PSCO ProtoSource Corporation (PK)

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS.

Certain statements in this section and elsewhere in this quarterly report on Form 10-QSB are forward-looking in nature and relate to the Company's plans, objectives, estimates and goals. Words such as "expects," "anticipates," "intends," "plans," "projects," "forecasts," "believes," and "estimates," and variations of such words and similar expressions, identify such forward-looking statements. Such statements are made pursuant to the safe harbor provisions of the private securities litigation reform act of 1995 and speak only as of the date of this report. The statements are based on current expectations, are inherently uncertain, are subject to risks and uncertainties and should be viewed with caution. Actual results and experience may differ materially from those expressed or implied by the forward-looking statements as a result of many factors, including, without limitation, those set forth under "Description of Business" in the Company's most recent Annual Report on Form 10-KSB. The Company makes no commitment to update any forward-looking statement or to disclose any facts, events, or circumstances after the date hereof that may affect the accuracy of any forward-looking statement.

Net Revenues - For the nine months ended September 30, 2007 and 2006, net revenues were $2,087,027 and $1,910,331 respectively. $2,012,891 of revenues are attributed to the operations of P2i Newspaper acquired January 1, 2004 and $74,136 are attributed to the operations of ProtoSource Acquisition II established August 15, 2007. This represents a combined increase of $176,696 in revenues over the previous year.

In respect to P2i Newspaper, an increase of $102,560 over last year is largely attributable to the following: 1.) A sales effort that has focused on media companies within the newspaper vertical that have a demand for the conversion of large volumes and 2.) The development of new revenue streams from new service offerings that include content verification and call center support services.

In respect to ProtoSource Acquisition II, Inc., net revenues totaling $74,136 are attributable to ISP service operations commencing September 1, 2007.

Operating Costs and Expenses - For the nine months ended September 30, 2007, operating costs and expenses totaled $2,011,478 versus $1,746,417 in 2006, a $265,061 rise over the previous year.

$93,214 of this amount is directly attributable to the operations of ProtoSource Acquisition II, Inc. which commenced operations September 1, 2007.

$171,847 of the additional operating costs and expenses are related to the operations of P2i Newspaper and are due to the following:

Approximately $28,000 of higher production expenditures necessary to meet the approximately 5% increase in revenues. However, during the nine months ended September 30, 2007, cost of revenues as a percentage of revenues fell about 1% under their mark in 2006. This was largely due to reductions in production staff levels with increasing efficiencies to overcome adverse changes in the Ringgit exchange rate.

For the nine months ended September 30, 2007, selling, general and administrative expenses posted an increase of approximately $171,000 over the previous year due to the following significant components:

A provision of approximately $53,000 was recorded for uncollectible billings to Brand X Networks, approximately $37,000 more in sales development efforts were incurred this year over the same period in 2006, a provision of about $56,000 was recorded in respect to advances taken during 2006 that are expected to be taken as officers' compensation in fiscal 2007, and approximately $25,000 more in accounting, legal, insurance and office expenses were recorded over last year's levels. Also in consideration of such comparative operating differences, 2006 operating costs and expenses included a $21,826 loss on disposal of computer equipment. {Administrative costs principally consist of the Company's management office and personnel, professional fees associated with maintenance of the Company, and officers' and directors' liability insurance costs.}

Interest Expense - Interest expense totaled $286,629 for the nine-month period ended September 30, 2007 versus $262,914 in the same period in 2006. The interest expense is a result of the convertible notes obtained during 2002, 2003, and 2004 to fund the operations of the Company and P2i Newspaper, pending and post merger.

Other income and charges - As a result of a foreclosure acquisition agreement dated August 15, 2007 with Brand X Networks, Inc., other income included an approximate $1,000 recovery of net assets from Brand X, and other charges included an impairment charge in connection with $529,179 in consideration given to P2i, Inc., a related party, under this arrangement.

Foreclosure acquisition agreement -- On August 16, 2007 the Company exercised its security interests and entered into a foreclosure acquisition agreement with Brand X Networks, Inc., taking possession of its business assets as collateral due to its inability to pay its debt to the Company. These assets were transferred to ProtoSource Acquisition II, Inc., a Nevada corporation (incorporated August 15, 2007) and a wholly owned subsidiary of the Company, on September 1, 2007.

In respect to the foreclosure acquisition agreement, ProtoSource Acquisition II, Inc. acquired computer equipment, computer software and supplies, office equipment, tools, furniture and fixtures and prepaid expenditures valued at approximately $57,000. It also assumed specific liabilities in respect to service providers and agreed to honor accrued vacation pay of former Brand X Networks, Inc. employees hired on September 1, 2007 by ProtoSource Acquisition
II. These liabilities approximated $56,000. As a consequence of this action, a net recovery of approximately $1,000, classified as "other income", was recorded during the current period.

As a further component to the reacquisition of the collateralized assets of Brand X Networks, Inc., the Company gave consideration to P2i, Inc. (a related party) who became a controlling owner of Brand X Networks, Inc. through its March 2006 purchase of the original note held by the Company in respect to the sale of the Company's ISP assets to Brand X. In consideration for P2i, Inc.'s management and controlling interest in Brand X Networks, Inc., and such that P2i, Inc. would not act to oppose the matter of foreclosure on the assets of Brand X Networks, the Company forgave P2i, Inc.'s existing liabilities to the Company through August 28, 2007 and will continue to support P2i, Inc. in the discharge of liabilities (arising prior to the January 1, 2004 P2i Newspaper merger with the Company) out of the Company's cash flow until such obligations are fully discharged. The value of this consideration is estimated to be in excess of $529,200, which has all been characterized as goodwill. This includes the net amount of $257,179 outstanding to the Company as of August 28, 2007 plus an additional $272,000. As a consequence of this action, during the current period the Company recorded a $257,179 write-off of amounts due to the Company and recorded an obligation in accrued expenses of $272,000. Because of the related party nature of this goodwill, management has deemed it to be impaired and has recorded the charge in other charges in the consolidated statement of operations.

Net revenues - For the three-month periods ended September 30, 2007 and 2006, net revenues were $732,897 and $641,945, respectively. $658,761 of revenues are attributed to the operations of P2i Newspaper acquired January 1, 2004 and $74,136 are attributed to the operations of ProtoSource Acquisition II established August 15, 2007. This represents a combined increase of $90,952 in revenues over the previous year.

In respect to P2i Newspaper, an increase of $16,817 over last year is largely attributable to a sales effort focused on media companies within the newspaper vertical that have a demand for the conversion of large volumes and development of new revenue streams from new service offerings that include content verification and call center support services.

Operating costs and expenses - For the three months ended September 30, 2007, operating costs and expenses totaled $720,649 versus $597,404 in 2006, a $123,245 rise over the same period in the previous year.

$93,214 of this amount is directly attributable to the operations of ProtoSource Acquisition II, Inc. which commenced operations September 1, 2007.

$30,031 of the additional operating costs and expenses are related to the operations of P2i Newspaper and are due to the following:

Approximately $39,000 of lower production expenditures to meet an approximately 3% increase in revenues was largely due to substantial reductions in production staff levels while simultaneously working to increase production efficiencies during the period. During the three months ended September 30, 2007, cost of revenues as a percentage of revenues fell about 7% under their mark in 2006.

For the three months ended September 30, 2007, selling, general and administrative expenses posted an increase of approximately $69,000 over the previous year due to the following significant components: About $18,000 more in sales development efforts were incurred over the same period in 2006, a provision of about $19,000 was recorded in respect to advances taken in 2006 that are expected to be taken as officers' compensation in fiscal 2007, approximately $20,000 additional consulting and legal fees were incurred, about $12,000 more in insurance costs were recorded over last year's levels during the same period.

Interest expense - Interest expense totaled $98,009 for the three-month period ended September 30, 2007 versus $90,591 in the same period in 2006. The interest expense is the result of the convertible notes obtained during 2002, 2003, and 2004 to fund the operations of the Company and P2i Newspaper, pending and post merger.

Other income and charges - As a result of a foreclosure acquisition agreement dated August 15, 2007 with Brand X Networks, Inc., other income included a $1,096 recovery of net assets from Brand X and other charges included a $529,179 consideration given to P2i, Inc., a related party, under this arrangement.

Foreclosure acquisition agreement -- On August 16, 2007 the Company exercised its security interests and entered into a foreclosure acquisition agreement with Brand X Networks, Inc., taking possession of its business assets as collateral due to its inability to pay its debt to the Company. These assets were transferred to ProtoSource Acquisition II, Inc., a Nevada corporation (incorporated August 15, 2007) and a wholly owned subsidiary of the Company on September 1, 2007.

In respect to the foreclosure acquisition agreement, ProtoSource Acquisition II, Inc. acquired computer equipment, computer software and supplies, office equipment, tools, furniture and fixtures and prepaid expenditures valued at approximately $57,000. It also assumed specific liabilities in respect to service providers and agreed to honor accrued vacation pay of former Brand X Networks, Inc. employees hired on September 1, 2007 by ProtoSource Acquisition
II. These liabilities approximated $56,000. As a consequence of this action, a net recovery of $1,096, classified as "other income" was recorded during the current period.

As a further component to the reacquisition of the collateralized assets of Brand X Networks, Inc., the Company gave consideration to P2i, Inc. (a related party) who became a controlling owner of Brand X Networks, Inc. through its March 2006 purchase of the original note held by the Company in respect to the sale of the Company's ISP assets to Brand X. In consideration for P2i, Inc.'s management and controlling interest in Brand X Networks, Inc., and such that P2i, Inc. would not act to oppose the matter of foreclosure on the assets of Brand X Networks, the Company forgave P2i, Inc.'s existing liabilities to the Company through August 28, 2007 and will continue to support P2i, Inc. in the discharge of liabilities (arising prior to the January 1, 2004 P2i Newspaper merger with the Company) out of the Company's cash flow until such obligations are fully discharged. The value of this consideration is estimated to be in excess of $529,200, which has all been characterized as goodwill. This includes the net amount of $257,179 outstanding to the Company as of August 28, 2007 plus an additional $272,000. As a consequence of this action, during the current period the Company recorded a $257,179 write-off of amounts due to the Company and recorded an obligation in accrued expenses of $272,000. Because of the related party nature of this goodwill, management has deemed it to be impaired and has recorded the charge in other charges in the consolidated statement of operations.

We assess liquidity by our ability to generate cash to fund our operations. Significant factors that affect the management of our liquidity include: current balances of cash, expected cash flows provided by operations, current levels of our accounts receivable and accounts payable balances, access to financing sources and our expected investment in equipment.

The Company experienced positive cash flows from operating activities for each of the nine-month periods ending September 30, 2007 and 2006.

Though the Company's net loss for the nine-month period ended September 30, 2007 was approximately $738,000, cash flows provided by operations approximated $148,000. In part, this was due to the following non-cash charges included in the net loss: Approximately $38,000 of depreciation and amortization, approximately $53,000 provision for bad debts, and approximately $257,000 of amounts due to the Company from P2i, Inc. related to a foreclosure acquisition agreement which were written off. In addition to non-cash charges to income, cash flows from operations were aided by approximately $537,000 of net changes in the Company's working capital components. Significant components affecting working capital and availability of cash - because they were accrued during the period but unpaid -- were as follows: Approximately a net amount of $263,000 payable to P2i, Inc. in respect to a foreclosure acquisition agreement was recorded, approximately $276,000 of accrued interest arising from the Company's convertible debt obligations and approximately $78,000 increase in accrued supplier and service provider obligations. These positive contributing factors of working capital and available cash were offset by approximately $78,000 increase in outstanding receivables and an approximately $2,000 reduction in levels of accrued payroll liabilities.

During the nine-month period ended September 30, 2007, the Company had negative cash flows from investing activities of approximately $91,000. This consisted of approximately $6,000 for acquisitions of new equipment, approximately $4,000 to security deposits, approximately $15,000 of advances to directors and officers, and approximately $67,000 of cash provided to a related company.

And during the nine-month period ended September 30, 2007, the Company used, through its financing activities, approximately $23,000 of funds for payments on capital lease obligations.

As of September 30, 2007, the Company had $47,298 in cash and $445,990 in accounts receivable and other current assets. Taken together with $4,709,670 of total current liabilities, this resulted in a negative working capital position of $4,216,382 at September 30, 2007. $3,834,983 of this amount pertains to the Company's obligations to its convertible debt holders and $262,800 of this amount pertains to the Company's obligations to P2i, Inc., a related party.

During 2002, the Company entered into an agreement with AAWC to act as a placement agent for the sale of convertible notes aggregating $1,300,000. The notes are secured by stock in P2i Newspaper, Inc. and accrue interest at 10% per annum. The Company pays the cost and obligations of the first $200,000 incurred with this financing and P2i Newspaper, Inc. has agreed to pay all remaining costs and obligations. Through December 31, 2003, $1,225,000 in funding had been completed. AAWC was paid a 10% commission and a 3% non-accountable expense. Substantially all of the proceeds from these notes have been loaned to P2i, Newspaper Inc. The loans were in the form of demand notes accruing interest at 8% per annum. These loans, with their related interest receivable, were written off in 2003.

During May 2003, the Company entered into an agreement with Carl R. Butera for the sale of a convertible note aggregating $200,000. The note is secured by stock in P2i Newspaper, Inc. and accrues interest at 10% per annum. Substantially all of the proceeds from this note have been loaned to P2i Newspaper, Inc. The loans were in the form of demand notes accruing interest at 8% per annum. These loans, with their related interest receivable, were written off in 2003.

During the twelve-month period ended December 31, 2003, the Company entered into certain agreements with AAWC to act as a placement agent for the sale of convertible notes aggregating $700,000. The notes are secured by stock in P2i and accrue interest at 10% per annum. P2i has agreed to pay the related costs and obligations. Through December 31, 2003, $600,000 in funding had been completed; an additional $100,000 was completed during January 2004. AAWC was paid a 10% commission and a 3% non-accountable expense. Substantially all of the proceeds from these notes have been loaned to P2i Newspaper, Inc. The loans were in the form of demand notes accruing interest at 8% per annum. These loans, with their related interest receivable, were written off in 2003.

During 2004, the Company entered into certain agreements with AAWC to act as a placement agent for the sale of convertible notes aggregating $500,000, of which $300,000 was raised during the first and second quarters of 2004. These notes accrue interest at 10% per annum. AAWC was paid a 10% commission and a 3% non-accountable expense. These notes, and all other notes, are secured by the assets of ProtoSource and P2i Newspaper.

On October 15, 2005, the Company entered into a 24-month term capital lease agreement with Bankers Capital for the purchase of computer and computer related items valued at $27,767 with monthly lease payments of $1,596 each. The lease term expires September 14, 2007 and the residual maturity date is October 15, 2007 with a $1.00 purchase option. $3,487 was paid to Bankers Capital at the start of the lease to cover the first payment, one payment held for a security deposit, and for UCC filing and documentation fees. Company officers, Peter A. Wardle and Thomas C. Butera, are personal guarantors of this agreement.

On July 15, 2006, the Company entered into a 24-month term capital lease agreement with Bankers Capital for the purchase of computer and computer related items valued at $26,827 with monthly lease payments of $1,521 each. The lease term expires June 14, 2008 and the residual maturity date is July 15, 2008 with a $1.00 purchase option. $3,438 was paid to Bankers Capital at the start of the lease to cover the first payment, one payment held for a security deposit, and for UCC filing and documentation fees. Company officers, Peter A. Wardle and Thomas C. Butera, are personal guarantors of this agreement.

In July 2007, the Company entered into an investment banking agreement with Colebrooke Capital, Inc. The agreement is for $2.5 million in potential capital funding. The fees under this arrangement are $7,500 down and $3,500 for the first 90 days of the agreement. Under this arrangement the Company will be required to a pay a 7% financing fee on any funds raised by Colebrooke Capital. Furthermore, in respect to capital transactions introduced by Colebrooke Capital, there will be a 5% transaction fee requirement, but no fees on any Company generated deals.

Management's discussion and analysis of its financial position and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

In accordance with SFAS No. 109, "Accounting for Income Taxes", the Company maintains a valuation allowance of $5,400,000 as of December 31, 2006 on deferred tax assets relating to its net operating losses which the Company has not determined to be more likely than not realizable.

In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets", goodwill is not amortized, rather, management tests goodwill annually for impairment in the fourth quarter.

The Company considers certain trade accounts receivable to be of doubtful collection; accordingly, the Company has a $68,605 allowance for doubtful accounts. The Company considers the balances of its note receivable of $162,582 and its unused services credit of $151,308 as uncollectible or unrealizable; accordingly, a $313,890 allowance for doubtful accounts was recorded in 2005.

In consideration of SEC Proposed Rule Release 33-8098, the Company does not maintain estimates for sales returns or credits, cancellations and warranties. Due to the peculiar nature of the type of services provided and the underlying processes employed by the Company to create and deliver completed product (without defect) to its customers, there is no material exposure to what would be classified as sales returns or credits. Likewise, cancellations and or warranties are not significantly measurable in respect to the type of electronic product (Internet Website content) deliverable to the Company's customers; and historically, there has been no basis or need for such.