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

FORM 10-Q

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

OR

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

For the transition period from _______ to _______

Commission File number # 000-24547

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

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

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

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

SCIENTIFIC LEARNING CORPORATION

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

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PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements

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Notes to Condensed Financial Statements

1.  Summary of Significant Accounting Policies

Description of Business

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

Use of Estimates

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

Interim Financial Information

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

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

Other Assets

Other assets consist of the following (in thousands):

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Notes to Condensed Financial Statements

1.  Summary of Significant Accounting Policies (continued)

Accrued restructuring costs

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

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

Net Loss Per Share  

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

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

Stock-Based Compensation

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

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

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Notes to Condensed Financial Statements

1.  Summary of Significant Accounting Policies (continued)

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

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

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

2.  Comprehensive Loss

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

3.  Guarantees

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

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4.  Related Party Transaction

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

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

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

Overview

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

Business Highlights

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

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

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

Results of Operations

Revenues

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

The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the quarters ended March 31, 2004 and 2003.

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

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

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

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

Unpredictability :  To achieve our sales growth objectives will depend on increasing mainstream customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators. Our sales force numbers are limited, which requires us to achieve increased sales productivity levels, in a K-12 market that is still negatively impacted by tight state and local funding. For a discussion of some of the other important factors that affect our results, see “Factors that May Affect Results of Operations or Stock Price.”  In addition, the revenue recognized from our sales can be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected. See “Management’s Discussion and Analysis – Application of Critical Accounting Policies” for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of sales and revenue at any given time. Booked sales tend to be seasonal in nature and the first quarter booked sales typically are the lowest of the year. 

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