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 June 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 July 15, 2006, there were 16,842,506 shares of Common Stock outstanding.
SCIENTIFIC LEARNING CORPORATION
INDEX TO FORM 10-Q FOR THE QUARTER ENDED June 30, 2006
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.
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.
The interim financial information as of June 30, 2006 and for the three and six months ended June 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 six months ended June 30, 2006 includes approximately $510,000
and $891,000, 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.
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 revenue relating to software licenses. VSOE of
Page 6
Notes to Condensed Financial Statements
1. Summary of Significant Accounting Policies (continued)
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.
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 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.
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.
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.
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
Page 7
Notes to Condensed Financial Statements
1. Summary of Significant Accounting Policies (continued)
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.
Basic net income per share is computed using the weighted average number of common shares outstanding
during the period. Diluted net income 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 warrants calculated using the treasury stock method.
On June 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 June 30,
2006, 126,882 shares were available for issuance under this plan.
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 six
months ended June 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 six months ended June 30, 2005:
Three months
ended June 30,
Six months
ended June 30,
(In thousands, except per share amounts)
2005
2005
Net income, as reported
$
3,593
$
4,883
Add: Share-based compensation expense included in
reported net income, net of related tax effects
19
113
Deduct: Total share-based compensation expense determined
under the fair value based method for all awards, net of
related tax effects
(451
)
(893
)
Net income, pro forma
$
3,161
$
4,103
Basic net income per share - as reported
$
0.22
$
0.29
Basic net income per share - pro forma
$
0.19
$
0.25
Diluted net income per share - as reported
$
0.20
$
0.28
Diluted net income per share - pro forma
$
0.18
$
0.23
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.
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 June 30,
2006
Six months
ended June 30,
2006
Cost of service and support revenues
$
57
$
97
Sales and marketing
216
354
Research and development
89
151
General and administrative
148
289
Share-based compensation effect on operating income (loss)
$
510
$
891
Income taxes
(39
)
(39
)
Net share-based compensation effects on net income
$
471
$
852
Share-based compensation effect on basic net income per
share
$
0.03
$
0.05
Share-based compensation effect on diluted net income per
share
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:
The following table summarizes all stock option activity under our share-based compensation plans for
the six months ending June 30, 2006:
Page 10
Notes to Condensed Financial Statements
2. Stock-Based Compensation (continued)
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
5,000
$
4.50
Exercised
(18,232
)
$
2.32
Forfeited or expired
(68,055
)
$
5.75
Outstanding at June 30, 2006
3,299,038
$
4.24
6.30
$
5,058,637
Vested and expected to vest at June
30, 2006
3,078,760
$
4.35
0.55
$
4,569,593
Exercisable at June 30, 2006
1,959,743
$
4.95
5.85
$
2,533,725
Aggregate intrinsic value of options outstanding at June 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 1,872,177
shares that had exercise prices that were lower than the $4.60 market price of our common stock at
June 30, 2006 (“in the money options”). The total intrinsic value of options exercised
during the six months ended June 30, 2006 and 2005 was $45,000 and $77,000, respectively. The total
fair value of options vested is $803,000 for the six months ended June 30, 2006.
As of June 30, 2006, total unrecognized compensation cost related to stock options granted under our
various plans was $1.9 million. We expect that cost to be recognized over a weighted-average period
of 1.6 years.
Restricted stock units were awarded for the first time in 2006 under our 1999 Equity Incentive Plan.
A total of 234,500 restricted stock units were granted and remain unvested as of June 30, 2006. 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 six months of fiscal 2006 was $4.88. As of June
30, 2006, there was $816,000 of total unrecognized compensation cost related to unvested restricted
stock units granted, which is expected to be recognized over a weighted-average period of 2.0 years.
No restricted stock units vested or were forfeited during the six months ended June 30, 2006.
As of June 30, 2006, we had issued 573,118 shares over the life of the ESPP. During the second quarters
of fiscal 2006 and fiscal 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:
Cash received under all share-based payment arrangements for the six months ended June 30, 2006 and
2005 was $42,000 and $86,000, respectively, all related to the exercise of stock options. The weighted-average
grant-date fair value of options and awards granted in the six months ended June 30, 2006 and 2005
was $4.88 and $4.33, 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 six months ended June 30, 2006 and 2005.
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 June 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 June 30, 2006 or December 31, 2005.
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 six months ended June 30, 2006, we recorded $37,000 and $75,000, respectively,
in royalties receivable from PSC. For the comparable periods in 2005, we recorded $13,000 and $25,000
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.
In the three months and six months ended June 30, 2006, we recorded an income tax provision of $13,000.
For the three months and six months ended June 30, 2005 we recorded income tax provisions of $73,000
and $99,000, respectively.
The tax provision for the three months and six months ended June 30, 2006 consists of federal alternative
minimum taxes and state taxes currently payable offset by the utilization of net operating losses
resulting in an effective tax rate of approximately 1% and 6%, respectively. The effective tax
rate is influenced by permanent book versus tax differences arising from the requirement to add back
stock compensation expenses, and temporary book versus tax differences arising from the timing of
the recognition of deferred revenue for tax purposes.
Page 12
Notes to Condensed Financial Statements
6. Provision for Income Taxes (continued)
The tax provision for the three months and six months ended June 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 of approximately 2%. The effect of book versus tax differences was insignificant
in these periods.
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.
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 appeal
is scheduled for hearing in September 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 13
Item 2. Management’s Discussion and Analysis of Financial Conditions 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.
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 six months ended June 30, 2006, K-12 schools accounted for 91% and 92% of booked
sales, respectively. By the end of June 2006, approximately 4,200 schools had purchased at least
$10,000 of our Fast ForWord product licenses and services. In late June 2006, we released our latest
product, Fast ForWord to Literacy Advanced; this new product had no material impact on our results
for the period ending June 30, 2006. As of June 30, 2006 we had 194 full-time employees, compared
to 178 at June 30, 2005.
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.
For the three months ended June 30, 2006 our total booked sales increased by 26% over the same period
in 2005, and for the six months ended June 30, 2006 total booked sales increased 31% 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 of 25%-35% in 2006, higher than our long-term target
growth rate of 20% to 30%.*
We also closed 35 transactions in excess of $100,000, compared to 25 in the second 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 June 30, 2006, our revenue decreased 2% compared to the same period in 2005;
for the six months ended June 30, 2006, revenue decreased 12% compared to the same period in 2005.
Product revenues declined 3% in the three months ended June 30, 2006 and 15% for the six months ended
June 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 flat and up 2%, respectively, in the three and six
month periods ending June 30, 2006, due to increases in the number of customers on support offsetting
a 2005 price decrease for new support customers.
For the three and six months ended June 30, 2006, gross profit decreased 6% and 18% 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 six months ended June 30, 2006 than they were in the comparable periods in 2005, primarily due
to staff additions in our new Tucson, AZ office, equity compensation expense and travel expenses.
We recorded lower net income for the three and six months ended June 30, 2006 compared to the same
periods in 2005 due to lower gross profit and higher operating expenses.
At June 30, 2006 and December 31, 2005, we had no outstanding debt.
Revenue decreased during the three and six months ended June 30, 2006 compared to the same periods 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 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. The decrease in revenue primarily reflects a decline in revenue attributable to sales in prior periods. For the three and six months ended June 30, 2006, our revenues from sales booked in prior periods declined 30% and 47% respectively to $4.2 million and $7.9 million, from $5.9 million and $14.9 million for the same periods in 2005. For the balance of 2006, we expect revenues from prior quarter’s sales to be more consistent with the first half of 2006 than with 2005. *
The decline in revenue from prior period sales was partially offset by an increase in revenue booked from current quarter sales in 2006. During the second quarter of 2006, approximately 57 % of sales booked in that quarter were recognized as revenue during the quarter compared to 61% in the second quarter of 2005. The comparable amounts for the first six months of 2006 and 2005 were 58% and 51% 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.*
Page 15
Product revenues, which comprise the bulk of our revenue, decreased during the three and six months
ended June 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 was flat in the three months ended June 30, 2006 compared to the three
months ended June 30, 2006, as greater numbers of customers on support and Progress Tracker were
offset by lower support pricing for new customers implemented in early 2005. For the six months ended
June 30, 2006, service and support revenues were up 2%. We expect service and support revenue to
grow modestly during the last half 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 revenues, and is not intended to represent a substitute
measure of revenues or any other performance measure calculated under GAAP.
The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue
for the three and six months ended June 30, 2006 and 2005.
Booked sales in the K-12 sector increased 27% to $13.9 million during the three months ended June 30, 2006, compared to $11.0 million in the same period in 2005. Booked sales to the K-12 sector for the three months ending June 30, 2006 and 2005 were 91% of total booked sales. We had one sale to an existing customer which was approximately 14% of the quarter’s total sales. Booked sales to the K-12 sector were $20.2 million for the six months ending June 30, 2006, a 33% increase compared to booked sales of $15.2 million during the same period in 2005.
Booked sales to non-school customers, primarily private practice clinicians, increased by $229,000, or 21%, for the three months ending June 30, 2006. For the six months ended June 30, 2006, booked sales in this sector were up $234,000, or 15%. We anticipate that during the remainder of 2006, booked sales to non-school customers will grow more modestly than they have so far in 2006.*
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 second quarter of 2006, we closed 35 sales that had a contract value in excess of $100,000 compared to 25 during the same period in 2005. For the six months ended June 30, 2006 we closed 53 sales in excess of $100,000 compared to 35 during the same period in 2005. For the six months ended June 30, 2006, 75% 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
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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 energy costs, which are a significant expense for our customers, and 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.
The overall gross profit margin decreased for the three and six months ended June 30, 2006 compared
to the same periods in 2005. In the three months ended June 30, 2006, margins declined primarily
due to lower margins in service and support partially offset by slightly lower product royalty and
materials expenses. These lower service and support margins reflect expenses associated with our
new Tucson, Arizona support center, which we expect to assume support responsibilities later this
year, replacing our outside vendor and also additional service staff hired in anticipation of increased
service sales.*
In the six months ended June 30, 2006, margins declined primarily due to less high margin product revenue.
Our revenue mix was 76% product and 24% service and support for the six months ended June 30, 2006,
compared to 80% product and 20% service and support for the six months ended June 30, 2005. In addition,
service margins declined because of the investments described above. Offsetting these decreases,
product margins improved due to lower materials expenses and lower royalties.
For the three and six months ending June 30, 2006, operating expenses were up $524,000 and $1.3 million over comparable 2005 periods. The primary driver of the increased expenses was equity compensation expense, for which there is no comparable 2005 expense. For the three and six months ended June 30, 2006, equity compensation expense was $451,000 and $893,000 representing 86% and 71% of the increase, respectively.
Sales and Marketing Expenses: For the three months ended June 30, 2006, our sales and marketing expenses increased $380,000 compared to the comparable period in 2005 primarily due to additional staff, equity compensation expense and higher commissions, partially offset by lower consulting expenses. For the six months ended June 30, 2006 sales and marketing expenses were up $996,000 due to additional staff and commissions, equity compensation
Page 17
expense and consulting expense. At June 30, 2006, we had 41 quota-bearing field sales personnel selling to public schools compared to 39 at June 30, 2005.
Research and Development Expenses: Research and development expenses increased in the three and six months ended June 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 six months ended June 30, 2006 was primarily due to equity compensation expense and patent prosecution legal fees.
General and Administrative Expenses: Expenses were flat for both the three and six month periods ended June 30, 2006, as equity compensation expense was offset by lower audit, legal, and consulting expenses.
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 $37,000 in the second quarter and $75,000 for the first two quarters in royalties received from PSC. For the comparable periods in 2005, we recorded $13,000 and $25,000 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.
In the three and six month periods ended June 30, 2006, we generated interest income almost exclusively
from our cash balances. 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 six months ended
June 30, 2006, interest income on officer loans was $1,000. For the same periods in 2005, interest
income from officer loans was $93,000 and $131,000. As of June 30, 2006, all officer loans have been
repaid.
In the three and six months ended June 30, 2006, we recorded an income tax provision of $13,000. For
the three and six months ended June 30, 2005 we recorded income tax provisions of $73,000 and $99,000,
respectively.
The tax provision for the three and six months ended June 30, 2006 consists of federal alternative
minimum taxes and state taxes currently payable offset by the utilization of net operating losses
resulting in an effective tax rate of approximately 1% and 6%, respectively. The effective tax rate
is influenced by permanent book versus tax differences arising from the requirement to add back stock
compensation expenses, and temporary book versus tax differences arising from the timing of the recognition
of deferred revenue for tax purposes.
The tax provision for the three and six months ended June 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 of approximately 2%. The effect of book versus tax differences was insignificant
in these periods.
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.
Our cash, cash equivalents and short term investments were $8.3 million at June 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
Page 18
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 used by operating activities for the six months ended June 2006 was $3.9 million versus cash
used of $4.1 million during the same period in 2005. This is the result of higher sales and collections
offset by higher spending in 2006 as compared to 2005. Our days sales outstanding (DSO) on booked
sales lengthened from 58 days at June 30, 2005 to 70 days at June 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 extended.
Net cash generated by investing activities for the six months ended June 30, 2006 was $2.9 million
compared to $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 six months ended June 30, 2006 and 2005 we had no borrowings.
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 are approximately $4,000 per
month through the lease termination in April 2009.
The following table summarizes our obligations at June 30, 2006 and the effects such obligations are
expected to have on our liquidity and cash flow in future periods.
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.
All remaining amounts due at December 31, 2005 were repaid during the three months ended March 31,
2006. We received the final loan repayment of $213,000, plus $1,000 in interest. For the same periods
in 2005, we received $1.0 million in loan repayments. There is no balance due in principal and accrued
interest as of June 30, 2006, as all amounts due have been repaid.
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.
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.
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 is primarily derived from the licensing of software and is recognized as follows:
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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.
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.
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 six 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.
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 June 30, 2006 all previously capitalized software development
expenses have been fully amortized. No software development costs were capitalized in the three or
six months ended June 30, 2006 or 2005.
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.
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.
Page 21
Item 3. Quantitative and Qualitative Disclosures about Market Risk
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 June 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.
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.
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 is scheduled for September 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.
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.
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.
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.
Page 23
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. As was the case for
the first half of 2006, in the second half of 2006, we expect that much more of our perpetual license
revenue in each quarter will be derived from sales in that 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.
We believe that cash flow from operations will be our primary source of funding for our operations
during 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. We expect to again generate positive cash flow from operations in 2006.* This will
require us to achieve certain levels of booked sales and expenses.
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.
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.
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 June
30, 2006, we had an accumulated deficit of approximately $77.9 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 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.
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 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 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.
Page 26
We expect to be required to comply with Sarbanes-Oxley Section 404 at 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,
our deadline for compliance will be December 31, 2007.
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.
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.
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.
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
Page 27
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 presently trades on the Nasdaq National Market, and our trading volume is low. For
example, during 2005, our average daily trading volume was approximately 15,111 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.
On June 6, 2006 the Company held its annual meeting of stockholders. At the meeting, the following matters were voted upon.
Proposal 1 - Election of Directors. Each of the three nominees was elected, as follows:
Nominee
Vote for Nominee
Vote Withheld from Nominee
Ajit M. Dalvi
15,357,005
650,687
Carleton A. Holstrom
15,856,005
151,687
Paula A. Tallal
15,856,005
151,687
The other directors whose term of office as a director continued after the meeting are: E. Vermont
Blanchard, Jr., Robert C. Bowen, Joseph B. Martin, Michael M. Merzenich, Rodman W. Moorhead, and
David M. Smith.
Proposal 2. Ratification of the selection of Ernst & Young LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2006. The proposal was passed, as follows:
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).
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: August 14, 2006
SCIENTIFIC LEARNING CORPORATION
(Registrant)
/s/ Jane A. Freeman
Jane A. Freeman Chief Financial Officer (Authorized Officer and Principal Financial and Accounting Officer)
