UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

OR

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

For the transition period from                      to                     

Commission File number # 000-24547

Scientific Learning Corporation

300 Frank H. Ogawa Plaza, Suite 600
Oakland, California 94612
(510) 444-3500
(Address of Registrants principal executive offices, including zip code, and
telephone number, including area code)

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

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

The number of shares of the Registrant’s Common Stock, $.001 par value per share, outstanding at April 30, 2005 was 16,683,898.

SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED March 31, 2005

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SCIENTIFIC LEARNING CORPORATION

See accompanying notes to condensed financial statements

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SCIENTIFIC LEARNING CORPORATION

See accompanying notes.

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SCIENTIFIC LEARNING CORPORATION

See accompanying notes.

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

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

Use of Estimates

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

Interim Financial Information

The interim financial information as of March 31, 2005 and for the three months ended March 31, 2005 and 2004 is unaudited, but includes all normal recurring adjustments that the Company considers necessary for a fair presentation of its financial position at such date and its results of operations and cash flows for those periods.

These condensed financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, contained in the Company’s Annual Report on Forms 10-K and 10-K/A for the year ended December 31, 2004, filed with the Securities and Exchange Commission.

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgments related to our specific transactions and transaction types.

Sales to our school customers typically include multiple elements (e.g. Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”). VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products.

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and is recognized as follows:

Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.

Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.

Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.

Service and support revenue

Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

Other Assets

Other assets consist of the following (in thousands):

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

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 is computed using the weighted average number of common shares outstanding during the period and, when dilutive, includes potential common shares from options and warrants calculated using the treasury stock method.

Stock-Based Compensation

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

Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value at the grant dates for awards under those plans calculated using the Black-Scholes valuation model, the Company’s pro forma net income (loss) and basic and diluted net income (loss) per share would have been as follows (in thousands, except per share amounts):

The fair value of the employee stock options was estimated using the following assumptions:

The fair value of employee stock purchase plan stock issued was estimated using the following assumptions:

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

The pro forma impact of options on net income (loss) for the three months ended March 31, 2005 and 2004 is not representative of the effects on net income for future periods, as future years will include the effects of additional periods of stock option grants.

SFAS 123(R), “Share-Based Payment”

On December 16, 2004 the FASB issued SFAS 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supercedes APB 25, “Accounting for Stock Issued to Employees,” and amends SFAS 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options and purchases under employee stock purchase plans, to be recognized in the statement of operations based on their fair values. Pro forma disclosure of fair value recognition will no longer be an alternative. SFAS 123(R) is effective for public companies for annual periods beginning after June 15, 2005, with earlier adoption permitted. We are required to adopt this new standard no later than our fiscal year beginning January 1, 2006. We have not determined a date for adoption of SFAS 123(R).

Although the adoption of SFAS 123(R)’s fair value method will have no adverse impact on our balance sheet or net cash flows, it will have a significant adverse impact on our net income and net income per share. The pro forma effects on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123 to share-based payments to employees in prior periods are disclosed in Note 1 under “Stock-Based Incentive Programs.” Although the pro forma effects of applying SFAS 123 may be indicative of the effects of applying SFAS 123(R), the provisions of these two statements differ in some important respects. The actual effects of adopting SFAS 123(R) will depend on numerous factors including the valuation model we use to value future share-based payments to employees, estimated forfeiture rates and the accounting policies we adopt concerning the method of recognizing the fair value of awards over the requisite service period.

2. Comprehensive Income

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

3. Warranties; Indemnification

The Company generally provides a warranty that its 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, the Company has not incurred any material costs associated with these warranties and has no accrual for such items at March 31, 2005.

From time to time, the Company enters into contracts that require the Company, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against the Company’s customers for violation of third party intellectual property rights caused by the Company’s products; (ii) claims resulting from personal injury or property damage resulting from the Company’s activities or products; (iii) claims by the Company’s office lessor arising out of the Company’s use of the premises; and (iv) agreements with the Company’s officers and directors under which the Company may be required to indemnify such persons for liabilities arising out of their activities on behalf of the Company. 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 the Company’s balance sheet as of March 31, 2005 or 2004.

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Notes to Condensed Financial Statements (continued)

4. Related Party Transaction

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

For the three months ended March 31, 2005 and 2004 the Company recognized $12,500 and $35,000 respectively, in other income for service provided to PSC and royalties for product licenses.

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

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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. All forward-looking statements, including but not limited to those identified with asterisks (*) in this report 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, in particular but not limited to those factors discussed under the caption “Factors That May Affect our Results or Stock Price.” 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 and distribute the Fast ForWord^® family of reading intervention software. Our innovative products apply advances in neuroscience and cognitive research to build the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrates that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. Our primary market is K-12 schools in the United States, to which we sell using a direct sales force. For the three months ended March 31, 2005, K-12 schools accounted for 90% of booked sales. By the end of March 2005, approximately 3,400 schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and approximately 515,000 individuals had enrolled in one of our products. As of March 31, 2005 we had 166 full-time employees, compared to 132 at March 31, 2004.

Business Highlights

Market Trends

The education market is growing.* Eduventures, a strategic consulting firm in the education industry, has estimated that in 2003, K-12 schools spent $3.3 billion on supplemental content, 4.5% more than in 2002, and projects that in 2005, K-12 schools will spend 7% more on supplemental content than in 2004.* The federal No Child Left Behind (NCLB) Act of 2001 established reading achievement, grade level

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proficiency, and accountability through assessment as important national priorities. NCLB also emphasizes the need to use proven practices and products grounded in scientifically based research to improve student performance. Our products align well with the emphases of NCLB, and we believe that this alignment assists us in marketing and selling our products.

The general availability of funding for public schools fluctuates from time to time. In recent years state and local education funding has been negatively affected by reduced levels of tax revenues due to the economic slowdown, and the education technology industry has generally experienced soft sales, typically attributed to tight funding. However, substantial federal funding resources remain, and many of those resources are focused on reading improvement. Eduventures estimates that total spending in the broad K-12 learning market increased by 4.8% during 2004. In fiscal 2005, state revenue is generally improving, according to a recent survey by the National Conference of State Legislatures, although states also face increasing budget pressures.*

Company Highlights

Our first quarter 2005 total booked sales increased by 8% over the corresponding quarter of 2004, and K-12 booked sales increased 6%. (Booked sales is a non-GAAP financial measure. For more information on booked sales and its reconciliation to revenue, see Revenue below.) These results were lower than our expectations. However, because the first quarter is typically our smallest sales quarter, we do not believe that our first quarter sales shortfall is indicative of our sales outlook for the year.* We expect booked sales to grow in the 18% to 24% range in 2005.*

We attribute our sales growth in a difficult market to our emphasis on reading improvement and measurable results, emphases which are shared by our K-12 customers and aligned with NCLB. One of our major goals is to increase the number of large sales, which we believe to be an important indicator of mainstream education industry acceptance and an important factor in continuing to increase the productivity of our sales force.* In the first quarter of 2005, we closed ten transactions in excess of $100,000 compared to four in the same period in 2004. Our goal is to continue to increase this number in the balance of 2005.* Larger sales tend to have a longer sales cycle and involve more political influences and can be more unpredictable. Increases in the proportion of our business from these large sales may cause increased fluctuations and unpredictability in the timing of our sales and revenue.*

For the three months ended March 31, 2005, our revenue grew 46% compared to the same period in 2004. This reflected a substantial increase in both product and service and support revenues. A significant factor in the increase in revenue was a change in our pricing structure. As a result of this pricing change, we now recognize revenue for most sales of perpetual licenses at delivery, rather than ratably over the period of related service revenue. Because of this change in the timing of revenue recognition from perpetual license sales, we expect that in 2005, total revenue will be higher and grow at a more rapid rate than booked sales.* Revenue also increased due to sales increases in 2004 and the first quarter of 2005.

For the three months ended March 31, 2005, gross margins increased primarily due to improved margins in services and support. Operating expenses were higher in the three months ended March 31, 2005 compared to the same period in 2004 mainly due to staff additions and consultants.

We recorded net income in the three months ended March 31, 2005 compared to a net loss in the comparable period in 2004 due to improved margins and higher revenues. In 2005, our goals include increasing both our net income and our profit margin.* To achieve these goals, we must increase our sales, achieve the necessary product mix, and improve sales force productivity.

While our goals for 2005 include increasing sales, revenue, profit and cash flow, we cannot assure you that we will achieve these goals. See Unpredictability and Business — Factors That May Affect Results of Operations and Stock Price below.

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At March 31, 2005 and December 31, 2004, we had no outstanding debt.

Results of Operations

Revenues

Revenues

Product revenues, which comprise the bulk of our revenue, increased substantially during the three months ended March 31, 2005 compared to the same period of 2004. The change in revenue was primarily due to three factors. First, during the fourth quarter of 2004, we made a pricing change for our Progress Tracker on line service. Prior to this change, we recognized revenue for sales of most perpetual licenses ratably over the period of related service revenue. As a result of the change, we now typically recognize perpetual license revenue at delivery. Second, our revenue was positively impacted by sales increases in 2004 and in the first quarter of 2005. (See Booked sales). These increases were partially offset by a deferral of revenue into the second and third quarters of 2005 for transactions that include new products that have not yet been delivered.

Our service and support revenue increased during the three months ended March 31, 2005, compared to the same period in 2004 primarily due to growth in on-site services. Support revenue is also growing, due to an increased number of customers.*

Future revenue: As a result of our December 2004 strategic pricing change, in 2005 we expect to recognize current sales into revenue substantially more quickly than we did in 2004.* See Revenue Recognition below for more detail about our revenue recognition practices. At the same time, we will also be recognizing deferred revenue from earlier years’ perpetual license sales into current revenue.* We expect that this non-recurring impact from our transition to a different pricing structure will result in 2005 revenue exceeding 2005 booked sales and that the 2005 revenue growth rate will exceed the revenue growth we currently project for 2006.

Booked sales and selling activity: Because a significant portion of our software, services and support revenue is recognized in periods after the invoice date, management uses booked sales to evaluate current selling activity. Booked sales is a non-GAAP financial measure that we believe is useful for investors as well as management as a measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenues are the GAAP measure most comparable 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.

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The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three months ended March 31, 2005 and 2004.

Booked sales in the K-12 sector, which accounted for 90% of booked sales in the first quarter of 2005, increased 6% to $4.2 million, compared to $4.0 million in the same period in 2004 This performance was below our long-term target growth range of 20%-30%. However, since the first quarter is historically our smallest sales quarter, we believe we are still on track for full year sales growth in our target range.*

Going forward, we plan to continue to concentrate our sales effort on large multiple-site opportunities in the K-12 market.* We believe large sales are an important indicator of mainstream education industry acceptance and an important factor in continuing to increase the productivity of our sales force. During the first quarter of 2005, we closed ten sales that had a contract value in excess of $100,000 compared to four during the same period in 2004.

Booked sales to non-school customers, primarily private practice clinicians, grew by 28% for the three months ending March 31, 2005 compared to 2004. This followed modest growth in 2004. We do not expect growth in this sector to continue at the rate of the 2005 first quarter, but we do expect modest growth in 2005 due to new product offerings and increased disposable income due to improvements in the overall economy.*

Unpredictability:

Since 2002, K-12 educational software sales have generally been soft across the industry. This trend has typically been attributed to federal, state and local budget pressures which make for an uncertain funding environment for our customers. We nevertheless believe that we are positioned to achieve continued growth in the K-12 market.* However, achieving our sales growth objectives will depend on increasing mainstream customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and the engagement of classroom teachers and administrators with product implementations. For a discussion of some of the other important factors that affect our results, see “Factors that May Affect Results of Operations or Stock Price.” In addition, the timing of a single large order or its implementation can significantly impact the level of sales and revenue at any given time. We expect that our December 2004 pricing change, which will cause us to recognize revenue more quickly, will make our quarterly revenue more unpredictable.*

Gross Profit and Cost of Revenues

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The overall gross profit margin increased for the three months ended March 31, 2005 compared to the same period in 2004. The primary reason was an increase in margins for service and support. For the three months ended March 31, 2005, margins in services and support improved due to increased operating leverage. In addition, margins improved because much of our service revenue is recognized on a ratable basis and we perform relatively few trainings in the first quarter, resulting in lower expenses associated with that revenue. Further, we had higher service and support expenses in 2004 due to the introduction of our Gateway Edition. Compared to the prior year period, product margins remained unchanged in the three months ending March 31, 2005.

Profit margins also improved due to a higher proportion of product revenue which has a better margin than service and support. For the three months ended March 31, 2005 and 2004, product revenues represented 76% of total revenues compared to 75% in the first quarter of 2004..

Operating Expenses

Sales and Marketing Expenses: For the three months ended March 31, 2005, our sales and marketing expenses increased due to additional staff, use of consultants, temporary staff, and marketing expenses. At March 31, 2005, we had 35 quota-bearing field sales personnel selling to public schools compared to 27 at March 31, 2004. We expect to increase our investment in sales and marketing as we focus on increasing sales in the K-12 market and adding additional sales people.*

Research and Development Expenses: Research and development expenses increased in the three months ended March 31, 2005 compared to the same period in 2004, primarily due to increased compensation expenses for staff and outside consultants. 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: General and administrative expenses increased for the three months ended March 31, 2005 primarily due to an increase of $156,000 in accounting expenses, pay increases and additional staff.

Other Income from Related Party

     In September 2003, we signed an agreement with Posit Science Corporation (“PSC”), formerly Neuroscience Solutions Corporation (“NSC”), transferring technology to PSC for use in the health field. For the first quarter of 2005, we have recorded $12,500 in royalties and services provided. For the three months ended March 31, 2004, $35,000 was recorded as other income. Amounts received to date and any future receipts are being reported as other income as we do not consider the sale of these rights to be part of recurring operations.

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