The overall gross profit margin increased slightly for the three months ended June 30, 2007 and was unchanged for the six months ended June 30, 2007, compared to the same periods in 2006. In the three months ended June 30, 2007, higher margin product revenues comprised 76% of total revenues compared to 81% in the comparable period in 2006, and product margins were up by 1%, mainly due to savings on fulfillment costs. The 46% revenue growth in service and support more than offset a 6% increase in service and support costs, resulting in an increase in the gross margin from 18% to 41%. The main reasons for this increase in gross margin were higher staff utilization and leverage from our new Tucson support center. In the six months ended June 30, 2007, service and support revenues increased by 41% and costs by 13%, resulting in a 13% improvement in gross profit.
Other Income from Related Party
In September 2003, we signed an agreement with Posit Science Corporation (“PSC”), transferring technology to PSC for use in the health field. During the six months ended June 30, 2007, we recorded $116,000 in royalty income from PSC. For the comparable period in 2006, we recorded $75,000 in royalty income. Amounts received to date and any future receipts are being reported as other income as we do not consider these royalties to be part of our recurring operations.
Interest and Other Income
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Interest and other income, net | | $ | 216 | | | 160% | | $ | 83 | | $ | 471 | | | 166% | | $ | 177 | |
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For the three months ended June 30, 2007, interest and other income consisted primarily of interest earned on our invested cash of $124,000 and a reclassification of $87,000 of service and support revenue relating to two customers for whom we are no longer performing services. In the three months ended June 30, 2006, interest and other income comprised mainly interest earned on our invested cash of $79,000.
For the six months ended June 30, 2007, interest and other income consisted primarily of interest earned on our invested cash of $292,000 and a reclassification of $174,000 of service and support revenue relating to two customers for whom we are no longer performing services. In the six months ended June 30, 2006, interest and other income comprised mainly interest earned on our invested cash of $172,000.
Provision for Income Taxes
In the six months ended June 30, 2007, we recorded an income tax provision of $4,000, based on our expectation that we will be profitable for the fiscal year. For the six months ended June 30, 2006 we recorded an income tax provision of $13,000. The tax provision principally consists of federal and state taxes currently payable offset by the utilization of net operating losses resulting in an effective tax rate of approximately 4.5%. In the three months ended June 30, 2007, we recorded an income tax provision of $112,000 in order to produce an effective tax rate of approximately 4.5% on a year to date basis. Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and previously reported net losses, we continue to maintain a full valuation allowance against our remaining net deferred tax assets.
Liquidity and Capital Resources
Our cash and cash equivalents were $9.4 million at June 30, 2007, compared to $16.4 million at December 31, 2006. We expect that our cash flow from operations and our current cash balances will be the primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures during at least the next 12 months. 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.
We have a line of credit with Comerica Bank totaling $5.0 million, which we recently extended to December 2, 2008. The line is subject to limitations based on our quick ratio and tangible net worth. Borrowings under the line are subject to various covenants, which may limit our financial and operating flexibility. At June 30, 2007, there were no borrowings outstanding under the line, other than an outstanding letter of credit for $0.2 million. As of June 30, 2007, we were in compliance with all our covenants.
If we are unable to achieve sufficient cash flow from operations, we may seek other sources of debt or equity financing, or may be required to reduce expenses. Reducing our expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.
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Historically, our first quarter is our lowest booked sales quarter, reflecting school purchasing cycles and a trend in our industry. Therefore, we may have negative cash flow in some quarters, particularly the first quarter, and may borrow funds from time to time. We generally use cash in operations during the first quarter and this trend continued in 2007. Our second quarter is historically our highest booked sales quarter, and the timing of sales and the payment terms given determine whether we generate or use cash. In the three months ended June 30, 2007, a large proportion of our sales did not require payment until the next quarter, which adversely impacted our cash position at the end of the quarter.
Net cash used in operating activities for the six months ended June 30, 2007 was $7.1 million compared to cash used of $3.9 million during the same period in 2006. This difference was primarily the result of higher spending, mainly due to increased headcount costs and higher bonus payments, and the timing of receipts from customers.
Net cash used in investing activities for the six months ended June 30, 2007 was $563,000, entirely due to capital spending. Net cash generated by investing activities for the six months ended June 30, 2006 was $2.9 million, primarily due to the maturity of $3.0 million of short term investments. We also received the final payment on our outstanding officer loans during the three months ended March 31, 2006 of $213,000. Capital spending for the six months ended June 30, 2006 was $317,000.
Financing activities generated $695,000 for the six months ended June 30, 2007, compared to $207,000 for the six months ended June 30, 2006, from the sale of stock upon option exercises and the employee stock purchase plan.
For the six months ended June 30, 2007 and June 30, 2006 we had no borrowings.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Contractual Obligations and Commitments
We have a non-cancelable lease agreement for our corporate office facilities. The minimum lease payment is approximately $78,000 per month through 2008. After 2008 the base lease payment increases at a compound annual rate of approximately 5%. The lease terminates in December 2013. We also have a lease agreement for our Tucson, Arizona office through April 2009 at an average rent of approximately $4,500 per month for the period subsequent to January 1, 2007.
We also make royalty payments to the institutions that 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 June 30, 2007 and the effects such obligations are expected to have on our liquidity and cash flow in future periods (dollars in thousands)
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(dollars in thousands) | | Total | | Less than 1 year | 2 - 3 years | 4 - 5 years | Thereafter |
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Operating lease obligations | | $ | 6,917 | | $ | 994 | | $ | 2,016 | | $ | 2,160 | | $ | 1,747 | |
Purchasing obligations | | | 1,125 | | | 150 | | | 300 | | | 300 | | | 375 | |
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Total | | $ | 8,042 | | $ | 1,144 | | $ | 2,316 | | $ | 2,460 | | $ | 2,122 | |
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Our purchase order commitments at June 30, 2007 are not material.
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
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liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.
We believe that the estimates, assumptions and judgments pertaining to revenue recognition, allowance for doubtful accounts, software development costs and long-lived assets are the most critical assumptions to understand in order to evaluate our reported financial results. A detailed discussion of our use of estimates, assumptions and judgments as they relate to these polices is presented below. We have discussed the application of these critical accounting policies with the Audit Committee of the Board of Directors.
Revenue Recognition
We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgment related to our specific transactions and transaction types.
Sales to our school customers typically include multiple elements (e.g., Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). We allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”), if VSOE exists for each element. As we do not have VSOE for software licenses, we normally recognize revenue using the residual method on arrangements with multiple elements that include software licenses, whereby the difference between the total arrangement fee and the total fair value of the undelivered elements (generally services and support) is recognized as revenue relating to software licenses. VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.
The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products. Deferred revenue is recognized as revenue as discussed below.
Product revenue
Product revenue is primarily derived from the licensing of software and is recognized as follows:
Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.
Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.
Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.
Service and support revenue
Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.
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Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. We adjust this allowance periodically based on our historical experience of bad debt write offs, which have been low in recent years. Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.
Income Taxes
We account for income taxes using the liability method, which requires the recognition of deferred tax assets or liabilities for the tax-effected temporary differences between the financial reporting and tax bases of our assets and liabilities and for net operating loss and tax credit carryforwards. We have recorded a full valuation allowance to reserve for the benefit of our deferred tax assets due to the uncertainty surrounding our ability to realize these assets.
Stock-Based Compensation
Under the fair value recognition provisions of SFAS No. 123R, we use the Black-Scholes option valuation model to estimate stock-based compensation expense at the grant date based on the fair value of the award and recognize the expense ratably over the requisite service period of the award. Determining the appropriate fair value model and assumptions used in calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected life. Stock compensation expense may be adjusted in the future if actual forfeiture rates differ significantly from our current estimates.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
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 and cash equivalents. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at June 30, 2007 would not have a material affect on our results of operations.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the required time periods. These procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
As required under Rule 13a-15(b) of the Exchange Act, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report, and concluded that our disclosure controls and procedures were effective as of June 30, 2007.
It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the Chief Financial Officer are made at the “reasonable assurance” level.
Changes in Internal Controls over Financial Reporting
There were no changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On July 15, 2005, SkyTech, Inc., or SkyTech, filed a complaint against us in the District Court for the State of Minnesota, Fourth Judicial District, alleging claims of fraud, breach of contract, breach of duty of good faith and fair dealing, tortuous interference, and indemnity. SkyTech alleged that it entered into an independent sales representative agreement, or the “Agreement”, with us in October 2002 pursuant to which it has an exclusive right to market our products to the “After School” market. SkyTech further alleged that we prevented SkyTech’s performance of the Agreement and that we wrongly terminated the Agreement. SkyTech asserted that it was entitled to an unspecified amount of damages comprised of lost commissions and other damages, attorney’s fees, costs and punitive damages. In addition to the SkyTech claims, SkyLearn, L.L.C and HEK, Inc., both of which claimed to be subcontractors of SkyTech, claimed that they suffered damages from our alleged actions with respect to SkyTech. In December 2005, the court granted our motion to dismiss the case and to compel arbitration. The Plaintiffs appealed the ruling. In December 2006, the Minnesota state court of appeals affirmed the trial court’s ruling and in February 2007 the Minnesota Supreme Court denied plaintiff’s request for review.
In October 2005, we initiated an arbitration proceeding before the American Arbitration Association in San Francisco, California. Our arbitration complaint alleged that SkyTech owed us for training charges that remain unpaid under the Agreement and sought declaratory relief regarding SkyTech’s claims against us. SkyTech asserted counterclaims against us in the arbitration, repeating the claims made in the Minnesota case and asserting damages of $10 million. In May 2007, both parties agreed to dismiss with prejudice all claims and counterclaims in the arbitration, and the arbitration matter has been closed.
Item 1A. Risk Factors
RISK FACTORS
The following factors as well as other information contained in this report should be considered in making any investment decision related to our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected and the trading price of our common stock could decline.
To grow our business, we need to increase acceptance of our products among K-12 education purchasers. Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.
We believe that to date most educators who have used Fast ForWord products are “early adopters.” Early adopters make up a relatively small proportion of 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 work because they increase learning capacity, are based on neuroscience research and focus on the development of cognitive skills. All of these concepts may be unfamiliar to educators. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.
In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires a substantial amount of time out of a limited and already crowded school day. Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us. In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased 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
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existing customers and improve student achievement results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner.
We encourage our customers to purchase significant levels of on-site service because we believe that these services enable more effective product use and lead to stronger student achievement gains. If we are unable to continue to convince customers to purchase these levels of service, customers may experience more difficulty with their implementations.
If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our revenue and growth prospects could be materially and adversely impacted and our profit could decline.
Our sales cycle tends to be long and somewhat unpredictable, which may result in delayed or lost revenue, which could materially and adversely impact our revenue and 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 profit.
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 as a result of many factors, including those discussed below.
A significant proportion of our customers’ purchases are made within the last two weeks of each quarter. We therefore have limited visibility on revenue for the quarter until the end of the quarter. If a customer unexpectedly postpones or cancels an expected purchase due to changes in the customer’s objectives, priorities, budget or personnel, we may experience an unexpected shortfall that cannot be made up in the quarter. The effect of the concentration of sales at the end of the quarter 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 quarterly revenue from perpetual licenses became more unpredictable in 2006 than in prior years. Since our December 2004 pricing change, we recognize revenue from most of our perpetual license sales at the time of sale. In addition to the variability in revenue recognition timing from our different license and service packages, this has resulted in a more seasonal revenue pattern. Before the pricing change, perpetual license revenue was recognized over the related service period and was somewhat more predictable.
In addition, 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. For example, for our fiscal quarter ended June 30, 2007, we recorded booked sales of over $7 million for one transaction, which represented approximately 38% of our booked sales for that quarter. Without that transaction, our booked sales for the quarter ended June 30, 2007 would have decreased relative to the quarter ended June 30, 2006 rather than increase by 28%.
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.
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Failure to achieve the financial results expected by investors and financial analysts in a given quarter could cause an immediate and significant decline in the trading price of our common stock.
Our historical profitability has been inconsistent, and our profitability levels continue to be uncertain.
We started operations in February 1996 and through 2002 incurred significant operating losses. We first became profitable in 2003, incurred a net loss in 2004, were again profitable in 2005 and had a modest operating loss and modest net income in 2006.We incurred a net loss in the first quarter of 2007 and had net income in the second quarter of 2007. At June 30, 2007, we had an accumulated deficit of $77.9 million from inception.
Our strategic and operating goals include increasing our booked sales, revenue and net income. In 2006, our booked sales increased 37% over 2005 levels, when booked sales had fallen approximately 15% from 2004. In the first six months of 2007, our booked sales increased 15% compared to the first six months of 2006. Our ability to achieve increased booked sales, revenue and net income depends on many factors, including but not limited to market acceptance of our products, availability of funding, customers’ prior experience with our products, and general economic conditions, some of which are outside of our control. To meet our targets, we will need to make substantial investments in operations. We cannot assure you that we will meet our targets with respect to revenue or operating results.
We rely on studies of student performance results to demonstrate the effectiveness of our products. If the validity of these studies or the conclusions that we draw from them are challenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.
We rely heavily on statistical studies of student results on assessments to demonstrate that our Fast ForWord products lead to improved student achievement. Reliance on these studies to support our claims about the effectiveness of our products involves risks, including the following:
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| • | The results of studies depend on schools’ appropriately implementing the products and adhering to the product protocol. If a school does not do so, the study may not show that our products produce substantial student improvements. |
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| • | 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. |
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| • | Schools studying the effectiveness of our products use the product with different types of students and use different assessments, sometimes making it difficult to aggregate or compare results. |
Our sales and marketing efforts, as well as our reputation, could be adversely impacted if the studies upon which we rely to demonstrate the effectiveness of our products, or the conclusions we draw from those studies, are seen to be insufficient.
If our products contain errors or if customer access to our Progress Tracker product 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. In the past, we have encountered unexpected bugs in our products shortly after release. We expect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products could lead to:
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Our Progress Tracker data tool is a web-delivered product. Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of that product. The servers that support Progress Tracker are currently located in a third-party co-location facility in Sacramento, California. While we believe that the services provided by this facility are robust, interruptions in customer access could be caused by the occurrence of a natural disaster, power loss, vandalism or other telecommunications problems. 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 our products do not work properly, or if there are problems with customer access to Progress Tracker, we may be required to issue credits, customers may elect not to renew their support or access contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability claims. We cannot be certain that the limitations of liability set forth in our agreements would be enforceable or would otherwise protect us from liability for damages. A material liability claim against us, regardless of its merit or its outcome, could result in substantial costs, significantly harm our business reputation and divert management’s attention from our operations.
We will be required to comply with the management report requirements of Sarbanes-Oxley Section 404 as of December 31, 2007. If we are unable to comply with Section 404 when we are required to do so or are unable to conclude that our internal control over financial reporting is effective for the 2007 fiscal year, such non-compliance or ineffective controls could have a materially adverse effect on us.
Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we will be required to provide a management report and auditors’ attestation and report on our internal control over financial reporting. We have not previously been subject to this requirement. Under current rules, our deadline for compliance will be December 31, 2007 for the management report requirement and December 31, 2008 for the auditor attestation requirement.
While we evaluate our internal controls on an on-going basis, we or our auditors may nevertheless discover significant deficiencies or material weaknesses in our internal controls. For instance, in connection with our restatements in 2005, we concluded that we had a material weakness in our internal controls relating to revenue and deferred revenue. To address this material weakness, we hired additional accounting staff and we implemented changes in our processes, procedures and controls relating to revenue and deferred revenue. In connection with the audit of our financial statements for the year ended December 31, 2005, management concluded and the Audit Committee concurred that, at December 31, 2005, we no longer had a material weakness in our internal control over financial reporting. Nevertheless, we cannot assure you that, in the course of implementing our processes to achieve compliance with Section 404, we or our auditors will not detect additional material weaknesses in our internal control over financial reporting.
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.
Sales of our products depend on the availability of government funding for public school reading intervention purchases, which is variable and outside the control of both us and our direct customers. If such funding becomes less available, our public school customers may be unable to purchase our products and services on a scale or at prices that we anticipate, which would materially and adversely impact our revenue and 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
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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.
We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, in particular IDEA (special education) and Title One funding. The current federal budget deficit and competing federal priorities may impact the availability of federal education funding. A cutback in federal education funding could have a materially adverse impact on our revenue.
State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. We expect that future levels of state and local school spending will continue to be significantly affected by the general economic conditions and outlook. A downturn in the economy that results in a significant reduction in state tax revenues could have a materially adverse impact on our revenue.
The availability of funding for instructional products like ours can also be affected by unpredictable events, such as increases in energy costs or damage due to severe weather. We believe that severe storms and spiking energy costs adversely impacted our sales in 2005. Unpredictable events of similar magnitude could adversely impact our revenue in the future.
We compete for sales with companies that have longer histories and greater resources than we do. We may not be able to compete effectively in the education market.
The market in which we operate is very competitive. While our products are highly differentiated by their neuroscience basis and their focus on building learning capacity and developing cognitive skills, we nevertheless compete vigorously for the funding available to schools. We compete not only against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading. 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, and have greater financial, technical, marketing and distribution resources than we do. Encouraged by the No Child Left Behind Act, new competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.
If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.
We depend on the performance of Robert Bowen, our Chairman and Chief Executive Officer, and on other senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. Mr. Bowen’s current employment agreement with us expires in June 2008. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.
Our current liquidity resources may not be sufficient to meet our needs.
We believe that cash flow from operations will be our primary source of funding for our operations during 2007 and the next several years. In 2006, we generated $4.3 million in cash from operating activities, and we ended the year with $16.4 million in cash and equivalents. In 2005, we used $2.1 million in cash in our operating activities, reflecting the decline in our booked sales from 2004 and higher expenses to support our growth goals. In the six months ended June 30, 2007, we used cash in our operating activities of $7.1 million, compared to $ 3.9 million in the first half of 2006. As of June 30, 2007, we had $ 9.4 million in cash and cash equivalents.
In addition, we have a line of credit with Comerica Bank totaling $5.0 million, which expires on December 30, 2008. At June 30, 2007 no borrowings were outstanding and we were in compliance with the covenants of that line.
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Funding our liquidity needs out of cash flow from operations will require us to achieve certain levels of booked sales 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 by reducing the resources available for sales, marketing, research or development efforts. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.
If we 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 2006, we generated approximately 76% of our booked sales from products that use this licensed technology. 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 not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents. Issued patents can prove to be invalid or unenforceable as a result of a variety of reasons, including deficiencies in prosecution. As a result of potential deficiencies during the prosecution of certain patents to which we have rights, it is possible that these patents may be subject to a claim of unenforceability or invalidity. 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 booked sales, revenue and net income. The Company also typically does not register 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. The degree of future protection for our proprietary rights is also uncertain for products or product improvements in early-stage development, because it is difficult to predict from early-stage development efforts which product(s) will ultimately be marketed or what form the ultimately marketed product(s) will take.
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.
We generally require the execution of a written licensing agreement, which restricts the use and copying of our software products. However, if unauthorized copying or misuse were to occur to a substantial degree, our sales could be adversely affected.
The export of some of our products was not made in compliance with applicable export control regulations, and as a result we may be subject to fines and penalties.
In September 2006, we began shipping a new version of our Fast ForWord products that uses limited encryption features. Such software is subject to U.S. export control regulations and requires a one-time review from the Bureau of Industry and Security, or BIS, of the U.S. Department of Commerce to obtain authorization to ship the product outside of the United States and Canada. Although we made the required filing on May 8, 2007 and received approval on May 31, 2007, our exports of this product between September 2006 and May 4, 2007 were not made in compliance with the regulations. We have voluntarily reported this violation to BIS. BIS can assess monetary fines and penalties for each export made in violation of the regulations. Although we do not expect that any fines or penalties imposed on us will be material, we cannot assure you that the actual amount of such fines and penalties, if any, will not have a material adverse effect on our financial condition.
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Our ability to utilize our net operating loss carryforwards may be limited.
Our federal net operating loss carryforwards are subject to limitations on how much may be utilized on an annual basis. The use of the net operating loss carryforwards is expected to have additional limitations resulting from certain future ownership changes or other factors under Section 382 of the Internal Revenue Code.
If our net operating loss carryforwards are further limited, and we have taxable income which exceeds the available net operating loss carryforwards for that period, we would incur an income tax liability even though net operating loss carryforwards may be available in future years prior to their expiration, and our future cash flow, financial position and financial results may be negatively impacted.
Our directors and executive officers and their affiliates effectively control the voting power of our company.
At June 30, 2007, Warburg, Pincus Ventures, our largest shareholder, owned approximately 45% of our outstanding stock, Trigran Investments owned approximately 10% of our outstanding stock, and our executive officers and directors held approximately 16% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of our company.
Our common stock is thinly traded and its price is volatile.
Our common stock presently trades on the Nasdaq Global Market, and our trading volume is low. For example, during the six months ended June 30, 2007, our average daily trading volume was approximately 9,700 shares. The market price of our common stock has been highly volatile since our July 1999 initial public offering and could continue to be subject to wide fluctuations. The last reported sales price of our common stock on the Nasdaq Global Market on July 23, 2007 was $7.10 per share. The 7,661,638 shares that Warburg Pincus Ventures and its affiliates are selling in our pending secondary offering represent 44.6% of our 17,178,660 outstanding shares of common stock as of June 30, 2007. After the completion of that offering, the market price of our common stock may decline significantly in response to the addition of such a large number of freely tradable shares into a thinly traded public market for our common stock.
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Item 4. Submission of Matters to a Vote of Security Holders
On June 1, 2007 the Company held its annual meeting of stockholders. At the meeting, the following matters were voted upon.
Proposal 1 - Election of Directors. Each of the three nominees was elected, as follows:
| | | | | |
Nominee | | Vote for Nominee | | Vote Withheld from Nominee | |
Robert C. Bowen | | 14,698,190 | | 579,096 | |
Joseph B. Martin | | 14,683,180 | | 594,106 | |
Edward Vermont Blanchard, Jr. | | 14,768,320 | | 508,966 | |
The other directors whose term of office as a director continued after the meeting are: Ajit Dalvi, Carleton A. Holstrom, Michael M. Merzenich, Rodman W. Moorhead, David M. Smith and Paula A. Tallal.
Proposal 2. Approval of amendment to the certificate of incorporation and bylaws to declassify the board of directors. The proposal was passed, as follows:
| | | |
Votes For | | 15,160,562 | |
Votes Against | | 105,899 | |
Abstentions | | 10,825 | |
Proposal 3. Approval of the 1999 Equity Incentive Plan, as amended to increase the number of shares authorized by 1,000,000 and to make other changes. The proposal was passed, as follows:
| | | |
Votes For | | 12,312,472 | |
Votes Against | | 172,088 | |
Abstentions | | 3,184 | |
Not Voted | | 2,789,542 | |
Proposal 4. Approval of the 1999 Employee Stock Purchase Plan, as amended to increase the number of authorized shares by 500,000. The proposal was passed, as follows:
| | | |
Votes For | | 12,386,680 | |
Votes Against | | 100,155 | |
Abstentions | | 909 | |
Not Voted | | 2,789,542 | |
Proposal 5. Ratification of the selection of Ernst & Young LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2007. The proposal was passed, as follows:
| | | |
Votes For | | 15,202,049 | |
Votes Against | | 68,980 | |
Abstentions | | 6,257 | |
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
| | | |
| Exhibit No. | | Description of Document |
|
| |
|
| 3.1(1) | | Amended and Restated Certificate of Incorporation. |
|
| 3.2 (2) | | Amended and Restated Bylaws |
|
| 3.3 (2) | | Certificate of Amendment to Amended and Restated Certificate of Incorporation |
|
| 31.1 | | Certification of Chief Executive Officer (Section 302). |
|
| 31.2 | | Certification of Chief Financial Officer (Section 302). |
|
| 32.1 | | Certification of Chief Executive Officer (Section 906). |
|
| 32.2 | | Certification of Chief Financial Officer (Section 906). |
| | |
(1) | | Incorporated by reference to exhibit previously filed with the Company’s Form 10-Q for the quarter ended March 31, 2007, file no. 000.2457. |
| | |
(2) | | Incorporated by reference to exhibits previously filed with the Company’s Amendment No. 1 to Registration Statement on Form S-1 filed July 13, 2007, registration no. 333-143093. |
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: July 25, 2007
| |
| SCIENTIFIC LEARNING CORPORATION
(Registrant) |
| |
| /s/ Jane A. Freeman |
|
|
| Jane A. Freeman |
| Chief Financial Officer |
| (Authorized Officer and Principal Financial and
Accounting Officer) |
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Index to Exhibits
| | |
(1) | | Incorporated by reference to exhibit previously filed with the Company’s Form 10-Q for the quarter ended March 31, 2007, file no. 000.2457. |
| | |
(2) | | Incorporated by reference to exhibits previously filed with the Company’s Amendment No. 1 to Registration Statement on Form S-1 filed July 13, 2007, registration no. 333-143093. |
