We account for stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS 123R”), which we adopted as of January 1, 2006, using the modified prospective method. We recognized stock-based compensation expense of $443,000 and $1.6 million in the three months and nine months ended September 30, 2008, respectively, compared with $701,000 and $1.6 million for the three and nine months ending September 30, 2007.
The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility, the estimated life of each award and estimated pre-vesting forfeitures. The fair value of these stock options was estimated assuming no expected dividends and estimates of expected life, volatility and risk-free interest rate at the time of grant. Estimated volatility is based on the historical prices of our common stock over the expected life of each option. Expected life of the options is based on our history of option exercise and cancellation activity. The risk free interest rates used are based on the U.S. Treasury yield curve in effect at the time of grants for periods corresponding with the expected life of the options. We use historical data to estimate pre-vesting option forfeitures. We recognize compensation expense for the fair values of these awards, which typically have graded vesting, on a straight-line basis over the requisite service period of each of these awards.
In the three months ended September 30, 2008 we made a grant of 30,000 stock options. In the three months ended September 30, 2007, we made grants of 225,000 stock options including a grant of 100,000 options containing a market condition made to a new Board member. As of September 30, 2008, none of the market conditions have been met and as a result no shares have vested.
The aggregate intrinsic value of options outstanding at September 30, 2008 was approximately $2.6 million and is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 1,427,532 shares that had exercise prices that were lower than the $3.29 market price of our common stock at September 30, 2008 (“in the money options”). The total intrinsic value of options exercised during the nine months ended September 30, 2008 and 2007 was $144,000 and $409,000, respectively. The intrinsic value of options vested during the nine months ended September 30, 2008 and 2007 was $669,000 and $1.5 million, respectively.
Notes to Condensed Financial Statements
3. Stock-Based Compensation (continued)
As of September 30, 2008, total unrecognized compensation cost related to stock options granted under our various plans was $542,000. We expect that cost to be recognized over a weighted-average period of 1.9 years.
Summary of Restricted Stock Units
We granted 382,900 and 306,500 restricted stock units during the nine month periods ended September 30, 2008 and 2007, respectively.
The fair value of restricted stock units was calculated based upon the fair market value of our stock at the date of grant, less an estimate of pre-vesting forfeitures. The weighted-average grant-date fair value of restricted stock units awarded during the nine months ending September 30, 2008 and 2007 was $4.74 and $7.05, respectively.
Disclosures Pertaining to All Share-Based Compensation Plans
Cash received under all share-based payment arrangements for the nine months ended September 30, 2008 and 2007 was $451,000 and $1,039,000 respectively, related to the exercise of stock options. Because of our net operating losses and related valuation allowance, we did not realize any tax benefits for the tax deductions from share-based payment arrangements during the nine months ended September 30, 2008 or 2007.
4. Comprehensive Loss
We have no items of other comprehensive loss, and accordingly, the comprehensive loss is equal to the net loss for all periods presented.
5. Warranties; Indemnification
We generally provide a warranty that our software products substantially operate as described in the manuals and guides that accompany the software for a period of 90 days. The warranty does not apply in the event of misuse, accident, and certain other circumstances. To date, we have not incurred any material costs associated with these warranties and have no accrual for such items at September 30, 2008.
From time to time, we enter into contracts that require us, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against our customers for violation of third party intellectual property rights caused by our products; (ii) claims resulting from personal injury or property damage resulting from our activities or products; (iii) claims by our office lessor arising out of our use of the premises; and (iv) agreements with our officers and directors under which we may be required to indemnify such persons for liabilities arising out of their activities on behalf of ourselves. Because the obligated amounts for these types of agreements usually are not explicitly stated, the overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have been recorded for these obligations on our balance sheet as of September 30, 2008 or December 31, 2007.
6. Related Party Transaction
In September 2003 we entered into an agreement with Posit Science Corporation (“PSC”), formerly Neuroscience Solutions Corporation (“NSC”), to provide PSC with exclusive rights in the healthcare field to certain intellectual property owned or licensed by us, along with transfer of certain healthcare research projects. A co-founder, substantial shareholder, and member of our Board of Directors, is a co-founder, officer, director and substantial shareholder of PSC.
During the three and nine months ended September 30, 2008, we recorded $55,000 and $150,000 in royalties receivable from PSC, respectively. For the comparable periods in 2007, we recorded $68,000 and $185,000. 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.
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Notes to Condensed Financial Statements
7. Bank Line of Credit
On June 30, 2008 we amended our existing revolving line of credit agreement with Comerica Bank. The maximum that can be borrowed under the agreement remains $5.0 million. The line expires on July 1, 2009. Borrowing under the line of credit bears interest at a floating prime rate, or a fixed rate of LIBOR plus 2.5%. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and a financial covenant requiring us to maintain a minimum adjusted quick ratio of 1.25 and a minimum net worth of $1 million. Our financial covenant in the prior agreement was to maintain a minimum adjusted quick ratio of 1.75, or a positive effective tangible net worth if the adjusted quick ratio was less than 1.75. The agreement allows us to issue letters of credit not to exceed $1.0 million. At September 30, 2008, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at September 30, 2008 and we were in compliance with all related covenants.
8. Provision for Income Taxes
In the nine months ending September 30, 2008, we recorded a year to date tax expense of $1.2 million. The total year to date tax expense consists of a $3,000 expense in the first quarter of 2008, a $1.2 million expense in the second quarter of 2008, and a $36,000 tax benefit in the current quarter. Total tax expense relates primarily to reestablishment of a full valuation allowance against deferred tax assets during Q2. The resulting year to date effective tax rate is (36.5)%. This nine-month period differs significantly from that of last year where no tax provision was recorded for the nine months ending September 30, 2007 due to taxes payable all being offset with released net operating losses. The effective tax rate for that period was 7.12%.
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. We intend to maintain the full valuation allowance until sufficient further positive evidence exists to support a reversal of the valuation allowance.
At September 30, 2008, we have unrecognized tax benefits of approximately $1.9 million. We have approximately $26,000 of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We do not believe there will be any material changes in our unrecognized tax 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 accompany statement of operations.
We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. We are subject to U.S. federal income tax examination for calendar tax years ending 2005 through 2007. In December 2007 we completed an audit from the I.R.S. for our 2004 and earlier tax years. Additionally, we are subject to various state income tax examinations from the 1997 through 2007 calendar tax years.
9. Commitments and Contingencies
Litigation with Former Sales Representative
On January 23, 2008, Robert G. (Jerry) Smith, a former account manager in Florida, filed a complaint against us in US District Court for the Middle District of Florida. The lawsuit claims breach of contract for unpaid wages of approximately $423,000. Smith alleges that he is owed additional commission relating to a large sale transaction in the second quarter of 2007. We are in the process of discovery in this matter.
We believe that this claim is not meritorious and that we do not have any significant liability to the claimant. We therefore do not believe that the resolution of this matter will have a material adverse effect on our financial position or results of operations.
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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 this report. We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.
Overview
Scientific Learning Corporation develops and distributes the Fast ForWord® family of software. These 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. On January 7, 2008, we completed the acquisition of substantially all of the assets of Soliloquy Learning, including the Reading Assistant™ product, for $10.7 million in cash. The Scientific Learning Reading Assistant combines advanced speech recognition technology with scientifically based intervention to help students strengthen reading fluency, vocabulary and comprehension to become proficient life-long readers. 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. We sell primarily to K-12 schools in the United States through a direct sales force. Since our inception, learners have used our Fast ForWord products over 1.3 million times and approximately 5,700 schools have purchased at least $10,000 of our Fast ForWord product licenses and services. As of September 30, 2008 we had 218 full-time equivalent employees, compared to 215 at December 31, 2007.
Business Highlights
We market our Fast ForWord products primarily as a reading intervention solution for struggling, at-risk, English Language Learners, and special education students. Approximately 70% of the estimated 55 million public and private school K-12 students in the United States test as not proficient in reading. While our installed base is growing, the approximately 5,700 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 125,000 K-12 schools in the U.S.
Federal education funds are a critical resource in helping school districts address the needs of the most challenged learners. We believe that a significant proportion of our sales are funded by federal sources, particularly Title One and IDEA (special education) grants. In the federal government’s fiscal year ended September 30, 2008 these programs totaled approximately $26.4 billion and are projected to total approximately $30.4 billion in fiscal 2009. In addition, schools receive significant funding from state and local governments. State and local governments are forecasting shortfalls in their taxation revenues for their fiscal 2009 because of significant adverse events in the credit and housing markets and a potential protracted national and global recession. Given such an environment, current economic conditions could have an adverse impact on future federal, state and local education spending, although we believe that education would remain among the top government priorities.
Sales of our products are included in the growing supplemental education materials segment of the overall education materials market. Simba Information’s Publishing for the PreK-12 Market 2008 – 2009 (April 2008) estimates that:
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| Ø | The total market for K-12 instructional materials is $9.36 billion, growing at 3.2% |
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| Ø | The electronic materials segment of that market is $2.04 billion |
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| Ø | The fastest growing electronic materials segment, which is where we compete, is electronic courseware at $928 million and expected to grow 9.3%. |
Company Highlights
For the three months ended September 30, 2008, our total revenue increased by 12% compared to the same period in 2007 and for the nine months ended September 30, 2008 our total revenue increased by 1%. For the three months and nine months ended September 30, 2008, product revenue remained flat and declined by 12% respectively, compared to the same periods in 2007. Service and support revenue increased by 34% and 32% for the three months and nine months ended September 30, 2008 respectively, primarily due to a higher number of schools on support, more services delivered, higher revenue for the Reading Progress Indicator and OEM revenue from the operations we purchased in our acquisition of Soliloquy in January 2008. In the nine months ended September 30, 2008, revenue and booked sales from Reading Assistant were still a relatively minor part of our business. During this period, revenue and booked sales from the Reading Assistant product and related OEM products and services (excluding support and service to schools, which we do not track separately) were less than 10% of the overall totals.
For the three months ended September 30, 2008, we closed 23 transactions in excess of $100,000, compared to 37 in the third quarter of 2007. These large transactions frequently require school board approvals and their timing is often difficult to predict.
Deferred revenue, which represents revenue to be recognized in future periods, was $23.1 million on September 30, 2008 compared to $24.3 million on September 30, 2007.
For the three months ended September 30, 2008, our total booked sales increased by 4% and for the nine months ended September 30, 2008 our total booked sales decreased by 11% compared to the same periods in 2007. (Booked sales is a non-GAAP financial measure. For more explanation on booked sales, see Revenue below). The decrease in year to date booked sales is mainly because one large transaction for approximately $7.4 million was booked in the second quarter of 2007 and no similar-sized transaction was booked in the nine month period ending September 30, 2008.
For the three months and nine months ended September 30, 2008, gross profit increased 7% and decreased by 4% respectively over the comparable periods in the prior year. A shift in revenue mix and additional costs arising from the Soliloquy acquisition negatively impacted product margins, but this was more than offset by continued improvements in our service and support margins in the three months ended September 30, 2008. Operating expenses increased by 2% and 8% for the three months and nine months ended September 30, 2008, respectively, mostly due to the addition of the Reading Assistant development team, amortization expenses resulting from the Soliloquy acquisition, and an increase in bad debt expense, partially offset by a decrease in consulting expense.
We recorded net income of $590,000 for the three months ended September 30, 2008 compared to net income of $246,000 in the same period in 2007. We recorded a net loss of $4.5 million for the nine months ended September 30, 2008 compared to net income of $277,000 in the same period in 2007.
At September 30, 2008 and 2007 we had no outstanding debt.
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Results of Operations
Revenues
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| | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
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Products | | $ | 7,475 | | 0 | % | | $ | 7,456 | | | $ | 21,009 | | -12 | % | | $ | 23,935 | |
Service and support | | | 5,220 | | 34 | % | | | 3,894 | | | | 14,252 | | 32 | % | | | 10,805 | |
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Total revenues | | $ | 12,695 | | 12 | % | | $ | 11,350 | | | $ | 35,261 | | 1 | % | | $ | 34,740 | |
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Product revenues remained flat and decreased by 12% during the three months and nine months ended September 30, 2008 respectively, compared to the same periods in 2007. The decrease in the nine months ended September 30, 2008 was mainly because one large transaction for approximately $7.4 million was booked in the second quarter of fiscal 2007 and no similarly-sized transaction was booked in 2008. This transaction included approximately $3.2 million of product revenue that was recognized during the nine months ended September 30, 2007. Our largest transaction in the nine months ended September 30, 2008 was for approximately $2.2 million, including approximately $300,000 of product revenue that was recognized in the three months ended September 30, 2008.
Our service and support revenue increased significantly during both the three months and nine months ended September 30, 2008 compared to the same period in 2007 due to a higher number of schools on support, more services delivered, higher revenue for the Reading Progress Indicator and OEM revenue from the operations we purchased in our acquisition of Soliloquy in January 2008.
Booked sales and selling activity: Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is a useful metric for investors as well as management because it is the most direct measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenues, and is not intended to represent a substitute measure of revenues or any other performance measure calculated under GAAP.
The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three and nine months ended September 30, 2008 and 2007:
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| | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
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Booked sales | | $ | 15,185 | | 4 | % | | $ | 14,535 | | | $ | 35,417 | | (11 | %) | | $ | 39,856 | |
Less revenue | | | 12,695 | | 12 | % | | | 11,350 | | | | 35,261 | | 1 | % | | | 34,740 | |
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Net increase in deferred revenue | | | 2,490 | | | | | | 3,185 | | | | 156 | | | | | | 5,116 | |
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Total deferred revenue end of period | | $ | 23,111 | | (5 | %) | | $ | 24,275 | | | $ | 23,111 | | (5 | %) | | $ | 24,275 | |
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Booked sales in the K-12 sector increased 6% to $13.9 million during the three months ended September 30, 2008, and decreased by 14% to $31.3 million for the nine months ended September 30, 2008, compared to the same periods in 2007. As previously noted, one large transaction for approximately $7.4 million was booked in the nine months ended September 30, 2007, whereas the largest transaction booked in the nine months ended September 30, 2008 was for approximately $2.2 million. This latter sale occurred in the three months ended September 30, 2008, and is the main reason for the increase in sales in this period as compared to the three months ended September 30, 2007.
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Booked sales to the K-12 sector for the three and nine months ended September 30, 2008 were respectively 91% and 88% of total booked sales, compared to 90% and 91% in the same periods in 2007. Booked sales to non-school customers, including both private practice clinicians and international customers, decreased by 11% for the three months ended September 30, 2008 compared to the same period in 2007. This decrease is primarily the result of one large transaction of $668,000 in the juvenile corrections market in the non-school sector in the third quarter of 2007, whereas no transaction of a similar size was booked in the same period in 2008. Booked sales to non-school customers increased by 20% for the nine months ended September 30, 2008 as a result of an increase in our international sales together with the OEM business that we acquired as a result of the Soliloquy acquisition in January 2008.
We believe large booked sales are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity. During the third quarter of 2008, we closed 23 K-12 sales that had a contract value in excess of $100,000, compared to 37 for the same period in 2007. For both the three months and nine months ended September 30, 2008, approximately 60% of our K-12 booked sales were realized from booked sales over $100,000. For the comparable periods in 2007, these large booked sales accounted for approximately 66% and 67% of K-12 booked sales. 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.
Although the current uncertain financial market, economic conditions, 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 market. 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 extraordinary federal commitments intended to stabilize the financial markets are likely to put pressure on all areas in the federal budget. States are forecasting shortfalls in their taxation revenues for their fiscal 2009 and 2010 because of the significant adverse conditions in the credit and housing markets and a potential protracted national and global recession. These conditions may impact 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. See “Management’s Discussion and Analysis – Application of Critical Accounting Policies” for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time. See “Risk Factors” for a further discussion of some of the factors that affect our sales and revenue.
Gross Profit and Cost of Revenues
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Gross profit on products | | $ | 6,876 | | $ | 6,997 | | | $ | 19,323 | | $ | 22,676 | |
Gross profit margin on products | | | 92 | % | | 94 | % | | | 92 | % | | 95 | % |
Gross profit on service and support | | | 2,809 | | | 2,022 | | | | 6,973 | | $ | 4,592 | |
Gross profit margin on services and support | | | 54 | % | | 52 | % | | | 49 | % | | 42 | % |
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Total gross profit | | $ | 9,685 | | $ | 9,019 | | | $ | 26,296 | | $ | 27,268 | |
Total gross profit margin | | | 76 | % | | 79 | % | | | 75 | % | | 78 | % |
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The overall gross profit margin decreased in both the three months and nine months ended September 30, 2008 compared to the same periods in the prior year due to a revenue mix shift. Higher margin product revenues made up 59% and 60% of total revenues in the three and nine months ended September 30, 2008, respectively, compared to
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66% and 69% in the same periods in 2007. Product margins also declined in both the three months and nine months ended September 30, 2008, mainly due to the impact of the amortization expense arising from the intangible assets acquired from Soliloquy and product costs associated with Reading Assistant. Service and support gross margins improved because a larger proportion of these revenues arose from support and Progress Tracker, which have higher margins than training and implementation services.
Operating Expenses
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Sales and marketing | | $ | 5,329 | | -13 | % | | $ | 6,143 | | | $ | 18,461 | | -2 | % | | $ | 18,745 | |
Research and development | | | 1,545 | | 52 | % | | | 1,016 | | | | 5,267 | | 56 | % | | | 3,385 | |
General and administrative | | | 2,398 | | 27 | % | | | 1,890 | | | | 6,346 | | 11 | % | | | 5,721 | |
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Total operating expenses | | $ | 9,272 | | 2 | % | | $ | 9,049 | | | $ | 30,074 | | 8 | % | | $ | 27,851 | |
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Sales and Marketing Expenses: For the three and nine months ended September 30, 2008, our sales and marketing expenses decreased by 13% and 2%, respectively, compared to the same periods in 2007. The decrease in the three months ended September 30, 2008 is mostly as a result of our holding fewer marketing events. At September 30, 2008, we had 51 quota-bearing sales personnel compared to 50 at September 30, 2007.
Research and Development Expenses: Research and development expenses increased by 52% and 56% in the three and nine months ended September 30, 2008, compared to the same periods in 2007. The main cause of these large increases is that research and development expenses now include the costs of the Reading Assistant development team from the Soliloquy acquisition. 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.
General and Administrative Expenses: For the three and nine months ended September 30, 2008, our general and administrative expenses increased by 27% and 11%, respectively, compared to the same periods in 2007. The increase in the three months ended September 30, 2008 is mainly due to an increase in bad debt expense of $430,000 and severance costs of $266,000. The increase in the nine months ended September 30, 2008 is also mostly caused by higher bad debt expense of $461,000 and severance costs of $266,000.
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 three and nine months ended September 30, 2008, we recorded $55,000 and $150,000 in royalties receivable from PSC, respectively. For the comparable periods in 2007, we recorded $68,000 and $185,000. 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 on invested cash | | | $ | 13 | | | -91 | % | | | $ | 144 | | | | $ | 97 | | | -78 | % | | | $ | 435 | | |
Reclassification of service revenue | | | | 73 | | | -14 | % | | | | 85 | | | | | 217 | | | -16 | % | | | | 259 | | |
Miscellaneous | | | | 0 | | | NA | | | | | 1 | | | | | 9 | | | NA | | | | | 7 | | |
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Interest and other income, net | | | $ | 86 | | | -63 | % | | | $ | 230 | | | | $ | 323 | | | -54 | % | | | $ | 701 | | |
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For the three months and nine months ended September 30, 2008, interest and other income consisted primarily of a reclassification of $73,000 and $217,000, respectively, of service and support revenue relating to two customers for
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whom we are no longer performing services, and interest on our invested cash of $13,000 and $97,000. In the three months and nine months ended September 30, 2007, interest and other income comprised mainly the same reclassification from service and support revenue of $85,000 and $259,000 and interest earned on our invested cash of $144,000 and $435,000, respectively. Interest income decreased 91% and 78% respectively for the three and nine months ended September 30, 2008, primarily due to lower cash balances as a result of cash used in the purchase of Soliloquy in January 2008 as well as decreasing interest rates.
Provision for Income Taxes
In the nine months ending September 30, 2008, we recorded a year to date tax expense of $1.2 million. The total year to date tax expense consists of a $3,000 expense in the first quarter of 2008, a $1.2 million expense in the second quarter of 2008, and a $36,000 tax benefit in the current quarter. Total tax expense relates primarily to reestablishment of a full valuation allowance against deferred tax assets during Q2. The resulting year to date effective tax rate is (36.5)%. This nine-month period differs significantly from that of last year where no tax provision was recorded for the nine months ending September 30, 2007 due to taxes payable all being offset with released net operating losses. The effective tax rate for that period was 7.12%.
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. We intend to maintain the full valuation allowance until sufficient further positive evidence exists to support a reversal of the valuation allowance.
At September 30, 2008, we have unrecognized tax benefits of approximately $1.9 million. We have approximately $26,000 of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We do not believe there will be any material changes in our unrecognized tax 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 accompany statement of operations.
We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. We are subject to U.S. federal income tax examination for calendar tax years ending 2005 through 2007. In December 2007 we completed an audit from the I.R.S. for our 2004 and earlier tax years. Additionally, we are subject to various state income tax examinations from the 1997 through 2007 calendar tax years.
Liquidity and Capital Resources
Our cash, cash equivalents and short term investments were $6.1 million at September 30, 2008, compared to $21.2 million at December 31, 2007. Our cash balances decreased primarily because of the $10.1 million payment for the acquisition of Soliloquy Learning, including direct transaction costs. In addition, we used $5.2 million of cash in operating activities in the nine months ended September 30, 2008.
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. In the three months ended September 30, 2008, we generated $3.6 million of cash from operations. 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, and that we will generate cash from operations during the remainder of 2008 that, together with the borrowing capacity under our credit line, will be sufficient to fund our operating requirements during the first half of fiscal 2009. 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 revolving line of credit agreement with Comerica Bank that expires on July 1, 2009. The maximum that can be borrowed under the agreement is $5.0 million. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and a financial covenant requiring us to maintain a minimum adjusted quick ratio of 1.25 and a minimum net worth of $1 million. The agreement allows us to issue
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letters of credit not to exceed $1.0 million. At September 30, 2008, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at September 30, 2008 and we were in compliance with all related 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.
Net cash used in operating activities for the nine months ended September 30, 2008 was $5.2 million compared to cash generated of $3.5 million during the same period in 2007. This difference was mainly the result of higher employee related expenses, primarily due to increased headcount arising from the Soliloquy acquisition, and lower collections resulting from lower sales.
Net cash used in investing activities for the nine months ended September 30, 2008 was $10.3 million, due principally to the acquisition of the assets of Soliloquy Learning. Net cash used in investing activities for the nine months ended September 30, 2007 was $991,000, due to capital spending.
Financing activities generated $451,000 for the nine months ended September 30, 2008, compared to $1,039,000 for the nine months ended September 30, 2007 from the sale of stock upon option exercises.
For the nine months ended September 30, 2008 and September 30, 2007 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 in Oakland, California. 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 expires in December 2013. We also have a lease agreement for our Tucson, Arizona office through May 2013 at an average rent of approximately $11,300 per month. In early 2008, we entered into a new lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet that expires in September 2011 at an average rent of approximately $11,500 per month.
We also make royalty payments to the institutions who participated in the original research that produced our initial products. Our minimum royalty payments are $150,000 per year.
The following table summarizes our obligations at September 30, 2008 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) | | Less than 1
year | | 2-3 years | | 4-5 years | | Thereafter | | Total | |
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Contractual Obligations: | | | | | | | | | | | | | | | | |
Operating lease obligations | | $ | 1,235 | | $ | 2,613 | | $ | 2,536 | | $ | 310 | | $ | 6,694 | |
Purchase obligations | | | 150 | | | 300 | | | 300 | | | 150 | | | 900 | |
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Total | | $ | 1,385 | | $ | 2,913 | | $ | 2,836 | | $ | 460 | | $ | 7,594 | |
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Our purchase order commitments at September 30, 2008 are not material.
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Application of Critical Accounting Policies
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, assumptions and judgments. We believe that the estimates, assumptions and judgments upon which we rely are reasonable based upon information available to us at the time. The estimates, assumptions and judgments that we make can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.
We believe that, as discussed in our most recent Report on Form 10-K, the estimates, assumptions and judgments pertaining to revenue recognition, the allowance for doubtful accounts, income taxes and stock based compensation are the most critical assumptions to understand in order to evaluate our reported financial results. There has been no change to these policies. Following the acquisition of Soliloquy, we now consider that our policy for accounting for goodwill and other intangible assets is also critical.
In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), we do not amortize goodwill and other intangible assets with indefinite lives. Our goodwill will be subject to annual impairment tests, which require us to estimate the fair value of our business compared to the carrying value. The impairment reviews require an analysis of future projections and assumptions about our operating performance. Should such review indicate the assets are impaired, we would record an expense for the impaired assets.
In accordance with Financial Accounting Standards Board Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, (“SFAS No. 144”), long-lived assets, such as property and equipment and intangible assets with definite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability would be measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. The determination of estimated future cash flows, however, requires management to make estimates. Future events and changes in circumstances may require us to record a significant impairment charge in the period in which such events or changes occur. Impairment testing requires considerable analysis and judgment in determining results. If other assumptions and estimates were used in our evaluations, the results could differ significantly.
Annual tests or other future events could cause us to conclude that impairment indicators exist and that our goodwill is impaired. For example, if we had reason to believe that our recorded goodwill and intangible assets had become impaired due to decreases in the fair market value of the underlying business, we would have to take a charge to income for that portion of goodwill or intangible assets that we believed was impaired. Any resulting impairment loss could have a material adverse impact on our financial position and results of operations.
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 September 30, 2008 would not have a material affect on our results of operations.
Item 4T. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the required time periods. These procedures are also designed to ensure that such information is
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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 interim Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q, and concluded that our disclosure controls and procedures were effective as of September 30, 2008.
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 interim 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 September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, it should be noted that Jane Freeman, our former Chief Financial Officer, resigned from the Company effective October 6, 2008 and Jon Corbett, our Controller and interim Chief Financial Officer, has tendered his resignation from the Company, which resignation will become effective on November 7, 2008.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Litigation with Former Sales Representative
On January 23, 2008, Robert G. Smith, a former account manager in Florida, filed a complaint against us in US District Court for the Middle District of Florida. The lawsuit claims breach of contract for unpaid wages of approximately $423,000. Smith alleges that he is owed additional commission relating to a large sale transaction in the second quarter of 2007. We are in the process of discovery in this matter.
We believe that this claim is not meritorious and that we do not have any significant liability to the claimant. We therefore do not believe that the resolution of this matter will have a material adverse effect on our financial position or results of operations.
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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.
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. The severity of the current economic downturn and the resulting potential funding difficulties may lengthen this cycle or make it less predictable. 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.
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 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 extraordinary federal spending relating to stabilizing the financial markets, the 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. States are forecasting shortfalls in their tax revenues for fiscal 2009, because of the significant adverse events in the credit and housing markets and a potential protracted national and global recession. While education spending remains an important priority for states, it faces competition from demands for relief for homeowners, transportation spending and rising health care costs. An economic downturn leading to 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.
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Sales in our non school markets may also be affected by current economic conditions.
Our non school sales consist principally of sales to private speech and language and other healthcare providers, sales to our international value-added resellers, and sales to government agencies for correctional institutions. Historically, sales to private providers have been adversely impacted by economic downturns, as many parents postpone or forego their services when their financial resources are reduced. Sales for correctional institutions may be affected by the same state and local government funding pressures as K-12 schools. We believe that the severity of the current global economic downturn could also materially adversely affect our international sales, although we do not have sufficient experience with our international channel to predict the impact.
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 2008 and the next several years. In 2007 and 2006, we generated $6.1 million and $4.3 million, respectively, in cash from operating activities. We ended 2007 with $21.2 million in cash and cash equivalents. We expended $10.7 million in cash in connection with the acquisition of the Reading Assistant product line. 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, and that we will generate substantial cash from operations during the second half of 2008. At September 30, 2008, we had $6.1 million in cash and cash equivalents.
In addition, we have a line of credit with Comerica Bank totaling $5.0 million, which expires on July 1, 2009. At September 30, 2008 no borrowings were outstanding and we were in compliance with the covenants of that line. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and a financial covenant requiring us to maintain a minimum adjusted quick ratio of 1.25 and net worth of $1 million. If we did not comply with the covenants, we would risk being unable to borrow under the credit line.
Funding our liquidity needs out of cash flow from operations will require us to achieve certain levels of booked sales 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.
It is difficult to accurately forecast our future financial results. This may cause us to fail to achieve the financial performance anticipated by investors and financial analysts, which could cause the price of our stock to decline.
Our revenue and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year. We started operations in February 1996 and through 2002 incurred significant operating losses. In both 2006 and 2007, we had an operating loss and modest net income. At September 30, 2008, we had an accumulated deficit of $81.3 million from inception.
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.
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.
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Our expense levels are based on our expectations of future revenue and are primarily fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, which could cause our net income to fluctuate unexpectedly.
Failure to achieve the financial results expected by investors and financial analysts in a given quarter could cause an immediate and significant decline in the trading price of our common stock.
To grow our business, we need to increase acceptance of our products among K-12 education purchasers. Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.
We believe that to date most educators who have used Fast ForWord products are “early adopters.” Early adopters make up a relatively small proportion of our K-12 market, so in order to grow our revenue and profit we need to increase our reach beyond early adopters to more conservative customers. We believe that our ability to grow acceptance of our products in the conservative K-12 education market will depend largely on the critical factors discussed below.
Our Fast ForWord products use an approach that differs from the approaches that schools have traditionally used to address reading problems. In particular, our products which are designed to develop the brain to process more efficiently, are based on neuroscience research and focus on building cognitive skills. These concepts may be unfamiliar to educators. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.
In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires at least 30 minutes per day out of a limited and already crowded school day. Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us. In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased revenue.
Our products are generally implemented in a computer lab with a lab coach or teacher rather than in the classroom with the students’ regular classroom teachers. To reach a broader group of customers, encourage additional sales from existing customers and improve student achievement results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner.
If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our revenue and growth prospects could be materially and adversely impacted and our profit could decline.
We may not achieve the benefits we expect from our acquisition of the Reading Assistant product, which could have a material adverse effect on our business, financial and operating results.
Our goals in acquiring the Reading Assistant product are to provide additional products to serve a broader range of students, to broaden our offering for English language learners for the U.S. K-12 market as well as the international market, and to further leverage our growing direct sales organization with additional complementary and effective products for sale. To fully realize the anticipated benefits from the acquisition, we face a number of challenges:
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• | We must significantly increase the volume of sales over the level historically achieved by Soliloquy. In addition, if our understanding about the Reading Assistant product, its ease of use, efficacy, and acceptability to educators is not correct, it will be more challenging to reach our expected sales volume. |
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• | We must successfully retain critical management and technical personnel who have joined us from the Soliloquy business. |
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• | We may experience unanticipated difficulties in further developing the Reading Assistant product. If so, development of product improvements and new products built on the Reading Assistant platform may be more costly and may take more time than we expect. |
We rely on studies of student performance results to demonstrate the effectiveness of our products. If the validity of these studies or the conclusions that we draw from them are challenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.
We rely heavily on statistical studies of student results on assessments to demonstrate that our products lead to improved student achievement. 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.
Our compliance with the continuing listing requirements of Nasdaq relating to our aggregate market capitalization means that, unless we regain compliance by November 21, 2008 we must transfer the listing of our common stock from the Nasdaq Global Market to the Nasdaq Capital Market or have our securities delisted, either of which outcomes could adversely effect the liquidity of our common stock.
On October 22, 2008, we received a letter from the NASDAQ Stock Market (Nasdaq) that we are no longer in compliance with Marketplace Rule 4450(b)(1)(A) which requires that the market value of our common stock be at least $50,000,000 in order to continue listing on the Nasdaq Global Market. As provided in the Nasdaq rules, we have 30 calendar days, or until November 21, 2008, to regain compliance. In order to regain compliance in this period, the market value of our common stock must be $50,000,000 or more for a minimum of 10 consecutive business days.
If we do not apply to transfer our securities to the Nasdaq Capital Market or regain compliance with the Nasdaq Global Market requirements by November 21, 2008 or if Nasdaq denies our application to transfer the listing of our securities to the Nasdaq Capital Market, Nasdaq will delist our securities from trading on Nasdaq, which would have a material adverse impact on the liquidity of its shares. Delisting may also preclude us from using certain state securities laws exemptions, which could make it more difficult and expensive for us to raise capital in the future. And even if listing of our securities is transferred to the Nasdaq Capital Market, the lower trading volume and generally smaller sizes of the companies listed on the Nasdaq Capital Market mean that it may be more difficult to buy and sell our shares on that market than on the Nasdaq Global Market.
If our products contain errors or if customer access to our web-delivered products and services is disrupted, we could lose new sales and be subject to significant liability claims.
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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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• | delays in or loss of market acceptance of our products; |
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• | diversion of our resources; |
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• | a lower rate of expansion purchases from current customers; |
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• | injury to our reputation; and |
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• | increased service expenses or payment of damages. |
Our Progress Tracker data tool, the Web-enabled version of the Reading Assistant product, and our new Virtual Academy and other online services all rely on the World Wide Web in order to function. Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of that product. The servers that support our Web-delivered products and services are located in third party facilities. While we believe that the services provided by these facilities 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 our Web-delivered products and services, 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 auditors’ attestation requirement of Sarbanes-Oxley Section 404 starting in fiscal 2009. If we or our auditors determine that our internal controls over financial reporting are not effective or if we are unable to comply with the auditors’ attestation requirement when we are required to do so, such ineffective controls or non-compliance could have a materially adverse effect on us.
Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we were required to provide an initial management assessment on our internal control over financial reporting for fiscal 2007 and we complied with that requirement in our Form 10-K.
We will be required to comply with the auditor’s attestation requirement in fiscal 2009. We cannot assure you that, in the course of completing the work to satisfy the auditors’ attestation requirement, we or our auditors will not detect a material weakness in our internal control over financial reporting or that we can satisfactorily comply with the attestation requirement.
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.
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We may not be able to compete effectively in the education market.
The market in which we operate is very competitive. We compete vigorously for the funding available to schools, including against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than we are, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.
Our Fast ForWord products are differentiated in the market by their basis in neuroscience research and their focus on improving brain processing efficiency and cognitive skills. Recently we have seen an increase in the number of neuroscientists working with other companies to repackage and commercialize their research, resulting in the introduction of other products based on neuroscience research and focusing on improving brain processing. We anticipate that this increase in “brain fitness” products will continue in the near future. To the extent that these products are adopted in place of our product, this could materially and adversely impact our revenue.
If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.
We depend on the performance of our senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.
If we are unable to maintain our access to the intellectual property rights that we license from third parties, our sales and net income will be materially and adversely affected.
Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey. In 2007, we generated approximately 78% 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 historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright. 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
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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.
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, for the first nine months of 2008, our average daily trading volume was approximately 20,000 shares. The market price of our common stock has been highly volatile since we became publicly traded and could continue to be subject to wide fluctuations.
The ownership of our common stock is concentrated.
At September 30, 2008, Trigran Investments owned approximately 27% of our outstanding stock, and our officers and directors held approximately 15% 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.
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Item 6. Exhibits
| | | | |
| Exhibit No. | | Description of Document | |
|
| |
|
| 3.1 (1) | | Amended and Restated Certificate of Incorporation. |
|
| 3.2 (2) | | Amended and Restated Bylaws |
|
| 10.1 (3)* | | Separation Agreement between the Company and Jane A. Freeman, dated
September 4, 2008. |
|
| 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 June 30, 2007, file no. 000.2457. |
| | |
| (2) | Incorporated by reference to exhibits previously filed with the Company’s Amendment No. 1 to the Registration Statement on Form S-1 filed on July 13, 2007, registration no. 333-143093. |
| | |
| (3) | Incorporated by reference to exhibit previously filed with the Company’s Form 8-K filed on September 5, 2008. |
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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: November 7, 2008
| |
| SCIENTIFIC LEARNING CORPORATION |
| (Registrant) |
| |
| /s/ Jonathan J.M. Corbett |
|
|
| Jonathan J.M. Corbett |
| 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 June 30, 2007, file no. 000.2457. |
| | |
| (2) | Incorporated by reference to exhibits previously filed with the Company’s Amendment No. 1 to the Registration Statement on Form S-1 filed on July 13, 2007, registration no. 333-143093. |
| | |
| (3) | Incorporated by reference to exhibit previously filed with the Company’s Form 8-K filed on September 5, 2008. |
