Scientific Learning
Corporation
(Exact name of registrant as specified in its charter)
| Delaware | 94-3234458 |
| (State or other jurisdiction of incorporation or | (I.R.S. Employer Identification No.) |
| organization) |
300 Frank H. Ogawa
Plaza, Suite 600
Oakland, California 94612
(510) 444-3500
(Address of Registrants principal executive offices, including zip code, and
telephone number, including area code)
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 July 31, 2004 was 16,604,510.
INDEX TO FORM 10-Q
FOR
THE QUARTER ENDED June 30, 2004
Page 2
| June 30, 2004 |
December 31, 2003 |
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| (Unaudited) | ||||||||
| Assets | ||||||||
| Current assets: | ||||||||
| Cash and cash equivalents | $ | 4,438 | $ | 3,648 | ||||
| Accounts receivable, net | 15,760 | 5,117 | ||||||
| Prepaid expenses and other current assets | 922 | 1,134 | ||||||
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| Total current assets | 21,120 | 9,899 | ||||||
| Property and equipment, net | 685 | 537 | ||||||
| Notes receivable from current and former officers | 3,114 | 3,114 | ||||||
| Other assets | 1,939 | 2,004 | ||||||
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| Total assets | $ | 26,858 | $ | 15,554 | ||||
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| Liabilities and stockholders’ deficit | ||||||||
| Current liabilities: | ||||||||
| Accounts payable | $ | 661 | $ | 481 | ||||
| Accrued liabilities | 3,308 | 3,832 | ||||||
| Borrowings under bank line of credit | 3,000 | — | ||||||
| Deferred revenue | 22,826 | 16,233 | ||||||
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| Total current liabilities | 29,795 | 20,546 | ||||||
| Deferred revenue, long-term | 2,267 | 1,289 | ||||||
| Other liabilities | 306 | 285 | ||||||
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| Total liabilities | 32,368 | 22,120 | ||||||
| Stockholders’ deficit: | ||||||||
| Common stock | 75,326 | 74,460 | ||||||
| Accumulated deficit | (80,836 | ) | (81,026 | ) | ||||
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| Total stockholders’ deficit | (5,510 | ) | (6,566 | ) | ||||
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| Total liabilities and stockholders’ deficit | $ | 26,858 | $ | 15,554 | ||||
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See accompanying notes to condensed financial statements.
Page 3
| Three months ended June 30, | Six months ended June 30, | |||||||||||||
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| 2004
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2003
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2004
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2003
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| Revenues: | ||||||||||||||
| Products | $ | 6,014 | $ | 6,217 | $ | 11,327 | $ | 11,548 | ||||||
| Service and support | 1,809 | 1,140 | 3,637 | 2,186 | ||||||||||
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| Total revenues | 7,823 | 7,357 | 14,964 | 13,734 | ||||||||||
| Cost of revenues: | ||||||||||||||
| Cost of products | 465 | 674 | 787 | 1,128 | ||||||||||
| Cost of service and support | 1,201 | 837 | 2,420 | 1,766 | ||||||||||
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| Total cost of revenues | 1,666 | 1,511 | 3,207 | 2,894 | ||||||||||
| Gross profit | 6,157 | 5,846 | 11,757 | 10,840 | ||||||||||
| Operating expenses: | ||||||||||||||
| Sales and marketing | 3,699 | 3,367 | 7,522 | 6,640 | ||||||||||
| Research and development | 820 | 935 | 1,705 | 1,844 | ||||||||||
| General and administrative | 1,212 | 1,284 | 2,223 | 2,396 | ||||||||||
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| Total operating expenses | 5,731 | 5,586 | 11,450 | 10,880 | ||||||||||
| Operating income (loss) | 426 | 260 | 307 | (40 | ) | |||||||||
| Other income from related party | 28 | — | 63 | — | ||||||||||
| Interest expense , net | (97 | ) | (316 | ) | (176 | ) | (625 | ) | ||||||
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| Net income (loss) before income taxes | $ | 357 | $ | (56 | ) | $ | 194 | $ | (665 | ) | ||||
| Provision for income taxes | 4 | — | 4 | — | ||||||||||
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| Net income (loss) | $ | 353 | $ | (56 | ) | $ | 190 | $ | (665 | ) | ||||
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| Basic net income (loss) per share: | $ | 0.02 | $ | (0.00 | ) | $ | 0.01 | $ | (0.04 | ) | ||||
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| Shares used in computing basic net income (loss) | 16,213,427 | 16,004,911 | 16,183,542 | 15,942,365 | ||||||||||
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| Diluted net income (loss) per share: | $ | 0.02 | $ | (0.00 | ) | $ | 0.01 | $ | (0.04 | ) | ||||
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| Shares used in computing diluted net income (loss) | 17,392,637 | 16,004,911 | 17,401,778 | 15,942,365 | ||||||||||
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See accompanying notes to condensed financial statements.
Page 4
| Six months ended June 30, | ||||||||
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| 2004
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2003
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| Operating Activities: | ||||||||
| Net income (loss) | $ | 190 | $ | (665 | ) | |||
| Adjustments to reconcile net income (loss) to cash used in operating activities: | ||||||||
| Depreciation and amortization | 349 | 772 | ||||||
| Amortization of deferred financing costs | 199 | 608 | ||||||
| Stock based compensation | 103 | 144 | ||||||
| Changes in operating assets and liabilities: | ||||||||
| Accounts receivable | (10,643 | ) | (1,653 | ) | ||||
| Prepaid expenses and other current assets | 13 | 552 | ||||||
| Accounts payable | 180 | 132 | ||||||
| Accrued liabilities | (524 | ) | (979 | ) | ||||
| Deferred revenue | 7,571 | 761 | ||||||
| Other liabilities | 21 | 105 | ||||||
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| Net cash used in operating activities | (2,541 | ) | (223 | ) | ||||
| Investing Activities: | ||||||||
| Purchases of property and equipment, net | (355 | ) | (102 | ) | ||||
| Other non-current assets | (77 | ) | (76 | ) | ||||
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| Net cash used in investing activities | (432 | ) | (178 | ) | ||||
| Financing Activities: | ||||||||
| Proceeds from issuance of common stock | 763 | 194 | ||||||
| Borrowings under bank line of credit | 3,000 | 2,000 | ||||||
| Repayments on borrowings under bank line of credit | — | (2,000 | ) | |||||
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| Net cash provided by financing activities | 3,763 | 194 | ||||||
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| Increase (decrease) in cash and cash equivalents | 790 | (207 | ) | |||||
| Cash and cash equivalents at beginning of the period | 3,648 | 4,613 | ||||||
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| Cash and cash equivalents at end of the period | $ | 4,438 | $ | 4,406 | ||||
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| Supplemental disclosure: | ||||||||
| Interest Paid | $ | 29 | $ | 84 | ||||
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See accompanying notes to condensed financial statements.
Page 5
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 June 30, 2004 and for the three and six months ended June 30, 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):
| June 30, 2004 |
December 31, 2003 |
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|---|---|---|---|---|---|---|---|
| Software development costs | $ | 3,089 | $ | 3,089 | |||
| Less accumulated amortization | (2,521 | ) | (2,379 | ) | |||
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| Software development costs, net | 568 | 710 | |||||
| Other non current assets | 1,371 | 1,294 | |||||
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| $ | 1,939 | $ | 2,004 | ||||
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Page 6
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 $1,370,000 through June 30, 2004. The balance of the lease termination fee, $880,000 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 June 30, 2004 (in thousands):
| Accrued
restructuring costs, beginning of the period |
Cash paid
|
Accrued restructuring costs, end of the period |
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|---|---|---|---|---|---|---|---|---|---|---|---|
| Lease obligations | $ | 1,328 | (440 | ) | $ | 888 | |||||
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Net Income (Loss) Per Share
Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Dilutive net income (loss) per share is computed using the weighted average number of common shares outstanding during the period and, when dilutive, includes potential common shares from options and warrants calculated using the treasury stock method.
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, the Company’s net income (loss) and basic and diluted per share amounts would have been impacted as indicated below (in thousands, except per share amounts):
Page 7
| Three months ended June 30, | Six months ended June 30, | |||||||||||||
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| 2004
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2003
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2004
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2003
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| Net income (loss), as reported | $ | 353 | $ | (56 | ) | $ | 190 | $ | (665 | ) | ||||
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| Deduct: Total stock-based employee | ||||||||||||||
| compensation expense determined under | ||||||||||||||
| fair va lue based method for all awards | 454 | 354 | 775 | 712 | ||||||||||
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| Net income (loss), proforma | $ | (101 | ) | $ | (410 | ) | $ | (585 | ) | $ | (1,377 | ) | ||
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| Net income (loss) per share: | ||||||||||||||
| Basic and diluted, as reported | $ | 0.02 | $ | (0.00 | ) | $ | 0.01 | $ | (0.04 | ) | ||||
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| Basic, pro forma | $ | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) | $ | (0.09 | ) | ||
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| Diluted, pro forma | $ | (0.01 | ) | $ | (0.03 | ) | $ | (0.03 | ) | $ | (0.09 | ) | ||
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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 income (loss) for the three and six months ended June 30, 2004 and 2003 is not representative of the effects on net income (loss) for future periods, as future years will include the effects of additional periods of stock option grants.
The Company has no items of other comprehensive income (loss), and accordingly the comprehensive income (loss) is equal to the net income (loss) for all periods reported.
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 June 30, 2004. To date, the Company’s product warranty expense has not been significant.
On 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.
Page 8
For the three and six months ended June 30, 2003 the Company recognized $28,000 and $63,000, respectively, in other income for service provided to NSC and royalties for product licenses.
Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operations
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 and six months ended June 30, 2004, K-12 schools accounted for 93% and 92% of booked sales, respectively. By the end of June 2004, approximately 2,800 schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and approximately 380,000 individuals had enrolled in one of our products. As of June 30, 2004 we had 139 full-time employees, compared to 126 at June 30, 2003.
For the three months ended June 30, 2004, our revenue grew 6% compared to the same period in 2003; for the six months ended June 30, 2004, revenue grew 9% compared to the same period in 2003. Our service and support revenue increased substantially during the three and six months ended June 30, 2004, compared to the same periods in 2003. Product revenues, which comprise the bulk of our revenue, declined slightly during the three and six months ended June 30, 2004 compared to the same periods in 2003.
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 an increased number of customers have renewed their support agreements. We expect service and support revenue to continue to grow more rapidly than product revenue during the remainder of 2004.
The decline in product revenues reflects a shift in sales mix both towards a greater proportion of services and support and toward a greater proportion of software products that have a longer revenue recognition period. We believe that the shift toward services reflects our service initiative, which has resulted in products making up a smaller portion of the typical bundle purchased. The other part of the mix shift reflects the movement of our customers to licenses with Progress Tracker, which are recognized over a longer period than are licenses without Progress Tracker. Progress Tracker, our online monitoring and diagnostic system, connects all levels at a customer to their students’ results, as well as to resources to help them improve their implementations. It also provides us with a detailed view of our customers’ implementations. A high proportion of our customers are now buying licenses with Progress Tracker and we expect that trend to continue into the future.
Booked Sales grew at a much more rapid rate than revenue. For the three months ended June 30, 2004 our total booked sales increased by 65% over the same period in 2003, and for the six months ended June 30, 2004 total booked sales increased 55% over the same period in 2003. (For more explanation on booked sales, see Revenue, below). During the 2004 second quarter, we closed a major contract with the School District of Philadelphia, with a total contract price of $10.4 million. Booked sales for the quarter included $6 million from that transaction. The remainder of the contract’s value represents future years of services and support, and is scheduled to be booked over the next five calendar years.
At June 30, 2004, borrowings under our credit line were $3.0 million compared to $5.0 million at June 30, 2003 and no borrowings at December 31, 2003. The credit line was repaid during July, and at July 31, 2004, we had no outstanding borrowings under the line.
Page 9
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| Three months ended June 30 | Six months ended June 30 | |||||||||||||||||
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| (dollars in thousands) | 2004 | Change | 2003 | 2004 | Change | 2003 | ||||||||||||
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| Products | $ | 6,014 | -3% | $ | 6,217 | $ | 11,327 | -2% | $ | 11,548 | ||||||||
| Service and support | $ | 1,809 | 59% | $ | 1,140 | $ | 3,637 | 66% | $ | 2,187 | ||||||||
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| Total revenues | $ | 7,823 | 6% | $ | 7,357 | $ | 14,964 | 9% | $ | 13,734 | ||||||||
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Revenues: The growth in revenues for the three and six months ended June 30, 2004 reflected an increase in services and support revenues compared to the comparable 2003 periods, partially offset by a decline in product revenues. The product revenue decline reflected the product mix shifts described in “Highlights” above as well as slow sales in the fourth quarter of 2003. In addition, many licenses sold in the second quarter had start dates delayed until the beginning of school in the third quarter. Service and support revenues increased primarily due to increased delivery of on-site services. Service and support revenue also grew as a result of the increase in the number of schools on support contracts.
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 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 six months ended June 30, 2004 and 2003.
| Three months ended June 30 | Six months ended June 30 | ||||||||||||||||
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| (dollars in thousands) | 2004 | Change | 2003 | 2004 | Change | 2003 | |||||||||||
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| Booked sales | $ | 18,154 | 65% | $ | 11,035 | $ | 22,535 | 55% | $ | 14,495 | |||||||
| Less revenue | $ | 7,823 | 6% | $ | 7,357 | $ | 14,964 | 9% | $ | 13,734 | |||||||
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| Net increase in deferred revenue | $ | 10,331 | $ | 3,678 | $ | 7,571 | $ | 761 | |||||||||
| Current and long-term deferred revenue | |||||||||||||||||
| beginning of the period | $ | 14,762 | $ | 12,667 | $ | 17,522 | $ | 15,584 | |||||||||
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| Current and long-term deferred revenue end of | |||||||||||||||||
| the period | $ | 25,093 | 54% | $ | 16,345 | $ | 25,093 | 54% | $ | 16,345 | |||||||
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Booked sales in the K-12 sector, which accounted for 93% of booked sales in the second quarter of 2004, grew 75% to $16.8 million, compared to $9.6 million in the same period in 2003, due to several large transactions, including our major sale to the School District of Philadelphia.
Booked sales to non-school customers, primarily private practice clinicians, declined by $100,000, or 7%, for the three months ending June 30, 2004. For the six months ended June 30, 2004 sales in this sector were down $32,000, or 2%. Sales to non-school customers have declined over the past several years.
During the remainder of 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 second quarter of 2004, we closed 29 sales that had a contract value in excess of $100,000 compared to 21 during the same period in 2003. For the six months ended June 30, 2004 we closed 33 sales in excess of $100,000 compared to 24 during the same period in 2003.
Page 10
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 the rest of 2004. However, achieving 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 limited sales force numbers require 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. During both the three and six months ended June 30, 2004, 2% of our total sales was software recognized at shipment, compared to 4% and 9% for the same periods in 2003. 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.
| Three months ended June 30, | Six months ended June 30, | |||||||||||||||||||||||
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| 2004 | 2003 | 2004 | 2003 | |||||||||||||||||||||
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| (dollars in thousands) | $ Profit
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Margin
%
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$ Profit
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Margin
%
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$ Profit
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Margin
%
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$ Profit
|
Margin
%
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| Gross profit on products | $ | 5,549 | 92% | $ | 5,543 | 89% | $ | 10,540 | 93% | $ | 10,420 | 90% | ||||||||||||
| Gross profit on services and support | $ | 608 | 34% | $ | 303 | 27% | $ | 1,217 | 33% | $ | 420 | 19% | ||||||||||||
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| Total gross profit | $ | 6,157 | 79% | $ | 5,846 | 79% | $ | 11,757 | 79% | $ | 10,840 | 79% | ||||||||||||
The overall gross profit margin was unchanged for the three and six months ended June 30, 2004 compared to the same periods in 2003, as improved margins on 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. Software margins improved due to lower amortization of research and development as well as lower royalty expenses.
In the second quarter of 2004 our mix was 77% product and 23% service and support compared to 85% product and 15% service and support in the same period in 2003. For the six months ended June 30, 2004 our mix was 76% product and 24% service and support compared to 84% product and 16% service and support in the same period in 2003. While in the first quarter of 2004, we incurred higher than planned service costs related to our Gateway Edition products, those higher costs did not continue in the second quarter.
Page 11
| Three months ended June 30, | Six months ended June 30, | |||||||||||||||||||
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| (dollars in thousands) | 2004 | Change | 2003 | 2004 | Change | 2003 | ||||||||||||||
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| Sales and marketing | $ | 3,699 | 10% | $ | 3,367 | $ | 7,522 | 13% | $ | 6,640 | ||||||||||
| Research and development | $ | 820 | -12% | $ | 935 | $ | 1,705 | -8% | $ | 1,844 | ||||||||||
| General and administrative | $ | 1,212 | -6% | $ | 1,284 | $ | 2,223 | -7% | $ | 2,396 | ||||||||||
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| Total operating expenses | $ | 5,731 | 3% | $ | 5,586 | $ | 11,450 | 5% | $ | 10,880 | ||||||||||
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Sales and Marketing Expenses: For the three and six months ended June 30, 2004, our sales and marketing expenses increased due to additional staff, use of consultants, temporary staff, and marketing expenses. At June 30, 2004, we had 26 quota-bearing sales personnel selling to public schools. During the remainder of 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 three and six months ended June 30, 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. Higher 2003 spending was due to expenses associated with a June 2003 product launch. We expect that research and development spending will increase in the second half of 2004 and, for the full year 2004, to be higher than 2003.
General and Administrative Expenses: General and administrative expenses decreased for the three and six months ended June 30, 2004 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.
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 second quarter of 2004 we recorded $12,500 in royalties received and $15,000 for services provided to NSC. For the first half of 2004, we have recorded $25,000 in royalties and $37,500 for services provided. 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.
| Three months ended June 30, | Six months ended June 30, | |||||||||||||||||||
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| (dollars in thousands) | 2004 | Change | 2003 | 2004 | Change | 2003 | ||||||||||||||
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| Interest income/(expense), net | ($97 | ) | -69% | ($316 | ) | ($176 | ) | -72% | ($625 | ) | ||||||||||
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Interest expense, net decreased for the three and six months ended June 30, 2004 compared to the same period in 2003 primarily because of lower amortization of deferred financing charges related to warrants issued in connection with earlier borrowing and lower borrowing in 2004 compared to 2003. The amortization of deferred financing charges was $99,000 and $199,000 for the three and six months ended June 30, 2004 compared to $304,000 and $608,000 for the same periods in 2003. The amortization of deferred financing charges will be complete in the quarter ending September 30, 2004.
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In the three months ending June 30, 2004, we recorded a tax provision in the amount of $4,000 relating to federal alternative minimum tax. The tax provision is based upon our estimate of the full year effective rate for the Company. There were no corresponding charges in the 2003 periods, as we had no taxable income.
Our cash and cash equivalents were $4.4 million at June 30, 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. All amounts outstanding under the credit facility were repaid during July 2004, and we do not expect to borrow under the credit facility during the remainder of 2004.
Net cash used in operating activities for the six months ended June 2004, was $2.5 million versus $223,000 during the same period in 2003. Payments for previously expensed restructuring charges were $440,000 and $885,000 for the three and six months ended June 30, 2004 and $467,000 and $1.0 million for the same periods in 2003. Cash generated was lower in 2004 as many of large sales were closed in the final days of the quarter, significantly increasing the accounts receivable balance compared to year end 2003.
Net cash used in investing activities for the six months ended June 30, 2004 was $432,000 compared to $178,000 for the same period in 2003. Spending in this area primarily consists of purchases of computer hardware and software. We expect that our capital spending will be higher in 2004 than in 2003, reflecting the purchase of new business systems software as well as additional computer hardware.
For the six months ended June 30, 2004 we borrowed $3.0 million under our bank line of credit. This compared to no net borrowing during the six month period ending June 30, 2003. As of July 31, 2004 we have approximately $10 million of cash and no borrowings outstanding under the line of credit, reflecting the collection of several large accounts receivable that were outstanding at June 30, 2004.
We have a line of credit with Comerica Bank totaling $7.0 million, which expires on January 14, 2005. The facility was partially secured by a letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus Ventures, our largest stockholder. The letter of credit was for $4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to July 30, 2004. 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. To date, we are in compliance with all covenants. The WPV line of credit expired on July 30, 2004.
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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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 June 30, 2004 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.
| (dollars in thousands) | Total | Less
than 1 year |
1 - 3 years | 4 - 5 years | Thereafter (1.) | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
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| Lease termination agreement | 888 | 888 | — | — | — | ||||||||||||
| Borrowing under bank line of credit | 3,000 | 3,000 | — | — | — | ||||||||||||
| Non-cancelable operating leases | 9,636 | 940 | 1,880 | 1,902 | 4,914 | ||||||||||||
| Minimum royalty payments | 1,500 | 150 | 300 | 300 | 750 | ||||||||||||
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| Total | $ | 15,024 | $ | 4,978 | $ | 2,180 | $ | 2,202 | $ | 5,664 | |||||||
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(1.) Non-cancelable operating leases expire December 31, 2013. Minimum royalty payments expire in 2014.
Our purchase order commitments at June 30, 2004 are not material.
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 June 30, 2004 was $3.6 million. Accrued interest of $496,000 for the periods ending June 30, 2004 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.
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.
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.
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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. Historically, 20%-30% of software licenses, services and support invoiced in a particular quarter have been recognized as revenue during that period. During the second quarter of 2004, this percentage declined to approximately 10% because more of our customers bought licenses that included our Progress Tracker monitoring and diagnostic system and many licenses purchased in the second quarter had start dates in August or September to coincide with the start of the school year. Going forward, we expect the majority of our software license sales to include Progress Tracker. Revenue from such sales will be recognized over a 12-month period.
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 85%-90% of our account receivable balance was included in deferred revenue.
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 2003 and the first half of 2004 our bad debt experience has been less than 1% of revenue. To the extent experience requires it, we may in the future adjust this reserve. For the second quarter of 2004, the reserve calculation was adjusted down, because at the time of estimating the allowance, several large accounts had already paid the balances outstanding at June 30. Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.
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.
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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 June 30, 2004 future revenues from sale of products for which development costs remain on the balance sheet are anticipated to exceed the $568,000 of unamortized development costs. No software development costs were capitalized in the three or six months ended June 30, 2004 or 2003.
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.
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, 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.
| • | Our products are novel to many educators, and have many attributes that are not common to educational software. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach. |
| • | Implementing our products in schools requires a substantial amount of time in a limited school day. Our new protocols have greatly reduced the daily time required to use our program, significantly decreasing one of the most critical challenges in broadly implementing our products. However, implementing the products still requires a substantial time commitment, which can be difficult for schools. |
| • | We have not yet widely demonstrated implementation models that are scalable, acceptable to educators and profitable, while remaining highly effective in improving student achievement. |
| • | We need to continue and expand our demonstration to educators that our products significantly improve student achievement. Unless our products are implemented well and used in accordance with one of our protocols, they may not achieve the desired student achievement results. |
The availability of government funding for public school reading intervention purchases, and for our products in particular, is uncertain.
| • | We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, so continuing to qualify for major sources of federal funding is critical to our sales success. The current federal budget deficit may impact the availability of federal education funding. |
| • | The general availability of funding for public schools fluctuates from time to time. State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. Since 2002, the education technology industry has generally experienced soft sales, frequently attributed to tight funding. We expect that future levels of state and local school spending will be significantly affected by the economic conditions and outlook. |
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| • | Public school calendars and budget cycles have caused, and we expect them to continue to cause, substantial quarterly fluctuations in sales and revenues. Like other companies in the instructional market, our sales to K-12 schools are typically particularly slow in the first quarter. |
| • | Demand for our products through private clinicians tends to be lower during the school year than in the summer, because our products’ intensive nature can be more conducive to use during school vacation. |
| • | In K-12 schools, the cost of some of our license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that is difficult to predict. When a district decides to finance its license purchases, the time required to obtain these approvals can be extended even further. |
We may experience difficulties in launching new products efficiently, on schedule and without significant technical issues.
| • | We are developing additional products in our Fast ForWord to Reading series as part of our strategy to reach mainstream reading intervention customers. Unexpected challenges could make these development projects longer or more expensive. |
| • | New technology products usually contain bugs that were not discovered in the testing process and tend to be more challenging to implement when they are first introduced, especially in the diverse and challenging K-12 technology environment. During the second quarter of 2003, we launched the new Gateway Edition of our major products. Although our customers received the added features and benefits of the Gateway Edition enthusiastically, we encountered technical issues with the new release that required significant time from our sales and service teams. This led to additional service and support costs, and slowed the purchasing decisions for a number of transactions, resulting in lower than expected fourth quarter sales and higher than planned service costs in the first quarter of 2004. |
| • | Introduction of new products can slow sales as customers take additional time to evaluate the new offering or wait until the new offering has been available for some period before purchasing. |
The factors discussed above could materially and adversely affect our business, results of operations, financial condition and the trading price of our stock.
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 June 30, 2004 would not have a material affect on our results of operations.
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 June 30, 2004.
During the quarter ended June 30, 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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On June 7, 2004, the Company held its annual meeting of stockholders. At the meeting, the following matters were voted upon.
Proposal 1 — Election of Directors. Each of the three nominees was elected, as follows:
| Nominee | Vote for Nominee | Vote Withheld from Nominee |
| Robert C. Bowen | 15,353,009 | 86,827 |
| Joseph B. Martin | 15,356,613 | 83,223 |
| Edward Vermont Blanchard, Jr. | 15,421,707 | 18,129 |
The other directors whose term of office as a director continued after the meeting are: Ajit Dalvi, Carleton A. Holstrom, Michael M. Merzenich, and Rodman W. Moorhead III and Paula A. Tallal.
Proposal 2. Approval of the Company’s 1999 Equity Incentive Plan and Milestone Equity Incentive Plan, as amended to increase the number of shares authorized for issuance under the Plans by 850,000 shares. The proposal was passed, as follows:
| Votes For | 11,649,639 | |
| Votes Against | 112,586 | |
| Abstentions | 7,002 | |
| Broker Non-Votes | 3,670,609 |
Proposal 3. Approval of the aggregate number of shares reserved under all of the Company’s equity incentive and purchase plans in order to comply with California securities laws. The proposal was passed, as follows:
| Votes For | 11,644,468 | |
| Votes Against | 117,757 | |
| Abstentions | 7,002 | |
| Broker Non-Votes | 3,670,609 |
(a) Exhibits
| Exhibit No. | Description of Document | ||
|
|
|
||
| 3.1(1) | Restated Certificate of Incorporation. | ||
| 3.2(2) | Amended and Restated Bylaws. | ||
| 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 3.3 previously filed with the Company’s Registration Statement on Form S-1 (SEC File No. 333-77133). |
| (2) | Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003 (SEC File No. 000-24547). |
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| (b) | Reports on Form 8-K. |
| i. | On April 27, 2004, the Company filed a Report on Form 8-K furnishing its press release announcing its financial results for the quarter ended March 31, 2004 and the transcript of its conference call discussing those earnings. |
| ii. | On June 15, 2004, the Company filed a Report on Form 8-K disclosing actions that could be viewed as waivers of its Code of Conduct with respect to previously-disclosed historical transactions involving ongoing conduct, as required by Nasdaq interpretations. |
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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: August 13, 2004
| SCIENTIFIC LEARNING CORPORATION (Registrant) /s/ Jane A. Freeman —————————————— Jane A. Freeman Chief Financial Officer (Authorized Officer and Principal Financial and Accounting Officer) |
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| Exhibit No. | Description of Document | ||
|
|
|
||
| 3.1(1) | Restated Certificate of Incorporation. | ||
| 3.2(2) | Amended and Restated Bylaws. | ||
| 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 3.3 previously filed with the Company’s Registration Statement on Form S-1 (SEC File No. 333-77133). |
| (2) | Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003 (SEC File No. 000-24547). |
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