Our total cost of revenue increased 9%, or $1.0 million, from $11.2 million in 2004 to $12.2 million in 2005.
Test Preparation Services cost of revenue increased 9%, or $0.7 million, from $7.3 million in 2004 to $8.0 million in 2005. This is in line with our expectation around enrollment increases, which caused variable costs such as teacher pay, site rent and course materials to increase. Gross margins were approximately 70% in both quarters.
K-12 Services cost of revenue increased 8%, or $0.2 million, from $2.7 million in 2004 to $2.9 million in 2005 and is primarily attributable to an increase in costs related to the servicing of customer contracts. The increase in gross margin from approximately 2% in 2004 to 44% in 2005 is affected by the timing of both revenue and cost recognition related to professional development and assessment services contracts. Excluding the impact of the timing of the above revenue and cost recognition, gross margin declined from 44.6%, for the three months ended September 30, 2004 to 39.5% for the three months ended September 30, 2005.
Admissions Services cost of revenue increased 10%, or $0.1 million, from $1.2 million in 2004 to $1.3 million in 2005, primarily due to higher costs to service our post-secondary-counseling customers. Gross margin in this division decreased from 56% to 54% primarily as a result of start-up costs and ongoing expense in support of the new counseling services contracts.
SG&A expenses increased 14%, or $2.7 million, from $19.2 million in 2004 to $21.9 million in 2005. Approximately $1.1 million of this increase pertains to professional fees that were primarily related to Sarbanes-Oxley compliance requirements and franchise renewal legal fees. Advertising and marketing expense for the third quarter increased by approximately $0.7 million over the same period in 2004, primarily related to SES marketing efforts and the 2005 Admission Services User Conference. In addition, corporate salaries and related expenses increased by approximately $0.8 million primarily in the Information Technology and Accounting departments, and we experienced an increase of $0.3 million in office rent and related expenses primarily within our Test Preparation Services division as a result of new administrative offices related to expansion.
During the third quarter of 2005, we sold the right to sell SES services to four of our independent franchisees for approximately $1.0 million.
The estimated effective tax rate used in 2005 was approximately 40%, as compared to 42% during 2004. However, during 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 allowances 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.
The trends experienced year-to-date are similar to those noted above for the third quarter. Year-to-date results reflect revenue growth in two of our three divisions. In the Test Preparation Services division, we experienced a significant increase in SAT enrollment which resulted in growth in its retail, tutoring and institutional revenue. K-12 Services division revenue increased primarily as a result of new contracts, the introduction of SideStreets and price increases on renewals. In the Admissions Services division, revenue decreased. While revenue from our marketing services products and counseling products increased, we experienced a larger decline in revenue from technology subscription services on a year-to-date basis. We are continuing our efforts to transform this division from a technology subscription business to a marketing services business that monetizes our reach into the high school and college populations.
Revenue
Our total revenue increased 14%, or $12.2 million, from $86.0 million in 2004 to $98.2 million in 2005.
Test Preparation Services revenue increased 15%, or $9.1 million, from $61.2 million in 2004 to $70.3 million in 2005, and was primarily comprised of an increase of approximately $8.4 million in revenue from our company-owned operations. The increased revenue from company-owned operations was primarily a result of an increase of approximately $7.3 million in course and tutoring revenue that reflected higher SAT, LSAT and MCAT enrollments, and an increase of approximately $1.1 million in SES sales to schools.
K-12 Services revenue increased 21%, or $3.6 million, from $16.7 million in 2004 to $20.3 million in 2005. As with the quarter, this increase is affected by timing of revenue recognition for certain prior year contracts related to professional development and assessment services. Excluding these timing differences, revenue for the nine-month period is 8% higher, when compared to the same period in 2004, primarily as a result of new contracts, the introduction of SideStreets and price increases on renewals.
Admissions Services revenue decreased 6%, or $0.5 million, from $8.1 million in 2004 to $7.6 million in 2005. This decrease resulted primarily from lower application and technology subscription fees that decreased by approximately $1.6 million, primarily as a result of customer non-renewals and customer credits. This decrease was partially offset by increases in marketing services revenue of approximately $1.0 million resulting primarily from our lead generation contracts.
Cost of Revenue
Our total cost of revenue increased 16%, or $5.0 million, from $30.1 million in 2004 to $35.1 million in 2005.
Test Preparation Services cost of revenue increased 17%, or $3.1 million, from $18.4 million in 2004 to $21.5 million in 2005, primarily due to enrollment increases, which caused variable costs such as teacher pay, site rent and course materials to increase proportionately. Gross margins were approximately the same in both periods.
K-12 Services cost of revenue increased 10%, or $1.0 million, from $9.4 million in 2004 to $10.4 million in 2005. This increase is primarily attributable to an increase in costs related to the servicing of customer contracts. The increase in gross margin from 44% in 2004 to 49% in 2005 is affected by the timing impact of both revenue and cost recognition related to professional development and assessment contracts. Excluding this timing impact, gross margin declined from 50.4% for the nine months ended September 30, 2004 to 47.9% for the nine months ended September 30, 2005.
Admissions Services cost of revenue increased 39%, or $0.9 million, from $2.3 million in 2004 to $3.2 million in 2005, primarily due to higher customer support costs and costs associated with our counseling contracts in Texas. Higher customer support costs along with several customer credits decreased gross margins from 71% in the nine-month period ending September 30, 2004 to 58% in the current nine-month period.
Selling, General and Administrative Expenses
SG&A expenses increased 10%, or $5.8 million year-to-date from $56.8 million in 2004 to $62.6 million in 2005. Approximately $3.5 million of this increase relates to professional fees primarily associated with Sarbanes-Oxley compliance requirements and legal fees related to the franchise renewal process. In addition, corporate salaries and related expenses increased by approximately $2.6 million, primarily in the Information Technology, Accounting and Legal departments.
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Income Taxes
The estimated effective tax rate used in 2005 was approximately 40%, as compared to 42% during the first nine months of 2004. However, during the first nine months 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 allowances 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.
Liquidity and Capital Resources
Our current primary sources of liquidity are cash and cash equivalents on hand and collections from customers. At September 30, 2005, we had approximately $7.5 million of cash and cash equivalents. The $11.7 million decrease in cash from the December 31, 2004 balance is primarily attributed to capital expenditures and payments against our debt obligations that more than offset the $0.5 million cash increase provided by operating activities. Our Test Preparation Services division has historically generated, and continues to generate, the largest portion of our cash flow 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 the schools and school districts serviced by our K-12 Services division and the post-secondary institutions serviced by our Admissions Services division, all of which pay us in arrears. Typical payment performance for these institutional customers, once invoiced, ranges from 60 to 90 days. Additionally, the long contract approval cycles and/or delays in purchase order generation with some of our contracts with large institutions or school districts can contribute to the level of variability in the timing of our cash receipts.
Cash provided by operating activities is net income adjusted for certain non-cash items and changes in operating assets and liabilities. During the first nine months of 2005, cash provided by operating activities was $0.5 million, compared to $6.0 million for the first nine months of 2004, a decrease of $5.5 million. The decrease is attributed to an increase in net income adjusted for non cash items of $1.5 million and the year-over-year reduction in accounts payable and accrued expenses of $2.9 million which was more than offset by the collection of $2.4 million less in receivables in 2005 as compared to 2004, an increase in other assets of $1.9 million, primarily related to our SideStreets inventory, and a decrease in deferred income of approximately $5.4 million.
During the first nine months of 2005, we used $8.2 million in cash for investing activities as compared to $6.0 million used during the first nine months of 2004. The increase of $3.7 million in capital expenditures is due primarily to software purchased and increased development projects including our investments in SideStreets content. In connection with the renovation of one of our New York City locations, our landlord contributed approximately $0.9 million to help defray our construction cost outlays during 2005. In addition, during the nine months ended September 30, 2004, we invested approximately $0.6 million and incurred approximately $0.2 million of acquisition costs for an approximate 25% equity interest in Oasis Children’s Services LLC, a privately held company.
Financing cash flows consist primarily of transactions related to our debt and equity structure. During the first nine months of 2005, we repaid approximately $2.0 million of the debt we had borrowed under a bank credit facility during the first nine months of 2004, and we repaid approximately $0.3 million less in other debt in 2005 than in 2004 which was almost offset by an increase in dividend payments on our Series B-1 Preferred Stock of $0.2 million. In 2004 we received approximately $9.9 million, net of issuance costs, from the sale of Series B-1 Preferred Stock and received approximately $0.4 million from the exercise of stock options.
We believe that our cash balances, together with cash generated from operations, should be sufficient to meet our normal operating requirements for at least the next 12 months. Additionally, we are evaluating several options to augment our cash flow in the short term, including obtaining a new credit facility. 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.
Impact of Inflation
Inflation has not had a significant impact on our historical operations.
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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 after school 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.
Recent Developments
During the third quarter of 2005, we completed the franchise renewal process with five of the seven domestic franchisees that were in our franchise system as of December 31, 2004. The renewal agreements took effect immediately and superseded the remaining term of the franchisees’ prior contracts. Of the two remaining franchisees, we terminated one franchisee for default in July 2005. We initiated an arbitration proceeding to confirm the validity of the termination and to recover amounts owed and seek damages from the former franchisee. We opened a company-owned office to service that franchisee’s former territory. We are currently in litigation with the remaining franchisee (which holds ten separate franchises, six of which expire at the end of 2005) regarding the contract terms to which the franchisee is entitled upon renewal. However, the franchisee has signed renewals for the six expiring agreements under a reservation of rights pending the outcome of the litigation, and has informed the Court of its intention to renew regardless of the outcome of the litigation.
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 LIBOR. During the three months ended September 30, 2005, we paid dividends on the Series B-1 Preferred Stock in an aggregate amount of $134,335 at the rate of 5.3%. 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.
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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, the 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.
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. |
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• | 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. |
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• | We are in the process of establishing written policies and procedures along with control matrices 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. |
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• | 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.
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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 a related matter, on September 1, 2005, The Princeton Review filed a request with the United Stated Patent and Trademark Office (“PTO”) for ex parte reexamination of the CollegeNet patent. On October 31, 2005, the PTO granted The Princeton Review’s request and ordered reexamination of all claims of the CollegeNet patent.
On August 29, 2005, Test Services, Inc. (“TSI”), a franchisee of The Princeton Review under ten separate franchise agreements, six of which expire on December 31, 2005, filed suit against us in the United States District Court for the District of Colorado. In this proceeding, TSI alleges that the terms we have offered for renewal of the franchise do not comply with TSI’s contractual renewal rights, seeks declaratory relief and specific performance and unspecified damages as to alleged breaches of the renewal provisions, and also alleges a violation of the Michigan franchise law. Notwithstanding its pursuit of this action, TSI’s entered into the tendered renewal agreements under a reservation of rights. TSI’s complaint also includes claims that we breached our existing franchise agreements with TSI that are unrelated to the core renewal dispute. TSI seeks damages for these alleged breaches in unspecified amounts, except that damages in excess of $500,000 are alleged in connection with one of the claims. A trial on the merits of the franchise renewal issues is scheduled to begin on November 14, 2005. With respect to the remaining claims, the Court has set a trial date in January 2007.
We do not believe that the resolution of the dispute regarding the terms upon which TSI may renew its franchise agreements with us will materially affect our financial condition or results of operations. With respect to TSI’s claims for damages for breach of the existing franchise agreements that are unrelated to this issue, the proceeding is at a preliminary stage and we are unable to predict its outcome with any degree of certainty. However, The Princeton Review believes that it has meritorious defenses to these claims 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.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
Not applicable
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Item 6. Exhibits
| Exhibit Number | | Description |
|
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| 10.1 | | Amendment to Employment Agreement, dated September 12, 2005, between The Princeton Review, Inc. and Stephen Melvin |
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| 10.2 | | Employment Agreement, dated September 9, 2005, between The Princeton Review, Inc. and Andrew Bonanni |
| | | |
| 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. |
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| 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. |
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| By: | /s/ ANDREW J. BONANNI |
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| | Andrew J. Bonanni |
| | Chief Financial Officer and Treasurer |
| | (Duly Authorized Officer and Principal Financial and Accounting Officer) |
| | |
| | November 9, 2005 |
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