UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004

OR

|_| TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to _______

Commission File number # 000-24547

Scientific Learning Corporation
(Exact name of registrant as specified in its charter)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X|     No |_|

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |_|      No |X|

The number of shares of the Registrant’s Common Stock, $.001 par value per share, outstanding at April 30, 2004 was 16,159,747

SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED March 31, 2004

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PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements

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Notes to Condensed Financial Statements

1.  Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation (the “Company”) is the leading provider of neuroscience-based software products that develop underlying cognitive skills required for reading and learning. The Company’s Fast ForWord® products are a series of reading intervention products for children, adolescents and adults. We sell primarily to K-12 schools through a direct sales force. The Company also sells to speech and language professionals. To support our products, we provide on-site and remote training and implementation services, as well as technical, professional and customer support and a wide variety of Web-based resources. 

Use of Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make certain estimates and assumptions that 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 that there are material differences between these estimates and actual results, our financial statements could be affected.

Interim Financial Information

The interim financial information as of March 31, 2004 and for the three months ended March 31, 2004 and 2003 is unaudited, but includes all normal recurring adjustments that the Company considers necessary for a fair presentation of its financial position at such date and its results of operations and cash flows for those periods. 

These condensed financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission.

Other Assets

Other assets consist of the following (in thousands):

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Notes to Condensed Financial Statements

1.  Summary of Significant Accounting Policies (continued)

Accrued restructuring costs

In October 2003 the Company entered into an agreement with its landlord to terminate the lease for its Oakland headquarters and commence a new lease agreement for a reduced amount of space in the same building. This reduction in space is expected to decrease total lease payments by approximately $6.5 million (net of lease termination fees described below) through 2008. Under these agreements the Company paid an increased security deposit of $550,000 and lease termination fees totaling $930,000 through March 31, 2004. The balance of the lease termination fee, $1.3 million, will be paid in equal monthly installments through December 31, 2004. The term of the new lease agreement expires December 31, 2013. 

The following table sets forth the restructuring activity during the quarter ended March 31, 2004
(in thousands):

Net Loss Per Share  

Basic and diluted net loss per share information for all periods is presented under the requirements of Statement of Financial Accounting Standards No. 128, “Earnings per Share.” Basic net loss per share has been computed using the weighted-average number of shares outstanding during the period and excludes any dilutive effects of stock options and warrants. Potentially dilutive securities have been excluded from the computation of diluted net loss per share, as their inclusion would be antidilutive.

If the Company had reported net income, the calculation of diluted earnings per share would have included approximately an additional 1,254,884 and 454,000 common equivalent shares (computed using the treasury stock method) related to the outstanding options and warrants for the quarter ended March 31, 2004 and 2003, respectively.

Stock-Based Compensation

The Company has elected to use the intrinsic value method in accounting for its employee stock options because the alternative, fair value accounting requires the use of option valuation models that were not developed for use in valuing employee stock options. Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. 

Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value at the grant dates for awards under those plans calculated using the Black-Scholes valuation model,

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Notes to Condensed Financial Statements

1.  Summary of Significant Accounting Policies (continued)

The Company’s net loss and basic and diluted net loss per share would have been increased to the pro forma amounts indicated below (in thousands, except per share amounts):

The fair value of the options was estimated using the following assumptions: a risk free interest rate of 3%, no dividend yield, a volatility factor of 85% and a weighted average expected life of the options of five years.

The pro forma impact of options on the net loss for the three months ended March 31, 2004 and 2003 is not representative of the effects on net loss for future periods, as future years will include the effects of additional periods of stock option grants. 

2.  Comprehensive Loss

The Company has no items of other comprehensive loss, and accordingly the comprehensive loss is equal to the net loss for all periods reported.

3.  Guarantees

The Company generally provides a warranty for its software products to its customers and accounts for its warranties under the FASB’s Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (FAS No.5) under which estimated losses are recorded if it is probable a liability has been incurred and the amount of the loss can be reasonably estimated. Warranty periods can vary from customer to customer but our standard warranty period is 90 days. In the event there is a failure of the product in breach of such warranties, the Company generally is obligated to correct the product or service to conform to the warranty provision or, if the Company is unable to do so, the customer is entitled to seek a refund of the purchase price of the product. The Company did not provide for a warranty accrual as of March 31, 2004. To date, the Company’s product warranty expense has not been significant.

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4.  Related Party Transaction

In September 2003 the Company entered into an agreement with Neuroscience Solutions Corporation (“NSC”) to provide NSC with exclusive rights in the healthcare field to certain intellectual property, patents and software owned or licensed by the Company, along with transfer of certain healthcare research projects. A co-founder, substantial shareholder, and member of the Board of Directors of the Company is a co-founder, officer, director and substantial shareholder of NSC. 

For the three months ended March 31, 2004 the Company recognized $35,000 in other income for service provided to NSC and royalties for product licenses. 

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Item 2.  Management’s Discussion and Analysis of Financial Conditions and Results of Operations

Overview

We develop and distribute the Fast ForWord® family of reading intervention software. Our innovative products apply advances in neuroscience and cognitive research to build the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrates that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. 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. Our primary market is K-12 schools in the United States, to which we sell using a direct sales force. For the three months ended March 31, 2004, K-12 schools accounted for 91% of our booked sales. By the end of March 2004, approximately 2,300 schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and over350,000 individuals had enrolled in one of our products. As of March 31, 2004, we had 132 full-time employees, compared to 126 at March 31, 2003. 

Business Highlights

For the quarter ended March 31, 2004 our revenue grew 12% compared to the same period in 2003. Our service and support revenue increased 75%. Product revenues, which comprise 74% of total revenue, were approximately equal to the first quarter of 2003 as a result of slow sales in the quarter ended December 31, 2003 and a shift in sales mix towards a greater proportion of services and support. Because we believe that services are critical to effective product implementation, we have had a major initiative to increase the amount of services we sell to customers, and we have an increasing number of customers who renew their support agreements. We expect service and support revenue to continue to grow more rapidly than product revenue during the remainder of 2004.

For the three months ended March 31, 2004 our total booked sales increased by 27% over same period in 2003, and K-12 booked sales increased 28%. (For more explanation on booked sales, see Revenue, below). First quarter 2004 booked sales were ahead of expectations. Historically, the first quarter has been our smallest sales quarter of the year. 

At March 31, 2004, our debt was $2.6 million compared to $6.3 million at March 31, 2003 and no debt at December 31, 2003. Due to the seasonality of our sales and working capital requirements, we typically use cash during the first quarter. 

Results of Operations

Revenues

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Booked sales and selling activity: Because a significant portion of our software, services and support revenue is recognized in periods after the invoice date, management uses booked sales to evaluate current selling activity. Booked sales is a non-GAAP financial measure that we believe is useful for investors as well as management as a 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. However, booked sales should not be considered in isolation from, 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 quarters ended March 31, 2004 and 2003.

Booked sales in the K-12 sector, which accounted for 91% of booked sales in the first quarter of 2004, grew 28% to $4.0 million, compared to $3.1 million in the same period in 2003, primarily due to the growth in service and support sales. 

Booked sales to non-school customers, primarily private practice clinicians, improved by 15% to $376,000 in the first quarter of 2004, compared to $326,000 in 2003. Our focus continues to be on K-12 sales; sales to non-school customers have declined over the past several years. 

In 2004, we plan to continue to concentrate our sales effort on large multiple-site opportunities in the K-12 market. We believe large sales are an important indicator of mainstream education industry acceptance and an important factor in continuing to increase the productivity of our sales force. During the first quarter of 2004, we closed four transactions which had a contract value in excess of $100,000 compared to three during the same period in 2003. 

We believe that our new update to the Gateway Edition has resolved most of the technical issues we experienced in the second half of 2003. Although federal, state and local budget pressures make for an uncertain funding environment for our customers, we believe that we are positioned to achieve continued growth in the K-12 market during 2004. We expect that the sales of services will continue to grow as a percent of total sales on a year-over-year basis. 

Unpredictability :  To achieve our sales growth objectives will depend on increasing mainstream 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 sales force numbers are limited, which requires us to achieve increased sales productivity levels, in a K-12 market that is still negatively impacted by tight state and local funding. For a discussion of some of the other important factors that affect our results, see “Factors that May Affect Results of Operations or Stock Price.”  In addition, the revenue recognized from our 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 sales and revenue at any given time. Booked sales tend to be seasonal in nature and the first quarter booked sales typically are the lowest of the year. 

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The overall gross profit margin was unchanged for the three months ended March 31, 2004 compared to the same period in 2003, as improved margins in both products and services and support were offset by revenue mix changes. Margin improvement in services and support was the result of improved operating leverage, as revenue growth provided better fixed cost coverage. In the first quarter of 2004 our mix was 74% product and 26% service and support compared to 84% product and 16% service and support in the same period in 2003. We also incurred higher than planned costs in the first quarter of 2004 for a field trial of our updated version of Gateway Edition and to support customers with technical issues. 

Operating Expenses

Sales and Marketing Expenses:  For the first quarter of 2004, our sales and marketing expenses increased due to additional staff, use of consultants, temporary staff, and marketing expenses. At March 31, 2004, we had 27 quota-bearing sales personnel selling to public schools. During 2004, we expect to increase our investment in sales and marketing as we focus on increasing sales in the K-12 market and adding additional sales people. 

Research and Development Expenses: Research and development expenses decreased slightly in the quarter ended March 31, 2004 compared to the same period in 2003. 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. We expect research and development expenses to increase on a year-over-year basis for the balance of 2004. 

General and Administrative Expenses:  General and administrative expenses decreased in this quarter compared to the same quarter in 2003 and we anticipate that they will continue to decrease in 2004 as a percentage of revenues. They are expected to increase slightly on a dollar basis to support growth in sales.

Other Income from Related Party

                In September 2003, we signed an agreement with Neuroscience Solutions Corporation (“NSC”), transferring technology to NSC for use in the health field. The transaction includes a license of the patents we own, a sublicense of the patents we license from others, the license of certain software we developed, and the transfer of assets related to certain research projects. During the first quarter of 2004 we recorded $12,500 in royalties and $22,500 for services provided to NSC. Amounts received to date and any future receipts are being reported as other income as we do not consider the sale of these rights to be part of recurring operations. 

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Interest expense, net decreased for the three months ended March 31, 2004 compared to the same period in 2003 primarily because of lower amortization of deferred financing and lower borrowing in 2004 compared to 2003. The amortization of deferred financing charges was $99,000 in the first quarter of 2004 compared to $304,000 in the same period of 2003. 

Provision for Income Taxes

To date, we have recorded no provision for income taxes as we have incurred a net loss for tax purposes. 

Liquidity and Capital Resources

Our cash and cash equivalents were $3.1 million at March 31, 2004, compared to $3.6 million at December 31, 2003. We expect that our cash flow from operations and our current cash balances will be the primary source of the funds for our operations and capital expenditures during 2004. Accomplishing this, however, will require us to meet specific sales targets in the K-12 market. We cannot assure you that we will meet our targets with respect to sales, revenues, expenses or operating results. Because of the seasonality of our sales and working capital requirements, we may have negative cash flow in some quarters, particularly the first quarter, and may borrow under our line of credit from time to time. We drew $2.6 million on our credit facility in the first quarter of 2004. 

Net cash used by operating activities in the first quarter of 2004 was $3.0 million, including payment of previously expensed restructuring charges of $445,000. For the same period in 2003, cash used by operating activities was $2.3 million, including $548,000 of previously expensed restructuring charges. 

Net cash used in investing activities for the three months ended March 31, 2004 was $181,000, consisting primarily of an increase in purchases of computer hardware and software. Our level of capital expenditures was low in the comparable period in 2003, which was approximately $61,000. In 2004, we expect that our capital spending will be modestly higher than in 2003 as we continue to upgrade computer equipment and purchase new software.

For the three months ended March 31, 2004 we funded operating and investing activities by borrowing $2.6 million on our bank line of credit. This compared to $1.3 million in bank borrowing for the same period in 2003. 

We have a line of credit with Comerica Bank totaling $7.0 million through July 22, 2004; after that date, the maximum that can be borrowed under the agreement is $5.0 million for the remainder of the term. The line expires on January 14, 2005. The facility is partially secured by a letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus Ventures, our largest stockholder. The letter of credit is for $4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to July 30, 2004. The non–guaranteed portion of the line is subject to limitations based on our accounts receivable balance. Borrowings under the line are subject to various covenants, which may limit our financial and operating flexibility. 

After 2004, we expect that cash flow from operations will continue to be our primary source of funds for the next several years. Again, this will require us to meet certain sales and expense levels. If the Company is unable to achieve sufficient cash flow from operations, the Company may seek other sources of debt or equity financing, or may be required to reduce expenses. Reducing the Company’s 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. 

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Contractual Obligations and Commitments

We have a non-cancelable lease agreement for our corporate office facilities. The minimum lease payment is approximately $78,000 per month through 2008. After 2008 the base lease payment increases at a compound annual rate of approximately 5%. The lease terminates in December 2013. 

The following table summarizes our outstanding borrowings and contractual obligations at March 31, 2004 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.

Our purchase order commitments at March 31, 2004 are not material.

Loans to Current and Former Officers

In March 2001 we made full recourse loans to certain of our officers, in amounts totaling $3.1 million. The total receivable including accrued interest at March 31, 2004 and 2003 was $3.6 million and $3.4 million, respectively. Accrued interest of $457,000 and $304,000 for the years ended March 31, 2004 and 2003 respectively was included in Other Assets on the Balance Sheet. In 2002 some of these officers left our Company. The Notes are full recourse loans secured by shares of our Common Stock owned by the current and former officers. The loans bear interest at 4.94%. Principal and interest are due December 31, 2005. 

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 the estimates, assumptions and judgments pertaining to revenue recognition, allowance for doubtful accounts, software development costs and long-lived assets are the most critical assumptions to understand in order to evaluate our reported financial results. A detailed discussion of our use of estimates, assumptions and judgments as they relate to these polices is presented below. We have discussed the application of these critical accounting policies with the Audit Committee of the Board of Directors. 

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Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” (SOP 97-2) as amended by Statement of Position 98-9. SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. For software orders with multiple elements, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence.” Vendor specific objective evidence of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is additionally measured by the renewal price. 

Our revenue recognition policy is also based on the Securities and Exchange Commission’s Staff Accounting Bulletin 104 (SAB 104), which requires companies that provide an ongoing service to recognize revenue over the term of the services agreement. 

Revenues from the licensing of software are recognized as follows: 1) for perpetual licenses purchased with Internet-based participant tracking services, revenue is recognized over a one-year period; 2) for limited term site licenses, revenue is recognized over the life of the license, typically 3 to 12 months; 3) for individual participant licenses, revenue is recognized over the average duration of the product’s use, typically 6 weeks; and 4) for perpetual licenses that are not purchased with Internet-based services, revenue is recognized when the product has been shipped, provided that the other criteria stated above are met. 

Service and support revenues are derived from a combination of on-site and remote training, implementation, technical and professional services and customer support. Revenue from services is recognized on delivery. Revenue from support is recognized over the contractual support period. 

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. Typically 20%-30% of software licenses, services and support invoiced in a particular quarter have been recognized as revenue during that period. This proportion varies with our product mix and is affected by the particular season. For example, we typically provide a significant portion of the implementation services invoiced in the third quarter during that quarter as schools begin their year, while a lesser proportion of services invoiced are usually recognized in the second quarter, when many schools close for the summer. Because we recognize the majority of our software license, service and support revenues over various terms as described above, at quarter end 75% – 80% of our account receivable balance is included in deferred revenue.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. These estimates are based on historical experience. In 2001 and early 2002 our experience was that bad debt expense was about 2% of revenue. In the later half of 2002 and 2003 our bad debt experience improved significantly to less than 1% of revenue and in 2003 we adjusted our bad debt allowance to reflect the improvement in our experience. To the extent experience requires it, we may in the future again adjust this reserve. Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant. 

Software Development Costs

We capitalize software development cost in accordance with Financial Accounting Standards Board (FASB) No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” under which software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated life of the related product. 

Prior to the establishment of technological feasibility we expense all software development cost associated with a product. Technological feasibility is deemed established upon completion of a working version. We estimate the useful life of our developed products to be 3 years.

On an ongoing basis, we evaluate the net realizable value of the capitalized software development cost by estimating the future revenue to be generated from the product and compare this estimate to the unamortized cost of the product. At March 31, 2004 future revenues from sale of products for which development costs remain on the balance sheet are anticipated to exceed the $639,000 of unamortized development costs.

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Impairment of Long-Lived Assets

We regularly review the carrying value of, capitalized software development costs and property and equipment. We continually make estimates regarding the probability of future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets.

FACTORS THAT MAY AFFECT RESULTS OF OPERATIONS OR STOCK PRICE

Our results are impacted by a variety of factors, many of which are beyond our control. The following factors, as well as other information discussed in this quarterly report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2003, (under the headings “Business – Factors that May Affect our Results or Stock Price” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), and other documents filed with the Securities and Exchange Commission should be carefully considered in evaluating our results and our business. 

The extent to which mainstream educational purchasers will broadly accept our products is unproven.

The availability of government funding for public school reading intervention purchases, and for our products in particular, is uncertain. 

Our business experiences seasonal fluctuations and a long sales cycle.

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We may experience difficulties in launching new products efficiently, on schedule and without significant technical issues.

The factors discussed above could materially and adversely affect our business, results of operations, financial condition and the trading price of our stock. 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our exposure to market risk for changes in interest rates relates primarily to the rate of interest we will pay on our new revolving credit facility with Comerica Bank. Interest rates on loans extended under that facility are at the bank’s prime rate plus 0.5%. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at March 31, 2004 would not have a material affect on our results of operations.

Item 4. Controls and Procedures

Based on the evaluation, required under Rule 13a-15(b) of the Exchange Act, conducted by the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2004. 

During the quarter ended March 31, 2004, there were no changes in the Company’s internal controls over financial reporting that materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting. 

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. The Company’s disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the Chief Executive Officer and the Chief Financial Officer have concluded that these controls and procedures are effective at the “reasonable assurance” level.

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PART II.  OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

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SIGNATURE

                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. 

Dated: May 14, 2004

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