SCIENTIFIC LEARNING CORP - FORM 10-Q

Attached files

file	filename
EX-31.2 - EXHIBIT 31.2 - SCIENTIFIC LEARNING CORP	ex31_2.htm
EX-32.1 - EXHIBIT 32.1 - SCIENTIFIC LEARNING CORP	ex32_1.htm
EX-31.1 - EXHIBIT 31.1 - SCIENTIFIC LEARNING CORP	ex31_1.htm
EX-32.2 - EXHIBIT 32.2 - SCIENTIFIC LEARNING CORP	ex32_2.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____ to _____

Commission File number 000-24547

Scientific Learning Corporation

(Exact name of registrant as specified in its charter)

	Delaware		94-3234458
	(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

300 Frank H. Ogawa Plaza, Suite 600

Oakland, California 94612

(510) 444-3500

(Address of Registrant’s principal executive offices, including zip code, and

telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.) Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨

Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the

Exchange Act). Yes ¨ No x

As of October 15, 2009, there were 18,157,965 shares of Common Stock outstanding.

SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q

FOR THE QUARTER ENDED September 30, 2009

PAGE

PART 1. FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited):
	Condensed Balance Sheets	3
	Condensed Statements of Operations	4
	Condensed Statements of Cash Flows	5
	Notes to Condensed Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	19
Item 4T.	Controls and Procedures	19

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	21
Item 1A.	Risk Factors	22
Item 6.	Exhibits	29
	Signature	30

Page 2

Index

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Scientific Learning Corporation
Condensed Balance Sheets
(In thousands)

	September 30,			December 31,
	2009			2008
	Unaudited
Assets
Current assets:
Cash and cash equivalents	$	16,908		$	7,550
Accounts receivable, net		10,284			7,717
Prepaid expenses and other current assets		1,726			1,341

Total current assets		28,918			16,608

Property and equipment, net		1,671			1,552
Goodwill		4,568			4,568
Other intangible assets, net		5,715			6,424
Other assets		2,096			1,108

Total assets	$	42,968		$	30,260


Liabilities and stockholders' equity
Current liabilities:
Accounts payable	$	953		$	674
Accrued liabilities		6,365			3,964
Deferred revenue		18,902			15,521

Total current liabilities		26,220			20,159
Deferred revenue, long-term		6,274			4,431
Other liabilities		713			625

Total liabilities		33,207			25,215


Stockholders' equity :
Common stock and addditional paid in capital		86,534			85,098
Accumulated deficit		(76,773	)		(80,053	)

Total stockholders' equity		9,761			5,045

Total liabilities and stockholders' equity	$	42,968		$	30,260

See accompanying notes.

Page 3

Index

SCIENTIFIC LEARNING CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Unaudited

	Three months ended September 30,						Nine months ended September 30,
	2009			2008			2009		2008

Revenues:
Products	$	15,510		$	7,475		$	25,630	$	21,009
Service and support		4,783			5,220			13,904		14,252
Total revenues		20,293			12,695			39,534		35,261

Cost of revenues:
Cost of products		1,015			599			1,961		1,686
Cost of service and support		2,236			2,411			6,442		7,279
Total cost of revenues		3,251			3,010			8,403		8,965

Gross profit		17,042			9,685			31,131		26,296

Operating expenses:
Sales and marketing		6,243			5,329			16,967		18,461
Research and development		1,846			1,545			4,588		5,267
General and administrative		2,169			2,398			6,019		6,346

Total operating expenses		10,258			9,272			27,574		30,074

Operating income (loss)		6,784			413			3,557		(3,778	)

Interest and other income (expense), net		(28	)		141			90		473

Income (loss) before income tax		6,756			554			3,647		(3,305	)
Income tax expense (benefit)		301			(36	)		367		1,207
Net income (loss)	$	6,455		$	590		$	3,280	$	(4,512	)

Basic net income (loss) per share:	$	0.36		$	0.03		$	0.18	$	(0.26	)
Shares used in computing basic net income (loss) per share		18,077			17,552			17,980		17,438
Diluted net income (loss) per share:	$	0.35		$	0.03		$	0.18	$	(0.26	)
Shares used in computing diluted net income (loss) per share		18,648			18,283			18,505		17,438

See accompanying notes.

Page 4

Index

Scientific Learning Corporation
Condensed Statements of Cash Flows
(In thousands)
Unaudited

	Nine months ended September 30,
	2009			2008

Operating Activities:
Net income (loss)	$	3,280		$	(4,512	)
Items to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		1,183			932
Stock based compensation		1,034			1,618
Increase in deferred tax asset valuation allowance		-			1,191
Changes in operating assets and liabilities:
Accounts receivable		(2,567	)		(4,580	)
Prepaid expenses and other current assets		(385	)		(164	)
Other assets		(11	)		(117	)
Accounts payable		279			(444	)
Accrued liabilities		2,401			682
Deferred revenue		5,224			46
Other liabilities		88			128

Net cash provided by (used in) operating activities		10,526			(5,220	)

Investing Activities:
Purchases of property and equipment, net		(584	)		(206	)
Additions to capitalized software		(986	)		-
Purchase of Soliloquy		-			(10,133	)

Net cash used in investing activities		(1,570	)		(10,339	)

Financing Activities:
Borrowings under bank line of credit		2,500			-
Repayment of borrowings		(2,500	)		-
Proceeds from issuance of common stock, net		402			451

Net cash provided by financing activities		402			451

Increase (decrease) in cash and cash equivalents		9,358			(15,108	)

Cash and cash equivalents at beginning of period		7,550			21,179

Cash and cash equivalents at end of period	$	16,908		$	6,071

See accompanying notes.

Page 5

Index

Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation develops, distributes and licenses technology that accelerates learning by improving the processing efficiency of the brain.

Our patented products build learning capacity by rigorously and systematically applying neuroscience-based learning principles to improve the fundamental cognitive skills required to read and learn. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. We sell primarily to K-12 schools in the United States through a direct sales force.

All of our activities are in one operating segment.

Our current operating assumptions and projections reflect management’s best estimate of future revenue, operating expenses, and capital commitments, and indicate that our current sources of liquidity, including the bank line of credit, should be sufficient to fund operations through at least September 30, 2010.

We were incorporated in 1995 in the State of California and were reincorporated in 1997 in the State of Delaware.

Use of Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent that there are material differences between these estimates and actual results, our financial statements could be affected.

Interim Financial Information

The interim financial information as of September 30, 2009 and for the three and nine months ended September 30, 2009 and 2008 is unaudited, and includes all normal recurring adjustments and an adjustment to account for the acquisition of Soliloquy Learning that we consider necessary for a fair presentation of our financial position at such date and our results of operations and cash flows for those periods. The balance sheet as of December 31, 2008 has been derived from audited financial statements at that date but does not include all of the information and notes required by generally accepted accounting principles (“GAAP”) for annual financial statements. In addition, the results of operations for the three months ended September 30, 2009 are not necessarily indicative of the results for the entire fiscal year ending December 31, 2009, or for any other period.

These condensed financial statements and notes should be read in conjunction with our audited financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2008, filed with the Securities and Exchange Commission.

Subsequent events

We have evaluated subsequent events through the issuance of our condensed financial statements on November 6, 2009.

Page 6

Index

Notes to Condensed Financial Statements

Summary of Significant Accounting Policies (continued)

Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share reflects the potential dilution of securities by adding common stock equivalents (computed using the treasury stock method) to the weighted-average number of common shares outstanding during the period, if dilutive. Potentially dilutive securities of 1,242,399 and 3,743,346 have been excluded from the computation of diluted net income per share in the nine month periods ending September 30, 2009 and 2008, respectively, as their inclusion is antidilutive.

The following table sets forth the computation of net income (loss) per share (in thousands, except per share data):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2009		2008		2009		2008
Net income (loss)	$	6,455	$	590	$	3,280	$	(4,512	)
Weighted average shares used in calculation of basic net loss per share		18,077		17,552		17,980		17,438
Effect of dilutive securities:
Employee stock options and awards		571		731		525		-
Weighted-average diluted common shares		18,648		18,283		18,505		17,438
Net income (loss) per common share - basic	$	0.36	$	0.03	$	0.18	$	(0.26	)

Net income (loss) per common share - diluted	$	0.35	$	0.03	$	0.18	$	(0.26	)

Recent Accounting Pronouncements

In April 2008 the FASB issued FASB Staff Position (FSP) SFAS 142-3, “Determination of the Useful Life of Intangible Assets.” FSP SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under Statement of Financial Accounting Standards ASC 350,” Intangibles – Goodwill and Other” (formerly SFAS 142, “Goodwill and Other Intangible Assets.”). This new staff position is intended to improve the consistency between the useful life of a recognized intangible asset under ASC 350 and the period of expected cash flows used to measure the fair value of the asset under Statement of Financial Accounting Standards ASC 805, “Business Combinations” (formerly SFAS 141(R), “Business Combinations.”) FSP SFAS 142-3 became effective beginning with our first quarter of 2009 and did not have a material impact on our financial condition or results of operations.

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162,” or SFAS No. 168. SFAS 168 replaces SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” to establish the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in preparation of financial statements in conformity with generally accepted accounting principles in the United States. SFAS No. 168 is effective for interim and annual periods ending after September 15, 2009. The adoption of SFAS No. 168 will not impact our financial position or results of operations.

Page 7

Index

Notes to Condensed Financial Statements

2. Restructuring

On September 1, 2009, we announced a plan to consolidate our product development and product management leadership functions in our Oakland, California headquarters. Under this plan, we expect to close our Waltham, Massachusetts office by the end of 2009. Approximately half of the Waltham office personnel are expected to remain with the company, while the remaining Waltham employees are expected to leave the company by the end of 2009. We notified the employees affected by the workforce reduction on September 1, 2009.

The Waltham office was acquired by Scientific Learning as part of its acquisition of the Reading Assistant product line in January 2008. We plan to continue to support and improve the Reading Assistant products, including the new Reading Assistant Expanded Edition that was launched in September 2009.

Restructuring costs were mainly recorded under Research and Development in our Condensed Statement of Operations and are shown in the following table (dollars in thousands):

Accrued at September 1, 2009	$	136
Cash paid		(14	)
Write offs		(9	)
Accrued at September 30, 2009	$	113

We expect to pay the majority of these costs during the fourth quarter of fiscal 2009. We also expect to incur additional restructuring costs in the fourth quarter as a result of closing the Waltham office prior to the end of the lease term.

3. Stock-Based Compensation

Accounting for Stock-Based Compensation

We recognized stock-based compensation expense of $286,000 and $1.0 million in the three months and nine months ended September 30, 2009, respectively, compared with of $443,000 and $1.6 million for the three and nine months ending September 30, 2008.

Valuation of Stock Option Awards

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility, the estimated life of each award and estimated pre-vesting forfeitures. The fair value of these stock options was estimated assuming no expected dividends and estimates of expected life, volatility and risk-free interest rate at the time of grant. Estimated volatility is based on the historical prices of our common stock over the expected life of each option. Expected life of the options is based on our history of option exercise and cancellation activity. The risk free interest rates used are based on the U.S. Treasury yield curve in effect at the time of grants for periods corresponding with the expected life of the options. We use historical data to estimate pre-vesting option forfeitures. We recognize compensation expense for the fair values of these awards, which typically have graded vesting, on a straight-line basis over the requisite service period of each of these awards.

Page 8

Index

Notes to Condensed Financial Statements

3. Stock-Based Compensation (continued)

Summary of Stock Options

We granted 487,900 and 30,000 stock options in the nine month periods ended September 30, 2009 and 2008, respectively, and 133,900 and 30,000 for the three month periods ended September 30, 2009 and 2008, respectively.

The aggregate intrinsic value of options outstanding at September 30, 2009 was approximately $3.3 million and is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 1,777,132 shares that had exercise prices that were lower than the $3.50 market price of our common stock at September 30, 2009 (“in the money options”). The total intrinsic value of options exercised during the nine months ended September 30, 2009 and 2008 was $121,000 and $144,000, respectively. The intrinsic value of options vested during the nine months ended September 30, 2009 and 2008 was $296,000 and $669,000, respectively.

As of September 30, 2009, total unrecognized compensation cost related to stock options granted under our various plans was $600,000. We expect that cost to be recognized over a weighted-average period of 2.9 years.

Summary of Restricted Stock Units

We granted 61,721 and 382,900 restricted stock units during the nine month periods ended September 30, 2009 and 2008, respectively, and zero and 2,500 restricted stock units for the three month periods ended September 30, 2009 and 2008, respectively.

The fair value of restricted stock units was calculated based upon the fair market value of our stock at the date of grant, less an estimate of pre-vesting forfeitures. The weighted-average grant-date fair value of restricted stock units awarded during the nine months ending September 30, 2009 and 2008 was $1.96 and $4.74, respectively, and zero and $3.60 for the three month periods ended September 30, 2009 and 2008, respectively.

Disclosures Pertaining to All Share-Based Compensation Plans

Cash received under all share-based payment arrangements for the nine months ended September 30, 2009 and 2008 was $402,000 and $451,000 respectively, related to the exercise of stock options. Because of our net operating losses and related valuation allowance, we did not realize any tax benefits for the tax deductions from share-based payment arrangements during the nine months ended September 30, 2009 or 2008.

4. Comprehensive Loss

We have no items of other comprehensive loss, and accordingly, the comprehensive loss is equal to the net loss for all periods presented.

5. Warranties; Indemnification

We generally provide a warranty that our software products substantially operate as described in the manuals and guides that accompany the software for a period of 90 days. The warranty does not apply in the event of misuse, accident, and certain other circumstances. To date, we have not incurred any material costs associated with these warranties and have no accrual for such items at September 30, 2009.

Page 9

Index

Notes to Condensed Financial Statements

5. Warranties; Indemnification (continued)

From time to time, we enter into contracts that require us, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against our customers for violation of third party intellectual property rights caused by our products; (ii) claims resulting from personal injury or property damage resulting from our activities or products; (iii) claims by our office lessor arising out of our use of the premises; and (iv) agreements with our officers and directors under which we may be required to indemnify such persons for liabilities arising out of their activities on behalf of ourselves. Because the obligated amounts for these types of agreements usually are not explicitly stated, the overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have been recorded for these obligations on our balance sheet as of September 30, 2009 or December 31, 2008.

6. Bank Line of Credit

On January 30, 2009 we amended our existing revolving line of credit agreement with Comerica Bank. The maximum that can be borrowed under the agreement is $5.0 million. The line expires on December 31, 2009. Borrowing under the line of credit bears interest at a “daily adjusting LIBOR rate.” Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and net worth not less than negative $2 million. The agreement includes a letter of credit sublimit not to exceed $1.0 million. At September 30, 2009, we have no outstanding borrowings, an outstanding letter of credit for $206,000, and we are in compliance with all of our covenants. During the three months ended September 30, 2009 we repaid the $2.5 million that we had borrowed in the three months ended March 31, 2009.

7. Provision for Income Taxes

In the three and nine months ending September 30, 2009, we recorded income tax expense of $301,000 and $367,000, respectively. For the three and nine months ended September 30, 2008 we recorded an income tax benefit of $36,000 and an expense of $1.2 million, respectively. The tax expense for the nine months ended September 30, 2009 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, federal tax expense, and state tax expense. The tax expense for the nine months ended September 30, 2008 consisted primarily of the establishment of valuation allowance against our deferred tax assets.

Statement of Financial Accounting Standards ASC 740, “Accounting for Income Taxes” provides for the recognition of deferred tax assets if realization of such assets is more likely than not. We have established and continue to maintain a full valuation allowance against our deferred tax assets as we do not believe that realization of those asserts is more likely than not.

At September 30, 2009, we have unrecognized tax benefits of approximately $1.9 million. We have approximately $4,000 of unrecognized tax benefits that, if recognized, would affect our effective tax rate. We do not believe there will be any material changes in our unrecognized tax positions over the next twelve months. Interest and penalty costs related to unrecognized tax benefits are insignificant and classified as a component of “Income Tax Expense” in the accompanying statement of operations.

We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. Tax returns remain open to examination by the appropriate governmental agencies for tax years 2006 to 2008. The federal and state taxing authorities may choose to audit tax returns for tax years beyond the statue of limitation period due to significant tax attribute carryforwards from prior years, making adjustments only to carryforward attributes. We are not currently under audit in any major tax jurisdiction.

Page 10

Index

Notes to Condensed Financial Statements

8. Software and web site development costs

Software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated lives of the related products. Technological feasibility is established upon completion of a working model. In the nine months ended September 30, 2009, we capitalized approximately $986,000 of costs relating to our new Reading Assistant product that had reached technological feasibility. We began amortizing these costs to cost of product revenues over the estimated useful life of the software, which is expected to be three years, starting when the product was released for sale in September 2009. We recorded amortization expense of $9,000 in the three months ended September 30, 2009.

At September 30, 2009 we have capitalized approximately $586,000 in web site development costs. We began to amortize these costs during the three months ended June 30, 2009, and we have recorded amortization expense of $42,000 through September 30, 2009. Costs will be amortized over a period corresponding to the estimated life of the related products, expected to be five years.

9. Fair value measurements

Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements.” Level 1 financial assets measured at fair value on a recurring basis consist of money market funds (cash equivalents) of approximately $16.7 million as of September 30, 2009 and approximately $6.8 million at December 31, 2008. We have no Level 2 or Level 3 financial assets measured at fair value on a recurring basis as of September 30, 2009 or at December 31, 2008.

10. Inventories

Inventories of $505,000 and $236,000 at September 30, 2009 and December 31, 2008, respectively, are included in “Prepaid expenses and other current assets” and consist entirely of finished goods.

Page 11

Index

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

This report contains forward-looking statements. Forward-looking statements are not historical facts but rather are based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” and variations and negatives of these words and similar expressions are used to identify forward-looking statements. Statements regarding our expectations for our future business results and financial position, our business strategies and objectives, and trends in our market are forward-looking statements. Forward-looking statements are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management’s Discussion and in the Risk Factors section of this report. We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

Overview

We develop, distribute and license technology that accelerates learning by improving the processing efficiency of the brain. Based on more than 30 years of neuroscience and cognitive research, our family of products improves brain fitness with technology-based exercises that build the cognitive skills required to read and learn effectively. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through participation in our products. Our products are marketed primarily to K-12 schools in the US, to whom we sell through a direct sales force. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. Since our inception, learners have used our products nearly 1.8 million times and approximately 6,000 schools have purchased at least $10,000 of our product licenses and services. As of September 30, 2009 we had 199 full-time equivalent employees, compared to 223 at December 31, 2008.

In January 2009 we announced a 14% reduction in our workforce which was implemented during the first quarter of 2009. On September 1, 2009, we announced a plan to consolidate our product development and product management leadership functions in our Oakland, California headquarters. Under this plan, we expect to close our Waltham, Massachusetts office by the end of 2009. Approximately seven Waltham employees are expected to leave the company by the end of 2009.

Business Highlights

We market our Fast ForWord and Reading Assistant products primarily as a reading intervention solution for struggling and special education students and English Language Learners. According to the U.S. Department of Education, in 2007, 33% of fourth graders in the United States had “below basic” reading scores and 67% were not proficient in reading, and between 1992 and 2007 there was only a modest improvement in the proportion of fourth graders performing at the “below basic” level. While our installed base is growing, the approximately 6,000 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 115,000 K-12 schools in the US.

Federal education funds are a critical resource in helping school districts address the needs of the most challenged learners. We believe that a significant proportion of our sales are funded by federal sources, particularly Title One and IDEA (special education) grants. With the passage of the American Recovery and Reinvestment Act (“ARRA” - the recent stimulus bill), these two federal sources are together projected to increase from $24.9 billion in the 2008 – 2009 school year to $37 billion in the 2009 – 2010 school year. In most states the ARRA funds have been and are being disbursed to school districts, and we believe that the ARRA funding has had a substantial positive impact on our 2009 sales.

Page 12

Index

State funds also provide school districts with funds that are used to purchase our products. State funds provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products. States faced severe budget shortfalls in fiscal 2009 and forecast continuing funding difficulties in 2010. The National Conference of State Legislatures estimates that the cumulative state budget gap was $113.2 billion in fiscal 2009, and in June 2009, forecast a cumulative budget gap for fiscal 2010 of $142.6 billion, involving 46 states.

Company Highlights

For the three months ended September 30, 2009, our total revenue increased by 60% compared to the three months ended September 30, 2008 and for the nine months ended September 30, 2009 our total revenue increased 12%. These revenue increases were primarily caused by strong sales driven by the improvement in the school funding environment, resulting from the temporary federal stimulus funding, and by sales productivity enhancements. Revenue for the three months ended September 30, 2009 also benefited from the recognition of approximately $2 million of revenue that was previously deferred at June 30, 2009 relating to our Reading Assistant Expanded edition product upon the product’s release in September 2009. Product revenue increased by 107% and 22% for the three and nine month periods ended September 30, 2009, respectively, compared to the same periods in 2008. Service and support revenue decreased by 8% in the three months ended September 30, 2009 compared to the three months ended September 30, 2008 and by 2% for the nine month period, mainly because of incremental OEM revenue that was recognized in 2008.

For the three months and nine months ended September 30, 2009, our total booked sales increased by 72% and 27%, respectively, over the same periods in 2008. (Booked sales is a non-GAAP financial measure. For more explanation on booked sales, see Revenue below). K-12 sales increased by 83% and 36% in the three and nine month periods ended September 30, 2009, respectively, compared to the same periods in 2008, and non school sales, including private practice, international and OEM customers, decreased by 38% and 35% in the same periods. The flow of federal stimulus funds to individual school districts and the spending requirements linked to these funds put school districts in a better position to execute new purchases during the quarter. Booked sales also benefited from a large $6.9 million deal that closed in early July. For the three months ended September 30, 2009, we closed 38 transactions in excess of $100,000, compared to 23 in the third quarter of 2008. We believe that the decrease in non school sales is primarily caused by adverse economic conditions affecting our customers in both the private practice and international markets.

For the three months and nine months ended September 30, 2009, gross margin improved by 8% and 4% compared to the same periods in 2008, mainly due to a change in revenue mix towards higher margin product. Operating expenses increased by 11% and decreased by 8% for the three months and nine months ended September 30, 2009, respectively, as cost savings resulting from our restructuring initiative in January 2009 were partially offset by increased bonus and commission expense arising from our strong financial performance in the current quarter.

We recorded a net income of $6.5 million for the three months ended September 30, 2009 compared to a net income of $590,000 in the same period in 2008. We recorded a net income of $3.3 million for the nine months ended September 30, 2009 compared to a net loss of $4.5 million in the same period in 2008.

At September 30, 2009 we had no borrowings under our credit line with Comerica Bank.

Page 13

Index

Results of Operations

Revenues

	Three Months Ended September 30,							Nine Months Ended September 30,
(dollars in thousands)	2009		Change			2008		2009		Change			2008
Products	$	15,510		107	%	$	7,475	$	25,630		22	%	$	21,009
Service and support		4,783		-8	%		5,220		13,904		-2	%		14,252
Total revenues	$	20,293		60	%	$	12,695	$	39,534		12	%	$	35,261

Product revenues increased by 107% and 22% during the three months and nine months ended September 30, 2009 respectively, compared to the same periods in 2008. The increase in the three months ended September 30, 2009 was due to higher booked sales, including one transaction for $6.9 million where we recognized product revenue of $3.2 million, and the recognition of approximately $2 million of revenue related to our Reading Assistant Expanded Edition product. This revenue resulted from sales in prior quarters that included Reading Assistant Expanded Edition software, which was deferred until the product’s release in September 2009. The increase in the nine months ended September 30, 2009 is primarily due to higher booked sales, reflecting the impact of federal stimulus funding and sales productivity improvements.

Our service and support revenue decreased by 8% and 2% respectively during the three months and nine months ended September 30, 2009 compared to the same periods in 2008, mainly due to the recognition during 2008 of OEM revenue relating to the operations we purchased in our acquisition of Soliloquy in January 2008. Excluding the impact of OEM revenue, service and support revenue is essentially flat over 2008.

Booked sales and selling activity: Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is a useful metric for investors as well as management because it is the most direct measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenues, and is not intended to represent a substitute measure of revenues or any other performance measure calculated under GAAP.

The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three and nine months ended September 30, 2009 and 2008:

	Three Months Ended September 30,							Nine Months Ended September 30,
(dollars in thousands)	2009		Change			2008		2009			Change			2008
Total deferred revenue beginning of period	$	18,614				$	20,621	$	19,952					$	22,955
Booked sales		26,122		72	%		15,185		45,115			27	%		35,417
Less: revenue		20,293		60	%		12,695		39,534			12	%		35,261
Other adjustments		733					-		(357	)					-
Total deferred revenue end of period	$	25,176		9	%	$	23,111	$	25,176			9	%	$	23,111

For the three months and nine months ended September 30, 2009, our total booked sales increased by 72% and 27%, respectively, over the same periods in 2008. K-12 sales increased by 83% and 36% in the three and nine month periods ended September 30, 2009, respectively, compared to the same periods in 2008. The flow of federal stimulus funds to individual school districts and the spending requirements linked to these funds put school districts in a better position to execute new purchases during the quarter. Booked sales also benefited from a large $6.9 million deal that closed in early July.

Page 14

Index

Booked sales to non school customers, including private practice clinicians and international customers, decreased by 38% and 35% in the three months and nine months ended September 30, 2009 compared to the same periods in 2008. We believe that the decrease in non school sales is primarily caused by adverse economic conditions affecting our customers in both the private practice and international markets.

During the third quarter of 2009, we closed 38 K-12 sales that had a contract value in excess of $100,000, compared to 23 for the same period in 2008. For the three months ended September 30, 2009, approximately 79% of our K-12 booked sales were realized from booked sales over $100,000. For the comparable period in 2008, these large booked sales accounted for approximately 60% of K-12 booked sales. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate. Because we discount product license fees but do not discount service and support fees, product booked sales and revenue are disproportionately affected by discounting. We cannot predict the size and number of large transactions in the future.

Although the current economic and financial conditions, the temporary nature of federal stimulus funding, and federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 market. However, achieving our growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators. Our K-12 growth prospects are also influenced by factors outside our control, including general economic conditions and the overall level, certainty and allocation of state, local and federal funding. While federal funding for education has grown steadily over the last few decades, the current extraordinary federal commitments intended to stabilize the financial markets are likely to put pressure on all areas in the federal budget. In addition, school district spending based on federal education stimulus funding is expected to decline after 2010 and end after 2011. States are forecasting continued shortfalls in their taxation revenues for their fiscal 2010 largely due to the significant adverse conditions in the credit and housing markets and the national and global recession. These conditions may impact state education spending. In addition, the revenue recognized from our booked sales can be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected. See “Management’s Discussion and Analysis – Application of Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2008 for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time. See “Risk Factors” for a further discussion of some of the factors that affect our sales and revenue.

Gross Profit and Cost of Revenues

	Three Months Ended September 30,						Nine Months Ended September 30,
(dollars in thousands)	2009			2008			2009			2008
Gross profit on products	$	14,495		$	6,876		$	23,669		$	19,323
Gross profit margin on products		93	%		92	%		92	%		92	%
Gross profit on service and support		2,547			2,809			7,462			6,973
Gross profit margin on services and support		53	%		54	%		54	%		49	%
Total gross profit	$	17,042		$	9,685		$	31,131		$	26,296
Total gross profit margin		84	%		76	%		79	%		75	%

The overall gross profit margin increased by 8% and 4% respectively in the three months and nine months ended September 30, 2009 compared to the same periods in the prior year, mainly due to a revenue mix shift. Higher margin product revenues made up 76% and 65% of total revenues in the three and nine months ended September 30, 2009, respectively, compared to 59% and 60% in the same periods in 2008. Product margins increased by 1% in the three months ended September 30, 2009, and were flat for the nine month period, as increased amortization expense arising from the intangible assets acquired from Soliloquy and product costs associated with Reading Assistant were offset by proportionately lower royalty costs. Service and support margins improved in the nine months ended September 30, 2009 compared to the same period in 2008 principally due to year over year price increases and cost savings resulting from more efficient delivery of services.

Page 15

Index

Operating Expenses

	Three Months Ended September 30,							Nine Months Ended September 30,
(dollars in thousands)	2009		Change			2008		2009		Change			2008
Sales and marketing	$	6,243		17	%	$	5,329	$	16,967		-8	%	$	18,461
Research and development		1,846		19	%		1,545		4,588		-13	%		5,267
General and administrative		2,169		-10	%		2,398		6,019		-5	%		6,346
Total operating expenses	$	10,258		11	%	$	9,272	$	27,574		-8	%	$	30,074

Sales and Marketing Expenses: For the three and nine months ended September 30, 2009, our sales and marketing expenses increased by 17% and decreased by 8%, respectively, compared to the same periods in 2008. The increase in the three months ended September 30, 2009 is mostly due to higher commission expense as a result of the strong sales performance. The decrease for the nine months ended September 30, 2009 is primarily due to lower headcount related costs as a result of the restructuring actions taken in January 2009. At September 30, 2009, we had 43 quota-bearing sales personnel compared to 51 at September 30, 2008.

Research and Development Expenses: Research and development expenses increased by 19% and decreased by 13% in the three and nine months ended September 30, 2009, compared to the same periods in 2008. The increase in the three months ended September 30, 2009 is mainly due to an increase in bonus expense of $273,000 and a decrease in OEM customization costs transferred to cost of revenue of $172,000. The decrease for the nine months ended September 30, 2009 is due to the capitalization of approximately $1.1 million of development costs, mostly relating to our Reading Assistant Expanded Edition product, and a decrease in headcount related costs of $366,000 as a result of the restructuring actions taken in January 2009, partially offset by a decrease in OEM customization costs transferred to cost of revenue of $415,000 and increased bonus expense of $402,000. Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs.

General and Administrative Expenses: For the three and nine months ended September 30, 2009, our general and administrative expenses decreased by 10% and 5%, respectively, compared to the same periods in 2008. The decreases in the three and nine months ended September 30, 2009 are mainly due to a decrease in bad debt expense of $394,000 and $316,000, respectively. Increases in bonus expense were largely offset by decreases in headcount related costs.

Interest and Other Income (Expense)

	Three Months Ended September 30,								Nine Months Ended September 30,
(dollars in thousands)	2009			Change			2008		2009			Change			2008
Net interest income (expense)	$	(5	)		-138	%	$	13	$	(24	)		-125	%	$	97
Reclassification of service revenue		40			-45	%		73		177			-18	%		217
Other		(63	)		-215	%		55		(63	)		-140	%		159
Interest and other income (expense), net	$	(28	)		-120	%	$	141	$	90			-81	%	$	473

Interest and other income decreased in both the three and nine month periods ended September 30, 2009 compared to the prior year periods because of lower reclassifications of service and support revenue relating to a customer for whom we are no longer performing services, less interest on our cash balances, interest expense on our bank loan from January through August 2009, a $54,000 loss on disposal of a fixed asset in the three months ended September 30, 2009 and the reclassification of royalty income from Posit Science which is now classified as product revenue.

Provision for Income Taxes

Page 16

Index

Liquidity and Capital Resources

Our cash and cash equivalents were $16.9 million at September 30, 2009, compared to $7.6 million at December 31, 2008.

We expect that during at least the next twelve months our cash flow from operations together with our current cash balances will be our primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures. Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter. Reflecting this pattern as well as the significant sales increase in the third quarter, in the first six months of 2009, we used $4.2 million in operating activities and in the three months ended September 30, 2009, we generated $14.7 million of cash from operations. We expect that cash flow from operations will be sufficient to fund our operating requirements during fiscal 2010. Accomplishing this, however, will require us to meet specific booked sales targets in the K-12 market. We cannot assure you that we will meet our targets with respect to booked sales, revenues, expenses or operating results.

We have a revolving line of credit agreement with Comerica Bank that expires on December 31, 2009. The maximum that can be borrowed under the agreement is $5.0 million. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and a financial covenant requiring us to maintain a minimum adjusted quick ratio of 1.15 and net worth not less than negative $2 million. The agreement allows us to issue letters of credit not to exceed $1.0 million. At September 30, 2009, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at September 30, 2009 and we were in compliance with all related covenants.

If we are unable to achieve sufficient cash flow from operations, we may seek other sources of debt or equity financing, or may be required to reduce expenses. Reducing our expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.

Net cash provided by operating activities for the nine months ended September 30, 2009 was $10.5 million compared to cash used of $5.2 million during the same period in 2008. This improvement was mainly the result of lower expenses as a result of our January 2009 restructuring actions and higher receivable collections resulting from our stronger sales performance.

Page 17

Index

Net cash used in investing activities for the nine months ended September 30, 2009 was $1.6 million, due to capital spending and additions to capitalized software. Net cash used in investing activities for the nine months ended September 30, 2008 was $10.3 million, due principally to the acquisition of the assets of Soliloquy Learning.

Financing activities generated $402,000 for the nine months ended September 30, 2009, compared to $451,000 for the nine months ended September 30, 2008, from proceeds from the exercise of stock options.

In the nine months ended September 30, 2009 we borrowed and repaid $2.5 million from our credit facility. In the nine months ended September 30, 2008 we had no borrowings.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements.

Contractual Obligations and Commitments

We have a non-cancelable lease agreement for our corporate office facilities. From 2009 through the end of the lease, the base lease payment increases at a compound annual rate of approximately 5%. The lease expires in December 2013. We also have a lease agreement for our Tucson, Arizona office through May 2013 at an average rent of approximately $11,000 per month, and a lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet at an average monthly rent of approximately $12,000 that expires in September 2011. We are seeking to enter into a sublease agreement for the Waltham lease as we are ceasing operations in that location (see Note 2).

The following table summarizes our obligations at September 30, 2009 and the effects such obligations are expected to have on our liquidity and cash flow in future periods:

(dollars in thousands)	Less than 1 year		2-3 years		4-5 years		Thereafter		Total
Contractual Obligations:
Operating lease obligations	$	1,294	$	2,606	$	1,250	$	311	$	5,461
Purchase obligations		150		300		300		150	$	900
Total	$	1,444	$	2,906	$	1,550	$	461	$	6,361

Our purchase order commitments at September 30, 2009 are not material.

Page 18

Index

Application of Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, assumptions and judgments. We believe that the estimates, assumptions and judgments upon which we rely are reasonable based upon information available to us at the time. The estimates, assumptions and judgments that we make can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.

We believe that, as discussed in our most recent Report on Form 10-K, the estimates, assumptions and judgments pertaining to revenue recognition, the allowance for doubtful accounts, income taxes, and stock based compensation are the most critical assumptions to understand in order to evaluate our reported financial results. There has been no change to these policies.

In addition, as discussed in Note 8 to the Condensed Financial Statements, in the nine months ended September 30, 2009 we capitalized approximately $986,000 of costs relating to a new Reading Assistant product that had reached technological feasibility. The rules that govern how development costs are accounted for can have a major impact on our reported financial results. Significant judgment is required in assessing whether and when products have reached technological feasibility. We are also required to use judgment to estimate the net realizable value of the asset by projecting future revenues and cash flows expected to be generated by the products, in order to determine whether the unamortized cost exceed the net realizable value. Moreover, any future changes to our software product offerings could result in write-offs of previously capitalized costs and have a significant impact on our financial results.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to the rate of interest that we earn on our cash and cash equivalents. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at September 30, 2009 would not have a material affect on our results of operations.

Item 4T. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the required time periods. These procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

As required under Rule 13a-15(b) of the Exchange Act, our management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q, and concluded that our disclosure controls and procedures were effective as of September 30, 2009.

It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the interim Chief Financial Officer are made at the “reasonable assurance” level.

Page 19

Index

Changes in Internal Controls over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Page 20

Index

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

None.

Page 21

Index

Item 1A. Risk Factors

RISK FACTORS

The following factors as well as other information contained in this report should be considered in making any investment decision related to our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected and the trading price of our common stock could decline.

Our sales cycle tends to be long and somewhat unpredictable, which may result in delayed or lost revenue, which could materially and adversely impact our revenue and profitability.

Like other companies in the instructional market, our sales to K-12 schools are affected by school purchasing cycles and procedures, which can be quite bureaucratic. The cost of some of our K-12 license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that can be difficult to predict. When a district decides to finance its license purchase, the time required to obtain necessary approvals can be extended even further. In addition, sales to schools are subject to budgeting constraints, which may require schools to find available discretionary funds, obtain grants or wait until subsequent budget cycles. As a result, our sales cycle generally takes months, and in some cases, can take a year or longer. We believe that the severity of the current economic downturn and the resulting funding uncertainties have lengthened this cycle and may be making it less predictable. Therefore, we may devote significant time and energy to a particular customer sale over the course of many months, and then not make the sale when expected or at all. This can result in lost opportunities that can materially and adversely impact our revenue and profit.

Sales of our products depend on the availability of government funding for public school reading intervention purchases, which is variable and outside the control of both us and our direct customers. If such funding becomes less available, our public school customers may be unable to purchase our products and services on a scale or at prices that we anticipate, which would materially and adversely impact our revenue and net income.

United States public schools are funded primarily through state and local tax revenues, which are devoted primarily to school building costs, teacher salaries and general operating expenses. Public schools also receive funding from the federal government through a variety of federal programs, many of which target children who are poor and/or are struggling academically. Federal funds typically are restricted to specified uses. We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, in particular IDEA (special education) and Title One funding.

State and local school funding is being significantly impacted by decreases in tax revenues due to the current severe economic downturn. States experienced substantial budget gaps in fiscal 2009 and face increasing pressure in 2010, primarily due to the significant adverse events in the credit, housing and job markets and the national and global recession. While education spending remains an important priority for states, it faces competition from demands for, among other things, relief for homeowners, transportation spending and rising healthcare costs. A continued reduction in state tax revenues could have a materially adverse impact on our revenue.

When state and local funding is reduced, federal funding becomes even more important for school districts. While the American Recovery and Reinvestment Act (ARRA) provides very substantial increases in funding for IDEA and Title One over a two-year period, the competition between vendors and programs for that funding is intense. In addition, there has been some uncertainty over the rules governing the use of the increased funding, causing confusion and delay among educators, and the release of ARRA education funding to school districts is still delayed in a few states. The current extraordinary levels of federal spending directed to economic recovery, the federal budget deficit and competing federal priorities could adversely impact the availability of federal education funding. A cutback in federal education funding could have a materially adverse impact on our revenue.

Page 22

Index

Sales in our non school markets may continue to be affected by the current global recession.

Our non school sales consist principally of sales to private speech and language and other healthcare providers, sales to our international value-added resellers, and sales to government agencies for correctional institutions. In addition, during 2009 we launched new products marketed to parents for at-home use by their children.

Historically, sales to private providers have been adversely impacted by economic downturns, as many parents postpone or forego these services when their financial resources are reduced. During the first nine months of 2009, sales to both private providers and to our international channel declined substantially compared to the prior year. We believe that this decline is mainly a result of present global economic difficulties. The current recession may likewise adversely affect our potential sales to parents of our new BrainSpark and BrainPro products. Sales for correctional institutions may be affected by the same state and local government funding pressures as K-12 schools.

Our current liquidity resources may not be sufficient to meet our needs.

We believe that cash flow from operations, together with our current cash balances, will be our primary source of funding for our operations during the remainder of 2009 and the next several years. During the first nine months of 2009, we have generated $10.5 million in cash from operations. In 2008, we used $13.6 million from our cash balances, with $10.1 million used for the acquisition of the Soliloquy business and $3.7 million used in operating activities. In the first quarter of 2009, we amended our $5 million credit line from Comerica Bank to extend the line through December 31, 2009 and to relax certain covenants. In January 2009, we drew down and in August 2009 we repaid $2.5 million under that line. At September 30, 2009, we had $16.9 million in cash and cash equivalents.

Historically, we have used cash in our operations during the first half of the year and built cash in the second half. This pattern results largely from our seasonally low sales in the first calendar quarter, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter. Reflecting this pattern as well as the significant sales increase in the third quarter, in the first six months of 2009, we used $4.2 million in operating activities and in the three months ended September 30, 2009, we generated $14.7million of cash from operations. While we expect that our current cash balances and cash generated from operations will be sufficient to fund our operating requirements during the next twelve months, this will require us to meet certain levels of booked sales and collections. We cannot assure you that we will meet our targets with respect to booked sales, revenues, expenses or operating results.

At September 30, 2009, no borrowing was outstanding under our credit line with Comerica and we were in compliance with the covenants of the line. Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica, and financial covenants requiring us to maintain a minimum adjusted quick ratio of 1.15 and net worth not less than negative $2 million. If we do not comply with the covenants, we risk being unable to borrow under the credit line.

Funding our liquidity needs out of cash flow from operations will require us to achieve certain levels of booked sales, collections, and expenses. If we are unable to achieve sufficient levels of cash flow from operations, or are unable to obtain waivers or amendments from Comerica in the event we do not comply with our covenants, we would be required either to obtain debt or equity financing from other sources, or to reduce expenses. Reducing our expenses could adversely affect our operations by reducing the resources available for sales, marketing, research or development efforts. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.

It is difficult to accurately forecast our future financial results. This may cause us to fail to achieve the financial performance anticipated by investors and financial analysts, which could cause the price of our stock to decline.

Our revenue and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year. We had net income of approximately $3.3 million in the first nine months of 2009. In 2008, we had an operating loss of approximately $2.6 million and a net loss of approximately $3.3 million. In 2007, we had an operating loss of approximately $1.2 million and net income of approximately $1.2 million.

Page 23

Index

A significant proportion of our customers’ purchases are made within the last two weeks of each quarter. We therefore have limited visibility on revenue for the quarter until the end of the quarter. If a customer unexpectedly postpones or cancels an expected purchase due to changes in the customer’s objectives, priorities, budget or personnel, we may experience an unexpected shortfall that cannot be made up in the quarter. The effect of the concentration of sales at the end of the quarter is compounded by the fact that our various license and service packages have substantially differing revenue recognition periods. Even when the amount and timing of a transaction can be accurately projected, it may be difficult to predict which license package a customer will purchase.

In addition, our sales strategy emphasizes district-level, multi-site transactions. The receipt or implementation of a single large order, or conversely its loss or delay, can significantly impact the level of sales booked and revenue recognized in a given quarter.

Our expense levels are based on our expectations of future revenue and are primarily fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, which could cause our net income to fluctuate unexpectedly.

Failure to achieve the financial results expected by investors and financial analysts in a given quarter could cause an immediate and significant decline in the trading price of our common stock.

To grow our K-12 business, we need to increase acceptance of our products among K-12 education purchasers. Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.

We believe that to date most educators who have used Fast ForWord products are “early adopters.” Early adopters make up a relatively small proportion of our K-12 market, so in order to grow our revenue and profit we need to increase our reach beyond early adopters to more conservative customers. We believe that our ability to grow acceptance of our products in the conservative K-12 education market will depend largely on the critical factors discussed below.

Our Fast ForWord products use an approach that differs from the approaches that schools have traditionally used to address reading problems. In particular, our products, which are designed to develop the brain to process more efficiently, are based on neuroscience research and focus on building cognitive skills. These concepts may be unfamiliar to educators. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.

In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires at least 30 minutes per day out of a limited and already crowded school day. Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us. In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased revenue.

Our products are generally implemented in a computer lab with a lab coach or teacher rather than in the classroom with the students’ regular classroom teachers. To reach a broader group of customers, encourage additional sales from existing customers and improve student achievement results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner.

If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our revenue and growth prospects could be materially and adversely impacted.

We rely on studies of student performance results to demonstrate the effectiveness of our products. If the validity of these studies or the conclusions that we draw from them are challenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.

We rely heavily on statistical studies of student results on assessments to demonstrate that our products lead to improved student achievement. Reliance on these studies to support our claims about the effectiveness of our products involves risks, including the following:

Page 24

Index

The results of studies depend on schools’ appropriately implementing the products and adhering to the product protocol. If a school does not do so, the study may not show that our products produce substantial student improvements.

Some studies on which we rely may be challenged because the studies use a limited sample size, lack a randomly selected control group, include assistance or participation from us or our scientists, or have other design characteristics that are not optimal. These challenges may assert that these studies are not sufficiently rigorous or free from bias, and may lead to criticism of the validity of the studies and the conclusions that we draw from them.

Schools studying the effectiveness of our products use the product with different types of students and use different assessments, sometimes making it difficult to aggregate or compare results.

Our sales and marketing efforts, as well as our reputation, could be adversely impacted if the studies upon which we rely to demonstrate the effectiveness of our products, or the conclusions we draw from those studies, are seen to be insufficient.

If our operations are disrupted due to weaknesses in our technology infrastructure, our business could be harmed.

Providing our services and conducting our general business operations both substantially rely on computer and network systems. We have recently experienced disruptions in both our customer and internal network services due to hardware failures. We are in the midst of a major project to upgrade many of our computer and network systems, which we believe have become outdated. If our customer systems are disrupted, we may be required to issue credits, customers may elect not to renew their contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability. If our internal systems are disrupted, we may lose productivity and incur delays in product development, sales operations or other functions.

If our products contain errors or if customer access to our web-delivered products and services is disrupted, we could lose new sales and be subject to significant liability claims.

Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released. In the past, we have encountered unexpected bugs in our products shortly after release. We expect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products could lead to:

delays in or loss of market acceptance of our products;

diversion of our resources;

a lower rate of expansion purchases from current customers;

injury to our reputation; and

increased service expenses or payment of damages.

Our Progress Tracker data tool, the Web-enabled version of the Reading Assistant product, our new Virtual Academy and other online services, and our new BrainSpark and BrainPro products all rely on the World Wide Web in order to function. Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of that product. The servers that support our Web-delivered products and services are located in third party facilities. While we believe that the services provided by these facilities are robust, interruptions in customer access could be caused by the occurrence of a natural disaster, power loss, vandalism or other telecommunications problems. We have experienced problems due to power loss in the past, and we will continue to be exposed to the risk of access failure in the future.

Page 25

Index

If our products do not work properly, or if there are problems with customer access to our Web-delivered products and services, we may be required to issue credits, customers may elect not to renew their support or access contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability claims. We cannot be certain that the limitations of liability set forth in our agreements would be enforceable or would otherwise protect us from liability for damages. A material liability claim against us, regardless of its merit or its outcome, could result in substantial costs, significantly harm our business reputation and divert management’s attention from our operations.

Our new BrainSpark and BrainPro products are marketed directly to parents. We may be unable to successfully penetrate this market.

In the US, we presently market primarily to K-12 public schools. Parents who purchase our products for use with their children do so through our much smaller channel, private providers, in which the marketing is done by the individual private provider. For the BrainSpark and Brain Pro offerings launched in 2009, we are marketing and selling directly to parents, a new market for us. We may find our marketing efforts in this market less effective or more expensive than we have planned. The current recession may make our marketing and sales efforts in this market more difficult than we expect. If our marketing efforts are less effective than we expect, we may be unable to achieve our planned level of sales and revenue from this market. If our sales and revenue are substantially less than expected, this may cause us to incur impairment charges against the capitalized development costs for these products.

We will be required to comply with the auditors’ attestation requirement of Sarbanes-Oxley Section 404 no later than fiscal 2010. If we or our auditors determine that our internal controls over financial reporting are not effective or if we are unable to comply with the auditors’ attestation requirement when we are required to do so, such ineffective controls or non-compliance could have a materially adverse effect on us.

Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we have been required to provide a management assessment on our internal control over financial reporting for fiscal 2007 and 2008, and we complied with that requirement.

We will be required to comply with the auditor’s attestation requirement in fiscal 2010. We cannot assure you that, in the course of completing the work to satisfy the auditors’ attestation requirement, we or our auditors will not detect a material weakness in our internal control over financial reporting or that we can satisfactorily comply with the attestation requirement.

Claims relating to data collection from our user base may subject us to liabilities and additional expense.

Schools and clinicians that use our products frequently use students’ names to register them in our products and enter into our database academic, diagnostic and/or demographic information about the students. In addition, the results of student use of our products are uploaded to our database. We have designed our system to safeguard this personally-identifiable information, but the protection of such information is an area of increasing public concern and significant government regulation, including but not limited to the Children’s Online Privacy Protection Act. If our privacy protection measures prove to be ineffective, we could be subject to liability claims for unauthorized access to or misuses of personally-identifiable information stored in our database. We may also face additional expenses to analyze and comply with increasing regulation in this area.

We may not be able to compete effectively in the education market.

The market in which we operate is very competitive. We compete vigorously for the funding available to schools, including against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than we are, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

Page 26

Index

Our Fast ForWord products are differentiated in the market by their basis in neuroscience research and their focus on improving brain processing efficiency and cognitive skills. Recently we have seen an increase in the number of neuroscientists working with other companies to repackage and commercialize their research, resulting in the introduction of other products based on neuroscience research and focusing on improving brain processing. We anticipate that this increase in “brain fitness” products will continue in the near future. To the extent that these products are adopted in place of our product, this could materially and adversely impact our revenue.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.

We depend on the performance of our senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

If we are unable to maintain our access to the intellectual property rights that we license from third parties, our sales and net income will be materially and adversely affected.

Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey. In 2008, we generated approximately 61% of our booked sales from products that use this licensed technology. If we were to lose our rights under these licenses (whether through expiration of our exclusive license period, expiration of the underlying patent’s exclusivity, invalidity or unenforceability of the underlying patents, a breach by us of the terms of the license agreements or otherwise), such a loss of these licensed rights or a requirement that we must re-negotiate these licenses could materially harm our booked sales, our revenue and our net income.

If we are unable to adequately protect our intellectual property rights or if we infringe on the rights of others, we could become subject to significant liabilities, need to seek licenses or lose our rights to sell our products.

Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. It is possible that our issued patents will not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents. Issued patents can prove to be invalid or unenforceable as a result of a variety of reasons, including deficiencies in prosecution. As a result of potential deficiencies during the prosecution of certain patents to which we have rights, it is possible that these patents may be subject to a claim of unenforceability or invalidity. If others are able to develop similar products due to the expiration, unenforceability or invalidity of the underlying patents, the resulting competition could materially harm our booked sales, revenue and net income. The Company historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright. The degree of future protection for our proprietary rights is also uncertain for products or product improvements in early-stage development, because it is difficult to predict from early-stage development efforts which product(s) will ultimately be marketed or what form the ultimately marketed product(s) will take.

In addition, we could become party to patent or trademark infringement claims, litigation or interference proceedings. These proceedings could result from claims that we are violating the rights of others or may be necessary to enforce our own rights. Any such proceedings would result in substantial expense and significant diversion of management effort, and the outcome of any such proceedings cannot be accurately predicted. An adverse determination in such proceedings could subject us to significant liabilities or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture or increase their market share with respect to related technologies.

Page 27

Index

We generally require the execution of a written licensing agreement, which restricts the use and copying of our software products. However, if unauthorized copying or misuse were to occur to a substantial degree, our sales could be adversely affected.

Our common stock is thinly traded and its price is volatile.

Our common stock presently trades on the Nasdaq Capital Market. In November 2008 we moved to the Nasdaq Capital Market from the Nasdaq Global Market, because the market value of our common stock fell below the required threshold for the Global Market due to declines in our stock price. Our trading volume is generally low. For example during the third quarter of 2009, our average daily trading volume was approximately 17,100 shares. As a result, the ability of holders of our common stock to sell such common stock and thereby monetize their investment may be limited. In addition, the market price of our common stock has been highly volatile since we became publicly traded and could continue to be subject to wide fluctuations.

The ownership of our common stock is concentrated.

At September 30, 2009, Trigran Investments owned approximately 28% of our outstanding stock, and our officers and directors held approximately 11% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of our company.

Page 28

Index

Item 6. Exhibits

Exhibit No.		Description of Document
3.1 (1)		Amended and Restated Certificate of Incorporation.
3.2 (2)		Amended and Restated Bylaws
31.1		Certification of Chief Executive Officer (Section 302).
31.2		Certification of Chief Financial Officer (Section 302).
32.1		Certification of Chief Executive Officer (Section 906).
32.2		Certification of Chief Financial Officer (Section 906).

(1)

Incorporated by reference to exhibit previously filed with the Company’s Form 10-Q for the quarter ended March 31, 2007, file no. 000.2457.

(2)

Incorporated by reference to exhibits previously filed with the Company’s Amendment No. 1 to the Registration Statement on Form S-1 filed on July 13, 2007, registration no. 333-143093.

Page 29

Index

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 6, 2009

	Scientific Learning Corporation
	(Registrant)
	/s/ Robert E. Feller
	Robert E. Feller
	Senior Vice President and Chief Financial Officer
	(Authorized Officer and Principal Financial and
	Accounting Officer)

Page 30

Index

Index to Exhibits

Exhibit No.		Description of Document
3.1 (1)		Amended and Restated Certificate of Incorporation.
3.2 (2)		Amended and Restated Bylaws
31.1		Certification of Chief Executive Officer (Section 302).
31.2		Certification of Chief Financial Officer (Section 302).
32.1		Certification of Chief Executive Officer (Section 906).
32.2		Certification of Chief Financial Officer (Section 906).

(1)

Incorporated by reference to exhibit previously filed with the Company’s Form 10-Q for the quarter ended March 31, 2007, file no. 000.2457.

(2)

Incorporated by reference to exhibits previously filed with the Company’s Amendment No. 1 to the Registration Statement on Form S-1 filed on July 13, 2007, registration no. 333-143093.

Page 31

Attached files

Stock widget

Investing forum

SCIENTIFIC LEARNING CORP Reports

Also read