In the quarter, five more school based research studies were published, demonstrating the significant impact of Fast ForWord software in a variety of districts, schools, and students. This brings the total of published studies in the year to 49 and 82 over the past 24 months. This large and growing body of research clearly shows that Fast ForWord applications are fast, effective, and enduring in changing student reading achievement.
I will now ask Jane Freeman to provide more detail on the financial results, as well as her own perspective.
Thanks, Bob. Booked sales for the fourth quarter were $5.6 million, down 32% compared to the fourth quarter of 2004. For the year, booked sales were $31.5 million, down 15% compared to 2004.
As Bob said, the sales shortfall was primarily in K-12 public schools, which declined 38% to $4.8 million in the fourth quarter and 17% for the year to $28.5 million. Those numbers, excluding the Philadelphia transactions in 2004 and 2005, were a decline of 4% for the year, and Philadelphia had no impact on fourth quarter results.
This decline, in the face of growing sales pipelines and a larger base of satisfied school customers, is very disappointing. We believe the reasons for the sales miss are a function of our push to close much larger transactions in large districts, general buying caution among decision-makers, funding issues in Texas, our largest state, and very poor results in the southeast.
As Bob discussed, the shortfall for both the quarter and the year was primarily in our larger sales, which are typically expansions of existing customers. Sales to new customers were good. Sales to school districts who haven’t purchased from us before were 25% of fourth quarter business compared to 13% last year.
For the year, sales to new school districts were 24% of K-12 sales compared to 16% last year. Our strongest region in terms of growth was the Midwest.
We continued to make good progress on the sales of services to customers. On-site services were 15% of K-12 sales for the year compared to 13% last year. In the fourth quarter, the numbers were 12% in both years.
Business outside of K-12 totaled about $700,000 for the quarter and increased more than 60% compared to the fourth quarter of 2004. We had nice growth off a small base in both our international and corrections businesses. For the year, sales outside of K-12 were $3 million and increased 2% year over year.
Revenue for the quarter was $7.0 million, down 14% year over year. For the year, revenue increased 30% to $40.3 million.
As expected, we have now annualized the impact of the strategic pricing change we made in late 2004. You can see this in our fourth quarter product revenue of $4.3 million, which was more closely aligned with sales activity. Q4 product revenue declined 27% year over year. For the year, product revenue increased 33% and totaled $30.3 million.
Service and support revenue increased 18% during the quarter and was modestly below our expectations as we did not deliver all the on-site training that we had expected. For the year, service and support revenue increased 23% to $10.1 million and reflects our growing sales of services and our expanding customer base on support.
Our sales mix has a significant impact on how much revenue we recognize in the quarter. In the fourth quarter, we recognized about 55% of fourth quarter booked sales into revenue. This is higher than the last couple of quarters, and toward the high end of what we would normally expect.
For the year, gross margins improved from 78% in 2004 to 81% in 2005. Product gross margins increased from 92% to 93% due to lower material costs as a percentage of revenue and lower amortization of capitalized software. Service margins improved from 39% to 44% in 2005, due to better leverage on fixed costs.
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FINAL TRANSCRIPT |
Feb. 23. 2006 / 2:00PM, SCIL - Q4 2005 Scientific Learning Earnings Conference Call |
Gross margins in the fourth quarter were 72% compared to 79% in the fourth quarter of 2004. The primary reason for this decline was the shift in revenue mix to a higher proportion of service and support revenue, which carries a lower gross margin.
In the fourth quarter we true up expenses for the year. Those true ups had a negative 2% impact on gross margins. Product margins were influenced negatively, and service margins were positively influenced by about equal percentage points. We think full year margins are a good way to think about the ongoing margins in the lines of business.
Costs were also impacted by a true up in incentive compensation to reflect sales results. The year over year swing in the fourth quarter was $1.6 million. Because of this swing, operating expenses declined 10% year over year in the fourth quarter and totaled $6.8 million in 2005 compared to $7.6 million in the fourth quarter of 2004.
Sales and marketing expense declined 12% year over year primarily because of compensation expense. Lower audit fees also had a positive impact on G&A, which declined 21% year over year.
For the year, operating expenses were $27.4 million and increased 10%, or $2.4 million over the year. The swing in incentive compensation year over year was a minus $2.8 million. Excluding this swing, expenses would have been up in the low 20 percentage points as we added to our sales organization, our service organization and invested in increased marketing.
We had an operating loss for the quarter of $1.8 million compared to an operating loss of $1.1 million in the fourth quarter of 2004. For the year, we had an operating profit of $5.3 million compared to an operating loss of $735,000 in 2004. Because of our $69 million NOL, effective tax rate for the year was 3%.
The net loss for the quarter was $1.5 million compared to a net loss of $1.0 million in 2004. For the year, net income was $5.6 million and $0.31 per share compared to a loss of $693,000 and $0.04 per share in 2004. As previously noted, both net income and earnings per share were below our expectations.
We ended the year with $17 million of deferred revenue, almost three times fourth quarter revenue, compared to $25.8 million in 2004. As expected, short term deferred revenue declined as we recognized a higher proportion of sales up front. We expect to recognize about $11.2 million in deferred revenue over the next twelve months.
Accounts receivable totaled $3.5 million at year end, down from $5.7 million on December 31, 2004. Collections remain in good shape, with DSOs on booked sales at 57 days this year compared to 62 at the end of last year.
We used $2.0 million in cash from operating activities in Q4. This reflects both the sales shortfall and some early payment on commissions and other activities. Last year we used about $24,000 in the fourth quarter.
For the year, we used $2.1 million in cash from operating activities. In 2004, we generated $6.3 million in cash from operating activities. The difference reflects lower sales, higher spending and lower accrued liabilities.
At year end, we had received payment on almost all of the outstanding officer loans and had $296,000 left. We’ve now received the balance.
We ended the year with $12.1 million of cash and short term investments compared to $10.3 million on December 31, 2004.
Despite our disappointment in2005 results, we are optimistic about sales growth in 2006 and believe our target range of 20% to 30% is both realistic and achievable. We see no reason the sales cycle will slow further. We have a larger and more experienced sales force, more market awareness in the Fast ForWord products and a larger installed base to serve both as references and expansion.
2006 will be the third year of a transition that began when we made a strategic pricing change at the end of 2004. While we believe we have fairly easy comparisons this year from a sales perspective, comparisons will be very challenging from a P&L perspective.
In 2005 revenue exceeded sales by $8.9 million. 2006 is expected to represent a more normal pattern, with revenue below sales.
As a result of the 2005 sales mix, we are more cautious, and we are reducing our guidance for 2006. Sales are expected to be in the range of $38 to $41 million, an increase of 20% to 30%, while revenue is expected to be in the range of $36 to $38 million, a decline of about 5% to 10%. The
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FINAL TRANSCRIPT |
Feb. 23. 2006 / 2:00PM, SCIL - Q4 2005 Scientific Learning Earnings Conference Call |
decline in revenue is expected to be entirely on the product side, because it was product revenue that was impacted by the change to up front accounting. Service and support revenue is expected to continue to increase, reflecting our growing customer base.
Because of the large amount of deferred product revenues that rolled off in the first half of 2005, we expect that total revenue in the first and second quarters will be below the levels of last year, and we won’t begin to see positive comparisons until the third quarter.
In the first quarter we expect to recognize about $3.8 million of our deferred revenue balance.
We expect a higher proportion of service and support in the revenue mix in 2006. While software and service and support margins should remain fairly stable, we expect that this change in mix will put a couple of points of pressure on overall gross margins.
We expect to implement FAS 123R as required in the first quarter. FAS 123R expense for share based compensation is expected to total about $1.7 million for the year. Just for comparison, the expense in the footnote in the 2005 10K is $2.0 million.
Excluding stock compensation, we expect operating expenses to increase in the mid to high single digits. This expense growth will continue to be driven by additions to our sales and service organizations and a more normal level of incentive compensation.
Reflecting the lower revenue and the pick up in FAS 123R expense, we expect to record a loss for the year between $1 and $2 million and a loss per share of $0.06 to $0.12.
Excluding 123R, reported results would be in the range of $700,000 profit to a $300,000 net loss. Because sales will be above revenue, we expect to build deferred revenue during the year. Cash flow from operating expenses will be positive at the high end of our growth targets and modestly negative at the low end.
Historically, we have used cash in the first quarter of every year. Seasonally, it is our smallest sales quarter. In addition, spending is high due to year-end compensation payouts, heavy marketing spending and the national sales and service meeting and quota club. We expect that we will be cash flow negative in the first quarter of 2006 as well.
2006 is the final year of P&L transition from the changes we made in 2004. In 2007, we expect that sales and revenue growth will be more closely aligned.
And now I’d like to turn the call back over to Bob.
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
Thanks, Jane. 2005 was a very challenging year. Strong revenue and profit growth was greatly diminished by our first year-on-year sales decline. Our inability to forecast this miss and the size is even more unacceptable. This surprise is definitely not the result of a lack of attention, discipline, or effort.
We are optimistic about getting our unique, growing family of Fast ForWord software back on our historical growth track. We have acted to refocus our sales and marketing resources on what we consider to be the sweet spot of the market. We have been successful in significantly adding to our sales capacity to support this broader focus, and we are retaining our top performers. We believe the improved funding environment, increased accountability requirements, a new funding formula in Texas, and strengthened sales management team will get our sales back into the 20 to 30% growth range.
Our strategic and operational goals remain focused on making Fast ForWord an accepted solution in the reading intervention market, increasing our sales capacity while driving productivity with our experienced account managers, and building our science and research as a differentiator. Our sales pipelines remain at record levels, representing the opportunity to return our sales growth to the targeted range
We are carefully examining every area of the business to insure that resources are being used effectively to drive market penetration by speeding decisions in our prospect base, as well as internally. We continue to look for ways to gain greater marketing leverage in effectively presenting and selling our different, but solid body of science and research to address the substantial problem of millions of struggling readers. The achievement results emerging from our existing district customers should provide the fuel for getting our expansion growth back on track.
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FINAL TRANSCRIPT |
Feb. 23. 2006 / 2:00PM, SCIL - Q4 2005 Scientific Learning Earnings Conference Call |
I remain very optimistic about the power of this important learning innovation. It does quickly change lives, and I believe the results will ultimately win the battle for mind share; however, we are prepared to quickly alter our approach to ensure that we maintain the health of our balance sheet while sustaining the business in bringing this great innovation to the worldwide learning market. I would emphasize that in the near term our primary focus remains on the K-12 market in North America while we continue to explore, learn, and position for growth in other markets, such as international and corrections. We appreciate your continued interest and support.
Operator, we will now be glad to take questions.
QUESTION AND ANSWER
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Operator |
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[OPERATOR INSTRUCTIONS] Your first question comes from the line of Kirsten Edwards with ThinkEquity Partners. Please proceed. |
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Unidentified Audience Member |
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Hi guys. It’s actually Ryan instead of Kirsten. |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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Hey Ryan. |
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Unidentified Audience Member |
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Hey, how’s it going? |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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Good. |
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Unidentified Audience Member |
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Good. In regards to your booked sales guidance of 20 to 30%, can you give us any color as to where the growth will come? Is it going to be front-end loaded, back-end loaded or evenly spread out? |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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We actually think the growth is going to be stronger in the last half of the year. The main reason for that is we think the Texas Legislature will not act until the June deadline. Faster action would release what we think is some pent up demand, but we think it will be June, and then we will be into fall when they start to see the money. So that’s one of the big factors. |
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Jane Freeman- Scientific Learning Corporation - Senior VP and CFO |
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Ryan, the other thing I might just mention is that this was a very unusual year in terms of the seasonality of our K-12 sales, and so part of the reason that we think it might be back-end loaded is because we expect to see a more normal pattern of seasonality. Usually, the fourth quarter is much stronger than it was this year. |
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FINAL TRANSCRIPT |
Feb. 23. 2006 / 2:00PM, SCIL - Q4 2005 Scientific Learning Earnings Conference Call |
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Unidentified Audience Member |
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Okay, thanks. With your strong pipeline, do you think that will be able to support the 20, 30% booked sales growth heading into 2007? |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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We certainly -- even at using now lower close range ratios the numbers that we have if there’s not a deterioration in these sales cycles - a further deterioration in sales cycles certainly the pipeline is adequate to support the 20, 30% growth. |
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Unidentified Audience Member |
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Okay, thanks. Could you just give us what sales force attrition was in 2005, as well as year to date in 2006? |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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There was a 20% attrition in the sales organization for 2005. That’s eight people. Seven of those were what we call positive turnover. In other words, it’s forced turnover. We lost one account manager, a first year rep that we didn’t want to lose, but one that we quickly replaced. We’ve had no turnover in the current year. |
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Unidentified Audience Member |
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Okay. |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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And again Ryan, as I just mentioned, we lost none of our senior people, so we’ve had real consistency in our senior reps. The attrition tends to be with the first and second year reps. Even when you’re hiring proven sales veterans with experience in selling technology based solutions, it’s hard to know whether or not they can sell this innovation. There’s no district call for a neuroscience based solution, so you have to create your buying event here. We move very quickly if it’s not a good fit. |
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Unidentified Audience Member |
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Okay, thanks. Just one last question. Is there any reason for us to believe that these lengthened purchase decisions should improve in 2006? |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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Well we’re not assuming there will be a big improvement. That’s not the basis on which we’ve built the plan. We believe we can get to our projected sales growth with the pipeline in ranges we experienced, and if the pipeline does not deteriorate. Now, if you look at this funding environment, and if more state money pours into K-12 education, even though that’s not a big source for us, you can argue that educators might in fact act faster when there’s some pent up demand, but we’re not assuming that. So we just believe the purchase cycle will not lengthen further. |
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Unidentified Audience Member |
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Okay, great. Thanks. I’ll pass it on. |
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Operator |
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Your next question comes from the line of [Lynn Schietler]. He’s a private investor. Please proceed. |
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FINAL TRANSCRIPT |
Feb. 23. 2006 / 2:00PM, SCIL - Q4 2005 Scientific Learning Earnings Conference Call |
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Lynn SchietlerPrivate Investor |
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Hi guys. Your perseverance should be acknowledged in trying to bring this important innovation to children who really need it, and it seems clear from this lengthy conference call that you’re paying enormous attention to the details of the business in trying to right the ship, but nonetheless the performance has led to very low institutional ownership, very low and scant trading volume, and almost non-existent analyst coverage. Can you comment on any attention you might be paying to that aspect of running a public company, and have you guys, with the Board, considered any strategic alternatives such as selling the business, which might put it in a better home for getting the intervention more broadly out there? And finally, is the large block owned by one institutional holder - insider an impediment in any way to that? |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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Well, we are thinly traded. We’re closely held. Approximately 50% of our stock is held by Warburg Pincus, and another 20% is held by insiders, officers and others. We also have one major investor that has, I think, 8% holdings, so we just don’t have a lot of public float. And even beyond that, most of our investors are long term investors and tend to buy and hold, and not trade. So there’s not a lot of trading activity. We’ve had more this year because we had some former officers that had loans, and they needed to sell to repay those loans; but typically, we don’t have a lot of activity. |
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Jane Freeman and I probably spoke at, at least three or four investment conferences. We also made visits, and in two cases, sponsored by ThinkEquity, who does have coverage of us and met with investors in New York, Boston and here, in the Bay Area. We’ve got more of those trips planned for this year. |
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We have considered and looked for acquisitions that would fit with our strategic approach. We’ve not been successful at reasonable prices of finding something that fits in the area. We constantly look for strategic partnerships and leverages that would help us, but we actually believe Warburg has been a great investor. They were a very early investor. Rod Moorhead, a partner at Warburg, serves on our Board, is a great Board member, and they’ve been a very patient, a very good investor, and we see that relationship as no impediment. I think they’re a great shareholder and have the interest in this innovation succeeding. Getting more float in the stock is a challenging problem. We believe that this problem will solve itself over the long haul, as we grow, if we can get back to our consistent sales growth. |
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Lynn SchietlerPrivate Investor |
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All right, well good luck and you’re doing important work. Thanks for taking the question. |
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Operator |
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[OPERATOR INSTRUCTIONS] Mr. Bowen, we have no further questions in the queue. |
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Bob Bowen- Scientific Learning Corporation - Chairman and CEO |
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Well Jane and I will be available to take calls today or tomorrow so if you have follow-on questions that you want feel free to give either one of us a call. Again, we thank you for your participation and your support. |
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Operator |
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Thank you ladies and gentlemen for participating in today’s conference. This concludes the presentation. You may all now disconnect. Have a great day. |
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FINAL TRANSCRIPT |
Feb. 23. 2006 / 2:00PM, SCIL - Q4 2005 Scientific Learning Earnings Conference Call |
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Scientific Learning Corporation
Supplemental Information
Reconciliation of Booked Sales, Revenue and Change in Deferred Revenue
$s in thousands
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Booked Sales | | $ | 8,212 | | $ | 5,580 | | $ | 37,260 | | $ | 31,538 | | $ | 38,000 | | $ | 41,000 | |
Less Revenue | | | 8,153 | | | 6,983 | | | 30,976 | | | 40,319 | | | 36,000 | | | 38,000 | |
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Net (Decrease) increase in current and long-term deferred | | $ | 59 | | $ | (1,403 | ) | $ | 6,284 | | $ | (8,781 | ) | $ | 2,000 | | $ | 3,000 | |
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Beginning balance in current and long-term deferred | | | 25,725 | | | 18,406 | | | 19,500 | | | 25,784 | | | 17,003 | | | 17,003 | |
Ending balance in current and long-term deferred | | $ | 25,784 | | $ | 17,003 | | $ | 25,784 | | $ | 17,003 | | $ | 19,003 | | $ | 20,003 | |
Booked sales is a non-GAAP financial measure that we believe to be a useful measure of the current level of business activity both for management and for investors. Booked sales equals the total value (net of allowances) of software and services invoiced in the period. Because a significant portion of our revenue is recognized over a period of months, booked sales is a better indicator of current activity. The table above shows the reconciliation of booked sales, revenue, and changes in deferred revenue.
The information included above for the 2006 full year is a projection, subject to the safe harbor created by Section 27A of the federal securities law. This projection is subject to substantial risks and uncertainties. Actual results may differ materially as a result of many factors, including but not limited to: general economic conditions; the extent of acceptance and purchase of the Company's products by target customers; seasonality and sales cycles in Scientific Learning's markets; competition; availability of funding to purchase the Company's products and generally available to schools; the extent to which the Company's marketing, sales and implementation strategies are successful; the Company's ability to continue to demonstrate the efficacy of its products, which depends on how the programs are administered, the demography of participants and other factors; the Company's ability to recruit and retain key personnel; the Company's ability to timely execute its new product development strategies; pricing pressures; and other risks detailed in the Company's SEC reports.
February 23, 2006
