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 September 30, 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 October 31, 2008: 
12,152,068








Table of Contents







AeroGrowInternational, Inc.


TABLE
OF CONTENTS


FORM
10-Q REPORT


September
30, 2008




PagePART
      I   Financial InformationItem
      1.
            Condensed Financial
      Statements
            1Condensed Balance
      Sheets as of September 30, 2008 (Unaudited) and March 31,
      2008
            1Condensed
      Statements of Operations for the Three and Six Months Ended September 30,
      2008 and September 30, 2007 (Unaudited)
            2Condensed
      Statements of Cash Flows for the Six Months Ended September 30, 2008 and
      September 30, 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
            23PART
      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
            24Item
      4.
            Submission of
      Matters to a Vote of Security Holders
            25Item
      5.
            Other
      Information
            26Item
      6.
            Exhibits
            26Signatures
            27




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.  n 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 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 with respect to 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.  Therefore, the Company’s actual
results could differ materially and adversely from those expressed in any
forward-looking statements as a result of various factors.  Factors that
could cause or contribute to the differences are discussed in “Risk Factors” and
elsewhere in the Company’s Annual Report on Form 10-K for the period ended March
31, 2008, and filed on June 26, 2008 with the Securities and Exchange Commission
(the “SEC”) and the Form S-3/A filed with the SEC September 28, 2007. 
Except as required by applicable law or regulation, the Company undertakes no
obligation to revise or update any forward-looking statements contained in this
Quarterly Report.  The information contained in this Quarterly Report is
not a complete description of the Company’s business or the risks associated
with an investment in the Company’s common stock.  Each reader should
carefully review and consider the various disclosures made by the Company in
this Quarterly Report and in the Company’s other filings with the
SEC.





i
 Table of Contents





Item1.Condensed
Financial Statements







AEROGROW
INTERNATIONAL, INC.


CONDENSED
BALANCE SHEETS


(Unaudited)




September
      30,
            
            
            March
      31,2008
            
            
            2008ASSETSCurrent
      assetsCash
            
            $
            414,461
            
            
            $
            1,559,792Restricted
      cash
            
            
            431,413
            
            
            
            86,676Accounts
      receivable, net of allowance for doubtful accounts of $605,986 and
      $511,710 at
              September
      30, 2008 and March 31, 2008, respectively
            
            
            12,226,425
            
            
            
            2,412,101Other
      receivable
            
            
            201,617
            
            
            
            422,530Inventory
            
            
            10,392,701
            
            
            
            4,688,444Prepaid
      expenses and other
            
            
            1,052,339
            
            
            
            762,013Total
      current assets
            
            
            24,718,956
            
            
            
            9,931,556Property
      and equipment, net of accumulated depreciation of $1,229,412 and $816,804
      at September 30, 2008 and March 31, 2008,
      respectively
            
            
            2,002,120
            
            
            
            1,830,646Other
      assetsPrepaid
      debt issuance costs
            
            
            310,593
            
            
            
            -Intangible
      assets, net of $36,386 and $17,432 of accumulated amortization
      at September 30, 2008 and
      March 31, 2008, respectively
            
            
            209,106
            
            
            
            56,263Deposits
            
            
            101,164
            
            
            
            101,164Total
      Other assets
            
            
            620,863
            
            
            
            157,427Total
      Assets
            
            $
            27,341,939
            
            
            $
            11,919,629LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilitiesCurrent
      portion  - long-term debt
            
            $
            2,150,588
            
            
            $
            128,927Due
      to factor
            
            
            -
            
            
            
            1,480,150Accounts
      payable
            
            
            10,745,818
            
            
            
            3,023,366Accrued
      expenses
            
            
            3,424,919
            
            
            
            2,452,025Customer
      deposits
            
            
            189,161
            
            
            
            232,200Deferred
      rent
            
            
            44,525
            
            
            
            65,037Total
      current liabilities
            
            
            16,555,011
            
            
            
            7,381,705Long-term
      debt
            
            
            8,709,695
            
            
            
            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, 12,109,253 and
      12,076,717 shares
              issued
      and outstanding at September 30, 2008 and March 31, 2008,
      respectively
            
            
            12,109
            
            
            
            12,076Additional
      paid-in capital
            
            
            44,092,187
            
            
            
            44,024,559Accumulated
      (deficit)
            
            
            (42,027,063)
            
            
            
            (39,628,084)Total
      stockholders' equity
            
            
            2,077,233
            
            
            
            4,408,551Total
      Liabilities and Stockholders' Equity
            
            $
            27,341,939
            
            
            $
            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
              September 30,
            
            
            Six Months ended
              September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007RevenueProduct
      sales
            
            $
            13,854,930
            
            
            $
            6,283,645
            
            
            $
            20,575,011
            
            
            $
            12,562,079Operating
      expensesCost
      of revenue
            
            
            8,026,325
            
            
            
            3,765,376
            
            
            
            11,713,148
            
            
            
            7,347,794Research
      and development
            
            
            416,778
            
            
            
            628,542
            
            
            
            1,142,193
            
            
            
            1,157,987Sales
      and marketing
            
            
            2,875,729
            
            
            
            3,156,414
            
            
            
            6,325,612
            
            
            
            6,091,537General
      and administrative
            
            
            1,902,113
            
            
            
            982,181
            
            
            
            3,420,825
            
            
            
            2,208,033Total
      operating expenses
            
            
            13,220,945
            
            
            
            8,532,513
            
            
            
            22,601,778
            
            
            
            16,805,351Profit
      (loss) from operations
            
            
            633,985
            
            
            
            (2,248,868
            )
            
            
            (2,026,767
            )
            
            
            (4,243,272
            )Other
      (income) expense, netInterest
      (income)
            
            
            (454
            )
            
            
            (32,341
            )
            
            
            (1,504
            )
            
            
            (70,200
            )Interest
      expense
            
            
            216,069
            
            
            
            125,664
            
            
            
            373,716
            
            
            
            191,849Other
      income
            
            
            -
            
            
            
            (2,929
            )
            
            
            -
            
            
            
            (2,929
            )Total
      other (income) expense, net
            
            
            215,615
            
            
            
            90,394
            
            
            
            372,212
            
            
            
            118,720Net
      income (loss)
            
            $
            418,370
            
            
            $
            (2,339,262
            )
            
            $
            (2,398,979
            )
            
            $
            (4,361,992
            )Net
      income (loss) per share, basic
            
            $
            (0.03
            )
            
            $
            (0.20
            )
            
            $
            (0.20
            )
            
            $
            (0.39
            )Net
      income (loss) per share, diluted
            
            $
            (0.03
            )
            
            $
            (0.20
            )
            
            $
            (0.20
            )
            
            $
            (0.39
            )Weighted
      average number of common shares outstanding used to calculate basic net
      income per share
            
            
            12,121,858
            
            
            
            11,469,707
            
            
            
            12,108,177
            
            
            
            11,278,598Effect
      of dilutive securities:Equity
      based compensation
            
            
            254,698
            
            
            
            -
            
            
            
            -
            
            
            
            -Weighted
      average number of common shares outstanding used to calculate diluted net
      income per share
            
            
            12,376,556
            
            
            
            11,469,707
            
            
            
            12,108,177
            
            
            
            11,278,598







See
accompanying notes to the condensed financial statements.







2
 Table of Contents





AEROGROWINTERNATIONAL, INC.


CONDENSED
STATEMENTS OF CASH FLOWS


(Unaudited)





Six
      months ended September 30,2008
            
            
            2007Cash
      flows from operating activities:Net
      (loss)
            
            $
            (2,398,979)
            
            
            $
            (4,361,992)Adjustments
      to reconcile net (loss) to cash provided (used) by
    operations:Issuance
      of common stock and options under equity compensation
plans
            
            
            17,317
            
            
            
            246,414Issuance
      of warrants for services
            
            
            -
            
            
            
            23,003Depreciation
      and amortization expense
            
            
            431,563
            
            
            
            184,746Allowance
      for bad debt
            
            
            94,276
            
            
            
            1,908Amortization
      of debt issuance costs
            
            
            85,070
            
            
            
            -Change
      in assets and liabilities:(Increase)
      in accounts receivable
            
            
            (9,908,600)
            
            
            
            (2,990,342)Decrease
      in other receivable
            
            
            220,913
            
            
            
            1,772(Increase)
      in inventory
            
            
            (5,704,257)
            
            
            
            (2,539,777)(Increase)
      decrease in other current assets
            
            
            (312,461)
            
            
            
            65,361(Increase)
      in prepaid debt issuance costs
            
            
            (373,528)
            
            
            
            -(Increase)
      in deposits
            
            
            -
            
            
            
            (34,087)Increase
      in accounts payable
            
            
            7,722,452
            
            
            
            843,353Increase
      in accrued expenses
            
            
            972,894
            
            
            
            377,624Increase
      (decrease) in customer deposits
            
            
            (43,039)
            
            
            
            900,568Increase
      (decrease) in deferred rent
            
            
            (20,512)
            
            
            
            7,504Net
      cash (used) by operating activities
            
            
            (9,216,891)
            
            
            
            (7,273,945)Cash
      flows from investing activities:Increase
      in restricted cash
            
            
            (344,737)
            
            
            
            (1,349)Purchases
      of equipment
            
            
            (584,082)
            
            
            
            (273,417)Patent
      expenses
            
            
            (171,797)
            
            
            
            (14,438)Net
      cash (used) by investing activities
            
            
            (1,100,616)
            
            
            
            (289,204)Cash
      flows from financing activities:Increase
      (decrease) in amount due to factor
            
            
            (1,480,150
            )
            
            
            2,932,296Proceeds
      from long-term debt
            
            
            10,664,200
            
            
            
            -Proceeds
      from issuance of common stock, net
            
            
            -
            
            
            
            4,433,372Proceeds
      from exercise and issuance of warrants
            
            
            25,000
            
            
            
            890,937Proceeds
      from the exercise of stock options
            
            
            25,343
            
            
            
            9,503Principal
      payments on capital leases
            
            
            (62,217)
            
            
            
            (4,473)Net
      cash provided by financing activities
            
            
            9,172,176
            
            
            
            8,261,635Net
      (decrease) increase in cash
            
            
            (1,145,331)
            
            
            
            698,486Cash,
      beginning of period
            
            
            1,559,792
            
            
            
            5,495,501Cash,
      end of period
            
            $
            414,461
            
            
            $
            6,193,987







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 following
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.





2.
            Basis
      of Presentation





Interim Financial
Information




The
unaudited interim financial statements of the Company included herein have been
prepared in accordance with the rules and regulations of the Securities and
Exchange Commission (“SEC”) for interim reporting, including the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X.  These condensed
statements do not include all disclosures required by accounting principles
generally accepted in the United States of America (“U.S.  GAAP”) for
annual audited financial statements and should be read in conjunction with the
Company’s audited consolidated financial statements and related notes included
in the Company’s Annual Report on Form 10-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 September 30, 2008, the
results of operations for the three and six months ended September 30, 2008 and
2007, and the cash flows for the six months ended September 30, 2008 and
2007.  The results of operations for the three and six months ended
September 30, 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.





Use of
Estimates




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





Net Income (Loss) per Share
of Common Stock




The
Company computes net 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 stock shareholders divided by the weighted average shares of common stock
outstanding for the period.  Diluted EPS is similar to basic EPS but
presents the dilutive effect on a per share basis of potential common stock
(e.g., convertible securities, options, and warrants) as if they had been
converted at the beginning of the periods presented.  Potential shares of
common stock that have an anti-dilutive effect (i.e., those that increase profit
per share or decrease loss per share) are excluded from the calculation of
diluted EPS.




4
 Table of Contents





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.  The amounts on deposit with
financial institutions exceed the federally insured limit as of September 30,
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 and cash equivalents, accounts receivable, and
accounts payable.  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 September 30, 2008, the Company
had three customers who represented 17.5%, 11.4% and 10.3% of the Company’s net
product sales.  For the three months ended September 30, 2007, the
Company had two customers who represented 24.0% and 17.8% of net product
sales.  For the six months ended September 30, 2008, the Company had
one customer who represented 13.7% of net product sales.  For the six
months ended September 30, 2007, the Company had one customer who represented
12.0% of net product sales.





Suppliers:




For the
three months ended September 30, 2008, the Company purchased inventories and
other inventory-related items from three suppliers totaling $5,068,874,
$2,119,490, and $2,052,164.  For the three months ended September 30,
2007, the Company purchased inventories and other inventory-related items from
two suppliers totaling $2,240,978 and $1,382,769.  For the six months
ended September 30, 2008, the Company purchased inventories and other inventory
related items from three suppliers totaling $6,065,355, $2,738,592 and
$2,386,644.  For the six months ended September 30, 2007, the Company
purchased inventories and other inventory related items from two vendors
totaling $3,287,599 and $2,062,819.  Although the Company believes
alternate sources of manufacturing could be obtained, loss of any of these three
suppliers 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.





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.




September
      30,
            
            
            March
      31,2008
            
            
            2008Finished
      goods
            
            $
            8,525,260
            
            
            $
            3,669,693Raw
      materials
            
            
            1,867,441
            
            
            
            1,018,751$
            10,392,701
            
            
            $
            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 September 30, 2008, and March 31, 2008, the
Company determined that no inventory obsolescence reserve was
required.






5
 Table of Contents




Revenue
Recognition




The
Company recognizes revenue from product sales, net of estimated returns, when
persuasive evidence of a sale exists: that is, a product is shipped under an
agreement with a customer; risk of loss and title has passed to the customer;
the fee is fixed or determinable; and collection of the resulting receivable is
reasonably assured.  Accordingly, the Company did not record $5,409 and
$280,493 of revenue as of September 30, 2008 and September 30, 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 September 30, 2008 and September 30, 2007, did not record $1,637 and
$84,507, 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.  The liability for sales returns is estimated
based upon historical experience of return levels.





Additionally,
the Company did not record $189,161 and $883,632 of revenue as of September 30,
2008 and September 30, 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 September 30, 2008 and September 30, 2007, recognition of
$91,000 and $510,462, 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 September 30, 2008 and September 30, 2007, the
Company had accrued $858,898 and $372,788 respectively, as its estimate for the
foregoing deductions and allowances.





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 September 30, 2008 and September 30, 2007, the
Company had deferred $481,526 and $0, respectively, related to such media
costs.  Advertising expenses for the three and six months ended September
30, 2008 and September 30, 2007 were $330,859 and $1,816,743, respectively, and
for the three and six months ended September 30, 2007 were $1,372,513 and
$2,739,724, respectively.





Warranty and Return
Reserves




The
Company records warranty liabilities at the time of sale for the estimated costs
that may be incurred under its basic warranty program.  The specific
warranty terms and conditions vary depending upon the product sold but generally
include technical support, repair parts, and labor for periods up to one
year.  Factors that affect the Company’s warranty liability include the
number of installed units currently under warranty, historical and anticipated
rates of warranty claims on those units, and cost per claim to satisfy the
Company’s warranty obligation.  Based upon the foregoing, the Company
has recorded as of September 30, 2008 and September 30, 2007 a provision for
potential future warranty costs of $74,484 and $49,424,
respectively.





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, customers are provided a fixed allowance,
usually in the 1% to 2% range, to cover returned goods from which this allowance
is deducted from payments from such customers.  As of September 30, 2008
and September 30, 2007, the Company has recorded a reserve for customer returns
of $330,668, and $139,019, respectively.




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 September 30, 2008.




6
 Table of Contents





New Accounting
Pronouncements





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 shall be 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 does not expect its adoption will 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 Derivate 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


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
$218,024 as of September 30, 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 $224,577 as of September 30, 2008.  In
addition, recorded in deposits, is a security deposit of $48,180 which will be
released upon the Company achieving certain financial requirements.  The
leases also required $21,465 in prepaid rents.






7
 Table of Contents




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 September 30,
2008, $1,002,507 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.  We granted
WLLC a security interest in all of the Company’s assets, subordinate to the
security interests in such assets to be 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 September 30, 2008, loans totaling
$1,014,792 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.  Loans under the Revolving Credit Facility bear interest at a
rate of Base Rate (as defined in the FCC Loan Agreement) plus 2%, with the
interest rate adjusting to Base Rate plus 1.5% as of January 1, 2009. 
 The Company must pay a minimum monthly interest payment equal to the
amount that would have been owed on an outstanding principal amount of
$3,000,000.  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 September 30, 2008, loans totaling
$8,646,902 were outstanding under the Revolving Credit Facility, including
accrued interest.




8
 Table of Contents




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 to 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.  As of 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.


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 September 30, 2008, the Company granted 343,487 options to
purchase the Company’s common stock at exercise prices ranging from $1.25 to
$2.07 per shares under the 2005 Equity Compensation Plan (“2005
Plan”).  Options granted during the three months ended September 30,
2008 were subject to shareholder approval.




For the
six months ended September 30, 2008, the Company granted 610,910 options to
purchase the Company’s common stock at exercise prices ranging from $1.25 to
$2.96 per share under the “2005 Equity Plan”.  The Company did not
grant any options during the six months ended September 30, 2007.


During
the three months ended September 30, 2008, 8,565 options to purchase common
stock were forfeited and 8,866 shares of common stock were issued upon exercise
of outstanding stock options under the Company’s equity compensation
plans.  During the three months ended September 30, 2007 there were no
forfeitures of options and 4,872 shares exercised.





During
the six months ended September 30, 2008 there were 14,632 options to purchase
common stock were forfeited and 22,536 shares exercised.  During the
six months ended September 30, 2007 there were no forfeitures of options and
4,872 shares exercised.





As of
September 30, 2008, the Company had granted options for 4,302 shares of the
Company’s common stock that are approved and unvested that will result in $9,201
of compensation expense in future periods if fully vested.  As of
September 30, 2008, the Company had granted 832,378 options, subject to
shareholder approval.  In accordance with SFAS No.  123R,
“Share-Based Payment,” compensation expense related to options granted subject
to shareholder approval is not determined until the options receive final
approval.





9
 Table of Contents




Information
regarding all stock options outstanding under the 2005 Plan as of September 30,
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
            
            
            10,314
            
            
            
            1.57
            
            
            $
            0.03
            
            
            
            
            10,314
            
            
            
            1.57
            
            
            $
            0.03Over
      $0.50 to $3.00
            
            
            692,868
            
            
            
            4.03
            
            
            $
            2.33
            
            
            
            
            267,018
            
            
            
            3.27
            
            
            $
            2.18Over
      $5.00 to $5.50
            
            
            1,365,877
            
            
            
            2.68
            
            
            $
            4.96
            
            
            
            
            1,231,703
            
            
            
            2.50
            
            
            $
            4.98Over
      $5.50
            
            
            58,634
            
            
            
            3.96
            
            
            $
            5.87
            
            
            
            
            56,424
            
            
            
            3.98
            
            
            $
            5.872,127,693
            
            
            
            3.28
            
            
            $
            4.05
            
            $    432,691
            
            
            1,565,459
            
            
            
            3.26
            
            
            $
            4.43
            
            $   266,528








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 (September 30, 2008) of the period
presented.  For the three months ended September 30, 2008, 8,866 options to
purchase the Company’s common stock were exercised under the plan resulting in
$8,257 in proceeds to the Company.  For the six months ended September 30,
2008, 22,536 options to purchase the Company’s common stock were exercised under
the 2005 Plan resulting in $25,343 in proceeds to the Company.


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
September 30, 2008, is presented below:




WeightedWarrantsOutstanding
            
            
            AverageExercise PriceOutstanding,
      April 1, 2008
            
            
            5,694,736
            
            
            $
            6.66Granted
            
            
            --
            
            
            $
            --Exercised
            
            
            (10,000)
            
            
            $
            2.50Expired
            
            
            --
            
            
            $
            --Outstanding,
      September 30, 2008
            
            
            5,684,736
            
            
            $
            6.67




As
of September 30, 2008, the Company had the following outstanding warrants to
purchase its common stock:





Weighted
            
            
            WeightedWarrants
            
            
            Average
            
            
            AverageOutstanding
            
            
            Exercise
      Price
            
            
            Remaining
      Life15,000
            
            
            $
            5.00
            
            
            
            0.60580,000
            
            
            $
            5.01
            
            
            
            1.95644,000
            
            
            $
            6.00
            
            
            
            2.622,232,300
            
            
            $
            6.25
            
            
            
            2.4050,000
            
            
            $
            6.96
            
            
            
            3.831,283,436
            
            
            $
            7.57
            
            
            
            3.49800,000
            
            
            $
            8.00
            
            
            
            5.9280,000
            
            
            $
            8.25
            
            
            
            5.925,684,736
            
            
            $
            6.67
            
            
            
            3.18




10.
              Subsequent
      Events


At the
Company’s October 2008 Annual Meeting of Shareholders, a total of 832,377
options, granted under the 2005 Plan but subject to shareholder approval, were
ratified, as noted below in Item 4. Submission of Matters to a Vote of Security
Holders.  These options have been included in the option information
presented above in Note 6. Equity Compensation Plans.  Expense related
to these options will be calculated in accordance with SFAS No. 123R and will be
recognized in future accounting periods.






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 six months ended September 30,
2008 and September 30, 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 September 30, 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 following 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 September 30, 2008 and 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 $5,409 and
$280,493 of revenue as of September 30, 2008 and September 30, 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 September 30, 2008 and September 30, 2007, did not record $1,637 and
$84,507, 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 production costs through resale of
the returned goods.  The liability for sales returns is estimated based
upon historical experience of return levels.





12
 Table of Contents




Additionally,
the Company did not record $189,161 and $883,632 of revenue as of September 30,
2008 and September 30, 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 September 30, 2008 and September 30, 2007, recognition of
$91,000 and $510,462, 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 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 September 30, 2008 and September 30, 2007, the Company
had accrued $858,898 and $372,788 respectively, as its estimate for the
foregoing deductions and allowances.




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 September 30, 2008 and September 30, 2007, the
Company had deferred $481,526 and $0, respectively, related to such media
costs.  Advertising expenses for the three and six months ended September
30, 2008 and September 30, 2007 were $330,859 and $1,816,743, respectively and
for the three and six months ended September 30, 2007 were $1,372,513 and
$2,739,724, respectively.





Warranty
and Return Reserves


The
Company records warranty liabilities at the time of sale for the estimated costs
that may be incurred under its basic warranty program.  The specific
warranty terms and conditions vary depending upon the product sold but generally
include technical support, repair parts, and labor for periods up to one
year.  Factors that affect the Company’s warranty liability include the
number of installed units currently under warranty, historical and anticipated
rates of warranty claims on those units, and cost per claim to satisfy the
Company’s warranty obligation.  Based upon the foregoing, the Company
has recorded as of September 30, 2008 and September 30, 2007 a provision for
potential future warranty costs of $74,484 and $49,424,
respectively.




The
Company reserves for known and potential returns from customers and associated
refunds or credits related to such returns based upon historical
experience.  In certain cases, customers are provided a fixed allowance,
usually in the 1% to 2% range, to cover returned goods from which this allowance
is deducted from payments from such customers.  As of September 30, 2008
and September 30, 2007, the Company has recorded a reserve for customer returns
of $330,668 and $139,019, 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 shareholders, the
options are not deemed to be granted until such time as the option agreement
receives shareholder 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. 
The adoption of SFAS No.  157 for financial assets and liabilities did not
have a material impact on the Company’s financial statements as of September 30,
2008.






13
 Table of Contents




Results
of Operations





Three
Months Ended September 30, 2008 and September 30, 2007





For the
quarter ended September 30, 2008, our sales totaled $13,854,930, a 120.5%
increase from the same period in 2007.  The growth in revenue came
from increased sales to retailer customers which were up 137.3% from 2007, and
to international distributors, that totaled almost $1 million in 2008 as
compared to no sales in 2007.  The increase in retail sales primarily
reflects a 157.1% increase in the number of storefronts carrying our products,
to 9,000 at September 30, 2008, as well as an increase in the number of our
products being carried in many of the store locations.  We began selling to
distributors outside of North America in late 2007, so the increase in
international sales in 2008 reflects our initial penetration into new markets in
Europe, Asia, and Australia.   Direct-to-consumer sales declined 4.7%
year-over-year as we reduced the number of airings of our direct response
infomercials during the 2008 quarter.





The gross
margin for the three months ended September 30, 2008, was 42.1%, up 2.0
percentage points from the prior year on the strength of improvements in cost of
revenue, including product and distribution costs, partially offset by a
decrease 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 increased 9.0% year-over-year, and decreased
as a percentage of revenue to 37.5% from 75.9% in the prior year. 
 The overall growth in the dollar amount of operating expenses other than
cost of revenue includes the impact of scale-related increases in costs related
to facilities, headcount, and business infrastructure, partially offset by
reductions in research and development costs and media production
costs.





For the
quarter ended September 30, 2008, net income totaled $418,370, an increase of
$2,757,632 from the $2,339,262 net loss reported for the quarter ended September
30, 2007.





The
following table sets forth, as a percentage of sales, our financial results for
the three months ended September 30, 2008, and the three months ended September
30, 2007:




Three
      Months Ended September 30,2008
            
            
            2007RevenueProduct
      sales - retail, net
            
            
            83.0
            %
            
            
            77.2
            
            %Product
      sales - direct to consumer, net
            
            
            9.9
            %
            
            
            22.8
            
            %Product
      sales – international, net
            
            
            7.1
            %
            
            
            –
            
            %Total
      sales
            
            
            100.0
            %
            
            
            100.0
            
            %Operating
      expensesCost
      of revenue
            
            
            57.9
            %
            
            
            60.0
            
            %Research
      and development
            
            
            3.0
            %
            
            
            10.0
            
            %Sales
      and marketing
            
            
            20.8
            %
            
            
            50.2
            
            %General
      and administrative
            
            
            13.7
            %
            
            
            15.6
            
            %Total
      operating expenses
            
            
            95.4
            %
            
            
            135.8
            
            %Profit/(loss)
      from operations
            
            
            4.6
            %
            
            
            (35.8
            )
            %






Three
      Months Ended September 30,Product
      Revenue
            
            2008
            
            
            2007Retail,
      net
            
            $
            11,508,030
            
            
            $
            4,850,298Direct
      to consumer, net
            
            
            1,365,438
            
            
            
            1,433,347International,
    net
            
            
            981,462
            
            
            
            –Total
            
            $
            13,854,930
            
            
            $
            6,283,645




14
 Table of Contents




For the
three months ended September 30, 2008, and September 30, 2007, revenue totaled
$13,854,930 and $6,283,645 respectively, an increase year-over-year of 120.5% or
$7,571,285.





The
increase in revenue during the quarter came primarily from sales to retailer
customers that totaled $11,508,030, an increase of 137.3%, or $6,657,732, from
the same period in 2007.  The increase reflects a combination of
factors, including a 157.1% increase in the number of storefronts selling our
products (to 9,000 storefronts as of September 30, 2008 from 3,500 storefronts
as of September 30, 2007), an increase in the number of our products being
carried on the shelves of the retail locations, and the effect of stocking
orders in the 2008 period for new customers and for customers transitioning to
our new product line (as described in our Form 10-Q for the quarter ended June
30, 2008 filed on August 7, 2008).





We did
not record $189,161 of revenue as of September 30, 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 September 30, 2008,
recognition of $91,000 of product and freight costs associated with such sale,
which have been included in inventory.





Direct to
consumer sales decreased 4.7% during the quarter ended September 30, 2008,
totaling $1,365,438 against $1,433,347 in the same quarter a year earlier. 
 The lower sales in 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.   During the quarter
ended September 30, 2008, we mailed 579,181 catalogues, as compared to 136,061
in the year earlier period.





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 $5,409
of revenue from Trial Sales as of September 30, 2008.  We also deferred, as
of September 30, 2008, recognition of $1,637 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.




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
September 30, 2008 and September 30, 2007 is as follows:





Three
      Months Ended September 30,2008
            
            
            2007Product
      RevenueAeroGardens
            
            $
            11,278,260
            
            
            $
            4,816,504Seed
      kits and accessories
            
            
            2,576,670
            
            
            
            1,467,141Total
            
            $
            13,854,930
            
            
            $
            6,283,645% of Total
      RevenueAeroGardens
            
            
            81.4
            %
            
            
            76.7
            %Seed
      kits and accessories
            
            
            18.6
            %
            
            
            23.3
            %Total
            
            
            100.0
            %
            
            
            100.0
            %





Sales of
AeroGardens for the quarter ended September 30, 2008, totaled $11,278,260, an
increase of 134.2% from the same period in 2007.   Seed kits and
accessories sales for the quarter ended September 30, 2008 of $2,576,670
increased 75.6% from a year earlier.   The increase in both categories
principally reflected the increase in overall sales to retailers, as described
above, with the higher growth rate in gardens reflecting the launch of
additional garden products in 2008.   Since the Company’s inception
through September 30, 2008, we have sold approximately 638,000 AeroGardens and
1,464,000 seed kits.





Cost of
revenue for the three months ended September 30, 2008 and September 30, 2007
totaled $8,026,325 and $3,765,376, respectively representing a year-over-year
increase of 113.2%.  As a percent of total revenue, these costs
declined 2.0 percentage points to 57.9% for the quarter ended September 30, 2008
from 59.9% a year earlier.  Cost of revenue include product costs for
purchased and manufactured products, freight costs for inbound freight from
manufacturers and outbound freight to customers, costs related to warehousing
and the shipping of products to customers, credit card processing fees for
direct sales, and duties and customs applicable to products imported.  The
dollar amount of cost of revenue increased primarily as a result of the 120.5%
increase in revenue discussed above, offset by cost savings associated with
improved purchasing, distribution logistics, and manufacturing
efficiencies.  As a percent of sales, cost of revenue decreased over the
prior period because of these factors, which were partially offset by the
increased ratio of lower-margin sales to retailers and to international
distributors relative to direct-to-consumer sales during the quarter. 
 In addition, we incurred expedited shipping charges totaling approximately
$230,000 in order to ensure timely delivery of product against retailer
requirements.   As a result of these impacts, the gross margin for the
quarter ended September 30, 2008, was 42.1%, up from 40.1% for the quarter ended
September 30, 2007.






15
 Table of Contents





Sales and
marketing costs for the three months ended September 30, 2008 totaled
$2,875,729, as compared to $3,156,414 for the three months ended September 30,
2007, a decrease of 8.9% or $280,685.   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 September 30,2008
            
            
            2007Advertising
            
            $
            330,859
            
            
            $
            1,372,513Personnel
            
            
            1,030,626
            
            
            
            786,802Sales
      commissions
            
            
            556,914
            
            
            
            183,765Trade
      shows
            
            
            68,489
            
            
            
            88,095All
      other
            
            
            888,841
            
            
            
            725,239$
            2,875,729
            
            
            $
            3,156,414





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 $330,859 for the quarter ended September 30,
2008, down 75.9% from the same period in 2007, reflecting fewer airings of our
short form and long form television advertisements during the quarter and a
comparison to the 2007 period in which $729,131 of infomercial production
expense was recognized.





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
September 30, 2008, personnel costs for sales and marketing were $1,030,626 as
compared to $786,802 for the three months ended September 30, 2007, an increase
of 31.0%.   The greater expense in 2008 reflects increased headcount
in a number of areas, including in our sales department, to manage the higher
level of sales to the retail channel, and in our operations department which
opened and staffed a new distribution center in Indianapolis, Indiana in July
2008.





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.   Year-over-year, sales
commissions increased 203.1%, principally reflecting the increase in sales to
retailers during the quarter ended September 30, 2008, as discussed above, as
well as a sales mix shift towards customers serviced by sales
representatives.





General
and administrative costs for the three months ended September 30, 2008 totaled
$1,902,113 as compared to $982,181 for the three months ended September 30,
2007, an increase of 93.7%, or $919,932.   As a percent of revenue,
these costs decreased to 13.7% from 15.6% in the prior year period. 
 The dollar increase reflects a combination of factors related to the
growth in our business including increases in executive and managerial
headcount, facility costs, insurance costs, and outside legal costs. 
 In addition, higher non-cash charges for bad debt expense (approximately
$223,000 higher because of the increase in our sales base) and depreciation and
amortization expense (approximately $143,000 higher reflecting our increased
asset base) were incurred in the 2008 period.




Research
and development costs for the quarter ended September 30, 2008 totaled $416,778,
a decrease of 33.7%, or $211,765, from the quarter ended September 30,
2007.   Spending in 2007 was higher because of costs incurred to
develop the new three and six pod gardens that were introduced in 2008, as well
as costs for the development of seed kit, live plant, and accessory line
extensions.





Our
profit from operations for the three months ended September 30, 2008 was
$633,985 as compared to an operating loss of $2,248,868 for the three months
ended September 30, 2007, a profit improvement of $2,882,853.





Other
income and expense for the quarter ended September 30, 2008 totaled to a net
expense of $215,615, up 138.5%, or $125,221 from the net expense of $90,394
recorded for the quarter ended September 30, 2007.   The increase
reflected a higher average level of interest bearing debt outstanding and new
capital leases entered into subsequent to September 30, 2007, combined with a
lower average level of interest-bearing cash equivalents during the
quarter.




The net
profit for the three months ended September 30, 2008 totaled $418,370, a
$2,757,632 improvement from the $2,339,262 loss reported a year
earlier.




16
 Table of Contents




Six
Months Ended September 30, 2008 and September 30, 2007





For the
six months ended September 30, 2008, sales increased 63.8% to $20,575,011 from
$12,562,079 for the six months ended September 30, 2007.   Sales in
all channels of distribution contributed to the increase as sales to retailers
rose 57.6%, direct-to-consumer sales increased 31.3%, and international sales
increased to over $1.7 million from zero in the year earlier
period.





The gross
margin also increased in the 2008 period relative to 2007, to 43.1% from 41.5%,
reflecting improvements in many components of cost of revenue, including product
and distribution costs, offset by a mix shift toward lower-margin sales to
retailers and international distributors, which accounted for 77.1% of total
sales for the six months ended September 30, 2008, up from 71.5% in the year
earlier period.





Operating
expenses, other than cost of revenue, increased by 15.1% year-over-year and
decreased to 52.9% of revenue from 75.3% a year earlier.   The dollar
increase reflects growth in both sales and marketing expense, and general and
administrative expense, which resulted primarily from requirements related to
the increased scale of our business.





The net
loss for the six months ended September 30, 2008 totaled $2,398,979, as compared
to a net loss of $4,361,992 in the year earlier period, an improvement of
$1,963,013.





The
following table sets forth, as a percentage of sales, our financial results for
the six months ended September 30, 2008 and the six months ended September 30,
2007:







Six
      Months Ended
              September
      30,2008
            
            
            2007RevenueProduct
      sales - retail, net
            
            
            68.8
            %
            
            
            71.5
            %Product
      sales - direct to consumer, net
            
            
            22.9
            %
            
            
            28.5
            %Product
      sales – international, net
            
            
            8.3
            %
            
            
            –
            %Total
      sales
            
            
            100.0
            %
            
            
            100.0
            %Operating
      expensesCost
      of revenue
            
            
            56.9
            %
            
            
            58.5
            %Research
      and development
            
            
            5.6
            %
            
            
            9.2
            %Sales
      and marketing
            
            
            30.7
            %
            
            
            48.5
            %General
      and administrative
            
            
            16.6
            %
            
            
            17.6
            %Total
      operating expenses
            
            
            109.8
            %
            
            
            133.8
            %Profit/(loss)
      from operations
            
            
            (9.8
            )
      %
            
            
            (33.8
            )
      %








Six
      Months Ended
              September
      30,Product
      Revenue
            
            2008
            
            
            2007Retail, net
            
            $
            14,150,605
            
            
            $
            8,979,900Direct to consumer,
      net
            
            
            4,704,848
            
            
            
            3,582,179International,
    net
            
            
            1,719,558
            
            
            
            –Total
            
            $
            20,575,011
            
            
            $
            12,562,079




For the
six months ended September 30, 2008 and September 30, 2007, revenue totaled
$20,575,011 and $12,562,079 respectively, an increase year-over-year of 63.8% or
$8,012,932.




17
 Table of Contents





The
year-over-year increase in revenue reflects growth in all of our channels of
distribution.  Retail sales increased 57.6% because of an increase in
the number of stores carrying our products and a greater average number of
products being carried per store, offset somewhat 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.





Direct-to-consumer
sales also increased, by 31.3%, principally as a result of an increase in the
number of catalogues mailed to 2,069,048 in the six months ended September 30,
2008 from 196,061 during the same period in 2007, 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 year-over-year increase in sales outside North
America wholly reflects the distribution penetration we have achieved since that
time in Europe, Asia, and Australia.




A summary
of the sales of AeroGardens and seed kits and accessories for the six months
ended September 30, 2008 and September 30, 2007 is as follows:




Six
      Months Ended
              September
      30,2008
            
            
            2007Product
      RevenueAeroGardens
            
            $
            16,261,676
            
            
            $
            8,979,900Seed
      kits and accessories
            
            
            4,313,335
            
            
            
            3,582,179Total
            
            $
            20,575,011
            
            
            $
            12,562,079% of Total
      RevenueAeroGardens
            
            
            79.0
            %
            
            
            71.5
            %Seed
      kits and accessories
            
            
            21.0
            %
            
            
            28.5
            %Total
            
            
            100.0
            %
            
            
            100.0
            %





AeroGarden
sales increased 81.1% year-over-year, reflecting the growth in all distribution
channels described above.  Seed kits and accessories increased by
20.4% 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 six months ended September 30, 2008 and September 30, 2007
totaled $11,713,148 and $7,347,794, an increase of 59.4%, principally resulting
from the increase in sales during the period.  As a percent of total
revenue, these costs declined 1.6 percentage points to 56.9% for the six months
ended September 30, 2008 from 58.5% a year earlier.  The improvement
in cost as a percent of revenue reflects cost reductions in the manufacturing
and distribution of our products, partially offset by the mix impact of higher
sales as a percent of total into lower-margin wholesale channels.  As
a result, the gross margin for the six months ended September 30, 2008 was
43.1%, up from 41.5 % for the same period in 2007.




Sales and
marketing costs for the six months ended September 30, 2008 totaled $6,325,612,
as compared to $6,091,537 for the six months ended September 30, 2007, an
increase of 3.8%.  The breakdown of sales and marketing costs for both
time periods is presented in the table below:





Six
      Months Ended
              September
      30,2008
            
            
            2007Advertising
            
            $
            1,816,743
            
            
            $
            2,739,724Personnel
            
            
            2,148,595
            
            
            
            1,450,930Sales
      commissions
            
            
            698,795
            
            
            
            420,458Trade
      shows
            
            
            181,708
            
            
            
            198,596All
      other
            
            
            1,479,771
            
            
            
            1,281,829$
            6,325,612
            
            
            $
            6,091,537






Advertising
expense totaled $1,816,743 for the six months ended September 30, 2008, a
decrease of 33.7% 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 which mailed 2,069,048 catalogues
in the 2008 period against 196,061 in the year earlier period.




18
 Table of Contents





For the
six months ended September 30, 2008, personnel costs for sales and marketing
totaled $2,148,595, an increase of 48.1% from the same period in
2007.  The increase was caused in part by higher headcount in our
customer support operations, including sales management, sales support, and
customer service.  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.





Year-over-year,
sales commissions increased 66.2% to $698,795, primarily reflecting the 57.6%
increase in sales to retailers during the six months ended September 30, 2008,
as discussed above.





General
and administrative costs for the six months ended September 30, 2008 totaled
$3,420,825 as compared to $2,208,033 for the six months ended September 30,
2007, an increase of 54.9%.  The increase principally reflects
increases in executive and managerial headcount, facility costs, insurance
costs, outside legal costs, as well as higher charges for bad debt expense
(approximately $225,000 higher because of the increase in our sales base) and
depreciation and amortization expense (approximately $247,000 higher reflecting
our increased scale of operations) were incurred in the 2008
period.  In addition, severance expense of $200,000 related to the
departure of our former chief financial officer contributed to the
year-over-year increase.




Research
and development costs for the six months ended September 30, 2008 totaled
$1,142,193 against $1,157,987 for the six months ended September 30,
2007.  Spending in 2008 was 1.4% lower because of costs incurred in
2007 to develop the new three and six pod gardens that were introduced in 2008,
as well as costs for the development of seed kit, live plant and accessory line
extensions.





Our loss
from operations for the six months ended September 30, 2008 was $2,026,767 as
compared to an operating loss of $4,243,272 for the six months ended September
30, 2007, an improvement of $2,216,505.





Other
income and expense for the six months ended September 30, 2008 and September 30,
2007 totaled to net expense of $372,212 and $118,720,
respectively.  The 213.5%, or $253,492 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 six months ended September 30, 2008 totaled $2,398,979, a
$1,963,013 improvement from the $4,361,992 reported for the same period in
2007.





Liquidity
and Capital Resources




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 September 30,
2008, $1,002,507 was outstanding under the First National Note, including
accrued interest.




19
 Table of Contents




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 to be 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 September 30, 2008, loans totaling
$1,014,792 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.  Loans under the Revolving Credit Facility bear interest at a
rate of Base Rate (as defined in the FCC Loan Agreement) plus 2%, with the
interest rate adjusting to Base Rate plus 1.5% as of January 1, 2009. 
 The Company must pay a minimum monthly interest payment equal to the
amount that would have been owed on an outstanding principal amount of
$3,000,000.  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 September 30, 2008, loans totaling
$8,646,902 were outstanding under the Revolving Credit Facility, including
accrued interest.





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 to 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.  As of 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.




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Cash
Requirements





In
addition to our contractual obligations through the balance of the fiscal year
for $410,538 of operating lease payments, $77,982 of capital lease payments, and
required debt service payments under our debt agreements, we will require cash
to:





·
            Fund
      ongoing 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 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 and cash equivalents at September 30,
2008, totaling $845,874 (including cash that is currently
restricted).





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 are constrained or prove to
be insufficient, 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 history of rapid
growth, and our expectation of continued growth through the current fiscal year
and beyond, we have determined that raising additional capital to support our
operations may be warranted.   Therefore, we have begun to assess
opportunities to access additional capital and to review potential structuring
alternatives.   The terms, conditions, and timing of any such
transactions have not been determined, and we may ultimately choose to
accelerate, delay or not pursue a transaction, depending on market
conditions.





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Assessment
of Future Liquidity and Results of Operations





Liquidity.Based on our
assumptions regarding projected operating cash flow, anticipated capital
expenditures, availability under our various credit facilities, and access to
other sources of funding, we believe we can adequately fund our operating
requirements.  In making this assessment, we have considered:





·
            Our
      cash and cash equivalents of $845,874 as of September30,
      2008,


·
            The
      availability of funding from the Revolving Credit Facility and other cash
      sources,


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


·
            The
      anticipated level of spending to support our planned initiatives over the
      remainder of 2008 and into 2009,
and


·
            Our
      expectations regarding cash flow from operations through our fiscal year
      ending March 31, 2009.





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 we received waivers of
non-compliance with all covenants, at September30, 2008,
there can be no assurance that we will continue to be in compliance with these
covenants over time, or that our lender will waive any future violations,
especially if our borrowings increase or our operating results are not
sufficient to cover our fixed financing payments.





Results of Operations. 
There are several factors that could affect our results of operations over the
remainder of the fiscal year ending March 31, 2009.  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.





Therefore,
although we believe we are well-positioned to execute our plans for the fiscal
year ending March 31, 2009, the factors noted above 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.




22
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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, cash equivalents, and short-term investments, and the value of
those investments.  Due to the short-term nature of our cash equivalents
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 September 30, 2008 and capital leases
totaled approximately $10.9 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 $109,000 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 September 30,
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.





Item 4T.  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
September 30, 2008.






23
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PART
II - OTHER INFORMATION





Item1.  Legal Proceedings





None.





Item
1A.  Risk Factors





Except as
set forth below, there have been no material changes during the quarter ended
September 30, 2008, to the risk factors set forth in Part 1, Item 1A of our
Annual Report on From 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
operating needs, or to support its projected growth.





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





None.





Item
3.  Defaults Upon Senior Securities





None.




24
 Table of Contents




Item
4.  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
 Table of Contents





Item5.  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 has granted the Company an
extension of time until November 24, 2008 to regain compliance with Nasdaq
Marketplace Rule 4310(c)(3).





If the
Company is unable to regain compliance with Nasdaq Marketplace Rule 4310(c)(3),
the Staff will provide the Company with written notification that its common
stock will be delisted.  At that time, the Company would have the
opportunity to appeal the Staff’s decision to a Nasdaq Listing Qualifications
Panel.




1  On
November 1, 2008, the name of our independent auditors changed to Eide Bailly
LLP as the result of a merger, as disclosed in our Current Report on Form 8-K,
filed November 3, 2008.


Item6.  Exhibits




3.1
            Articles
      of Incorporation of the Company (incorporated by reference to Exhibit 3.1
      of our Current Report on Form 8-K/A-2, filed November 16,
      2006)3.2
            Certificate
      of Amendment to Articles of Incorporation, dated November 3, 2002
      (incorporated by reference to Exhibit 3.2 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.3
            Certificate
      of Amendment to Articles of Incorporation, dated January 31, 2005
      (incorporated by reference to Exhibit 3.3 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.4
            Certificate
      of Change to Articles of Incorporation, dated July 27, 2005 (incorporated
      by reference to Exhibit 3.4 of our Current Report on Form 8-K/A-2, filed
      November 16, 2006)3.5
            Certificate
      of Amendment to Articles of Incorporation, dated February 24, 2006
      (incorporated by reference to Exhibit 3.5 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.6
            Amended
      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
            First
      Amendment to Loan and Security Agreement between the Company and FCC, LLC
      d/b/a/ First Capital, dated July 31, 2008 (incorporated by referenced
      to Exhibit 10.1 of our Current Report on Form 8-K, filed August 6,
      2008).10.2
            Employment Agreement between the Company and H. 
      MacGregor Clarke, dated as of May 23, 200831.1
            Certifications of the Chief Executive Officer Under
      Section 302 of the Sarbanes-Oxley Act*31.2
            Certifications of the Chief Financial Officer Under
      Section 302 of the Sarbanes-Oxley Act*32.1
            Certifications of the Chief Executive Officer Under
      Section 906 of the Sarbanes-Oxley Act*32.2
            Certifications of the Chief Financial Officer Under
      Section 906 of the Sarbanes-Oxley
Act*


_______________________





*
            Filed
      Herewith











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 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:  November
      6, 2008
            
            /s/ Jervis B. 
      PerkinsBy:
      Jervis B.  PerkinsIts:
      Chief Executive Officer (Principal Executive Officer) and
      DirectorDate:  November
      6, 2008
            
            /s/ H.  MacGregor
      ClarkeBy:
      H.  MacGregor ClarkeIts:
      Chief Financial Officer (Principal Financial Officer)Date: 
      November 6, 2008
            
            /s /Grey H. 
      GibbsBy:
      Grey H.  GibbsIts:
      Controller (Principal Accounting
Officer)









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