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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2003

or

For the transition period from                                to                               

Commission file number: 000-25755

WorldGate Communications, Inc.
(Exact name of registrant as specified in its charter)

(215) 354-5100
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 Par Value
(Title of Class)

        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 to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ý]        No [o]

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes [ý]        No [o]

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes [o]        No [ý]

        The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $7.8 million as of June 30, 2003, based on the closing sale price per share of common stock, as quoted on the NASDAQ Small Cap Market.

        The number of shares of the registrant's common stock outstanding as of March 5, 2004 was 23,364,420.

DOCUMENTS INCORPORATED BY REFERENCE

        [None]

WORLDGATE COMMUNICATIONS, INC.

ANNUAL REPORT ON FORM 10-K
For the Fiscal Year Ended December 31, 2003

TABLE OF CONTENTS

WORLDGATE COMMUNICATIONS, INC.

        This report contains forward-looking statements that involve risks and uncertainties. These forward-looking statements are based on management's current expectations and are subject to a number of uncertainties and risks that could cause actual results to differ significantly from those anticipated in these forward-looking statements. Factors that may cause such a difference include, but are not limited to, those set forth in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" as well as those discussed elsewhere in this report.

PART I

Item 1. Business

        WorldGate Communications, Inc., or WorldGate or the Company, was incorporated in Delaware in 1996 to succeed to the business of our predecessor, WorldGate Communications, L.L.C., which commenced operations in March 1995. In April 1999, we completed our initial public offering of 5,750,000 shares of our common stock. Since January 9, 2003 our common stock has been listed on the NASDAQ Small Cap Market. Previously our common stock was traded on the NASDAQ National Market. Our common stock is traded under the symbol "WGAT". Our executive offices are located at 3190 Tremont Avenue, Suite 100, Trevose, Pennsylvania 19053.

Overview

        WorldGate has developed a video phone, designed specifically for personal video communication, that we believe is differentiated, both from competitors and from previous efforts at personal video telephony, by providing: true to life communication, ease of deployment by high-speed data or HSD operators as well as businesses, a highly styled ergonomic design, and interoperation with the public switched telephone network, or PSTN.

        We are currently in the process of completing the final design for the video phone product, have received the first manufacturing prototypes for end-user trials, and expect to be conducting field trials over the April through May 2004 period. We intend to use third party contract manufacturers to manufacture the product for us, and anticipate a commercial launch for the product in the August through September 2004 time frame.

        The initial market for video phones is expected to be comprised of existing HSD customers, including both existing digital subscriber line, or DSL, and cable modem subscribers. We believe this HSD connectivity infrastructure leverages the convergence of the latest compression technology, processing power and increased bandwidth availability to help ensure, enable and maintain dedicated high quality end-to-end connections. Kagan Worldwide Media estimates that by the end of 2008 there will be almost 45 million modem subscribers in the United States while the international market is projected to approach 170 million DSL and cable modems by 2008. These modem users provide a large, and we believe conducive, target market for a quality, low cost video phone offering. Additional video phone growth is expected to be derived from new technology adopters and regular long distance communicators such as families and close friends. We also expect that the business-to-business opportunity will be attractive as a means to improve interpersonal communication and multi-location productivity.

        Our business model is based on the sale of video phones. We expect to market and sell our products to cable and DSL operators as well as to consumers through traditional consumer electronics distribution channels. We believe that cable and DSL operators could realize significant recurring revenue streams associated with offering this product. We have also developed this product to require very minimal capital investment or incremental costs by such operators. Our marketing objective is to

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have our video phones supplement and hopefully replace ordinary home and business phones worldwide.

        Since our formation in 1995 and until very recently, WorldGate has been in the business of developing and selling interactive television, or ITV, technology, products and services for use in conjunction with cable TV broadband networks (the "ITV Business"). Using our solutions, cable TV operators branded, marketed, and offered a wide variety of ITV packages to consumers. These packages included walled gardens of information, communications solutions complete with Internet-based e-mail and chat, and Web surfing, all presented and engaged on the TV set.

        During the third quarter of 2003, we completed a sale of significant assets, including our ITV intellectual property rights and our membership interest in TVGateway, LLC, for $3 million in cash to TVGateway, LLC, a company we were instrumental in forming. Our transaction with TVGateway, LLC marked a shift in our business away from the ITV Business and toward a new video phone product and associated business. Although we continued to support our current ITV Business into the first quarter of 2004, the development of our video phone product became a primary business focus. We advised our ITV customers of our de-emphasis of ITV going forward. We informed them that we were willing to continue our efforts into 2004 as long as we could do so on a profitable basis. In January, with all our customers having taken steps to terminate their ITV service in their markets, we decided to formally exit our ITV business. The funds we received from the sale of assets to TVGateway, LLC, as well as the funds we received as a result of private placements of our securities on December 1, 2003, December 4, 2003, and January 21, 2004, have permitted us to fund the development of our new business.

General Product Description

        WorldGate's principal product, going forward, will be a personal video phone, or PVP, which we intend to market under the trademark Ojo. The Ojo PVP is designed for use on the existing HSD (cable modem or DSL) infrastructure. The Ojo phone will also connect to the analog phone line for interoperability with the voice only communications offered by the existing "plain old telephone service," or POTS, network. Ojo will be usable both for video calls and for ordinary analog calls.

        The Ojo PVP solution consists of two primary components:

        A display unit, that includes the camera, video screen and external interface ports, is the device that the consumer will think of as the video phone itself. The video screen is used to display menus and provide a user interface as well as to view the images of the local and remote parties. Considerable effort has been expended in the ergonomic and stylistic design of the display unit. For example, it is taller than most conventional phones to ensure that the user is looking into the unit and not down at the unit. Similarly the camera of the unit is looking at the user at face level, instead of "up the user's nose." The display unit can be used as a standard speaker phone to receive (and in combination with the handset discussed below, to make) both audio and audio/video calls. The display unit is designed to be aesthetically usable in any room. Particular attention was given to the user Interface to ensure that Ojo was installable and usable without the need to refer constantly to a manual.

        The display contains RJ-45 jacks for connection to the cable or DSL modem and to an external device such as a PC, and an RJ-11 jack for connection to the PSTN or to a "Voice over Internet Protocol", or VoIP, terminal adapter. The consumer simply plugs the display unit into the high-speed modem and into the standard house power outlet to facilitate access to the necessary data network. In addition to a connection to the high-speed modem, the display unit also connects to the standard phone line. This connection, while not required for a video phone call, is used to allow the Ojo video phone to also be used as a standard telephone.

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        The Ojo video phone has a wireless handset that functions as a typical cordless phone. It includes a cordless telephone with internal speaker and microphone, a monochrome graphical display and most of the user controls for the device (numeric keypad, navigation device, talk, mute and end buttons). Although the handset is discussed as a separate component, it will generally be seated in the lower portion of the display unit where it will serve as the navigation device while its batteries are being charged. The handset fits into a cradle on the display unit. It is designed to be used both as part of a video call, or alone for standard POTS phone calls. Since the Ojo unit is designed to receive and make audio calls as well as video calls, the handset functions as a typical cordless phone and has the features a user typically expects for a cordless phone. Although video calls can be received at the display unit even when the handset is not present, the handset is the primary component used to operate the video phone (in a manner similar to a television remote control).

        An extension of the Ojo PVP product line is an accessory package that facilitates "transportability" of the display unit throughout the house. This accessory package includes the necessary interfaces and transceivers to connect to the cable or DSL modem and PSTN in one area of the house while permitting the Ojo display unit to be located in another area of the same house. This eliminates the need to have the Ojo display co-located with the PC and modem.

Material Developments for WorldGate since December 31, 2002

        The following is a summary of material developments for us that have occurred since December 31, 2002:

        Sale of the Company's ITV Assets.    On September 30, 2003, we sold certain intellectual property rights and certain software and equipment related to our ITV Business to TVGateway, LLC, for $2.4 million in cash, pursuant to an Asset Purchase Agreement (the "Purchase Agreement"), which we executed with TVGateway in August 2003. Pursuant to the Purchase Agreement, the Company retained a royalty-free license to the intellectual property rights that were sold, enabling us to use the intellectual property rights to continue to conduct our business as then being conducted. Concurrently with the execution of the Purchase Agreement, the Company and TVGateway also entered into a redemption agreement pursuant to which the Company redeemed its equity interest in TVGateway for $600,000 in cash, paid concurrently with the execution of the redemption agreement. The intellectual property rights had previously been expensed as incurred. Similarly, the Company did not carry an equity balance for its interest in TVGateway. The aggregate effect of these transactions was a gain of $3 million, which is reported in other income.

        Additional Investment by Certain Institutional Investors.    In December 2003, and January 2004, WorldGate announced investments aggregating to a total of $3.1 million by certain institutional investors. These investors purchased an aggregate of 3,000,000 shares of newly issued common stock. The investors also received a right, for a limited period of time, to purchase additional shares of up to 20% of the common stock purchased by the investors in their investment, at the same price as their investment, and five-year warrants to purchase up to 30% of the common stock purchased by the investors in their investment, at an exercise price equal to a twenty-five percent premium to their purchase price for the investment. The purchase price for the 2 million shares purchased in the December 2003 transactions was $0.80 per share, with the warrants having a $1.00 per share exercise price. The purchase price for the 1 million shares purchased in the January 2004 transaction was $1.50 per share, with the warrants having a $1.875 per share exercise price. All additional invested rights associated with the December 2003 transaction were exercised during January and February of 2004, resulting in an incremental investment of $320,000.

        Mototech Agreements.    In December 2003, WorldGate announced that it reached an agreement with Mototech, Inc. for the purchase of 625,000 shares of newly issued common stock at $0.80 per share, in return for future design and engineering services by Mototech. WorldGate previously

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announced in November 2003, that it had contracted with Mototech to assist the Company with the design and volume manufacture of WorldGate's Ojo personal video phone. The purchase price for these shares will be paid by an equivalent reduction in the development and initial procurement payments that would otherwise be due to Mototech. Mototech is an affiliate of Accton Technology Group. They currently manufacture and distribute a full range of high performance high speed data and computer networking products, including cable set top boxes, home gateways, wireless LANs, hubs, switches, routers, and other related products.

        New product development and technology demonstrations.    WorldGate developed the capability of delivering high quality video telephony over the Internet using our proprietary H.264 based signal processing technology, and successfully demonstrated our technology to several broadband operators and retailers. Quality calls were made over the public Internet both domestically and internationally with the Company's Ojo video phone.

Business Strategy

        General.    Our business model, as is typical of a consumer electronics product, is based upon the sale of Ojo video phones and does not rely upon any service fees or other recurring revenue stream for WorldGate, although such recurring streams may materialize. Cable and DSL operators, however, can realize significant recurring revenue streams associated with offering products such as our Ojo video phone, and accordingly we believe they will embrace the concept and business model. WorldGate plans to distribute the Ojo video phone through and in partnership with HSD providers, as well as through traditional electronics distribution channels. Video phone service, using the Ojo video phone, is expected to be offered by HSD providers as a means of attracting new HSD subscribers as well as maintaining existing subscribers. The suggested consumer offering follows the traditional HSD model. Video phone service subscribers will be able to either purchase Ojo or lease a unit from the HSD service provider.

        Manufacturing.    We anticipate that Ojo video phones will be manufactured in Asia, to take advantage of the base of lower labor, tooling and component costing. A formal relationship with Mototech Inc. has already been established for the volume manufacture of Ojo. Mototech, along with U.S. Robotics and SMC Networks, are affiliates of the Accton Technology Group. Mototech's responsibilities in this role include:

Product design finalization for manufacturing
Component selection and procurement
Tool sourcing and management
Coordination of Ojo manufacturing
Implementation and monitoring of Ojo's Quality Plan
Product cost reduction

        As part of our agreement with Mototech we will retain formal sign-off control over any product, specification, or component changes proposed by Mototech. We also maintain all rights to the Ojo technology and intellectual property as part of our relationship with Mototech. We have also maintained the right to second source the Ojo product.

        Product Sales and Distribution.    WorldGate intends to partner with experienced distribution partners to market and distribute the Ojo video phone. We are in the process of negotiating contracts with prospective partners to market and distribute the Ojo video phone, and hope to finalize some of the contracts for these partnerships within the next few months. Such partnerships are intended to reduce our working capital requirements by minimizing our sales and inventory costs, and provide an entree to more extensive and accelerated coverage than would be permitted by an internal organization. The name recognition, "shelf-space" potential and technology/product validation provided

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by such partners are also expected to provide a significant advantage. Through our distribution partners, Ojo will be marketed domestically and internationally to both the residential and business sectors through the standard consumer and business electronics channels, as well as through broadband providers such as cable and DSL service operators in a manner similar to broadband modems.

        Schedule.    Initial prototype units for Ojo have been received and we will commence field trials with these units during the April through May 2004 time frame. The Company has received expressions of interest from six of the top ten largest multiple system operators, or MSOs, to undertake field trials. These field trials are intended to provide information on consumer response to Ojo, technical performance and validate our objectives and business models. First production units for Ojo are expected to be available in the August through September 2004 time frame. Prior to that, we will seek to secure deployment commitments from multiple operators and from electronic product retailers to ensure wide availability.

Competition

        Many of the current video phone manufactures have focused on two applications—business video phones and video conferencing. Business video phones are designed to be located on an executive's desk and used to communicate with colleagues, employees and customers. Video conferencing units are designed for conference rooms where multiple people on one end engage with multiple people on the other end. The following is a brief description of the potential competitors and their impact on the market.

        Business Phone Products.    Most of these products are targeted for corporate use and are priced at $650.00 and up per unit. Generally, the ergonomic design of these units emulates that of a traditional office telephone with the addition of a camera and display. The products use standard corporate gray or black material colors, familiar button shapes and designs, traditional style handsets for non-speakerphone conversation and often have business feature sets. For connectivity these products use IP, POTS or ISDN. The main competitors in this sector include Viseon Inc., 8x8 Inc., Motion Media PLC, and Leadtek Research Inc.

        Video Conference Products.    D-Link Systems, Inc. produces a TV-based video phone product that is targeted to consumers and promotes its compatibility with DSL and cable modem technologies. D-Link uses the home television as the display device and utilizes either the TV's speaker or connection to a standard analog phone for the audio portion of the call. The main disadvantages of this product are convenience and non-personal video. The D-Link requires a television to send and receive calls. In many cases, this would obstruct the ability to watch television while a call is in progress thereby disrupting family television watching for the length of the call. Also, the videoconference nature of the product eliminates the ability to communicate on a private, one-on-one level. The main competitors in this sector include D-Link Systems, Inc., Sorenson Media and Polycom Inc.

        Telephone Products.    Vialta, Inc. produces the "Beamer", an H.324 (POTS) video phone that is designed for connection to a standard telephone. The product utilizes a standard analog telephone for connection to the PSTN and as the listening device. Since the unit uses traditional telephone lines for connectivity it cannot take advantage of the high-speed data systems available through cable and DSL modems.

        Web Cam Products.    Web cams are different from other competitive products in that they did not arise from either business video phones or video conferencing. Rather, they began in the early days of the Internet when "techies" were expanding the capabilities of PC-based content and applications with low-cost attachments to the computer. Currently, web cams are often used to display visual information rather than as a means for personal communication. Many popular web sites use web cams to show traffic, weather, adult activities and other visually interesting subjects. Software such as Net Meeting,

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Instant Messenger and MSN messenger are being supported in web cams to enable a video chat option to these Internet-based services. Competitors in this category include Logitech, Inc., Intel Corporation, 3Com Corporation, and Creative Technology, Ltd.

        Hybrid Web Cam-Business Phone Products.    In recent months, Cisco Systems, Inc. introduced a hybrid video phone product that is designed for the business phone market. The Cisco product consists of a web cam device and host software that enables video phone functionality when used in conjunction with an IP phone and call processing hardware. We believe this product requires a significant capital investment for implementing the call processing hardware and IP phones.

Intellectual Property

        We plan to rely on patent, trade secret, trademark and copyright law to protect our video phone intellectual property. Although we have filed multiple patent applications for our technology, our patent position is subject to complex factual and legal issues that may give rise to uncertainty as to the validity, scope and enforceability of a particular patent. Accordingly, there can be no assurance that any patents will be issued pursuant to our current or future patent applications or that patents issued pursuant to such applications will not be invalidated, circumvented or challenged. Moreover, there can be no assurance that the rights granted under any such patents will provide competitive advantages to us or be adequate to safeguard and maintain our proprietary rights. In addition, effective patent, trademark, copyright and trade secret protection may be unavailable, limited or not applied for in certain foreign countries.

Government Regulation

        Our Ojo video phone will be required to comply with various laws and government regulations, including Parts 15 and 68 of the FCC's regulations, which relate to radio frequency devices and to terminal equipment that is connected to the telephone network. The legal and regulatory environment that pertains to our business is uncertain and changing rapidly. New legislation or regulation could be introduced that could substantially impact our ability to launch and promote the Ojo video phone. For example, in the United States, the FCC and state regulatory commissions could undertake an examination of whether to impose surcharges or additional regulations upon certain providers of Internet protocol, or IP, based communication services. The imposition of regulations on IP communications services may negatively impact our business.

Research and Development

        To date, engineering and product development has been a significant focus of WorldGate. The principal focus of WorldGate's current engineering and development activities is development and enhancement of our Ojo video phone. Development of the Ojo video phone has required combining technical experience and knowledge from two historically separate industries, cable and telephony. Our engineering and development expenditures in connection with our Ojo video phone were approximately $0, $3,256,000 and $6,469,000 for the years ended December 31, 2001, 2002, and 2003, respectively.

Employees

        As of December 31, 2003, on a consolidated basis, we had approximately 30 full-time employees. All of our employees are located in Trevose, Pennsylvania. None of our employees are represented by a labor union, and we have no collective bargaining agreement. We consider our employee relations to be good.

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Financial Information Relating to Foreign and Domestic Operations and Export Sales

*

These represent export sales. Contracts and orders are denominated in U.S. dollars.

Item 2. Properties.

        Our corporate headquarters is located in Trevose, Pennsylvania in a leased facility consisting of approximately 72,000 square feet. The lease for this space will expire in June 2009, with an option to extend for an additional 10 years. As discussed in Item 3 below, we have not paid our rent on our current facility since May 2003 and our landlord has the right to regain possession of the facility at any time.

Item 3. Legal Proceedings.

        We have not paid our rent on our current facility since May 2003. As a result, our landlord, 3190 T General, Inc. in September 2003, filed an action in the Court of Common Pleas, Bucks County Pennsylvania to perfect its interest to take possession of our facility at any time, and to establish damages for past rent and expenses. Although a judgment has been granted allowing our landlord to regain possession of the facility, we remain in the facility and are in the process of negotiating a settlement of our lease obligation with the landlord in an effort to reduce our outstanding liability and secure the continued right to occupy the facility with a reduced ongoing lease obligation, although there can be no assurance that a settlement can be obtained. In lieu of monthly rent payments of $104,000 (offset by monthly sublease payments by TVGateway of $19,000 during the period February 1, 2003 through January 31, 2004), our landlord is drawing down from our security deposit to satisfy the unpaid rent of $618,000 as of December 31, 2003. As of December 31, 2003, the amount of the deposit remaining after deduction for the unpaid rent is $132,000.

Item 4. Submission of Matters to a Vote of Security Holders.

        At the annual meeting (the "Annual Meeting") of the Company's stockholders held on September 22, 2003, our stockholders elected six members to the Company's Board of Directors. Those elected to the Board were Hal M. Krisbergh, Steven C. Davidson, Clarence L. Irving, Jr., Martin Jaffe, Jeff Morris and Lemuel Tarshis. Stockholders also approved the plan of recapitalization and authorized the board of directors to implement or abandon, in the board's discretion, a twenty-for-one reverse stock split of the Company's common stock. The Company has decided not to implement the plan of recapitalization at this time. After the stockholders took the foregoing actions, the Annual Meeting was

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adjourned to allow continued voting on the sale of assets to TVGateway, which was approved by the stockholders when the Annual Meeting was reconvened on September 30, 2003.

(1)

Election of Directors:

(2)

Reverse Stock Split

(3)

Sale of TVGateway Assets

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.

        Our common stock, $0.01 par value, commenced trading on the NASDAQ National Market under the symbol "WGAT" since our initial public offering in April 15, 1999. The Company applied for and received permission, effective January 9, 2003 to transfer the listing of its common stock to the NASDAQ Small Cap Market. The following table shows the high and low sales price as reported by the NASDAQ National Market and the NASDAQ Small Cap Market, as is applicable, for each quarter of 2002 and 2003.

        On March 5, 2004, the last reported sale price of our common stock as reported on the NASDAQ Small Cap Market was $1.69 per share.

        As of March 5, 2004, we had 344 holders of record of our common stock.

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Dividends

        We have never paid or declared any cash dividends on our common stock. We do not anticipate paying any cash dividends in the foreseeable future. We currently expect to retain future earnings, if any, to finance the growth and development of our business.

Security Ownership of Certain Beneficial Owners and Management

        The following table sets forth information as of December 31, 2003 regarding securities authorized for issuance under the Company's equity compensation plans:

Equity Compensation Plan Information

(1)

In November 2003 the Company's board of directors unanimously approved a new Equity Incentive Plan that will be subject to shareholder approval at our next annual shareholders meeting. The plan as approved by the board does not authorize any incremental shares for issuance thereunder, but rather transfers the balance available for issuance under the 1996 Stock Option Plan after all issuances thereunder.

Sale of Unregistered Securities

(1)

In December 2003 we completed a private placement of 2,000,000 shares (the "December 2003 Shares") of our common stock to certain institutional investors. The shares were sold for $0.80 per share, resulting in gross proceeds from the offering of $1.6 million. The investors also received a right, for a limited period of time, to purchase additional shares of up to 20% of the common stock purchased by the investors in the placement at $0.80 a share. The investors were also issued warrants (the "December 2003 Warrants") to purchase in the aggregate up to 600,000 additional shares of common stock at a per share exercise price of $1.00.

The December 2003 Shares and the December 2003 Warrants were issued in reliance upon the exemption from the registration requirements of the Securities Act of 1933 afforded to transactions not involving a public offering by Section 4(2) of that Act and Rule 506 thereunder. The December 2003 Shares and the December 2003 Warrants issued in the offering have been subsequently registered for resale by the investors on January 9, 2004.

(2)

In December 2003, WorldGate announced that it reached an agreement with Mototech, Inc. for the purchase of 625,000 shares of newly issued common stock at $0.80 per share, in return for future design and engineering services by Mototech. WorldGate previously announced in November 2003 that it had contracted with Mototech to assist the Company with the design and volume manufacture of WorldGate's Ojo personal video phone. The purchase price for these shares was paid by an equivalent reduction in the development and initial procurement payments that would otherwise be due to Mototech. Mototech is an affiliate of Accton Technology Group. They currently manufacture and distribute a full range of high performance high speed data and computer networking products, including cable set top boxes, home gateways, wireless LANs, hubs, switches, routers, and other related products.

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Item 6. Selected Financial Data.

        The following table represents selected consolidated financial information for the five-year period ended December 31, 2003. This data should be read in conjunction with our financial statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report.

(1)

For purposes of computing the net loss per common share, net loss has been reduced by the accretion on preferred stock.

(2)

"As adjusted net loss available to common stockholders" and "As adjusted basic and diluted net loss per common share" amounts reflect the exclusion of amortization of goodwill of approximately $241 and $361 for the years ended December 31, 2000 and 2001, respectively. These amounts are presented to comply with SFAS 142 as if this standard had been adopted at the beginning of the respective periods. There was no amortization of goodwill or intangible assets during the year ended December 31, 1999.

(3)

The loss on the extinguishment of debt has been reclassified from an extraordinary item to a component of the loss from operations in accordance with the Company's adoption of SFAS 145.

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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Dollar amounts contained in this Item 7 are in thousands, except for share and per share amounts)

FORWARD-LOOKING AND CAUTIONARY STATEMENTS

        We may from time to time make written or oral forward-looking statements, including those contained in the following Management's Discussion and Analysis of Financial Condition and Results of Operations. The words "estimate," "project," "believe," "intend," "expect," and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. In order to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, we are hereby identifying certain important factors that could cause our actual results, performance or achievement to differ materially from those that may be contained in or implied by any forward-looking statement made by or on behalf of WorldGate. The factors, individually or in the aggregate, that could cause such forward-looking statements not to be realized include, without limitation, the following: (1) difficulty or inability to raise additional financing on terms acceptable to us, (2) difficulty in developing and implementing marketing and business plans, (3) continued losses, (4) industry competition factors and other uncertainty that a market for our products will develop, (5) challenges associated with broadband operators (including, uncertainty that they will offer our products, inability to predict the manner in which they will market and price our products and existence of potential conflicts of interests and contractual limitations impeding their ability to offer our products), (6) departure of one or more key persons, (7) delisting of our Common Stock from the NASDAQ Small Cap Market, (8) changes in regulatory requirements, and (9) other risks identified in our filings with the Securities and Exchange Commission. We caution you that the foregoing list of important factors is not intended to be, and is not, exhaustive. We do not undertake to update any forward-looking statement that may be made from time to time by or on behalf of WorldGate.

Results of Operations:

Critical Accounting Policies and Estimates

        Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. These generally accepted accounting principles require 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 net sales and expenses during the reporting period. Actual results could differ from those estimates.

        Our significant accounting policies are described in note 2 to our consolidated financial statements included elsewhere in this report. We believe that the following discussion addresses our critical accounting policies, which are those that are most important to the portrayal of our financial condition and results and require management's most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

        Revenue Recognition.    Revenue is recognized when persuasive evidence of an arrangement exists, the price is fixed or determinable, the collectibility is reasonably assured, and either the delivery and the acceptance of the equipment has occurred or services have been rendered. In the event terms of the sale provide for a lapsing customer acceptance period, we recognize revenue based upon the expiration of the lapsing acceptance period or customer acceptance, whichever occurs first. There are inherent difficulties in predicting the timing and magnitude of equipment sales. As such, the potential for fluctuations in quarterly revenues and operating results exists. Revenue related to services is generally recognized upon performance of the services requested by a customer order. Revenue from license agreements is recognized in accordance with the contract terms, generally based on the number

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of monthly subscribers. Included in our financial statements is a provision for the estimated amount of future returns that we believe is appropriate based on historical experience and current trends. While such returns have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same return rates that we have in the past. This policy relates to our ITV business. We expect to introduce our new product, Ojo video phone, in the August through September 2004 time frame.

        Accounts Receivable.    We generate accounts receivable primarily from sales of equipment to and services performed for our cable operator customers and from services performed for managing the TVGateway joint venture. This equipment is primarily headend equipment for use in deploying the Company's interactive television services. The services represent fees from the cable operator based on the number of subscribers using our services and fees for managing the TVGateway joint venture. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. If economic or political conditions were to change in the countries where we do business, it could have an impact on the results of our operations, and our ability to realize the full value of our accounts receivable. This policy relates to our ITV business. We expect to introduce our new product, Ojo personal video phone, in the August through September 2004 time frame.

        Inventories.    We value our inventories, which consist primarily of raw materials, work in process and finished goods equipment to be sold to our customers for use in deploying interactive television services, at the lower of cost or market. The cost is determined on an average cost basis. A periodic review of inventory quantities on hand is performed in order to determine and record a provision for excess and obsolete inventories. Factors related to current inventories such as technological obsolescence and market conditions are analyzed to determine estimated net realizable values. A provision is recorded to reduce the cost of inventories to the estimated net realizable values. Any significant unanticipated changes in the factors noted above could have an impact on the value of our inventories and our reported operating results. With the current shift in focus to our new video phone business, our inventory balance of $1,622, relating solely to our ITV business, was fully reserved for at December 31, 2003.

        Long-Lived Assets.    Our long-lived assets consist of property and equipment. These long-lived assets are recorded at cost and are depreciated or amortized using the straight-line method over their estimated useful lives. The carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flows from such assets are separately identifiable and are less than the carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value of the long-lived asset. Fair market value is determined by using the anticipated cash flows discounted at a rate commensurate with the risk involved. Measurement of the impairment, if any, will be based upon the difference between carrying value and the fair value of the asset. If useful life estimates or anticipated cash flows change in the future, we may be required to record an impairment charge.

        Accounting for Income Taxes.    As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as depreciation of property and equipment and valuation of inventories, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not more likely than not, we must establish valuation

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allowances. To the extent we establish valuation allowances or increase the allowances in a period, we must include an expense within the tax provision in the statement of operations.

        We have a full valuation allowance against the net deferred tax asset of $72,901 as of December 31, 2003, due to the Company's lack of earnings history and the uncertainty as to the reliability of the asset. In the future, if sufficient evidence of our ability to generate sufficient future taxable income becomes apparent, we would be required to reduce our valuation allowance, resulting in a benefit from income tax in the consolidated statement of operations.

        Accounting for Contractual Obligation related to Equity Financing.    In July 2000, four cable operators purchased shares in the Company. As part of the financing arrangement, the Company agreed to provide the four cable operators with a credit to be used to purchase products that pertain to the development and deployment of the WorldGate service equal to 25% of the amount they invested. The Company recorded a liability to satisfy this obligation based on the Company's best estimate of what it would cost to satisfy the credit. The Company's policy has been not to adjust the liability after it had been established. When equipment credits are utilized by the cable operators, the value of the equipment is reflected in its entirety in the cost of revenues and a portion of the recorded contractual obligation is adjusted against additional paid in capital. The equipment credit expired on August 24, 2003. In August 2003, the unused credit balance of $3,283 was reclassified from the recorded liability to additional paid in capital.

2003 versus 2002

        Since our formation in 1995 and into January 2004, our company has been in the business of developing and selling interactive television ("ITV") technology, products and services for use in conjunction with cable TV broadband networks (the "ITV" Business"). Using our solutions, cable TV operators branded, marketed, and offered a wide variety of ITV packages to consumers. These packages included walled gardens of information, communications solutions complete with Internet-based e-mail and chat, and Web surfing, all presented and engaged on the TV set.

        During the third quarter of 2003, we completed a sale of certain assets, including our ITV intellectual property rights and our membership interest in TVGateway, LLC, for $3 million in cash to TVGateway, LLC, a company we were instrumental in forming. Our transaction with TVGateway, LLC marked a shift in our business away from the ITV Business and toward a new video phone product and associated business. Although we continued to support our current ITV Business during the first quarter of 2004, our new video phone product became our primary product focus. We advised our ITV customers of our de-emphasis of ITV going forward. We informed them that we were willing to continue our efforts into 2004 as long as we could do so on a profitable basis. In January, with all our customers having taken steps to terminate their ITV service in their markets, we decided to formally end our ITV business. The funds we received from the sale of assets to TVGateway, LLC, as well as the funds we received as a result of private placements of our securities on December 1, 2003 and December 4, 2003, have permitted us to fund the development of our new business in 2004.

Revenues

        Revenues.    For the year ended December 31, 2003, the revenues of the Company were primarily the result of first quarter products sales and consulting fees to TVGateway, LLC, a then unconsolidated entity, subscriber fees from cable operators providing WorldGate interactive television products and services, and certain excess inventory and equipment sold during the year. Revenues for the twelve months ended December 31, 2003 were $3,886, compared to $13,878 for the same period in 2002. This revenue decrease of $9,992 from 2002 to 2003 is attributable to reduced consulting fees with TVGateway, partially offset by increased equipment sales of approximately $1 million to TVGateway in the first quarter of 2003. For the twelve months ended December 31, 2003, TVGateway consulting fees

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were $794, compared to $11,484 for the twelve months ended December 31, 2002. During the fourth quarter of 2003, the Company sold approximately $300 of excess inventory at auction.

Costs and Expenses

        Cost