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, 2008ORo
            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    oNon-accelerated
      filer      o (Do not check if
      smaller reporting company)
            Smaller
      reporting company 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 February 05, 2009: 
13,345,877




Table of Contents





AeroGrowInternational, Inc.


TABLE
OF CONTENTS


FORM
10-Q REPORT


December
31, 2008




PagePART
      I   Financial InformationItem
      1.
              Condensed Financial
      Statements
              1Condensed Balance
      Sheets as of December 31, 2008 (Unaudited) and March 31,
      2008
              1Condensed
      Statements of Operations for the Three and Nine Months Ended December 31,
      2008 and December 31, 2007 (Unaudited)
              2Condensed
      Statements of Cash Flows for the Nine Months Ended December 31, 2008 and
      December 31, 2007 (Unaudited)
              3Notes to
      the Condensed Financial Statements
    (Unaudited)
              4Item
      2.
              Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
              12Item
      3.
              Quantitative and
      Qualitative Disclosures About Market Risk
              23Item
      4T.
              Controls and
      Procedures
              24PART
      II  Other InformationItem
      1.
              Legal
      Proceedings
              24Item
      1A.
              Risk
      Factors
              24Item
      2.
              Unregistered Sales
      of Equity Securities and Use of Proceeds
              24Item
      3.
              Defaults Upon
      Senior Securities
              25Item
      4.
              Submission of
      Matters to a Vote of Security Holders
              25Item
      5.
              Other
      Information
              26Item
      6.
              Exhibits
              27Signatures
              28




NOTE
CONCERNING FORWARD-LOOKING INFORMATION




The
following discussion contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, 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 the AeroGrow
International, Inc.’s (the “Company’s) intent, belief, or current expectations
regarding the Company’s strategies, plans, and objectives, the Company’s product
release schedules, the Company’s ability to design, develop, manufacture, and
market products, the Company’s intentions regarding  strategic
acquisitions, the ability of the Company’s products to achieve or maintain
commercial acceptance, and the Company’s ability to obtain financing for the
Company’s obligations.  Such statements are not guarantees of future
performance and are subject to risks, uncertainties, and assumptions that are
difficult to predict. 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 those
differences are discussed in “Risk Factors” and elsewhere in the Company’s
Annual Report on Form 10-K for the period ended March 31,
2008.  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 Securities and Exchange Commission.








Table of Contents




Item1. Condensed Financial
Statements







AEROGROW
INTERNATIONAL, INC.


CONDENSED
BALANCE SHEETS




December
      31,
                              
                              
                              March
      31,2008
                              
                              
                              2008ASSETS
                              
                              (Unaudited)Current
      assetsCash
                              
                              $
                              834,181
                              
                              
                              $
                              1,559,792Restricted
      cash
                              
                              
                              431,999
                              
                              
                              
                              86,676Accounts
      receivable, net of allowance for doubtful accounts of $177,958 and
      $511,710 at
                                December
      31, 2008 and March 31, 2008, respectively
                              
                              
                              6,164,936
                              
                              
                              
                              2,412,101Other
      receivables
                              
                              
                              225,474
                              
                              
                              
                              422,530Inventory,
      net of inventory obsolescence reserve of $174,545 and $0 at December 31,
      2008 and March 31, 2008, respectively
                              
                              
                              11,041,422
                              
                              
                              
                              4,688,444Prepaid
      expenses and other
                              
                              
                              863,570
                              
                              
                              
                              762,013Total
      current assets
                              
                              
                              19,561,582
                              
                              
                              
                              9,931,556Property
      and equipment, net of accumulated depreciation of $1,440,825 and $816,804
      at December 31, 2008 and March 31, 2008, respectively
                              
                              
                              1,841,714
                              
                              
                              
                              1,830,646Other
      assetsDeferred
      debt issuance costs, net of accumulated amortization of $166,250 and $0 at
      December 31,
                                2008
      and March 31, 2008, respectively
                              
                              
                              279,412
                              
                              
                              
                              -Intangible
      assets, net of $48,853 and $17,432 of accumulated amortization at December
      31, 2008
                                and
      March 31, 2008, respectively
                              
                              
                              212,418
                              
                              
                              
                              56,263Deposits
                              
                              
                              101,164
                              
                              
                              
                              101,164Total
      other assets
                              
                              
                              592,994
                              
                              
                              
                              157,427Total
      assets
                              
                              $
                              21,996,290
                              
                              
                              $
                              11,919,629LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesCurrent
      portion  - long-term debt
                              
                              $
                              8,942,402
                              
                              
                              $
                              128,927Due
      to factor
                              
                              
                              -
                              
                              
                              
                              1,480,150Accounts
      payable
                              
                              
                              8,833,832
                              
                              
                              
                              3,023,366Accrued
      expenses
                              
                              
                              4,541,556
                              
                              
                              
                              2,452,025Customer
      deposits
                              
                              
                              472,255
                              
                              
                              
                              232,200Deferred
      rent
                              
                              
                              60,535
                              
                              
                              
                              65,037Total
      current liabilities
                              
                              
                              22,850,580
                              
                              
                              
                              7,381,705Long-term
      debt
                              
                              
                              49,876
                              
                              
                              
                              129,373Stockholders'
      equityPreferred
      stock, $.001 par value, 20,000,000 shares authorized, none issued or
      outstanding
                              
                              
                              -
                              
                              
                              
                              -Common
      stock, $.001 par value, 75,000,000 shares authorized, 13,342,877 and
      12,076,717 shares
                                issued
      and outstanding at December 31, 2008 and March 31, 2008,
      respectively
                              
                              
                              13,342
                              
                              
                              
                              12,076Additional
      paid-in capital
                              
                              
                              45,511,777
                              
                              
                              
                              44,024,559Accumulated
      (deficit)
                              
                              
                              (46,429,285
                              )
                              
                              
                              (39,628,084
                              )Total
      stockholders' equity (deficit)
                              
                              
                              (904,166
                              )
                              
                              
                              4,408,551Total
      liabilities and stockholders' equity (deficit)
                              
                              $
                              21,996,290
                              
                              
                              $
                              11,919,629







See
accompanying notes to the condensed financial statements.







1
 Table of Contents




AEROGROWINTERNATIONAL, INC.


CONDENSED
STATEMENTS OF OPERATIONS


(Unaudited)








Three Months ended
                                December 31,
                              
                              
                              Nine Months ended
                                December 31,2008
                              
                              
                              2007
                              
                              
                              2008
                              
                              
                              2007RevenueProduct
      sales
                              
                              $
                              11,010,885
                              
                              
                              $
                              14,637,742
                              
                              
                              $
                              31,585,896
                              
                              
                              $
                              27,199,821Operating
      expensesCost
      of revenue
                              
                              
                              7,558,322
                              
                              
                              
                              8,938,857
                              
                              
                              
                              19,271,470
                              
                              
                              
                              16,286,651Research
      and development
                              
                              
                              703,133
                              
                              
                              
                              682,453
                              
                              
                              
                              1,845,326
                              
                              
                              
                              1,840,441Sales
      and marketing
                              
                              
                              4,704,912
                              
                              
                              
                              4,997,801
                              
                              
                              
                              11,030,524
                              
                              
                              
                              11,089,338General
      and administrative
                              
                              
                              2,037,797
                              
                              
                              
                              1,471,364
                              
                              
                              
                              5,458,622
                              
                              
                              
                              3,679,397Total
      operating expenses
                              
                              
                              15,004,164
                              
                              
                              
                              16,090,475
                              
                              
                              
                              37,605,942
                              
                              
                              
                              32,895,827Profit
      (loss) from operations
                              
                              
                              (3,993,279
                              )
                              
                              
                              (1,452,733
                              )
                              
                              
                              (6,020,046
                              )
                              
                              
                              (5,696,006
                              )Other
      (income) expense, netInterest
      (income)
                              
                              
                              (939
                              )
                              
                              
                              (31,679
                              )
                              
                              
                              (2,443
                              )
                              
                              
                              (101,879
                              )Interest
      expense
                              
                              
                              409,882
                              
                              
                              
                              234,833
                              
                              
                              
                              783,598
                              
                              
                              
                              426,681Other
      income
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              (2,929
                              )Total
      other (income) expense, net
                              
                              
                              408,943
                              
                              
                              
                              203,154
                              
                              
                              
                              781,155
                              
                              
                              
                              321,873Net
      profit (loss)
                              
                              $
                              (4,402,222
                              )
                              
                              $
                              (1,655,887
                              )
                              
                              $
                              (6,801,201
                              )
                              
                              $
                              (6,017,879
                              )Net
      profit (loss) per share, basic and diluted
                              
                              $
                              (0.35
                              )
                              
                              $
                              (0.13
                              )
                              
                              $
                              (0.56
                              )
                              
                              $
                              (0.52
                              )Weighted
      average number of common shares outstanding, basic and
    diluted
                              
                              
                              12,546,780
                              
                              
                              
                              12,371,517
                              
                              
                              
                              12,250,693
                              
                              
                              
                              11,529,472










See
accompanying notes to the condensed financial statements.




2
 Table of Contents








AEROGROWINTERNATIONAL, INC.


CONDENSED
STATEMENTS OF CASH FLOWS


(Unaudited)





Nine
      months ended December 31,2008
                          
                          
                          2007Cash
      flows from operating activities:Net
      (loss)
                          
                          $
                          (6,801,201
                          )
                          
                          $
                          (6,017,879
                          )Adjustments
      to reconcile net (loss) to cash provided (used) by
    operations:Issuance
      of common stock and options under equity compensation
plans
                          
                          
                          538,552
                          
                          
                          
                          370,441Issuance
      of warrants for services
                          
                          
                          -
                          
                          
                          
                          57,558Depreciation
      and amortization expense
                          
                          
                          655,443
                          
                          
                          
                          321,226Allowance
      for bad debt
                          
                          
                          (333,752
                          )
                          
                          
                          101,536Amortization
      of debt issuance costs
                          
                          
                          166,250
                          
                          
                          
                          -Change
      in assets and liabilities:(Increase)
      in accounts receivable
                          
                          
                          (3,419,083
                          )
                          
                          
                          (4,922,717
                          )(Increase)
      decrease in other receivable
                          
                          
                          197,056
                          
                          
                          
                          (104,121
                          )(Increase)
      in inventory
                          
                          
                          (6,352,978
                          )
                          
                          
                          (1,851,138
                          )(Increase)
      in other current assets
                          
                          
                          (123,692
                          )
                          
                          
                          (466,145
                          )(Increase)
      in prepaid debt issuance costs
                          
                          
                          (423,527
                          )
                          
                          
                          -(Increase)
      decrease in deposits
                          
                          
                          -
                          
                          
                          
                          (67,504
                          )Increase
      in accounts payable
                          
                          
                          5,810,465
                          
                          
                          
                          463,934Increase
      in accrued expenses
                          
                          
                          2,089,531
                          
                          
                          
                          1,169,669Increase
      in customer deposits
                          
                          
                          240,055
                          
                          
                          
                          490,397Increase
      (decrease) in deferred rent
                          
                          
                          (4,502
                          )
                          
                          
                          11,256Net
      cash (used) by operating activities
                          
                          
                          (7,761,383
                          )
                          
                          
                          (10,443,487
                          )Cash
      flows from investing activities:Increase
      in restricted cash
                          
                          
                          (345,323
                          )
                          
                          
                          (1,893
                          )Purchases
      of equipment
                          
                          
                          (635,089
                          )
                          
                          
                          (460,531
                          )Patent
      expenses
                          
                          
                          (187,575
                          )
                          
                          
                          (33,722
                          )Net
      cash (used) by investing activities
                          
                          
                          (1,167,987
                          )
                          
                          
                          (496,146
                          )Cash
      flows from financing activities:Increase
      (decrease) in amount due to factor
                          
                          
                          (1,480,150
                          )
                          
                          
                          3,805,387Proceeds
      from debt net
                          
                          
                          8,822,948
                          
                          
                          
                          -Proceeds
      from issuance of common stock net
                          
                          
                          -
                          
                          
                          
                          4,433,372Proceeds
      from exercise of warrants
                          
                          
                          898,289
                          
                          
                          
                          940,875Proceeds
      from the exercise of stock options
                          
                          
                          51,643
                          
                          
                          
                          17,515Principal
      payments on capital leases
                          
                          
                          (88,971
                          )
                          
                          
                          (23,195
                          )Net
      cash provided (used) by financing activities
                          
                          
                          8,203,759
                          
                          
                          
                          9,173,954Net
      increase (decrease) in cash
                          
                          
                          (725,611
                          )
                          
                          
                          (1,765,679
                          )Cash,
      beginning of period
                          
                          
                          1,559,792
                          
                          
                          
                          5,495,501Cash,
      end of period
                          
                          $
                          834,181
                          
                          
                          $
                          3,729,822




See
accompanying notes to the condensed financial statements.







3
 Table of Contents





AEROGROWINTERNATIONAL INC.


NOTES
TO 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.  On January 12, 2006, the Company and Wentworth I,
Inc., a Delaware corporation (“Wentworth”), entered into an Agreement and Plan
of Merger (the “Merger Agreement”), which was consummated on February 24,
2006.  Under the Merger Agreement, Wentworth merged with and into the
Company, and the Company was the surviving corporation (the
“Merger”).  The Merger, for accounting and financial reporting
purposes, has been accounted for as an acquisition of Wentworth by the
Company.  The Company therefore uses the historical financial
statements of the Company before the merger as the financial statements of the
Company after the Merger.





The
Company’s principal business is developing, marketing, and distributing advanced
indoor aeroponic garden systems designed and priced to appeal to the consumer
gardening, cooking, and small indoor appliance markets worldwide.  The
Company’s principal activities from 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 AeroGarden system and in
March 2006, began shipping these systems to retail and catalogue customers.
Prior to March 2006 when the Company commenced sales of its aeroponic garden
systems, the Company was considered a Development Stage Enterprise in accordance
with Statement of Financial Accounting Standards (“SFAS”) No. 7, “Accounting and
Reporting by Development Stage Enterprises.” Today the Company manufactures,
distributes, and markets over 11 different models of its AeroGarden systems in
multiple colors, as well as over 50 varieties of seed kits and a full line of
accessory products through multiple channels including retail, catalogue, and
direct-to-consumer sales in the United States as well as selected markets in
Europe, Asia, and Australia.


2.
Liquidity and 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-K for the year ended March 31, 2008,
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, 2008, the
results of operations for the three and nine months ended December 31, 2008 and
2007, and the cash flows for the nine months ended December 31, 2008 and
2007.  The results of operations for the three and nine months ended
December 31, 2008, 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, 2008, is derived from the Company’s audited financial
statements.





The
Company has incurred net losses since its inception, including a net loss for
the nine months ended December 31, 2008 of $6,801,201.  As further
discussed in the Liquidity and Capital Resources section of Item 2. Management’s
Discussion and Analysis of Financial Condition and Results of Operations, the
Company does not believe that currently available cash and existing sources of
capital are sufficient to meet the Company’s cash requirements for the next 12
months.  Consequently, the Company has engaged an investment banker to
pursue a transaction to raise new capital and to explore various other strategic
alternatives that could enable the Company to meet its operating
requirements.  In the event the Company is unable to complete such a
transaction, existing sources of liquidity are estimated to be sufficient to
fund the Company’s operations, as currently structured, for approximately the
next three to six months.  If faced with an inability to complete a
transaction, it is likely the Company would attempt to restructure its business
to reduce the capital resources required to support continued
operations.  However, there can be no assurances that such actions
would be undertaken on a sufficiently timely basis, or would ultimately be
successful in re-sizing the Company’s operational requirements to the available
resources.





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.





4
 Table of Contents




Net Profit (Loss) per Share
of Common Stock




The
Company computes net profit (loss) per share of common stock in accordance with
SFAS No. 128, “Earnings per Share,” and SEC Staff Accounting Bulletin No.
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 stockholders 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 profit per share or decrease loss per share) are excluded from the
calculation of diluted EPS.





Reclassifications




Certain
prior year amounts have been reclassified to conform to current year
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.




Concentrations of
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 as well as our outstanding debt.  The amounts
on deposit with financial institutions exceed the federally insured limit as of
December 31, 2008, and March 31, 2008.  However, management believes
that the financial institutions are financially sound and the risk of loss is
minimal.





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





Customers:




The
Company maintains a credit insurance policy on many of its trade accounts
receivables.  For the three months ended December 31, 2008, the
Company had one customer who represented 10.7% of the Company’s net product
sales.  For the three months ended December 31, 2007, the Company had
one customer who represented 14.1% of net product sales.  For the nine
months ended December 31, 2008, the Company had one customer who represented
12.0% 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.


Suppliers:




For the
three months ended December 31, 2008, the Company purchased inventories and
other inventory-related items from three suppliers totaling $2,728,645,
$1,108,342, and $956,742.  For the three months ended December 31,
2007, the Company purchased inventories and other inventory-related items from
two suppliers totaling $1,691,625 and $2,991,821.  For the nine months
ended December 31, 2008, the Company purchased inventories and other inventory
related items from three suppliers totaling $8,794,000, $3,846,934, and
$3,343,386.  For the nine months ended December 31, 2007, the Company
purchased inventories and other inventory related items from two suppliers
totaling $4,137,401 and $5,232,799.  Although the Company believes
alternate sources of manufacturing could be obtained, loss of any of these
suppliers currently being used by the Company could have an adverse impact on
operations.





The
Company’s primary contract manufacturers are located in China.  As a
result, the Company may be subject to political, currency, regulatory, and
weather/natural disaster risks.  Although the Company believes
alternate sources of manufacturing could be obtained, these risks could have an
adverse impact on operations.





Debt Issuance
Costs





The
Company has incurred $395,663 in debt issuance which are recorded as a deferred
charge and is amortized on a straight-line basis over the term of the debt
instrument.








5
 Table of Contents





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 Accounting Research Bulletin (“ARB”) No. 43, Chapter 4,
“Inventory Pricing.”  A majority of the Company’s products are
manufactured overseas and are recorded at cost.




December
      31,
                          
                          
                          March
      31,2008
                          
                          
                          2008Finished
      goods
                          
                          $
                          9,306,230
                          
                          
                          $
                          3,669,693Raw
      materials
                          
                          
                          1,735,192
                          
                          
                          
                          1,018,751$
                          11,041,422
                          
                          
                          $
                          4,688,444




The
Company determines an 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, 2008, the Company determined that an
inventory obsolescence reserve totaling $174,545 was required.  As of
March 31, 2007, the Company determined that no inventory obsolescence reserve
was required.


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.  Accordingly, the Company did not record $430 and
$782,624 of revenue for the three and nine months ending December 31, 2008 and
December 31, 2007, respectively, related to the unpaid balance due for
direct-to-consumer sales because the consumer has 36 days to evaluate the
product, and is required to pay only the shipping and handling costs before
making the required installment payments after the expiration of the 36-day
trial period.  The Company also did not record $131 and $237,083,
respectively, of production costs associated with the foregoing revenue because
the consumer is required to return unpurchased product at the end of the trial
period, enabling the Company to recover the production costs through resale of
the returned goods.





Additionally,
the Company did not record $475,112 and $551,420 of revenue for the three and
nine months ending December 31, 2008 and December 31, 2007, respectively,
related to the wholesale sales value of inventory held by its retail shopping
channel customers because these sales are contingent upon the shopping channels
selling the goods.  Deferred payments for these goods are charged to
Customer Deposits.  The Company also deferred, as of December 31, 2008
and December 31, 2007, recognition of $196,395 and $300,153, respectively, of
product and freight costs associated with these wholesale sales, which have been
included in inventory.


The
Company records estimated reductions to revenue for customer and distributor
programs and incentive offerings, including promotions, rebates, and other
volume-based incentives.  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, 2008 and December
31, 2007, the Company had accrued $698,130 and $684,511, respectively, as its
estimate for the foregoing deductions and allowances.





The
Company reserves for known and potential returns from customers.  The
calculation of refunds or credits for customer returns is based upon historical
experience. In certain cases, wholesale customers are provided a fixed
allowance, usually in the 1% to 2% range to cover product returns that they may
experience from their customers.  As of December 31, 2008 and December
31, 2007, the Company has recorded a reserve for customer returns of $302,401,
and $424,036, respectively.  In addition, as of December 31, 2008, the
Company accrued $1,725,213 in accrued expenses for estimated returns and
markdown associated with several large retail accounts.





Advertising and Production
Costs




The
Company records costs related to its direct response advertisements, including
postage and printing costs incurred in conjunction with mailing direct response
catalogues, and related costs, in accordance with the Statement of Position
(“SOP”) No. 93-7, “Reporting on Advertising Costs.” SOP No. 93-7 stipulates that
direct response 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.  The costs related to other forms of general advertising are
expensed at the time the advertising is first run in accordance with SOP No.
93-7.  As of December 31, 2008 and December 31, 2007, the Company had
deferred $359,665 and $493,086, respectively, related to such media
costs.  Advertising expenses for the three and nine months ended
December 31, 2008 were $2,094,269 and $3,911,012, respectively, and for the
three and nine months ended December 31, 2007 were $2,788,834 and $5,528,558,
respectively.





6
 Table of Contents




Warranty
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.  Based upon the foregoing,
the Company has recorded as of December 31, 2008 and December 31, 2007 a
provision for potential future warranty costs of $52,932 and $58,981,
respectively.


New Accounting
Pronouncements





In
September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements.”  This Statement defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles,
and expands disclosures about fair value measurements.  The Statement
applies to fair value measurements required under other accounting guidance that
require or permit fair value measurements.  Accordingly, this
Statement does not require any new fair value measurements.  The
guidance in this Statement does not apply to the Company’s stock-based
compensation plans accounted for in accordance with SFAS No. 123 (R),
“Share-Based Payment.” Except as described below, SFAS No. 157 is effective for
the Company as of the beginning of fiscal year 2009.  In February
2008, the FASB issued two Staff Positions that amend SFAS No.
157.  The first FASB Staff Position (FSP), No. FAS 157-1, excludes
from the scope of SFAS No. 157 accounting pronouncements that address fair value
measurements for purposes of lease classification and
measurement.  The second FSP, No. FAS 157-2, delays the effective date
of SFAS No.157 for nonfinancial assets and nonfinancial liabilities, except for
items that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually).  Application of SFAS No. 157
to these items will be effective for the Company as of the beginning of fiscal
year 2010.  In October 2008, the FASB issued FSP No. FAS 157-3, which
clarifies the application of SFAS No. 157 in a market that is not
active.  The Company anticipates that the adoption of SFAS No. 157, as
amended by these Staff Positions, will not have a material impact on the
Company’s financial position or results of
operations.


In May
2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 162
“The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162
identifies the sources of accounting principles and the framework for selecting
the principles used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally
accepted accounting principles.  This statement will become effective
60 days following the SEC’s approval of the Public Company Accounting Oversight
Board amendments to United States Auditing Standards Section 411, “The
Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles.” The Company has adopted SFAS No. 162 which did not have a material
impact on the Company’s financial statements.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities—An Amendment of FASB Statement
No. 133.” SFAS No. 161 establishes the disclosure requirements for
derivative instruments and for hedging activities with the intent to provide
financial statement users with an enhanced understanding of the entity’s use of
derivative instruments, the accounting of derivative instruments and related
hedged items under SFAS No. 133, “Accounting for Derivative Instruments and
Hedging Activities,” and its related interpretations, and the effects of these
instruments on the entity’s financial position, financial performance, and cash
flows.  This statement is effective for financial statements issued for
fiscal years beginning after November 15, 2008.  The Company does
not expect its adoption will have a material impact on the Company’s financial
statement disclosures.





In
December 2007, the FASB issued SFAS No. 141(R), “Business Combinations,” which
amends SFAS No. 141, and provides revised guidance for recognizing and measuring
identifiable assets and goodwill acquired, liabilities assumed, and any
non-controlling interest in the acquiree.  It also provides disclosure
requirements to enable users of the financial statements to evaluate the nature
and financial effects of the business combination. SFAS No. 141(R) is effective
for fiscal years beginning on or after January 1, 2009, and is to be applied
prospectively.  The Company is currently evaluating the potential
impact of adopting this statement on its financial position, results of
operations, and cash flows and does not expect that the adoption will have a
material impact on the Company’s financial statements.





In
December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51,” which
establishes accounting and reporting standards pertaining to ownership interests
in subsidiaries held by parties other than the parent, the amount of net income
attributable to the parent and to the non-controlling interest, changes in a
parent's ownership interest, and the valuation of any retained non-controlling
equity investment when a subsidiary is deconsolidated. SFAS No. 160 also
establishes disclosure requirements that clearly identify and distinguish
between the interests of the parent and the interests of the non-controlling
owners. SFAS No. 160 is effective for fiscal years beginning on or after January
1, 2009.  The Company does not expect that the adoption will have a
material impact on the Company's financial statements.





In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities—Including an Amendment of FASB
Statement 157.” The Company adopted SFAS No. 159 beginning April 1,
2008.  The adoption of and SFAS No. 159 for financial assets and
liabilities did not have a material impact on the Company’s financial
statements.





7
 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 November 2010 of
$179,033 as of December 31, 2008.  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 $202,059 as of December 31,
2008.  In addition, the Company has recorded in deposits, a security
deposit of $48,180 which will be released when the Company achieves certain
financial requirements. The leases also required $21,465 in prepaid
rents.  The capital lease obligations are recorded in short-term and
long-term debt.


4.
Long-Term Debt and Current Portion – Long-Term Debt


On May
19, 2008, the Company and Jack J. Walker, one of the Company’s directors, acting
as co-borrowers, entered into a Business Loan Agreement with First National Bank
(the “Business Loan Agreement”) for a loan to the Company in the principal
amount of $1,000,000 (the “First National Loan”).  The Company has
agreed, among other things, that while the Business Loan Agreement is in effect,
the Company will not (without First National Bank's prior written consent): (i)
incur or assume indebtedness, except for trade debt in the ordinary course of
business, capital leases in an amount not to exceed $500,000, and capital
expenditures of not more than $500,000 during any fiscal year; (ii) sell,
transfer, mortgage, assign, pledge, lease, grant a security interest in, or
encumber any of the Company’s assets (except as specifically allowed), or
(iii) sell with recourse any of the Company’s accounts, except to First
National Bank.  In the event of a default under the First National
Loan, at First National Bank's option, all indebtedness owed under the First
National Loan will become immediately due and
payable.


Pursuant
to the Business Loan Agreement, the Company and Mr. Walker provided First
National Bank with a promissory note for a principal amount of up to $1,000,000
(the “First National Note”).  The First National Note has an initial
interest rate of 5.5% and matures on May 19, 2009. The First National Note
provides for monthly payments of interest only, with the balance of principal
and all accrued but unpaid interest due and payable on May 19,
2009.  The First National Note also provides for a minimum interest
charge of $250, but otherwise may be prepaid at any time without penalty. In the
event of a default under the First National Note, the interest rate will be
increased by a margin of 4% over the current rate of interest.  As of
December 31, 2008, $998,062 was outstanding under the First National Note,
including accrued interest.





On May
22, 2008, the Company also entered into a Loan Agreement (the “WLLC Loan
Agreement”) and associated Promissory Note with WLoans, LLC, a Colorado limited
liability company (“WLLC”), as lender, and Jack J. Walker.  The WLLC
Loan Agreement provides for a loan up to a maximum of $1,500,000 for business
purposes, at an annual interest rate of 12% (the “WLLC Loan”).  Mr.
Walker is the manager of WLLC and owns a 73.3% membership interest in WLLC, with
the remaining membership interest owned by other officers and directors of the
Company.  As a condition of the WLLC Loan, the Company paid WLLC a
non-refundable commitment fee of $37,500. Further, in consideration of WLLC
holding available funds equal to the principal amount not yet disbursed, the
Company must pay a non-refundable fee of 1% of the retained funds as a holding
fee, payable quarterly.  If not paid sooner, the WLLC Loan, if drawn
upon, will be due and payable on April 1, 2009.  The Company granted
WLLC a security interest in all of the Company’s assets, subordinate to the
security interests in such assets granted to FCC and First National Bank (each
as described herein).  Further, in the event we receive any equity
financing, all obligations due under the WLLC Loan Agreement become immediately
due and payable.  In the event of any default under the WLLC Loan
Agreement, WLLC may, at its option, declare all amounts owed immediately due and
payable, foreclose on the security interest granted, and increase the annual
rate of interest to 18%.  As of December 31, 2008, loans totaling
$1,236,934 were outstanding under the WLLC Loan Agreement, including accrued
interest.





The WLLC
Loan Agreement also set forth the terms and conditions under which Mr. Walker
agreed to act as co-borrower on the First National Loan.  In
consideration for Mr. Walker's agreement to act as co-borrower, the Company
agreed to: (i) pay Mr. Walker a service fee of $50,000; (ii) allow Mr. Walker to
purchase the First National Loan in the event of the Company’s default under the
First National Loan and to repay Mr. Walker any amounts expended by Mr. Walker
on the First National Loan, together with interest at an annual rate of 18%; and
(iii) terminate and release Mr. Walker from any obligation under the First
National Loan on the one-year anniversary of the execution date of the First
National Loan Agreement.





On June
23, 2008, the Company entered into a Loan and Security Agreement with FCC, LLC,
d/b/a First Capital (“FCC”) (the “FCC Loan Agreement”), for a revolving credit
facility in the amount of $12,000,000 (the “Revolving Credit
Facility”).  Mr. Walker provided a guarantee against certain
contingent liabilities related to the FCC Loan Agreement.  In return
for this guarantee, the Company paid Mr. Walker a fee of $7,500.





The
Revolving Credit Facility has an initial two-year term, with one-year renewals
thereafter. Continued availability of the Revolving Credit Facility is subject
to the Company’s compliance with customary financial and reporting
covenants.  The purpose of the Revolving Credit Facility is to provide
additional working capital.  As collateral for the Revolving Credit
Facility, the Company granted to FCC a first priority security interest over all
of the Company’s assets, including, but not limited to, accounts receivable,
inventory, and equipment.  As of December 31, 2008, loans totaling
$6,587,952 were outstanding under the Revolving Credit Facility, including
accrued interest, and there was an estimated remaining availability of
approximately $600,000.  The amount available under the Revolving
Credit Facility varies from day-to-day, depending on the level of sales,
accounts receivable collections, and inventory on-hand
levels.


As of
June 30, 2008, the Company was not in compliance with two covenants under the
FCC Loan Agreement.  As of July 31, 2008, FCC and AeroGrow executed an
amendment to the FCC Loan Agreement (the “First FCC Amendment”).  The
First FCC Amendment re-set the covenant levels for June 30, 2008 and future
periods, thus waving the non-compliance as of June 30, 2008, under the old
covenants, temporarily reduced certain restrictions on the Company’s ability to
borrow against inventory, and increased the interest rate from Base Rate plus 2%
to the current rate of Base Rate plus 3.5%.  After the First FCC
Amendment, the Company was in compliance with the revised covenants as of June
30, 2008.





8
 Table of Contents




As of
September 30, 2008, the Company was not in compliance with two covenants under
the revised FCC Loan Agreement.  On October 24, 2008, FCC and the
Company executed a second amendment to the FCC Loan Agreement (the “Second FCC
Amendment”).  The Second FCC Amendment waived the covenant violations
as of September 30, 2008.  In addition, the Second FCC Amendment
changed the definition of Base Rate to be the higher of the prime rate or
one-month LIBOR + 2.75%, and adjusted the interest calculation under the FCC
Loan Agreement such that the interest rate resets monthly, rather than
daily.





As of
October 27, 2008, FCC and the Company executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory.





On
January 16, 2009, the Company and FCC executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory as of January 1, 2009.





As of
December 31, 2008, the Company was not in compliance with three covenants under
the revised FCC Loan Agreement.  Effective as of January 31, 2009, FCC
and the Company executed a forbearance agreement related to the FCC Loan
Agreement (the “Forbearance Agreement”).  Pursuant to the terms of the
Forbearance Agreement, FCC agreed to forbear its rights and remedies under the
FCC Loan Agreement and related documents with respect to any existing defaults
under the FCC Loan Agreement (the “Existing Defaults”) until the earlier of June
30, 2009, or the date of occurrence of a default other than the Existing
Defaults.  The Forbearance Agreement also increases the Company’s
ability to borrow against inventory and accounts receivable during the term of
the Forbearance Agreement (the “Additional Borrowing Capacity”).  In
return for FCC providing the forbearance period and the Additional Borrowing
Capacity, the Company agreed to pay FCC a $25,000 forbearance fee (in five
monthly installments), an amendment fee equal to 1.5% per month on the average
utilization of the Additional Borrowing Capacity, and issue to FCC a minimum of
250,000 warrants to purchase common stock of the Company at a purchase price of
$1.00 per share.  Simultaneously with the execution of the Forbearance
Agreement, Mr. Walker provided a $1 million guarantee against certain
liabilities under the FCC Loan Agreement.  As compensation for
providing the guarantee, the Company will issue Mr. Walker 50,000 warrants to
purchase common stock of the Company at a purchase price of $1.00 per
share.  In accordance with SFAS No. 78, the loans outstanding under
the FCC Loan Agreement are classified as current because the term of the
Forbearance Agreement does not exceed one year.


5.
Due to Factor


On
February 9, 2007, the Company entered into an agreement with Benefactor Funding
Corp. (“Benefactor”), whereby Benefactor agreed to factor the company’s retail
accounts receivable invoices.  As of March 31, 2008, Benefactor had
advanced the Company $1,480,150 against invoices totaling
$1,915,815.  The factored receivables are considered recourse and are
presented at gross value in the accompanying balance sheets.  On April
16, 2008, the Company gave notice to Benefactor of its intent to terminate the
facility.  The facility was terminated on June 24, 2008.


6.
Equity Compensation Plans
 For the
three months ended December 31, 2008, the Company granted 23,160 options to
purchase the Company’s common stock at an exercise price of $2.86 per share
under the 2005 Equity Compensation Plan (“2005 Plan”).





For the
nine months ended December 31, 2008, the Company granted 634,070 options to
purchase the Company’s common stock at exercise prices ranging from $1.25 to
$2.96 per share under the 2005 Plan.  During the nine months ended
December 31, 2007, the Company granted 5,000 options at a exercise price of
$5.15.


During
the three months ended December 31, 2008, 126,257 options to purchase common
stock were forfeited and 21,040 shares of common stock were issued upon exercise
of outstanding stock options under the Company’s equity compensation
plans.  During the three months ended December 31, 2007 there were no
forfeitures of options and 5,701 options were exercised.





During
the nine months ended December 31, 2008, 140,889 options to purchase common
stock were forfeited and 43,576 options were exercised.  During the
nine months ended December 31, 2007 there were 11,433 forfeitures of options and
10,573 options were exercised.








9
 Table of Contents




As of
December 31, 2008, the Company had granted options for 386,465 shares of the
Company’s common stock that are approved and unvested that will result in
$525,686 of compensation expense in future periods if they become fully
vested.


Information
regarding all stock options outstanding under the 2005 Plan as of December 31,
2008 is as follows:





OPTIONS
      OUTSTANDING
                                  
                                  OPTIONS
      EXERCISABLEWeighted-
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  Weighted-Average
                                  
                                  
                                  Weighted-
                                  
                                  
                                  
                                  
                                  
                                  
                                  Average
                                  
                                  
                                  Weighted-Remaining
                                  
                                  
                                  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
                                  
                                  
                                  8,125
                                  
                                  
                                  
                                  1.56
                                  
                                  
                                  $
                                  0.03
                                  
                                  
                                  
                                  
                                  8,125
                                  
                                  
                                  
                                  1.56
                                  
                                  
                                  $
                                  0.03Over
      $0.50 to $3.00
                                  
                                  
                                  576,754
                                  
                                  
                                  
                                  3.93
                                  
                                  
                                  $
                                  2.27
                                  
                                  
                                  
                                  
                                  333,608
                                  
                                  
                                  
                                  3.69
                                  
                                  
                                  $
                                  2.28Over
      $4.50 to $5.50
                                  
                                  
                                  1,360,043
                                  
                                  
                                  
                                  2.45
                                  
                                  
                                  $
                                  4.96
                                  
                                  
                                  
                                  
                                  1,225,869
                                  
                                  
                                  
                                  2.26
                                  
                                  
                                  $
                                  4.98Over
      $5.50
                                  
                                  
                                  58,634
                                  
                                  
                                  
                                  3.71
                                  
                                  
                                  $
                                  5.87
                                  
                                  
                                  
                                  
                                  56,424
                                  
                                  
                                  
                                  3.73
                                  
                                  
                                  $
                                  5.872,003,556
                                  
                                  
                                  
                                  3.29
                                  
                                  
                                  $
                                  4.13
                                  
                                  $    1,402
                                  
                                  
                                  1,624,026
                                  
                                  
                                  
                                  3.26
                                  
                                  
                                  $
                                  4.36
                                  
                                  $   1,402




The
aggregate intrinsic value in the preceding table represents the difference
between the Company’s closing stock price and the exercise price of each
in-the-money option on the last trading day (December 31, 2008) of the period
presented.  For the three months ended December 31, 2008, 21,040
options to purchase the Company’s common stock were exercised under the plan
resulting in $26,300 in proceeds to the Company.  For the nine months
ended December 31, 2008, 43,576 options to purchase the Company’s common stock
were exercised under the 2005 Plan resulting in $51,643 in proceeds to the
Company.





At the
Company’s October 2008 Annual Meeting of Stockholders, a total of 832,378
options, granted under the 2005 Plan but subject to stockholder approval, were
ratified.  These options have been included in the option information
presented above.  Expense related to these options was calculated in
accordance with SFAS No. 123R, “Shares Based Payment”.  Expense
recognized during the quarter ended December 31, 2008 related to options
previously vested of $310,793.


7.
Income Taxes


In
September 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting
for Uncertainty in Income Taxes.” FIN No. 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. At the
adoption date of April 1, 2007, the Company had no unrecognized tax
benefits.





The
Company is subject to U.S. federal income tax as well as income tax of several
state jurisdictions, including primarily Colorado and
California.  With few exceptions, the Company is no longer subject to
U.S. federal, state, and local income tax examinations by tax authorities for
the years before 2004 for federal and 2003 for state returns.  Some federal
and state income tax returns for 2003 through 2007 were filed on a delinquent
basis in the applicable jurisdictions.


8.
Related Party Transactions


See Note
4, Long-Term Debt and Current Portion — Long-Term Debt.




10
 Table of Contents


9.
Stockholders’ Equity


A summary
of the Company’s warrant activity for the period from April 1, 2008, through
December 31, 2008, is presented below:




WarrantsOutstanding
                                
                                
                                WeightedAverageExercise
      PriceOutstanding,
      April 1, 2008
                                
                                
                                5,694,736
                                
                                
                                $
                                6.66Granted
                                
                                
                                594,990
                                
                                
                                $
                                2.00Exercised
                                
                                
                                (1,199,979
                                )
                                
                                $
                                .75Expired
                                
                                
                                (15,000
                                )
                                
                                $
                                5.00Outstanding,
      December 31, 2008
                                
                                
                                5,074,747
                                
                                
                                $
                                7.36





As
of December 31, 2008, the Company had the following outstanding warrants to
purchase its common stock:





Weighted
                            
                            
                            WeightedWarrants
                            
                            
                            Average
                            
                            
                            AverageOutstanding
                            
                            
                            Exercise
      Price
                            
                            
                            Remaining
      Life594,990
                            
                            
                            $
                            2.00
                            
                            
                            
                            2.84450,000
                            
                            
                            $
                            5.01
                            
                            
                            
                            1.70509,000
                            
                            
                            $
                            6.00
                            
                            
                            
                            2.371,937,300
                            
                            
                            $
                            6.25
                            
                            
                            
                            2.1550,000
                            
                            
                            $
                            6.96
                            
                            
                            
                            3.58653,457
                            
                            
                            $
                            7.57
                            
                            
                            
                            3.24800,000
                            
                            
                            $
                            8.00
                            
                            
                            
                            5.6780,000
                            
                            
                            $
                            8.25
                            
                            
                            
                            5.675,074,747
                            
                            
                            $
                            7.36
                            
                            
                            
                            3.87





Between
November 17, 2008 and November 21, 2008, the Company agreed to reduce the per
share exercise prices of certain of its outstanding warrants to purchase shares
of its common stock from original exercise prices ranging from $5.00 to $8.25 to
reduced exercise prices ranging from $0.66 to $0.75 in connection with an
agreement by the holders of such warrants to immediately exercise such
warrants.  In connection with such warrant exercises, the Company
received $873,289 in cash proceeds and issued 1,189,979 shares of its common
stock.





In
connection with the warrant repricing and exercise of such warrants, the Company
issued replacement warrants to such warrant holders (the “Replacement
Warrants”), permitting the holder to purchase one share of the Company’s common
stock for every two shares that were purchased pursuant to the exercise of such
repriced warrants at an exercise price of $2.00 per share.  In total,
Replacement Warrants representing the right to purchase 594,990 shares of
Company’s common stock were issued, and the Replacement Warrants have
termination dates ranging from September 13, 2010 to September 4,
2014.





The
shares of common stock issued upon exercise of the repriced warrants and the
issuance of the Replacement Warrants were done in reliance on Section 4(2) of
the Securities Act of 1933, as amended, and Rule 506 promulgated
thereunder.






11
 Table of Contents




Item2. Management’sDiscussion and Analysis of Financial Condition and Results of
Operations





The
discussion contained herein is for the three and nine months ended December 31,
2008 and December 31, 2007, as well as March 31, 2008. 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, 2008 (this “Quarterly
Report”).





Overview





AeroGrow
International, Inc. was incorporated in the State of Nevada on March 25,
2002.  On January 12, 2006, the Company and Wentworth I, Inc., a
Delaware corporation (“Wentworth”), entered into an Agreement and Plan of Merger
(the “Merger Agreement”), which was consummated on February 24,
2006.  Under the Merger Agreement, Wentworth merged with and into the
Company, and the Company was the surviving corporation (the
“Merger”).  The Merger, for accounting and financial reporting
purposes, has been accounted for as an acquisition of Wentworth by the
Company.  The Company therefore uses the historical financial
statements of the Company before the merger as the financial statements of the
Company after the Merger.





The
Company’s principal business is developing, marketing, and distributing advanced
indoor aeroponic garden systems designed and priced to appeal to the consumer
gardening, cooking, and small indoor appliance markets worldwide.  The
Company’s principal activities from 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 AeroGarden system and, in
March 2006, began shipping these systems to retail and catalogue
customers.  Prior to March 2006 when the Company commenced sales of
its aeroponic garden systems, the Company was considered a Development Stage
Enterprise in accordance with Statement of Financial Accounting Standards
(“SFAS”) No. 7, “Accounting and Reporting by Development Stage Enterprises.”
Today the Company manufactures, distributes, and markets over 11 different
models of its AeroGarden systems in multiple colors, as well as over 50
varieties of seed kits and a full line of accessory products through multiple
channels including retail, catalogue, and direct-to-consumer sales in the United
States as well as selected countries in Europe, Asia, and in
Australia.




Our
Critical Accounting Policies





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 Accounting Research Bulletin No. 43, Chapter 4, “Inventory
Pricing.”  A majority of the Company’s products are manufactured
overseas and are recorded at cost.





The
Company determines an 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, 2008, the Company determined that an
inventory obsolescence reserve totaling $174,545 was required.  As of
March 31, 2008, the Company determined that no inventory obsolescence reserve
was required.





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.  Accordingly, the Company did not record $430 and
$782,624 of revenue as of December 31, 2008 and December 31, 2007, respectively,
related to the unpaid balance due for direct-to-consumer sales because the
consumer has 36 days to evaluate the product, and is required to pay only the
shipping and handling costs before making the required installment payments
after the expiration of the 36-day trial period.  The Company also, as
of December 31, 2008 and December 31, 2007, did not record $131 and $237,083,
respectively, of production costs associated with the foregoing revenue because
the consumer is required to return unpurchased product at the end of the trial
period, enabling the Company to recover the production costs through resale of
the returned goods.





Additionally,
the Company did not record $475,112 and $551,420 of revenue as of December 31,
2008 and December 31, 2007, respectively, related to the wholesale sales value
of inventory held by its retail shopping channel customers because these sales
are contingent upon the shopping channels selling the goods. Deferred payments
for these goods are charged to customer deposits.  The Company also
deferred, as of December 31, 2008 and December 31, 2007, recognition of $196,395
and $300,153, respectively, of product and freight costs associated with these
wholesale sales, which have been included in
inventory.


The
Company records estimated reductions to revenue for customer and distributor
programs and incentive offerings, including promotions, rebates, and other
volume-based incentives. 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, 2008 and December 31, 2007, the
Company had accrued $698,130 and $684,511 respectively, as its estimate for the
foregoing deductions and allowances.





12
 Table of Contents




The
Company reserves for known and potential returns from customers.  The
calculation of refunds or credits for customer returns is based upon historical
experience.  In certain cases, wholesale customers are provided a
fixed allowance, usually in the 1% to 2% range, to cover product returns that
they may experience from their customers.  As of December 31, 2008 and
December 31, 2007, the Company has recorded a reserve for customer returns of
$302,401, and $424,036 respectively.  In addition, as of December 31,
2008, the Company accrued $1,725,213 in accrued expenses for possible returns
and markdown associated with several large retail accounts.




Advertising
and Production Costs


The
Company records costs related to its direct response advertisements, including
postage and printing costs incurred in conjunction with mailing direct response
catalogues, and related costs, in accordance with the Statement of Position
(“SOP”) No. 93-7, “Reporting on Advertising Costs.” SOP No. 93-7 stipulates that
direct response 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.  The costs related to other forms of general advertising are
expensed at the time the advertising is first run in accordance with SOP No.
93-7.  As of December 31, 2008 and December 31, 2007, the Company had
deferred $359,665 and $493,086, respectively, related to such media costs.
Advertising expenses for the three and nine months ended December 31, 2008 were
$2,094,269 and $3,911,012 respectively, and for the three and nine months ended
December 31, 2007 were $2,788,834 and $5,528,558, respectively.





Warranty
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.  Based upon the foregoing,
the Company has recorded as of December 31, 2008 and December 31, 2007 a
provision for potential future warranty costs of $52,932 and $58,981,
respectively.




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
customers are included in sales.




Equity
Compensation Plans


In
December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
123R, “Share-Based Payment.” 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 described in such statement and
recognition of the resulting compensation expense in the Company’s financial
statements.  Prior to January 1, 2006, the Company accounted for
employee stock options using the intrinsic value method under Accounting
Principles Board No. 25, “Accounting for Stock Issued to Employees,” and related
interpretations, which generally results in no employee stock option
expense.  Option expense is determined as of the grant date, which is
when the parties to an option agreement reach a mutual understanding of the key
terms and conditions relating to the grant.  In the event the option
agreement requires subsequent approval by the Company’s stockholders, the
options are not deemed to be granted until such time as the option agreement
receives stockholder approval, in accordance with the provisions of SFAS No.
123R.  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.





Fair
Value


The
Company adopted SFAS No. 157, “Fair Value Measurements,” for financial assets
and liabilities, which provides a single definition of fair value, establishes a
framework for the measurement of fair value, and expands disclosure about the
use of fair value to measure assets and liabilities. In February 2007, the FASB
issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities—Including an Amendment of FASB Statement 157.” The Company adopted
SFAS No. 159 beginning April 1, 2008.  The adoption of SFAS No. 157
and SFAS No. 159 for financial assets and liabilities did not have a material
impact on the Company’s financial statements as of December 31,
2008.






13
 Table of Contents




Results
of Operations





Three
Months Ended December 31, 2008 and December 31, 2007





For the
three months ended December 31, 2008, our sales totaled $11,010,885, a 24.8%
decrease from the same period in 2007.  The revenue decline reflected
a 38.7% decrease in sales to retailer customers and a 4.7% decrease in
direct-to-consumer sales, partially offset by a 44.8% increase in sales to
international distributors.  Macroeconomic factors and changes in
retailer buying patterns caused shipments into the retail channel to decline by
approximately 19%, despite an overall 64% increase in consumer purchases of
AeroGarden units from our top 11 retailer customers that provide us with their
sales data.  Compounding the decline in shipments to retailers was the
impact of approximately $1.84 million in gross sales allowances we recognized in
the three months ended December 31, 2008, the result of discounting programs in
the 2008 holiday period and estimates of the impact of similar programs in the
future.  The decline in direct-to-consumer sales reflected a reduction
in the number of airings of our direct response infomercials during the three
months ending December 31, partially offset by the impact of increased catalogue
operations and web marketing activity.  We began selling to
distributors outside of North America in late 2007, so the increase in
international sales during the three months ended December 31, 2008 primarily
reflects our initial penetration into new markets in Europe, Asia, and
Australia.


The gross
margin for the three months ended December 31, 2008, was 31.4%, down from 38.9%
for the same period in 2007 because of the impact on sales of the $1.84 million
in sales allowances, and because of a $174,545 inventory reserve established
during the three months ended December 31, 2008.  Excluding these
items, the gross margin for the three months ended December 31, 2008 would have
increased by approximately 4 percentage points, reflecting improvements in
product and distribution costs, and an increase in direct-to-consumer sales as a
percentage of total sales, which have higher margins than sales to retailers and
international distributors.





Operating
expenses other than cost of revenue totaled $7.4 million during the three months
ended December 31, 2008, an increase of $294,224, or 4.1%, from the same period
in 2007.  The higher costs in 2008 include a $362,701 increase in
non-cash stock option expense, reflecting a cumulative expense catch up related
to the October 1, 2008 approval by our stockholders of changes to the 2005
Plan.  In addition, we recognized $264,059 in severance charges
incurred as a result of a 35% reduction in our workforce in mid-December
2008.  These increased costs were partially offset by reductions in
sales and marketing costs, including advertising and sales commissions, and
reduced spending on general and administrative expenses.





For the
three months ended December 31, 2008, our net loss totaled $4,402,222, as
compared to the $1,655,887 net loss reported for the three months ended December
31, 2007.





The
following table sets forth, as a percentage of sales, our financial results for
the three months ended December 31, 2008, and the three months ended December
31, 2007:





Three
      Months Ended December 31,2008
                                                            
                                                            
                                                            2007RevenueProduct
      sales - retail, net
                                                            
                                                            
                                                            51.1
                                                            %
                                                            
                                                            
                                                            62.6
                                                            %Product
      sales - direct to consumer, net
                                                            
                                                            
                                                            44.2
                                                            %
                                                            
                                                            
                                                            34.9
                                                            %Product
      sales – international, net
                                                            
                                                            
                                                            4.7
                                                            %
                                                            
                                                            
                                                            2.5
                                                            %Total
      sales
                                                            
                                                            
                                                            100.0
                                                            %
                                                            
                                                            
                                                            100.0
                                                            %Operating expensesCost
      of revenue
                                                            
                                                            
                                                            68.6
                                                            %
                                                            
                                                            
                                                            61.1
                                                            %Research
      and development
                                                            
                                                            
                                                            6.4
                                                            %
                                                            
                                                            
                                                            4.7
                                                            %Sales
      and marketing
                                                            
                                                            
                                                            42.7
                                                            %
                                                            
                                                            
                                                            34.1
                                                            %General
      and administrative
                                                            
                                                            
                                                            18.5
                                                            %
                                                            
                                                            
                                                            10.1
                                                            %Total
      operating expenses
                                                            
                                                            
                                                            136.2
                                                            %
                                                            
                                                            
                                                            110.0
                                                            %Profit/(loss)
      from operations
                                                            
                                                            
                                                            (36.2
                                                            )%
                                                            
                                                            
                                                            (10.0
                                                            )%








14
 Table of Contents





Three
      Months Ended December 31,Product Revenue
                                  
                                  2008
                                  
                                  
                                  2007Retail,
      net
                                  
                                  $
                                  5,621,688
                                  
                                  
                                  $
                                  9,168,337Direct-to-consumer,
      net
                                  
                                  
                                  4,867,808
                                  
                                  
                                  
                                  5,109,405International,
    net
                                  
                                  
                                  521,389
                                  
                                  
                                  
                                  360,000Total
                                  
                                  $
                                  11,010,885
                                  
                                  
                                  $
                                  14,637,742





For the
three months ended December 31, 2008, and December 31, 2007, revenue totaled
$11,010,885 and $14,637,742 respectively, a decrease year-over-year during the
same period of 24.8%.





The
decrease in revenue during the three months ended December 31, 2008 came
primarily from sales to retailer customers that totaled $5,621,688, a decrease
of 38.7%, or $3,546,649, from the same period in 2007.  Retailer
customers include traditional brick and mortar retailers, online e-tailers,
television shopping channels, and catalogue merchants.  The decline in
sales to retailers reflected the sharp deterioration in the macroeconomic
environment during the three months ended December 31, 2008 as evidenced by the
global credit crisis, deepening recession, and the consequent impact on consumer
spending during the holiday shopping season.  This combination of
factors caused retailers to be more conservative in their purchasing decisions
than a year ago, reducing the wholesale demand for our products, despite a 64%
year-over-year increase in AeroGarden units sold to consumers by our top 11
retailers that provide us with their sales data, during the three months ended
December 31, 2008. The decline in AeroGrow net sales to retailer customers was
further exacerbated by the impact of approximately $795,000 in markdown
allowances provided to retailers during the holiday season to share in the cost
of store level discounting, and by an estimated impact of approximately
$1,046,000 in reserves recognized in anticipation of future markdown allowances
and potential product returns from certain retailers in future
periods.  These actions were taken in recognition of the unusual
environment currently facing the retail industry and were designed to assist our
customers in increasing sales of AeroGardens, reduce their stocking levels of
inventory, and strengthening our partnership with key retailer
customers.  Excluding the impact of these actions from the three
months ended December 31, 2008, results in an adjusted retailer revenue decline
of approximately 19% from the same period in 2007.





As of
December 31, 2008, our products were being sold in over 9,000 traditional “brick
and mortar” storefronts, as compared to approximately 4,300 as of December 31,
2007.  As of September 30, 2008, AeroGrow products were being sold
through approximately the same number of storefronts as at December 31,
2008.  Because of the impact of non-“brick and mortar” retailers,
which do not have storefronts, on our retail sales, we do not believe “sales per
store” is a meaningful metric for assessing our retail
business.  However, because of the impact of the deteriorating economy
following the high load-in level of shipments to retailers in the three months
ended September 30, 2008, we did experience a decline in order rates from our
key customers during the three months ended December 31, 2008.
 
 We did
not record $475,112 of revenue as of December 31, 2008, related to the wholesale
sales value of inventory held by our retail shopping channel customers because
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, 2008,
recognition of $196,395 of product and freight costs associated with such sales,
which have been included in inventory.





For the
three months ended December 31, 2008, our total direct-to-consumer sales totaled
$4,867,808, a decrease of $241,597, or 4.7%, from the same period in
2007.  The lower sales during the three months ended December 31, 2008
reflect a reduction in the number of television infomercial airings relative to
the same period in 2007, partially offset by the impact of an expanded direct
catalogue business (over 1.4 million catalogues mailed during the three months
ended December 31, 2008, up from 561,000 during the same period in 2007), and
increased online marketing activity.





From time
to time, 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
(“Trial Sales”).  We do not recognize the revenue from Trial Sales
until the expiration of the trial period.  Accordingly, we did not
record $430 of revenue from Trial Sales as of December 31, 2008. We also
deferred, as of December 31, 2008, recognition of $131 of production costs
associated with Trial Sales because the customers are required to return
unpurchased product at the end of the trial period, enabling us to recover these
costs through resale of the returned goods.  All costs associated with
the acquisition of Trial Sales, including media, telemarketing, order
processing, fulfillment, and outbound freight were expensed as incurred during
the quarter.






15
 Table of Contents




Our
products consist of AeroGardens as well as seed kits and accessories, which
represent recurring revenue related to AeroGardens sold.  A summary of
the sales of these two product categories for the three months ended December
31, 2008 and December 31, 2007 is as follows:





Three
      Months Ended December 31,2008
                            
                            
                            2007Product RevenueAeroGardens
                            
                            $
                            8,683,670
                            
                            
                            $
                            12,145,733Seed
      kits and accessories
                            
                            
                            2,327,215
                            
                            
                            
                            2,492,009Total
                            
                            $
                            11,010,885
                            
                            
                            $
                            14,637,742% of Total RevenueAeroGardens
                            
                            
                            78.9
                            %
                            
                            
                            83.0
                            %Seed
      kits and accessories
                            
                            
                            21.1
                            %
                            
                            
                            17.0
                            %Total
                            
                            
                            100.0
                            %
                            
                            
                            100.0
                            %





Sales of
AeroGardens during the three months ended December 31, 2008, totaled $8,683,670,
a decrease of 28.5% from the same period in 2007.  The decline was
caused by the impact of factors discussed above including the macroeconomic
environment, markdown and return allowances, and more conservative retailer
purchasing practices.  In addition, initial stocking shipments were
made for new accounts during the three months ended December 31, 2007 while
stocking shipments during the same period in 2008 were made primarily during the
three months ended September 30, 2008.  Seed kits and accessories
sales for the three months ended December 31, 2008 of $2,327,215 decreased 6.6%
from the same period in 2007.  The lower rate of decline in these
recurring sales relative to garden sales reflected the impact of the increased
installed base of gardens (approximately 746,000 sold since the Company’s
inception).  Through December 31, 2008, cumulative seed kits sold
totaled 1,631,067.





Cost of
revenue for the three months ended December 31, 2008 and December 31, 2007
totaled $7,558,322 and $8,938,857, respectively, representing a same period
decrease of 15.4%.  Cost of revenue includes 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.  As a percent of total net revenue, these costs increased
7.6 percentage points to 68.6% for the three months ended December 31, 2008 from
61.1% a year earlier.  Reported cost of revenue as a percent of net
revenue was adversely impacted by the effect of markdown and return allowances
that reduced net revenue, as well as by the establishment of a $174,545
inventory reserve during the three months ended December 31,
2008.  Excluding the impact of these items for the three months ended
December 31, 2008, cost of revenue as a percent of adjusted net revenue totaled
approximately 57%, a reduction of approximately 4 percentage points from the
same period in 2007.  This adjusted decline reflected the impact of
several factors including lower manufactured product costs, and reductions in
freight out, warehousing and handling costs afforded by the company-owned
distribution operation in Indianapolis, Indiana that was opened in July
2008.  In addition, an increase in the percentage mix of higher margin
direct-to-consumer sales during the three months ended December 31, 2008 had the
impact of reducing the overall cost of revenue as a percent of
sales.





The
dollar amount of cost of revenue decreased primarily as a result of the decrease
in adjusted revenue discussed above and the cost savings associated with
improved purchasing, distribution logistics, and manufacturing
efficiencies.  These decreases were partially offset by the impact of
the inventory reserve established as of December 31, 2008.





As a
result of these impacts, the gross margin for the three months ended December
31, 2008, was 31.4%, down from 38.9% for the three months ended December 31,
2007.





Sales and
marketing costs for the three months ended December 31, 2008 totaled $4,704,912,
as compared to $4,997,801 for the three months ended December 31, 2007, a
decrease of 5.9% or $292,889.  Sales and marketing costs include all
costs associated with the marketing, sales, operations, customer support, and
sales order processing for our products and consist of the
following:





Three
      Months Ended December 31,2008
                        
                        
                        2007Advertising
                        
                        $
                        2,094,269
                        
                        
                        $
                        2,788,834Personnel
                        
                        
                        974,178
                        
                        
                        
                        1,011,499Sales
      commissions
                        
                        
                        205,455
                        
                        
                        
                        455,758Trade
      shows
                        
                        
                        489
                        
                        
                        
                        88,095All
      other
                        
                        
                        1,430,521
                        
                        
                        
                        653,615$
                        4,704,912
                        
                        
                        $
                        4,997,801






16
 Table of Contents


Advertising
is principally comprised of the costs of developing and airing our infomercials
and short-form television commercials, the costs of development, production,
printing, and postage for our catalogues, and mailing and web media costs for
search and affiliate web marketing programs.  Each of these are key
components of our integrated marketing strategy because they help build
awareness of, and consumer demand for, our products, for all our channels of
distribution, in addition to generating direct-to-consumer
sales.  Advertising expense totaled $2,094,269 for the three months
ended December 31, 2008, down 24.9% from the same period in 2007, reflecting
fewer airings of our short form and long form television advertisements,
partially offset by higher television production costs and higher print media
costs reflecting the increase in the number of catalogues printed and mailed
during the quarter.





Sales and
marketing personnel costs shown above consist of salaries, payroll taxes,
employee benefits, and other payroll costs for our sales, operations, customer
service, graphics, and marketing departments.  For the three months
ended December 31, 2008, personnel costs for sales and marketing were $974,178
as compared to $1,011,499 for the three months ended December 31, 2007, a
decrease of 3.7%.  The decrease in 2008 reflects lower headcount,
principally in our customer service department, partially offset by higher
headcount in our operations department which opened and staffed a new
distribution center in Indianapolis, Indiana in July 2008.  In
mid-December 2008, we implemented staff reductions totaling approximately 35% of
our workforce, with significant reductions coming in our customer service and
marketing-related departments.  As a result, the sales and marketing
expense for the three months ended December 31, 2008, includes the impact of
severance expense totaling $101,788, including the impact of eliminating the
Chief Marketing Officer position.





Sales
commissions, ranging from 2.5% to 7% of collections from our retailer customers,
are paid to sales representative organizations that assist us in developing and
maintaining our relationships with retailers.  As compared to the same
period in 2007, sales commissions decreased 54.9%, principally reflecting the
decrease in sales to retailers during the three months ended December 31, 2008,
discussed above.





General
and administrative costs for the three months ended December 31, 2008 totaled
$2,037,797 as compared to $1,471,364 for the three months ended December 31,
2007, an increase of 38.5%, or $566,433.  The increase reflects a
combination of factors including a total increase in non-cash compensation
expense of $332,548, as stockholder approval of amendments to our 2005 Plan on
October 1, 2008 caused us to recognize $220,711 in expense for previous vested
options during the three months ended December 31, 2008.  We also
incurred severance of $162,271 upon the departure of our former CEO and vice
president of human resources during the 2008 period.  Depreciation and
amortization increased $87,399 in the three months ended December 31, 2008
relative to the same period in 2007.  In addition, bank fees and legal
charges related to our debt facilities were approximately $163,000 higher during
the 2008 period relative to the three months ended December 31,
2007.


Research
and development costs for the three months ended December 31, 2008 totaled
$703,133, an increase of 3.0%, or $20,680, from the three months ended December
31, 2007.





Our loss
from operations for the three months ended December 31, 2008 was $3,993,279 as
compared to an operating loss of $1,452,733 for the three months ended December
31, 2007, an increase in the loss of $2,540,546.





Other
income and expense for the three months ended December 31, 2008 totaled to a net
expense of $408,943, up 101.3%, or $205,789 from the net expense of $203,154
recorded for the three months ended December 31, 2007.  The increase
reflected a higher average level of interest bearing debt outstanding and new
capital leases entered into subsequent to December 31, 2007, combined with a
lower average level of interest-bearing cash equivalents during the
quarter.





The net
loss for the three months ended December 31, 2008 totaled $4,402,222, a
$2,746,335 increase from the $1,655,887 loss reported a year
earlier.





Nine
Months Ended December 31, 2008 and December 31, 2007





For the
nine months ended December 31, 2008, sales increased 16.1% to $31,585,896 from
$27,199,821 for the nine months ended December 31, 2007.  Sales in all
channels of distribution contributed to the increase as sales to retailers rose
8.9%, direct-to-consumer sales increased 10.1%, and international sales
increased to over $2.2 million from $360,000 in the year earlier
period.





The gross
margin decreased in the 2008 period relative to 2007, to 39.0% from
40.1%.  The decline came despite improvements in many components of
cost of revenue, including product and distribution costs, and a mix shift in
our domestic operations to higher margin direct-to-consumer and seed kit
sales.  These were more than offset by the impact of sales allowances
and inventory reserves recognized during the quarter ended December 31, 2008,
and the impact of the increase in our international sales to distributors, which
carry a lower margin, and which accounted for 7.1% of total sales for the nine
months ended December 31, 2008, up from 1.3% in the year earlier
period.





Operating
expenses, other than cost of revenue, totaled $18,334,472 and were up 10.4% on a
year-over-year basis.  As a percent of revenue, these expenses
decreased to 58.1% of revenue from 61.1% a year earlier.  The dollar
increase principally reflects growth in general and administrative expense
related to the scale of our business, as well as severance expense totaling
approximately $464,000, and approximately $334,000 in higher depreciation and
amortization expense.


The net
loss for the nine months ended December 31, 2008 totaled $6,801,201, as compared
to a net loss of $6,017,879.




17
 Table of Contents




The
following table sets forth, as a percentage of sales, our financial results for
the nine months ended December 31, 2008 and the nine months ended December 31,
2007:




Nine
      Months Ended
                                          December
      31,2008
                                        
                                        
                                        2007RevenueProduct
      sales - retail, net
                                        
                                        
                                        62.6
                                        %
                                        
                                        
                                        66.7
                                        %Product
      sales – direct-to-consumer, net
                                        
                                        
                                        30.3
                                        %
                                        
                                        
                                        32.0
                                        %Product
      sales – international, net
                                        
                                        
                                        7.1
                                        %
                                        
                                        
                                        1.3
                                        %Total
      sales
                                        
                                        
                                        100.0
                                        %
                                        
                                        
                                        100.0
                                        %Operating expensesCost
      of revenue
                                        
                                        
                                        61.0
                                        %
                                        
                                        
                                        59.9
                                        %Research
      and development
                                        
                                        
                                        5.9
                                        %
                                        
                                        
                                        6.8
                                        %Sales
      and marketing
                                        
                                        
                                        34.9
                                        %
                                        
                                        
                                        40.8
                                        %General
      and administrative
                                        
                                        
                                        17.3
                                        %
                                        
                                        
                                        13.5
                                        %Total
      operating expenses
                                        
                                        
                                        119.1
                                        %
                                        
                                        
                                        121.0
                                        %Profit/(loss)
      from operations
                                        
                                        
                                        (19.1
                                        )%
                                        
                                        
                                        (21.0
                                        )%




Nine
      Months Ended
                            December
      31,Product Revenue
                          
                          2008
                          
                          
                          2007Retail, net
                          
                          $
                          19,772,293
                          
                          
                          $
                          18,148,237Direct-to-consumer,
      net
                          
                          
                          9,572,656
                          
                          
                          
                          8,691,584International,
    net
                          
                          
                          2,240,947
                          
                          
                          
                          360,000Total
                          
                          $
                          31,585,896
                          
                          
                          $
                          27,199,821




For the
nine months ended December 31, 2008 and December 31, 2007, revenue totaled
$31,585,896 and $27,199,821 respectively, an increase of 16.1%, or $4,386,075,
from the same period in 2007.





The same
period increase in revenue reflects growth in all of our channels of
distribution.  Retail sales increased 8.9% because of an increase in
the number of stores carrying our products, a greater average number of products
being carried per store, and large initial stocking orders shipped to major
retail chains in the three months ending September 30, 2008.  These
increases were partially offset by the impact of lower sales in our fiscal first
quarter ended June 30, 2008, caused by the timing of the transition by some of
our retailer customers to our new products, and by lower sales in our fiscal
third quarter ended December 31, 2008, caused by the deteriorating economy,
declines in consumer spending, and the impact of markdown and return
allowances.





Direct-to-consumer
sales also increased, by 10.1%, principally as a result of an increase in the
number of catalogues mailed to over 3.5 million in the nine months ended
December 31, 2008 from approximately 756,000 during the same period in 2007 and
increased online marketing activity, partially offset by a reduction in the
number of airings of our infomercial advertisements in the 2008
period.  International distribution of our products did not commence
until late 2007, therefore the majority of the year-over-year increase in sales
outside North America reflects the distribution penetration we have achieved
since that time in Europe, Asia, and Australia.





18
 Table of Contents





A summary
of the sales of AeroGardens and seed kits and accessories for the nine months
ended December 31, 2008 and December 31, 2007 is as follows:





Nine
      Months Ended
                                    December
      31,2008
                                  
                                  
                                  2007Product RevenueAeroGardens
                                  
                                  $
                                  24,945,346
                                  
                                  
                                  $
                                  22,605,871Seed
      kits and accessories
                                  
                                  
                                  6,640,550
                                  
                                  
                                  
                                  4,593,950Total
                                  
                                  $
                                  31,585,896
                                  
                                  
                                  $
                                  27,199,821% of Total RevenueAeroGardens
                                  
                                  
                                  79.0
                                  %
                                  
                                  
                                  83.1
                                  %Seed
      kits and accessories
                                  
                                  
                                  21.0
                                  %
                                  
                                  
                                  16.9
                                  %Total
                                  
                                  
                                  100.0
                                  %
                                  
                                  
                                  100.0
                                  %





AeroGarden
sales increased 10.3% year-over-year, reflecting the growth in all distribution
channels described above.  Seed kits and accessories increased by
44.5% on the strength of increased penetration in all distribution channels and
the impact of the increase in the cumulative installed base of
gardens.





Cost of
revenue for the nine months ended December 31, 2008 and December 31, 2007
totaled $19,271,470 and $16,286,651, an increase of 18.3%, principally resulting
from the increase in sales during the period.  As a percent of total
revenue, these costs increased by 1.1 percentage points to 61.0% for the nine
months ended December 31, 2008 from 59.9% a year earlier.  The
increase in cost as a percent of revenue reflects an increase in lower margin
sales to international distributors, the impact of markdown and returns
allowances on net revenue, and the inventory reserve established in the third
fiscal quarter of 2008, partially offset by cost reductions in the manufacturing
and distribution of our products and a mix impact of higher sales as a percent
of total into higher margin direct-to-consumer channels and into higher margin
seed kit sales.  As a result, the gross margin for the nine months
ended December 31, 2008 was 39.0%, as compared to 40.1% for the same period in
2007.




Sales and
marketing costs for the nine months ended December 31, 2008 totaled $11,030,524,
as compared to $11,089,338 for the nine months ended December 31, 2007, a
decrease of 0.5%.  The breakdown of sales and marketing costs for both
time periods is presented in the table below:





Nine
      Months Ended
                          December
      31,2008
                        
                        
                        2007Advertising
                        
                        $
                        3,911,012
                        
                        
                        $
                        5,528,558Personnel
                        
                        
                        3,122,773
                        
                        
                        
                        2,462,428Sales
      commissions
                        
                        
                        904,250
                        
                        
                        
                        876,215Trade
      shows
                        
                        
                        182,197
                        
                        
                        
                        286,691All
      other
                        
                        
                        2,910,292
                        
                        
                        
                        1,935,446$
                        11,030,524
                        
                        
                        $
                        11,089,338





Advertising
expense totaled $3,911,012 for the nine months ended December 31, 2008, a
decrease of 29.3% from the same period in 2007, reflecting reduced infomercial
production costs and television media costs, partially offset by an increase in
the costs related to our catalogue operations.





For the
nine months ended December 31, 2008, personnel costs for sales and marketing
totaled $3,122,773, an increase of 26.8% from the same period in
2007.  The increase was caused in part by higher average headcount in
our customer support operations, including sales management, sales support, and
customer service through most of the period.  In addition, staffing
for our new distribution center in Indianapolis, Indiana (opened in July 2008),
contributed to the overall increase in sales and marketing personnel
costs.  In mid-December 2008, we implemented staff reductions totaling
approximately 35% of our workforce, with significant reductions coming in our
customer service and marketing-related departments.  As a result of
this reduction, sales and marketing severance expense totaling $101,788 was
recognized in the quarter ending December 31, 2008.





19
 Table of Contents




Year-over-year,
sales commissions increased 3.2% to $904,250, reflecting the increase in sales
to retailers during the nine months ended December 31, 2008, as discussed above,
offset by a mix shift to larger retail chain customers for which sales
commissions are lower.





General
and administrative costs for the nine months ended December 31, 2008 totaled
$5,458,662 as compared to $3,679,397 for the nine months ended December 31,
2007, an increase of 48.4%.  The increase principally reflects
increases in executive and managerial headcount, facility costs, insurance
costs, and outside legal costs, as well as higher charges for depreciation and
amortization expense ($334,217 higher reflecting our increased scale of
operations), severance expense of $362,271 related to overall staff reductions,
including the departure of our former chief executive officer, chief financial
officer, and vice president of human resources, and $168,111 in increased
non-cash compensation expense.  Research and development costs for the
nine months ended December 31, 2008 totaled $1,845,326 against $1,840,441 for
the nine months ended December 31, 2007.





Our loss
from operations for the nine months ended December 31, 2008 was $6,020,046 as
compared to an operating loss of $5,696,006 for the nine months ended December
31, 2007.





Other
income and expense for the nine months ended December 31, 2008 and December 31,
2007 totaled net expense of $781,155 and $321,873, respectively.  The
142.7%, or $459,282 increase in 2008 reflected a higher average level of
interest bearing debt and capital leases outstanding, combined with a lower
average level of interest-bearing cash equivalents during the
quarter.





The net
loss for the nine months ended December 31, 2008 totaled $6,801,201 as compared
to a loss of $6,017,879 reported for the same period in 2007.





After
adjusting the net loss for non-cash items, including depreciation, amortization,
bad debt allowances and issuances of common stock and options under the 2005
Plan, the net cash loss for the nine months ended December 31, 2008 totaled
$5,774,708 as compared to a $5,167,118 net cash loss in the prior
year.  The $607,590 increase in the net cash loss resulted primarily
from the higher net loss in 2008.





Changes
in working capital accounts used cash of $1,986,675 during the nine months ended
December 31, 2008, reflecting increases in inventory and accounts receivable
balances, partially offset by increases in current liability accounts,
principally accounts payable.  We source the majority of our inventory
from Chinese manufacturers and therefore face production and delivery lead times
that average 60 to 90 days.  In order to be prepared to meet
anticipated fall and holiday demand for our products, we contracted to purchase
inventory in the quarter ended September 30, 2008.  As consumer demand
declined in response to the global credit crisis in October and November, we
reduced our orders for product from China to the extent possible, but because of
the long procurement lead times we face, were unable to effectively manage
inventory levels to the new lower demand expectations.  As a result,
inventory on hand at December 31, 2008 totaled $11,041,422, representing
approximately 157 days of sales activity at the average daily rate of sales
experienced during the nine months ended December 31, 2008.  Net
accounts receivable totaled $6,164,936 as of December 31, 2008, representing
approximately 53 days of sales activity at the average daily rate of sales
experienced during the nine months ended December 31, 2008.  Accounts
payable totaled $8,833,832 as of December 31, 2008, representing approximately
64 days of daily expense activity at the average daily rate of expenses
experienced during the nine months ended December 31,
2008.


Net cash
used by operating activities totaled $7,761,383 for the nine months ended
December 31, 2008, as compared to $10,443,487 in the year earlier
period.  The cash requirement in 2008 was funded by increases in net
borrowings under our debt facilities and capital leases of $8,733,977, a
reduction in our cash balances of $725,611, and proceeds from the exercise of
warrants and options to purchase our common stock totaling
$949,932.  Included in the latter amount is $873,289 in proceeds from
warrants exercised in November 2008, when the Company reset the exercise price
on 1,189,979 warrants, in accordance with the terms and conditions of the
warrants, from a range of $5.00 – $8.25 per share to a range of $0.66 – $0.75
per share in return for an agreement by the warrant holders to exercise the
warrants immediately.  In addition, the warrant holders were issued an
aggregate of 594,990 new warrants with an exercise price of $2.00 per share,
representing one-half new warrant for every existing warrant exercised at the
reset exercise price.





Liquidity
and Capital Resources




First
National Loan





On May
19, 2008, the Company and Jack J. Walker, one of the Company’s directors, acting
as co-borrowers, entered into a Business Loan Agreement with First National Bank
(the “Business Loan Agreement”) for a loan to the Company in the principal
amount of $1,000,000 (the “First National Loan”).  The Company has
agreed, among other things, that while the Business Loan Agreement is in effect,
the Company will not (without First National Bank's prior written consent): (i)
incur or assume indebtedness, except for trade debt in the ordinary course of
business, capital leases in an amount not to exceed $500,000, and capital
expenditures of not more than $500,000 during any fiscal year; (ii) sell,
transfer, mortgage, assign, pledge, lease, grant a security interest in, or
encumber any of the Company’s assets (except as specifically allowed), or
(iii) sell with recourse any of the Company’s accounts, except to First
National Bank. In the event of a default under the First National Loan, at First
National Bank's option, all indebtedness owed under the First National Loan will
become immediately due and payable.





Pursuant
to the Business Loan Agreement, the Company and Mr. Walker provided First
National Bank with a promissory note for a principal amount of up to $1,000,000
(the “First National Note”).  The First National Note has an initial
interest rate of 5.5% and matures on May 19, 2009. The First National Note
provides for monthly payments of interest only, with the balance of principal
and all accrued but unpaid interest due and payable on May 19,
2009.  The First National Note also provides for a minimum interest
charge of $250, but otherwise may be prepaid at any time without
penalty.  In the event of a default under the First National Note, the
interest rate will be increased by a margin of 4% over the current rate of
interest.  As of December 31, 2008, $998,062 was outstanding under the
First National Note, including accrued interest.





20
 Table of Contents




WLLC
Loan Agreement





On May
22, 2008, the Company also entered into a Loan Agreement (the “WLLC Loan
Agreement”) and associated Promissory Note with WLoans, LLC, a Colorado limited
liability company (“WLLC”), as lender, and Jack J. Walker.  The WLLC
Loan Agreement provides for a loan up to a maximum of $1,500,000 for business
purposes, at an annual interest rate of 12% (the “WLLC Loan”). Mr. Walker is the
manager of WLLC and owns a 73.3% membership interest in WLLC, with the remaining
membership interest owned by other officers and directors of the
Company.  As a condition of the WLLC Loan, the Company paid WLLC a
non-refundable commitment fee of $37,500. Further, in consideration of WLLC
holding available funds equal to the principal amount not yet disbursed, the
Company must pay a non-refundable fee of 1% of the retained funds as a holding
fee, payable quarterly.  If not paid sooner, the WLLC Loan, if drawn
upon, will be due and payable on April 1, 2009.  We granted WLLC a
security interest in all of the Company’s assets, subordinate to the security
interests in such assets granted to FCC and First National Bank (each as
described herein).  Further, in the event we receive any equity
financing, all obligations due under the WLLC Loan Agreement become immediately
due and payable.  In the event of any default under the WLLC Loan
Agreement, WLLC may, at its option, declare all amounts owed immediately due and
payable, foreclose on the security interest granted, and increase the annual
rate of interest to 18%.  As of December 31, 2008, loans totaling
$1,236,934 were outstanding under the WLLC Loan Agreement, including accrued
interest.





The WLLC
Loan Agreement also set forth the terms and conditions under which Mr. Walker
agreed to act as co-borrower on the First National Loan. In consideration for
Mr. Walker's agreement to act as co-borrower, the Company agreed to: (i) pay Mr.
Walker a service fee of $50,000; (ii) allow Mr. Walker to purchase the First
National Loan in the event of the Company’s default under the First National
Loan and to repay Mr. Walker any amounts expended by Mr. Walker on the First
National Loan, together with interest at an annual rate of 18%; and (iii)
terminate and release Mr. Walker from any obligation under the First National
Loan on the one-year anniversary of the execution date of the First National
Loan Agreement.





Revolving
Credit Facility





On June
23, 2008, the Company entered into a Loan and Security Agreement with FCC, LLC,
d/b/a First Capital (“FCC”) (the “FCC Loan Agreement”) for a revolving credit
facility in the amount of $12,000,000 (the “Revolving Credit
Facility”).  Mr. Walker provided a guarantee against certain
contingent liabilities related to the FCC Loan Agreement.  In return
for this guarantee, the Company paid Mr. Walker a fee of $7,500.





The
Revolving Credit Facility has an initial two-year term, with one-year renewals
thereafter.  Continued availability of the Revolving Credit Facility
is subject to the Company’s compliance with customary financial and reporting
covenants.  The purpose of the Revolving Credit Facility is to provide
additional working capital.  As collateral for the Revolving Credit
Facility, the Company granted to FCC a first priority security interest over all
of the Company’s assets, including, but not limited to, accounts receivable,
inventory, and equipment.  As of December 31, 2008, loans totaling
$6,587,951 were outstanding under the Revolving Credit Facility, including
accrued interest, and there was an estimated remaining availability of
approximately $600,000.  The amount available under the Revolving
Credit Facility varies from day-to-day, depending on the level of sales,
accounts receivable collections, and inventory on-hand
levels.


As of
June 30, 2008, the Company was not in compliance with two covenants under the
FCC Loan Agreement.  As of July 31, 2008, FCC and AeroGrow executed an
amendment to the FCC Loan Agreement (the “First FCC Amendment”).  The
First FCC Amendment re-set the covenant levels for June 30, 2008 and future
periods, thus waving the non-compliance as of June 30, 2008, under the old
covenants, temporarily reduced certain restrictions on the Company’s ability to
borrow against inventory, and increased the interest rate from Base Rate plus 2%
to the current rate of Base Rate plus 3.5%.  After the First FCC
Amendment, the Company was in compliance with the revised covenants as of June
30, 2008.





As of
September 30, 2008, the Company was not in compliance with two covenants under
the revised FCC Loan Agreement.  On October 24, 2008, FCC and the
Company executed a second amendment to the FCC Loan Agreement (the “Second FCC
Amendment”).  The Second FCC Amendment waived the covenant violations
as of September 30, 2008.  In addition, the Second FCC Amendment
changed the definition of Base Rate to be the higher of the prime rate or
one-month LIBOR + 2.75%, and adjusted the interest calculation under the FCC
Loan Agreement such that the interest rate resets monthly, rather than
daily.





As of
October 27, 2008, FCC and the Company executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory.





On
January 16, 2009, the Company and FCC executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory as of January 1, 2009.





As of
December 31, 2008, the Company was not in compliance with three covenants under
the revised FCC Loan Agreement.  Effective as of January 31, 2009, FCC
and the Company executed a forbearance agreement related to the FCC Loan
Agreement (the “Forbearance Agreement”).  Pursuant to the terms of the
Forbearance Agreement, FCC agreed to forbear its rights and remedies under the
FCC Loan Agreement and related documents with respect to any existing defaults
under the FCC Loan Agreement (the “Existing Defaults”) until the earlier of June
30, 2009, or the date of occurrence of a default other than the Existing
Defaults.  The Forbearance Agreement also increases the Company’s
ability to borrow against inventory and accounts receivable during the term of
the Forbearance Agreement (the “Additional Borrowing Capacity”).  In
return for FCC providing the forbearance period and the Additional Borrowing
Capacity, the Company agreed to pay FCC a $25,000 forbearance fee (in five
monthly installments), an amendment fee equal to 1.5% per month on the average
utilization of the Additional Borrowing Capacity, and issue to FCC a minimum of
250,000 warrants to purchase common stock of the Company at a purchase price of
$1.00 per share.  Simultaneously with the execution of the Forbearance
Agreement, Mr. Walker provided a $1 million guarantee against certain
liabilities under the FCC Loan Agreement.  As compensation for
providing the guarantee, the Company has agreed to issue Mr. Walker 50,000
warrants to purchase common stock of the Company at a purchase price of $1.00
per share.  In accordance with SFAS No. 78, the loans outstanding
under the FCC Loan Agreement are classified as current because the term of the
Forbearance Agreement does not exceed one year.





21
 Table of Contents




Cash
Requirements





In
addition to our contractual obligations through the balance of the fiscal year
for $206,144 of operating lease payments, $38,991 of capital lease payments, and
required debt service payments under our debt agreements, we will require cash
to:





·
            Fund
      our operations and working capital
requirements,


·
            Develop
      and execute our product development and market introduction
      plans,


·
            Execute
      our sales and marketing plans,


·
            Fund
      research and development efforts,
and


·
            Expand
      our international presence, particularly in Europe and
    Asia.





We expect
to partially fund these, and any other cash requirements, with cash provided by
operations, our $12 million Revolving Credit Facility, and other debt
facilities, as well as with existing cash at December 31, 2008, totaling
$1,266,180 (including cash that is currently restricted as collateral for a
letter of credit issued by First National Bank on behalf of the
Company).  At this time, given the impact of macroeconomic factors on
our business, we believe we will also need additional funding to successfully
operate our business over the near term.  As a result, we have engaged
an investment banker to assist us in exploring strategic alternatives to address
our funding requirements, with a goal of raising new long-term capital in a
range of $8 to $12 million.  In addition, we held a Special Meeting of
Stockholders on February 5, 2009, at which the stockholders approved an
amendment to the Company’s Articles of Incorporation that authorizes the
Company’s Board of Directors to approve the terms and conditions of preferred
stock issued by the Company (see Item 4. Submission of Matters to a Vote of
Security Holders).





We cannot
predict with certainty the cash and other ongoing operational requirements for
our proposed plans as market conditions, competitive pressures, regulatory
requirements, and customer requirements can change rapidly.  If we are
unable to generate cash from operations at currently estimated levels, or if our
access to new borrowings under our debt agreements is constrained, or if we
cannot raise additional capital, our ability to execute our operational plans
could be adversely impacted.





We do not
expect to enter into additional capital leases to finance major
purchases.  At present, we have no binding commitments with any third
parties to obtain any material amount of equity or debt financing other than the
financing arrangements described in this report.  However, given our
operating history, and our expectation of future growth, we have determined that
raising additional capital to support our operations is
necessary.  Therefore, with the assistance of our investment banker,
we are assessing opportunities to access additional capital, reviewing potential
strategic alternatives, and discussing our requirements with potential
investors.  The terms, conditions, and timing of any future
transactions have not been conclusively determined.





Assessment
of Future Liquidity and Results of Operations





Liquidity. To assess
our ability to fund ongoing operating requirements over the next 12 months, we
have developed assumptions regarding our business plan, projected operating cash
flow, anticipated capital expenditures, availability under our various existing
credit facilities, and our ability to secure additional
capital.  Critical sources of funding, and key assumptions
include:





·
            Our
      cash of $1,266,180 (including restricted cash) as of December 31,
      2008,


·
            The
      continued availability of funding from the Revolving Credit Facility and
      our other existing credit facilities.  As of December 31, 2008,
      there was approximately $600,000 in remaining availability under the
      Revolving Credit Facility.  The amount available under the
      Revolving Credit Facility varies from day-to-day, depending on the level
      of sales, accounts receivable collections, and inventory on-hand
      levels,


·
            The
      continued support of our suppliers,


·
            The
      successful completion of a transaction to raise $8 to $12 million in
      additional capital,


·
            Our
      anticipated sales to retail customers, international distributors, and
      consumers,


·
            The
      anticipated level of spending to support our planned initiatives,
      and


·
            Our
      expectations regarding cash flow from
  operations.





The
availability of borrowings under the Revolving Credit Facility is subject to
covenants and limitations that require us to maintain compliance with specified
operating and financial covenants.  Although our lender agreed to
forbear its rights and remedies with respect to our non-compliance with these
covenants at December 31, 2008, there can be no assurance that we will regain
compliance with these covenants over time, or that our lender will waive or
forbear its rights and remedies with respect to any future violations,
especially if our borrowings increase or our operating results are not
sufficient to cover our fixed financing payments.





22
 Table of Contents




Our
ability to meet our operating requirements also relies on raising additional
capital, as we believe that currently available cash and other sources of
liquidity are insufficient to adequately fund our operations for the next 12
months.  Through our financial intermediary we are discussing
strategic alternatives with potential investors.  However, given the
current state of the capital markets in general, and concerns regarding the
retail and consumer products sector in particular, there can be no assurance
that we will be able to raise additional capital in a sufficient amount or on a
timely enough basis to meet our operating requirements.  In the event
we are unable to raise new long-term capital, the Company’s existing sources of
liquidity may be sufficient to fund our operations, as currently structured and
based on the assumptions, qualifications and contingencies detailed above, for
approximately the next three to six months.  If faced with an
inability to raise new long-term capital, it is likely we would attempt to
restructure our business to reduce the capital resources required to support our
continued operations.  However, there can be no assurances that such
actions would be undertaken on a sufficiently timely basis, or would ultimately
be successful in re-sizing the Company’s operational requirements to the
available resources.


Results of Operations. 
There are several factors that could affect our future results of
operations.  These factors include, but are not limited to, the
following:





·
            Sell-through
      of our products by our retailer customers to consumers, and the consequent
      impact on expected re-orders from our retailer
  customers,


·
            Uncertainty
      regarding the impact of macroeconomic conditions on the retail market and
      on consumer spending,


·
            Uncertainty
      regarding the impact of macroeconomic conditions, particularly with regard
      to the capital markets, on our access to sufficient capital to support our
      current and projected scale of
operations,


·
            The
      effectiveness of our consumer-focused marketing efforts in generating both
      direct-to-consumer sales, and sales to consumers by our retailer
      customers, and


·
            Sufficient
      capacity to meet demand and a continued, uninterrupted supply of product
      from our third-party manufacturing suppliers in
  China.





Based on
the qualifications and contingencies presented above regarding liquidity, we
believe we can execute our operating plans.  However, the factors
noted above regarding results of operations could impact our expected financial
results, either positively or negatively.  As a result, we cannot be
certain that third-party financial forecasts will prove to be
accurate.





Off-Balance
Sheet Arrangements





We have
certain current commitments under capital leases and have not entered into any
contracts for financial derivative such as futures, swaps, and
options.  We do not believe that these arrangements are material to
our current or future financial condition, results of operations, liquidity,
capital resources or capital expenditures.


Item3.
Quantitative andQualitativeDisclosures About Market
Risk





Interest
Rate Risk




Our
interest income and expense is most sensitive to fluctuations in the general
level of U.S. dollar interest rates.  As such, changes in U.S. dollar
interest rates affect the interest we pay on our debt, the interest we earn on
our cash, and short-term investments, and the value of those
investments.  Due to the short-term nature of our cash and
investments, we have concluded that a change in interest rates does not pose a
material market risk to us with respect to our interest income.  The
interest payable under our various debt agreements is determined in part based
on the prime rate and LIBOR and, therefore, is affected by changes in market
interest rates. Interest rates on our capital leases are dependent on interest
rates in effect at the time the lease is drawn upon. Interest-bearing debt
outstanding at December 31, 2008 and capital leases totaled approximately
$9.0 million. Assuming this amount was outstanding throughout our fiscal
year, we would have a resulting decline in future annual earnings and cash flows
of approximately $90,000 for every 1% increase in borrowing
rates.  Our level of borrowings will fluctuate throughout the year in
line with the seasonality of our sales, profits, and cash flow.  As a
result, the amount of debt outstanding at any given time can be higher or lower
than the amount outstanding as of December 31, 2008.




Foreign
Currency Exchange Risk





We
transact business primarily in U.S. currency.  Although we purchase
our products in U.S. dollars, the prices charged by our Chinese factories are
predicated upon their costs for components, labor, and
overhead.  Therefore, changes in the valuation of the U.S. dollar in
relation to the Chinese currency may cause our manufacturers to raise prices of
our products, which could reduce our profit margins.




23
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Item4T.
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 of 1934, as amended (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 officer
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, 2008.




PART
II - OTHER INFORMATION





Item1. Legal Proceedings





None.





Item1A. Risk Factors





Except as
set forth below, there have been no material changes during the quarter ended
December 31, 2008, to the risk factors set forth in Part 1, Item 1A of our
Annual Report on Form 10-K for the year ended March 31, 2008.





Risks
Related to Our Capitalization


Recent
events in the global capital markets have generally had a significant impact on
the ability of borrowers to access loans, and issuers to access equity
capital.  While the Company’s access to such sources of funds have not
been impacted to date, there can be no guarantee that market conditions will not
impact the Company’s ability to secure the funds it requires to meet its current
operating needs, or to support its future business plans.





The
Company has engaged an investment banker to assist in assessing strategic
alternatives with a goal of raising $8 to $12 million of new long-term
capital.  As described in the “Liquidity and Capital Resources”
section, the Company believes this new capital is necessary to allow it to
successfully operate its business over the short-term, and to execute its
longer-term business plans.  In addition, the Company believes that
its currently available capital resources are insufficient to adequately fund
its operations for the next 12 months.





Item2. Unregistered Sales of Equity Securities and Use of
Proceeds





Between
November 17, 2008 and November 21, 2008, the Company agreed to reduce the per
share exercise prices of certain of its outstanding warrants to purchase shares
of its common stock from original exercise prices ranging from $5.00 to $8.25 to
reduced exercise prices ranging from $0.66 to $0.75 in connection with an
agreement by the holders of such warrants to immediately exercise such
warrants.  In connection with such warrant exercises, the Company
received $873,289 in cash proceeds and issued 1,189,979 shares of its common
stock.





In
connection with the warrant repricing and exercise of such warrants, the Company
issued replacement warrants to such warrant holders (the “Replacement
Warrants”), permitting the holder to purchase one share of the Company’s common
stock for every two shares that were purchased pursuant to the exercise of such
repriced warrants at an exercise price of $2.00 per share.  In total,
Replacement Warrants representing the right to purchase 594,990 shares of
Company’s common stock were issued, and the Replacement Warrants have
termination dates ranging from September 13, 2010 to September 4,
2014.






24
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The
shares of common stock issued upon exercise of the repriced warrants and the
issuance of the Replacement Warrants were done in reliance on Section 4(2) of
the Securities Act of 1933, as amended, and Rule 506 promulgated
thereunder.





Item3. Defaults Upon Senior Securities





None.





Item4. Submission of Matters to a Vote of Security
Holders




We held
our annual meeting of shareholders on October 1, 2008.   At the
meeting, the shareholders present in person or by proxy voted on the following
matters.




1.
            Shareholders
      approved an amendment to the 2005 Plan to authorize an additional
      2,000,000 shares for issuance (the “Additional
  Shares”).




Votes
      For
                    
                    
                    Votes
      Against
                    
                    
                    Votes
      Abstained
                    
                    
                    Broker
      Non-Votes3,513,261
                    
                    
                    
                    955,284
                    
                    
                    
                    45,364
                    
                    
                    
                    3,278,581




2.
            Shareholders
      ratified grants totaling 832,377 shares that were made contingent upon
      shareholder approval of the amendment authorizing the Additional
      Shares.




Votes
      For
                    
                    
                    Votes
      Against
                    
                    
                    Votes
      Abstained
                    
                    
                    Broker
      Non-Votes3,513,261
                    
                    
                    
                    955,284
                    
                    
                    
                    45,364
                    
                    
                    
                    3,278,581




3.
            Shareholders
      elected the six named below to our Board of Directors to hold office until
      the annual meeting of shareholders in 2009 and until their successors are
      elected and qualified.




Director
      Nominee
                      
                      Votes
      For
                      
                      
                      Votes
      WithheldJack
      J.  Walker
                      
                      
                      7,599,513
                      
                      
                      
                      192,977Jervis
      B.  Perkins
                      
                      
                      7,595,645
                      
                      
                      
                      196,845Linda
      Graebner
                      
                      
                      7,598,832
                      
                      
                      
                      193,658Peter
      A.  Michel
                      
                      
                      7,594,355
                      
                      
                      
                      198,135Suresh
      Kumar
                      
                      
                      7,594,842
                      
                      
                      
                      197,648Michael
      D.  Dingman, Jr.
                      
                      
                      7,594,665
                      
                      
                      
                      197,825




4.
              Shareholders
      ratified the appointment of Gordon, Hughes & Banks, LLP as it is
      independent auditors.1




Votes
      For
                    
                    
                    Votes
      Against
                    
                    
                    Votes
      Abstained7,544,487
                    
                    
                    
                    147,873
                    
                    
                    
                    100,130







25
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On
February 5, 2009, the Company held a Special Meeting of
Stockholders.  At the meeting, the stockholders present in person or
by proxy voted on the following matters.




1.
            Stockholders
      approved an amendment to our Articles of Incorporation giving our Board of
      Directors the authority to designate the rights and preferences of
      AeroGrow’s preferred stock.




Votes
      For
                  
                  
                  Votes
      Against
                  
                  
                  Votes
      Abstained6,449,229
                  
                  
                  
                  430,005
                  
                  
                  
                  70,689




Item 5. Other
Information





On August
11, 2008, the Company was notified by The Nasdaq Stock Market (“Nasdaq,” and the
staff of Nasdaq, the “Staff”) that it was not in compliance with Nasdaq
Marketplace Rule 4310(c)(3).  Marketplace Rule 4310(c)(3) requires
that the Company maintain either (i) stockholders’ equity of at least
$2,500,000, (ii) a market value of its listed securities of at least
$35,000,000, or (iii) net income from continuing operations of at least
$500,000 during the last fiscal year or two of the last three fiscal
years.  As reported in the Company’s Form 10-Q for the period ended
June 30, 2008, stockholders’ equity was approximately $1,648,300, and as of
August 8, 2008, the market value of the Company’s common stock was
$28,351,421.  The Company has not generated net income from operations
during any of the past three fiscal years.





The Staff
is reviewing the Company’s eligibility for continued listing on The Nasdaq
Capital Market.  To facilitate this review, the Staff requested that
the Company provide, on or before August 26, 2008, the Company’s specific plan
to achieve and sustain compliance with all Nasdaq listing requirements,
including the time frame for completion of the plan.  The Company
timely filed this plan with the Staff, and the Staff granted the Company an
extension of time until November 24, 2008 to regain compliance with Nasdaq
Marketplace Rule 4310(c)(3).





On
November 26, 2008, the Staff issued a Determination Letter informing the Company
that unless the Company requested an appeal of the Staff determination, trading
of the Company’s common stock would be suspended at the opening of business on
December 5, 2008, and a Form 25-NSE would be filed with the Securities and
Exchange Commission, which would remove the Company’s securities from listing
and registration on Nasdaq.  The Company requested an appeal of the
Staff determination on December 3, 2008, and participated in the subsequent
appeal hearing on January 8, 2009.  As of the date of this filing, the
determination of the appeals panel (the “Appeals Panel”) is still
pending.





If the
Appeals Panel determines that the Company has presented a definitive plan that
will likely enable it to achieve and sustain long-term compliance with the
Nasdaq listing requirements, it may grant the Company a temporary conditional
listing to enable the Company to regain compliance.  If the Appeals
Panel does not grant a temporary conditional listing, and the Company has not
regained compliance with the Nasdaq listing requirements, then the Company will
be notified that the Appeals Panel has determined to delist the Company's
securities and the Company’s securities will be suspended from trading on
Nasdaq, effective on the second business day after the decision is
issued.  The Company may appeal the Appeals Panel's decision to the
Nasdaq Listing Council (the “Listing Council”). The Listing Council may also
decide to call the decision of the Appeals Panel for review.  An
appeal to the Listing Council would not stay the Appeals Panel's decision or the
suspension of the trading of the company's shares pending a final determination
by the Listing Council.





As of
December 31, 2008, the Company was not in compliance with certain covenants
under the revised FCC Loan Agreement.  On February 9, 2009, FCC and
the Company executed a forbearance agreement related to the FCC Loan Agreement
(the “Forbearance Agreement”) effective as of January 31,
2009.  Pursuant to the terms of the Forbearance Agreement, FCC agreed
to forbear its rights and remedies under the FCC Loan Agreement and related
documents with respect to any existing defaults under the FCC Loan Agreement
(the “Existing Defaults”) until the earlier of June 30, 2009, or the date of
occurrence of a default other than the Existing Defaults.  The
Forbearance Agreement also increases the Company’s ability to borrow against
inventory and accounts receivable during the term of the Forbearance Agreement
(the “Additional Borrowing Capacity”).  In return for FCC providing
the forbearance period and the Additional Borrowing Capacity, the Company agreed
to pay FCC a $25,000 forbearance fee (in five monthly installments), an
amendment fee equal to 1.5% per month on the average utilization of the
Additional Borrowing Capacity, and issue to FCC a minimum of 250,000 warrants to
purchase common stock of the Company at a purchase price of $1.00 per
share.  Simultaneously with the execution of the Forbearance
Agreement, Mr. Walker provided a $1 million guarantee against certain
liabilities under the FCC Loan Agreement.  As compensation for
providing the guarantee, the Company will issue Mr. Walker 50,000 warrants to
purchase common stock of the Company at a purchase price of $1.00 per
share.  In accordance with SFAS No. 78, the loans outstanding under
the FCC Loan Agreement are classified as current because the term of the
Forbearance Agreement does not exceed one year.  A copy of the
Forbearance Agreement is attached as Exhibit 10.3 to this Form
10-Q.





26
 Table of Contents




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
            Certificate
      of Amendment to Articles of Incorporation (incorporated by reference to
      Exhibit A to our definitive proxy statement filed January 2,
      2009.3.7
            Amended
      and Restated Bylaws of the Company (incorporated by reference to Exhibit
      3.1 of our Current Report on Form 8-K, filed September 26,
      2008)10.1
            Second
      Amendment to Loan and Security Agreement between the Company and FCC, LLC
      d/b/a/ First Capital, dated October 24, 2008 (incorporated by
      referenced to Exhibit 10.1 of our Current Report on Form 8-K, filed
      October 30, 2008)10.2
            Temporary
      Amendment to Loan and Security Agreement between the Company and FCC, LLC
      d/b/a/ First Capital, dated October 27, 2008 (incorporated by
      referenced to Exhibit 10.2 of our Current Report on Form 8-K, filed
      October 30, 2008)10.3*
            Forbearance Agreement among the Company, FCC, LLC d/b/a/
      First Capital, and Jack J. Walker, effective January 31,
      200931.1*
            Certifications of the Chief Executive Officer Under
      Section 302 of the Sarbanes-Oxley Act31.2*
            Certifications of the Chief Financial Officer Under
      Section 302 of the Sarbanes-Oxley Act32.1*
            Certifications of the Chief Executive Officer Under
      Section 906 of the Sarbanes-Oxley Act32.2*
            Certifications of the Chief Financial Officer Under
      Section 906 of the Sarbanes-Oxley Act*
            Filed
      Herewith







27
 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
      12, 2009
                  
                  /s/ Jervis B.
      PerkinsBy:
      Jervis B. PerkinsIts:
      Chief Executive Officer (Principal Executive Officer) and
      DirectorDate:  February
      12, 2009
                  
                  /s/ H. MacGregor
      ClarkeBy:
      H. MacGregor ClarkeIts:
      Chief Financial Officer (Principal Financial Officer)Date: 
      February 12, 2009
                  
                  /s /Grey H.
      GibbsBy:
      Grey H. GibbsIts:
      Controller (Principal Accounting
Officer)







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