Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended March 31, 2005.

For the transition period from              to             .

Commission File No. 000-50570

ALPHASMART, INC.

(Exact name of registrant as specified in its charter)

973 University Avenue

Los Gatos, CA 95032

(408) 355-1000

(Address, including zip code, of principal executive offices, 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 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

As of May 4, 2005, there were 14,910,215 shares of the Registrant’s Common Stock outstanding.

Table of Contents

ALPHASMART, INC.

INDEX

2

Table of Contents

PART I

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS (unaudited)

ALPHASMART, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

Table of Contents

ALPHASMART, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

Table of Contents

ALPHASMART, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE LOSS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

5

Table of Contents

ALPHASMART, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

6

Table of Contents

ALPHASMART, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1 — BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of AlphaSmart, Inc. (the “Company” or “AlphaSmart”) and related notes include, in the opinion of management, all adjustments (consisting only of normal recurring adjustments) that are necessary for a fair statement of the financial position and statements of stockholders’ equity as of March 31, 2005 and December 31, 2004, and the results of operations and cash flows for the three months ended March 31, 2005 and 2004. This Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements and related notes included in our Form 10-K/A filed with the Securities and Exchange Commission on April 15, 2005. The results of operations for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the entire 2005 fiscal year, which ends on December 31, 2005, or any other future period.

In accordance with the rules and regulations of the Securities and Exchange Commission, unaudited condensed consolidated financial statements may omit or condense certain information and disclosures normally required for a complete set of financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. The condensed consolidated balance sheet at December 31, 2004 was derived from audited financial statements, but does not include all disclosures required by GAAP. We believe that the notes to the condensed consolidated financial statements contain disclosures adequate to make the information presented not misleading.

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary AlphaSmart Europe Limited, which was incorporated in the United Kingdom. All significant intercompany transactions and account balances between AlphaSmart, Inc. and AlphaSmart Europe Limited have been eliminated.

Foreign Currency Translation

The functional currency of the Company’s subsidiary is the British Pound. Assets and liabilities are translated using the exchange rate in effect at the balance sheet date and revenue and expense accounts are translated at the average exchange rate during the period. Resulting translation adjustments are recorded directly to accumulated other comprehensive income (loss).

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ materially from these estimates.

Inventory

Inventory, which includes raw materials and finished goods, is stated at the lower of cost or market with cost being determined using the first in, first out (“FIFO”) method.

7

Table of Contents

Inventory consisted of the following (in thousands):

Warranty Accrual

The Company’s products carry a limited warranty ranging from one to three years that includes repair services or replacement parts as needed. The Company accrues estimated expenses for warranty obligations at the time that products are shipped based on historical experience and the Company’s estimate of the level of future costs. The factors that affect the Company’s warranty liability include the number of units sold, historical rates of warranty claims and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. Warranty costs are included in the accompanying condensed consolidated statements of operations under cost of revenue.

Changes in the Company’s estimated product warranty liability during the three months ended March 31, 2005 and 2004 were as follows (in thousands):

Revenue Recognition

Revenue is recognized when it is earned in accordance with applicable accounting standards, including Statement of Position No. 97-2, “Software Revenue Recognition,” as amended. The Company recognizes revenue from the sale of its devices and software upon shipment to the customer, provided at the time of shipment there is persuasive evidence of an arrangement with the customer, the fee is fixed or determinable, collection of the receivable is reasonably assured, and there are no remaining unfulfilled obligations.

Revenue recognized is net of an estimated amount for the return of devices and software. The Company measures estimated future returns related to the current period by analyzing historical returns, current economic trends and changes in customer demand and acceptance of its devices and software.

The Company does not provide free updates to its devices or software, however the Company does provide limited customer support, which includes email and phone support as well as software bug fixes which can be downloaded from its website. The Company accrues for the costs associated with providing such customer support as part of cost of revenue at the time the revenue is recognized.

Software Development Costs

Software development costs have been accounted for in accordance with Statement of Financial Accounting Standards, or “SFAS”, No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed.” Costs incurred in the research and development of new products and enhancements to existing products are charged to expense as incurred until technological feasibility of the product or enhancement has been established through the inclusion of a detailed program design. Capitalized development costs are amortized to cost of revenue over the estimated useful life of the product. The Company had $347,000 and $351,000 of capitalized software development costs included in other assets as of March 31, 2005 and December 31, 2004, respectively, and recorded $4,000 and $0 as amortization expense during the three months ended March 31, 2005 and 2004, respectively.

8

Table of Contents

Segment Reporting

The Financial Accounting Standards Board or “FASB” issued SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” which establishes annual and interim reporting standards for an enterprise’s business segments and related disclosures about its products, services, geographical areas and major customers. The method of determining what information to report is based on the way management organizes the operating segments within the Company for making operating decisions and assessing financial performance.

The Company’s chief operating decision-maker is considered to be the Chief Executive Officer (“CEO”). The CEO reviews financial information for purposes of making operational decisions and assessing financial performance. This financial information is consistent with the information presented in the accompanying statements of operations. The Company operates in one reportable segment, the education market.

Stock-Based Compensation

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123” (or “SFAS No. 148”), which amends FASB Statement No. 123, “Accounting for Stock-Based Compensation” (or “SFAS No. 123”), to provide alternative methods of transition for voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods ending after December 15, 2002. The Company uses the intrinsic value method of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” in accounting for its employee stock options, and presents disclosure of pro forma information required under SFAS No. 123, “Accounting for Stock-Based Compensation.”

Had compensation cost for the Company’s stock option grants to employees been determined based on the fair values of the stock option at the date of grant consistent with the provisions of SFAS No. 123, the Company’s net income would have changed to the pro forma amounts as follows (in thousands, except per share data):

9

Table of Contents

Comprehensive Income

Comprehensive income (loss) includes foreign currency translation adjustments, the impact of which has been excluded from net income (loss) and reflected as equity. The component of comprehensive income (loss) is reported on the Company’s condensed consolidated statements of stockholders’ equity.

A summary of comprehensive income (loss) is as follows (in thousands):

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board or “FASB” issued Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment. The new pronouncement replaces the existing requirements under SFAS No. 123 and APB 25. According to SFAS No. 123(R), all forms of share-based payments to employees, including employee stock options and employee stock purchase plans, would be treated the same as any other form of compensation by recognizing the related cost in the statement of operations. This pronouncement eliminates the ability to account for stock-based compensation transactions using APB No. 25 and generally would require that such transactions be accounted for using a fair-value based method. On April 14, 2005, the Securities and Exchange Commission (SEC) announced the adoption of a new rule that amended the compliance dates for SFAS No. 123(R). Under the new rule, companies are allowed to implement SFAS No. 123(R) at the beginning of the next fiscal year, instead of the next reporting period, that begins after June 15, 2005. SFAS No. 123(R) provides transition alternatives for public companies to restate prior interim periods or prior years. The Company is in the process of evaluating the impact of this standard on its financial statements and will implement SFAS No. 123(R) for the fiscal year beginning January 1, 2006.

NOTE 3 — NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average number of vested common shares outstanding for the period. Diluted net income per share is computed giving effect to all potential dilutive common stock, including options, common stock subject to repurchase and redeemable convertible preferred stock.

10

Table of Contents

A reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) per share is as follows (in thousands):

For the three months ended March 31, 2005, the company excluded all outstanding options and shares subject to repurchase, totaling 711,000 shares, from the calculation of diluted weighted average shares outstanding as the effect was anti-dilutive. For the three months ended March 31, 2004, approximately 487,000 common stock options were excluded from the calculation of diluted weighted average shares outstanding as the effect was anit-dilutive due to the exercise prices of these options being greater than the average market price of the common shares for the period.

NOTE 4 — BORROWINGS

The Company had a revolving line of credit with a bank in the amount of $3.0 million, which was terminated by the Company and the lender in April 2005. At March 31, 2005 the Company had no outstanding balance under this line of credit.

NOTE 5 — MANDATORILY REDEEMABLE PREFERRED STOCK

During 1999, the Company authorized and issued 100,000 shares of mandatorily redeemable preferred stock at a price of $69.46 per share. In accordance with the terms of the Company’s certificate of incorporation, the Company, within 10 days of the closing of an initial public offering of the Company’s common stock, was obligated to redeem the outstanding shares for the redemption proceeds of $69.46 per share plus all accrued and unpaid dividends and such additional amount as was necessary to increase the aggregate redemption proceeds to $103.35 per share. Within 10 days of the closing of the Company’s initial public offering on February 11, 2004, all 100,000 shares of mandatorily redeemable preferred stock were redeemed for an aggregate amount of $10,335,000.

NOTE 6 — CONTINGENCIES AND COMMITMENTS

Claims

On November 20, 2003, one of AlphaSmart’s contract manufacturers, Wolf Electronix, Inc. (“Wolf”), filed a lawsuit against AlphaSmart in United States District Court for the District of Utah, alleging that AlphaSmart breached its contract with Wolf and violated a U.S. federal antidiscrimination statute by no longer using Wolf for volume order manufacturing. Wolf was seeking an injunction and unspecified damages in connection with its complaint. On December 17, 2003, AlphaSmart answered the complaint and denied Wolf’s allegations. On April 7, 2005, AlphaSmart and Wolf engaged in a court-ordered settlement conference, and on April 11, 2005, the Company and Wolf agreed to settle the lawsuit. The terms of the settlement require the Company to make a net payment of $355,000 after recovery from insurers, in full settlement of the lawsuit, which has been fully accrued at March 31, 2005. Pursuant to the parties’ settlement agreement, a stipulation dismissing the lawsuit with prejudice was filed on April 19, 2005. The court dismissed the lawsuit on April 28, 2005.

11

Table of Contents

From time to time AlphaSmart is involved in litigation arising out of claims in the normal course of business. Based on the information presently available, including discussion with outside legal counsel, AlphaSmart believes that there are no claims or actions pending or threatened against us, the ultimate resolution of which will have a material adverse effect on AlphaSmart’s financial position, liquidity or results of operations.

Commitments

The Company has entered into operating leases for its facilities with original terms ranging from one to five years. The Company has also entered into royalty agreements with rights to license software and technology used in its products with future minimum royalty payments. At March 31, 2005, the future minimum lease payments under all noncancelable leases and sub-leases and minimum royalty payments having initial terms longer than one year are as follows (in thousands):

NOTE 7 — INCOME TAXES

Deferred tax assets and liabilities result primarily from temporary timing differences between book and tax valuation of assets and liabilities. The provision for income taxes reflects the estimated annualized effective tax rate applied to earnings including the effect of treating estimated nondeductible merger related expenses, totaling $1.1 million, as a discrete item in the quarter. The Company has recorded an effective tax benefit rate of 12% for the first quarter. In addition, the calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax regulations. The Company records liabilities for anticipated tax audit issues based on its estimate of whether, and the extent to which additional taxes may be due. Actual tax liabilities may be different than the recorded estimates and could result in an additional charge or benefit to the tax provision in the period when the ultimate tax assessment is determined.

12

Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding:

These statements involve risks and uncertainties as well as assumptions that, if they were to never materialize or prove incorrect, could cause actual results to differ materially from those projected, expressed or implied in the forward-looking statements. These risks and uncertainties include those set forth under “Factors That May Affect Future Results of Operations” below and elsewhere in this Form 10-Q and that are otherwise described from time to time in AlphaSmart’s filings with the Securities and Exchange Commission.

Overview

We provide affordable, portable personal learning solutions for the K-12 classroom. Our portable personal learning solutions include computer-companion products that are designed to improve and assess students’ academic skills, increase teachers’ classroom productivity, and reduce administrators’ total cost of ownership for district-wide technology literacy and access. Our computer-companion products are based on three rugged hardware platforms: the Neo by AlphaSmart, the Dana by AlphaSmart and the AlphaSmart 3000 platform that we sell to schools and school districts. An AlphaSmart solution consists of these devices with integrated keyboard, display, and proprietary or licensed operating system and basic application software. They are further enhanced with instructional and assessment software for specific educational subjects as well as management tools for teachers.

On January 24, 2005 we entered into an Agreement and Plan of Merger and Reorganization with Renaissance Learning, Inc. Under the terms of this agreement, Renaissance Learning, Inc. will acquire AlphaSmart in a two step-merger, and each of our stockholders will be entitled to receive $3.75 for each share of our common stock, with the option to be paid in cash, Renaissance Learning, Inc. common stock or some combination of the two, subject to pro-ration so that the total consideration paid will aggregate no more than 45% stock and no less than 55% cash. Renaissance Learning, Inc. intends to operate the AlphaSmart business in a wholly owned subsidiary, and the merger is expected to close sometime in the second quarter of 2005.

We began shipping our first generation product, called the AlphaSmart, in 1993. Our second-generation product, the AlphaSmart Pro, began shipping in 1995, followed by the AlphaSmart 2000 in 1997. Each of these products was a single purpose device designed to aid students in learning keyboarding and writing skills. In 2000, we introduced one of our current platforms, the AlphaSmart 3000, the first device that could be updated with additional proprietary, third party and licensed applications, which we call SmartApplets. In 2001, we added our management tools, which include administrative software, a mobile cart and a USB hub, which we call the AlphaHub. The AlphaHub enables teachers to configure a group of up to 30 AlphaSmart 3000s in the cart and to manage the devices from a single PC in the classroom. In 2001, we began selling SmartOption Bundles, which include up to 30 devices and related management tools. In October 2002, we began shipping our Palm OS-based platform, the Dana by AlphaSmart, directed at the higher grade levels in the K-12 market, while still continuing to ship the AlphaSmart 3000, which has been more successful at the lower grade levels. We began shipping the Dana Wireless in August 2003 and our newest product, Neo by AlphaSmart, in August 2004. Neo has a 50% larger screen, enhanced system software, new font technology and twice the memory, compared to its predecessor, the AlphaSmart 3000.

13

Table of Contents

Net Revenue. Our net revenue is derived primarily from the sale of the AlphaSmart 3000, Neo by AlphaSmart and Dana by AlphaSmart platforms, either on an individual device basis or as part of a bundle. We have sold our devices in over 8,500 of the approximately 15,000 U.S. school districts and, in the three months ended March 31, 2005 and 2004, more than 80% of our net revenue was from districts to which we had previously sold devices.

Because the U.S. K-12 budget cycle runs from July 1 through June 30 each year, our net revenue tends to be highest in the second calendar quarter of each year, as schools spend the remaining funds in the current year budget. We also generally see a slow down in spending in July and early August of each year, followed by an increase in late August and early September as the new school year commences. As a result, we typically expect our net revenue to be higher in the second and third calendar quarters of each year than in the first and fourth calendar quarters.

We sell to schools and school districts, both directly and through value-added resellers, or VARs, and through international distribution channels. Until June 30, 2003, we also sold through our catalog-based channel. Direct sales were 79% of our net revenue in the three months ended March 31, 2005 and 83% in the three months ended March 31, 2004. As of June 30, 2003, we discontinued our domestic catalog-based channel and added several new direct sales employees. International sales were 18% of our net revenue in the three months ended March 31, 2005 and 15% in the three months ended March 31, 2004. In the international markets we intend to continue to sell through our reseller channels as well as direct sales employees.

Cost of Revenue; Gross Margin. Cost of revenue consists of:

A third party manufacturer manufactures our devices. Accordingly, a significant portion of our cost of revenue consists of payments to this party manufacturer. We also provide a limited three-year warranty on the AlphaSmart 3000 and Neo by AlphaSmart platforms, and a limited one-year warranty on the Dana by AlphaSmart platform. We estimate and record the cost of the warranty at the time of sale.

Our gross margin has been and will be affected by a variety of factors, including the mix and average selling price of our products, the cost of components and manufacturing labor, the cost of third party software, fluctuations in volume, competition, warranty and support costs, component shortages and the mix of distribution channels through which our products are sold. Our Dana platform, which we began shipping in October 2002, carries a higher average selling price and a lower gross margin percentage than our AlphaSmart 3000 and Neo by AlphaSmart platforms.

Research and Development. Research and development expense consists primarily of salaries and related overhead expense for development and engineering personnel, fees paid to consultants and outside contractors, and prototype costs related to the design, development, testing and enhancement of the AlphaSmart platforms. We expense our research and development costs as they are incurred or capitalize them under SFAS No. 86 where appropriate.

Sales and Marketing. Sales and marketing expense consists primarily of salaries, commissions and related overhead expense for personnel engaged in marketing and sales and costs associated with promotional and other marketing activities.

General and Administrative. General and administrative expense consists primarily of salaries and related overhead expense for executive, finance, accounting, information technology and human resources personnel; accounting and legal fees; merger related costs; and other corporate expense.

Other Expense. Other expense relates primarily to interest payments on outstanding balances on our term loan and revolving line of credit with a bank, as well as interest accretion, and premium, under our mandatorily redeemable preferred stock. For further discussion regarding these obligations, you should read “Liquidity and Capital Resources.” In the first quarter of 2004, we used a portion of the proceeds of our 2004 public offering to repay the term loan in its entirety and to fully redeem the mandatorily redeemable preferred stock, including accrued dividends and a redemption premium.

14

Table of Contents

Provision for Income Taxes. Deferred tax assets and liabilities result primarily from temporary timing differences between book and tax valuation of assets and liabilities. The provision for income taxes reflects the estimated annualized effective tax rate applied to earnings including the effect of treating estimated nondeductible merger related expenses as a discrete item in the quarter. In addition, the calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax regulations. The Company records liabilities for anticipated tax audit issues based on its estimate of whether, and the extent to which, additional taxes may be due. Actual tax liabilities may be different than the recorded estimates and could result in an additional charge or benefit to the tax provision in the period when the ultimate tax assessment is determined.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue Recognition. Revenue is recognized when it is earned in accordance with applicable accounting standards, including Statement of Position No. 97-2, “Software Revenue Recognition,” as amended. We recognize revenue from the sale of our devices and software upon shipment to the customer, provided at the time of shipment there is persuasive evidence of an arrangement with the customer, the fee is fixed or determinable, collection of the receivable is reasonably assured and there are no remaining unfulfilled obligations.

Revenue recognized is net of an estimated amount for the return of devices and software. We measure estimated future returns related to the current period by analyzing historical returns, current economic trends and changes in customer demand and acceptance of our devices and software. The balance of our allowance for sales returns was $29,000 as of March 31, 2005.

We do not provide free updates to our devices or software; however, we do provide limited customer support through our technical support and repair center, located in Red Bluff, California, as well as our customer service center in Irving, Texas and the customer care and logistics center in Stockton-on-Tees, United Kingdom, which include email and phone support. In addition, we offer software bug fixes which can be downloaded from our website. We accrue for the costs associated with providing such customer support as a cost of revenue at the time the revenue is recognized.

Allowance for Doubtful Accounts. We assess collection risk based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. We do not request collateral from our customers. If we determine that collection of a fee is not reasonably assured, we defer the fee and recognize net revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash. We also maintain allowances for doubtful accounts for estimated collection risk losses resulting from the inability of our customers to make required payments. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The balance of the allowance for doubtful accounts was $92,000 as of March 31, 2005.

Obsolete or Slow-Moving Inventory. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Prepaid Royalties. In some cases where we pre-pay our royalties relating to the licensing of third party software, amortization is recorded based on the number of units shipped times royalty cost per-unit basis. The royalty cost per unit is computed using estimates of expected sales over the life of the licensing contract. In the event of a significant decline in the estimated sales, we would have to accelerate the amortization of prepaid royalties by increasing the royalty cost per unit for future periods. For example, in the fourth quarter of 2004, we incurred a charge related to revisions of our estimates under our agreement with PalmSource, Inc.

Warranty Accrual. We provide for the estimated cost of product warranties at the time net revenue is recognized. While we engage in product quality programs and processes, including monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. If actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. The balance of the reserve for warranty obligations was $253,000 as of March 31, 2005.

15

Table of Contents

Valuation Allowance for Deferred Tax Assets. We have not recorded a valuation allowance to reduce our deferred tax assets, as we believe those assets are more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be not able to realize our deferred tax assets in the future in excess of our net recorded amount, a valuation allowance may be necessary and may decrease income in the period such a determination is made.

Results of Operations

The following table sets forth the percentage of consolidated net revenue represented by items in our condensed consolidated income statements for the periods presented:

Three Months Ended March 31, 2005 and 2004

Net Revenue

Net revenue from the sale of our products decreased by 20.5% to $7.0 million for the three months ended March 31, 2005, from $8.8 million for the three months ended March 31, 2004. We believe the decrease in net revenue resulted from softness in technology spending in the K-12 education market generally, as well as increased customer demand for solutions that meet specific education needs, which increased competitive pressure on our platforms, particularly the Dana platform, which faced increased competitive pressure from PCs. Dana shipments accounted for approximately 27% of net revenue for the three months ended March 31, 2005 compared to 29% for the three months ended March 31, 2004. U.S. sales accounted for 82% of our net revenue for the three months ended March 31, 2005 and 85% of our net revenue for the three months ended March 31, 2004. Net revenue from our direct sales channels accounted for 79% of our net revenue for the three months ended March 31, 2005 and 83% of our net revenue for the three months ended March 31, 2004. We expect the trends toward increased international revenue and decreased direct sales revenue to continue over the remainder of 2005.

16

Table of Contents

Gross Margin

Gross margin was 47.7% for the three months ended March 31, 2005 compared to 51.3% for the three months ended March 31, 2004. The decrease was due primarily to a combination of higher royalty costs on the Dana and lower revenue on fixed overhead costs. We expect margins to trend slightly higher over the next couple quarters as a result of higher revenue trends in our second and third quarters measured against fixed overhead costs.

Research and Development

Research and development expense decreased 17.7% to $505,000 for the three months ended March 31, 2005, from $614,000 for the three months ended March 31, 2004. As a percentage of net revenue, research and development expenses increased to 7.2% for the three months ended March 31, 2005 from 7.0% for the same period in 2004. The decrease was primarily a result of a reduction in bonuses of $33,000 and cost savings of $70,000 due to the consolidation of research and development facilities. We expect research and development costs to increase marginally in absolute dollars as we continue to invest in new product development over the remainder of 2005.

Sales and Marketing

Sales and marketing expense was $1.8 million for each of the three month periods ended March 31, 2005 and 2004. As a percentage of net revenue, sales and marketing expenses increased to 25.8% for the three months ended March 31, 2005 from 21.0% for the same period in 2004. We expect sales and marketing expense to increase marginally in absolute dollars over the remainder of 2005.

General and Administrative

General and administrative expense increased 138.7% to $2.3 million for the three months ended March 31, 2005, from $977,000 for the three months ended March 31, 2004. As a percentage of net revenue, general and administrative expenses increased to 33.4% for the three months ended March 31, 2005 from 11.1% for the same period in 2004. The increase was primarily due to $990,000 of merger related expenses and $417,000 of litigation and settlement expenses to settle the Wolf lawsuit. We expect general and administrative expense to decrease significantly, as we expect to complete our proposed merger with Renaissance Learning, Inc. during the second quarter of 2005.

Other Expense, net

Other expense decreased to $20,000 for the three months ended March 31, 2005 compared to $623,000 for the three months ended March 31, 2004, primarily reflecting $588,000 of premium and interest expense on the redemption of mandatorily redeemable preferred stock for the three months ended March 31, 2004. We expect other expense to remain relatively flat or to fluctuate slightly due to currency exchange rates for the remainder of 2005.

Provision for Income Taxes

We accrued income taxes at an effective tax benefit rate of 12% for the three months ended March 31, 2005 and an effective tax rate of 86% for the three months ended March 31, 2004. For the three months ended March 31, 2005, the difference between the federal rate of 34% and the effective benefit rate used is primarily due to state income taxes and the impact of treating the nondeductible merger related expenses incurred as a discrete item in the quarter, offset by research and development credits. For the three months ended March 31, 2004, the difference between the federal rate of 34% and the effective rate used is primarily due to state income taxes and the impact of treating the nondeductible premium and interest expense incurred on the redemption of the mandatorily redeemable preferred stock as a discrete item in the quarter, offset by research and development credits. We expect the effective tax rate to be higher in Q2 due to additional nondeductible merger costs. We will continue to assess the impact of the merger costs on future quarters and adjust the tax rate accordingly.

Liquidity and Capital Resources

As of March 31, 2005, cash and cash equivalents totaled $2.9 million, compared to $4.1 million as of December 31, 2004. Cash equivalents are short-term, interest-bearing, investment-grade securities with original or remaining maturities of ninety days or less as of the date of purchase.

Net cash used in operating activities was $1.3 million for the three months ended March 31, 2005 and consisted primarily of our net loss of $1.2 million and an increase in other current assets of $1.4 million, partially offset by an increase in accrued liabilities. The increase in other current assets related primarily to the increase in amounts due from our contract

17

Table of Contents

manufacturer, amounts recoverable from our insurer in connection with our lawsuit settlement with Wolf Electronix, Inc., and merger related costs. The increase in accrued liabilities related primarily to merger related costs and settlement costs from our lawsuit with Wolf Electronix, Inc. For the three months ended March 31, 2004, net cash used in operating activities was $470,000 and consisted primarily of a net change in assets and liabilities of $1.2 million, partially offset by depreciation and amortization of $108,000 and premium and interest expense on mandatorily redeemable preferred stock of $588,000. The increase in accounts receivable of $1.1 million related to increased shipments at quarter end, the increase in other current assets of $1.0 million related primarily to prepaid royalties, the reduction in other assets of $1.5 million related to costs netted against proceeds from our initial public offering, and the net reduction in accounts payable and accrued liabilities of $632,000 related primarily to the payment of accrued public offering costs.

Net cash used in investing activities of $9,000 and $260,000 for the three months ended March 31, 2005 and 2004, respectively, resulted from purchases of property and equipment during both periods.

Net cash provided by financing activities was $88,000 for the three months ended March 31, 2005 and consisted primarily of proceeds from the issuance of common stock under our stock purchase and stock option plans. Net cash provided by financing activities was $6.0 million for the three months ended March 31, 2004 and consisted of net proceeds from the sale of common stock in an initial public offering of $20.4 million, partially offset by the repayment of a loan facility of $4.0 million and the redemption of mandatorily redeemable preferred stock of $10.3 million.

On February 11, 2004, we completed an initial public offering of 4.0 million shares of our common stock at a price of $6.00 per share. The offering provided net proceeds to us of $20.4 million, which is net of underwriters’ discounts and commissions of $1.7 million, and related legal, accounting, printing and other expenses totaling $1.9 million. We used $4.0 million of the proceeds to repay an outstanding term loan, $873,000 to pay down a line of credit, and $10.3 million to redeem 100,000 shares of mandatorily redeemable preferred stock. We have used and intend to continue to use the remaining net proceeds of the offering for working capital and general corporate purposes, including product research and development, marketing programs, further development of our sales force and capital expenditures. Pending these uses, we have invested the net proceeds of the offering in short-term, interest-bearing, investment-grade securities.

The Company had a revolving line of credit with a bank in the amount of $3.0 million, which was to expire on May 31, 2005. At March 31, 2005 the Company had no outstanding balance under this line of credit. In April 2005 the Company terminated the line of credit.

At March 31, 2005, the future minimum lease payments under all noncancelable leases and sub-leases and minimum royalty payments having initial terms longer than one year are as follows (in thousands):

Our future liquidity and capital requirements will depend on numerous factors, including

18

Table of Contents

We believe that our cash and cash equivalents of $2.9 million as of March 31, 2005 will be sufficient to meet our operating and capital requirements through at least the next 12 months. However, it is possible that we may require additional financing within this period. In addition, even if we have sufficient funds to meet our anticipated cash needs in the next 12 months, we may need to raise additional funds beyond this time. We may be required to raise those funds through public or private financings, strategic relationships or other arrangements. We cannot assure that such funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. If we fail to raise capital when needed, our failure could have a negative impact on our profitability and our ability to pursue our business strategy.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board or “FASB” issued Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment. The new pronouncement replaces the existing requirements under SFAS No. 123 and APB 25. According to SFAS No. 123(R), all forms of share-based payments to employees, including employee stock options and employee stock purchase plans, would be treated the same as any other form of compensation by recognizing the related cost in the statement of operations. This pronouncement eliminates the ability to account for stock-based compensation transactions using APB No. 25 and generally would require that such transactions be accounted for using a fair-value based method. On April 14, 2005, the Securities and Exchange Commission (SEC) announced the adoption of a new rule that amended the compliance dates for SFAS No. 123(R). Under the new rule, companies are allowed to implement SFAS No. 123(R) at the beginning of the next fiscal year, instead of the next reporting period, that begins after June 15, 2005. SFAS No. 123(R) provides transition alternatives for public companies to restate prior interim periods or prior years. The Company is in the process of evaluating the impact of this standard on its financial statements and will implement SFAS No. 123(R) for the fiscal year beginning January 1, 2006.

19

Table of Contents

FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS

There are numerous risks associated with the pending merger with Renaissance Learning, Inc.

On January 25, 2005, we announced that we had entered into a definitive agreement to be acquired by Renaissance Learning, Inc. in a merger transaction. The transaction is subject to a number of risks, including risks related to:

In addition, if the merger is not consummated for any reason, we may be subject to a number of risks, including:

In connection with the proposed merger, AlphaSmart and Renaissance Learning, Inc. filed a proxy statement/prospectus with the Securities and Exchange Commission on February 25, 2005, as amended on April 13, 2005 and on May 3, 2005 (File No. 333-122993). The proxy statement/prospectus contains important information about AlphaSmart, Renaissance Learning, Inc., the proposed merger, risks relating to the merger, and related matters. We urge all of our stockholders to read the proxy statement/prospectus.

If fewer teachers and administrators adopt educational technology solutions and embrace one-to-one computing than AlphaSmart expects, or if AlphaSmart’s current and future platforms do not obtain broad market acceptance for other reasons, AlphaSmart may be unable to sustain or increase its net revenue and its business and financial results could be adversely affected.

AlphaSmart’s business depends on an increasing number of teachers and administrators adopting educational technology solutions and embracing the concept of one student to one computer, or one-to-one computing. There is the risk, however, that one-to-one computing may not produce the expected educational benefits or teachers and administrators may not recognize the benefits. As a result, fewer teachers and administrators may incorporate AlphaSmart’s platforms into their classrooms than AlphaSmart expects, which could result in AlphaSmart’s inability to increase or sustain its net revenue and materially adversely affect AlphaSmart’s business, financial condition and results of operations. Also, market acceptance of AlphaSmart’s platforms may be negatively influenced by a number of other factors, including:

20

Table of Contents

Furthermore, the K-12 educational technology market in which AlphaSmart competes is characterized by new product introductions and, to a lesser extent, technological changes. These trends may reduce sales of AlphaSmart’s existing platforms. AlphaSmart’s success depends on its ability to respond to these trends by enhancing its existing platforms and developing and successfully introducing new platforms.

AlphaSmart’s sales are primarily to educational institutions. A decline of investment in, or loss or reduction of government funding for, educational technology could result in AlphaSmart being unable to sustain or increase its net revenue, which would negatively affect AlphaSmart’s business and financial results.

Substantially all of AlphaSmart’s net revenue is derived from sales to educational institutions, individual teachers and their suppliers. AlphaSmart cannot assure you that educational institutions and/or individual teachers will continue to invest in technology-based platforms. Due to AlphaSmart’s dependence on educational institutions, the funding of which depends largely on government support, a substantial decrease in funding for educational technology would have a material adverse effect on AlphaSmart’s business, financial condition and results of operations. The sources of funding for AlphaSmart’s platforms depend heavily on local, state and federal political bodies and, as a result, education budgets may vary from year to year. In this regard, government funding provided under Title II, Part D of the Elementary and Secondary Education Act, also know as the Enhancing Education Through Technology Act of 2001, was reduced from $700 million to $500 million for the 2005 government fiscal year (October 2004 to September 2005). The funding under this act may be further reduced or even completely eliminated for the coming government fiscal year. This reduction, as well as other significant reductions in education funding, particularly in states like California and Texas in which AlphaSmart has many customers, would likely result in reduced technology spending and materially adversely affect AlphaSmart’s financial results. For instance, AlphaSmart believes that the challenging spending environment AlphaSmart faced throughout 2004 and the first quarter of 2005 resulted in part from reduced educational technology budgets, which adversely affected AlphaSmart’s net revenue during this time frame.

AlphaSmart must adapt to a recent trend among its customers toward the purchase of products based on integrated solutions that address specific educational needs.

Partially as a result of recent government mandates, most notably the No Child Left Behind Act, school districts are much more focused on implementing technology solutions that address very specific student performance issues. As a result, particularly in the last 18 months, schools are making more technology purchase decisions based on their need for integrated solutions that can directly address student skill development and then provide data on the assessment of that development. Schools previously emphasized getting technology such as AlphaSmart’s into the classroom, rather than identifying technology solutions that can assess and address specific performance issues and needs. This trend has increased the importance of software applications to AlphaSmart’s platforms, which AlphaSmart believes are becoming an increasingly important component of its ability to access the K-12 classroom market. Accordingly, AlphaSmart will need to develop software solutions internally to complement its platforms or enter into additional agreements with third parties with respect to these software solutions. For instance, AlphaSmart believes that developing management software for its Dana by AlphaSmart platform is essential for the success of that platform. Although AlphaSmart believes it can develop and market these kinds of solutions, AlphaSmart believes this trend has been partially responsible for the challenging spending climate AlphaSmart encountered in the last 18 months.

Unless AlphaSmart maintains a strong brand identity, develops the Dana by AlphaSmart and Neo by AlphaSmart brands and protects its brands, AlphaSmart’s business may not grow and its financial results may suffer.

AlphaSmart believes that building and enhancing the value of its brands is critical to attracting purchasers of its platforms. One of AlphaSmart’s strategies is to leverage the strength of the AlphaSmart brand. For example, in 2002 AlphaSmart introduced its Dana by AlphaSmart brand, in 2004 AlphaSmart introduced its Neo by AlphaSmart brand, and in the future AlphaSmart may introduce new brands. AlphaSmart’s success in developing brand awareness will depend on its ability to provide educational technology that meets the needs of students, teachers and administrators. AlphaSmart cannot assure you that it will be successful in promoting its existing or new brands. AlphaSmart will need to increase spending on brand-building strategies, which include advertising, promotional programs and sales force efforts. Net revenue from these activities may not be sufficient to offset associated costs.

AlphaSmart seeks to protect its brands, trademarks and logos through a variety of strategies, including domestic and foreign trademark registrations. However, AlphaSmart may be unable to stop third parties from adopting similar names, trademarks

21

Table of Contents

and logos, especially in international markets where intellectual property rights may be less protected or more difficult to enforce. In addition, it is possible that the brands, logos and trademarks AlphaSmart uses may infringe on the rights of others or may be challenged as infringing, and AlphaSmart may have to devote time and money to defending such claims.

AlphaSmart’s platforms compete against PCs, which have greater functionality. If AlphaSmart’s customers and potential customers decide that the benefits of greater functionality outweigh the advantages of AlphaSmart’s platforms, AlphaSmart may suffer competitive losses and its business and financial results would suffer.

AlphaSmart’s indirect competitors include sellers of desktop, laptop, tablet and notebook personal computers, or PCs, which typically have more functionality than AlphaSmart’s platforms. AlphaSmart also competes against providers of PC-based solutions referred to as mobile labs, which generally consist of carts containing thirty or fewer wirelessly networked laptops that can be wheeled from classroom to classroom. AlphaSmart believes that its business depends, in part, on teachers and administrators preferring the lower total cost of ownership, greater durability and targeted functionality associated with AlphaSmart’s platforms to the greater functionality of PCs. However, because of the greater functionality and memory that most PCs have compared to AlphaSmart’s platforms, the recent trend among AlphaSmart’s customers toward demand for integrated solutions may cause customers seeking such integrated solutions to choose PCs over AlphaSmart’s platforms. Furthermore, AlphaSmart expects the price of PCs to continue to decrease, and their durability may increase or PC makers may develop technology that allows teachers to target the functionality of PCs in a classroom environment. As a result of these factors, customers or prospective customers may choose to purchase PCs instead of AlphaSmart’s platforms. For instance, the success of AlphaSmart’s Dana platform, which is targeted at higher grade levels, has been adversely affected by competition from sellers of laptop computers.

AlphaSmart’s sales cycle can be long and unpredictable, and this can lead to fluctuating financial results.

Most of AlphaSmart’s customers are public institutions, such as public school districts, that depend on public funding sources. Funding sources can be found at all levels of government through a wide variety of programs. Identifying the decision maker and a potential funding source is often time consuming. Larger orders, in particular, can take months or years to complete. Other variables also complicate the purchasing process, including the timing of disbursement of funds from funding sources and the person-to-person sales contact process. Sales may take much longer than anticipated, may fall outside the approved budget cycle and, therefore, may not occur due to the loss of funding. As a result of these factors, AlphaSmart’s sales cycle is unpredictable and typically lasts six to 18 months. This unpredictability could cause AlphaSmart’s net revenue and financial results to vary significantly from quarter to quarter. The recent trend towards schools demanding integrated technology solutions that can assess and address specific student performance issues has, AlphaSmart believes, lengthened the sales cycle.

AlphaSmart must manage risks associated with its reliance on third parties to develop software applications for its platforms.

To augment AlphaSmart’s software development activities, AlphaSmart relies on third parties to help develop software applications for its platforms. For instance, AlphaSmart licenses technology included in its KeyWords SmartApplet from Renaissance, and Don Johnston, Incorporated developed the Co:Writer SmartApplet. To increase the attractiveness of its technology platforms, AlphaSmart intends to enter into additional third party relationships for the development of additional software applications for its platforms. AlphaSmart also outsources a portion of AlphaSmart’s internal software development function. Some of these third parties have limited operating histories and limited access to capital. Furthermore, AlphaSmart relies on these third parties to protect their intellectual property rights and to not infringe the rights of others. As a result, AlphaSmart has less control over software development and engineering processes, and associated intellectual property protection and infringement risks, than if AlphaSmart developed software internally. AlphaSmart relies on these third parties to deliver software or other technology that meet AlphaSmart’s specifications in a timely and cost-effective manner, and delays or cost overruns in software developments or intellectual property infringement claims could negatively affect customer relations and AlphaSmart’s competitive position.

The failure of government sponsored education initiatives to endorse, or be complementary to, AlphaSmart’s platforms could adversely affect AlphaSmart’s ability to access some education technology markets.

Substantially all of AlphaSmart’s net revenue is derived from sales to educational institutions, individual educators and their suppliers, the funding of which depends largely on government support. A decrease in government sponsorship of education initiatives that endorse, or are complementary to, the principles and methodologies underlying and associated with AlphaSmart’s platforms, could result in a reduction of funding available to educational institutions to acquire AlphaSmart’s platforms. In the event of such reduction, AlphaSmart may be unable to increase or sustain its net revenue and its business, financial condition and results of operations would be adversely affected. For example, in 2003 the State of Michigan

22

Table of Contents

mandated that all seventh grade students have access to laptop computers. The state specifications for what constitutes a laptop computer include larger screen sizes and video and audio features that AlphaSmart’s platforms do not support. If other jurisdictions adopt similar policies, AlphaSmart’s ability to sell its platforms in these jurisdictions would be adversely affected.

Because AlphaSmart’s product offering is not diversified, a decrease in sales of its platforms may seriously harm its business.

AlphaSmart’s three platforms, AlphaSmart 3000, Neo by AlphaSmart and Dana by AlphaSmart, are in a narrow category of products, namely computing devices for use in the K-12 classroom. AlphaSmart does not offer a diversified product line or services, as some of its competitors do. Consequently, if sales of AlphaSmart’s platforms decline precipitously, its business would be seriously harmed, and it may be difficult for it to recover because AlphaSmart does not have the breadth of products that would enable it to sustain its business while seeking to develop new types of products or services or other markets for its platforms. In addition, because AlphaSmart’s technical know-how and intellectual property have limited application, AlphaSmart may be unable to leverage AlphaSmart’s technical know-how and intellectual property to diversify AlphaSmart’s product line or develop other products or sources of revenue outside AlphaSmart’s current niche market.

The success of the Dana by AlphaSmart platform depends substantially on PalmSource, AlphaSmart’s license from PalmSource and the success of the Palm OS operating system. If the Palm OS operating system is unsuccessful or if AlphaSmart’s relationship with PalmSource terminates, AlphaSmart would have to design-in or license an alternative operating system, which could take a long period of time, and AlphaSmart’s net revenue, business and financial condition would be materially and adversely affected.

AlphaSmart currently licenses the Palm OS operating system from PalmSource for use in AlphaSmart’s Dana by AlphaSmart platform. The use of, and interoperability with, the Palm OS operating system is an important part of the Dana by AlphaSmart platform. As a result, the success of AlphaSmart’s Dana by AlphaSmart platform substantially depends on AlphaSmart’s relationship with PalmSource and the success of PalmSource and the Palm OS. If the Palm OS business is unsuccessful, or if PalmSource encounters financial or other difficulties that affect its operations or the popularity of the Palm OS, the success of AlphaSmart’s Dana by AlphaSmart platform would be adversely affected. Also, unless extended by mutual agreement, AlphaSmart’s license agreement with PalmSource will terminate in December 2008.

AlphaSmart’s license with PalmSource also provides that PalmSource may allow AlphaSmart to examine or modify the source code to the Palm OS software. If an entity that develops, manufactures, markets and/or distributes handheld or mobile computing devices or related operating systems software acquires more than 20% of AlphaSmart’s outstanding stock or directly merges with AlphaSmart, AlphaSmart would be required to return any PalmSource code that AlphaSmart may have and AlphaSmart’s right to examine or modify PalmSource’s code would terminate. If this license is terminated, or if PalmSource encounters financial or other difficulties that affect the Palm OS popularity, AlphaSmart may be required to license a substitute operating system, which could be less desirable, time consuming and more costly in terms of cash and other resources. Alternatively, AlphaSmart could develop AlphaSmart’s own operating system, but this would take considerable time, resources and expense, would likely divert AlphaSmart’s engineers’ attention from platform innovations and may not have the advantages of the Palm OS applications compatibility.

Shipments of platforms could be delayed and AlphaSmart’s business may be seriously harmed if AlphaSmart’s suppliers, particularly single source suppliers, do not satisfy AlphaSmart’s requirements and alternative sources are not available.

AlphaSmart relies on its suppliers to deliver necessary components to its contract manufacturer in a timely manner based on AlphaSmart’s forecasts. AlphaSmart does not, and AlphaSmart’s contract manufacturer does not, carry a significant inventory of these components. At various times, some of AlphaSmart’s platforms’ key components, including display components and flash memory, have been in short supply. Delays in AlphaSmart’s supply chain would harm AlphaSmart’s ability to deliver AlphaSmart’s platforms on a timely basis. The cost, quality and availability of components are essential to the successful production and timely sale of AlphaSmart’s platforms. If AlphaSmart’s suppliers are unable to meet AlphaSmart’s demand for these components, AlphaSmart will be required to work around these shortages, which may have a material adverse effect on AlphaSmart’s manufacturing costs and AlphaSmart’s business, financial condition and results of operations. Each of AlphaSmart’s platforms contains certain components, including the following, that have a single source supplier:

23

Table of Contents

If any supplier of these components were unable or unwilling to meet AlphaSmart’s needs, qualifying new suppliers would likely be time-consuming and cause production delays.

In addition, although AlphaSmart is evaluating other manufactures, All Quality & Services, Inc. is currently the only manufacturer of its platforms. AlphaSmart does business with All Quality & Services essentially on a purchase order basis and does not have a long term contract with them. Should All Quality & Services ever become unable or unwilling to manufacture AlphaSmart’s platforms, it could take AlphaSmart between 8 to 10 weeks to obtain a new manufacturer and begin to resume shipments of their platforms.

AlphaSmart must maintain customer loyalty, or the net revenue it derives from repeat customers will decrease.

In the first quarter of 2005, more than 80% of AlphaSmart’s net revenue came from districts to which AlphaSmart had previously sold units. If AlphaSmart’s current and repeat customers decide to purchase technology other than AlphaSmart’s, or if they decide to allocate funding away from educational technology, AlphaSmart’s net revenue would decline.

The loss of AlphaSmart’s senior management could have a material adverse effect on AlphaSmart’s business.

AlphaSmart depends on the continued service of its senior management. AlphaSmart’s management team, Ketan D. Kothari, Manish D. Kothari and Joseph Barrus, has a substantial role in AlphaSmart’s product development, AlphaSmart’s reputation and contacts with customers and third party developers and AlphaSmart’s business culture. AlphaSmart does not have formal employment agreements with any of these persons, and AlphaSmart has no current intention of entering into any such employment agreements. The loss of services of any of these persons could harm AlphaSmart’s business.

AlphaSmart does not know whether additional financing will be available when needed, on favorable terms or at all.

AlphaSmart believes that its cash and cash equivalents of $2.9 million as of March 31, 2005 will be sufficient to meet its operating and capital requirements through at least the next 12 months. However, it is possible that AlphaSmart may require additional financing within this period. In addition, even if AlphaSmart has sufficient funds to meet its anticipated cash needs in the next 12 months, AlphaSmart may need to raise additional funds beyond this time. AlphaSmart may be required to raise those funds through public or private financings, strategic relationships or other arrangements. AlphaSmart cannot assure that such funding, if needed, will be available on favorable terms, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. To the extent that AlphaSmart raises additional funds through strategic relationships, AlphaSmart may be required to relinquish some rights to technologies or products, or grant licenses on unfavorable terms. If AlphaSmart fails to raise capital when needed, AlphaSmart’s failure could have a negative impact on AlphaSmart’s profitability and AlphaSmart’s ability to pursue its business strategy.

If AlphaSmart’s customers delay purchases to evaluate new products and platforms it may introduce in the future, AlphaSmart’s financial results could be adversely affected.

AlphaSmart intends to continue to introduce new products and platforms. In response to these introductions, AlphaSmart’s customers may delay purchases of AlphaSmart’s existing platforms and products, which could adversely affect AlphaSmart’s financial results. For example, AlphaSmart believes that the introduction of Neo in the second quarter of 2004 may have adversely affected net revenue during that period as a result of school districts delaying their purchasing decision to evaluate the Neo product.

Loss of the right to use the one-button-send feature included in the AlphaSmart 3000, Neo and Dana devices could adversely affect AlphaSmart’s business.

AlphaSmart licenses from a third party the right to use the one button send feature in AlphaSmart’s AlphaSmart 3000, Neo and Dana devices. If AlphaSmart loses the right to use this technology, AlphaSmart would be required to either license alternative methods of delivering the functionality that is currently provided by the one button send feature or design around the patent. AlphaSmart could experience production delays while it attempts to secure suitable technology alternatives. Such delays could adversely affect its business. Also, if AlphaSmart is successful in obtaining technology alternatives, such technology may not be as effective as, and may be more costly than, the technology AlphaSmart currently uses.

24

Table of Contents

AlphaSmart’s quarterly operating results are likely to fluctuate, which could cause it to miss expectations about these results and cause the trading price of AlphaSmart’s common stock to decline.

AlphaSmart’s operating results are likely to fluctuate substantially from quarter to quarter for a variety of reasons, many of which are beyond its control. As a result, AlphaSmart believes that you should not rely on period-to-period comparisons of its financial results as an indication of its future performance. Factors that are likely to cause AlphaSmart’s quarterly net revenue and operating results to fluctuate include those disclosed in these risk factors and others such as:

If AlphaSmart’s quarterly net revenue or operating results fall below the expectations of market analysts or investors, its stock price could decline substantially. For instance, in the third quarter of 2004 AlphaSmart failed to meet analyst’s expectations for its financial results, and its stock price declined.

AlphaSmart’s quarterly results have fluctuated in the past due in part to school funding calendars, and these seasonal fluctuations make predicting its sequential quarterly results difficult.

AlphaSmart’s sales are typically substantially higher in its second quarter, when districts use end of year funds, and in AlphaSmart’s third quarter, when districts use beginning of year funds. As a result of these fluctuations and other risks AlphaSmart has described in these risk factors, financial results for a quarter are not indicative of any subsequent quarter. This can make predicting AlphaSmart’s financial results difficult.

AlphaSmart’s platforms compete with other solutions. If AlphaSmart’s customers and potential customers choose these other solutions, AlphaSmart may suffer competitive losses and its financial results would suffer.

In addition to competing with PC manufacturers, AlphaSmart also competes against sellers of other technology solutions, such as personal digital assistants, or PDAs, based on operating systems such as the Palm OS, Win CE or embedded Linux. Although PDAs generally have a smaller screen than AlphaSmart’s platforms and generally do not include integrated keyboards, they offer some of the same benefits to students, teachers and administrators as AlphaSmart’s platforms. For instance, PDAs generally have a lower initial cost and are more portable than PCs. As such, customers or prospective customers may choose to purchase PDAs instead of AlphaSmart’s platforms. Also, historical competitors have in the past attempted to replicate AlphaSmart’s technology and market it to the U.S. K-12 market. Although AlphaSmart believe these competitors currently have little or no market share, they have at times caused AlphaSmart to reduce prices in order to obtain

25

Table of Contents

customer sales. This type of competition could in the future cause AlphaSmart to lower prices in some markets, or any of such companies could emerge as more significant competitors. Furthermore, there are a number of significantly larger companies with which AlphaSmart does not currently compete that do not currently offer the same or similar technology solutions for the education market but that could, with limited barriers to entry, compete directly in the future.

AlphaSmart expects its competitors, including providers of PCs, to continue to reduce their prices; to improve the performance of their current platforms; and to introduce new platforms, services and technologies. Successful new platform introductions or enhancements by AlphaSmart’s competitors could reduce the sales and market acceptance of AlphaSmart’s platforms, cause intense price competition or make AlphaSmart’s platforms obsolete. Many of AlphaSmart’s direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than AlphaSmart does. These competitors may be able to respond more rapidly than AlphaSmart can to changes in preferences or requirements in the educational technology market or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their platforms than AlphaSmart does. To be competitive, AlphaSmart must continue to invest resources in research and development, sales and marketing and customer support. AlphaSmart cannot be sure that it will have sufficient resources to make these investments or that it will be able to make the technological advances necessary to be competitive. Increased competition could result in price reductions, fewer customer orders, reduced margins and loss of market share. AlphaSmart’s failure to compete successfully against current or future competitors could seriously harm its business.

If AlphaSmart’s third party manufacturers are unable to perform, or if AlphaSmart does not provide its manufacturers with accurate demand forecasts, AlphaSmart could experience production delays or increased expenditures, which could adversely affect its net revenue or operating results.

AlphaSmart relies on third party manufacturers for a substantial portion of the procurement, production and testing of AlphaSmart’s platforms. Although AlphaSmart believes it could find alternate manufacturers, if these manufacturers are unable to perform their functions, AlphaSmart could experience disruptions in its operations and delays in its shipments. Furthermore, AlphaSmart must provide these manufacturers with accurate rolling demand forecasts. If AlphaSmart’s actual requirements exceed its forecasts, these manufacturers may be unable to manufacture its products in a timely manner to meet customer demand. If AlphaSmart’s forecasts are more than its actual requirements, AlphaSmart could be required to reimburse its manufacturers for their component purchases on its behalf if they are unable to use those components in AlphaSmart’s products.

Dana by AlphaSmart, AlphaSmart’s platform based on the Palm OS operating system, is targeted in part at the higher education market, a market in which AlphaSmart has little experience. AlphaSmart’s lack of experience in the higher education market could adversely affect its ability to penetrate that market.

Historically, almost all of AlphaSmart’s net revenue has come from the K-12 market. AlphaSmart has not yet been successful selling Dana by AlphaSmart to the higher education market in significant quantities. AlphaSmart believes that its Dana by AlphaSmart platform, which began shipping in October 2002, will be useful in the higher education market. However, AlphaSmart does not have the experience and customer contacts in the higher education market that it has in the K-12 market. As a result, AlphaSmart may be unable to market its Dana devices successfully to the higher education market or other markets in which they would otherwise be useful. Furthermore, AlphaSmart could incur costs related to its efforts to penetrate the higher education market that are not offset by related net revenue.

Failure to manage growth of its direct and indirect sales force effectively could increase costs that are not offset by increased net revenue, result in reduced net revenue and harm its operating results.

AlphaSmart intends to expand its international presence, market and sell its Dana devices in selected markets, such as journalism and higher education, and continue to adapt its focus in the U.S. K-12 markets by focusing its sales efforts at the district level and by adapting to the recent trend toward customer demand for integrated solutions. These strategies require AlphaSmart to manage its direct and indirect sales force teams effectively. Internationally, almost all of AlphaSmart’s historical sales have been conducted through resellers. To increase its international presence, AlphaSmart must enter into reseller agreements in its existing international markets and in the additional markets it enters or it must hire and train direct international sales employees in these markets. In the U.S. K-12 markets, AlphaSmart intends to hire additional direct sales employees within the next year. In hiring these employees, AlphaSmart needs to select the proper markets in which to focus the new employees and assess the start-up costs associated with establishing a customer base and contacts in the selected markets. Furthermore, to be successful selling its platforms in the United States, AlphaSmart must continue to adapt its sales strategy to its customers’ focus on integrated solutions and also must focus its sales efforts at the district level, where more education technology purchase decisions are being made. Also, as AlphaSmart increases its installed base and introduces new

26

Table of Contents

products, it will need to manage the training and staffing of AlphaSmart’s customer care services. For instance, AlphaSmart recently opened a customer care center in Irving, Texas. If AlphaSmart does not manage these challenges effectively, AlphaSmart may be unable to capitalize on available opportunities or it may expend costs that are not justified by related net revenue.

The loss of key employees, or the inability to attract key employees, could limit AlphaSmart’s ability to develop new platforms and result in lost sales and diversion of management.

AlphaSmart’s success depends in part on its ability to attract and retain qualified management, sales and marketing and engineering personnel. As AlphaSmart enters new markets, such as higher education, vertical markets and international markets, AlphaSmart will need to hire sales and other personnel with familiarity with these markets.

AlphaSmart may be unable to protect its intellectual property adequately or cost-effectively, which may cause it to lose market share or reduce its prices.

AlphaSmart’s success depends to a significant degree on its ability to protect and preserve the proprietary aspects of AlphaSmart’s technology. However, AlphaSmart may be unable to prevent third parties from using its technology without its authorization. Although AlphaSmart has been issued patents in the United States and Europe, it does not currently rely on patents to protect its core intellectual property. To protect its intellectual property, AlphaSmart generally enters into confidentiality or license agreements with its employees, consultants and third party developers and controls access to and limits distribution of AlphaSmart’s proprietary technology. However, these measures afford only limited protection and may be inadequate. Enforcing these or other rights AlphaSmart has related to its technology could be costly, time-consuming and distracting. Others may develop non-infringing technologies that are similar or superior to AlphaSmart’s. If competitors are able to develop such technology, they may be able to market and sell products that compete with AlphaSmart’s, and this competition could adversely affect AlphaSmart’s business.

AlphaSmart’s future results could be harmed by economic, political, regulatory and other risks associated with international sales and operations.

To date, AlphaSmart has generated substantially all of its net revenue from sales in the United States. In the first quarter of 2005, approximately 18% of AlphaSmart’s net revenue was generated from international sales. AlphaSmart intends to continue to expand its presence in such markets and enter additional international markets in the near future, and these expansion efforts will be subject to economic, political, regulatory, and other risks generally associated with international sales and operations. To the extent that AlphaSmart’s net revenue from international operations represents an increasing portion of its net revenue, AlphaSmart will be subject to increased exposure to international risks, including changes in a specific country’s or region’s political or economic conditions and difficulty in managing widespread sales and support operations.

Future changes in financial accounting standards or practices may cause adverse unexpected fluctuations and affect AlphaSmart’s reported results of operations.

For example, recent changes requiring that AlphaSmart record compensation expense in the statement of operations for employee stock options using the fair value method or changes in existing taxation rules related to stock options could have a significant negative effect on its reported results.

AlphaSmart’s business could be harmed by lawsuits that have been filed, or may in the future be filed, against PalmSource involving the Palm OS operating system.

Suits against PalmSource involving the Palm OS operating system, which AlphaSmart licenses from PalmSource, could adversely affect AlphaSmart. A disruption in PalmSource’s business because of these suits could disrupt AlphaSmart’s operations and result in higher costs. PalmSource is or has been a defendant in several patent infringement lawsuits involving the Palm OS operating system. Although AlphaSmart has not been a party to these cases, AlphaSmart could be adversely affected by a determination adverse to PalmSource as a result of market uncertainty or platform changes that could arise from such a determination.

27

Table of Contents

AlphaSmart could become subject to litigation regarding intellectual property, which could divert management attention, be costly to defend and prevent it from using or selling the challenged technology.

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. This litigation is particularly prevalent in the technology industry. In addition, in recent years, there has been an increase in the filing of suits alleging infringement of intellectual property rights, which pressure defendants into entering settlement arrangements quickly to dispose of such suits, regardless of their merits. Other companies or individuals may pursue litigation against AlphaSmart with respect to intellectual property-based claims, including any such claims related to use of AlphaSmart’s existing brands, trademarks and logos. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to AlphaSmart’s platforms that could arise in the future, AlphaSmart could be required to obtain licenses to the infringing technology; begin using other brands, trademarks and logos; pay substantial damages under applicable law; cease the manufacture, use and sale of platforms found to be infringing; or expend significant resources to develop non-infringing technology. AlphaSmart’s insurance may not cover potential claims or may not be adequate to indemnify it for damages it incurs. Also, litigation frequently involves substantial expenditures and can require significant management attention, even if AlphaSmart ultimately prevails.

Being a public company has increased AlphaSmart’s administrative costs and could make it more difficult to attract and retain key personnel.

AlphaSmart became a public company in February 2004. As a public company, AlphaSmart is incurring significant legal, accounting and other expenses that it did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC, has required changes in corporate governance practices of public companies. In addition to final rules and rule proposals already made by the SEC, The Nasdaq Stock Market revised its requirements for companies that are Nasdaq-listed. These new rules and regulations have increased AlphaSmart’s legal and financial compliance costs and made some activities more time consuming and/or costly. For example, partially in connection with becoming a public company AlphaSmart has added additional independent directors, created several board committees, implemented additional internal controls and disclosure controls and procedures, retained a transfer agent, a bank note company, and a financial printer, adopted an insider trading policy and has all of the internal and external costs of preparing and distributing periodic public reports in compliance with AlphaSmart’s obligations under the securities laws. These new rules and regulations could also make it more difficult to attract and retain qualified members of AlphaSmart’s board of directors, particularly to serve on AlphaSmart’s audit committee, and qualified executive officers.

Any errors or defects contained in AlphaSmart’s platforms, or failure to comply with applicable safety standards, could result in delayed shipments or rejection or recall of AlphaSmart’s platforms, damage to AlphaSmart’s reputation and exposure to regulatory or other legal action.

AlphaSmart has experienced, and in the future may experience, delays in releasing some of its platforms, and recalls of existing platforms, due to defects or errors in its platforms. For instance, in May 2003 AlphaSmart issued a recall on approximately 9,000 Dana devices as a result of a defect in the display screens that in some cases resulted in the backlight to the screen malfunctioning. Although the recall is complete, AlphaSmart cannot assure you that AlphaSmart’s platforms in the future will not contain other errors or defects that are discovered after commercial shipments have begun. Children could sustain injuries from AlphaSmart’s platforms, and AlphaSmart may be subject to claims or lawsuits resulting from such injuries. Any such injuries or recalls could result in the rejection of AlphaSmart’s platforms by AlphaSmart’s customers, damage to AlphaSmart’s reputation, lost sales, diverted development resources and increased customer service and support costs and warranty claims, any of which could harm AlphaSmart’s business.

28

Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have limited exposure to financial market risks, including changes in interest rates and foreign currency exchange rates.

Interest Rate Risk

Our exposure to interest rate risk relates primarily to our investment portfolio and credit facilities. All investments are classified as cash equivalents carried at cost and are deposited with financial institutions that approximate market value. We do not plan to use derivative financial instruments in our investment portfolio. If market rates were to increase immediately and uniformly by 10% from levels at March 31, 2005, the decline in fair value of the portfolio would not be material. We plan to ensure the safety and preservation of our invested principal funds by limiting default risks, market risk and reinvestment risk. We plan to mitigate default risk by investing in high-credit quality securities.

Our exposure to market risk also relates to the increase or decrease in the amount of interest expense we must pay on our revolving line of credit with a bank. At March 31, 2005 the Company had no outstanding balance under this line of credit. Amounts owed under our revolving line of credit accrue interest at a rate equal to a bank rate that was 5.75% per annum at March 31, 2005. In April 2005, the Company and the lender terminated the line of credit.

The risk associated with fluctuating interest expense is limited to these debt instruments, and we do not believe that a 10% change in the interest rate would have a significant impact on our interest expense.

Foreign Currency Risk

Although we pay salaries that are fixed in British pounds to our European employees, to date, our exposure to foreign currency rate fluctuations has not been significant. Substantially all of our international sales are transacted in U.S. dollars. To date, we do not use derivative financial instruments for speculative trading purposes, nor do we hedge any foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.

Our Chief Executive Officer and our Chief Financial Officer participated in the evaluation of the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934, as amended (the “Exchange Act”), Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, and have concluded that our disclosure controls and procedures were effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

Changes in Internal Controls.

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

29

Table of Contents

PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On November 20, 2003, one of AlphaSmart’s contract manufacturers, Wolf Electronix, Inc. (“Wolf”), filed a lawsuit against AlphaSmart in United States District Court for the District of Utah, alleging that AlphaSmart breached its contract with Wolf and violated a U.S. federal antidiscrimination statute by no longer using Wolf for volume order manufacturing. Wolf was seeking an injunction and unspecified damages in connection with its complaint. On December 17, 2003, AlphaSmart answered the complaint and denied Wolf’s allegations. On April 7, 2005, AlphaSmart and Wolf engaged in a court-ordered settlement conference, and on April 11, 2005, the Company and Wolf agreed to settle the lawsuit. The terms of the settlement require the Company to make a net payment of $355,000 after recovery from insurers, in full settlement of the lawsuit, which has been fully accrued at March 31, 2005. Pursuant to the parties’ settlement agreement, a stipulation dismissing the lawsuit with prejudice was filed on April 19, 2005. The court dismissed the lawsuit on April 28, 2005.

From time to time AlphaSmart is involved in litigation arising out of claims in the normal course of business. Based on the information presently available, including discussion with outside legal counsel, AlphaSmart believes that there are no claims or actions pending or threatened against us, the ultimate resolution of which will have a material adverse effect on AlphaSmart’s financial position, liquidity or results of operations.

ITEM 5. OTHER INFROMATION

Additional Information About the Proposed Merger with Renaissance Learning, Inc. and Where to Find It

Renaissance Learning, Inc. has filed a registration statement on Form S-4, which includes a proxy statement/prospectus and other relevant materials in connection with the proposed merger transaction involving AlphaSmart and Renaissance, with the Securities and Exchange Commission (SEC) on February 25, 2005, as amended on April 13, 2005 and on May 3, 2005 (File No. 333-122993). INVESTORS AND SECURITY HOLDERS ARE URGED TO READ THIS FILING BECAUSE IT CONTAINS IMPORTANT INFORMATION REGARDING THE PROPOSED MERGER TRANSACTION. Investors and security holders may obtain free copies of these documents and other documents filed with the SEC at the SEC’s website at www.sec.gov. In addition, investors and security holders may obtain free copies of the documents filed with the SEC by AlphaSmart at AlphaSmart’s website at www.alphasmart.com or by contacting AlphaSmart investor relations at IR@alphasmart.com or via telephone at 408-355-1029. Investors and security holders may obtain free copies of the documents filed with the SEC by Renaissance Learning by directing such requests to Renaissance Learning, Inc., Attention: Corporate Secretary, 2911 Peach Street, P.O. Box 8036, Wisconsin Rapids, Wisconsin 54995 or via telephone at 715-424-3636.

ITEM 6. EXHIBITS

30

Table of Contents

31

Table of Contents

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.

32