Scientific Learning 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2010
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)
300 Frank H. Ogawa Plaza, Suite 600
Oakland, California 94612
(Address of Registrant’s 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 ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.) Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o Accelerated filer o Non-accelerated filer o
Smaller reporting company x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of October 15, 2010, there were 18,592,577 shares of Common Stock outstanding.
INDEX TO FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2010
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONDENSED CONSOLIDATED BALANCE SHEETS
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Notes to Condensed Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Description of Business
Scientific Learning Corporation (the “Company”) develops, distributes and licenses technology that accelerates learning by improving the processing efficiency of the brain.
The Company’s patented products build learning capacity by rigorously and systematically applying neuroscience-based learning principles to improve the fundamental cognitive skills required to read and learn. To facilitate the use of the Company’s products, the Company offers a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. The Company sells primarily to K-12 schools in the United States through a direct sales force.
All of the Company’s activities are in one operating segment.
The Company was incorporated in 1995 in the State of California and was reincorporated in 1997 in the State of Delaware.
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, the Company’s financial statements could be affected.
Interim Financial Information
The interim condensed consolidated financial information as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 is unaudited, and includes all necessary adjustments, which consisted only of normal recurring adjustments for a fair presentation of the Company’s financial position at such dates and the Company’s results of operations and cash flows for those periods. The balance sheet as of December 31, 2009 has been derived from audited financial statements at that date but does not include all of the information and notes required by generally accepted accounting principles (“GAAP”) for annual financial statements. In addition, the results of operations for the three and nine months ended September 30, 2010 are not necessarily indicative of the results for the entire fiscal year ending December 31, 2010, or for any other period.
These condensed consolidated financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, filed with the Securities and Exchange Commission.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company and its wholly owned China subsidiary Shanghai Zhiyong Information Technology Co., Ltd. All significant intercompany balances and transactions have been eliminated in consolidation.
Notes to Condensed Consolidated Financial Statements
1. Summary of Significant Accounting Policies (continued)
Foreign Currency Translation
The functional currency of the Company’s foreign subsidiary is the local currency, Chinese RMB. Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are recorded as part of a separate component of stockholders’ equity. Foreign currency transaction gains and losses are included in Other income (expense). All assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the exchange rate as of the balance sheet date. Revenues and expenses are translated at the average exchange rate during the period. Equity transactions are translated using historical exchange rates.
Net 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 reflects the potential dilution of securities by adding common stock equivalents (computed using the treasury stock method) to the weighted-average number of common shares outstanding during the period, if dilutive. Potentially dilutive securities of 3,236,957 have been excluded from the computation of diluted net loss per share in the three and nine month periods ended September 30, 2010 and 1,242,399 have been excluded from the computation of diluted net income per share in the three and nine month periods ending September 30, 2009 as their inclusion would be antidilutive.
The following table sets forth the computation of net income (loss) per share (in thousands, except per share data):
Recent Accounting Pronouncements>
In January 2010 the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures about Fair Value Measurements” which amends Subtopic 820-10 to require new disclosures and update existing disclosures. This update is intended to provide a greater level of information and more robust disclosures about valuation techniques and inputs to fair value measurements. ASU 2010-06 became effective beginning with the Company’s first quarter of 2010 and did not have a material impact on the Company’s financial condition or results of operations.
On September 1, 2009, the Company announced a plan to consolidate its product development and product management functions in the Company’s Oakland, California headquarters. Under this plan, the Company closed its Waltham, Massachusetts office, and most Waltham employees left the Company by the end of 2009. The Company notified the employees affected by the workforce reduction on September 1, 2009. The Company’s lease on the Waltham office expires on September 30, 2011. In January 2010, the Company signed an agreement to sublease the property through October 2010 and in September 2010 an addendum was signed to extend the sublease through September 2011.
Notes to Condensed Consolidated Financial Statements
2. Restructuring (continued)
These restructuring costs were mainly recorded under Research and development in the condensed consolidated statement of operations. The Company expects to pay the remaining employee costs by October 2010 and the facility costs through September 2011. Accrued costs are shown in the following table:
3. Stock-Based Compensation
Accounting for Stock-Based Compensation
The Company recognized stock-based compensation expense of $340,000 and $1.2 million in the three and nine months ended September 30, 2010 respectively, compared with $286,000 and $1.0 million in the three and nine months ended September 2009.
Summary of Stock Options
The Company granted 265,250 and 487,900 stock options during the nine month periods ended September 30, 2010 and 2009, respectively.
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, 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 the Company’s common stock over the expected life of each option. Expected life of the options is based on the Company’s history of option exercise and cancellation 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. The Company uses historical data to estimate pre-vesting option forfeitures. The Company recognizes compensation expense for the fair values of these awards, which typically have graded vesting, on a straight-line basis over the requisite service period of each of these awards.
The aggregate intrinsic value of options outstanding at September 30, 2010 was approximately $5.5 million and is calculated as the difference between the exercise price of the underlying options and the market price of the Company’s common stock for the 2,089,772 shares that had exercise prices that were lower than the $4.71 market price of the common stock at September 30, 2010 (“in the money options”). The total intrinsic value of options exercised during the nine months ended September 30, 2010 and 2009 was $101,000 and $121,000, respectively. The intrinsic value of options vested during the nine months ending September 30, 2010 and 2009 was $312,000 and $296,000 respectively. The weighted-average grant-date fair value of options awarded during the nine months ending September 30, 2010 and 2009 was $2.74 and $1.07, respectively.
Notes to Condensed Consolidated Financial Statements
3. Stock-Based Compensation (continued)
As of September 30, 2010, total unrecognized compensation cost related to stock options granted under the Company’s various plans was $879,000. The Company expects these costs to be recognized over a weighted-average period of 2.70 years.
Summary of Restricted Stock Units
The Company granted 257,939 and 61,721 restricted stock units during the nine month periods ended September 30, 2010 and 2009, respectively.
The fair value of restricted stock units was calculated based upon the fair market value of the Company’s 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 nine months ending September 30, 2010 and 2009 was $4.72 and $1.96, respectively. The intrinsic value of awards vested during the nine months ending September 30, 2010 and 2009 was $716,000 and $663,000 respectively.
As of September 30, 2010, total unrecognized compensation cost related to restricted stock units granted under the Company’s various plans was $1.3 million. The Company expects these costs to be recognized over a weighted-average period of 2.75 years.
Disclosures Pertaining to All Share-Based Compensation Plans
Cash received under all share-based payment arrangements for the nine months ended September 30, 2010 and 2009 was $386,000 and $402,000, respectively, related to the exercise of stock options. Because of the Company’s net operating losses and related valuation allowance, the Company did not realize any tax benefits for the tax deductions from share-based payment arrangements during the nine months ending September 30, 2010 or 2009.
Total comprehensive income (loss) was as follows:
The Company generally provides a warranty that the Company’s 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, the Company has not incurred any material costs associated with these warranties and has no accrual for such items at September 30, 2010.
From time to time, the Company enters into contracts that require the Company, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against the Company’s customers for violation of third party intellectual property rights caused by the Company’s products; (ii) claims resulting from personal injury or property damage resulting from the Company’s activities or products; (iii) claims by the Company’s office lessor arising out of the use of the premises; and (iv) agreements with the Company’s officers and directors under which the Company may be required to indemnify such persons for liabilities arising out of their activities on behalf of the Company. 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 as of September 30, 2010.
Notes to Condensed Consolidated Financial Statements
6. Bank Line of Credit
On February 28, 2010, the Company amended its existing revolving line of credit agreement with Comerica Bank. The maximum that can be borrowed under the agreement is $7.5 million. The line expires on December 31, 2011.
Borrowing under the line of credit bears interest at a “daily adjusting LIBOR rate”. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants requiring the Company to maintain a minimum adjusted quick ratio of 1.15 and positive net worth. The agreement includes a letter of credit sublimit not to exceed $1.0 million. At September 30, 2010, the Company had an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at September 30, 2010, and the Company was in compliance with all its covenants.
7. Provision for Income Taxes
In the three and nine months ending September 30, 2010, the Company recorded income tax expense of $44,000 and $136,000, respectively. For the three and nine months ended September 30, 2009, the Company recorded income tax expense of $301,000 and $367,000, respectively. The tax expense for the three and nine months ended September 30, 2010 consists primarily of deferred tax expense relating to the amortization of acquired goodwill and state tax expense. The tax expense for the three and nine months ended September 30, 2009 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, federal tax expense, and state tax expense.
The Company has established and continues to maintain a full valuation allowance against its deferred tax assets as the Company does not believe that realization of those assets is more likely than not.
At September 30, 2010, the Company has unrecognized tax benefits of approximately $2.4 million. The Company has approximately $18,000 of unrecognized tax benefits that, if recognized, would affect its effective tax rate. The Company does not believe there will be any material changes in its unrecognized tax benefits over the next twelve months. Interest and penalty costs related to unrecognized tax benefits are insignificant and are classified as a component of “Income tax expense” in the accompanying condensed consolidated statement of operations.
The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. Tax returns remain open to examination by the appropriate governmental agencies for tax years 2006 through present. The federal and state taxing authorities may choose to audit tax returns for tax years beyond the statute of limitation period due to significant tax attribute carryforwards from prior years, making adjustments only to carryforward attributes. The Company is not currently under audit in any major tax jurisdiction.
8. Software and Web Site Development Costs
Software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated lives of the related products. Technological feasibility is established upon completion of a working model. In 2009, the Company capitalized approximately $986,000 of costs relating to the Company’s new Reading Assistant product that had reached technological feasibility. The Company began amortizing these costs to cost of product revenues over the estimated useful life of the software, which is expected to be three years, starting when the product was released for sale in September 2009. The Company recorded amortization expense of $82,000 and $247,000 in the three and nine months ended September 30, 2010, respectively.
The Company also capitalizes web site application, infrastructure development and content development costs where a website or software is developed for its internal needs and the Company does not plan to market the software externally. The Company capitalized approximately $153,000 of software and website development costs in the nine months ended September 30, 2010.
Notes to Condensed Consolidated Financial Statements
9. Fair Value Measurements
The Company generally invests its excess cash in investment grade short-term fixed income securities and money market funds. The portion in cash and cash equivalents represents highly liquid instruments with insignificant interest rate risk and original maturities of three months or less. Unrealized gains and losses related to available for sale securities are reported in “Comprehensive income (loss)” as disclosed in Note 4.
The Company has established a three-tier fair value hierarchy, categorizing the inputs used to measure fair value. The hierarchy can be described as follows: Level 1- observable inputs such as quoted prices in active markets; Level 2- inputs other than the quoted prices in active markets that are observable either directly or indirectly; and Level 3- unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.
Cash equivalents consist of money market instruments and commercial paper that have original maturities of 90 days or less. These instruments are classified in Level 1 of the fair value hierarchy. The Company also invests in federal agency and corporate bonds with an original maturity date of greater than 90 days that are classified as short-term investments. These instruments are classified within Level 2 of the fair value hierarchy. The Company has no Level 3 financial assets.
The Company’s valuation techniques used to measure the fair values of money market funds that were classified as Level 1 in the table below were derived from quoted market prices. The Company’s valuation techniques used to measure the fair values of the Company’s U.S. Treasury, U.S. government and U.S. government agency debt securities, corporate bonds and commercial paper that are classified as Level 2 in the table below, generally all of which mature within two years and the counterparties to which have high credit ratings, were derived from non-binding market consensus prices that are corroborated by observable market data or quoted market prices for similar instruments.
The Company’s financial assets are summarized below:
As of December 31, 2009, the Company’s financial assets of approximately $20.2 million were entirely comprised of money market accounts which were classified as Level 1 in the fair value hierarchy. The Company had no Level 2 or Level 3 financial assets.
The fair value of investments with contractual maturities is as follows:
Notes to Condensed Consolidated Financial Statements
9. Fair Value Measurements (continued)
The Company has the ability, if necessary, to liquidate any of its investments in the next 12 months. Accordingly, those investments with contractual maturities greater than one year from the date of purchase are classified as short-term on the accompanying condensed consolidated balance sheet.
Inventories of $438,000 and $495,000 at September 30, 2010 and December 31, 2009, respectively, are included in “Prepaid expenses and other current assets” and consist entirely of finished goods.
11. Commitments and Contingencies
The Company leases office space and equipment under noncancelable operating leases with various expiration dates. The Company also makes royalty payments to the institutions who participated in the original research that produced its initial products. The Company's royalty payments are $150,000 per year through December 31, 2014.
As of September 30, 2010, the Company's future minimum lease payments and future payments under its royalty agreements are as follows:
Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operations
This report contains forward-looking statements. Forward-looking statements are not historical facts but rather are 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. Statements regarding our expectations for our future business results and financial position, our business strategies and objectives, and trends in our market are forward-looking statements. Forward-looking statements 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 the Risk Factors section of this report. 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, distribute and license technology that accelerates learning by improving the processing efficiency of the brain. Based on more than thirty years of neuroscience and cognitive research, our family of products improves brain fitness with technology-based exercises that build the cognitive skills required to read and learn effectively. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through participation in our products. Our products are marketed primarily to K-12 schools in the US, to whom we sell through a direct sales force. 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. Since our inception, learners have used our products over two million times and approximately 6,900 schools have purchased at least $10,000 of our product licenses and services. As of September 30, 2010, we had 212 full-time equivalent employees, compared to 201 at December 31, 2009.
We market our Fast ForWord and Reading Assistant products primarily as a reading intervention solution for struggling and special education students and English Language Learners. According to the U.S. Department of Education, in 2009, 33% of fourth graders in the United States had “below basic” reading scores and 67% were not proficient in reading. Between 1992 and 2009 there was only a modest improvement in the proportion of fourth graders performing at the “below basic” level; between 2007 and 2009 there was no change in fourth-grade reading skills. While our installed base is growing, the approximately 6,900 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 117,000 K-12 schools in the US.
States provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products. Additionally, federal education funds are a critical resource in helping school districts address the needs of the most challenged learners. We believe that a significant proportion of our sales are funded by federal sources, particularly Title One and IDEA (special education) grants. With the passage of the American Recovery and Reinvestment Act (“ARRA” - the recent stimulus bill), these two federal sources are estimated to have increased from $24.9 billion in the 2008 – 2009 school year to $37 billion in the 2009 – 2010 school year. In most states the ARRA funds have been and are being disbursed to school districts, and we believe that the ARRA funding had a substantial positive impact on our booked sales in 2009.
During the first three quarters of 2010, school districts have focused more attention on balancing operating budgets than on investing in tools to improve student achievement. We experienced a substantial decline in booked sales in the third quarter of 2010 compared to the third quarter of 2009, which we believe resulted from state budget pressures, uncertainty about future education policy, and an increasing trend toward using federal funds wherever possible to save teacher jobs and core programs rather than on supplemental programs focused on struggling learners. In February 2010, the Center on Budget and Policy Priorities estimated that for the current fiscal year, which began July 2010, 46 states had budget shortfalls totaling $121 billion, or 19% of budgets in those states. The fact that schools have until September 2011 to spend remaining ARRA funds gives them the flexibility to wait for news regarding additional federal funding to save teacher jobs, and developing education policy. As a result, we believe that many school districts delayed purchase decisions that have historically been made in the early weeks of the summer.
Despite the recent attention school districts have paid to balancing their budgets, we believe our solutions will remain well-positioned for federal Title I, IDEA and competitive funding opportunities such as Race to the Top and School Improvement Grants, due to the continued emphasis on national achievement mandates and education reform.
For the three months ended September 30, 2010, our total revenue decreased by 50% compared to the three months ended September 30, 2009 and for the nine months ended September 30, 2010 our total revenue decreased 15% over the corresponding period in 2009. Our total booked sales decreased by 56% for the three months ended September 30, 2010 and decreased 30% for the nine months ended September 30, 2010 compared to the same periods in 2009. (Booked sales is a non-GAAP financial measure. For more explanation on booked sales, see Revenues below). K-12 booked sales decreased by 59% in the three months ended September 30, 2010, and by 33% in the nine months ended September 30, 2010 compared to the same periods in 2009. For the three months ended September 30, 2010, we closed 19 transactions in excess of $100,000, compared to 38 in the three months ended September 30, 2009. Non-school sales, including private practice, international, direct to consumer, virtual schools and OEM customers, increased by 16% in the three months ended September 30, 2010 and 9% in the nine months ended September 30, 2010 compared to the same periods in 2009. Operating expenses decreased by 20% and increased by 3% in the three and nine months ended September 30, 2010 compared with the same period in 2009.
Results of Operations
For the three and nine months ended September 30, 2010, product revenue decreased by 67% and 31% respectively, compared to the same periods in 2009, mainly as a result of lower booked product sales. Service and support revenue grew by 8% and 14% for the three and nine month periods in 2010 as compared to the same periods in 2009, primarily due to the increased delivery of both on-line and traditional service offerings for training and implementation, and more schools using our Progress Tracker reporting tool.
Booked sales and selling activity: Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity. We define booked sales as the total value (net of allowances) of software, services and support invoiced in the period. 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. 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 reconciliation table below shows the relationship among booked sales, revenue and deferred revenue. We record booked sales into 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. “Other adjustments” primarily reflects booked sales that are not recognized into revenue or deferred revenue in the quarter because, for example, the sales terms include a cancellation clause or the sale was FOB destination and had not been delivered that resulted in the recognition of those sales in later quarters.
The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three and nine months ended September 30, 2010 and 2009:
Booked sales in the K-12 sector decreased by 59% to $10.4 million during the three months ended September 30, 2010, and decreased by 33% to $28.5 million during the nine months ended September 30, 2010, compared to $25.3 million and $42.4 million during the respective three and nine month periods in 2009. As described above, state budget pressures caused many school districts to delay purchases during the third quarter of 2010. Booked sales to the K-12 sector for the three and nine months ended September 30, 2010 were 92% and 91%, respectively, of total booked sales. Booked sales to the K-12 sector for the three and nine months ended September 30, 2009 were 97% and 94%, respectively, of total booked sales.
We believe large booked sales transactions are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity. The funding environment this year has made it particularly difficult to close large transactions. During the third quarter of 2010, we closed 19 sales that had a contract value in excess of $100,000, compared to 38 in the same period in 2009. For the three months ended September 30, 2010 and 2009 respectively, approximately 33% and 77% of our booked sales resulted from booked sales over $100,000. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked 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. We cannot predict the size and number of large transactions in the future.
Booked sales to non-school customers increased by 16% to $1 million for the three months ended September 30, 2010 compared to the same period in 2009. This increase reflects higher sales to private practice clinicians, international VARs, consumers and virtual schools. For the nine months ended September 30, 2010, sales to non-school customers increased 9% to $2.9 million compared to the prior year period as growth in the consumer, virtual school and OEM businesses offsets declines in sales to private providers.
Although the current economic and financial conditions, the temporary nature of federal stimulus funding, and 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 and non-school markets. However, achieving our 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 general economic conditions and the overall level, certainty and allocation of state, local and federal funding. While federal funding for education has grown steadily over the last few decades, the current level of federal spending and the federal deficit are likely to put pressure on all areas in the federal budget. In addition, school district spending based on federal education stimulus funding is expected to decline after 2011. States continue to experience severe budget pressure from the adverse conditions in the job, housing and credit markets. These conditions may continue to impact state education spending. In addition, the revenue recognized from our booked 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. 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
The overall gross profit margin declined by 11% in the third quarter and 5% in the first nine months of 2010 compared to the corresponding periods in 2009. These decreases in gross margin were driven by declines in the proportion of higher margin product revenue.
Higher margin product revenues made up 49% and 53% of total revenues in the three and nine months ending September 30, 2010 respectively, compared to 76% and 65% in the same periods in 2009. Product margins decreased by 4% and 1% in the three and nine months ending September 30, 2010, respectively, over the same periods in 2009, mainly due to lower revenues over which fixed costs could be allocated. Service and support margins increased by 3% and 2% in the three and nine months ending September 30, 2010, respectively, compared to the same periods in 2009, reflecting higher delivery of services in 2010.
Sales and Marketing Expenses: Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials. The decrease in sales and marketing expenses in the three and nine months ended September 30, 2010 compared to the same periods in 2009 is primarily due to lower commission and bonus expense, as we do not expect to meet our sales quotas for the current year. At September 30, 2010 we had 51 quota-bearing sales personnel compared to 43 at September 30, 2009.
Research and Development Expenses: 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 research and development expenses during the three and nine months ended September 30, 2010 compared to the same periods in 2009 is primarily due to increased headcount and consulting expenses in product development and product management.
General and Administrative Expenses: General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees. The decrease in general and administrative expenses in the three months ended September 30, 2010 compared to the same period in 2009 is primarily due to lower bonus expense. General and administrative expenses remained unchanged for the nine months ended September 30, 2010 compared to the same period in 2009 as a result of lower bonus expense offset by increased legal and consulting expenses related to our exploration of strategic alternatives in the area of mergers and acquisitions, which are presently not being pursued.
Provision for Income Taxes
In the three and nine months ending September 30, 2010 we recorded income tax expense of $44,000 and $136,000, respectively. For the three and nine months ended September 30, 2009 we recorded income tax expense of $301,000 and $367,000, respectively. The tax expense for the three and nine months ended September 30, 2010 consists primarily of deferred tax expense relating to the amortization of acquired goodwill and state tax expense. The tax expense for the three and nine months ended September 30, 2009 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, federal tax expense, and state tax expense.
We have established and continue to maintain a full valuation allowance against our deferred tax assets as we do not believe that realization of those assets is more likely than not.
At September 30, 2010, we have unrecognized tax benefits of approximately $2.4 million. We have approximately $18,000 of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We do not believe there will be any material changes in our unrecognized tax benefits over the next twelve months. Interest and penalty costs related to unrecognized tax benefits are insignificant and are classified as a component of “Income tax expense” in the accompanying statement of operations.
We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. Tax returns remain open to examination by the appropriate governmental agencies for tax years 2006 through present. The federal and state taxing authorities may choose to audit tax returns for tax years beyond the statute of limitation period due to significant tax attribute carryforwards from prior years, making adjustments only to carryforward attributes. We are not currently under audit in any major tax jurisdiction.
Liquidity and Capital Resources
Our cash, cash equivalents and short term investments were $17.2 million at September 30, 2010, compared to $20.7 million at December 31, 2009.
We expect that during at least the next twelve months our cash flow from operations together with our current cash balances will be our primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures. Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter. This pattern continued during the first half of 2010, during which we used $5.7 million in operations. We generated $3.1 million in cash from operations during the third quarter of 2010 compared to $14.7 during the third quarter of 2009. Continuing to fund our cash needs through operations will require us to meet specific booked sales targets. We cannot provide assurance that we will meet our targets with respect to booked sales, revenues, expenses or operating results.
On February 28, 2010, we amended our existing revolving line of credit agreement with Comerica Bank. The maximum that can be borrowed under the agreement is $7.5 million. The line expires on December 31, 2011. Borrowing under the line of credit bears interest at a “daily adjusting LIBOR rate”. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and positive net worth. The agreement includes a letter of credit sublimit not to exceed $1.0 million. At September 30, 2010, we had an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at September 30, 2010, and we were in compliance with all our covenants.
Net cash used in operating activities for the nine months ended September 30, 2010 was $2.5 million versus cash generated of $10.5 million during the same period in 2009.
Net cash used in investing activities for the nine months ended September 30, 2010 was $10.5 million, of which $9.1 million was used for the purchase of short-term investments (net of sales and maturities of $2.8 million) and $1.4 million was used for capital spending. Net cash used in investing activities for the nine months ended September 30, 2009 was $1.6 million, of which $584,000 was used for purchase of property and equipment and $986,000 was used in development of our Reading Assistant product.
Financing activities generated $386,000 for the nine months ended September 30, 2010 resulting from proceeds from the exercise of stock options. Financing activities for the nine months ended September 30, 2009 included the $2.5 million borrowing offset by the $2.5 million repayment on our line of credit as well as proceeds of $402,000 from the exercise of stock options.
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 in Oakland, California. The minimum lease payment was approximately $78,000 per month through 2008. From 2009 through the end of the lease, the base lease payment increases at a compound annual rate of approximately 5%. The lease expires in December 2013. We also have lease agreements for our Tucson, Arizona office through May 2013 at an average rent of approximately $11,000 per month, and for our former Reading Assistant operations in Waltham, Massachusetts through September 2011 at an average monthly rent of approximately $12,000. Following the closure of the Waltham office in December 2009, we have sublet this property through September 2011 at a monthly rent of approximately $5,000. In June 2010, we signed a lease for an office in Shanghai, China for 2,500 square feet at a rate of approximately $4,000 per month through May 2012 to be used for research and development.
We also make royalty payments to the institutions who participated in the original research that produced our initial products. Our minimum royalty payments are $150,000 per year.
The following table summarizes our obligations at September 30, 2010 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.
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, as discussed in our most recent Report on Form 10-K, the estimates, assumptions and judgments pertaining to revenue recognition, income taxes, stock-based compensation and the capitalization of software development costs and website development costs are the most critical assumptions to understand in order to evaluate our reported financial results. There has been no change to these policies.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk represents the risk of loss that may result from the change in value of a financial instrument due to fluctuations in its market price. Our exposure to market risk is related to our short-term investments in federal agency and corporate bonds at September 30, 2010. We had no investments subject to market risk at December 31, 2009. The following table categorizes our market risk sensitive financial instruments by type of security and, where applicable, by maturity date.
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to the rate of interest that we earn on our cash, cash equivalents and short-term investments. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at September 30, 2010 would not have a material effect on our results of operations. We had no investments subject to interest rate risk at December 31, 2009.
Item 4T. 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, such as this Quarterly Report on Form 10-Q, 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 Quarterly Report on Form 10-Q, and concluded that our disclosure controls and procedures were effective as of September 30, 2010.
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 that occurred during the nine months ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
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.
Sales of our products depend on the availability and extent 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 net income.
United States 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 are struggling academically. Federal funds typically are restricted to specified uses.
The funding for a substantial portion of our K-12 sales typically comes from federal sources, in particular IDEA (special education) and Title One funding. In 2009 our sales were significantly and favorably impacted by the substantial increases in IDEA and Title One funding under the American Recovery and Reinvestment Act (ARRA). The competition between vendors and programs for ARRA funding is intense, and these increases have been authorized for a limited duration. The ARRA funding is expected to decrease after 2010 or 2011, although some new programs – Race to the Top and Investing in Innovation – are expected to continue. Likewise, the current extraordinary levels of federal spending directed to economic recovery, the federal budget deficit and competing federal priorities could adversely impact the availability of federal education funding. A cutback in federal education funding or a change in the funding rules to allow general rather than restricted uses of the funding could have a materially adverse impact on our revenue.
State and local school funding continues to be significantly impacted by decreases in tax revenues due to the current economic downturn. States face significant budget pressure, primarily due to the significant adverse events in the job, credit, and housing markets. While education spending remains an important priority for states, it faces competition from demands for, among other things, relief for homeowners, transportation spending and rising healthcare costs. Many states have reduced their funding to schools for the coming school year, resulting in teacher layoffs and program restrictions. A continued reduction in state tax revenues could have a materially adverse impact on our revenue.
Our sales cycle tends to be long and somewhat unpredictable, which may result in delayed or lost sales, materially and adversely impacting our revenue and profitability.
Like other companies in the instructional market, our 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, 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 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 lost opportunities that can materially and adversely impact our revenue and operating results.
Sales in our non-school markets may continue to be affected by current global economic difficulties.
Our non school sales consist principally of sales to private speech, language and other healthcare providers and sales to our international value-added resellers. In addition, during 2009 we launched new products marketed directly to parents for at-home use by their children.
Historically, sales to private providers have been adversely impacted by economic downturns, as many parents postpone or forego these services when their financial resources are reduced. During 2009 and the first half of 2010, our non-school sales declined compared to the prior year period. We believe that this decline was mainly a result of economic conditions. Non-school sales increased in the 2010 third quarter compared to the prior year period, but are still down for the first nine months of 2010 compared to the 2009 period.
It is difficult to accurately forecast our future financial results. 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 revenue and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year. In 2009, we had net income of $4.8 million; in 2008, we had a net loss of approximately $3.3 million. In 2007, we had net income of approximately $1.2 million.
Our sales strategy emphasizes 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. This uncertainty is compounded by the fact that our various license and service packages have substantially differing revenue recognition periods. Even when the amount and timing of a transaction can be accurately projected, it may be difficult to predict which license package a customer will purchase.
Our expense levels are based on our expectations of future revenue 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 revenue 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.
To grow our K-12 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 our K-12 market, so in order to grow our revenue and profit we need to increase our reach 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, which are designed to develop the brain to process more efficiently, are based on neuroscience research and focus on building cognitive skills. 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 at least 30 minutes per day 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 revenue.
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 reach a broader group of 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.
If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our revenue and growth prospects could be materially and adversely impacted.
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 products lead to improved student achievement, which involves certain risks. For example, a school may fail to appropriately implement the products or to adhere to the product protocol, resulting in a study that does not produce substantial student improvements. In addition, 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 us or our 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. 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.
If our operations are disrupted due to weaknesses in our technology infrastructure, our business could be harmed.
Providing our services and conducting our general business operations both substantially rely on computer and network systems. We have recently experienced disruptions in both our customer and internal network services due to hardware failures. We are in the midst of a major project to upgrade many of our computer and network systems, which we believe have become outdated. If our customer systems are disrupted, we may be required to issue credits, customers may elect not to renew their contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability. If our internal systems are disrupted, we may lose productivity and incur delays in product development, sales operations or other functions.
If our products contain errors or if customer access to our web-delivered products and services is disrupted, we could lose new sales and be subject to significant liability claims.>
Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released. We expect that, as we have experienced in the past, despite our testing, errors will be found in new products and product enhancements in the future. We plan to launch important product improvements in 2011.
Many of our products and services rely on the World Wide Web in order to function. Unanticipated problems affecting our network systems, third party facilities, telecommunications or electricity supply could cause interruptions or delays in the delivery of that product. We have experienced problems due to power loss in the past, and we will continue to be exposed to the risk of access failure in the future.
If there are significant errors in our products or problems with customer access to our Web-delivered products and services, we could be required to issue credits or we could experience delays in or loss of market acceptance of our products, diversion of our resources, decreases in expansions or renewals, injury to our reputation, increased service expenses or payment of damages.
Our cash flow is highly variable and may not be sufficient to meet all of our objectives.
We believe that cash flow from operations, together with our current cash balances, will be our primary source of funding for our operations during the remainder of 2010 and the next several years. During 2009, we generated $14.5 million in cash from operations. In 2008, we used $13.6 million of our cash and cash equivalent balances, with $10.1 million used for the acquisition of the Soliloquy business and $3.7 million used in operating activities.
Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter.
In February 2010 we amended our credit line with Comerica Bank, which now has a limit of $7.5 million and will expire December 31, 2011. In January 2009, we drew down and in August 2009 we repaid $2.5 million under that line. At September 30, 2010, no borrowing was outstanding under our credit line with Comerica and we were in compliance with the covenants of the line. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and positive net worth. If we do not comply with the covenants, we risk being unable to borrow under the credit line.
Funding our liquidity needs out of cash flow from operations will require us to achieve certain levels of booked sales, collections, and expenses. If we are unable to achieve sufficient levels of cash flow from operations, or are unable to obtain waivers or amendments from Comerica in the event we do not comply with our covenants, we would be required either to obtain debt or equity financing from other sources, or to reduce expenses. Reducing our expenses could adversely affect our operations. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.
Our new product development office in China exposes us to new risks, including those associated with currency exchange rates, Chinese government regulation and business practices, and intellectual property.
We established a wholly-owned subsidiary in Shanghai during the second quarter of 2010. The new entity will provide product development services to us, and we expect to have hired 5 to 10 developers by the end of 2010. To date, substantially all of our operations have been located in the United States, and our sales outside the United States and Canada have been made in US Dollars to local distributors. Because our new Shanghai subsidiary will conduct its operations in Chinese RMB, we will now have the risk of unexpected and possibly sudden increases in expenses caused by shifts in currency exchange rates. In addition, Chinese government regulations and business practices are quite different from those in the United States, and operating under those regulations and challenges may pose unexpected costs, delays or difficulties. Further, intellectual property protection is not as strong in China as in the US, and operating a product development group in China may increase our risk of infringement or misappropriation of our intellectual property by others.
Our new BrainSpark and BrainPro products are marketed directly to parents. We may be unable to successfully penetrate this market.
In the US, we presently market primarily to K-12 public schools. Parents who purchase our products for use with their children primarily do so through our much smaller channel, private providers, in which the marketing is done by the individual private provider. For the BrainSpark and BrainPro offerings, we market and sell directly to parents, a new market for us. We may find our marketing efforts in this market less effective or more expensive than we have planned. The current economic downturn may make our marketing and sales efforts in this market more difficult than we expect. If our marketing efforts are less effective than we expect, we may be unable to achieve our planned level of sales and revenue from this market. If our sales and revenue are substantially less than expected, this may cause us to incur impairment charges against the capitalized development costs for these products.
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 not be able to compete effectively in the education market.
The market in which we operate is very competitive. We compete vigorously for the funding available to schools, including 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. Many of the companies providing these competitive offerings are much larger than we are, are more established in the school market than we are, offer a broader range of products to schools, have already offered more Web-based products, and have greater financial, technical, marketing and distribution resources than we do. 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.
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 our 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 maintain our access to the intellectual property rights that we license from third parties, our sales and net income will be materially and adversely affected.
Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey. In 2009, we generated approximately 60% of our booked sales from products that use this licensed technology. We also have incorporated technology and content licensed from other third parties as part of our products and services. If we were to lose our rights under these licenses (whether through expiration of our exclusive license period, expiration of the underlying patent’s exclusivity, invalidity or unenforceability of the underlying patents, a breach by us of the terms of the license agreements or otherwise), such a loss of these licensed rights or a requirement that we must re-negotiate these licenses could materially harm our booked sales, our revenue and our net income.
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 be found invalid or will not offer sufficient protection against competitors, that our trademarks will be challenged or infringed, or that our pending patent applications will not result in the issuance of patents. If others are able to develop similar products due to the expiration, unenforceability or invalidity of the underlying patents, the resulting competition could materially harm our sales. The Company historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright.
In addition, we could become party to patent 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, and the outcome of any such proceedings cannot be accurately predicted. 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. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture or increase their market share with respect to related technologies.
Further, if unauthorized copying or misuse of our products were to occur to a substantial degree, our sales could be adversely affected.
Our common stock is thinly traded and its price is volatile.
Our common stock presently trades on the Nasdaq Global Market, and our trading volume is generally low. For example during the third quarter of 2010, our average daily trading volume was approximately 18,000 shares. As a result, the ability of holders of our common stock to sell such common stock and thereby monetize their investment may be limited. In addition, the market price of our common stock has been highly volatile since we became publicly traded and could continue to be subject to wide fluctuations.
The ownership of our common stock is concentrated.
At September 30, 2010, Trigran Investments owned approximately 28% of our outstanding stock, and our officers and directors held approximately 11% 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.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. (reserved)
Item 5. Other Information
Item 6. Exhibits
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 1, 2010
Index to Exhibits