Scientific Learning 10-Q 2011
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 March 31, 2011
oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO .>
COMMISSION FILE NO. 000-24547
SCIENTIFIC LEARNING CORPORATION
(Exact name of registrant as specified in its charter)
300 Frank H. Ogawa Plaza, Suite 600
Oakland, CA 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: o
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: o
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 April 28, 2011, there were 18,783,746 shares of Common Stock outstanding.
PART I – FINANCIAL INFORMATION
SCIENTIFIC LEARNING CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
See accompanying notes to unaudited condensed consolidated financial statements.
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SCIENTIFIC LEARNING CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
See accompanying notes to unaudited condensed consolidated financial statements.
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SCIENTIFIC LEARNING CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to unaudited condensed consolidated financial statements.
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Notes to Condensed Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Description of Business
Scientific Learning Corporation, together with its subsidiaries (collectively, the “Company”) develops, distributes and licenses technology that accelerates learning by applying proven research on how the brain learns.
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.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries Shanghai Zhiyong Information Technology Co., Ltd. and Scientific Learning Puerto Rico, Inc. All significant intercompany balances and transactions have been eliminated in consolidation.
Interim Financial Information
The interim consolidated financial information as of March 31, 2011 and for the three months ended March 31, 2011 and 2010 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, 2010 has been derived from audited consolidated 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 months ended March 31, 2011 are not necessarily indicative of the results for the entire fiscal year ending December 31, 2011, 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 Part II, Item 7 – “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, 2010, filed with the Securities and Exchange Commission.
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 the three months ended March 31, 2011 and 2010, the Company did not capitalize any software development costs. The Company amortizes these costs to cost of product revenues over the estimated useful life of the software, which is three years. The Company recorded amortization expense of $25,000 and $82,000 in the three months ended March 31, 2011 and 2010, respectively.
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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 $0.3 million and $14,000 of software and website development costs in the three months ended March 31, 2011 and 2010, respectively. The Company recorded amortization expense of $29,000 and $0.2 million in the three months ended March 31, 2011 and 2010, respectively.
Net Loss Per Share
The Company uses the treasury stock method to reflect the potential dilutive effect of common stock equivalents, including options and restricted stock units. Basic net loss per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net loss per share reflects the potential dilution of securities by adding common stock equivalents to the weighted-average number of common shares outstanding during the period, if dilutive. Potentially dilutive securities of 0.7 million and 1.0 million have been excluded from the computation of diluted net loss per share in the three months ended March 31, 2011 and 2010, respectively, as their effect is antidilutive.
Recent Accounting Pronouncements>
There are no material changes from the pronouncements disclosed in Part II, Item 8 — “Financial Statements and Supplementary Data” of our Annual Report on Form 10-K for the year ended December 31, 2010.
2. 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. Short-term investments are classified as available for sale and are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component stockholders’ equity. There was an unrealized loss of $4,000 related to agency bonds as of March 31, 2011. There were no unrealized gains and losses as of March 31, 2010. The Company had no realized gains or losses on short-term investments in the three months ended March 31, 2011 and 2010.
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 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 accounts 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 following is a summary of the fair value of the major categories of financial instruments held by the Company (in thousands):
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The following is a summary of the Company’s financial assets that are accounted for at fair value on a recurring basis by level in accordance with the fair value hierarchy described above (in thousands):
The fair value of short-term investments with contractual maturities is as follows at March 31, 2011 (in thousands):
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 in the accompanying condensed consolidated balance sheets.
3. Share-Based Compensation
The Company granted 47,500 stock options and 58,328 restricted stock units during the three months ended March 31, 2011. The Company granted 92,500 stock options and 42,939 restricted stock units during the three months ended March 31, 2010.
The fair value of each option award is estimated on the date of grant using a Black-Scholes Merton option pricing model with subjective assumptions, including expected stock price volatility, the estimated life of each award and estimated pre-vesting forfeitures noted in the table below.
Expected volatility – Based on the historical prices of common stock over the expected life of each option.
Expected life – Based on the history of option exercise and cancellation activity of the options
Risk-free interest rate – 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.
Dividend yield – As the Company has not paid, nor does it currently plan to pay, dividends in the future, the assumed dividend yield is zero.
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The fair value of stock options granted was estimated using the following weighted-average assumptions:
Total comprehensive loss was as follows (in thousands):
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 March 31, 2011.
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 March 31, 2011.
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 March 31, 2011, the Company had an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at March 31, 2011, and the Company was in compliance with all its covenants.
7. Provision for Income Taxes
In the three months ending March 31, 2011 and 2010 the Company recorded income tax expense of $39,000 and $46,000, respectively. The tax expense for the three months ended March 31, 2011 and 2010 consists primarily of deferred tax expense relating to the amortization of acquired goodwill and state tax expense.
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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 March 31, 2011, the Company has unrecognized tax benefits of approximately $2.4 million. The Company has approximately $14,000 of unrecognized tax benefits that, if recognized, would affect the effective tax rate. The Company does not believe there will be any material changes in the unrecognized tax positions over the next twelve months. Interest and penalty costs related to unrecognized tax benefits are insignificant and classified as a component of “Income Tax Expense” in the accompanying 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 to 2010. 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.
Inventories of $0.3 million at March 31, 2011 and December 31, 2010 are included in “Prepaid expenses and other current assets” and consist entirely of finished goods.
9. 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 minimum royalty payments are $150,000 per year through December 31, 2014.
As of March 31, 2011, the Company’s future minimum lease payments and future payments under its royalty agreements are as follows (in thousands):
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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 our most recent Report on Form 10-K. 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 applying proven research on how the brain learns. 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 U.S., 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 nearly three million times and over 7,000 schools have purchased at least $10,000 of our product licenses and services. As of March 31, 2011, we had approximately 214 full-time equivalent employees, compared to 210 at March 31, 2010.
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, 67% of fourth graders in the United States were not “proficient” in reading and 33% performed below the “basic” level. Between 2007 and 2009, there was no change in average 4th grade reading scores. While our installed base is growing, the over 7,000 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 U.S.
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 I and IDEA (special education) grants.
In the first quarter of 2011, many school districts continued to struggle with current and anticipated budget shortfalls. 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 $130 billion, or 20% of budgets in those states. Continued state and local budget pressures, uncertainty about future education policies, 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 resulted in a difficult K-12 market. We expect these trends to continue and to pose challenges to selling our products. However, schools have only until September 2011 to spend remaining stimulus funds from the American Recovery and Reinvestment Act of 2009, and we are very focused on pursuing that funding. In addition, we are hopeful that the first quarter release of SciLEARN Enterprise and subsequent platform upgrades expected to be released during 2011 will help us close more large transactions than in 2010.
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Our total revenue decreased by 6% during the three months ended March 31, 2011 as compared to 2010. Despite the challenges associated with the current environment, we experienced a 1% increase in booked sales in the first quarter of 2011 as compared to the same period in 2010. (Booked sales is a non generally accepted accounting principles (“GAAP”) financial measure. For more explanation on booked sales, see Revenues below.) This increase is due primarily to significant growth in our Direct-to-Consumer and Virtual School businesses and non-recurring revenue associated with an OEM contract related to the Reading Assistant product. However, K-12 booked sales decreased by 7% during the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.
In the three months ended March 31, 2011, we closed two transactions in excess of $0.5 million totaling $2.0 million compared to two such transactions totaling $1.3 million in the three months ended March 31, 2010. Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, increased by 79% or $0.6 million during the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.
Operating expenses increased by 2% during the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.
Consolidated Results of Operations
The following table sets forth information relating to our revenues (dollar amounts in thousands):
For the three months ended March 31, 2011, product revenue was roughly unchanged from the three months ended March 31, 2010. Service and support revenue decreased by 11% for the three months ended March 31, 2011 compared to the three months ended March 31, 2010, primarily due to fewer implementations and lower deferred revenue recognized from 2010 booked sales.
We believe that recurring revenue is an important measure of our operating performance. In the three months ended March 31, 2011, the recurring portion of our revenue stream increased 2.0% to $3.0 million from the three months ended March 31, 2010. The following table sets forth information relating to our recurring revenues (dollar amounts in thousands):
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1We derive recurring product revenue from subscription fees paid by U.S. and international customers to access our applications. Recurring service and support revenue consists of support and maintenance for our software products and fees paid to access our web-delivered reporting tools, Progress Tracker and Reading Progress Indicator.
Historically, our non-recurring revenue has resulted primarily from sales of perpetual licenses to on-premise software, and much of our revenue has resulted from relatively large transactions. In the first quarter of 2011, we released the first version of our new SciLEARN platform, SciLEARN Enterprise, an on-premise solution that permits large customers to host our solutions on-premise and deploy from their own central server out to multiple school sites. In the second quarter of 2011, we plan to release the second version of our SciLEARN platform, SciLEARN On-Demand , which will give our customers the option to access our solutions online, via the SciLEARN platform hosted by us. We expect that the SciLEARN On-Demand platform will increase the proportion of our revenue that is recurring. Over time, we expect that SciLEARN On-Demand, together with new per student pricing options we are introducing in the second quarter and changes in our business model, will increase our volume of smaller transactions, shorten sales cycles, and increase our ability to drive predictable, recurring revenue.
Booked sales are 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. Revenue on a GAAP basis is recorded for booked sales when all four of the requirements for revenue recognition have been met; if any of the requirements to recognize revenue are not met, the sale is recorded as deferred revenue. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenue, and is not intended to represent a substitute measure of revenue or any other performance measure calculated under GAAP.
The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three months ended March 31, 2011 and 2010 (dollar amounts in thousands):
Booked sales in the K-12 sector decreased by 7% to $6.7 million in the three months ended March 31, 2011 compared to $7.3 million in the three months ended March 31, 2010. As described above, state budget pressures continue to cause many school districts to struggle to maintain their core functions. Booked sales to the K-12 sector for the three months ended March 31, 2011 and in the three months ended March 31, 2010 were 83% and 91%, respectively, of total booked sales. “Other adjustments” in the three months ended March 31, 2011and 2010 consists primarily of the recognition of deferred revenue and the related receivable for 2010 booked sales with Free-On-Board (“FOB”) destination delivery terms that were not delivered until 2011.
We believe large booked sales, which we define as transactions totaling more than $0.5 million, are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity. In the three months ended March 31, 2011and 2010, we closed two transactions in excess of $0.5 million. We believe for 2011, large deals will continue to drive our core K-12 business. Over time as our model shifts, we expect to become less dependent on large deals, and our new on-demand version of the SciLEARN platform should enable us to significantly increase the number of smaller, more predictable transactions and recurring revenue.
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In the three months ended March 31, 2011 and 2010, budget shortfalls of our customers and potential customers made it especially difficult to close large deals in our pipeline. For the three months ended March 31, 2011 and 2010, 25% and 16%, respectively, of our booked sales arose from transactions over $0.5 million. 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 79% to $1.3 million in the three months ended March 31, 2011 as compared to $0.8 million in the three months ended March 31, 2010. This increase reflects higher sales to consumers and virtual schools, as well as a non-recurring revenue of $0.7 million associated with an OEM contract related to the Reading Assistant product.
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 following table sets forth information relating to our gross profit (dollar amounts in thousands):
The overall gross profit margin increased by 2% in the three months ended March 31, 2011 compared to the three months ended March 31, 2010 due to increases in the proportion of higher margin product revenue and decreased product costs. Product revenues made up 52% of total revenues in the three months ended March 31, 2011, compared to 50% in the three months ended March 31, 2010.
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The following table sets forth information relating to our expenses (dollar amounts in thousands):
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 $1.0 million decrease in sales and marketing expenses in the three months ended March 31, 2011 compared to the three months ended March 31, 2010 is primarily due to the decrease in headcount and related travel of employees due to the re-organization of our sales force in 2010, which reduced the number of sales directors and field account managers and added to our inside sales organization. At March 31, 2011 we had 49 quota-bearing sales personnel compared to 51 at March 31, 2010.
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. Research and development expenses increased $1.0 million in the first quarter of 2011 compared to the same quarter in 2010. During the first quarter of 2011, we continued to make critical investments in product development which resulted in increased headcount of ten employees and an increase of $0.3 million in consulting expenses from the three months ended March 31, 2010. We also continued ramping-up our new development office in Shanghai, China.
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 $0.3 million increase in general and administrative expenses in the three months ended March 31, 2011 compared to the three months ended March 31, 2010 is primarily due to increased investment in systems and personnel to support back-office operations and allow on-demand access to our products.
Provision for Income Taxes
In the three months ending March 31, 2011 and 2010, we recorded income tax expense of $39,000 and $46,000. The tax expense for the three months ended March 31, 2011 and 2010 consists primarily of deferred tax expense relating to the amortization of acquired goodwill 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. There was no change in our valuation allowance for the three months ended March 31, 2011.
The difference between the statutory tax rate and our effective tax rate of (1.7)% and (1.5%) for the three months ending March 31, 2011and 2010, respectively, is attributable to the current period benefit that is not expected to be realized during the year or recognized as a deferred tax asset at year end.
Liquidity and Capital Resources
Our cash, cash equivalents and short-term investments were $12.4 million at March 31, 2011, compared to $15.0 million at December 31, 2010.
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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.We expect that this pattern will continue, that we will use cash in operations during the first half of 2011 and that our current cash balances will be sufficient to fund our operating requirements during that period. Accomplishing this, however, will require us to meet specific booked sales targets in the K-12 market. We cannot assure you 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 March 31, 2011, we had an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at March 31, 2011, and we were in compliance with all our covenants.
Net cash used in operating activities for the three months ended March 31, 2011 was $2.3 million versus cash used of $3.8 million during the three months ended March 31, 2010.The decrease of cash used in operating activities was primarily the result of decreased annual bonus payments to employees and cash received from a large deal offset in part by our increased net loss.
Net cash provided by investing activities for the three months ended March 31, 2011 was $0.2 million, a $9.0 million increase from the same period in 2010. In the first quarter of 2010, we invested $10.0 million of cash in short term-investments. A similar investment did not occur in 2011.
Financing activities for the three months ended March 31, 2011 and 2010 generated zero and $0.1 million, respectively, from proceeds from the exercise of stock options.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Contractual Obligations and Commitments
There have been no material changes during the period covered by this report, outside of the ordinary course of our business, to the contractual obligations specified in the table disclosed in Part II, Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Contractual Obligations” of our Annual Report on Form 10-K for the year ended December 31, 2010.
Application of Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with accounting principles 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 consolidated 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 consolidated 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.
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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 March 31, 2011 and 2010.
Interest Rate Risk
The primary objectives of our investment activities are to preserve principal, provide liquidity and maximize income without significantly increasing risk. By policy, we do not enter into investments for trading or speculative purposes. Some of the securities we invest in are subject to market risk. This means that a change in prevailing interest rates may cause the fair value of the investment to fluctuate. To minimize this risk, we invest in a variety of securities, which primarily consist of money market funds, commercial paper, municipal securities and other debt securities of domestic corporations. Due to the nature of these investments and relatively short duration of the underlying securities, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future interest income. During the three months ended March 31, 2011 and 2010, a 10% appreciation or depreciation in overall interest rates would not have had a material impact on our interest income or the fair value of our marketable securities.
Foreign currency exchange risk
Our sales contracts are primarily denominated in U.S. dollars and, therefore, the majority of our revenues are not subject to foreign currency risk. We are directly exposed to changes in foreign exchange rates to the extent such changes affect our expenses related to our foreign assets and liabilities. Our only exposure in regard to our foreign assets and liabilities is with our Chinese subsidiary whose functional currency is the Chinese Renminbi.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, 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 March 31, 2011.
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 three months ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 1A. Risk Factors
There are no material changes from the risk factors previously disclosed in Part I, Item 1A — “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2010.
Item 3. Defaults Upon Senior Securities
Item 4. (Removed and reserved)
Item 5. Other Information
Item 6. Exhibits
Refer to the Exhibit Index for a list of the exhibits being filed or furnished with or incorporated by reference into this Quarterly Report on Form 10-Q.
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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: May 2, 2011
Scientific Learning Corporation
/s/ Robert E. Feller
Robert E. Feller
Chief Financial Officer