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Scientific Learning 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2



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

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006

OR

o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____ to _____

Commission File number 000-24547

Scientific Learning Corporation
(Exact name of registrant as specified in its charter)

 

 

 

 

 

 

Delaware

 

94-3234458

 

 

(State or other jurisdiction of incorporation or
organization)

 

(I.R.S. Employer Identification No.)

 

300 Frank H. Ogawa Plaza, Suite 600
Oakland, California 94612
(510) 444-3500
(Address of Registrants principal executive offices, including zip code, and
telephone number, including area code)

          Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes x     No o

          Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer o     Accelerated filer o      Non-accelerated filer x

          Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o     No x

          As of October 15, 2006, there were 16,889,954 shares of Common Stock outstanding.




SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED September 30, 2006

 

 

 

 

 

 

 

PAGE

 

 

 

 

PART 1. FINANCIAL INFORMATION

 

Item 1.

Financial Statements (Unaudited):

 

 

 

 

Condensed Balance Sheets

 

3

 

 

Condensed Statements of Operations

 

4

 

 

Condensed Statements of Cash Flows

 

5

 

 

Notes to Condensed Financial Statements

 

6

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

15

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

 

23

 

Item 4.

Controls and Procedures

 

23

 

 

 

 

 

 

PART II. OTHER INFORMATION

 

Item 1.

Legal Proceedings

 

24

 

Item 1A.

Risk Factors

 

24

 

Item 6.

Exhibits

 

29

 

 

Signature

 

30

Page 2



PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SCIENTIFIC LEARNING CORPORATION
CONDENSED BALANCE SHEETS
(In thousands)
Unaudited

 

 

 

 

 

 

 

 

 

 

September 30,
2006

 

December 31,
2005

 

 

 


 


 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

13,337

 

$

9,022

 

Short-term investments

 

 

 

 

3,043

 

Accounts receivable, net

 

 

10,850

 

 

3,519

 

Notes and interest receivable from current and former officers

 

 

 

 

297

 

Prepaid expenses and other current assets

 

 

1,404

 

 

1,312

 

 

 



 



 

 

 

 

 

 

 

 

 

Total current assets

 

 

25,591

 

 

17,193

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

 

801

 

 

469

 

Other assets

 

 

917

 

 

1,072

 

 

 



 



 

 

 

 

 

 

 

 

 

Total assets

 

$

27,309

 

$

18,734

 

 

 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity (deficit)

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

223

 

$

214

 

Accrued liabilities

 

 

5,703

 

 

2,966

 

Deferred revenue

 

 

15,513

 

 

11,171

 

 

 



 



 

 

 

 

 

 

 

 

 

Total current liabilities

 

 

21,439

 

 

14,351

 

Deferred revenue, long-term

 

 

5,491

 

 

5,832

 

Other liabilities

 

 

401

 

 

386

 

 

 



 



 

 

 

 

 

 

 

 

 

Total liabilities

 

 

27,331

 

 

20,569

 

 

 

 

 

 

 

 

 

Stockholders’ equity (deficit):

 

 

 

 

 

 

 

Common stock and additional paid-in capital

 

 

78,196

 

 

76,265

 

Accumulated deficit

 

 

(78,218

)

 

(78,100

)

 

 



 



 

 

 

 

 

 

 

 

 

     Total stockholders’ equity (deficit):

 

 

(22

)

 

(1,835

)

 

 



 



 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity (deficit)

 

$

27,309

 

$

18,734

 

 

 



 



 

See accompanying notes

Page 3



SCIENTIFIC LEARNING CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Unaudited

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 




 

 

 

2006

 

2005

 

2006

 

2005

 

 

 


 




 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Products

 

$

7,006

 

$

7,261

 

$

22,882

 

$

25,950

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Service and support

 

 

2,919

 

 

2,551

 

 

7,827

 

 

7,386

 

 

 



 






 



 

Total revenues

 

 

9,925

 

 

9,812

 

 

30,709

 

 

33,336

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of products

 

 

433

 

 

454

 

 

1,282

 

 

1,508

 

Cost of service and support

 

 

2,089

 

 

1,352

 

 

5,916

 

 

4,211

 

 

 



 






 



 

Total cost of revenues

 

 

2,522

 

 

1,806

 

 

7,198

 

 

5,719

 

 

 



 






 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

 

7,403

 

 

8,006

 

 

23,511

 

 

27,617

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

5,084

 

 

3,476

 

 

15,906

 

 

13,303

 

Research and development

 

 

1,057

 

 

934

 

 

3,170

 

 

2,808

 

General and administrative

 

 

1,837

 

 

1,256

 

 

5,035

 

 

4,430

 

 

 



 






 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

 

7,978

 

 

5,666

 

 

24,111

 

 

20,541

 

 

 



 






 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

 

(575

)

 

2,340

 

 

(600

)

 

7,076

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income from related party

 

 

38

 

 

12

 

 

112

 

 

37

 

Interest and other income, net

 

 

192

 

 

89

 

 

370

 

 

311

 

 

 



 






 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income tax

 

 

(345

)

 

2,441

 

 

(118

)

 

7,424

 

Income tax provision (benefit)

 

 

(13

)

 

179

 

 

 

 

279

 

 

 



 






 



 

Net income (loss)

 

$

(332

)

$

2,262

 

$

(118

)

$

7,145

 

 

 



 






 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

 

$

(0.02

)

$

0.14

 

$

(0.01

)

$

0.43

 

 

 



 






 



 

Shares used in computing basic net income (loss) per share

 

 

16,861

 

 

16,731

 

 

16,823

 

 

16,696

 

 

 



 






 



 

 

Diluted net income (loss) per share

 

$

(0.02

)

$

0.13

 

$

(0.01

)

$

0.40

 

 

 



 






 



 

Shares used in computing diluted net income (loss) per share

 

 

16,861

 

 

17,726

 

 

16,823

 

 

17,710

 

 

 



 






 



 

See accompanying notes

Page 4



SCIENTIFIC LEARNING CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
Unaudited

 

 

 

 

 

 

 

 

 

 

Nine months ended September 30,

 

 

 


 

 

 

2006

 

2005

 

 

 


 


 

 

 

 

 

 

 

 

 

Operating Activities:

 

 

 

 

 

 

 

Net income (loss)

 

$

(118

)

$

7,145

 

Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

 

380

 

 

547

 

Increase in interest receivable from current and former officers

 

 

 

 

(157

)

Stock based compensation

 

 

1,680

 

 

183

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable

 

 

(7,331

)

 

712

 

Prepaid expenses and other current assets

 

 

(92

)

 

(98

)

Other assets

 

 

24

 

 

25

 

Accounts payable

 

 

9

 

 

(357

)

Accrued liabilities

 

 

2,737

 

 

(805

)

Deferred revenue

 

 

4,001

 

 

(7,378

)

Other liabilities

 

 

15

 

 

32

 

 

 



 



 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

 

1,305

 

 

(151

)

 

 

 

 

 

 

 

 

Investing Activities:

 

 

 

 

 

 

 

Purchases of property and equipment, net

 

 

(581

)

 

(150

)

Maturity (purchase) of investments

 

 

3,043

 

 

(2,999

)

 

Repayment of current and former officer loans

 

 

213

 

 

2,244

 

 

 



 



 

 

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

 

2,675

 

 

(905

)

 

 

 

 

 

 

 

 

Financing Activities:

 

 

 

 

 

 

 

Proceeds from issuance of common stock, net

 

 

335

 

 

299

 

 

 



 



 

 

 

 

 

 

 

 

 

Net cash provided by financing activities

 

 

335

 

 

299

 

 

 



 



 

 

 

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

 

4,315

 

 

(757

)

 

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

 

9,022

 

 

10,281

 

 

 



 



 

 

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

13,337

 

$

9,524

 

 

 



 



 

 

 

 

 

 

 

 

 

See accompanying notes.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental schedule of noncash financing activities:

 

 

 

 

 

 

 

Common stock surrendered in connection with repayment of officer loans

 

$

84

 

 

 

Page 5



Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation provides neuroscience-based software products that build learning capacity by developing the underlying cognitive skills required for reading and learning. We operate in one operating segment. Our Fast ForWord® products are a series of reading intervention products for children, adolescents and adults. We sell primarily to K-12 schools through a direct sales force. We also sell to speech and language professionals. To support our products, we provide on-site and remote training and implementation services, as well as technical, professional and customer support and a wide variety of Web-based resources.

Use of Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent that there are material differences between these estimates and actual results, our financial statements could be affected.

Interim Financial Information

The interim financial information as of September 30, 2006 and for the three and nine months ended September 30, 2006 and 2005 is unaudited, but includes all normal recurring adjustments that we consider necessary for a fair presentation of our financial position at such date and our results of operations and cash flows for those periods.

As discussed in Note 2, we adopted Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment,” on January 1, 2006 using the modified prospective transition method. Accordingly, our operating income and loss for the three and nine months ended September 30, 2006 includes approximately $789,000 and $1.7 million, respectively, in share-based employee compensation expense for stock options, restricted stock units and our Employee Stock Purchase Plan. Because we elected to use the modified prospective transition method, results for prior periods have not been restated.

The condensed financial statements and notes should be read in conjunction with our audited financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission.

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgment related to our specific transactions and transaction types.

Sales to our school customers typically include multiple elements (e.g., Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). We allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”), if VSOE exists for each element. As we do not have VSOE for software licenses, we normally recognize revenue using the residual method on arrangements with multiple elements that include software licenses, whereby the difference between the total arrangement fee and the total fair value of the undelivered elements (generally services and support) is recognized as software license revenue. VSOE of fair value

Page 6



Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products. Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and is recognized as follows:

 

 

 

 

Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.

 

 

 

 

Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.

 

 

 

 

Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.

Service and support revenue

Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

Cash and Cash Equivalents

We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents, which primarily consist of cash on deposit with banks, money market funds, and US Government debt with a maturity of three months or less, are stated at cost, which approximates fair value.

Short-Term Investments

We determine the appropriate classification of investments at the time of purchase in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and reevaluate such determination at each balance sheet date. In August 2005 we purchased $2,999,000 in debt securities issued by the U.S. Treasury that matured in February 2006. We classified this investment as held-to-maturity and at December 31, 2005 it was stated at an amortized cost of $3,043,000. The carrying value of short-term investments approximates fair value due to their short-term nature.

Recent Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation Number 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” an interpretation of SFAS No. 109, “Accounting for Income Taxes.” This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of FIN 48 on our financial statements.

Page 7



Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Other Assets

Other assets consist of the following (in thousands):

 

 

 

 

 

 

 

 

 

 

September 30,
2006

 

December 31,
2005

 

 

 


 


 

Software development costs

 

$

3,089

 

$

3,089

 

Less accumulated amortization

 

 

(3,089

)

 

(2,959

)

 

 



 



 

Software development costs, net

 

 

 

 

130

 

Long term lease deposits

 

 

855

 

 

855

 

Other non current assets

 

 

62

 

 

87

 

 

 



 



 

 

 

$

917

 

$

1,072

 

 

 



 



 

Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed using the weighted average number of common shares outstanding during the period and, when dilutive, includes potential common shares from options and awards calculated using the treasury stock method.

The following table sets forth the computation of the numerators and denominators used in the basic and diluted net income (loss) per share amounts for the periods indicated (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 









 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

Numerator for basic and diluted net income (loss) per share – net income (loss)

 

$

(332

)

$

2,262

 

$

(118

)

$

7,145

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

 

 

 

 

Denominator for basic net income (loss) per share – weighted average shares

 

 

16,861

 

 

16,731

 

 

16,823

 

 

16,696

 

Effect of dilutive stock options and awards

 

 

 

 

995

 

 

 

 

1,014

 

 

 













Denominator for diluted net income (loss) per share

 

 

16,861

 

 

17,726

 

 

16,823

 

 

17,710

 

 

 













Page 8



Notes to Condensed Financial Statements

2. Stock-Based Compensation

Stock-Based Compensation Plans

On September 30, 2006, we had four active share-based compensation plans, which are described below.

In May 1999, our stockholders approved our 1999 Equity Incentive Plan. The total number of shares authorized for issuance under the plan is 5,492,666. Option awards have generally been granted with an exercise price equal to the market price of our common stock at the date of grant, and generally vest based on four years of continuous service with a ten-year contractual term. Restricted stock units awarded under this plan generally vest over four years of continuous service in annual or semi-annual installments.

In May 1999, our stockholders approved the 1999 Non-Employee Directors’ Stock Option Plan. The total number of shares authorized for issuance under this plan is 250,000.

In May 2002, the Board of Directors approved the 2002 CEO Stock Option Plan, which was subsequently approved by the shareholders in May 2003. The total number of shares authorized for issuance under this plan is 470,588.

In May 1999 the stockholders approved the 1999 Employee Stock Purchase Plan (ESPP), which became effective upon the completion of the initial public offering of our common stock. The total number of shares authorized for issuance under the plan is 700,000. Eligible employees may purchase common stock at 85% of the lesser of the fair market value of our common stock on the first day of the applicable one-year offering period or the last day of the applicable six-month purchase period. At September 30, 2006, 126,882 shares were available for issuance under this plan.

Adoption of SFAS No. 123R

Prior to January 1, 2006, we accounted for our stock plans under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). We adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”), effective January 1, 2006 using the modified prospective transition method. Under that transition method, stock-based compensation expense recognized during the three and nine months ended September 30, 2006 includes: (a) stock options granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”) adjusted for estimated pre-vesting forfeitures, and (b) stock options and restricted stock units granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. Under the modified prospective transition method, results for prior periods are not restated.

SFAS No. 123R requires us to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS 123 for periods prior to January 1, 2006, we accounted for forfeitures as they occurred.

In anticipation of the adoption of SFAS No. 123R, we did not modify the terms of any previously granted options. We made minor changes to our equity compensation program by reducing the overall number of shares covered by equity compensation grants and granting restricted stock units beginning in the first quarter of 2006.

The following table presents the pro forma effect on net income and net income per share if we had applied the fair value recognition provisions of SFAS No. 123 to options granted under our share-based compensation arrangements during the three months and nine months ended September 30, 2005:

Page 9



Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

 

 

 

 

 

 

 

 

 

 

Three months
ended
September 30,

 

Nine months
ended
September 30,

 

 

 





(In thousands, except per share amounts)

 

 

2005

 

 

2005

 

 

 







 

Net income, as reported

 

$

2,262

 

$

7,145

 

    Add: Share-based compensation expense included in reported net income, net of related tax effects

 

 

 

 

183

 

    Deduct: Total share-based compensation expense determined under the fair value based method for all awards, net of related tax effects

 

 

(585

)

 

(1,549

)

 

 







Net income, pro forma

 

$

1,677

 

$

5,779

 

 

 







 

 

 

 

 

 

 

 

Basic net income per share - as reported

 

$

0.14

 

$

0.43

 

 

Basic net income per share - pro forma

 

$

0.10

 

$

0.35

 

 

Diluted net income per share - as reported

 

$

0.13

 

$

0.40

 

 

Diluted net income per share - pro forma

 

$

0.09

 

$

0.33

 

For purposes of this pro forma disclosure, we estimated the value of the options using the Black-Scholes option valuation model and amortized the fair value of options granted to expense over the option vesting period.

Compensation Cost

The following table summarizes the effects of share-based compensation resulting from the application of SFAS 123R (in thousands, except per share amounts):

 

 

 

 

 

 

 

 

 

 

Three months
ended
September 30,

 

Nine months
ended
September 30,

 

 

 

2006

 

2006

 

 

 





 

 

 

 

 

 

 

 

Cost of service and support revenues

 

 

51

 

 

148

 

Sales and marketing

 

 

185

 

 

539

 

Research and development

 

 

83

 

 

234

 

General and administrative

 

 

470

 

 

759

 

 

 







Share-based compensation effect on operating income (loss)

 

 

789

 

 

1,680

 

Income taxes

 

 

(16

)

 

(55

)

 

 







Net share-based compensation effects on net loss

 

$

773

 

$

1,625

 

 

 







 

 

 

 

 

 

 

 

Share-based compensation effect on basic net loss per share

 

$

0.05

 

$

0.10

 

 

 







 

 

 

 

 

 

 

 

Share-based compensation effect on diluted net loss per share

 

$

0.04

 

$

0.09

 

 

 







Page 10



Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

Valuation of Stock Option Awards

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility, and the estimated life of each award and estimated pre-vesting forfeitures. The fair value of these stock options was estimated assuming no expected dividends and estimates of expected life, volatility and risk-free interest rate at the time of grant. Estimated volatility is based on the historical prices of our common stock over the expected life of each option. Expected life of the options is based on our history of option exercise activity. The risk free interest rates used are based on the U.S. Treasury yield curve in effect at the time of grants for periods corresponding with the expected life of the options. We use historical data to estimate pre-vesting option forfeitures. We recognize compensation expense for the fair values of these awards, which have graded vesting, on a straight-line basis over the requisite service period of each of these awards.

The fair value of stock options granted was estimated using the following weighted-average assumptions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 









Risk-free interest rate

 

5.1

%

 

3.7

%

 

5.1

%

 

3.4

%

 

Expected volatility

 

80

%

 

105

%

 

80

%

 

106

%

 

Expected life (in years)

 

4.0

 

 

4.0

 

 

4.0

 

 

4.0

 

 

Dividend yield

 

0.0

%

 

0.0

%

 

0.0

%

 

0.0

%

 

Summary of Stock Options

The following table summarizes all stock option activity under our share-based compensation plans for the nine months ending September 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding Options

 

 

 


 

 

 

Shares

 

Weighted-
Average
Exercise
Price

 

Weighted-
Average
Remaining
Contractual
Term (Years)

 

Aggregate
Intrinsic
Value

 

 

 


 


 


 


 

Outstanding at December 31, 2005

 

 

3,380,325

 

$

4.26

 

 

 

 

 

 

 

Granted

 

 

120,000

 

$

4.33

 

 

 

 

 

 

 

Exercised

 

 

(65,679

)

$

2.60

 

 

 

 

 

 

 

Forfeited or expired

 

 

(85,061

)

$

6.08

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

Outstanding at September 30, 2006

 

 

3,349,585

 

$

4.25

 

 

6.04

 

$

6,292,927

 

 

 



 



 



 



 

Vested and expected to vest at September 30, 2006

 

 

3,161,829

 

$

4.34

 

 

0.46

 

$

5,775,177

 

 

Exercisable at September 30, 2006

 

 

2,098,625

 

$

4.95

 

 

5.68

 

$

3,301,643

 

 

 



 



 



 



 

The aggregate intrinsic value of options outstanding at September 30, 2006 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 2,069,204 shares that had exercise prices that were lower than the $5.25 market price of our common stock at September 30, 2006 (“in the money options”). The total intrinsic value of options exercised during the nine months ended September 30, 2006 and

Page 11



Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

2005 was $128,000 and $140,000, respectively. The fair value of options vested during the nine months ended September 30, 2006 was $1.6 million.

As of September 30, 2006, total unrecognized compensation cost related to stock options granted under our various plans was $1.7 million. We expect that cost to be recognized over a weighted-average period of 1.4 years.

Summary of Restricted Stock Units and Restricted Stock Awards

The following table summarizes all restricted stock unit activity under our share-based compensation plans for the nine months ending September 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding Restricted Stock Units

 

 

 


 

 

 

Shares

 

Weighted-
Average
Purchase
Price

 

Weighted-
Average
Remaining
Contractual
Term (Years)

 

Aggregate
Intrinsic
Value

 

 

 


 


 


 


 

Outstanding at December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

Awarded

 

 

236,500

 

$

0.00

 

 

 

 

 

 

 

Released

 

 

 

$

0.00

 

 

 

 

 

 

 

Forfeited or expired

 

 

(1,000

)

$

0.00

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

Outstanding at September 30, 2006

 

 

235,500

 

$

0.00

 

 

1.78

 

$

1,236,375

 

 

 



 



 



 



 

Vested and expected to vest at September 30, 2006

 

 

192,840

 

$

0.00

 

 

1.65

 

$

1,012,410

 

 

 



 



 



 



 

Restricted stock units were awarded for the first time in 2006 under our 1999 Equity Incentive Plan. The fair value of these grants was calculated based upon the fair market value of our stock at the date of grant, less an estimate of pre-vesting forfeitures. The weighted-average grant-date fair value of restricted stock units awarded during the first nine months of fiscal 2006 was $4.88.

During the nine months ending September 30, 2006 and 2005, respectively, we also granted 17,079 and 10,896 restricted stock awards with a weighted average grant date fair value of $4.34 and $6.28.

Employee Stock Purchase Plan (“ESPP”)

As of September 30, 2006, we had issued 573,118 shares over the life of the ESPP. During the nine months ending September 30, 2006 and 2005, we issued 39,998 and 26,013 shares, respectively. We currently have 126,882 shares in reserve for future issuance under the plan.

ESPP awards for offering periods prior to and after the adoption of SFAS No. 123R were valued using the Black-Scholes model using the following assumptions:

Page 12



Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

2006

 

2005

 

2006

 

2005

 

 








Risk-free interest rate

 

4.8%

 

3.2%

 

4.0%

 

2.4%

Expected volatility

 

32%

 

37%

 

41%

 

47%

Expected life (in years)

 

0.5-1.0 years

 

0.5 – 1.0 years

 

0.5-1.0 years

 

0.5-1.0 years

Dividend yield

 

0.0%

 

0.0%

 

0.0%

 

0.0%

Disclosures Pertaining to All Share-Based Compensation Plans

Cash received under all share-based payment arrangements for the nine months ended September 30, 2006 and 2005 was $335,000 and $299,000, respectively, related to the exercise of stock options and the purchase of ESPP shares. The weighted-average grant-date fair value of options, restricted stock units and restricted stock awards granted in the nine months ended September 30, 2006 and 2005 was $4.21 and $4.41 per share, respectively. Because of our net operating losses and related valuation allowance, we did not realize any tax benefits for the tax deductions from share-based payment arrangements during the nine months ended September 30, 2006 and 2005.

3. Comprehensive Income

We have no items of other comprehensive income, and accordingly, our comprehensive income is equal to net income for all periods presented.

4. Warranties; Indemnification

We generally provide a warranty that our software products substantially operate as described in the manuals and guides that accompany the software for a period of 90 days. The warranty does not apply in the event of misuse, accident, and certain other circumstances. To date, we have not incurred any material costs associated with these warranties and have no accrual for such items at September 30, 2006.

From time to time, we enter into contracts that require us, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against our customers for violation of third party intellectual property rights caused by our products; (ii) claims resulting from personal injury or property damage resulting from our activities or products; (iii) claims by our office lessors arising out of our use of the premises; and (iv) agreements with our officers and directors under which we may be required to indemnify such persons for liabilities arising out of their activities on behalf of ourselves. Because the obligated amounts for these types of agreements usually are not explicitly stated, the overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have been recorded for these obligations on our balance sheet as of September 30, 2006 or December 31, 2005.

5. Related Party Transaction

In September 2003 we entered into an agreement with Posit Science Corporation (“PSC”), formerly Neuroscience Solutions Corporation (“NSC”), to provide PSC with exclusive rights in the healthcare field to certain intellectual property owned or licensed by us, along with transfer of certain healthcare research projects. A co-founder, substantial shareholder, and member of our Board of Directors, is a co-founder, officer, director and substantial shareholder of PSC.

During the three months and nine months ended September 30, 2006, we recorded $38,000 and $112,000, respectively,in royalties receivable from PSC. For the comparable periods in 2005, we recorded $12,000 and $37,000 in royalties receivable. Amounts received to date and any future receipts are being reported as other income as we do not consider these royalties to be part of our recurring operations.

Page 13



Notes to Condensed Financial Statements

6. Provision for Income Taxes

In the three months ended September 30, 2006, we recorded an income tax benefit of $13,000. In the nine months ended September 30, 2006, we recorded no income tax provision due to our loss. For the three months and nine months ended September 30, 2005 we recorded income tax provisions of $179,000 and $279,000, respectively.

The tax provision for the three months and nine months ended September 30, 2005 principally consisted of federal and state taxes currently payable offset by the utilization of net operating losses resulting in an effective tax rate for the nine months ended September 30, 2005 of approximately 3.75%.

Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and previously reported net losses, we continue to maintain a full valuation allowance against our remaining net deferred tax assets.

7. Commitments and Contingencies

On July 15, 2005, SkyTech, Inc. (“SkyTech”) filed a complaint against us in the District Court for the State of Minnesota, Fourth Judicial District, alleging claims of fraud, breach of contract, breach of duty of good faith and fair dealing, tortious interference, and indemnity. SkyTech alleged that it entered into an independent sales representative agreement (the “Agreement”) with us in October 2002 pursuant to which it has an exclusive right to market our products to the “After School” market. SkyTech further alleged that we prevented SkyTech’s performance of the Agreement and that we wrongly terminated the Agreement. SkyTech asserted that it was entitled to an unspecified amount of damages comprised of lost commissions and other damages, attorney’s fees, costs and punitive damages. In addition to the SkyTech claims, SkyLearn, L.L.C, and HEK, Inc., both of which claimed to be subcontractors of SkyTech, claimed that they suffered damages from our alleged actions with respect to SkyTech. In December 2005 the court granted our motion to dismiss the case and to compel arbitration. The Plaintiffs have filed an appeal of the ruling, and the hearing on the appeal was held in September 2006. We presently anticipate a ruling on the appeal by the end of 2006.

In October 2005 we initiated an arbitration proceeding before the American Arbitration Association in San Francisco, California. Our arbitration complaint alleges that SkyTech owes us for training charges that remain unpaid under the Agreement and seeks declaratory relief regarding SkyTech’s claims against us. SkyTech has asserted counterclaims against us in the arbitration, repeating the claims made in the Minnesota case and asserting damages of $10 million. This arbitration is on hold pending the outcome of the appeal in the Minnesota state court.

We believe that we have meritorious defenses to Skytech’s claims and intend to defend ourselves vigorously. We do not believe that the resolution of this matter will have a material adverse effect on our financial position or results of operations.

Page 14



Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not historical facts but rather are statements based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” and variations and negatives of these words and similar expressions are used to identify forward-looking statements. All forward-looking statements, including but not limited to those identified with asterisks (*) in this report, are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management’s Discussion and in Part II, Item 1A, Risk Factors. We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

Overview

We develop and distribute the Fast ForWord® family of reading intervention software. Our innovative products apply advances in neuroscience and cognitive research to increase learning capacity by building the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrates that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. Our primary market is K-12 schools in the United States, to which we sell using a direct sales force. For the three and nine months ended September 30, 2006, K-12 schools accounted for 95% and 93% of booked sales, respectively. By the end of September 2006, approximately 4,400 schools had purchased at least $10,000 of our Fast ForWord product licenses and services. As of September 30, 2006 we had 192 full-time employees, compared to 176 at September 30, 2005.

Business Highlights

The K-12 education market is large and growing. According to the National Center for Education Statistics, there are 54 million K-12 students with the number growing to nearly 57 million in 2014. Eduventures, a strategic consulting firm in the education industry, has estimated that in 2003, K-12 schools spent $3.3 billion on supplemental content for all subject areas. Another market gauge, provided by the Education Market Report’s Complete K-12 Newsletter (July 2005), estimated the market for all educational software at approximately $800 million for the 2004-2005 school year. This represents growth of approximately 10% over 2003-2004, compared to declining or flat sales in the years from 2001 to 2004.

According to a recent survey by the National Conference of State Legislatures, state budget conditions continue to improve.* State budget overruns are declining, although states still report increasing spending demands for Medicaid and other health care programs, corrections, pensions, education and other priorities.*

Among the federal education programs, we believe that Title 1 and IDEA (special education) have been the most significant sources of funds for purchases of Fast ForWord licenses. The 2006 federal appropriations for these programs are at approximately the same level as in 2005. The current federal budget deficit and competing priorities, however, may adversely impact the continuing availability of federal education funding.

The federal No Child Left Behind (NCLB) Act of 2001 established reading achievement, grade level proficiency, and accountability through assessment as important national priorities. NCLB also emphasizes the need to use proven practices and products grounded in scientifically based research to improve student performance. Our products align well with the emphases of NCLB, and we believe that this alignment assists us in marketing and selling our products.

Page 15



Company Highlights

For the three months ended September 30, 2006 our total booked sales increased by 38% over the same period in 2005, and for the nine months ended September 30, 2006 total booked sales increased 34% over the same period in 2005. (Booked sales is a non-GAAP financial measure. For more explanation on booked sales, see Revenue, below). We expect to see booked sales growth in excess of 35% in 2006, higher than our long-term target growth rate of 20% to 30%.*

In the 2006 third quarter, we closed 30 transactions in excess of $100,000, compared to 15 in the third quarter of 2005. One of our major goals is to increase the number of large sales, which we believe to be an important indicator of education industry acceptance and critical to booked sales growth. These large transactions frequently require school board approvals and their timing is often difficult to predict.

For the three months ended September 30, 2006, our revenue increased 1% compared to the same period in 2005; for the nine months ended September 30, 2006, revenue decreased 8% compared to the same period in 2005. Product revenues declined 4% in the three months ended September 30, 2006 and 12% for the nine months ended September 30, 2006. In both cases, this product revenue decline was the result of lower product revenue from prior period sales more than offsetting increases in product revenue from sales made in the current quarter. Service and support revenue was up 14% and 6%, respectively, in the three and nine month periods ending September 30, 2006, due to increases in the number of customers on support.

For the three and nine months ended September 30, 2006, gross profit decreased 8% and 15% respectively compared to the same periods in 2005, due primarily to a lower proportion of high margin product revenue and also lower margins on our service and support business. Operating expenses were higher in the three and nine months ended September 30, 2006 than they were in the comparable periods in 2005, primarily due to staff additions, consulting, travel and stock-based compensation expense.

We recorded lower net income for the three and nine months ended September 30, 2006 compared to the same periods in 2005 due to lower gross profit and higher operating expenses.

At September 30, 2006 and December 31, 2005, we had no outstanding debt.

Results of Operations

Revenues

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 


 



 

 

2006

 

Change

 

2005

 

2006

 

Change

 

2005

 

 

 






 







Products

 

$

7,006

 

 

-4%

 

$

7,261

 

$

22,882

 

 

-12%

 

$

25,950

 

Service and support

 

 

2,919

 

 

14%

 

 

2,551

 

 

7,827

 

 

6%

 

 

7,386

 





















Total revenues

 

$

9,925

 

 

1%

 

$

9,812

 

$

30,709

 

 

-8%

 

$

33,336

 





















Revenue increased during the three months ended September 30, 2006 compared to the same period in 2005. Revenues each quarter are derived from sales in the current quarter and from sales in prior quarters. Since our strategic pricing change in December 2004, we have recognized substantially more revenue at the time of sale, thereby reducing the proportion of sales that we defer and recognize into revenue in subsequent periods. For the three and nine months ended September 30, 2006, our revenues from sales booked in prior periods declined 19% and 38% respectively to $4.8 million and $12.8 million, from $5.9 million and $20.8 million for the same periods in 2005. In the fourth quarter, we expect revenues from prior quarter sales to be more consistent with the first three quarters of 2006 than with 2005. *

In the 2006 third quarter, the decline in revenue from prior period sales was more than offset by an increase in revenue booked from current quarter sales in 2006. This increase primarily reflected the substantial increase in the quarter’s booked sales compared to 2005. During the third quarter of 2006, approximately 41% of sales booked in the 2006 third quarter were recognized as revenue during the quarter compared to 43% in the third quarter of 2005. Due to the seasonality of our transaction mix, the third quarter generally has the lowest proportion of current quarter sales

Page 16



recognized into revenue.* The comparable amounts for the first nine months of 2006 and 2005 were 52% and 48% respectively. The proportion of booked sales recognized into revenue in the quarter in which the sale was made can vary widely depending on the mix of our transactions. We are typically unable to predict this mix in advance.*

Product revenue, which comprises the bulk of our revenue, decreased during the three and nine months ended September 30, 2006 compared to the same periods in 2005. The decrease in product revenue was primarily the result of lower recognized revenue from sales booked in prior quarters, partially offset by higher revenue from current quarter sales.

Our service and support revenue increased 14% in the three months ended September 30, 2006 compared to the three months ended September 30, 2005, due to greater numbers of customers on support and Progress Tracker and because we provided more training and on site service to customers. For the nine months ended September 30, 2006, service and support revenues were up 6%. We expect service and support revenue to grow modestly during the fourth quarter of 2006.*

Booked sales and selling activity: Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is a useful metric for investors as well as management because it is the most direct measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenue, and is not intended to represent a substitute measure of revenue or any other performance measure calculated under GAAP.

The following reconciliation table sets forth our booked sales, revenue and change in deferred revenue for the three and nine months ended September 30, 2006 and 2005.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended Sept. 30,

 

Nine months ended Sept. 30,

 

(dollars in thousands)

 

2006

 

Change

 

2005

 

2006

 

Change

 

2005

 















Booked sales

 

$

12,686

 

38

%

 

$

9,171

 

$

34,710

 

34

%

 

$

25,958

 

Less revenue

 

$

9,925

 

1

%

 

$

9,812

 

$

30,709

 

(8

%)

 

$

33,336

 





















Net increase/(decrease) in deferred revenue

 

$

2,761

 

 

 

 

($

641

)

$

4,001

 

 

 

 

($

7,378

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deferred revenue beginning of period

 

$

18,243

 

 

 

 

$

19,047

 

$

17,003

 

 

 

 

$

25,784

 





















Total deferred revenue end of period

 

$

21,004

 

14

%

 

$

18,406

 

$

21,004

 

14

%

 

$

18,406

 





















Short-term deferred revenue end of period

 

$

15,513

 

33

%

 

$

11,706

 

$

15,513

 

33

%

 

$

11,706

 

Long-term deferred revenue end of period

 

$

5,491

 

(18

%)

 

$

6,700

 

$

5,491

 

(18

%)

 

$

6,700

 





















Total deferred revenue end of period

 

$

21,004

 

14

%

 

$

18,406

 

$

21,004

 

14

%

 

$

18,406

 





















Booked sales in the K-12 sector increased 43% to $12.0 million during the three months ended September 30, 2006, compared to $8.4 million in the same period in 2005. Booked sales to the K-12 sector for the three months ending September 30, 2006 were 95% of booked sales, compared to 92 % for the three months ending September 30, 2005. For the comparable nine month periods, K-12 represented 93% and 91% of booked sales in 2006 and 2005 respectively. We had one transaction from an existing customer that was more than 10% of the booked sales for the three month period. Booked sales to the K-12 sector were $32.2 million for the nine months ending September 30, 2006, a 36% increase compared to booked sales of $23.6 million during the same period in 2005. The fourth quarter of 2005 was a difficult sales quarter, and as a result, we expect strong sales growth in the fourth quarter of 2006.*

Booked sales to non-school customers, primarily private practice clinicians, decreased by $71,000, or 9%, for the three months ending September 30, 2006. For the nine months ended September 30, 2006, booked sales in this sector increased $162,000, or 7%.

We believe large sales are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales and sales force productivity.* During the third quarter of 2006, we closed sales to 30 school districts that had a contract value in excess of $100,000 compared to 15 during the same period in

Page 17



2005. For the nine months ended September 30, 2006 we closed 83 sales in excess of $100,000 compared to 50 during the same period in 2005. For the nine months ended September 30, 2006, 74% of our K-12 booked sales were realized from sales over $100,000. For the comparable period in 2005, these large sales accounted for 63% of booked sales. We cannot predict the size and number of large transactions in the future.*

Although federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 market.* However, achieving our sales growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators.* Our K-12 growth prospects are also influenced by factors outside our control, including the overall level, certainty and allocation of state, local and federal funding. For a discussion of some of the other important factors that affect our results, see “Risk Factors.”

In addition, the revenue recognized from our sales can be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected. Large sales include volume discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large sales and smaller sales in a given quarter may fluctuate. Because we discount product license fees but do not discount service and support fees, product booked sales and revenue are disproportionately affected by discounting. See “Management’s Discussion and Analysis – Application of Critical Accounting Policies” for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time.

Gross Profit and Cost of Revenues

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended Sept. 30,

 

Nine months ended Sept. 30,

 

 

 


 



 

 

2006

 

2005

 

2006

 

2005

 

 

 


 


 


 


 

(dollars in thousands)

 

$ Profit

 

Margin %

 

$ Profit

 

Margin %

 

$ Profit

 

Margin %

 

$ Profit

 

Margin %

 



















Gross profit on products

 

$

6,573

 

94

%

 

$

6,807

 

94

%

 

$

21,600

 

94

%

 

$

24,442

 

94

%

 

Gross profit on services and support

 

$

830

 

28

%

 

$

1,199

 

47

%

 

$

1,911

 

24

%

 

$

3,175

 

43

%

 



























Total gross profit

 

$

7,403

 

75

%

 

$

8,006

 

82

%

 

$

23,511

 

77

%

 

$

27,617

 

83

%

 



























The overall gross profit margin decreased for the three and nine months ended September 30, 2006 compared to the same periods in 2005. In the three months ended September 30, 2006, margins declined due to lower margins in service and support as we invested in our new Tucson, Arizona support center, which we expect to assume support responsibilities during the fourth quarter of 2006, replacing our outside vendor. We also hired additional service staff hired in anticipation of increased service sales.*

In the nine months ended September 30, 2006, margins declined due to less high margin product revenue as well as lower margins in service and support. Our revenue mix was 75% product and 25% service and support for the nine months ended September 30, 2006, compared to 78% product and 22% service and support for the nine months ended September 30, 2005. In addition, service and support margins declined because of the investments described above.

Operating Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended Sept. 30,

 

Nine months ended Sept. 30

 

 

 


 



(dollars in thousands)

 

2006

 

Change

 

2005

 

2006

 

Change

 

2005

 















Sales and marketing

 

$

5,084

 

46

%

 

$

3,476

 

$

15,906

 

20

%

 

$

13,303

 

Research and development

 

$

1,057

 

13

%

 

$

934

 

$

3,170

 

13

%

 

$

2,808

 

General and administrative

 

$

1,837

 

46

%

 

$

1,256

 

$

5,035

 

14

%

 

$

4,430

 





















Total operating expenses

 

$

7,978

 

41

%

 

$

5,666

 

$

24,111

 

17

%

 

$

20,541

 





















Operating Expenses:

For the three and nine months ending September 30, 2006, operating expenses increased $2.3 million and $3.6 million over comparable 2005 periods. The increase compared to last year’s third quarter is due to expected increases for incentive compensation compared to reduced levels related to lower sales activity in 2005 as well as the adoption of FAS 123R in 2006. Stock-based compensation expense, which is included in both operating expenses and service and

Page 18



support costs, totaled $787,000 in the quarter ended September 30, 2006. Excluding both of these factors, operating expenses increased 3% during the three months ended September 30, 2006, compared to the same period in 2005. For the three and nine months ended September 30, 2006, stock-based compensation expense was $739,000 and $1.5 million representing 32% and 42% of the increase, respectively. In 2005, we expensed $183,000 in equity based compensation during the nine month period. The other major variable in this expense growth is commissions. For the three and nine months ended September 30, 2006, commission expense increased $986,000 and $1.2 million representing 43% and 33% of the increase, respectively.

Sales and Marketing Expenses: For the three months ended September 30, 2006, our sales and marketing expenses increased $1.6 million compared to the comparable period in 2005 primarily due to higher commissions, stock-based compensation expense and non-commission incentive compensation. For the nine months ended September 30, 2006 sales and marketing expenses were up $2.6 million due to additional staff and commissions, stock-based compensation expense and incentive compensation. At September 30, 2006, we had 42 quota-bearing field sales personnel selling to public schools and corrections compared to 36 at September 30, 2005.

Research and Development Expenses: Research and development expenses increased in the three and nine months ended September 30, 2006 compared to the same periods in 2005. Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs. The increase in spending in both the three and nine months ended September 30, 2006 was primarily due to stock-based compensation expense, incentive compensation and patent prosecution legal fees.

General and Administrative Expenses: Expenses increased for both the three and nine month periods ended September 30, 2006, as higher stock-based compensation expense and incentive compensation were only partially offset by lower audit, legal, and consulting expenses.

Other Income from Related Party

In September 2003, we signed an agreement with Posit Science Corporation (“PSC”), transferring technology to PSC for use in the health field. During 2006 we recorded $38,000 in the third quarter and $112,000 for the first three quarters in royalties received from PSC. For the comparable periods in 2005, we recorded $13,000 and $37,000 in royalties. Amounts received to date and any future receipts are being reported as other income as we do not consider these royalties to be part of our recurring operations.

Interest and Other Income, net

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 


 



(dollars in thousands)

 

2006

 

Change

 

2005

 

2006

 

Change

 

2005

 















Interest income, net

 

$

192

 

115

%

 

$

89

 

$

370

 

19

%

 

$

311

 





















In the three and nine month periods ended September 30, 2006, we generated interest income from our cash balances. Additionally, we recognized $55,000 in one time income from former customer. In the same periods of 2005, the interest income from our cash balances was supplemented by interest income on loans to current and former officers. For the nine months ended September 30, 2006, interest income on officer loans was $1,000. For the same periods in 2005, interest income from officer loans was $26,000 and $157,000. All officer loans were repaid by March 31, 2006.

Provision for Income Taxes

In the three months ended September 30, 2006, we recorded an income tax benefit of $13,000. In the nine months ended September 30, 2006, we recorded no income tax provision due to our loss. For the three months and nine months ended September 30, 2005 we recorded income tax provisions of $179,000 and $279,000, respectively.

The tax provision for the three months and nine months ended September 30, 2005 principally consisted of federal and state taxes currently payable offset by the utilization of net operating losses resulting in an effective tax rate for the nine months ended September 30, 2005 of approximately 3.75%.

Page 19



Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and previously reported net losses, we continue to maintain a full valuation allowance against our remaining net deferred tax assets.

Liquidity and Capital Resources

Our cash, cash equivalents and short term investments were $13.3 million at September 30, 2006, compared to $12.1 million at December 31, 2005. We expect that our cash flow from operations and our current cash balances will be the primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures during at least the next twelve months.* Accomplishing this, however, will require us to meet specific booked sales targets in the K-12 market. We cannot be certain that we will meet our targets with respect to booked sales, revenues, expenses or operating results.

If we are unable to achieve sufficient cash flow from operations, we may seek other sources of debt or equity financing, or may be required to reduce expenses.* Reducing our expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development.* We cannot be certain that we will be able to secure additional debt or equity financing on acceptable terms, if at all.

Historically, our first quarter is our lowest sales quarter, reflecting school purchasing cycles and a trend in our industry.* Therefore, we may have negative cash flow in some quarters, particularly the first quarter, and may borrow from time to time.* We generally expect to generate cash in the third quarter.*

Net cash generated by operating activities for the nine months ended September 2006 was $1.3 million versus cash used of $0.2 million during the same period in 2005. This is the result of higher sales and collections partially offset by higher spending in 2006 as compared to 2005. Our days sales outstanding (DSO) on booked sales lengthened from 60 days at September 30, 2005 to 77 days at September 30, 2006. This is within our recent historical range for DSO at the end of quarters, which since 2004 has ranged between 49 and 92 days, dependent on the timing of sales and the credit terms provided.

Net cash generated by investing activities for the nine months ended September 30, 2006 was $2.7 million compared to cash used of $0.9 million for the same period in 2005, primarily reflecting the maturity of a $3.0 million short-term investment. This was partially offset by higher capital spending in 2006 than in 2005 and lower officer loan repayments in 2006 as compared to 2005. Capital spending primarily consists of purchases of computer hardware and software. We expect that our capital spending will be higher in 2006 than in 2005 on a full year basis. *

For the nine months ended September 30, 2006 and 2005 we had no borrowings.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements.

Contractual Obligations and Commitments

We have a non-cancelable lease agreement for our corporate office facilities. The minimum lease payment is approximately $78,000 per month through 2008. After 2008 the base lease payment increases at a compound annual rate of approximately 5%. The lease terminates in December 2013. We also have a new lease agreement for a Tucson, Arizona facility. Minimum lease payments for the Tucson office are approximately $4,000 per month through the lease termination in April 2009.

Page 20



The following table summarizes our obligations at September 30, 2006 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(dollars in thousands)

 

Total

 

Less than 1
year

 

2 - 3 years

 

4 - 5 years

 

Thereafter 1.

 













Non-cancelable operating leases

 

$

7,647

 

$

992

 

$

1,986

 

$

2,087

 

$

2,582

 

Minimum royalty payments

 

 

1,238

 

 

150

 

 

300

 

 

300

 

 

488

 


















Total

 

$

8,885

 

$

1,142

 

$

2,286

 

$

2,387

 

$

3,070

 


















1. Non-cancelable operating leases expire December 31, 2013. Minimum royalty payments expire in 2014.
Our purchase order commitments at September 30, 2006 are not material.

Loans to Current and Former Officers

In March 2001 we made full recourse loans to certain of our officers, in amounts totaling $3.1 million. In 2002 some of these officers left our Company. The notes were full recourse loans secured by shares of our Common Stock owned by our current and former officers. The loans bore interest at 4.94%. Principal and interest were due December 31, 2005, and were fully repaid by March 31, 2006.

Application of Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, assumptions and judgments. We believe that the estimates, assumptions and judgments upon which we rely are reasonable based upon information available to us at the time. The estimates, assumptions and judgments that we make can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.

We believe that the estimates, assumptions and judgments pertaining to revenue recognition, allowance for doubtful accounts, software development costs and long-lived assets are the most critical assumptions to understand in order to evaluate our reported financial results. A detailed discussion of our use of estimates, assumptions and judgments as they relate to these polices is presented below. We have discussed the application of these critical accounting policies with the Audit Committee of the Board of Directors.

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgment related to our specific transactions and transaction types.

Sales to our school customers typically include multiple elements (e.g., Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”), if VSOE exists for each element. If we lack VSOE for one or more delivered elements in an arrangement (typically software), we recognize revenue using the residual method, whereby the difference between the total arrangement fee and the total fair value of the undelivered elements is recognized as revenue relating to the delivered elements. VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

Page 21



The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products. Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and is recognized as follows:

Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.

Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.

Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.

Service and support revenue

Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. These estimates are based on historical experience. In 2005 and the first nine months of 2006 our bad debt experience has been less than 1% of revenue. To the extent experience requires it, we may in the future adjust this allowance.* Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.

Software Development Costs

We capitalize software development cost in accordance with Financial Accounting Standards Board (FASB) Statement No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” under which software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated life of the related product.

Prior to the establishment of technological feasibility we expense all software development cost associated with a product. Technological feasibility is deemed established upon completion of a working version.

On an ongoing basis, we evaluate the net realizable value of the capitalized software development cost by estimating the future revenue to be generated from the product and compare this estimate to the unamortized cost of the product. At September 30, 2006 all previously capitalized software development expenses have been fully amortized. No software development costs were capitalized in the three or nine months ended September 30, 2006 or 2005.

Impairment of Long-Lived Assets

We regularly review the carrying value of, capitalized software development costs and property and equipment. We continually make estimates regarding the probability of future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

Page 22



Stock-Based Compensation

Under the fair value recognition provisions of SFAS No. 123R, we use the Black-Scholes option valuation model to estimate stock-based compensation expense at the grant date based on the fair value of the award and recognize the expense ratably over the requisite service period of the award. Determining the appropriate fair value model and assumptions used in calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected life. Stock compensation expense may be adjusted in the future if actual forfeiture rates differ significantly from our current estimates.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Not applicable.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the required time periods. These procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

As required under Rule 13a-15(b) of the Exchange Act, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report, and concluded that our disclosure controls and procedures were effective as of September 30, 2006.

It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the Chief Financial Officer are made at the “reasonable assurance” level.

Changes in Internal Controls over Financial Reporting

There were no changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Page 23



PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On July 15, 2005, SkyTech, Inc. (“SkyTech”) filed a complaint against us in the District Court for the State of Minnesota, Fourth Judicial District, alleging claims of fraud, breach of contract, breach of duty of good faith and fair dealing, tortious interference, and indemnity. SkyTech alleged that it entered into an independent sales representative agreement (the “Agreement”) with us in October 2002 pursuant to which it has an exclusive right to market our products to the “After School” market. SkyTech further alleged that we prevented SkyTech’s performance of the Agreement and that we wrongly terminated the Agreement. SkyTech asserted that it was entitled to an unspecified amount of damages comprised of lost commissions and other damages, attorney’s fees, costs and punitive damages. In addition to the SkyTech claims, SkyLearn, L.L.C and HEK, Inc., both of which claimed to be subcontractors of SkyTech, claimed that they suffered damages from our alleged actions with respect to SkyTech. In December 2005, the court granted our motion to dismiss the case and to compel arbitration. The Plaintiffs have filed an appeal of the ruling, and the hearing on the appeal was held in September 2006. We presently anticipate a ruling on the appeal by the end of 2006.

In October 2005 we initiated an arbitration proceeding before the American Arbitration Association in San Francisco, California. Our arbitration complaint alleges that SkyTech owes us for training charges that remain unpaid under the Agreement and seeks declaratory relief regarding SkyTech’s claims against us. SkyTech has asserted counterclaims against us in the arbitration, repeating the claims made in the Minnesota case and asserting damages of $10 million. This arbitration is on hold pending the outcome of the appeal in the Minnesota state court.

Item 1A. Risk Factors

The following factors as well as other information contained in this report should be considered in making any investment decision related to our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected and the trading price of our common stock could decline.

To grow our business, we need to increase acceptance of our products among K-12 education purchasers. Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.

We believe that to date most educators who have used Fast ForWord products are “early adopters.” Early adopters make up a relatively small proportion of the K-12 market, so in order to grow our revenue and profit, we need to increase our booked sales beyond early adopters to more conservative customers. We believe that our ability to grow acceptance of our products in the conservative K-12 education market will depend largely on the critical factors discussed below.

Our Fast ForWord products use an approach that differs from the approaches that schools have traditionally used to address reading problems. In particular, our products work because they increase learning capacity, are based on neuroscience research and focus on the development of cognitive skills. All of these concepts may be unfamiliar to educators. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.

In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires a substantial amount of time out of a limited and already crowded school day. Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us. In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased booked sales.

Our products are generally implemented in a computer lab with a lab coach or teacher rather than in the classroom with the students’ regular classroom teachers. To better reach mainstream customers, encourage additional sales from existing customers and improve student achievement results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner.

Page 24



We encourage our customers to purchase significant levels of field service because we believe that these services enable more effective product use and lead to stronger student achievement gains. If we are unable to continue to convince customers to purchase these levels of service, customers may experience more difficulty with their implementations.

If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our sales and growth prospects could be materially and adversely impacted and our profitability could decline.

It is difficult to accurately forecast our future financial results, and we believe that in 2006 our quarterly revenue has become more difficult to predict. This may cause us to fail to achieve the financial performance anticipated by investors and financial analysts, which could cause the price of our stock to decline.

Our booked sales, revenues and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter as a result of many factors, including those discussed below.

A significant proportion of our customers’ purchases are made within the last two weeks of each quarter. We therefore have limited visibility on actual booked sales for the quarter until the end of the quarter. If a customer unexpectedly postpones or cancels an expected purchase due to changes in the customer’s objectives, priorities, budget or personnel, we may experience an unexpected booked sales shortfall that cannot be made up in the quarter.

The timing of the recognition of revenue from our booked sales can also be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it may be difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be projected.

Since our December 2004 pricing change, we recognize revenue from most of our perpetual license sales at the time of sale. Before that change, perpetual license revenue was recognized over the related service period. Because of this transition, in 2005 we recognized substantial revenue from perpetual licenses booked in 2003 and 2004, as well as perpetual license sales in 2005. In the first three quarters of 2006, a greater proportion of our perpetual license revenue was derived from sales in that quarter. We expect this to continue in the fourth quarter.* Because our booked sales are difficult to predict, our quarterly perpetual license revenue has therefore become more unpredictable.

In addition, our sales strategy emphasizes large, district-level, multi-site transactions. The receipt or implementation of a single large order, or conversely its loss or delay, can significantly impact the level of sales booked and revenue recognized in a given quarter.

Our expense levels are based on our expectations of future booked sales and are primarily fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected booked sales shortfall, which could cause our net income to fluctuate unexpectedly.

Failure to achieve the financial results expected by investors and financial analysts in a given quarter could cause an immediate and significant decline in the trading price of our common stock.

Our sales cycle tends to be long and somewhat unpredictable, which may result in delayed or lost revenue, which could materially and adversely impact our revenue and net income.

Like other companies in the instructional market, our booked sales to K-12 schools are affected by school purchasing cycles and procedures, which can be quite bureaucratic. The cost of some of our K-12 license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that can be difficult to predict. When a district decides to finance its license purchase, the time required to obtain necessary approvals can be extended even further. In addition, booked sales to schools are subject to budgeting constraints, which may require schools to find available discretionary funds, obtain grants or wait until subsequent budget cycles. As a result, our sales cycle generally takes several months, and in some cases, can take a year or longer. Therefore, we may devote significant time and energy to a particular customer sale over the course of many months, and then not make the sale when expected or at all. This can result in lower revenue and lost opportunities that can materially and adversely impact our revenue and net income.

Page 25



We may be unable to continue to be profitable.

We started operations in February 1996 and through 2002 incurred significant operating losses. We first became profitable in 2003, incurred a net loss in 2004 and were again profitable in 2005. At September 30, 2006, we had an accumulated deficit of approximately $78 million from inception.

Our strategic and operating goals include increasing our booked sales and cash flow. Our ability to achieve increased booked sales and cash flow depends on many factors, including but not limited to market acceptance of our products, availability of funding, customers’ prior experience with our products, and general economic conditions, some of which are outside of our control. To meet our booked sales targets, we will need to incur substantial expenditures. We cannot assure you that we will meet our targets with respect to booked sales, revenues or operating results.

We rely on studies of student performance results to demonstrate the effectiveness of our products. If the validity of these studies or the conclusions that we draw from them are challenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.

We rely heavily on statistical studies of student results on assessments to demonstrate that our Fast ForWord products lead to improved student achievement. Reliance on these studies to support our claims about the effectiveness of our products involves risks, including the following:

 

 

 

 

The results of studies depend on schools’ appropriately implementing the products and adhering to the product protocol. If a school does not do so, the study may not show that our products produce substantial student improvements.

 

 

 

 

Some studies on which we rely may be challenged because the studies use a limited sample size, lack a randomly selected control group, include assistance or participation from the Company or its scientists, or have other design characteristics that are not optimal. These challenges may assert that these studies are not sufficiently rigorous or free from bias, and may lead to criticism of the validity of the studies and the conclusions that we draw from them.

 

 

 

 

Schools studying the effectiveness of our products use the product with different types of students and use different assessments, sometimes making it difficult to aggregate or compare results.

Our sales and marketing efforts, as well as our reputation, could be adversely impacted if the studies upon which we rely to demonstrate the effectiveness of our products, or the conclusions we draw from those studies, are seen to be insufficient. The federal NCLB legislation has placed an increasing emphasis on the need for scientifically-based research. To the extent that scientifically-based research becomes more important to the education market, challenges to the research that we use in marketing our products could become more potentially harmful to us.

Claims relating to data collection from our user base may subject us to liabilities and additional expense.

Schools and clinicians that use our products frequently use students’ names to register them in our products and enter into our database academic, diagnostic and/or demographic information about the students. In addition, the results of student use of our products are uploaded to our database. We have designed our system to safeguard this personally-identifiable information, but the protection of such information is an area of increasing public concern and significant government regulation, including but not limited to the Children’s Online Privacy Protection Act. If our privacy protection measures prove to be ineffective, we could be subject to liability claims for unauthorized access to or misuses of personally-identifiable information stored in our database. We may also face additional expenses to analyze and comply with increasing regulation in this area.

We may experience difficulties in launching new products efficiently, without significant technical issues, and on schedule. This could materially slow booked sales or decrease profitability.

We launched new products in 2005 and the first half of 2006 and we expect to launch additional products in the remainder of 2006 and future years.* Unexpected challenges could make these development projects longer or more expensive than planned. In addition, new technology products usually contain bugs that are not discovered in the

Page 26



testing process, and tend to be more challenging to implement when they are first introduced, especially in the diverse and challenging K-12 technology environment. Any significant defect or deficiency in our products could cause customers to cancel or delay orders, cause us to incur significant expenses remedying the problem, and harm our reputation.

Booked sales of our products depend on the availability of government funding for public school reading intervention purchases, which is variable and outside the control of both us and our direct customers. If such funding becomes less available, our public school customers may be unable to purchase our products and services on a scale or at prices that we anticipate, which would materially and adversely impact our revenue and profitability.

US public schools are funded primarily through state and local tax revenues, which are devoted primarily to school building costs, teacher salaries and general operating expenses. Public schools also receive funding from the federal government through a variety of federal programs, many of which target children who are poor and/or struggling academically. Federal funds typically are restricted to specified uses.

We believe that the funding for a substantial portion of our K-12 booked sales comes from federal funding, in particular special education and Title 1 funding. The current federal budget deficit and competing federal priorities may impact the availability of federal education funding. A cutback in federal education funding could slow our booked sales.

State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. We expect that future levels of state and local school spending will continue to be significantly affected by the general economic conditions and outlook.* A downturn in the economy might slow our booked sales. Increased energy costs for schools may also affect the level of resources available for purchasing our products.

We compete for sales with companies that have longer histories and greater resources than we do. We may not be able to compete effectively in the education market.

The market in which we operate is very competitive. While our products are highly differentiated by their neuroscience basis and their focus on increasing learning capacity and developing cognitive skills, we nevertheless compete vigorously for the funding available to schools. We compete not only against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading skills. Many of the companies providing these competitive offerings are much larger than Scientific Learning, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Encouraged by the No Child Left Behind Act, new competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

We expect to be required to comply with Sarbanes-Oxley Section 404 no sooner than the end of 2007. We are presently engaged in a process of evaluating and documenting our internal control over financial reporting with the goal of achieving compliance by that deadline. The process is very costly and requires significant internal resources. If we are unable to comply with Section 404 when we are required to do so or are unable to conclude that our internal control over financial reporting is effective, such non compliance or ineffective controls could have a materially adverse effect on us.

Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we will be required to provide a management report and auditors’ attestation and report on our internal control over financial reporting. We have not previously been subject to this requirement. Under current rules and with the current market valuation of our outstanding shares held by non-affiliates, our deadline for compliance will be December 31, 2007. The SEC has proposed an amendment to the current rules that would extend the deadline for the auditor’s attestation requirement to December 31, 2008, assuming that our public float does not exceed $75 million at June 30, 2006.

Page 27



Historically, we have understood the importance of internal control over financial reporting, and on an ongoing basis, we evaluate our controls, assess whether we should improve them and, when appropriate, implement improvements. In connection with our restatements in 2005, we concluded that we had a material weakness in our internal controls relating to revenue and deferred revenue. To address this material weakness, we hired additional accounting staff and we implemented changes in our processes, procedures and controls relating to revenue and deferred revenue. In connection with the audit of our financial statements for the year ended December 31, 2005, management concluded and the Audit Committee concurred that, at December 31, 2005, we no longer had a material weakness in our internal control over financial reporting. We cannot assure you that, in the course of implementing our processes to achieve compliance with Section 404, we will not detect additional material weaknesses in our internal control over financial reporting.

Our current liquidity resources may not be sufficient to meet our needs.

We believe that cash flow from operations will be our primary source of funding for our operations during the remainder of 2006 and the next several years.* In 2003 and 2004 we generated $3.9 million and $6.3 million respectively in cash from operating activities. In 2005, we used $2.1 million in cash in our operating activities, reflecting the decline in our booked sales and higher expenses to support our growth goals. During the first three quarters of 2006, we generated $1.3 million in cash from operating activities. At September 30, 2006 we had $13.3 million in cash and cash equivalents.

In addition, we have a line of credit with Comerica Bank totaling $5.0 million, which expires June 2, 2007. At June 30, 2006 no borrowings were outstanding and we were in compliance with the covenants of that line.

If our operations did not generate sufficient cash flow to fund our activities and if in that event we were also not able to obtain sufficient funding from our line of credit, then we would need either to obtain debt or equity financing from other sources or to reduce expenses. Reducing our expenses could adversely affect our operations by reducing the resources available for sales, marketing, research or development efforts. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.

We depend on the performance of Robert Bowen, our Chairman and Chief Executive Officer, and on other senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

If we are unable to adequately protect our intellectual property rights or if we infringe on the rights of others, we could become subject to significant liabilities, need to seek licenses or lose our rights to sell our products.

Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. It is possible that our issued patents will not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents. In addition, we could become party to patent, copyright or trademark infringement claims, litigation or interference proceedings. These proceedings could result from claims that we are violating the rights of others or may be necessary to enforce our own rights. Any such proceedings would result in substantial expense and significant diversion of management effort. An adverse determination in such proceedings could subject us to significant liabilities or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.

Our most important products are based on licensed inventions owned by two universities. If we were to lose our rights under this license, it would materially harm our business. The licensor may terminate the license if we fail to perform our obligations and do not timely cure the violation. We believe that we are currently in compliance with the license in all material respects.

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Our directors and executive officers and their affiliates effectively control the voting power of our company.

At December 31, 2005, Warburg, Pincus Ventures, our largest shareholder, owned approximately 46%of the Company’s outstanding stock and, in the aggregate, our directors and executive officers and their affiliates held more than 60% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of our company.

Our common stock is thinly traded and its price is volatile.

Our common stock presently trades on the Nasdaq National Market, and our trading volume is low. For example, during the first three quarters of 2006, our average daily trading volume was approximately 6,000 shares. The market price of our common stock has been highly volatile since our July 1999 initial public offering and could continue to be subject to wide fluctuations.

Item 6. Exhibits and Reports on Form 8-K

          (a) Exhibits

 

 

 

 

 

 

Exhibit No.

 

Description of Document

 


 


 

3.1

(1)

 

Restated Certificate of Incorporation.

 

3.2

(2)

 

Amended and Restated Bylaws.

 

31.1

 

 

Certification of Chief Executive Officer (Section 302).

 

31.2

 

 

Certification of Chief Financial Officer (Section 302).

 

32.1

 

 

Certification of Chief Executive Officer (Section 906).

 

32.2

 

 

Certification of Chief Financial Officer (Section 906).

 

 

 

 

 

(1)

Incorporated by reference to Exhibit 3.3 previously filed with the Company’s Registration Statement on Form S-1 (SEC File No. 333-77133).

 

(2)

Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003 (SEC File No. 000-24547).

Page 29



SIGNATURE

          Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 8, 2006

 

 

 

SCIENTIFIC LEARNING CORPORATION

 

(Registrant)

 

 

 

/s/ Jane A. Freeman

 


 

Jane A. Freeman

 

Chief Financial Officer

 

(Authorized Officer and Principal Financial and Accounting Officer)

Page 30



Index to Exhibits

 

 

 

Exhibit No.

 

Description of Document


 


3.1 (1)

 

Restated Certificate of Incorporation.

3.2 (2)

 

Amended and Restated Bylaws.

31.1

 

Certification of Chief Executive Officer (Section 302).

31.2

 

Certification of Chief Financial Officer (Section 302).

32.1

 

Certification of Chief Executive Officer (Section 906).

32.2

 

Certification of Chief Financial Officer (Section 906).

 

 

 

(1)

Incorporated by reference to Exhibit 3.3 previously filed with the Company’s Registration Statement on Form S-1.

 

(2)

Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003.



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