report on Form 8-K/A-2, filed November 16,
      2006)3.2
            Certificate
      of Amendment to Articles of Incorporation, dated November 3, 2002
      (incorporated by reference to Exhibit 3.2 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.3
            Certificate
      of Amendment to Articles of Incorporation, dated January 31, 2005
      (incorporated by reference to Exhibit 3.3 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.4
            Certificate
      of Change to Articles of Incorporation, dated July 27, 2005 (incorporated
      by reference to Exhibit 3.4 of our Current Report on Form 8-K/A-2, filed
      November 16, 2006)3.5
            Certificate
      of Amendment to Articles of Incorporation, dated February 24, 2006
      (incorporated by reference to Exhibit 3.5 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.6
            Amended
      Bylaws of the Company (incorporated by reference to Exhibit 3.6 of our
      Current Report on Form 8-K/A-2, filed November 16,
2006)10.1
            Letter
      Agreement between the Company and Jervis B. Perkins, dated November 12,
      2007 (incorporated by reference to Exhibit 10.1 of our Current Report on
      Form 8-K, filed November 14, 2007)31.1
            Certifications
      of the Chief Executive Officer Under Section 302 of the Sarbanes-Oxley
      Act*31.2
            Certifications
      of the Chief Financial Officer Under Section 302 of the Sarbanes-Oxley
      Act*32.1
            Certifications
      of the Chief Executive Officer Under Section 906 of the Sarbanes-Oxley
      Act*32.2
            Certifications
      of the Chief Financial Officer Under Section 906 of the Sarbanes-Oxley
      Act*





*
            Filed
      Herewith






20
 Table of Contents








SIGNATURES





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




AeroGrow
      International Inc.Date:  February
      13, 2008
            
            /s/Michael
      BissonnetteBy:
      Michael BissonnetteIts:
      Chief Executive Officer (Principal Executive Officer) and
      DirectorDate: : February
      13, 2008
            
            /s/Mitchell
      B. RubinBy:
      Mitchell B. RubinIts:
      Chief Financial Officer (Principal Financial Officer and Principal
      Accounting Officer)









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 Table of Contents