BROADCAST INTERNATIONAL INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Note Regarding Forward-Looking Statements This report contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risk and uncertainties. Any statements about our expectations, beliefs, plans, objectives, strategies or future events or performance constitute forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as "anticipate," "estimate," "plan," "project," "continuing," "ongoing," "expect," "believe," "intend" and similar words or phrases. Accordingly, these statements involve estimates, assumptions and uncertainties that could cause actual results to differ materially from those expressed or implied therein. All forward-looking statements are qualified in their entirety by reference to the factors discussed in this report and to the following risk factors discussed more fully in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011: · dependence on commercialization of our CodecSys technology; · our need and ability to raise sufficient additional capital; · uncertainty about our ability to repay our outstanding convertible notes; · our continued losses; · delays in adoption of our CodecSys technology; · concerns of OEMs and customers relating to our financial uncertainty; · restrictions contained in our outstanding convertible notes; · general economic and market conditions; · ineffective internal operational and financial control systems; · rapid technological change; · intense competitive factors; · our ability to hire and retain specialized and key personnel; · dependence on the sales efforts of others; · dependence on significant customers; · uncertainty of intellectual property protection; · potential infringement on the intellectual property rights of others; · extreme price fluctuations in our common stock; 24-------------------------------------------------------------------------------- · price decreases due to future sales of our common stock; · future shareholder dilution; and · absence of dividends.

Because the risk factors referred to above could cause actual results or outcomes to differ materially from those expressed or implied in any forward-looking statements made by us or on our behalf, you should not place undue reliance on any forward-looking statement. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of future events or developments. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

Critical Accounting Policies The preparation of financial statements in conformity with U.S. GAAP requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our assumptions and estimates, including those related to recognition of revenue, valuation of investments, valuation of inventory, valuation of intangible assets, valuation of derivatives, measurement of stock-based compensation expense and litigation.

We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discuss our critical accounting policies in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011. There have been no other significant changes in our critical accounting policies or estimates since those reported in our Annual Report.

Executive Overview The current recession and market conditions have had substantial impacts on the global and national economies and financial markets. These factors, together with soft credit markets, have slowed business growth and generally made potential funding sources more difficult to access. We continue to be affected by prevailing economic and market conditions, which present considerable risks and challenges to us.

On July 1, 2010, we released CodecSys 2.0, which has been installed in various large telecoms and labs for evaluation by potential customers. In 2011 we continued development of additional sales channel partners by integrating CodecSys on hardware manufactured and sold by Fujitsu, which has adopted CodecSys as its compression technology for use in its NuVola cloud initiative and has commenced sales and marketing efforts including CodecSys as an integral part of the products. We continue to make sales presentations and respond to requests for proposals at other large telecoms, cable companies and broadcasting companies. These presentations have been made with our technology partners which are suppliers of hardware and software for video transmission applications in media room environments such as IBM, HP Fujitsu and Microsoft. In October 2011, we completed our first sale of CodecSys to a small cable operator in Mexico as part of its Over the Top ("OTT") product offering operating on Fujitsu hardware. It is currently in operation and demonstrates that the CodecSys product offering does operate to its operating specifications in a working environment, which we believe will help in our sales and marketing efforts. Although license revenue from the CodecSys technology has been minimal to date, we believe we have made significant progress and continue to believe that our CodecSys technology holds substantial revenue opportunities for our business. We have continued to market our products to the industry and have recently entered into sales agreements with four additional cable, satellite and broadcast companies for their OTT initiatives. Revenues from these sales will be first recorded in the third and fourth quarters of 2012.

On July 31, 2009, we entered into a $10.1 million, three-year contract with Bank of America, a Fortune 10 financial institution, to provide technology and digital signage services to approximately 2,100 of its more than 6,000 retail and administrative locations throughout North America. This contract has been extended to February 1, 2013. BofA is in the process of expanding its network to additional locations and we now furnish services to approximately 33,000 screens at more than 2,500 locations. In addition, BofA selected us to be its vendor for certain additional audio visual services. A factor in securing this contract was the benefits of the CodecSys technology in delivering our services. For the quarter ended September 30, 2012, we realized approximately $1,680,927 in revenue from this contract, which contributed approximately 82% of our revenues for the quarter. BofA is in the process of soliciting requests for proposals from competing vendors, to which we have responded as well.

25 --------------------------------------------------------------------------------Our revenues for the quarter ended September 30, 2012 decreased by approximately $231,796 or 10% compared to the quarter ended September 30, 2011. Although we experienced a decrease in our revenues our gross margin increased approximately $20,290 or 3% for the quarter ended September 30, 2012 compared to the same period in 2011. However, we continue to deplete our available cash and need future equity and debt financing as we continue to spend more money than we generate from operations.

To fund operations through the remainder of the current year, we engaged our investment banker to raise funds through the issuance of convertible promissory notes. We anticipate issuing promissory notes with a principal amount of up to $5,000,000 ("2012 Convertible Debt Offering") due and payable on or before July 13, 2013. As of September 30, 2012, we have issued notes with an aggregate principal value of $2,800,000 as explained below. The notes bear interest at 12% per annum and may be convertible to common stock at a $.25 per share conversion price. We also granted holders of the notes warrants with a five year life to acquire up to 200,000 shares of our common stock for each $100,000 of principal amount of the convertible notes. The notes are secured by all of our assets with the exception of the equipment and receivables secured by the equipment lessor for equipment used in providing services for our largest customer's digital signage network. On July 13, 2012, we entered into a note and warrant purchase and security agreement with individual investors and broke escrow on the initial funding under the 2012 Convertible Debt Offering, the principal amount of which was $1,900,000, which included the conversion of $900,000 of previously issued short term debt (See Bridge Loan described below) to the 2012 Convertible Debt Offering, which extinguished the Bridge Loan. We realized $923,175 of cash in the initial closing and issued warrants to acquire 3,800,000 shares of our common stock. We paid $76,825 in investment banking fees and costs of the offering. On August 15, 2012, we continued sales of convertible debt under the 2012 Convertible Debt Offering by issuing short term debt with a principal amount of $900,000, from which we realized cash of $851,624 after payment of investment banking fees of $48,376.

On March 26, 2012, we closed on an equity financing (the "2012 Equity Financing") as well as a restructuring of our outstanding senior convertible indebtedness (the "2012 Debt Restructuring"), resulting in complete satisfaction of our senior indebtedness.

We entered into an Engagement Agreement, dated October 28, 2011, with MDB Capital Group, LLC ("MDB"), pursuant to which MDB agreed to act as the exclusive agent of the Company on a "best efforts" basis with respect to the sale of the Company's securities of up to a maximum gross consideration of $6,000,000, subsequently verbally increased to $10,000,000, subject to a minimum gross consideration of $3,000,000. The Company agreed to pay to MDB a commission of 10% of the gross offering proceeds received by the Company, to grant to MDB warrants to acquire up to 10% of the shares of our common stock issued in the financing, and to pay the reasonable costs and expenses of MDB related to the offering.

Pursuant to the Engagement Agreement, we entered into a Securities Purchase Agreement ("SPA") dated March 23, 2012 with select institutional and other accredited investors for the private placement of 27,800,000 units of its securities. The SPA included a purchase price of $.25 per unit, with each unit consisting of one share of common stock and two forms of Warrant: (1) The "A" Warrant grants the investors the right to purchase an additional share of common stock for each two shares of common stock purchased, for a term of six years and at an exercise price of $.35 per share; and (2) The "B" Warrant will not be exercisable unless and until the occurrence of a future issuance of stock at less than $0.25 per share, but, in the event of such issuance, grants the investors the right to acquire additional shares at a price of $0.05 to reduce the impact of the dilution caused by such issuance, but in no event shall the number of shares to be issued under the B Warrant cause us to exceed the number of authorized shares of common stock. The shares in excess of our authorized shares that would have been issuable under the B Warrant shall be "net settled" by payment of cash in an amount equal to the number of shares in excess of the authorized common shares multiplied by the closing price of our common stock as of the trading day immediately prior to the applicable date of the exercise of such B Warrant. The B Warrant shall be extinguished upon the earlier of: (a) a subsequent financing of at least $5 million on terms no more favorable than that received by the investors in the 2012 Equity Financing; (b) after the effective date of the registration statement registering securities issued in the Equity Financing if the volume-weighted average closing price of the Company's common stock exceeds $.50 per share for a period of 30 trading days and no Volume Failure (as defined in the B Warrant) (measuring the daily average dollar volume of our Common Stock against a minimum volume of $500,000 per day) exists during such period, and the Company is then current in its public filings; or (c) 78 months.

26 --------------------------------------------------------------------------------Net proceeds from the 2012 Equity Financing, after deducting the commissions and the estimated legal, printing and other costs and expenses related to the financing, were approximately $6.1 million. Coincident to the closing of the 2012 Equity Financing, we also closed on the 2012 Debt Restructuring. In connection therewith, the Company paid $2.75 million to Castlerigg Master Investment Ltd. ("Castlerigg"), and issued to Castlerigg 2,000,000 shares of common stock in full and complete satisfaction of the remaining principal balance and all accrued interest of the Amended and Restated Note. In consideration of negotiating the 2012 Debt Restructuring, we issued to one of our placement agents 586,164 shares of our common stock and paid $275,041.

In December 2011, we entered into a loan with 7 accredited individuals and entities under the terms of which we borrowed $1,300,000 to be used as working capital ("Bridge Loan"). The Bridge Loan bears an interest rate of 18% per annum and had a maturity date of February 28, 2012, which was subsequently extended to the earlier of the date nine months from the original maturity date or the date we close on an additional sale of our securities that results in gross proceeds to us of $12 million. In consideration of the Bridge Loan we granted to the holders of the Bridge Loan warrants with a five year term to purchase 357,500 shares of our common stock at an exercise price of $0.65 per share. In consideration of the extension of the maturity date of the Bridge Loan, we granted the holders of the Bridge Loan warrants with a six year term to purchase 247,500 shares of our common stock at an exercise price of $0.35 per share.

In connection with the 2012 Equity Financing and under the terms of the SPA, two of the above described bridge lenders converted the principal balance of their portion of the bridge loan in the amount of $400,000 to common stock and warrants as part of and on the same terms as the 2012 Equity Financing. In addition, one other entity converted the amount owed by us for equipment purchases in the amount of $500,000 to common stock and warrants as part of and on the same terms as the 2012 Equity Financing. The proceeds from these conversions were treated as funds raised with respect to the financing.

In connection with the 2012 Equity Financing and under the terms of the SPA, the Company agreed to prepare and file, and did file, within 60 days following the issuance of the securities, a registration statement covering the resale of the shares of common stock sold in the financing and the shares of common stock underlying the Warrants. The Company did file the registration statement on April 9, 2012 and it was declared effective on August 1, 2012.

In April 2012, an additional investment was accepted by us as part of the 2012 Equity Financing in the aggregate amount of $154,000, which included cash of $100,000 and the conversion of $54,000 of director fees owed to two of our directors to stock and warrants on the same terms as the offering. This resulted in the issuance of 616,000 shares of common stock and the issuance of warrants to acquire up to 308,000 shares of our common stock. In connection with this part of the transaction we paid a commission of $15,400 to our investment banker and issued to the broker warrants to acquire 92,400 shares of our common stock on the same terms as in the financing.

During 2010 we sold 1,601,666 shares of our common stock to 19 separate investors at a purchase price of $1.00 per share together with a warrant to purchase additional shares of our stock for $1.50 per share. The warrant expires at the end of three years. The net proceeds from the sale of these shares were used for general working capital purposes. Each of the investors was given the right to adjust their purchase in the event we sold additional equity at a price and on terms different from the terms on which their equity was purchased. Upon completion of the 2010 Equity Financing described below, each of the investors converted their purchase to the terms contained in the 2010 Equity Financing. This resulted in the issuance of an additional 2,083,374 shares of common stock and the cancellation of 2,495,075 warrants with an exercise price of $1.50 and the issuance of 2,079,222 warrants with an exercise price of $1.00 and an expiration date of five years from the conversion.

On December 24, 2010, we closed on an equity financing (the "2010 Equity Financing") as well as a restructuring of our then outstanding convertible indebtedness (the "2010 Debt Restructuring"). The 2010 Equity Financing and the 2010 Debt Restructuring are described as follows.

We entered into a Placement Agency Agreement, dated December 17, 2010, with Philadelphia Brokerage Corporation ("PBC"), pursuant to which PBC agreed to act as the exclusive agent of the Company on a "best efforts" basis with respect to the sale of up to a maximum gross consideration of $15,000,000 of units of the Company's securities, subject to a minimum gross consideration of $10,000,000. The Units consisted of two shares of our common stock and one warrant to purchase a share of our common stock. The Company agreed to pay PBC a commission of 8% of the gross offering proceeds received by the Company, to issue PBC 40,000 shares of its common stock for each $1,000,000 raised, and to pay the reasonable costs and expenses of PBC related to the offering. The Company also agreed to pay PBC a restructuring fee in the amount of approximately $180,000 upon the closing of the 2010 Equity Financing and the simultaneous 2010 Debt Restructuring.

27 --------------------------------------------------------------------------------Pursuant to the Placement Agency Agreement, we entered into Subscription Agreements dated December 23, 2010 with select institutional and other accredited investors for the private placement of 12,500,000 units of our securities. The Subscription Agreements included a purchase price of $1.20 per unit, with each unit consisting of two shares of common stock and one warrant to purchase an additional share of common stock. The warrants have a term of five years and had an exercise price of $1.00 per share, but are now exercisable at $0.78 per share pursuant to the 2012 Equity Financing.

Net proceeds from the 2010 Equity Financing, after deducting the commissions and debt restructuring fees payable to PBC and the estimated legal, printing and other costs and expenses related to the financing, were approximately $13.5 million. We used a portion of the net proceeds of the Equity Financing to pay down debt and the remainder was used for working capital.

On November 29, 2010, we entered into a bridge loan transaction with three accredited investors pursuant to which we issued unsecured notes in the aggregate principal amount of $1.0 million. Upon the closing of the 2010 Equity Financing, the lenders converted the entire principal amount plus accrued interest into the same units offered in the 2010 Equity Financing and the proceeds from the bridge loan transaction were treated as funds raised with respect to the financing.

In connection with the 2010 Equity Financing and under the terms of the Subscription Agreements, the Company agreed to prepare and file and did file, within 60 days following the issuance of the securities, a registration statement covering the resale of the shares of common stock sold in the financing and the shares of common stock underlying the Warrants. The registration statement continues to be effective.

On December 24, 2010, we also closed on the 2010 Debt Restructuring. In connection therewith, we (i) issued an Amended and Restated Senior Convertible Note in the principal amount of $5.5 million (the "Amended and Restated Note") to Castlerigg Master Investment Ltd. ("Castlerigg"), (ii) paid $2.5 million in cash to Castlerigg, (iii) cancelled warrants previously issued to Castlerigg that were exercisable for a total of 5,208,333 shares of common stock, (iv) issued 800,000 shares of common stock to Castlerigg in satisfaction of an obligation under a prior loan amendment, (v) entered into the Letter Agreement pursuant to which we paid Castlerigg an additional $2.75 million in cash in lieu of the issuance of $3.5 million in stock and warrants as provided in the loan restructuring agreement under which the Amended and Restated Note and other documents were issued (the "Loan Restructuring Agreement"), and (vi) entered into an Investor Rights Agreement with Castlerigg dated December 23, 2010. As a result of the foregoing, Castlerigg forgave approximately $7.2 million of principal and accrued but unpaid interest.

The Amended and Restated Note, dated December 23, 2010, was a senior, unsecured note that matured in three years from the closing and bore interest at an annual rate of 6.25%, payable semi-annually. We paid the first year's interest of approximately $344,000 at the closing. The Amended and Restated Note was fully satisfied as described above.

In connection with the 2010 Debt Restructuring, the Company amended the note with the holder of a $1.0 million unsecured convertible note, pursuant to which the maturity date of the note was extended to December 31, 2013. We also issued 150,000 shares to the holder of this note and a warrant to acquire up to 75,000 shares of our common stock as consideration to extend the term of the note. The warrant is exercisable for $0.90 per share and has a five year life.

Results of Operations for the Nine Months ended September 30, 2012 and September 30, 2011 Revenues We generated $5,790,363 in revenue during the nine months ended September 30, 2012. During the same nine month period in 2011, we generated revenue of $6,321,495. The decrease in revenue of $531,132 was due primarily to a decrease in revenue from sales of equipment and installation fees from our digital signage contract with our largest customer, a financial services company, which accounted for approximately 84% of our revenues for the nine months ending September 30, 2012. License fees increased by $337,851, but system sales and installation revenues decreased by $1,156,931 in the nine months ended September 30, 2012, almost all of which changes were due to fewer work orders from our major digital signage customer. The increase in license fees and the decrease in system sales and installation revenues actually resulted in an increase in gross margin due to higher gross margins in the license fee category than for system sales and installation services. In addition, revenue from studio and production services increased by $111,766 and revenue from web services and other services increased by $180,548 both of which partially offset the loss of revenue due to sales of equipment and installation activities.

28 --------------------------------------------------------------------------------Sales revenues from our largest customer accounted for approximately 84% and 91% of total revenues for the nine months ended September 30, 2012 and 2011, respectively. Revenues from all of our customers, except our largest customer, increased by $347,223 or 63% in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. This increase resulted primarily from the addition of one new customer to which we provide web hosting and streaming services.

Cost of Revenues Cost of revenues decreased by approximately $556,721 to $3,857,682 for the nine months ended September 30, 2012 from $4,414,402 for the nine months ended September 30, 2011. Costs of equipment and installation services decreased by $339,771 primarily due to decreased installation of new equipment used in the continued expansion of our largest customer's digital signage network. In addition, depreciation decreased by $135,754 due to equipment used in our largest network being fully depreciated and costs of the production and maintenance department decreased by $79,482 due to cost reduction efforts by management.

Expenses General and administrative expenses for the nine months ended September 30, 2012 were $3,589,602 compared to $5,124,883 for the nine months ended September 30, 2011. The decrease of $1,535,281 resulted primarily from a decrease of approximately $1,757,022 in the amount charged for the issuance of options and warrants. This decrease was partially offset by an increase of $128,557 in temporary help expenses, $60,845 in increased consulting fees, and $30,649 in increased employee and related expenses.

Research and development in process decreased by $447,056 for the nine months ended September 30, 2012 to $1,346,540 from $1,793,596 for the nine months ended September 30, 2011. The decrease resulted primarily from a decrease of $228,110 in consulting expenses, $108,780 in conventions and travel expenses, $62,298 in temporary help expenses, and $60,970 in expenses related to grants of options and warrants.

Sales and marketing expenses increased $732,964 to $1,557,735 for the nine months ending September 30, 2012 from $824,771 for the nine months ended September 30, 2011. The increase reflects an increase in employee and related costs of $423,792, an increase of $198,978 in general operating costs including travel and tradeshow expenses and an increase in other professional services and consulting fees of $ 93,504. The increase in sales and marketing expenses primarily reflects increased staff and activity in marketing the CodecSys technology.

Interest Expense For the nine months ended September 30, 2012, we incurred interest expense of $1,066,598 compared to interest expense for the nine months ended September 30, 2011 of $745,925. The increase of $320,673 resulted primarily from the interest recorded to account for the issuance of our Bridge Loan and the issuance of our 2012 Convertible Debt, which was not outstanding during the nine months ended September 30, 2011 and resulted in the increase in interest expense. Of the total interest expense recorded for the nine months ended September 30, 2012, $310,000 was the amount incurred on the $1,000,000 principal outstanding on our 8.0% unsecured convertible note, $290,216 was incurred on our 2012 Convertible Debt, $217,520 was incurred on our Bridge Note and $96,512 was incurred on our equipment lease financing. Of the total amount of our interest expense, $353,451 was interest actually paid or accrued and $713,147 was non-cash interest expense related to the note accretion on our $1,000,000 unsecured convertible note and amortization of debt offering costs related to other indebtedness.

Net Income We realized a net loss for the nine months ended September 30, 2012 of $49,357 compared with net income for the nine months ended September 30, 2010 of $3,729,513. The change from realizing net income to a net loss aggregated $3,778,870 and was due primarily to a decrease in gain related to our derivative valuation calculation of warrants and convertible notes of $6,617,504, an increase of $619,075 in equity issuance costs related to warrants issued and the increase in interest expense of $320,674 discussed above. The decrease was partially offset by a gain of $2,542,854 realized on the extinguishment of debt resulting from the payoff of our 6.25% senior convertible note.

29 --------------------------------------------------------------------------------Results of Operations for the Three Months ended September 30, 2012 and September 30, 2011 Revenues We generated $2,045,277 in revenue during the three months ended September 30, 2012. During the same three-month period in 2011, we generated revenue of $2,277,074. The decrease in revenue of $231,795 was due primarily to a decrease of $518,198 in system sales and installation and service work resulting from decreased work orders for the digital signage network of our largest customer. The decrease was partially offset by an increase of $138,322 in license fees, $80,543 in studio and production fees and $67,898 in web hosting and other fees.

Our largest customer's sales revenues accounted for approximately 82% and 92% of total revenues for the quarters ended September 30, 2012 and 2011, respectively. Revenues from all customers other than our largest customer increased by $187,560 during the quarter ended September 30, 2012 compared to the quarter ended September 30, 2011 more than half of which were derived from a new web hosting customer. Any material reduction in revenues generated from our largest customer could cause a substantial deterioration in our results of operations, financial condition and liquidity. Although our sales declined, our gross margin actually increased slightly due to the fact that services that were performed were services with higher margins than our equipment sales and service work.

Cost of Revenues Costs of revenues decreased by approximately $252,086 to $1,266,224 for the three months ended September 30, 2012 from $1,518,310 for the three months ended September 30, 2011. The decrease was due primarily to a decrease of $115,471 in cost of equipment sales and services due to fewer work orders being issued for equipment and services on our largest customer's digital signage network and a decrease in the amount of depreciation recorded of $131,123 related to equipment that is now fully depreciated.

Expenses General and administrative expenses for the three months ended September 30, 2012 were $1,001,001 compared to $1,280,183 for the three months ended September 30, 2010. The decrease of approximately $279,182 resulted primarily from a decrease of $195,466 in option and warrant expenses, $56,650 in employee and related costs and $48,500 in director fees.

Research and development in process decreased by $245,071 for the three months ended September 30, 2012 to $325,126 from $570,197 for the three months ended September 30, 2011. This decrease resulted primarily from decreased consulting fees of $110,585 and a decrease of $111,377 in various operating expense categories including temporary help, travel, and tradeshows and conventions.

Sales and marketing expenses increased $40,669 for the three months ended September 30, 2012 to $442,495 from $401,826 for the three months September 30, 2011. The increase was due primarily to increased consulting fees of $52,554 and increased employee and related expenses of $31,968, which were partially offset by a decrease in advertising and promotion of $19,854.

Interest Expense For the three months ended September 30, 2012, we incurred interest expense of $460,388 compared to interest expense for the three months ended September 30, 2011 of $176,047. The increase of $284,340 resulted primarily from interest expense of $313,647 attributable to our Bridge Loan and our 2012 Convertible Debt Offering, which were not outstanding during the three months ended September 30, 2011. The increase in interest expense was partially offset by a decrease in interest expense related to equipment financing for our largest customer of $51,752. The $460,388 of interest expense recorded consisted primarily of $355,092 of non-cash interest expense recorded to account for the accretion of note liability on our balance sheet and amortization of debt offering costs.

30 --------------------------------------------------------------------------------Net Income We realized a net loss for the three months ended September 30, 2012 of $711,072 compared to net income of $4,034,154 for the three months ended September 30, 2011. The difference between our net loss in 2012 compared to our net income in 2011 of $4,745,226 was primarily the result of recording a decreased gain related to the derivative valuation of warrants and convertible notes for the three months ended September 30, 2012 of $4,799,784, increased interest expense recorded of $284,341 as explained above and $200,252 of expenses incurred relative to the extinguishment of debt and retirement of debt offering costs. The decrease in our total net income was partially offset by a decrease in loss from operations of $546,132 resulting from decreased operating expenses and an increase in gross margin as explained above.

Liquidity and Capital Resources At September 30, 2012, we had cash of $373,119, total current assets of $2,074,563, total current liabilities of $8,868,262 and total stockholders' deficit of $6,307,552. Included in current liabilities is $4,346,021, which relates to the value of the embedded derivatives for our 8.0% unsecured convertible note and our 2012 Convertible Notes and related warrants and warrants issued pursuant to our 2012 Equity Financing.

We experienced negative cash flow used in operations during the nine months ending September 30, 2012 of $3,286,334 compared to negative cash flow used in operations for the nine months ended September 30, 2011 of $4,135,209. In July 2012 we commenced expense reduction actions designed to decrease our negative cash flow. We reduced salaries and general and administrative expenses. Our expenditures for development and sales of CodecSys now total approximately $300,000 per month, which approximates our current monthly excess of cash expenses over income. The negative cash flow was met by cash reserves from the completion of our 2012 Equity Financing and the issuance of our 2012 Convertible Debt in the total amount of $2,800,000, which included $900,000 of Bridge Loan indebtedness that was converted to the 2012 Convertible Debt. We expect to continue to experience negative operating cash flow as long as we continue our current expenditures related primarily to bringing our CodecSys products to market, continue our development of CodecSys or until we begin to receive licensing revenue from sales of our CodecSys proprietary software or increase sales in our network division by adding new customers.

To fund operations through the remainder of the current year, we engaged Philadelphia Brokerage Corporation to raise funds through the issuance of convertible promissory notes. We anticipate issuing promissory notes with an aggregate principal amount of up to $5,000,000 ("2012 Convertible Debt Offering"). The notes will be due and payable on or before July 13, 2013. The notes will bear interest at 12% per annum and be convertible to common stock at a $.25 per share conversion price. We will also grant to holders of the notes warrants with a five year life to acquire up to 200,000 shares of our common stock for each $100,000 of principal amount of the convertible notes. The notes will be secured by all of our assets with the exception of the equipment and receivables secured by the equipment lessor, which are related to our largest customer's digital signage network. On July 13, 2012, we entered into a note and warrant purchase and security agreement with individual investors and broke escrow on the initial funding under the 2012 Convertible Debt Offering. The principal amount of the initial notes issued was $1,900,000, which included the conversion of $900,000 of previously issued short term debt (See Bridge Loan described below) to the 2012 Convertible Debt Offering. At the initial escrow break, we realized $1,000,000 of cash and issued warrants to acquire 3,800,000 shares of our common stock. We paid $76,825 in investment banking fees and costs of the offering. On August 15, 2012, we continued sales of convertible debt under the 2012 Convertible Debt Offering by issuing short term debt with a principal amount of $900,000, from which we realized cash of $851,000 after payment of investment banking fees of $49,000.

On March 26, 2012, we closed on an equity financing (the "2012 Equity Financing") as well as a restructuring of our outstanding senior convertible indebtedness (the "2012 Debt Restructuring") resulting in complete satisfaction our senior indebtedness.

We entered into an Engagement Agreement, dated October 28, 2011, with MDB Capital Group, LLC ("MDB"), pursuant to which MDB agreed to act as the exclusive agent of the Company on a "best efforts" basis with respect to the sale of up to a maximum gross consideration of $6,000,000, subsequently verbally increased to $10,000,000, of the Company's securities, subject to a minimum gross consideration of $3,000,000. The Company agreed to pay to MDB a commission of 10% of the gross offering proceeds received by the Company, to grant to MDB warrants to acquire up to 10% of the shares of our common stock and warrants issued in the financing, and to pay the reasonable costs and expenses of MDB related to the offering.

31 --------------------------------------------------------------------------------Pursuant to the Engagement Agreement, we entered into a Securities Purchase Agreement ("SPA") dated March 23, 2012 with select institutional and other accredited investors for the private placement of 27,800,000 units of its securities. The SPA included a purchase price of $.25 per unit, with each unit consisting of one share of common stock and two forms of Warrant: (1) The "A" Warrant grants the investors the right to purchase an additional share of common stock for each two shares of common stock purchased, for a term of six years and at an exercise price of $.35 per share; and (2) The "B" Warrant will not be exercisable unless and until the occurrence of a future issuance of stock at less than $0.25 per share, but, in the event of such issuance, grants the investors the right to acquire additional shares at a price of $0.05 to reduce the impact of the dilution caused by such issuance, but in no event shall the number of shares to be issued under the B Warrant cause us to exceed the number of authorized shares of common stock. The shares in excess of our authorized shares that would have been issuable under the B Warrant shall be "net settled" by payment of cash in an amount equal to the number of shares in excess of the authorized common shares multiplied by the closing price of our common stock as of the trading day immediately prior to the applicable date of the exercise of such B Warrant. The B Warrant shall be extinguished upon the earlier of: (a) a subsequent financing of at least $5 million on terms no more favorable than that received by the investors in the 2012 Equity Financing; (b) after the effective date of the registration statement registering securities issued in the Equity Financing if the volume-weighted average closing price of the Company's common stock exceeds $.50 per share for a period of 30 trading days and no Volume Failure (as defined in the B Warrant) (measuring the daily average dollar volume of our Common Stock against a minimum volume of $500,000 per day) exists during such period, and the Company is then current in its public filings; or (c) 78 months.

Net proceeds from the 2012 Equity Financing, after deducting the commissions and the estimated legal, printing and other costs and expenses related to the financing, were approximately $6.1 million. Coincident to the closing of the 2012 Equity Financing, we also closed on the 2012 Debt Restructuring. In connection therewith, the Company paid $2.75 million to Castlerigg Master Investment Ltd. ("Castlerigg"), and issued to Castlerigg 2,000,000 shares of common stock in full and complete satisfaction of the senior convertible note and all accrued interest then owing. In consideration of negotiating the 2012 Debt Restructuring, we issued to one of our placement agents 586,164 shares of our common stock and paid cash of $275,041.

In December 2011, we entered into a loan with 7 accredited individuals and entities under the terms of which we borrowed $1,300,000 to be used as working capital ("Bridge Loan"). The Bridge Loan bears interest at the rate of 18% per annum and had a maturity date of February 28, 2012, which was subsequently extended to the earlier of the date nine months from the original maturity date or the date we close on an additional sale of our securities that results in gross proceeds to us of $12 million. In consideration of the Bridge Loan we granted to the holders of the Bridge Loan warrants with a five year term to purchase 357,500 shares of our common stock at an exercise price of $0.65 per share. In consideration of the extension of the maturity date of the Bridge Loan, we granted the holders of the Bridge Loan warrants with a six year term to purchase 247,500 shares of our common stock at an exercise price of $0.35 per share.

In connection with the 2012 Equity Financing and under the terms of the Subscription Agreements, two of the above described bridge lenders converted the principal balance of their portion of the bridge loan in the amount of $400,000 to common stock and warrants as part of and on the same terms as the 2012 Equity Financing. The proceeds from this conversion were treated as funds raised with respect to the financing. In July, the remaining $900,000 of the bridge loan principal was converted to debt as part of the 2012 Convertible Debt Offering.

In connection with the 2012 Equity Financing and under the terms of the SPA, the Company agreed to prepare and file, and did file, within 60 days following the issuance of the securities, a registration statement covering the resale of the shares of common stock sold in the financing and the shares of common stock underlying the Warrants. The registration statement was declared effective August 1, 2012.

In October 2011, we secured favorable terms with a single company on purchases of certain equipment installed and sold to our customers in the amount of $700,000, which was outstanding at the end of the year. The payment for the equipment was deferred for a 90 day period for a 10% premium to the amounts advanced. This company converted $500,000 of the amount owed by us to common stock and warrants as part of and on the same terms as the 2012 Equity Financing. The proceeds from this conversion were treated as funds raised with respect to the financing.

We entered into a Placement Agency Agreement, dated December 17, 2010, with Philadelphia Brokerage Corporation ("PBC"), pursuant to which PBC agreed to act as the exclusive agent of the Company on a "best efforts" basis with respect to the sale of up to a maximum gross consideration of $15,000,000 of units of the Company's securities, subject to a minimum gross consideration of $10,000,000. The Company agreed to pay PBC a commission of 8% of the gross offering proceeds received by the Company, to issue PBC 40,000 shares of its common stock for each $1,000,000 raised, and to pay the reasonable costs and expenses of PBC related to the offering. The Company also agreed to pay PBC a restructuring fee in the amount of approximately $180,000 upon the closing of the 2010 Equity Financing and simultaneous 2010 Debt Restructuring.

32 --------------------------------------------------------------------------------Pursuant to the Placement Agency Agreement, we entered into Subscription Agreements dated December 23, 2010 with select institutional and other accredited investors for the private placement of 12,500,000 units of our securities. The Subscription Agreements included a purchase price of $1.20 per unit, with each unit consisting of two shares of common stock and one warrant to purchase an additional share of common stock. The warrants have a term of five years and had an exercise price of $1.00 per share when issued, but are now exercisable at $0.78 per share due to adjustments in price incident to the 2012 Equity Financing.

Net proceeds from the 2010 Equity Financing, after deducting the commissions and debt restructuring fees payable to PBC and the estimated legal, printing and other costs and expenses related to the financing, were approximately $13.5 million. We used a portion of the net proceeds of the 2010 Equity Financing to pay down our senior debt, brought our accounts payable current, and the remainder was used for working capital.

On December 24, 2010, we also closed on the 2010 Debt Restructuring. In connection therewith, we (i) issued the Amended and Restated Note in the principal amount of $5.5 million to Castlerigg, (ii) paid $2.5 million in cash to Castlerigg, (iii) cancelled warrants previously issued to Castlerigg that were exercisable for a total of 5,208,333 shares of common stock, (iv) issued 800,000 shares of common stock to Castlerigg in satisfaction of an obligation under a prior loan amendment, (v) entered into the Letter Agreement with Castlerigg dated December 23, 2010 pursuant to which we paid Castlerigg an additional $2.75 million in cash in lieu of the issuance of $3.5 million in stock and warrants as provided in the Loan Restructuring Agreement, and (vi) entered into an Investor Rights Agreement with Castlerigg dated December 23, 2010. As a result of the foregoing, Castlerigg forgave approximately $7.2 million of principal and accrued but unpaid interest.

The Amended and Restated Note, dated December 23, 2010, was a senior, unsecured note that matured in three years from the closing and bore interest at an annual rate of 6.25%, payable semi-annually. We paid the first year's interest of approximately $344,000 at the closing. The Amended and Restated Note was fully satisfied as described above.

The Investor Rights Agreement provides Castlerigg with certain registration rights with respect to the Company's securities held by Castlerigg. These registration rights include an obligation of the Company to issue additional warrants to Castlerigg if certain registration deadlines or conditions are not satisfied. The agreement also contains full-ratchet anti-dilution price protection provisions in the event the Company issues stock or convertible debt with a purchase price or conversion price less than the conversion price described above.

In connection with the 2010 Debt Restructuring, the Company amended the note with the holder of a $1.0 million unsecured convertible note, pursuant to which the maturity date of the note was extended to December 31, 2013. We also issued 150,000 to the holder of this note as consideration to extend the term of the note and issued to the holder a warrant to acquire up to 75,000 shares of our common stock. The warrant is exercisable at $.90 per share and the term of the warrant is for five years.

On November 29, 2010, we entered into a bridge loan transaction with three accredited investors pursuant to which we issued unsecured notes in the aggregate principal amount of $1.0 million. Upon the closing of the 2010 Equity Financing, the lenders converted the entire principal amount plus accrued interest into the same units offered in the Equity Financing and the proceeds from the bridge loan transaction were treated as funds raised with respect to the financing.

In connection with the 2010 Equity Financing and under the terms of the Subscription Agreements, the Company agreed to prepare and file, and did file, within 60 days following the issuance of the securities, a registration statement covering the resale of the shares of common stock sold in the financing and the shares of common stock underlying the Warrants. During March 2010 through October 2010, we raised approximately $2.485 million through the sale of common stock and the issuance of convertible notes to purchasers at an investment or conversion price of $1.00 per share. The financing included the sale of 1,535,000 shares of our common stock and the issuance of convertible notes in the aggregate principal amount of $950,000. We also issued to these purchasers warrants to acquire shares of our common stock at an exercise price of $1.50 per share, which are exercisable anytime during a three year period. At the time of these sales, we agreed to certain price protection provisions whereby if we were to sell equity at a price lower than $1.00 per share before December 31, 2010, the purchasers would be able to elect to exchange and receive equity on the same financial terms and conditions as the new investors.

33 --------------------------------------------------------------------------------All holders of the convertible notes converted the notes and aggregate accrued interest of $10,075 into 960,075 shares of our common stock at a conversion price of $1.00 per share. In addition, the holders received warrants to acquire up to 960,075 shares our common stock at an exercise price of $1.50 per share. The shares issued upon conversion of the notes, together with the 1,535,000 shares issued to the purchasers of the common stock, total 2,495,075 shares of our common stock. In addition, warrants to purchase an aggregate of 2,495,075 shares at an exercise price of $1.50 were held by the purchasers in this financing. The warrants could be exercised at any time for a period of three years.

Upon completion of the 2010 Equity Financing, each of the investors in these sales elected to treat their purchases according to the terms contained in the 2010 Equity Financing. This resulted in the issuance of an additional 2,083,374 shares of common stock and the cancellation of 2,495,075 warrants with an exercise price of $1.50 and the issuance of 2,079,222 warrants with an exercise price of $1.00 and an expiration date of five years from the conversion.

During 2010, we entered into two Accounts Receivable Purchase Agreements with one individual for an aggregate amount of $775,000. In these agreements, we pledged certain outstanding accounts receivable in exchange for an advance payment and a commitment to remit to the purchaser the amount advanced upon collection from our customer. Terms of the first agreement under which we were advanced $275,000 include a 3% discount with a 3% interest fee for every 30 days the advances remain outstanding. Terms of the second agreement under which we were advanced $500,000 include a 10% discount with a 0.5% interest fee for every 30 days the advances remain outstanding.

During 2010, we entered into a $500,000 line of credit for equipment financing to purchase equipment for our largest customer's digital signage network. The terms of the line of credit include a 3% interest fee for every 30 days the advances on the line of credit remain outstanding. We received total advances on the line of credit of $500,000 and subsequent to the completion of the Equity Financing repaid the line of credit. We used the proceeds to purchase and install the equipment at our customer's locations.

In August 2009, we entered into a sale and leaseback agreement which financed the purchase and installation of equipment to retrofit our new customer's approximately 2,100 retail sites with our digital signage product offering. We received approximately $4,100,000 from the sale of the equipment in exchange for making lease payments over a 36 month period of approximately $144,000 per month.

On December 24, 2007, we entered into a securities purchase agreement in connection with our senior secured convertible note financing in which we raised $15,000,000 (less $937,000 of prepaid interest). We used the proceeds from this financing to support our CodecSys commercialization and development and for general working capital purposes. The senior secured convertible note has been retired as described above. During 2010, we capitalized interest of $1,491,161 related to the senior secured convertible note.

On November 2, 2006, we closed on a convertible note securities agreement dated October 28, 2006 with an individual that provided we issue to the convertible note holder (i) an unsecured convertible note in the principal amount of $1,000,000 representing the funding received by us from an affiliate of the convertible note holder on September 29, 2006, and (ii) four classes of warrants (A warrants, B warrants, C warrants and D warrants) which gave the convertible note holder the right to purchase a total of 5,500,000 shares of our common stock. The holder of the note no longer has any warrants to purchase any of our stock. The unsecured convertible note was due October 16, 2009 and was extended to December 22, 2010 and the annual interest rate was increased to 8%, payable semi-annually in cash or in shares of our common stock if certain conditions are satisfied The unsecured convertible note was convertible into shares of our common stock originally at a conversion price of $1.50 per share, convertible any time during the term of the note, and is subject to standard anti-dilution rights, pursuant to which the note is now convertible at a conversion price of $.25 per share. The term of the convertible note has been extended and now is due December 31, 2013. In connection with the extension of the note, we issued to the holder of the note 150,000 shares of common stock and a five year warrant to acquire up to 75,000 shares of our common stock and an exercise price of $.90 per share to extend the term of the note. In addition, we committed to pay accrued interest due on the convertible note through the issuance of common stock and warrants on the same terms as the Equity Financing.

34 --------------------------------------------------------------------------------The conversion feature and the prepayment provision of our $5.5 million Amended and Restated Note and our $1.0 million unsecured convertible note have been accounted for as embedded derivatives and valued on the respective transaction dates using a Black-Scholes pricing model. The warrants related to the $1.0 million unsecured convertible notes have been accounted for as derivatives and were valued on the respective transaction dates using a Black-Scholes pricing model as well. At the end of each quarterly reporting date, the values of the embedded derivatives and the warrants are evaluated and adjusted to current market value. The conversion features of the convertible notes and the warrants may be exercised at any time and, therefore, have been reported as current liabilities. Prepayment provisions contained in the convertible notes limit our ability to prepay the notes in certain circumstances. For all periods since the issuance of the senior secured convertible note and the unsecured convertible note, the derivative values of the respective prepayment provisions have been nominal and have not had any offsetting effect on the valuation of the conversion features of the notes. For a description of the accounting treatment of the senior secured convertible note financing, see Note 7 to the Notes to Condensed Consolidated Financial Statements (Unaudited) included elsewhere herein.

On March 21, 2011, we converted $784,292 of our short-term debt into equity through the issuance of common stock and warrants to two lenders at the same unit pricing as the 2010 Equity Financing. In consideration of converting the short- term loans on the basis of $1.20 for two shares of common stock plus one warrant at an exercise price of $1.00, we issued 1,307,153 shares of common stock and warrants to acquire up to 653,576 shares of common stock, which warrants have a five year term and are exercisable at $1.00 per share. Our objective for converting the short-term debt into equity was to conserve cash.

Our monthly operating expenses, including our CodecSys technology research and development expenses, exceeded our monthly net sales by approximately $475,000 per month during the six months ended June 30, 2012. We did not have sufficient capital resources at June 30, 2012 to fund our negative cash flow for the remainder of the year without raising additional capital and therefore commenced the 2012 Convertible Debt Offering. The foregoing estimates, expectations and forward-looking statements are subject to change as we make strategic operating decisions from time to time and as our expenses and sales fluctuate from period to period.

The amount of our operating deficit could decrease or increase significantly depending on strategic and other operating decisions, thereby affecting our need for additional capital. We expect our operating expenses will continue to outpace our net sales until we are able to generate additional revenue. Our business model contemplates that sources of additional revenue include (i) sales from our private communication network services, (ii) sales resulting from new customer contracts, and (iii) sales, licensing fees and/or royalties related to commercial applications of our CodecSys technology, including sales resulting from marketing efforts by companies such as Fujitsu, IBM, HP and Microsoft.

Our long-term liquidity is dependent upon execution of our business model and the realization of additional revenue and working capital as described above, and upon capital needed for continued commercialization and development of the CodecSys technology. Commercialization and future applications of the CodecSys technology are expected to require additional capital estimated to be approximately $2.0 million annually for the foreseeable future. This estimate will increase or decrease depending on specific opportunities and available funding.

To date, we have met our working capital needs primarily through funds received from sales of our common stock and from convertible debt financings. Until our operations become profitable, we will continue to rely on proceeds received from external funding. We expect additional investment capital may come from (i) the exercise of outstanding warrants to purchase our capital stock currently held by existing warrant holders; (ii) additional private placements of our common stock with existing and new investors; and (iii) the private placement of other securities with institutional investors similar to those institutions that have provided funding in the past.

Off-Balance Sheet Arrangements We have no off-balance sheet arrangements.

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