Admissions Services revenue decreased from $5.4 million in 2004 to $4.8 million in 2005, representing an 11% decrease. This decrease resulted primarily from lower application and technology subscription fees which decreased by approximately $1.4 million. This decrease was partially offset by increases in marketing services revenue of approximately $844,000.
Our total cost of revenue increased from $19.0 million in 2004 to $22.9 million in 2005, representing a 21% increase.
Test Preparation Services cost of revenue increased from $11.1 million in 2004 to $13.5 million in 2005, representing a 21% increase, primarily as a result of increasing the number of courses and tutoring sessions delivered year to date. Gross margins were approximately the same in both periods.
K-12 Services cost of revenue increased from $6.7 million in 2004 to $7.4 million in 2005, representing an 11% increase. This increase is primarily attributable to an increase in customer support costs, which lowered gross margins from approximately 52% in the first half of 2004 to 50% in the current year.
Admissions Services cost of revenue increased from $1.2 million in 2004 to $1.9 million in 2005, representing a 68% increase, primarily due to greater customer support costs and costs associated with our large counseling contract with Colorado. Higher customer support costs and customer credits issued, which lowered revenues, also negatively affected the gross margins in this division which fell from 79% to 60%.
Selling, general and administrative expenses increased from $37.6 million in 2004 to $40.7 million in 2005, representing an 8% increase. This increase resulted from the following:
We expect that we will incur between $1.0 and $1.5 million in professional fees related to Sarbanes-Oxley compliance in the second half of 2005.
The estimated effective tax rate used in 2005 was approximately 40%, as compared to 42% during the first half of 2004. However, during the first half of 2005 we continued to record a valuation allowance against the increase in our deferred tax asset. If we achieve profitability for the 2005 fiscal year, any tax provision recorded as a result of these pre-tax profits will be offset by a reversal of the tax valuation allowance previously recorded, which reversal would be for the same amount as the provision. This will result in zero net tax expense for all periods until the valuation allowance is fully reversed.
Our current primary sources of liquidity are cash and cash equivalents on hand and collections from customers. At June 30, 2005, we had approximately $11.5 million of cash and cash equivalents. Our Test Preparation Services division has historically generated, and
continues to generate, the largest portion of our cash from its retail classroom and tutoring courses. These customers usually pay us in advance or contemporaneously with the services we provide, thereby supporting our short-term liquidity needs. Increasingly, however, across all of our divisions, we are generating a greater percentage of our cash from contracts with institutions such as K-12 schools and school districts and post-secondary institutions, which pay us in arrears. Typical payment terms for these institutional customers, once invoiced, range from 60 to 90 days. Additionally, the long contract approval cycles of some of our contracts with large institutions or school districts can contribute to the level of variability in the timing of our cash receipts, as these contracts sometimes require performance to begin significantly in advance of collection of payments.
During 2004 and the first quarter of 2005, we experienced an increase in the aging of receivables from many of these customers, partially as a result of decreased focus on collections due to enormous strains on accounting resources required by the internal controls assessment mandated by Section 404 of Sarbanes-Oxley. We have hired additional employees to collect these outstanding amounts and have experienced an improvement in our “days sales outstanding” which decreased to 62 days at June 30, 2005, from 78 days at March 31, 2005.
Cash provided by operating activities is net loss adjusted for certain non-cash items and changes in assets and liabilities. During the first half of 2005, cash provided by operating activities was $1.5 million, compared to $803,000 used in the first half of 2004. In 2005, the majority of the cash provided by operating activities was due primarily to lower working capital requirements as receivables were collected. This was partially offset by decreases in accounts payable and recognition of previously deferred income.
Investing cash flows consist primarily of capital expenditures. We used $6.0 million in net cash for investing activities during the first half of 2005, compared to $4.4 million during the first half of 2004. The increase in capital expenditures is due primarily to software purchased, increased development projects and new office construction.
Financing cash flows consist primarily of transactions related to our debt structure. During the first half of 2005 we repaid approximately $2.0 million of debt we borrowed under a bank credit facility as well as other less significant payments made on capital leases and notes payable.
We anticipate that our cash balances, together with cash generated from operations, will be sufficient to meet our normal operating requirements for at least the next 12 months. Our future capital requirements will depend on a number of factors, including market acceptance of our products and services and the resources we devote to developing, marketing, selling and supporting these products and services. We expect to continue to devote substantial capital resources to product development and support and advertising, marketing and promotional activities. We may also seek another credit facility to buffer our working capital requirements.
Impact of Inflation
Inflation has not had a significant impact on our historical operations.
Seasonality in Results of Operations
We experience, and we expect to continue to experience, seasonal fluctuations in our revenue because the markets in which we operate are subject to seasonal fluctuations based on the scheduled dates for standardized admissions tests and the typical school year. These fluctuations could result in volatility or adversely affect our stock price. We typically generate the largest portion of our test preparation revenue in the third quarter. However, as SES revenue grows, we expect this revenue will be concentrated in the fourth and first quarters, or to more closely reflect the afterschool programs’ greatest activity during the school year. The electronic application revenue recorded in our Admissions Services division is highest in the first and fourth quarters, corresponding with the busiest times of the year for submission of applications to academic institutions. Our K-12 Services division may also experience seasonal fluctuations in revenue, which is dependent on the school year, and it is expected that the revenue from new school sales during the year will be recognized primarily in the fourth quarter and the first quarter of the following year.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Included in our cash and cash equivalents are short-term money market funds. The fair value of these money market funds would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due primarily to the short-term nature of the portfolio. Our Series B-1 Preferred Stock requires the payment of quarterly dividends at the greater of 5% or 1.5% above 90-day
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LIBOR. During the three months ended June 30, 2005, we paid dividends on the Series B-1 Preferred Stock in an aggregate amount of $126,389 at the rate of 5%. A 100 basis point increase in the dividend rate would have resulted in a $25,000 increase in dividends paid during this period. We do not currently hold or issue derivative financial instruments
Revenue from our international operations and royalty payments from our international franchisees constitute an insignificant percentage of our revenue. Accordingly, our exposure to exchange rate fluctuations is minimal.
Item 4. Controls and Procedures
We conducted an evaluation of the effectiveness of the design and operation of our “disclosure controls and procedures,” as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Exchange Act, (“Disclosure Controls”) as of the end of the period covered by this Quarterly Report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).
Scope of the Controls Evaluation
The evaluation of our Disclosure Controls included a review of the controls’ objectives and design, our implementation of the controls and the effect of the controls on the information generated for use in this Quarterly Report. In the course of the controls evaluation, we sought to identify data errors, control problems or acts of fraud and confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the CEO and CFO, concerning the effectiveness of the controls can be reported in our Quarterly Reports on Form 10-Q and in our Annual Reports on Form 10-K. Many of the components of our Disclosure Controls are also evaluated on an ongoing basis by other personnel in our accounting, finance and legal functions. The overall goals of these various evaluation activities are to monitor our Disclosure Controls and to modify them on an ongoing basis as necessary.
A control system can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
Conclusions
As described in detail in Item 9A of the company’s Form 10-K/A, dated May 2, 2005 (“Form 10-K/A”), the company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2004. Management’s assessment identified three material weaknesses in internal control over financial reporting as of that date. These material weaknesses were identified in the areas of capitalized software development costs, financial statement close process and revenue recognition. During the period covered by this Quarterly Report, we continued to implement the extensive remediation described in more detail below. While our management believes that these material weaknesses are in the process of being remediated, we have not conducted enough testing to be certain of the results of these remediation efforts. Accordingly, our CEO and CFO concluded, after the evaluation described above, that our Disclosure Controls were not effective, as of the end of the period covered by this Quarterly Report, in ensuring that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Notwithstanding this conclusion, the company’s preparation of its financial statements for the period covered by this report, and its evaluation of Disclosure Controls as of the end of such period, were conducted with particular attention to the material weaknesses identified by management in the Form 10-K/A and the remediation activities discussed below, and management continued to retain third party consultants and hire additional accounting personnel during the period to provide certain compensating controls and other assistance in areas where material weaknesses were identified. Accordingly, management believes that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects our financial condition, results of operations and cash flows as of and for the periods presented.
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Changes in Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting that occurred during the period covered by this Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, except for the following remediation:
| • | We have hired and continue to hire more qualified and experienced accounting personnel to perform the month-end review and closing processes as well as provide additional oversight and supervision within the accounting department. |
| | |
| • | We are in the process of implementing a tier one accounting and financial reporting software system to further automate and integrate and thereby improve the company’s financial reporting processes and systems by removing unnecessary manual interfaces and to facilitate the revenue recognition of multiple element contracts. This system is expected to be fully implemented in 2006. |
| | |
| • | We are in the process of establishing written policies and procedures to ensure that account reconciliation and amounts recorded, as well as the review of these areas, are substantiated by detailed and contemporaneous documentary support and that reconciling items are investigated, resolved and recorded in a timely manner. |
| | |
| • | We have initiated programs providing ongoing training and professional education and development plans for the accounting department and improving internal communications procedures throughout the company. |
In addition to the foregoing remediation efforts, we continue to work with a consulting firm to assist us with the continuing improvement of our internal control processes.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On September 10, 2003, CollegeNet, Inc. filed suit in Federal District Court in Oregon, alleging that The Princeton Review infringed a patent owned by CollegeNet related to the processing of on-line applications. CollegeNet never served The Princeton Review and no discovery was ever conducted. However, based on adverse rulings in other lawsuits concerning the same patent, CollegeNet dismissed the 2003 case without prejudice on January 9, 2004 against The Princeton Review. Thereafter, on August 2, 2005, the Federal Circuit Court of Appeals issued an opinion favorable to CollegeNet from its appeal from the adverse rulings. Then on August 3, 2005, CollegeNet filed suit again against The Princeton Review alleging an infringement of the same CollegeNet patent related to processing on-line applications. At this time The Princeton Review has not been served and accordingly it has no answer date and no discovery has been conducted. CollegeNet seeks injunctive relief and unspecified monetary damages. Because this potential proceeding is at a very preliminary stage, we are unable to predict its outcome with any degree of certainty. However, The Princeton Review believes that it has meritorious defenses to CollegeNet’s claims of infringement and intends to vigorously defend.
In addition to the foregoing, from time to time, we are involved in legal proceedings incidental to the conduct of our business, none of which is likely to have a material adverse effect on us.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
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Item 4. Submission of Matters to a Vote of Security Holders
(a) We held our Annual Meeting of Stockholders on June 9, 2005.
(b) Proxies for the meeting were solicited pursuant to Regulation 14 under the Exchange Act; there was no solicitation in opposition to the Board Nominating Committee’s nominees listed in the Proxy Statement, and all such nominees were elected.
Directors elected to the 2008 Class were Robert E. Evanson, John S. Katzman and John C. Reid.
Election of Directors:
| For | | Withheld |
|
| |
|
Robert E. Evanson | 26,436,735 | | 66,420 |
John S. Katzman | 25,318,166 | | 1,184,989 |
John C. Reid | 26,174,814 | | 328,341 |
Other directors whose terms continue after the meeting were Richard Katzman, Richard Sarnoff, Sheree Speakman and Howard Tullman.
(c) The appointment of Ernst & Young LLP, independent registered public accounting firm, to audit our consolidated financial statements for the year 2005 was ratified by the following vote:
For | | | 26,438,010 | |
Against | | | 64,085 | |
Abstain | | | 1,060 | |
Item 5. Other Information
On June 6, 2005, the Nominating Committee of our Board of Directors was reconstituted to consist solely of independent directors. Effective as of that date, our Nominating Committee was comprised of John C. Reid (Chair), Sheree T. Speakman and Howard A. Tullman. As of July 28, 2005, the Nominating Committee was again reconstituted and currently consists of Sheree T. Speakman (Chair), Robert E. Evanson and John C. Reid.
Additionally, on July 28, 2005, the Audit and Compensation Committees of our Board of Directors were reconstituted as follows:
Audit Committee: Robert E. Evanson (Chair), Sheree T. Speakman and Howard A. Tullman.
Compensation Committee: Howard A. Tullman (Chair), Robert E. Evanson and John C. Reid
Each of the directors named in this Item 5 is “independent” in accordance with the standards established by Nasdaq.
Item 6. Exhibits
| Exhibit Number | | Description |
|
| |
|
| 31.1 | | Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 31.2 | | Certification Pursuant to Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 32.1 | | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| THE PRINCETON REVIEW, INC. |
| | |
| By: | /s/ STEPHEN MELVIN |
| |
|
| | Stephen Melvin |
| | Chief Financial Officer and Treasurer |
| | (Duly Authorized Officer and |
| | Principal Financial and |
| | Accounting Officer) |
August 9, 2005 | | |
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