[February 14, 2011] ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read together with the information contained in the Consolidated Financial Statements and related Notes included in the annual report. Overview We are a leading online service provider of live and on-demand Internet video, corporate audio and web communications and content management applications, provided primarily to corporate (including large as well as small to medium sized businesses), education and government customers. We had approximately 96 full time employees as of February 4, 2011, with operations organized in two main operating groups: · Digital Media Services Group · Audio and Web Conferencing Services Group Our Digital Media Services Group consists primarily of our Webcasting division, our DMSP ("Digital Media Services Platform") division and our MP365 ("MarketPlace365") division. The DMSP division includes the related UGC ("User Generated Content") and Smart Encoding divisions. Our Webcasting division, which operates primarily from Pompano Beach, Florida and has its main sales facility in New York City, provides an array of corporate-oriented, web-based media services to the corporate market including live audio and video webcasting and on-demand audio and video streaming for any business, government or educational entity. Our DMSP division, which operates primarily from Colorado Springs, Colorado, provides an online, subscription based service that includes access to enabling technologies and features for our clients to acquire, store, index, secure, manage, distribute and transform these digital assets into saleable commodities. Our UGC division, which also operates as Auction Video and operates primarily from Colorado Springs, Colorado, provides a video ingestion and flash encoder that can be used by our clients on a stand-alone basis or in conjunction with the DMSP. Our Smart Encoding division, which operates primarily from San Francisco, California, provides both automated and manual encoding and editorial services for processing digital media. This division also provides hosting, storage and streaming services for digital media, which are provided via the DMSP. Our MP365 division, which operates primarily from Pompano Beach, Florida with additional operations in San Francisco, California, enables publishers, associations, tradeshow promoters and entrepreneurs to self-deploy their own online virtual marketplaces using the MarketPlace365TM platform. Our Audio and Web Conferencing Services Group consists of our Infinite Conferencing ("Infinite") division and our EDNet division. Our Infinite division operates primarily from the New York City area and provides "reservationless" and operator-assisted audio and web conferencing services. Our EDNet division, which operates primarily from San Francisco, California, provides connectivity (in the form of high quality audio, compressed video and multimedia data communications) within the entertainment and advertising industries through its managed network, which encompasses production and post-production companies, advertisers, producers, directors, and talent. For segment information related to the revenue and operating income of these groups, see Note 7 to the Consolidated Financial Statements. Recent Developments A 1-for-6 reverse stock split of the outstanding shares of our common stock was effective on April 5, 2010. Except as otherwise indicated, all related amounts reported in our consolidated financial statements and in this 10-Q, including common share quantities, convertible debenture conversion prices and exercise prices of options and warrants, have been retroactively adjusted for the effect of this reverse stock split. 55 -------------------------------------------------------------------------------- On September 17, 2010, we entered into a Purchase Agreement (the "Purchase Agreement") with Lincoln Park Capital Fund, LLC ("LPC"), whereby LPC agreed to an initial purchase of 300,000 shares of our common stock and 420,000 shares of our Series A-14 Preferred Stock ("Series A-14"), together with warrants to purchase 540,000 of our common shares. In accordance with the Purchase Agreement, LPC also received 50,000 shares of our common stock as a one-time commitment fee and a cash payment of $26,250 as a one-time structuring fee. On September 24, 2010, we received net proceeds of $873,750 from LPC in exchange for our issuance of the above shares and warrants. In accordance with the Purchase Agreement, LPC also committed to purchase, at our sole discretion, up to an additional 830,000 shares of our common stock in installments over the term of the Purchase Agreement, generally at prevailing market prices, but subject to the specific restrictions and conditions in the Purchase Agreement. During the period from October 1, 2010 through February 4, 2011 LPC purchased an additional 540,000 shares of our common stock under that Purchase Agreement for net proceeds of approximately $454,000, leaving a remaining commitment to purchase 290,000 additional common shares. From January through May 2010 we borrowed an aggregate of $1.0 million from four individual investors under the terms of unsecured subordinated convertible notes. The remaining principal balance of these notes was $714,000 as of September 30, 2010, $503,000 of which was satisfied by us on October 1, 2010 by the payment of cash and the issuance of common shares and the remaining principal balance of $211,000 satisfied by monthly principal payments during the three months ended December 31, 2010 plus the issuance of common shares during January 2011. On March 18, 2009, we terminated the Merger Agreement for the acquisition of Narrowstep, which Merger Agreement we had first entered into on May 29, 2008. The Merger Agreement could be terminated by either Onstream or Narrowstep at any time after November 30, 2008 provided that the terminating party was not responsible for the delay. On December 1, 2009, Narrowstep filed a complaint against us in the Court of Chancery of the State of Delaware, alleging breach of contract, fraud and three additional counts and seeking (i) $14 million in damages, (ii) reimbursement of an unspecified amount for all of its costs associated with the negotiation and drafting of the Merger Agreement, including but not limited to attorney and consulting fees, (iii) the return of Narrowstep's equipment alleged to be in our possession, (iv) reimbursement of an unspecified amount for all of its attorneys fees, costs and interest associated with this action and (v) any further relief determined as fair by the court. After reviewing the complaint document, we determined that Narrowstep had no basis in fact or in law for any claim and accordingly, this matter was not reflected as a liability on our financial statements. On December 30, 2010 Narrowstep counsel advised the Court in writing that Narrowstep had reached an agreement in principle with us to dismiss their lawsuit with prejudice, provided that both parties executed a mutual release. Under this mutual release, which has been agreed to in principle by both parties but is still being finalized, no further actions will be filed against each other or affiliated parties in connection with this matter. This resolution of this matter will not have a material adverse impact on our future financial position or results of operations. Our securities are listed on The NASDAQ Capital Market. We are currently not compliant with NASDAQ's minimum audit committee size requirement of three independent members, as set forth in Listing Rule 5605 (c) (2) (a) (the "Rule"), for which compliance is necessary in order to be eligible for continued listing on The NASDAQ Capital Market. On June 24, 2010, we received a letter from NASDAQ stating that unless we regain compliance with the Rule as of the earlier of our next annual shareholders' meeting or June 5, 2011, our common stock will be subject to immediate delisting. Until that time, our shares will continue to be listed on The NASDAQ Capital Market. 56 -------------------------------------------------------------------------------- On June 14, 2010, we were notified that Mr. Robert J. Wussler, who was then a director and a member of our audit committee, had passed away on June 5, 2010. He has not at the present time been replaced on the audit committee, which currently has two independent members. We are in the process of evaluating independent candidates to fill the vacancy left as a result of Mr. Wussler's passing, both on the Board as well as the audit committee. We will make that selection as soon as possible. On January 28, 2011 we received a letter from NASDAQ stating that as a result of our common stock closing at a bid price of $1.00 per share or more for the ten consecutive business days ended January 27, 2011, we were considered in compliance with Listing Rule 5550 (a)(2)(a). We had previously been out of compliance with the minimum bid price requirements set forth in this listing rule, for which compliance is necessary in order to be eligible for continued listing on The NASDAQ Capital Market. Revenue Recognition Revenues from recurring service are recognized when (i) persuasive evidence of an arrangement exists between us and the customer, (ii) the goods or service has been provided to the customer, (iii) the price to the customer is fixed or determinable and (iv) collectibility of the sales price is reasonably assured. Our Digital Media Services Group recognizes revenues from the acquisition, editing, transcoding, indexing, storage and distribution of its customers' digital media, as well as from live and on-demand internet webcasting and internet distribution of travel information. The Webcasting division charges for live and on-demand webcasting at the time an event is accessible for streaming over the Internet. Charges to customers by the DMSP division are generally based on a monthly subscription fee, as well as charges for hosting, storage and professional services. Fees charged to customers for customized applications or set-up are recognized as revenue at the time the application or set-up is completed. Charges to customers by the Smart Encoding and UGC divisions are generally based on the activity or volumes of such media, expressed in megabytes or similar terms, and are recognized at the time the service is performed. This division also provides hosting, storage and streaming services for digital media, which are provided via the DMSP. Our Audio and Web Conferencing Services Group recognizes revenue from audio and web conferencing as well as customer usage of digital telephone connections. The Infinite division generally charges for audio conferencing and web conferencing services on a per-minute usage rate, although webconferencing services are also available for a monthly subscription fee allowing a certain level of usage. Audio conferencing and web conferencing revenue is recognized based on the timing of the customer's use of those services. The EDNet division primarily generates revenue from customer usage of digital telephone connections controlled by them. EDNet purchases digital phone lines from telephone companies and sells access to the lines, as well as separate per-minute usage charges. Network usage and bridging revenue is recognized based on the timing of the customer's usage of those services. We include the DMSP and UGC divisions' revenues, along with the Smart Encoding division's revenues from hosting, storage and streaming, in the DMSP and Hosting revenue caption. We include the EDNet division's revenues from equipment sales and rentals and the Smart Encoding division's revenues from encoding and editorial services in the Other Revenue caption. Results of Operations Our consolidated net loss for the three months ended December 31, 2010 was approximately $898,000 ($0.10 loss per share) as compared to a loss of approximately $4.3 million ($0.58 loss per share) for the corresponding period of the prior fiscal year, a decrease in our loss of approximately $3.4 million (79%). The decreased net loss was primarily due to a $3.1 million non-cash charge for the impairment of goodwill and other intangible assets in the first quarter of the prior fiscal year, versus no such charge in the first quarter of the current fiscal year. We accelerated the most recent annual valuation of our goodwill and intangible assets from the first quarter of fiscal 2011 to the fourth quarter of fiscal 2010, and as a result of that valuation we recorded a $1.6 million charge for the impairment of goodwill, which was reflected in our results for the three months ended September 30, 2010. 57 --------------------------------------------------------------------------------The following table shows, for the periods indicated, the percentage of revenue represented by items on our consolidated statements of operations. Three Months Ended December 31, 2010 2009 Revenue: DMSP and hosting 11.5 % 13.6 % Webcasting 34.3 34.7 Audio and web conferencing 42.7 39.1 Network usage 11.0 11.2 Other 0.5 1.4 Total revenue 100.0 % 100.0 % Costs of revenue: DMSP and hosting 5.2 % 6.2 % Webcasting 8.5 8.0 Audio and web conferencing 14.2 13.2 Network usage 4.9 4.6 Other 0.5 2.6 Total costs of revenue 33.3 % 34.6 % Gross margin 66.7 % 65.4 % Operating expenses: Compensation 49.8 % 51.0 % Professional fees 12.8 11.8 Other general and administrative 12.5 13.4 Impairment loss on goodwill and other intangible assets - 76.2 Depreciation and amortization 9.1 13.9 Total operating expenses 84.2 % 166.3 % Loss from operations (17.5 )% (100.9 )% Other expense, net: Interest expense (7.2 )% (5.8 )% Gain for adjustment of derivative liability to fair value 3.3 - Other income (expense), net 0.2 - Total other expense, net (3.7 )% (5.8 )% Net loss (21.2 )% (106.7 )% 58-------------------------------------------------------------------------------- The following table is presented to illustrate our discussion and analysis of our results of operations and financial condition. This table should be read in conjunction with the consolidated financial statements and the notes therein. For the three months ended December 31, Increase (Decrease) 2010 2009 Amount Percent Total revenue $ 4,237,253 $ 4,069,113 $ 168,140 4.1 % Total costs of revenue 1,411,234 1,406,476 4,758 0.3 % Gross margin 2,826,019 2,662,637 163,382 6.1 % General and administrative expenses 3,183,248 3,099,729 83,519 2.7 % Impairment loss on goodwill and other intangible assets - 3,100,000 (3,100,000 ) (100.0 )% Depreciation and amortization 386,197 567,361 (181,164 ) (31.9 )% Total operating expenses 3,569,445 6,767,090 (3,197,645 ) (47.3 )% Loss from operations (743, 426 ) (4,104,453 ) (3,361,027 ) (81.9 )% Other expense, net (154,267 ) (236,588 ) (82,321 ) ( 34.8 )% Net loss $ (897,693 ) $ (4,341,041 ) $ (3,443,348 ) (79.3 )% Revenues and Gross Margin Consolidated operating revenue was approximately $4.2 million for the three months ended December 31, 2010, an increase of approximately $168,000 (4.1%) from the prior fiscal year, due to increased revenues of the Audio and Web Conferencing Services Group. Audio and Web Conferencing Services Group revenues were approximately $2.3 million for the three months ended December 31, 2010, an increase of approximately $213,000 (10.3%) from the corresponding period of the prior fiscal year. This increase was primarily a result of increased audio conferencing revenues in the Infinite division. The number of minutes billed by the Infinite division was approximately 24.3 million for the three months ended December 31, 2010, as compared to approximately 20.3 million minutes billed for the corresponding period of the prior fiscal year. However, the average revenue per minute was approximately 7.5 cents for the three months ended December 31, 2010, as compared to approximately 7.9 cents for the corresponding period of the prior fiscal year. The average revenue per minute statistic includes auxiliary services and fees that are not billed to the customer on a per minute basis. The average revenue per minute also includes conferencing revenue rebilled to our third party customers by another Onstream division and thus included in that other division's reported revenues. For some time the Infinite division sales force has been focusing on entering into agreements with organizations with resources to provide Infinite's audio and web conferencing services to certain targeted groups. This included agreements with Proforma, a leading provider of graphic communications solutions, a reseller agreement with Copper Conferencing, a leading, carrier-class conferencing services provider for small and medium-sized businesses, a master agency agreement with Presidio Networked Solutions, a systems integrator and a collaboration with PeerPort to launch WebMeet Community, an integrated suite of virtual collaboration services. In March 2010 we announced the expansion of Infinite's alliance with BT Conferencing by providing a jointly developed conferencing platform to Infinite's reservationless client base. Although these relationships and initiatives are important as a basis for building future sales, in some cases we expect a lead time of a year or longer before they are reflected in actual recorded sales. We believe that the current levels of Infinite division revenues are a reflection of these and other sales initiatives. 59 -------------------------------------------------------------------------------- We expect the above trend to continue and accordingly we expect the fiscal 2011 revenues of the Audio and Web Conferencing Services Group (for the year as a whole) to exceed the fiscal 2010 amounts, although this increase cannot be assured. Digital Media Services Group revenues were approximately $1.9 million for the three months ended December 31, 2010, a decrease of approximately $45,000 (2.3%) from the corresponding period of the prior fiscal year. This decrease was primarily due to an approximately $63,000 (11.5%) net decrease in DMSP and hosting revenues from the corresponding period of the prior fiscal year. This decrease in DMSP and hosting revenues included (i) an approximately $41,000 decrease in hosting and bandwidth charges to certain larger DMSP customers serviced by our Smart Encoding division and (ii) an approximately $22,000 decrease in the DMSP division's revenues from its "Store and Stream" and "Streaming Publisher" products. As of December 31, 2010, we had 347 monthly recurring subscribers to the "Store and Stream" and/or "Streaming Publisher" applications of the DMSP, which applications were developed as a focused interface for small to medium business (SMB) clients, as compared to 344 subscribers as of December 31, 2009. Including large DMSP hosting customers supported by our Smart Encoding Division, these customer counts were 357 and 363, respectively. We expect this DMSP customer base to grow, especially as a result of the launch of MP365 discussed below. In addition to the "Store and Stream" and "Streaming Publisher" applications of the DMSP, we are continuing to work with several entities assisting us in the deployment via the DMSP of enabling technologies necessary to create social networks with integrated professional and user generated multimedia content. One of the key components of our March 2007 acquisition of Auction Video was the video ingestion and flash transcoder, already integrated at the time into the DMSP as an integral component of the services offered to social network providers and other User Generated Video (UGV) applications. Auction Video's technology may be used in various applications such as online Yellow Pages listings, delivering video to mobile phones, multi-level marketing and online newspaper classified advertisements, and can also provide for direct input from webcams and other imaging equipment. In addition, our Auction Video service was approved by eBay to provide video hosting services for eBay users and PowerSellers (high volume users of eBay). The Auction Video acquisition was another strategic step in providing a complete range of enabling, turnkey technologies for our clients to facilitate "video on the web" applications, which we believe will make the DMSP a more competitive option as an increasing number of companies look to enhance their web presence with digital rich media and social applications. In addition to the beneficial effect of the Auction Video technology on DMSP revenues, we believe that our ownership of that technology will provide us with other revenue opportunities, including software sales and licensing fees, although the timing and amount of these revenues cannot be assured. In March 2008 we retained the law firm of Hunton & Williams to assist in expediting the patent approval process and helping protect our rights related to our patent pending UGV technology. In April 2008, we revised the original patent application primarily for the purpose of splitting it into two separate applications, which, while related, are being evaluated separately by the U.S. Patent Office ("USPO"). With respect to the claims pending in the first of the two applications, the USPO issued non-final rejections in August 2008, February 2009 and May 2009, as well as final rejections in January 2010 and June 2010. Our responses to certain of these rejections included modifications to certain claims made in the original patent application. In response to the latest rejection we filed a Notice of Appeal with the USPO on November 22, 2010 and we filed an appeal brief with the USPO on February 9, 2011. The USPO has until approximately April 9, 2011 to file their response, after which a decision would be made as to our appeal by a three member panel, either based on the filings or a hearing if requested by us. Regardless of the ultimate outcome of this matter, our management has determined that an adverse decision with respect to this patent application would not have a material adverse effect on our financial position or results of operations. The USPO has taken no formal action with regard to the second of the two applications. Certain of the former owners of Auction Video, Inc. have an interest in proceeds that we may receive under certain circumstances in connection with these patents. 60 -------------------------------------------------------------------------------- Webcasting revenues increased by approximately $45,000 (3.2%) for the three months ended December 31, 2010 as compared to the corresponding period of the prior fiscal year. The number of webcasts produced, approximately 1,900 for the three months ended December 31, 2010, was approximately equal to the number of webcasts produced during the corresponding period of the prior fiscal year and the average revenue per webcast event of approximately $774 for the three months ended December 31, 2010 was approximately equal to the corresponding period of the prior fiscal year. The number of webcasts reported, as well as the resulting calculation of the average revenue per webcast event, does not include any webcast events attributed with $100 or less revenue, based on our determination that excluding such low-priced or even no-charge events increases the usefulness of this statistic. The average revenue per webcast also includes webcasting revenue rebilled to our third party customers by another Onstream division and thus included in that other division's reported revenues. In addition, we believe that the following factors will favorably impact our webcasting revenues for fiscal 2011: · Expanding government related business - In November 2007 we announced that we had been awarded a stake in a three-year Master Services Agreement (MSA) by the State of California to provide video and audio streaming services to the state and participating local governments. In August 2008 we announced that we had been awarded three new multi-year public sector webcasting services contracts with the United States Nuclear Regulatory Commission (NRC), California State Department of Technology Services (DTS), and California State Board of Equalization (BOE). In April 2009 we announced that, in addition to the extension of the NRC contract for the first full year after a successful initial test period, we were engaged to perform webcasting services for use by the U.S. Department of Interior, Minerals Management Service, via a strategic partner relationship. In November 2009, we announced that we were engaged to perform webcasting services for the Department of the Treasury's Internal Revenue Service (IRS) and to provide webinar services for use by the U.S. Department of Housing and Urban Development's Federal Housing Administration (FHA) Philadelphia Homeownership Center (HOC), via a strategic partner relationship. We also announced the extension of the NRC contract, discussed above, for the second full year. We recognized aggregate revenues for the above government-related contracts of approximately $136,000 and $65,000 for the three months ended December 31, 2010 and 2009, respectively, which represents a 109.2% increase. We recognized aggregate revenues for the above government-related contracts of approximately $509,000 and $322,000 for the years ended September 30, 2010 and 2009, respectively, which represents a 58.1% increase. Our financial statements for these periods include webcasting revenues from government related business not included in these numbers, as these numbers only relate to the specific government related contracts that we have publicly announced, as listed above. 61 -------------------------------------------------------------------------------- · New products and technology - iEncode™ is a full-featured, turnkey, standalone webcasting solution, designed to operate inside a corporate LAN environment with multicast capabilities. Although iEncode™ sales have been limited to date, we expect them to start to increase to more meaningful levels during fiscal 2011. We have relatively recently completed several feature enhancements to our proprietary webcasting platform including a premium Flash webcasting service announced by us in November 2010 for the Google Android™ smartphone platform. In addition to delivering webcasts to Android based mobile users, the new Flash-based webcasting solution enhances our traditional online webcasting service to existing clients as well as opens up a new market for us with enterprise customers. · BT reseller agreement - In October 2009, we announced an expansion of our business relationship with BT Conferencing, a division of BT Group plc, one of the world's leading providers of communications solutions and services, via the signing of a new webcasting, iEncode, and digital media services reseller agreement. Prior to this agreement, and continuing to the current time, we recognized significant webcasting revenues from a BT business group that had succeeded to our business relationship with another reseller, by virtue of BT's acquisition of that reseller. Under the reseller agreement announced in October 2009, another business group within BT Conferencing will also be offering our webcasting, iEncode and digital media services to its new and existing clients worldwide. The implementation of this new agreement is in process and is expected to first impact our revenues in a meaningful way during fiscal 2011. · Organizational changes - In October 2010, we announced Ari Kestin's appointment as the Executive Vice President and General Manager of our Webcasting division. In his new role with the Webcasting division, Mr. Kestin will be responsible for all client-facing activities, sales and marketing, operations, partnerships, product and application development within the division. Mr. Kestin will also continue as President of the Infinite division, a position he has held since June 2009. As a result of the above factors, we expect fiscal 2011 webcasting revenues (for the year as a whole) to exceed the corresponding fiscal 2010 amounts, although such increase cannot be assured. During fiscal 2009, we began the development of the MarketPlace365™ (MP365) platform, which enables the creation of on-line virtual marketplaces, trade shows and social communities, with the goal of generating business leads for our customers, the MP365 site promoters. There are currently four active MP365 promoter sites - SUBWAY (a private marketplace for internal use by SUBWAY vendors, franchisees and staff and the first site launched in July 2010), Home Service Expo (a general public accessible marketplace providing services for homeowners in the Dade, Broward and Palm Beach counties of Florida launched in November 2010), Green Light Expo (a general public accessible global products and services expo targeting all things green for lifestyle and business applications launched in November 2010) and ProActive Capital Forum (general public accessible and believed to be the first 24/7/365 financial tradeshow concentrating on companies in the life-sciences and technology areas launched in November 2010). Fred DeLuca, co-founder and co-owner of SUBWAY and active in the management of that company, is one of our major shareholders and also controls Rockridge Capital Holdings, LLC, an entity to which we owe approximately $1.5 million as of December 31, 2010 and which debt is convertible into shares of our common stock under certain conditions. The promoter of Green Light Expo's MP365 site is also affiliated with SUBWAY. 62 -------------------------------------------------------------------------------- In addition to the four active marketplaces, we have signed MP365 promoter contracts for another 20 marketplaces, several of which we expect will launch and become active in the coming weeks and months. In addition, we have entered into several MP365 agent agreements, including the following: · In December 2009, we announced an agreement with the Tarsus Group plc ("Tarsus") for them to market MP365 to Tarsus' more than 19,000 trade shows and 2,000 suppliers that are part of their Trade Show News Network ("TSNN"), a leading online resource for the trade show, exhibition and event industry. · In February 2010, we announced an agreement with the Trade Show Exhibitors Association ("TSEA") for them to market MP365 to TSEA's members, vendors and sponsors. · In April 2010, we announced an agreement with AMC Institute, to provide MP365, as well as our full suite of digital media and communications services, to the organization's 150 association management company members who represent over 1,500 associations throughout the U.S., Canada, Europe and Asia. · In May 2010, we announced an MP365 agent agreement with Conventions.net, which has thousands of industry suppliers in over 150 categories and plans to showcase the MP365 platform through its website and other marketing vehicles. We will charge each promoter a monthly fee based on the number of exhibitors within their MP365 marketplace, as well as a share of the revenue from advertising in their MP365 marketplace, but we also expect to recognize additional revenue beyond these exhibitor and advertising fees since MP365 will integrate with and utilize almost all of our other technologies including DMSP, webcasting, UGC and conferencing. Special pricing and payment terms have been granted to SUBWAY and may be granted to other MP365 promoters, particularly during the initial stages of introducing the MP365 platform. Once we are past the initial introductory stage and as the process of launching MP365 sites continues, we expect that revenues from MP365 will begin to be a meaningful part of our overall operating results. However, the attainment of any revenue from a MP365 marketplace or promoter contract will be subject to various factors, including the implementation of the MP365 product by the promoter/purchaser, including the sales of booths to exhibitors and related advertising, which amount and timing cannot be assured. Due to the anticipated increase in webcasting revenues, as well as our anticipation of meaningful revenues in fiscal 2011 from the recently launched MP365 platform, both as discussed above, we expect the fiscal 2011 revenues of the Digital Media Services Group (for the year as a whole) to exceed the corresponding fiscal 2010 amounts, although such increase cannot be assured. Consolidated gross margin was approximately $2.8 million for the three months ended December 31, 2010, an increase of approximately $163,000 (6.1%) from the corresponding period of the prior fiscal year. This increase was primarily due to approximately $142,000 additional gross margin from the Audio and Web Conferencing Services Group, corresponding to the $213,000 increase in Audio and Web Conferencing Services Group revenues as discussed above. Our consolidated gross margin percentage was 66.7% for the three months ended December 31, 2010, versus 65.4% for the corresponding period of the prior fiscal year. Based on our expectation that the fiscal 2011 revenues of both the Audio and Web Conferencing Services Group and the Digital Media Services Group (for the year as a whole) will exceed the corresponding fiscal 2010 amounts, as discussed above, we expect consolidated gross margin (in dollars) for fiscal year 2011 (for the year as a whole) to exceed the corresponding fiscal 2010 amounts, although such increase cannot be assured. However, it is possible that gross margin as a percentage of the related revenue for fiscal year 2011 may be lower than such percentage for fiscal year 2010, since (i) we expect continued price pressure in fiscal 2011, as compared to fiscal 2010, arising from competition in all of our major product lines and (ii) it is possible that the Infinite division's cost of sales, on a per-minute basis, may increase in fiscal 2011, as compared to fiscal 2010, in order for us to attract larger customers by increasing the reliability of the subcontractors supporting our service offerings. 63 --------------------------------------------------------------------------------Operating Expenses Consolidated operating expenses were approximately $3.6 million for the three months ended December 31, 2010, a decrease of approximately $3.2 million (47.3%) from the corresponding period of the prior fiscal year, primarily due to a $3.1 million non-cash charge for the impairment of goodwill and other intangible assets in the first quarter of the prior fiscal year, versus no such charge in the first quarter of the current fiscal year. We accelerated the most recent annual valuation of our goodwill and intangible assets from the first quarter of fiscal 2011 to the fourth quarter of fiscal 2010, and as a result of that valuation we recorded a $1.6 million charge for the impairment of goodwill, which was reflected in our results for the three months ended September 30, 2010. The valuations of Infinite, EDNet and Acquired Onstream incorporate our management's estimates of future sales and operating income, which estimates in the cases of Infinite and Acquired Onstream are dependent on products (audio and web conferencing and the DMSP, respectively) from which significant sales and/or sales increases may be required to support that valuation. Furthermore, even if our market value were to exceed our net book value in the future, annual reviews for impairment in future periods may result in future periodic write-downs. Tests for impairment between annual tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of the net carrying amount. The decrease in depreciation and amortization expense for the three months ended December 31, 2010 of approximately $181,000 was 31.9% of that expense for the corresponding period of the prior fiscal year. This decrease is primarily due to (i) an approximately $93,000 reduction of depreciation expense related to certain equipment and purchased software reaching the end of the useful lives assigned to them for book depreciation purposes, (ii) an approximately $74,000 reduction of amortization expense related to certain intangible assets as a result of the impairment losses we recorded during the year ended September 30, 2010, which were recorded as a reduction of the historical depreciable cost basis of those assets as of those dates, as well as certain intangible assets reaching the end of the lives assigned to them for book amortization purposes and (iii) an approximately $58,000 reduction of depreciation expense related to the DMSP as a result of certain DMSP components reaching the end of the useful lives assigned to them for book depreciation purposes. These decreases were partially offset by an approximately $42,000 increase in depreciation expense for internally developed software, including iEncode and MP365, recently placed into service. Excluding any impact arising from fiscal 2011 goodwill impairment charges as compared to those costs in fiscal 2010, we expect our consolidated operating expenses for fiscal year 2011 to be equal to or less than the corresponding prior year amounts, expressed as a percentage of revenues, although this cannot be assured. Other Expense Other expense of approximately $154,000 for the three months ended December 31, 2010 represented an approximately $82,000 (34.8%) decrease as compared to the corresponding period of the prior fiscal year. This decrease arose from an approximately $139,000 gain recognized in the three months ended December 31, 2010 and arising from the adjustment of a derivative liability to fair value, versus no such item in the corresponding period of the prior fiscal year. The impact of this valuation gain was partially offset by an increase in interest expense of approximately $65,000 for the three months ended December 31, 2010 as compared to the corresponding period of the prior fiscal year, primarily arising from new interest bearing debt and increased effective interest rates. 64 -------------------------------------------------------------------------------- Due to the price-based anti-dilution protection provisions (also known as "down round" provisions) included in warrants issued by us in September 2010 in connection with the LPC Purchase Agreement and in accordance with ASC Topic 815, "Contracts in Entity's Own Equity", we are required to recognize these warrants as a liability at their fair value on each reporting date. These warrants were reflected as a non-current liability of $386,404 on our September 30, 2010 consolidated balance sheet. However, since the fair value of this liability was $247,743 as of December 31, 2010, an adjustment for the $138,661 decrease in that liability's carrying value on our balance sheet was reflected as other income in our consolidated statement of operations for the three months ended December 31, 2010. Subsequent changes in the fair value of this liability will be recognized in our consolidated statement of operations as other income or expense. From January through May 2010 we borrowed an aggregate of $1.0 million from four individual investors under the terms of unsecured subordinated convertible notes. The remaining principal balance of these notes was $714,000 as of September 30, 2010, $503,000 of which was satisfied by us on October 1, 2010 by the payment of cash and the issuance of common shares (the Greenberg Note and the Wilmington Notes) and the remaining principal balance of $211,000 was satisfied by monthly principal payments during the three months ended December 31, 2010 plus the issuance of common shares during January 2011 (the Lehmann Note). The Lehmann Note, which had an effective interest rate of approximately 77.0% per annum, as well as the write-off of the unamortized debt discount at the time the Greenberg Note and Wilmington Notes were repaid, accounted for approximately $43,000 of interest expense for the three months ended December 31, 2010, related to debt which did not exist during the three months ended December 31, 2009. In addition to the increased interest from the new debt as noted above, our line of credit arrangement (the "Line") was amended in December 2009 and as a result the interest rate modified to be 13.5% per annum, adjusted for future changes in the prime rate, plus a weekly monitoring fee of one twentieth of a percent (0.05%) of the borrowing limit. The interest rate at the time of the amendment was 14.25% per annum (prime rate plus 11%) but there was no monitoring fee. Based on the amended terms, interest expense, including the monitoring fee, for the Line increased by approximately $10,000 for the three months ended December 31, 2010, as compared to the three months ended December 31, 2009. As a result of the January 2011 renegotiation of the terms of the $200,000 CCJ Note, including related changes to Series A-13 Preferred also held by CCJ, the effective interest rate on the CCJ Note increased from 47.4% per annum to approximately 78.5% per annum - see the discussion of Liquidity and Capital Resources below for details. Although a significant portion of the remaining outstanding balance due on the borrowings made during fiscal 2010 was recently repaid using proceeds from non-interest bearing equity financing as well as the issuance of common shares, based on the remaining outstanding interest-bearing debt, the increased interest rate on the Line that was not effective for the entirety of fiscal 2010, the increased effective interest rate on the CCJ Note from January 2011 and potential further borrowings in fiscal 2011 in order to address our working capital deficit, we anticipate our interest expense during fiscal 2011 to at least be equal to, or potentially greater than, that expense for fiscal 2010. Liquidity and Capital Resources Our financial statements for the three months ended December 31, 2010 reflect a net loss of approximately $898,000 and cash used in operations for that period of approximately $79,000. Although we had cash of approximately $138,000 at December 31, 2010, our working capital was a deficit of approximately $3.8 million at that date. 65 -------------------------------------------------------------------------------- During the three months ended December 31, 2010, we obtained financing primarily from the sale of our common stock under the terms of the LPC Purchase Agreement, discussed in more detail below and which resulted in net cash proceeds of approximately $268,000 during the period. Amounts outstanding under the Line, which are subject to the amount and aging of our accounts receivable, decreased by approximately $140,000 as a result of our net repayments required during the period. On September 17, 2010, we entered into a Purchase Agreement (the "Purchase Agreement") with Lincoln Park Capital Fund, LLC ("LPC"), whereby LPC agreed to an initial purchase of 300,000 shares of our common stock and 420,000 shares of our Series A-14 Preferred Stock ("Series A-14"), together with warrants to purchase 540,000 of our common shares. In accordance with the Purchase Agreement, LPC also received 50,000 shares of our common stock as a one-time commitment fee and a cash payment of $26,250 as a one-time structuring fee. On September 24, 2010, we received net proceeds of $873,750 from LPC in exchange for our issuance of the above shares and warrants. After deducting legal, accounting and other out-of-pocket costs incurred by us in connection with this transaction, the net cash proceeds were $824,044. During the period from October 1, 2010 through February 4, 2011 LPC purchased an additional 540,000 shares of our common stock under that Purchase Agreement for net proceeds of approximately $454,000. LPC has also committed to purchase, at our sole discretion, up to an additional 290,000 shares of our common stock in installments over the remaining term of the Purchase Agreement, generally at prevailing market prices, but subject to the specific restrictions and conditions in the Purchase Agreement. There is no upper limit to the price LPC may pay to purchase these additional shares. The purchase of our shares by LPC will occur on dates determined solely by us and the purchase price of the shares will be fixed on the purchase date and will be equal to the lesser of (i) the lowest sale price of our common stock on the purchase date or (ii) the average of the three (3) lowest closing sale prices of our common stock during the twelve (12) consecutive business days prior to the date of a purchase by LPC. LPC shall not have the right or the obligation to purchase any shares of our common stock from us at a price below $0.75 per share. In addition, we have agreed to use our best efforts to get, within 190 days from the date of the Purchase Agreement, shareholder approval to sell up to an additional 1,900,000 of our common shares to LPC, which upon such approval LPC has agreed to purchase, at our sole discretion and subject to the same restrictions and conditions in the Purchase Agreement. The Purchase Agreement has a term of 25 months but may be terminated by us at any time after the first year at our discretion without any cost to us and may be terminated by us at any time in the event LPC does not purchase shares as directed by us in accordance with the terms of the Purchase Agreement. LPC may terminate the Purchase Agreement upon certain events of default set forth therein, including but not limited to the occurrence of a material adverse effect, delisting of our common stock and the lack of immediate relisting on one of the specified alternate markets and the lapse of the effectiveness of the applicable registration statement for more than the specified number of days. The Purchase Agreement restricts our use of variable priced financings for the greater of one year or the term of the Purchase Agreement and, in the event of future financings by us, allows LPC the right to participate under conditions specified in the Purchase Agreement. The shares of common stock sold and issued under the Purchase Agreement and the shares of common stock issuable upon conversion of Series A-14, were sold and issued pursuant to a prospectus supplement filed by us on September 24, 2010 with the Securities and Exchange Commission in connection with a takedown of an aggregate of 1.6 million shares from our Shelf Registration. In connection with the Purchase Agreement, we also entered into a Registration Rights Agreement (the "Registration Rights Agreement") with LPC, dated September 17, 2010, under which we agreed, among other things, to use our best efforts to keep the registration statement effective until the maturity date as defined in the Purchase Agreement and to indemnify LPC for certain liabilities in connection with the sale of the securities. 66 -------------------------------------------------------------------------------- From January through May 2010 we issued the unsecured subordinated convertible Greenberg Note, Wilmington Notes and Lehmann Note, for aggregate gross proceeds of $1.0 million. The remaining principal balance of the Greenberg and Wilmington Notes, representing $750,000 in original borrowing, was $503,000 as of September 30, 2010. This $503,000 balance, as well as all accrued but unpaid interest, was satisfied by us on October 1, 2010 with cash payments aggregating $400,000 plus the issuance of 137,901 unregistered common shares. The remaining principal balance of the Lehmann Note, representing $250,000 in original borrowing, was $211,000 as of September 30, 2010 and was satisfied by monthly principal payments of $13,000 each during the three months ended December 31, 2010 plus the issuance of 200,000 unregistered common shares during January 2011 for the remaining balance. The effective rate of the Lehmann Note was initially calculated to be approximately 77.0% per annum, assuming a six month loan term and excluding the finder's fees payable by us to a third party in cash and equal to 7% of the borrowed amount. The maximum allowable borrowing amount under the Line is now $2.0 million, subject to certain formulas with respect to the amount and aging of the underlying receivables. The outstanding balance (approximately $1.4 million as of February 4, 2011) bears interest at 13.5% per annum, adjustable based on changes in prime after December 28, 2009, plus a weekly monitoring fee of one twentieth of a percent (0.05%) of the borrowing limit. The outstanding principal under the Line may be repaid at any time, but no later than December 2011, which term may be extended by us for an extra year, subject to compliance with all loan terms, including no material adverse change, as well as concurrence of the Lender. The Line is also subject to us maintaining an adequate level of receivables, based on certain formulas, as well as our compliance with a quarterly debt service coverage covenant (the "Covenant"), effective with the September 30, 2010 quarter. We were in compliance with this covenant for the September 30, 2010 quarter. The Covenant, as defined in the applicable loan documents, requires that our net income or loss, adjusted to remove all non-cash expenses as well as cash interest expense, be equal to or greater than that same cash interest expense. Calculated strictly on this basis, we were in compliance with the Covenant for the three months ended December 31, 2010. The Lender has raised the question as to whether the net income or loss used in the Covenant calculation should also be adjusted to remove non-cash revenues (i.e. the $138,661 gain for adjustment of derivative liability to fair value). Although an adjustment for non-cash revenues is not specified in the applicable loan documents, if this adjustment to remove non-cash revenues were made, we would not be in compliance with that Covenant for the quarter ended December 31, 2010. In its February 14, 2011 communication to us, the Lender indicated that it believed that we had failed to comply with the Covenant and that it would construe such situation to be a default if not corrected within 30 days. The Lender also indicated that, while it reserves all its rights and remedies provided in the loan agreement, it is not their intention to accelerate the repayment of this loan. We are obligated under a Note (the "Rockridge Note") issued to Rockridge Capital Holdings, LLC ("Rockridge"), an entity controlled by one of our largest shareholders, which had an outstanding principal balance of approximately $1.5 million at December 31, 2010. The Rockridge Note is secured by a first priority lien on all of our assets, such lien subordinated only to the extent higher priority liens on assets, primarily accounts receivable and certain designated software and equipment, are held by certain of our other lenders. We also entered into a Security Agreement with Rockridge that contains certain covenants and other restrictions with respect to the collateral. The Rockridge Note is repayable in equal monthly installments of $41,409 extending through August 14, 2013 (the "Maturity Date"), which installments include principal (except for a $500,000 balloon payable at the Maturity Date and which balloon payment is also convertible into restricted ONSM common shares under certain circumstances) plus interest (at 12% per annum) on the remaining unpaid balance. Upon notice from Rockridge at any time prior to the Maturity Date, up to fifty percent (50%) of the outstanding principal amount of the Rockridge Note (excluding the balloon payment subject to conversion per the previous sentence) may be converted into a number of restricted shares of ONSM common stock. If we sell all or substantially all of our assets, or at any time after September 4, 2011 and prior to the Maturity Date, the remaining outstanding principal amount of the Rockridge Note may be converted by Rockridge into a number of restricted shares of ONSM common stock. The above conversions are subject to a minimum of one month between conversion notices (unless such conversion amount exceeds $25,000) and will use a conversion price of eighty percent (80%) of the fair market value of the average closing bid price for ONSM common stock for the twenty (20) days of trading on The NASDAQ Capital Market (or such other exchange or market on which ONSM common shares are trading) prior to such Rockridge notice, but such conversion price will not be less than $2.40 per share. 67 -------------------------------------------------------------------------------- The Note and Stock Purchase Agreement also provides that Rockridge may receive an origination fee, upon not less than sixty-one (61) days written notice to us, of 366,667 restricted shares of our common stock (the "Shares"). The value of those Shares is subject to a limited guaranty of no more than an additional payment by us of $75,000 which will be effective in the event the Shares are sold for an average share price less than the minimum of $1.20 per share. We have recorded no accrual for this matter on our financial statements as of December 31, 2010, since we believe that the variables affecting any eventual liability cannot be reasonably estimated. However, if the closing ONSM share price of $1.06 per share on February 4, 2011 was used as a basis of calculation, the required payment would be approximately $59,000. The effective interest rate of the Rockridge Note is approximately 28.0% per annum. This rate excludes the potential effect of a premium to market prices if the balloon payment is satisfied in common shares instead of cash as well as the potential effect of any appreciation in the value of the Shares at the time of issuance beyond their value at the date of the Rockridge Agreement or the Amendment, as applicable. We are obligated under convertible Equipment Notes with a face value of $1.0 million and a maturity date of June 3, 2011, which are collateralized by specifically designated software and equipment owned by us with a cost basis of approximately $1.5 million, as well as a subordinated lien on certain other of our assets to the extent that the designated software and equipment, or other software and equipment added to the collateral at a later date, is not considered sufficient security for the loan. Interest is payable every 6 months in cash or, at our option, in restricted ONSM common shares, based on a conversion price equal to seventy-five percent (75%) of the average ONSM closing price for the thirty (30) trading days prior to the date the applicable payment is due. On December 2, 2010, we elected to issue 76,769 unregistered shares of our common stock to the holders in lieu of $60,493 cash interest on these Equipment Notes for the period from May 2010 through October 2010, which was recorded as interest expense of $71,395 on our books, based on the fair value of those shares on the issuance date. The Equipment Notes may be converted to restricted ONSM common shares at any time prior to their maturity date, at the holder's option, based on a conversion price equal to seventy-five percent (75%) of the average ONSM closing price for the thirty (30) trading days prior to the date of conversion, but in no event may the conversion price be less than $4.80 per share. In the event the Notes are converted prior to maturity, interest on the Equipment Notes for the remaining unexpired loan period will be due and payable in additional restricted ONSM common shares in accordance with the same formula for interest as described above. We are obligated under an unsecured subordinated note payable note (the "CCJ Note") issued to CCJ Trust ("CCJ"), with an outstanding balance of $200,000 as of December 31, 2010. The CCJ Note originally bore interest at 8% per annum and was payable in equal monthly installments of principal and interest for 48 months plus a $100,000 principal balloon at maturity (the "CCJ Note") although none of those payments were made by us. To resolve this payment default, the CCJ Note was amended in January 2011 to prospectively increase the interest rate to 10% per annum, payable quarterly, and to require two principal payments of $100,000 each on December 31, 2011 and December 31, 2012, respectively. This amendment also called for our cash payment of the previously accrued interest in the amount of $16,263 on or before January 31, 2011. The remaining principal balance of this note may be converted at any time into our common shares at the greater of (i) the previous 30 day market value or (ii) $2.00 per share (which was $3.00 per share prior to the January 2011 renegotiation). In conjunction with and in consideration of the January 2011 note amendment, it was agreed that certain terms of the 35,000 shares of Series A-13 held by CCJ at that date would be modified. The effective interest rate of the CCJ Note prior to the January 2011 amendment was approximately 47.4% per annum, including the Black-Scholes value of warrants given plus the value of an increase granted in the number of common shares underlying the Series A-13 shares versus the Series A-12 shares that were exchanged for them. The effective rate of 47.4% per annum also included 11.2% per annum related to dividends that would have accrued to CCJ as a result of the later mandatory conversion date of the Series A-13 shares versus the mandatory conversion date of the Series A-12 shares. Following the January 2011 amendment, the effective interest rate of the CCJ Note increased to approximately 78.5% per annum, to reflect the value of the increased value of common shares underlying the Series A-13 shares as a result of the modified terms as well as the increase in the periodic cash interest rate from 8% to 10% per annum. The effective rate of 78.5% per annum also includes 9.3% per annum related to dividends that could accrue to CCJ as a result of the later mandatory conversion date of the Series A-13 shares as a result of the modified terms. 68 -------------------------------------------------------------------------------- Projected capital expenditures for the twelve months ending December 31, 2011 total approximately $1.3 million which includes software and hardware upgrades to the DMSP, the webcasting system (including iEncode) and the audio and web conferencing infrastructure, as well as costs of software development and hardware costs in connection with the introduction and establishment of the MarketPlace365 platform. This total includes at least $550,000 of projected capital expenditures which we have determined may be financed, deferred past the twelve month period or cancelled entirely, depending on our other cash flow considerations. This total excludes approximately $255,000 reflected by us as accounts payable at December 31, 2010, representing amounts that are presently the subject of litigation and which will not be reflected as capital expenditures in our cash flow statement until paid. We have estimated that we would require an approximately 7-8% increase in our consolidated revenues, as compared to our revenues for the twelve months ended September 30, 2010, in order to adequately fund our anticipated operating cash expenditures for the twelve months ending September 30, 2011 (including cash interest expense and a basic level of capital expenditures). Due to seasonality, this increase would be accomplished if we were to achieve average quarterly revenues during the twelve months ending September 30, 2011 equivalent to the revenues for the third quarter of fiscal 2010. We have estimated that, in addition to this revenue increase, we will also require additional debt or equity financing of approximately $1.5 to $2.0 million (in addition to recent sales of common shares discussed above) over the twelve months ending September 30, 2011 to satisfy principal repayments due against existing debt as well as past due trade payables that we believe are necessary to pay to continue our operations. However, approximately $1.0 million of this $1.5 to $2.0 million (related to the repayment of the Equipment Notes as discussed above) would not be required until June 2011. If we were to achieve revenue increases in excess of this 7-8%, or if any of our lenders elected to convert a portion of the existing debt to equity as allowed for under its terms, the required financing could be less than this $1.5 to $2.0 million. However, if we did not achieve these revenue increases, or if our operating expenses, cash interest or capital expenditures were higher than anticipated over the twelve months ending September 30, 2011, the required financing could be greater than this $1.5 to $2.0 million. We have implemented and continue to implement specific actions, including hiring additional sales personnel, developing new products and initiating new marketing programs, geared towards achieving revenue increases. The costs associated with these actions were contemplated in the above calculations. However, in the event we are unable to achieve the required revenue increases, we believe that a combination of identified decreases in our current level of expenditures that we would implement and the raising of additional capital in the form of debt and/or equity that we believe we could obtain from identified sources would be sufficient to allow us to operate for the next twelve months. We will closely monitor our revenue and other business activity to determine if further cost reductions, the raising of additional capital, or other activity is considered necessary. A prospectus allowing us to offer and sell up to $6.6 million of our registered common shares ("Shelf Registration") was declared effective by the SEC on April 30, 2010. In connection with the LPC Purchase Agreement 1.6 million common shares (including shares issuable upon conversion of preferred shares) were included in a prospectus supplement filed by us on September 17, 2010 with the SEC as a takedown under the Shelf Registration. However, there is no assurance that we will sell additional shares to LPC under the Purchase Agreement or that we will sell additional shares under the Shelf Registration, or if we do make such sales what the timing or proceeds will be. In addition, we may incur fees in connection with such sales. Furthermore, sales under the Shelf Registration that exceed in aggregate twenty percent (20%) of our outstanding shares would be subject to prior shareholder approval. 69 -------------------------------------------------------------------------------- On January 4, 2011, we received a funding commitment letter (the "Funding Letter") from J&C Resources, Inc. ("J&C") irrevocably agreeing to provide us, within twenty (20) days after our notice given on or before December 31, 2011, aggregate cash funding of up to $500,000, which may be requested in multiple tranches. Mr. Charles Johnston, one of our directors, is the president of J&C. This Funding Letter was obtained by us solely to demonstrate our ability to obtain short-term funds in the event other funding sources are not available, but does not represent any obligation on our part to accept such funding on these terms and is not expected by us to be exercised. The cash provided under the Funding Letter would be in exchange for our issuance of (a) a note or notes with interest payable monthly at 15% per annum and principal payable on the earlier of a date twelve months from funding or July 1, 2012 and (b) our issuance of 1 million unregistered common shares, which shares would be prorated in the case of partial funding. The note or notes would be unsecured and subordinated to all of our other debts, except to the extent such the terms of such debts would allow pari passu status. Furthermore, the note or notes would not be subject to any provisions, other than with respect to priority of payments or collateral, of our other debts. Upon receipt by us of an equivalent amount in dollars of investment from any other source after the date of this Funding Letter, other than funding received in connection with the LPC Purchase Agreement, this Funding Letter will be terminated. We have incurred losses since our inception, and have an accumulated deficit of approximately $124.4 million as of December 31, 2010. Our operations have been financed primarily through the issuance of equity and debt. Cash required to fund our continued operations will be affected by numerous known and unknown risks and uncertainties including, but not limited to, our ability to successfully market and sell the DMSP, iEncode and MarketPlace365 as well as our other existing products and services, the degree to which competitive products and services are introduced to the market, our ability to control and/or reduce expenses, our need to invest in new equipment and/or technology, and our ability to service and/or refinance our existing debt and accounts payable. We cannot assure that our revenues will continue at their present levels, nor can we assure that they will not decrease. As long as our cash flow from sales remains insufficient to completely fund operating expenses, financing costs and capital expenditures, we will continue depleting our cash and other financial resources. Other than working capital which may become available to us from further borrowing or sales of equity (including but not limited to proceeds from the LPC Purchase Agreement, Shelf Registration or Funding Letter, as discussed above), we do not presently have any additional sources of working capital other than cash on hand and cash, if any, generated from operations. As a result of the uncertainty as to our available working capital over the upcoming months, we may be required to delay or cancel certain of the projected capital expenditures, some of the planned marketing expenditures, or other planned expenses. In addition, it is likely that we will need to seek additional capital through equity and/or debt financing. If we raise additional capital through the issuance of debt, this will result in increased interest expense. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our company held by existing shareholders will be reduced and those shareholders may experience significant dilution. Our continued existence is dependent upon our ability to raise capital and to market and sell our services successfully. However, there are no assurances whatsoever that we will be able to sell additional common shares or other forms of equity under the LPC Purchase Agreement, the Shelf Registration or otherwise and/or that we will be able to borrow further funds under the Funding Letter or otherwise and/or that we will increase our revenues and/or control our expenses to a level sufficient to provide positive cash flow. 70 -------------------------------------------------------------------------------- Cash used in operating activities was approximately $79,000 for the three months ended December 31, 2010, as compared to approximately $524,000 used in operations for the corresponding period of the prior fiscal year. The $79,000 reflects our net loss of approximately $898,000, reduced by approximately $910,000 of non-cash expenses included in that loss and by approximately $47,000 arising from a net decrease in non-cash working capital items during the period and increased for an approximately $139,000 non-cash gain for adjustment of derivative liability to fair value. The net decrease in non-cash working capital items for the three months ended December 31, 2010 is primarily due to an approximately $323,000 decrease in accounts receivable, partially offset by an approximately $184,000 decrease in accounts payable, accrued liabilities and amounts due to directors and officers. This compares to a net increase in non-cash working capital items of approximately $413,000 for the corresponding period of the prior fiscal year, primarily due to an approximately $398,000 increase in accounts receivable. The primary non-cash expenses included in our loss for the three months ended December 31, 2010 were approximately $386,000 of depreciation and amortization, approximately $226,000 of employee compensation expense arising from the issuance of stock and options and approximately $141,000 of amortization of deferred professional fee expenses paid for by issuing stock and options. The primary sources of cash inflows from operations are from receivables collected from sales to customers. Future cash inflows from sales are subject to our pricing and ability to procure business at existing market conditions. Cash used in investing activities was approximately $233,000 for the three months ended December 31, 2010 as compared to approximately $263,000 for the corresponding period of the prior fiscal year. Current and prior period investing activities related to the acquisition of property and equipment. Cash used in financing activities was approximately $375,000 for the three months ended December 31, 2010 as compared to approximately $576,000 provided by financing activities for the corresponding period of the prior fiscal year. Current year financing activities primarily related to repayments of notes and leases payable and convertible debentures, partially offset by proceeds from the sale of common stock and proceeds from notes payable. Prior year financing activities primarily related to net proceeds from notes payable and convertible debentures, net of repayments. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles ("GAAP") and our significant accounting policies are described in Note 1 to those statements. The preparation of financial statements in accordance with GAAP requires that we make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying footnotes. Our assumptions are based on historical experiences and changes in the business environment. However, actual results may differ from estimates under different conditions, sometimes materially. Critical accounting policies and estimates are defined as those that are both most important to the management's most subjective judgments. Our most critical accounting policies and estimates are described as follows. Our prior acquisitions of several businesses, including the Onstream Merger and the Infinite Merger, have resulted in significant increases in goodwill and other intangible assets. Goodwill and other unamortized intangible assets, which include acquired customer lists, were approximately $13.6 million at December 31, 2010, representing approximately 69% of our total assets and approximately 118% of the book value of shareholder equity. In addition, property and equipment as of December 31, 2010 includes approximately $2.1 million (net of depreciation) related to the DMSP and other capitalized internal use software, representing approximately 11% of our total assets and approximately 18% of the book value of shareholder equity. 71 -------------------------------------------------------------------------------- In accordance with GAAP, we periodically test these assets for potential impairment. As part of our testing, we rely on both historical operating performance as well as anticipated future operating performance of the entities that have generated these intangibles. Factors that could indicate potential impairment include a significant change in projected operating results and cash flow, a new technology developed and other external market factors that may affect our customer base. We will continue to monitor our intangible assets and our overall business environment. If there is a material adverse and ongoing change in our business operations (or if an adverse change initially considered temporary is determined to be ongoing), the value of our intangible assets, including those of our DMSP or Infinite divisions, could decrease significantly. In the event that it is determined that we will be unable to successfully market or sell our DMSP or audio and web conferencing services, an impairment charge to our statement of operations could result. Any future determination requiring the write-off of a significant portion of unamortized intangible assets, although not requiring any additional cash outlay, could have a material adverse effect on our financial condition and results of operations. We follow a two step process for impairment testing of goodwill. The first step of this test, used to identify potential impairment and described above, compares the fair value of a reporting unit with its carrying amount, including goodwill. The second step, if necessary, measures the amount of the impairment, including a comparison and reconciliation of the carrying value of all of our reporting units to our market capitalization, after appropriate adjustments for control premium and other considerations. If our market capitalization, after appropriate adjustments for control premium and other considerations, is determined to be less than our net book value (i.e., stockholders' equity as reflected in our financial statements), that condition might indicate an impairment requiring the write-off of a significant portion of unamortized intangible assets, although not requiring any additional cash outlay, could have a material adverse effect on our financial condition and results of operations. Our common stock has demonstrated significant volatility in recent months, from $1.04 per share as of September 30, 2010 to $0.80 per share as of December 31, 2010 to $1.40 per share as of January 21, 2011 to $1.06 per share as of February 4, 2011. If the price of our common stock and our market value were to decline to the level experienced in December 2010, such condition could result in future non-cash impairment charges to our results of operations related to our goodwill and other intangible assets arising either from an interim impairment review as of March 31, 2011 or from our next scheduled recurring annual impairment review, as of September 30, 2011. We will closely monitor and evaluate all such factors as of March 31, 2011 and subsequent periods, in order to determine whether to record future non-cash impairment charges. 72-------------------------------------------------------------------------------- [ Back To TMCnet.com's Homepage ]