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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, 2012 

or 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM           TO           . 

COMMISSION FILE NO. 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)

 

(IRS Employer Identification Number)

 

300 Frank H. Ogawa Plaza, Suite 600 

Oakland, CA 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: o 

 

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: o 

 

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 o 

Accelerated filer o

Non-accelerated filer o

 

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 o   No x 

 

As of November 8,  2012,  there were 23,367,585 shares of Common Stock outstanding.

  

 


 

TABLE OF CONTENTS

 

 

 

 

Item Number

 

Page

PART 1.  FINANCIAL INFORMATION 

 

 

Item 1.

Condensed Consolidated Financial Statements (Unaudited):

 

 

 

Condensed Consolidated Balance Sheets

 

2

 

Condensed Consolidated Statements of Operations

 

3

 

Condensed Consolidated Statements of Comprehensive Loss

 

4

 

Condensed Consolidated Statements of Cash Flows

 

5

 

Notes to Condensed Consolidated Financial Statements

 

6

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

13

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

 

24

Item 4T.

Controls and Procedures 

 

25

 

 

 

PART II. OTHER INFORMATION 

 

 

Item 1.

Legal Proceedings

 

26

Item 1A.

Risk Factors

 

26

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

29

Item 3.

Defaults Upon Senior Securities

 

29

Item 4.

Mine Safety Disclosures

 

29

Item 5.

Other Information

 

29

Item 6.

Exhibits

 

29

 

SIGNATURES

 

 

 

  

 

 

1 

 


 

 

PART I –  FINANCIAL INFORMATION 

Item 1. Financial Statements 

 

 

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

 

 

 

 

 

 

 

 

September 30, 2012

 

 

December 31, 2011

 

Assets

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

Cash and cash equivalents

$

2,617 

 

$

5,871 

 

Accounts receivable, net of allowance for doubtful accounts of $177 and $159, respectively

 

4,610 

 

 

4,433 

 

Prepaid expense and other current assets

 

820 

 

 

1,709 

 

Total current assets

 

8,047 

 

 

12,013 

 

 

 

 

 

 

 

 

Property and equipment, net

 

2,450 

 

 

3,326 

 

Goodwill

 

4,568 

 

 

4,568 

 

Intangible assets

 

130 

 

 

518 

 

Other assets

 

1,087 

 

 

1,438 

 

Total assets

$

16,282 

 

$

21,863 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity (net capital deficiency)

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

Accounts payable

$

507 

 

$

881 

 

Accrued liabilities

 

3,192 

 

 

3,556 

 

Loan payable

 

1,397 

 

 

 -

 

Deferred revenue, short-term

 

12,156 

 

 

12,606 

 

Total current liabilities

 

17,252 

 

 

17,043 

 

Deferred revenue, long-term

 

3,584 

 

 

4,716 

 

Warrant liability

 

1,012 

 

 

 -

 

Other liabilities

 

659 

 

 

785 

 

Total liabilities

 

22,507 

 

 

22,544 

 

 

 

 

 

 

 

 

Commitments and contingencies (see Note 8 to the condensed consolidated financial statements)

 

 

 

 

 

 

 

 

 

 

 

 

 

Stockholders' equity (net capital deficiency):

 

 

 

 

 

 

Common stock $0.001 par value: 40,000,000 authorized, 23,367,585 and 19,005,153 shares issued and outstanding, respectively, and additional paid-in capital

 

95,614 

 

 

90,735 

 

Accumulated deficit

 

(101,842)

 

 

(91,419)

 

Accumulated other comprehensive income

 

 

 

 

Total stockholders' equity (net capital deficiency)

 

(6,225)

 

 

(681)

 

 

 

 

 

 

 

 

Total liabilities and stockholder's equity (net capital deficiency)

$

16,282 

 

$

21,863 

 

 

See accompanying notes to unaudited condensed consolidated financial statements. 

 

 

 

 

2 

 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2012

 

 

2011

 

2012

 

 

2011

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

Subscription

$

1,200 

 

$

529 

$

2,884 

 

$

1,392 

 

License

 

2,018 

 

 

5,738 

 

6,918 

 

 

17,768 

 

Service and support

 

3,610 

 

 

4,269 

 

11,260 

 

 

14,208 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

6,828 

 

 

10,536 

 

21,062 

 

 

33,368 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

 

 

Cost of subscription

 

288 

 

 

245 

 

793 

 

 

340 

 

Cost of license

 

236 

 

 

342 

 

735 

 

 

987 

 

Cost of service and support

 

1,322 

 

 

2,190 

 

4,752 

 

 

6,426 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenues

 

1,846 

 

 

2,777 

 

6,280 

 

 

7,753 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

4,982 

 

 

7,759 

 

14,782 

 

 

25,615 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

3,367 

 

 

4,682 

 

12,634 

 

 

14,075 

 

Research and development

 

1,395 

 

 

2,347 

 

5,898 

 

 

7,801 

 

General and administrative

 

1,948 

 

 

1,922 

 

6,137 

 

 

6,343 

 

Restructuring

 

1,462 

 

 

 -

 

1,462 

 

 

 -

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

8,172 

 

 

8,951 

 

26,131 

 

 

28,219 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating loss

 

(3,190)

 

 

(1,192)

 

(11,349)

 

 

(2,604)

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest and other income (expense), net

 

1,030 

 

 

(5)

 

1,095 

 

 

10 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss before provision for income taxes

 

(2,160)

 

 

(1,197)

 

(10,254)

 

 

(2,594)

 

Provision for income taxes

 

86 

 

 

46 

 

169 

 

 

128 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

$

(2,246)

 

$

(1,243)

$

(10,423)

 

$

(2,722)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss per share:

 

 

 

 

 

 

 

 

 

 

 

Basic net loss per share

$

(0.10)

 

$

(0.07)

$

(0.48)

 

$

(0.14)

 

Diluted net loss per share

$

(0.10)

 

$

(0.07)

$

(0.48)

 

$

(0.14)

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in computation of per share data:

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average shares outstanding

 

23,368 

 

 

18,883 

 

21,933 

 

 

18,807 

 

Diluted weighted average shares outstanding

 

23,368 

 

 

18,883 

 

21,933 

 

 

18,807 

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

3 

 


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

Nine Months Ended September 30,

 

 

 

2012

 

 

2011

 

 

2012

 

 

2011

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

$

(2,246)

 

$

(1,243)

 

$

(10,423)

 

$

(2,722)

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized gain on securities

 

 -

 

 

 

 

 -

 

 

 -

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive loss

$

(2,246)

 

$

(1,238)

 

$

(10,423)

 

$

(2,722)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

  

4 

 


 

 

  

 

 

 

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

Nine Months Ended September 30,

 

 

2012

 

 

2011

Operating Activities:

 

 

 

 

 

Net loss

$

(10,423)

 

$

(2,722)

Adjustments to reconcile net loss to cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

1,866 

 

 

1,389 

Impairment charge

 

200 

 

 

 -

Stock based compensation

 

615 

 

 

1,005 

Change in fair value of warrant

 

(1,356)

 

 

 -

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(177)

 

 

(3,251)

Prepaid expenses and other current assets

 

889 

 

 

489 

Other assets

 

25 

 

 

69 

Accounts payable

 

(374)

 

 

203 

Accrued liabilities

 

(364)

 

 

(73)

Deferred revenue

 

(1,582)

 

 

(2,409)

Other liabilities

 

(126)

 

 

(26)

Net cash used in operating activities

 

(10,807)

 

 

(5,326)

 

 

 

 

 

 

Investing Activities:

 

 

 

 

 

Purchases of property and equipment, net

 

(476)

 

 

(1,773)

Purchases of investments

 

 -

 

 

(4,633)

Sales and maturities of investments

 

 -

 

 

8,555 

Net cash provided by (used in) investing activities

 

(476)

 

 

2,149 

 

 

 

 

 

 

Financing Activities:

 

 

 

 

 

Borrowings under bank line of credit

 

7,897 

 

 

 -

Repayment of borrowings under bank line of credit

 

(6,500)

 

 

 -

Proceeds from exercise of options

 

152 

 

 

177 

Proceeds from issuance of common stock, net

 

6,512 

 

 

 -

Net settlement of common stock

 

(32)

 

 

(111)

Net cash provided by financing activities

 

8,029 

 

 

66 

 

 

 

 

 

 

Decrease in cash and cash equivalents

 

(3,254)

 

 

(3,111)

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

5,871 

 

 

5,415 

 

 

 

 

 

 

Cash and cash equivalents at end of period

$

2,617 

 

$

2,304 

 

 

 

 

 

 

Supplemental disclosure of cash flow information

 

 

 

 

 

Cash paid for income taxes

$

32 

 

$

25 

Cash paid for interest

$

48 

 

$

10 

 

 

 

 

 

 

Non-cash financing activity

 

 

 

 

 

Issuance of common stock warrant in connection with common stock offering

$

2,368 

 

$

 -

 

See accompanying notes to unaudited condensed consolidated financial statements. 

5 

 


 

  

Notes to Unaudited Condensed Consolidated Financial Statements 

 

1. Summary of Significant Accounting Policies

Description of Business  

 

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

The Company’s 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 the Company’s products, the Company offers a variety of on-site and remote professional and technical services, as well as phone, email and web-based support.  The Company sells primarily to K-12 schools in the United States through a direct sales force. 

All of the Company’s activities are in one operating segment. 

The Company was incorporated in 1995 in the State of California and was reincorporated in 1997 in the State of Delaware. 

Liquidity and Cash Flow 

In the nine months ended September 30, 2012, the Company used $10.8 million cash in operations, while in the nine months ended September 30, 2011, it used $5.3 million.  The Company expects to be able to fund its operations through at least September 2013, primarily from its current cash balances and cash borrowings available under its credit line from Comerica Bank (“Comerica”).  However, this plan is dependent upon (1) achieving certain levels of booked sales, (2) improved cash flows from operating activities as a result of expense reductions, and (3) the continued availability and seasonal usage of our line of credit with Comerica.  A provision in our line of credit agreement enables Comerica to prevent the Company from borrowing or request that any outstanding borrowings be repaid at any time, regardless of whether covenants are met.  As such, it is not certain that the Company will be able to draw on its line, and may need to seek additional funding sources. The Company’s ability to continue as a going concern is dependent upon many factors. If the Company does not have sufficient funds to meet its liquidity needs, it may need to further reduce its operating expenses. In the third quarter of 2012, the Company reduced headcount by 30% in an effort to reduce its operating expenses (see Restructuring footnote disclosure).  Further reducing its expenses could adversely affect its operations. In addition, the Company may be required to sell assets, issue additional equity securities or incur additional debt, and it may need to obtain waivers or amendments from Comerica in the event it does not comply with its covenants. The Company may not be able to accomplish any of these alternatives.  

On March 28, 2012, the Company closed its sale of 4,176,420 shares of common stock at a price of $1.73 per share in a  private transaction to several investors, which resulted in approximately $6.5 million in net proceeds to the Company.  As a part of the transaction, the Company issued warrants to the investors for an aggregate of 2,505,852 additional shares of common stock.  The warrants have an exercise price of $1.82 per share and are exercisable until 60 months after issuance. 

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, the Company’s financial statements could be affected.  

 

Principles of Consolidation 

 

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries in Shanghai, China and Puerto Rico.  All significant intercompany balances and transactions have been eliminated in consolidation. 

 

Reclassifications 

 

As a result of the shift in the Company’s business model, beginning in 2012, the Company has presented revenues and cost of revenues for subscriptions, licenses, and services and support. The Company has reclassified all prior year amounts to reflect the current year presentation, and the reclassification of prior year amounts did not have an impact on the Company’s total net revenues or results of operations. 

6 

 


 

 

Subscription revenue primarily includes revenue from annual or monthly customer subscriptions to the Company’s web-based applications, including Fast ForWord,  Reading Assistant,  and BrainPro. License revenue includes revenue from sales of licenses to the Company’s software applications. Service and support revenue is primarily derived from annual agreements for the Company to host software applications purchased by its customers through perpetual licenses and provide reporting services, support, and maintenance, as well as ad hoc trainings, professional development, consulting, and other technical service agreements.  

 

Interim Financial Information 

 

The interim consolidated financial information as of September 30, 2012 and for the three and nine months ended September 30, 2012 and 2011 is unaudited, and includes all necessary adjustments, which consisted only of normal recurring adjustments, for a fair presentation of the Company’s financial position at such dates and the Company’s results of operations and cash flows for those periods. The balance sheet as of December 31, 2011 has been derived from audited consolidated 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 and nine months ended September 30, 2012 are not necessarily indicative of the results for the entire year ending December 31, 2012, or for any other period. 

 

These unaudited, condensed consolidated financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto and Part II, Item 7 – “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, 2011, filed with the Securities and Exchange Commission. 

 

Software and Web Site Development Costs 

 

The Company capitalizes certain software development costs incurred subsequent to the establishment of technological feasibility and amortizes those costs over the estimated lives of the related products. The annual amortization is computed using the straight-line method over the remaining estimated economic life of the product. Technological feasibility is established upon completion of a working model. In the three and nine months ended September 30, 2012, the Company capitalized zero and  $56,000, respectively, of costs relating to new products that had reached technological feasibility. In the three and nine months ended September 30, 2011, the Company capitalized $23,000 and $41,000, respectively, of costs relating to new products that had reached technological feasibility. For the three and nine months ended September 30, 2012, the Company recorded amortization expense of  $44,000 and $127,000, respectively. For the three and nine months ended September 30, 2011, the Company recorded amortization expense of $25,000 and  $74,000, respectively.  

 

The Company also capitalizes costs related to internal use software and website application, infrastructure development and content development costs.  Costs related to preliminary project activities and post implementation activities were expensed as incurred. Internal-use software is amortized on a straight line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. The capitalized costs are included in “Property and equipment” in the consolidated balance sheet. In each case the software or website is for internal needs, and the Company does not plan to market the software externally. For the three and nine months ended September 30, 2012, the Company capitalized approximately  $10,000 and  $317,000 of software and website development costs, respectively. For the three and nine months ended September 30, 2011, the Company capitalized approximately $288,000 and $930,000 of software and website development costs, respectively. For the three and nine months ended September 30, 2012, the Company recorded amortization expense of  $235,000 and  $682,000 respectively. For the three and nine months ended September 30, 2011, the Company recorded amortization expense of $108,000 and $337,000, respectively. 

 

Net Loss Per Share 

 

The Company uses the treasury stock method to reflect the potential dilutive effect of common stock equivalents, including options restricted stock units and warrants, if dilutive. Basic net loss per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net loss per share reflects the potential dilution of securities by adding common stock equivalents to the weighted-average number of common shares outstanding during the period, if dilutive.  For the three and nine months ended September 30, 2012, 1.8 million and 1.9 million stock options and awards along with 2.5 million common stock warrants were excluded from the calculation of diluted net loss per share because their effect is anti-dilutive.  For the three and nine months ended September 30, 2011, 2.0 million and 1.9 million stock options and awards were excluded from the calculation of diluted net loss per share because their effect is anti-dilutive.  

 

7 

 


 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

2012

 

2011

 

2012

 

2011

Net loss

$

(2,246)

 

$

(1,243)

 

$

(10,423)

 

$

(2,722)

 

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average shares outstanding

 

23,368 

 

 

18,883 

 

 

21,933 

 

 

18,807 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

Employee stock options and awards

 

 -

 

 

 -

 

 

 -

 

 

 -

 

 

 

 

 

 

 

 

 

 

 

 

Diluted weighted average shares outstanding

 

23,368 

 

 

18,883 

 

 

21,933 

 

 

18,807 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss per share:

 

 

 

 

 

 

 

 

 

 

 

Basic net loss per share

$

(0.10)

 

$

(0.07)

 

$

(0.48)

 

$

(0.14)

Diluted net loss per share

$

(0.10)

 

$

(0.07)

 

$

(0.48)

 

$

(0.14)

 

 

 

Recent Accounting Pronouncements 

 

Presentation of Comprehensive Income – In May 2011, the Financial Accounting Standards Board (“FASB”) issued guidance to require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company adopted this guidance beginning in 2012 and has presented the information in two separate but consecutive statements resulting in the new condensed consolidated statement of comprehensive loss included herein.  

 

There are no other material changes from the pronouncements disclosed in part II, Item 8 – “Financial Statements and Supplementary Data” of our Annual Report on Form 10-K for the year ended December 31, 2011.

  

 

2. Warrant Liability 

 

In connection with the Company’s private common stock offering that closed on March 28, 2012, the Company issued 2,505,852 common stock warrants.  The warrants have an exercise price of $1.82 per share and expire five years from the date of issuance. In addition, the warrants contain a cash settlement provision that may be triggered upon request by the warrant holders if the Company is acquired or a merger event, as defined by the warrant agreement, occurs.  Under the FASB Accounting Standards Codification (“ASC”) Topic 815, Derivatives and Hedging, an equity contract that can be settled in cash at the request of the holder must be classified as an asset or a liability. The accounting guidance also requires that the warrants be re-measured at fair value at each reporting date, with the change in fair value recorded in the Company’s condensed consolidated statement of operations. At September 30, 2012 the estimated fair value of the warrants was $1.0 million and is recorded as a liability on the Company’s condensed consolidated balance sheet. For the three and nine months ended September 30, 2012, there was a decrease of $1,068,000 and $1,356,000, respectively, to the warrant liability which was recorded in interest and other income on the condensed consolidated statements of operations. The fair value was estimated using the Black-Scholes Merton option pricing model (see Note 3, Fair Value Measurements). Upon exercise or expiration, the fair value of the respective warrants will be reclassified to stockholders’ equity (net capital deficiency).  As of September 30, 2012, all common stock warrants were outstanding.

  

8 

 


 

 

3. Fair Value Measurements 

 

A portion of the Company’s cash and cash equivalents are held in money market funds, which are highly liquid instruments with insignificant interest rate risk and original maturities of three months or less.  

 

The Company has established a three-tier fair value hierarchy, categorizing the inputs used to measure fair value. The hierarchy can be described as follows: Level 1- observable inputs such as quoted prices in active markets; Level 2- inputs other than the quoted prices in active markets that are observable either directly or indirectly; and Level 3- unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.  

 

Cash equivalents consist of money market instruments that have original maturities of 90 days or less. These instruments are valued using quoted prices in active markets and as such are classified in Level 1 of the fair value hierarchy.  The Company had no Level 2 financial instruments as of September 30, 2012 and December 31, 2011. 

 

At September 30, 2012, the Company had outstanding warrants to purchase shares of its common stock, which were issued on March 28, 2012.  The warrants are measured at fair value each reporting period and are classified as liabilities with a fair value of $1.0 million at September 30, 2012.  The warrants are valued using the Black-Scholes Merton option pricing model using valuation assumptions determined by management and are classified as Level 3 in the Company’s fair value hierarchy.  As of September 30, 2012, the Company used the following assumptions when determining the fair value of the common stock warrants:  

 

 

 

 

 

 

Expected life (in years)

4.5 

 

Risk-free interest rate

0.54 

%

Dividend yield

%

Expected volatility

67 

%

 

 

The Company assessed the sensitivity of the fair value of the warrants with respect to the assumptions above and noted that a change in the price of our common stock of 10% would affect the fair value of the warrants by 16% or $0.2 million.  A change in volatility of 10% would affect the fair value of the warrants by 14% or $0.1 million. 

 

 

The following table summarizes the changes in fair value for the outstanding common stock warrants for the three and nine months ended September 30, 2012  (in thousands): 

 

 

 

 

 

 

 

Three Months Ended September 30, 2012

Nine Months Ended September 30, 2012

Beginning balance

$  

2,080

 -

Total change in fair value

 

(1,068)

1,012

Balance at September 30, 2012

$  

1,012

1,012

 

 

 

The following table represents the fair value hierarchy for assets and liabilities, which are measured at fair value on a recurring basis as of September 30, 2012 (in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2012

 

Level 1

  

Level 2

  

Level 3

  

Total

Assets:

 

 

  

 

 

  

 

 

  

 

 

Money market instruments

$  

649 

 

$  

 -

 

$  

 -

  

$  

649 

Liabilities:

 

 

 

 

 

 

 

 

 

 

 

Common stock warrants

$  

 -

 

$  

 -

 

$  

1,012 

 

$  

1,012 

 

At December 31, 2011, the Company held $4.6 million of money market instruments, which were classified as Level 1 in the Company’s fair value hierarchy.

 

As of September 30, 2012 the Company had outstanding borrowings of $1.4 million on its bank line of credit with Comerica (see Note 6).  The fair value of the amount outstanding approximates the carrying value due to the time to maturity and interest rate.

 

9 

 


 

 

   

 

4. Share-Based Compensation 

 

The Company granted 278,000 stock options and 113,257 restricted stock units during the nine months ended September 30, 2012. The Company granted 101,500 stock options and 78,328 restricted stock units during the nine months ended September 30, 2011. 

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes Merton option pricing model with subjective assumptions, including expected stock price volatility, the estimated life of each award and estimated pre-vesting forfeitures noted in the table below. 

  

Expected volatility – Based on the historical prices of common stock over the expected life of each option. 

  

Expected life – Based on the history of option exercise and cancellation activity of the options. 

 

Risk-free interest rate – 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. 

  

Dividend yield – As the Company has not paid, nor does it currently plan to pay, dividends in the future, the assumed dividend yield is zero. 

 

 

The fair value of stock options granted was estimated using the following weighted-average assumptions: 

  

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

Nine Months Ended September 30,

 

2012

 

2011

2012

 

2011

Expected life (in years)

5.5 

 

 

5.5 

 

5.5 

 

 

5.5 

 

Risk-free interest rate

0.8 

%

 

%

%

 

2.2 

%

Dividend yield

%

 

%

%

 

%

Expected volatility

63 

%

 

62 

%

63 

%

 

62 

%

 

 

 

 

5. Warranties and Indemnification 

 

The Company generally provides a warranty that the Company’s software products will 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 September 30, 2012. 

 

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 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 are not explicitly stated, the overall maximum amount of these obligations cannot be reasonably estimated. As such, no liabilities have been recorded for these obligations as of September 30, 2012.

  

10 

 


 

 

6. Bank Line of Credit 

 

On February 9, 2012, the Company amended its existing revolving line of credit agreement with Comerica Bank (“Comerica”).  The amendment lowered the amount that can be borrowed, extended the term of the line of credit, and updated the financial covenants.  The maximum that can be borrowed under the agreement is $5.0 million.  The line now expires on December 31, 2013. Borrowings under the line of credit bear interest at Prime plus 1.25%, are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants that required the Company to maintain a specified minimum adjusted quick ratio and a specified level of net worth. The required levels varied over the course of the year.  On March 15, 2012, the Company borrowed $3.0 million under the line of credit and repaid the balance on March 29, 2012.  

 

On June 12, 2012, the Company and Comerica entered into the First Amendment to their Amended and Restated Loan and Security Agreement entered into in February 2012 (the “Restated Agreement”). The amendment changed the adjusted quick ratio and amended the minimum net worth requirement, which varied over the term of the Restated Agreement. Compliance with these covenants was to be assessed monthly in the event that there were outstanding borrowings. Otherwise compliance with the covenants was to be assessed quarterly.  On July 6, 2012, the Company drew down $4.9 million of the $5.0 million available under its line of credit with Comerica pursuant to the terms of the Restated Agreement.  

 

On August 14, 2012, the Company and Comerica entered into the Second Amendment to its Amended and Restated Loan and Security Agreement entered into in February 2012 (the “Second Restated Agreement”). Under the terms of the Second Restated Agreement, the financial covenants have been amended as follows: (1) amended the adjusted quick ratio requirement to varying levels, which range from 0.6:1.0 to 1.0:1.0, over the  term of the agreement; (2) added a booked sales to plan ratio covenant whereby the Company is required to maintain certain levels of booked sales on a three-month rolling basis; (3) added a minimum cash balance covenant whereby the Company is required to maintain a minimum cash balance of $2.0 million; and (4) removed the net worth covenant.  Compliance with these covenants is required to be maintained on a monthly basis. 

 

On August 15, 2012, the company repaid $3.5 million on the line of credit with Comerica.  As of September 30, 2012, the Company has $1.4 million outstanding on the line of credit.  During the month ending September 30, 2012, the company did not achieve certain levels of booked sales on a three-month rolling basis and therefore was not in compliance with the financial covenant under the terms of the Second Restated Agreement.  On October 16, 2012, the Company received a certificate from Comerica waiving the booked sales covenant violation for the period ending September 30, 2012.

  

7. Provision for Income Taxes  

 

In the three and nine months ended September 30, 2012, the Company recorded income tax expense of  $86,000 and  $169,000, respectively. The tax expense for the three and nine months ended September 30, 2012 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, current state tax expense and current foreign tax expense. In the three and nine months ended September 30, 2011, the Company recorded income tax expense of $46,000 and $128,000, respectively. The tax expense for the three and nine months ended September 30, 2011 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, current state tax expense and current foreign tax expense.  

 

The Company has established and continues to maintain a full valuation allowance against its deferred tax assets as the Company does not believe that the realization of those assets is more likely than not.  

 

At September 30, 2012, the Company has unrecognized tax benefits of approximately $2.8 million. The Company has approximately $15,000 of unrecognized tax benefits that, if recognized, would affect the effective tax rate. The Company does not believe there will be any material changes in the 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 “Provision for income taxes” in the accompanying statements of operations. The Company files 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 2007 to 2011. The federal and state taxing authorities may choose to audit tax returns for tax years beyond the statute of limitation period due to significant tax attribute carryforwards from prior years, making adjustments only to carryforward attributes. The Company is not currently under audit in any major tax jurisdiction.

11 

 


 

8. Commitments and Contingencies 

 

The Company leases office space and equipment under noncancelable operating leases with various expiration dates.    On June 18, 2012, the Company entered into the Second Amendment to the Tri-Pointe Office Lease (the “Amendment”) with Tri-Pointe Tucson, LLC regarding the Company’s offices in Tucson, Arizona.  This Amendment extended the lease term to August 31, 2017, moved the leased premises in Arizona to another building and expanded the premises to approximately 10,823 square feetIn addition, the company leases certain equipment under capital lease arrangements that extend through 2014 for the amounts of $44,000 remaining in 2012, $101,000 in 2013, and $25,000 in 2014. The Company also makes royalty payments to the institutions who participated in the original research that produced its initial products. The Company’s minimum royalty payments are $150,000 per year through December 31, 2014.    As of September 30, 2012, the Company’s future minimum lease payments and future payments under its royalty agreements are as follows (in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Remaining 2012

 

2013

 

2014

 

2015

 

2016 and thereafter

 

Total

Contractual Obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Lease obligations

 

$

380 

 

$

1,496 

 

$

243 

 

$

224 

 

$

384 

 

$

2,727 

Minimum royalty obligations

 

 

 -

 

 

150 

 

 

150 

 

 

 -

 

 

 -

 

 

300 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

380 

 

$

1,646 

 

$

393 

 

$

224 

 

$

384 

 

$

3,027 

 

 

 

 

 

 

Additionally, subsequent to September 30, 2012, the Company entered into a Lease Extension and Modification Agreement in respect to its corporate headquarters in Oakland, California (the “Modification”).  The Modification reduced lease payments by  $10,000 per month starting January 2013 through December 2013 and extended the lease term to December 31, 2015, for a reduced amount of space during the extension period.  In addition, the terms of the Modification allow the Company to apply $50,000 of its security deposit per month towards its rental payments starting October 2012 through December 2013. 

 

The Modification regarding the Company’s headquarters in Oakland, California,  executed subsequent to September 30, 2012, will reduce the future minimum lease payments by $150,000 and $720,000 for the three months remaining of 2012 and 12 months ended 2013, respectively.  The Modification will increase the future minimum lease payments by approximately $400,000 for each of the years 2014 and 2015.  These changes to our future minimum lease payments are excluded from the table above. 

  

 

9. Restructuring  

 

During the third quarter of 2012, as part of the Company’s strategy to better align its costs and organization structure with the current economic environment and improve its profitability, the Company implemented two reductions in its workforce of approximately 30% in the aggregate as compared to staff levels at the end of the second quarter of 2012.  The restructuring charge of $1.5 million included severance and related costs associated with 65 employees notified of termination during the third quarter of 2012. 

 

During the third quarter of 2012, the Company paid $0.6 million of the severance costs.  As of September 30, 2012, $0.9 million remains recorded within accrued liabilities.  A significant portion of this liability is related to severance payments for two officers that departed the Company in the third quarter of 2012, but are payable over an extended period of time.    This amount is expected to be fully paid by the first quarter of 2014. 

  

 

10. Subsequent Events 

 

The Company’s shares of common stock were delisted  from the NASDAQ Stock Market (“NASDAQ”) effective October 18, 2012 due to non-compliance with NASDAQ Marketplace Rule 5450(b)(2)(A).  The Company’s shares of common stock are currently quoted on the Over The Counter bulletin board (OTCbb) under the ticker symbol SCIL.  The Company intends to seek relisting of its shares of common stock on a national exchange as soon as possible once it regains compliance with all applicable listing standards.

12 

 


 

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 our most recent Report on Form 10-K as amended by the Risk Factors sections of our subsequent Reports on Form 10-Q. 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 Securities and Exchange Commission, or 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 applying proven research on how the brain learns.  We are differentiated by our continuous focus on the “science of learning” – combining advances in the field of brain research with standards-based learning objectives to achieve dramatic student gains. 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 U.S., 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.  As of September 30, 2012, we had 146 full-time equivalent employees, compared to 234 at September 30, 2011. 

 

Business Highlights  

 

We market our products primarily as learning acceleration solutions, to be used in a blended model with existing teaching and curriculum materials, at both the elementary and secondary school levels. According to the U.S. Department of Education (USDE), in 2011, 67% of fourth graders in the United States were not “proficient” in reading and 33% performed below the “basic” level. Between 2009 and 2011, there was no change in average fourth grade reading scores. As of September 30, 2012, 3,379 schools were licensed to use our products, a small fraction of the approximately 116,000 K-12 schools in the U.S.  

 

States provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products.  Additionally, 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 (aid for school districts with a high percentage of low-income students) and IDEA (Individuals with Disabilities Education Act, primarily special education) grants. 

 

In 2011 we introduced our On Demand MySciLEARN (Company-hosted) platform and per student license pricing in the U.S. K-12 market for our Fast ForWord product.  In June 2012 we introduced a new version of our Reading Assistant product on the MySciLEARN platform.  We believe these introductions will allow us to better address the U.S. K-12 school market and the international, consumer and virtual school markets with improved access and ease-of-use.  Over time we anticipate that the result of the transition to an On Demand, Software as a Service (SaaS) platform will be a significant increase in our subscription base with more predictable transactions and recurring revenue and that we will become less dependent on large perpetual license transactions.  As of September 30, 2012, approximately 70% of the schools licensed to use our products are using our On Demand MySciLearn platform.  

 

In the first nine months of 2012, school districts continued to focus more attention on balancing operating budgets than on investing in tools to improve student achievement.  We experienced a decline in revenue and booked sales in the first nine months of 2012 compared to the first nine months of 2011, which we believe resulted from state budget pressures, uncertainty about future education policies, and an increasing trend toward using federal funds wherever possible to save teacher jobs and core programs rather than on supplemental programs focused on struggling learners. According to the Center on Budget and Policy Priorities, in the 2012-2013 school year, elementary and high schools in at least approximately 25 states are receiving less state funding than in the prior school year, and in approximately 35 states, school funding now stands below 2008 levels. 

 

13 

 


 

Despite the recent attention school districts have paid to balancing their budgets, we believe our solutions will remain well-positioned for federal Title One, IDEA and competitive funding opportunities such as Race to the Top and School Improvement Grants, due to the continued emphasis on achievement mandates and education reform. 

 

Company Highlights  

 

Our total revenue decreased by 35%  and 37%  during the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011.  We experienced a 36% and 36% decrease in booked sales in the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011.  (Booked sales is not a generally accepted accounting principles (“GAAP”) financial measure. For more explanation on booked sales, see discussion below.) The change in booked sales is due primarily to a decline in K-12 booked sales of 38%  and 40% during the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011. We believe that the decline in booked sales year-to-date reflects continued budget pressures on schools and a change in our business model to increase the focus on selling lower priced subscription and per student licenses compared to perpetual licenses.

 

This change in business model combined with a weak environment has resulted in a lower average transaction value.  In the three and nine months ended September 30, 2012, we closed one transaction in excess of $0.5 million. In the three and nine months ended September 30, 2011, we closed one and three transactions, respectively, in excess of $0.5 million.  

 

Over time, we believe our On Demand MySciLEARN platform will enable us to significantly increase the number of smaller, more predictable transactions and recurring revenue.  In the three months ended September 30, 2012, subscription booked sales increased by 174% and represented 19% of booked sales compared to 4% of total booked sales in the same period of 2011.  For the nine months ended September 30, 2012, subscription booked sales increased 332% to 20% of total booked sales in the same period of 2011 as compared to 3% of total booked sales in the nine months ended September 30, 2011.  

 

K-12 booked sales decreased by 38% to $6.9 million in the three months ended September 30, 2012 and by 40% to $16.2 million for the nine months ended September 30, 2012 as compared to the same periods of 2011.  Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, decreased by 19% to $0.8 million and 8%  to  $3.3 million during the three and nine months ended September 30, 2012 as compared to the same periods in 2011 due to changes in pricing and the timing of certain international transactions. 

 

Operating expenses decreased by 9%  and 7% during the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011, which is due primarily to a decrease in sales and marketing expenditures due to lower sales commissions and reduced headcount as a result of two reductions in force during the third quarter of 2012.  In addition, the decrease is also due to lower expenditures in research and development due to the completion and release of our On Demand MySciLEARN platform in the prior year.  In the third quarter of 2012, we took action to reduce our ongoing expense structure which included the elimination of 65 positions and resulted in $1.5 million in severance charges.  Excluding these charges, operating expenses would have decreased 25% and 13% for the three and nine months ended September 30, 2012 as compared to the same periods of 2011.  

 

During the second and third quarters of 2012, we had three key personnel changes. In April 2012, Linda L. Carloni, our Senior Vice President and General Counsel, announced that she would be retiring with her last day being no later than September 30, 2012. On June 29, 2012, we hired Chris J. Brookhart as General Counsel and Mrs. Carloni’s retirement date was July 26, 2012.  On July 6, 2012, we received notification from Robert E. Feller, our Senior Vice President and Chief Financial Officer, that he was electing to resign. On July 11, 2012, our Board of Directors appointed Jane A. Freeman to be our CFO and Treasurer effective immediately. On July 8, 2012 our Board of Directors appointed Robert C. Bowen as our Chief Executive Officer effective immediately, in place of D. Andrew Myers.  It was mutually agreed that Mr. Myers would step down from the CEO position and resign as a director of the Company.  Mr. Bowen previously served as our CEO from 2002 to 2008 and Ms. Freeman previously served as our CFO and Treasurer from 2000 to 2008. 

 

14 

 


 

Consolidated Results of Operations 

 

Revenues 

 

The following table sets forth information relating to our revenues (dollar amounts in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

 

Nine Months Ended September 30,

 

 

 

2012

 

2011

 

% Change

 

2012

 

2011

 

% Change

Subscription

$

1,200 

 

$

529 

 

127% 

 

$

2,884 

 

$

1,392 

 

107% 

License

 

2,018 

 

 

5,738 

 

(65)%

 

 

6,918 

 

 

17,768 

 

(61)%

Service and support

 

3,610 

 

 

4,269 

 

(15)%

 

 

11,260 

 

 

14,208 

 

(21)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

$

6,828 

 

$

10,536 

 

(35)%

 

$

21,062 

 

$

33,368 

 

(37)%

 

As a result of the shift in our business model, beginning in 2012, we have presented revenues and cost of revenues for subscriptions, licenses, and services and support. We have reclassified all prior year amounts to reflect the current year presentation and the reclassification of prior year amounts did not have an impact on our total net revenues or results of operations. 

 

Subscription revenue primarily includes revenue from annual or monthly customer subscriptions to our web-based applications, including Fast ForWord,  Reading Assistant, and BrainPro. We expect that subscription revenue will grow as our customers migrate to the subscription model when they renew their annual contracts and we continue to add new subscription customers. 

 

License revenue includes revenue from sales of perpetual licenses to our software applications. We do not expect perpetual license revenue to return to its levels recorded in prior years as a result of our conversion to a SaaS-based subscription business model. 

 

Service and support revenue is primarily derived from annual agreements for us to host software applications purchased by our customers as perpetual licenses and provide reporting services, support, and maintenance, as well as ad hoc trainings, professional development, consulting, and other technical service agreements. We expect service and support revenue to continue to decline as customers migrate to our  MySciLEARN platform and shift towards lower-priced web-based trainings. 

 

For the three and nine months ended September 30, 2012, subscription revenue increased by 127% and 107% respectively, compared to the same periods in 2011, mainly as a result of the introduction of our On Demand platform in 2011 and a sales mix shift to subscription licenses for On Demand versions of our applications. License revenue decreased by 65% and 61% for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011, mainly as a result of lower booked sales in the period and a shift towards subscription sales. Service and support revenue decreased by 15% and 21% for the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011, primarily due to the decrease in the number of service days delivered, a smaller number of customers on support and lower average pricing, as we continue to shift On Demand versions of our applications and to web-based training and away from higher-priced on-site services. 

 

We continue to focus on increasing both the number of customers using our applications and the percentage of those customers on the On Demand MySciLEARN platform in order to drive increased recurring revenue. In the first quarter of 2012 we released an updated version of the MySciLEARN On Demand. In the second quarter of 2012 we released our Reading Assistant product on the On Demand MySciLEARN platform. At September 30, 2012, the total number of active school sites was approximately 3,400 sites, an increase of approximately 10% compared to 3,080 sites as of September 30, 2011,  with 70% of those sites using the MySciLEARN On Demand platform to access our applications.   

 

15 

 


 

 

Booked sales  

 

Booked sales are 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 subscriptions, licenses, and services and support invoiced in the period. Revenue on a GAAP basis is recorded for booked sales when all four of the requirements for revenue recognition have been met; if any of the requirements to recognize revenue are not met, the sale is recorded as deferred revenue. 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 revenue, and is not intended to represent a substitute measure of revenue 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, 2012 and 2011 (dollar amounts in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

 

Nine Months Ended September 30,

 

 

 

 

 

2012

 

 

2011

 

% Change

 

 

2012

 

 

2011

 

% Change

Total deferred revenue beginning of period

 

$

14,833 

 

$

17,763 

 

(17)%

 

$

17,322 

 

$

21,871 

 

(21)%

Booked sales

 

 

7,737 

 

 

12,166 

 

(36)%

 

 

19,480 

 

 

30,367 

 

(36)%

Less: revenue recognized

 

 

6,828 

 

 

10,536 

 

(35)%

 

 

21,062 

 

 

33,368 

 

(37)%

Adjustments

 

 

(2)

 

 

69 

 

(103)%

 

 

-

 

 

592 

 

n/a

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deferred revenue end of period

 

$

15,740 

 

$

19,462 

 

(19)%

 

$

15,740 

 

$

19,462 

 

(19)%

 

Booked sales in the K-12 sector decreased by 38% to $6.9 million in the three months ended September 30, 2012 compared to $11.2 million in the three months ended September 30, 2011. Booked sales in the K-12 sector decreased by 40% to $16.2 million in the nine months ended September 30, 2012 compared to $26.7 million in the nine months ended September 30, 2011. As described above, state and local budget pressures continued to cause many school districts to struggle to maintain their core functions. Booked sales to the K-12 sector were 90% and 92% of total booked sales for the three months ended September 30, 2012 and 2011, respectively. Booked sales to the K-12 sector were 83% and 88% of total booked sales for the nine months ended September 30, 2012 and 2011, respectively. 

 

Booked sales to non-school customers decreased by 19% to $0.8 million  in the three months ended September 30, 2012 as compared to $1.0 million in the three months ended September 30, 2011. Booked sales to non-school customers decreased by 8% to $3.3 million  in the nine months ended September 30, 2012 as compared to $3.6 million in the nine months ended September 30, 2011. The decreases reflect lower sales to private providers.     

 

 “Adjustments” in the three months ended September 30, 2012 consist primarily of adjustment for a manual credit for an order booked in a previous period.    Adjustments” in the three and nine months ended September 30, 2011 consist primarily of the deferral of revenue and the related receivable for booked sales with Free-On-Board (“FOB”) destination delivery terms that were not delivered at the end of the second quarter 2011. 

 

Over time, we expect that MySciLEARN, together with per student pricing options we introduced in the second quarter of 2011 and changes in our business model, will increase our volume of smaller transactions, shorten sales cycles, and increase our ability to drive predictable, recurring revenue.  

 

For the three and nine months ended September 30, 2012 compared to the same periods in 2011, our transaction count increased 9% from 605 transactions to 657 transactions and 17% from 1,331 transactions to 1,560, respectively, and our average transaction price declined.  The decline is a function of lower average prices for subscription and per student options compared to perpetual licenses and to a smaller number of large booked sales in the nine months ended September 30, 2012 compared to the same period of 2011. 

 

16 

 


 

Historically, large booked sales, which we define as transactions totaling more than $500,000, have been an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity. In the three and nine months of 2012, budget shortfalls of our current and potential customers made it difficult to close large deals in our pipeline. In the three and nine months ended September 30, 2012, we closed one transaction in excess of $0.5 million, representing 3% of our booked sales for the nine months ended September 30, 2012. In the three and nine months ended September 30, 2011, we closed one and three transactions in excess of $0.5 million, respectively, representing 5% and 8% of our booked sales for those same periods. 

 

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 license fees but do not discount service and support fees for non-subscription orders, license booked sales and revenue are disproportionately affected by discounting.  We cannot predict the size and number of large transactions in the future. MySciLEARN, together with per student pricing options we introduced in the second quarter of 2011 and changes in our business model, are designed to decrease our dependence on large transactions by increasing our volume of smaller transactions and shortening sales cycles.  

 

We continue to focus on increasing the percentage of subscription bookings. In the three months ended September 30, 2012 compared to the same period in 2011, the subscription booked sales increased 174% to $1.5 million. In the nine months ended September 30, 2012 compared to the same period in 2011, the subscription booked sales increased 332% to $3.9 million. Subscription bookings as a percentage of total booked sales increased to 19% from 4% for the three months ended September 30, 2012 and increased to 20% from 3% for the nine months ended September 30, 2012 compared to the same periods in 2011.    The following table sets forth information relating to our subscription booked sales (dollar amounts in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

 

Nine Months Ended September 30,

 

 

 

 

 

2012

 

 

2011

 

% Change

 

 

2012

 

 

2011

 

% Change

Subscription booked sales

 

$

1,465 

 

$

535 

 

174% 

 

$

3,933 

 

$

910 

 

332% 

Non-subscription booked sales

 

 

6,272 

 

 

11,631 

 

(46)%

 

 

15,547 

 

 

29,457 

 

(47)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Booked sales

 

$

7,737 

 

$

12,166 

 

(36)%

 

$

19,480 

 

$

30,367 

 

(36)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Subscription booked sales as a % of total booked sales

 

 

19% 

 

 

4% 

 

 

 

 

20% 

 

 

3% 

 

 

Non-subscription booked sales as a % of total booked sales

 

 

81% 

 

 

96% 

 

 

 

 

80% 

 

 

97% 

 

 

 

 

Non-subscription booked sales represents the sale of licenses, services and support for perpetual licenses and On  Premise products. 

 

Although the current economic and financial conditions along with 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 and non-school markets for our On Demand products. However, achieving our objectives will depend on increasing customer acceptance of our On Demand 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 On Demand sales 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 level of federal spending and the federal deficit are putting pressure on all areas in the federal budget. States continue to experience severe budget pressure from the adverse conditions in the job, housing and credit markets. These conditions may continue to 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. 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. 

17 

 


 

 

 

Gross Profit and Cost of Revenues 

 

The following table sets forth information relating to our gross profit (dollar amounts in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

2012

 

 

2011

 

2012

 

 

2011

Gross profit on subscriptions

$

912 

 

$

284 

$

2,091 

 

$

1,052 

Gross profit on licenses

 

1,782 

 

 

5,396 

 

6,183 

 

 

16,781 

Gross profit on service and support

 

2,288 

 

 

2,079 

 

6,508 

 

 

7,782 

 

 

 

 

 

 

 

 

 

 

 

Total gross profit

$

4,982 

 

$

7,759 

$

14,782 

 

$

25,615 

 

 

 

 

 

 

 

 

 

 

 

Gross profit margin on subscriptions

 

76% 

 

 

54% 

 

73% 

 

 

76% 

Gross profit margin on licenses

 

88% 

 

 

94% 

 

89% 

 

 

94% 

Gross profit margin on service and support

 

63% 

 

 

49% 

 

58% 

 

 

55% 

Total gross profit margin

 

73% 

 

 

74% 

 

70% 

 

 

77% 

 

The overall gross profit margin decreased by 1% and 7% in the three and nine months ended September 30, 2012, respectively, compared to the same periods in 2011 due primarily to a smaller proportion of higher margin license revenue.  

 

Gross profit margin on subscriptions increased by 22% and decreased by 3%  in the three and nine months ended September 30, 2012 compared to the same periods in 2011.  Subscription revenue for the three and nine months ended September 30, 2011 consisted of international and consumer sales which have a higher gross margin.  For the three and nine months ended September 30, 2012, subscription revenue included revenue from annual and monthly customer subscriptions to our web-based applications, including Fast ForWord,  Reading Assistant, and BrainPro.    The increase in gross profit margin for the three months ended September 30, 2012 as compared to the same period in the prior year is primarily due to an increase in subscription revenue.  These applications require an increased level of infrastructure costs, which resulted in a decrease in the gross profit margin for the nine months ended September 30, 2012, as compared to the same period in the prior year, when we were just beginning to build the infrastructure to support our On Demand products. 

 

Gross profit margin on licenses decreased by 6% and 5%, respectively, in the three and nine months ended September 30, 2012 compared to the same periods in 2011 primarily due to fixed costs for minimum royalty payments, amortization of purchased software, and freight and fulfillment charges spread over lower license revenue.  

 

Gross profit margin on service and support increased by 14% and 3%, respectively, in the three and nine months ended September 30, 2012 compared to the same periods in 2011 primarily due to a 46% reduction of headcount as a result of our restructuring activities taken during the the third quarter of 2012. 

 

18 

 


 

 

Operating Expenses 

 

The following table sets forth information relating to our expenses (dollar amounts in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

 

 

Nine Months Ended September 30,

 

 

 

 

 

2012

 

 

2011

 

% Change

 

 

2012

 

 

2011

 

% Change

Sales and marketing

 

$

3,367 

 

$

4,682 

 

(28)%

 

$

12,634 

 

$

14,075 

 

(10)%

Research and development

 

 

1,395 

 

 

2,347 

 

(41)%

 

 

5,898 

 

 

7,801 

 

(24)%

General and administrative

 

 

1,948 

 

 

1,922 

 

1% 

 

 

6,137 

 

 

6,343 

 

(3)%

Restructuring

 

 

1,462 

 

 

 -

 

 

 

 

1,462 

 

 

 -

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

8,172 

 

$

8,951 

 

(9)%

 

$

26,131 

 

$

28,219 

 

(7)%

 

  

Sales and Marketing Expenses: Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials. Sales and marketing decreased $1.3 million and $1.4 million, respectively, for the three and nine months ended September 30, 2012 compared to the same periods in 2011 primarily due to a reduction in headcount and lower commissions. At September 30, 2012, we had 37 quota-bearing sales personnel compared to 49 at September 30, 2011. 

 

Research and Development Expenses: 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. Research and development expenses decreased $1.0 million and $1.9 million in the three and nine months ended September 30, 2012 compared to the same periods in 2011 primarily due to a reduction in headcount and less spending on development as the second version of our On Demand offering was released early in 2012.  

 

General and Administrative Expenses:  General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees. General and administrative expenses remained relatively flat for the three months ended September 30, 2012, and decreased $0.2 million for nine months ended September 30, 2012, respectively, as compared to the same periods in 2011.  The decrease in the nine months ended 2012 is primarily due to a  reduction of headcount and less spending in consulting and overall lower stock compensation expense as compared to the same period as 2011. 

 

Restructuring:   During the third quarter of 2012, as part of our strategy to better align our costs and organization structure with the current economic environment and improve our profitability, we implemented reductions in our workforce totaling approximately 30% as compared to staff levels at the end of the second quarter.  The restructuring charge of $1.5 million included severance and related costs associated with 65 employees notified of termination during the third quarter of 2012. 

 

We expect that these reductions will result in future expense savings of approximately $6 million per year, with the majority of impact affecting  cost of sales service, sales and marketing expense and research and development expense.  We paid $0.6 million of the restructuring charges in the third quarter of 2012 and we expect to pay the remaining $0.9 million by the first quarter of 2014. 

19 

 


 

 

Other Income and Expenses 

 

The following table sets forth information relating to our interest and other income and expenses (in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

2012

 

 

2011

 

 

2012

 

 

2011

Change in fair value of warrant

$

1,068 

 

$

 -

 

$

1,356 

 

$

 -

Write off of long-term investment

 

 -

 

 

 -

 

 

(200)

 

 

 -

Disposal of fixed asset

 

 -

 

 

 -

 

 

(14)

 

 

 -

Interest and other income (expense)

 

(38)

 

 

(5)

 

 

(47)

 

 

10 

Total interest and other income

$

1,030 

 

$

(5)

 

$

1,095 

 

$

10 

 

The change in fair value of warrant relates to the change in fair value of our common stock warrants which were issued on March 28, 2012. The fair value was estimated using the Black-Scholes Merton option pricing model, which requires the input of highly subjective assumptions as determined by the Company’s management. To the extent these assumptions change in future periods, the fair value of the common stock warrants may increase or decrease and the change in fair value will be recorded in our results of operations.  The decrease in the fair value of warrant during the three and nine months ended 2012 is primarily due to the decrease in the Company’s stock price over the time period.  

 

We assessed the financial condition of a company in which we have a long-term investment and wrote off that investment because of a lower assessment of its prospects. 

 

Disposal of fixed asset relates to a write off for certain capitalized software amounts for which we determined would have no future use, in the first quarter of 2012. 

 

Interest and other income (expense) includes foreign exchange gains and losses as well as interest paid on amounts borrowed. 

 

 

Provision for Income Taxes  

 

In the three and nine months ended September 30, 2012, we recorded income tax expense of $86,000 and $169,000, respectively.  The tax expense for the three and nine months ended September 30, 2012 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, current state tax expense and current foreign tax expense.   

 

In the three and nine months ended September 30, 2011, we recorded income tax expense of $46,000 and $128,000, respectively.  The tax expense for the three and nine months ended September 30, 2011 consists primarily of deferred tax expense relating to the amortization of acquired goodwill and state tax expense.  

 

The Company has established and continues to maintain a full valuation allowance against its deferred tax assets as the Company does not believe that realization of those assets is more likely than not. There was no change in our valuation allowance for the three and nine months ended September 30, 2012. 

 

Our effective tax rate was (4.0)% and (1.6)% for the three and nine months ended September 30, 2012 compare to (3.8)% and (4.9)% for the three and nine months ended September 30, 2011. 

 

Liquidity and Capital Resources 

 

Our cash and cash equivalents were $2.6 million at September 30, 2012, compared to $5.9 million at December 31, 2011 and $3.2 million at June  30, 2012. 

 

20 

 


 

We expect that during the next twelve months our current cash balances and cash borrowings available under our credit line will be our primary sources of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures.  Based upon our current forecasts, we expect to generate positive cash flow over the course of the next twelve months. However, our business is seasonal and therefore we expect to borrow under our line of credit with Comerica Bank (“Comerica”) or find alternative sources of financing in order to fund our operations in the event we are unable to borrow under our current line of credit agreement. Historically, we have used cash in our operations during the first half of the year and have improved cash from operations in the second half. This pattern results largely from our seasonally low sales in the first and fourth calendar quarters, which reflects our industry pattern, and the time needed to collect on sales made towards the end of the second quarter.   

 

We have used cash from operations of $10.8 million in the nine months ended September 30, 2012, an increase from cash used from operations of $5.3 million in the nine months ended September 30, 2011. Our cash used in operations has increased in fiscal 2012 as a result of our lower booked sales as compared to the prior year, as we have continued to experience a decline in booked sales due to the funding constraints in the K-12 market and our business transition from selling perpetual software licenses to a SaaS model.  

 

Based on our current forecasts, we expect that we will generate cash from operations in the fourth quarter of 2012 and to be cash flow positive from operations during the first nine months of fiscal 2013. However, our booked sales and cash collections are seasonal and we expect to fund operations through our current cash balances and the availability of our Comerica line of credit during that period of time. We have implemented restructuring plans designed to reduce operating expenses and we believe that improved cash flows from operating activities as a result of our reduction in future expenses; and planned usage of our line of credit with Comerica during the first six months of 2013, will enable us to have sufficient cash to continue through September 2013.    Accomplishing this, however, will require us to achieve certain levels of booked sales, cash collections, and expenses. We cannot assure you that we will achieve these levels.  If we are unable to achieve the needed levels of booked sales and cash collections, we expect to further reduce our expenses to ensure that we have sufficient liquidity to continue our operations through at least September 30, 2013. Reducing expenses beyond the actions we took in the third quarter 2012 could have a negative impact on our future growth potential.  In addition, we may be required to sell assets, issue additional equity securities or incur additional debt, and we may need to obtain waivers or amendments from Comerica in the event we do not comply with our covenants. We may not be able to accomplish any of these alternatives. In addition, our line of credit agreement with Comerica enables Comerica to prevent us from borrowing or request that any outstanding borrowings be repaid at any time, regardless of whether covenants are met.  As such, it is not certain that we will be able to utilize cash available under the line of credit. 

 

On March 28, 2012, we closed our sale of 4,176,420 shares of common stock at a price of $1.73 per share in a private offering to several investors, which resulted in approximately $6.5 million in net proceeds.  As a part of the transaction, we issued warrants to the investors to purchase an aggregate of 2,505,852 additional shares of common stock.  These warrants have an exercise price of $1.82 per share and are exercisable until 60 months after the issuance.  

 

The 2,505,852 warrants issued contain a cash settlement provision that may be triggered upon request by the warrant holders if we are acquired or a merger event, as defined by the warrant agreement, occurs.  Under the FASB ASC Topic 815, Derivatives and Hedging, an equity contract that can be settled in cash at the request of the holder must be classified as an asset or a liability. The accounting guidance also requires that the warrants be re-measured at fair value at each reporting date, with the change in fair value recorded in our condensed consolidated statement of operations. At September 30, 2012 the estimated fair value of the warrants was $1.0 million and is recorded as a liability on our condensed consolidated balance sheet. The fair value was estimated using the Black-Scholes Merton option pricing model. Upon exercise or expiration, the fair value of the respective warrants will be reclassified to stockholders’ equity (net capital deficiency).  As of September 30, 2012, all common stock warrants were outstanding. 

 

During 2012, the Company amended its line of credit with Comerica three times. 

 

On February 9, 2012, the Company amended its existing revolving line of credit agreement with Comerica.  The amendment lowered the amount that can be borrowed, extended the term of the line of credit, and updated the financial covenants.  The maximum that can be borrowed under the agreement is $5.0 million.  The line now expires on December 31, 2013. Borrowings under the line of credit bear interest at Prime plus 1.25%, are subject to reporting covenants requiring the provision of financial statements to Comerica, and, as amended, financial covenants that required the Company to maintain a specified minimum adjusted quick ratio and a specified level of net worth. The required levels varied over the course of the year.  On March 15, 2012, the Company borrowed $3.0 million under the line of credit and repaid the balance on March 29, 2012.  

 

21 

 


 

On June 12, 2012, the Company and Comerica entered into the First Amendment to their Amended and Restated Loan and Security Agreement entered into in February 2012 (the “Restated Agreement”). The amendment changed the adjusted quick ratio and amended the minimum net worth requirement, which varied over the term of the Restated Agreement. Compliance with these covenants was to be assessed monthly in the event that there were outstanding borrowings. Otherwise compliance with the covenants was to be assessed quarterly.  On July 6, 2012, the Company drew down $4.9 million of the $5.0 million available under its line of credit with Comerica pursuant to the terms of its amended and Restated Agreement.  

 

On August 14, 2012, the Company and Comerica entered into the Second Amendment to its Amended and Restated Loan and Security Agreement entered into in February 2012 (the “Second Restated Agreement”). Under the terms of the Second Restated Agreement, the financial covenants have been amended as follows: (1) amended the adjusted quick ratio requirement to varying levels, which range from 0.6:1.0 to 1.0:1.0, over the  term of the agreement; (2) added a booked sales to plan ratio covenant whereby the Company is required to maintain certain levels of booked sales on a three-month rolling basis; (3) added a minimum cash balance covenant whereby the Company is required to maintain a minimum cash balance of $2.0 million; and (4) removed the net worth covenant.  Compliance with these covenants is required to be maintained on a monthly basis. 

 

On August 15, 2012, the Company repaid $3.5 million on the line of credit with Comerica.  As of September 30, 2012, the Company had $1.4 million outstanding on the line of credit.  During the month ending September 30, 2012, the Company did not achieve certain levels of booked sales on a three-month rolling basis and therefore was not incompliance with the financial covenant under the terms of the Second Restated Agreement.  On October 16, 2012, the Company received a certificate from Comerica waiving the booked sales violation for the period ending September 30, 2012.  

 

During the third quarter of 2012, as part of our strategy to better align our costs and organization structure with the current economic environment and improve our profitability, we implemented two reductions in our workforce of approximately 30% as compared to staff levels at the end of the second quarter.  The restructuring charge of $1.5 million included severance and related costs associated with 65 employees notified of termination during the third quarter of 2012. 

 

We expect that these reductions will result in future expense savings of approximately $6 million per year, with the majority of impact affecting  cost of service, sales and marketing expense and research and development expense.  We paid $0.6 million of the restructuring charges in the third quarter of 2012 and we expect to pay the remaining $0.9 million by the first quarter of 2014. 

 

Additionally, subsequent to September 30, 2012, we entered into a Lease Extension and Modification Agreement in respect to the Company’s corporate headquarters in Oakland, California (the “Modification”).  The Modification reduced lease payments by $10,000 per month starting January 2013 through December 2013 and extended the lease term to December 31, 2015, for a reduced amount of space during the extension period.  In addition, the terms of the Modification allow the Company to apply $50,000 of its security deposit per month towards its rental payments starting October 2012 through December 2013.  The Modification will reduce the future minimum lease payments by $150,000 and $720,000 for the three months remaining of 2012 and 12 months ended 2013, respectively.  The Modification will increase the future minimum lease payments by approximately $400,000 for each of the years 2014 and 2015.

 

Net cash used in operating activities for the nine months ended September 30, 2012 was $10.8 million compared to cash used of $5.3 million during the nine months ended September 30, 2011. The increase in cash used in operating activities was primarily the result of lower levels of booked sales in the period. 

 

Net cash used in investing activities for the nine months ended September 30, 2012 was $0.5 million compared to net cash provided by investing activities of $2.1 million for the nine months ended September 30, 2011. In the nine months ended September 30, 2012, we had $0.5 million of net purchases of property and equipment. In the nine months ended September 30, 2011, net sales of investments were $3.9 million offset in part by $1.7 million of capital expenditures primarily related to critical investments in product development.   

 

Financing activities for the nine months ended September 30, 2012 was $8.0 million due to $6.5 million from the issuance of common stock as part of our private offering and $0.2 million from proceeds from the exercise of stock options. Financing activities for the nine months ended September 30, 2011 was $0.2 million from proceeds from the exercise of stock options offset by $0.1 million of net settlement of restricted stock unit awards. 

 

 

Off-Balance Sheet Arrangements 

 

We have no off-balance sheet arrangements. 

22 

 


 

Contractual Obligations and Commitments  

 

Other than what is noted below, there have been no material changes during the period covered by this report, outside of the ordinary course of our business, to the contractual obligations specified in the table disclosed in Part II, Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Contractual Obligations” of our Annual Report on Form 10-K for the year ended December 31, 2011. 

 

On June 18, 2012, we entered into the Second Amendment (the “Amendment”) with Tri-Pointe Tucson, LLC for our Tri-Pointe Office Lease. The Amendment extended the lease terms to August 31, 2017, moved the leased premises to another building and expanded the premises to approximately 10,823 square feet. Base annual rent per square foot is $19.50 effective for the year starting September 1, 2012, increasing in steps to $21.53 for the final year of the lease. 

 

On October 3, 2012, we entered into a Lease Extension and Modification Agreement (the “Modification”) in respect to the lease of its Oakland, California headquarters The terms of the modified agreement extended the lease terms to December  31, 2015, relinquished approximately 16,300 square feet of space, reduced rent by  $10,000 per month for the twelve months of 2013, and entitled us to use $50,000 per month of our $850,000 security deposit towards payment of our monthly rent for the 15-month period starting October 1, 2012 through December 31, 2013.    The lease for the remaining approximately 14,200 square feet under the lease is being extended pursuant to the Modification for two-years from January 1, 2014 to December 31, 2015, at a rate of $33,370 per month during the two-year extension.  We are not obligated to pay any common area operating expenses, and there will be no annual rate increase during the two-year extension. 

 

 

Application of Critical Accounting Policies 

 

Our consolidated financial statements are prepared in accordance with 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 consolidated 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 consolidated financial statements would be affected.  

 

As discussed in our most recent Report on Form 10-K, the estimates, assumptions and judgments pertaining to revenue recognition, income taxes, stock-based compensation and the capitalization of software development costs and website development costs are the most critical assumptions to understand in order to evaluate our reported financial results. As a result of our issuance of common stock warrants in March 2012, we updated our application of critical accounting policies to include our policy for the warrant liability. 

 

Warrant Liability 

 

In connection with our private common stock offering that closed on March 28, 2012, we issued 2,505,852 common stock warrants.  The warrants have an exercise price of $1.82 per share and expire five years from the date of issuance. In addition, the warrants contain a cash settlement provision that may be triggered upon request by the warrant holders if we are acquired or a merger event occurs.  Under the FASB ASC Topic 815, Derivatives and Hedging, an equity contract that can be settled in cash at the request of the holder must be classified as an asset or a liability. The accounting guidance also requires that the warrants be re-measured at fair value at each reporting date, with the change in fair value recorded in our condensed consolidated statement of operations. At September 30, 2012 the estimated fair value of the warrants was $1.0 million and is recorded as a liability on our condensed consolidated balance sheets. For the three and nine months ended September 30, 2012, there was a decrease of $1,068,000 and $1,356,000, respectively, to the warrant liability which was recorded in interest and other income on our condensed consolidated statement of operations. The fair value was estimated using the Black-Scholes Merton option pricing model, which requires the input of highly subjective assumptions as determined by management. To the extent these assumptions change in future periods, the fair value of the common stock warrants may increase or decrease and the change in fair value will be recorded in our results of operations. 

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk 

 

Market risk represents the risk of loss that may result from the change in value of a financial instrument due to fluctuations in its market price. We had no investments subject to market risk at September 30, 2012.  

 

 

Interest Rate Risk 

The primary objectives of our investment activities are to preserve principal, provide liquidity and maximize income without significantly increasing risk. By policy, we do not enter into investments for trading or speculative purposes. All of our cash and cash equivalents are held with Comerica Bank in either our money market or operating account. Declines in interest rates, however, will reduce future interest income. During the three months ended September 30, 2012, a 10% appreciation or depreciation in overall interest rates would not have had a material impact on our interest income.

As of September 30, 2012 , our total debt was comprised of borrowing of approximately $1.4 million under our revolving line of credit agreement with Comerica. During the three months ended September 30, 2012, a 10% appreciation or depreciation in overall interest rates would not have had a material impact on our interest expense or existing principle balance.

 

Foreign currency exchange risk 

Our sales contracts are primarily denominated in U.S. dollars and, therefore, the majority of our revenues are not subject to foreign currency risk. We are directly exposed to changes in foreign exchange rates to the extent such changes affect our expenses related to our foreign assets and liabilities. Our only exposure in regard to our foreign assets and liabilities is with our Chinese subsidiary whose functional currency is the Chinese Renminbi. For the three and nine months ended September 30, 2012 and 2011, our foreign currency exchange risk was not material and we do not expect it to become material in the next twelve months. 

 

 

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Item 4. 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, 2012.  

 

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 Chief Financial Officer are made at the “reasonable assurance” level. 

 

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, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 

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PART II. OTHER INFORMATION 

Item 1. Legal Proceedings 

 

None. 

 

Item 1A. Risk Factors  

 

Other than what is noted below, there are no material changes from the risk factors previously disclosed in Part I, Item 1A — “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2011, as amended by Part II, Item 1A – “Risk Factors” of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, filed August 14, 2012, and such risk factors are incorporated herein by reference. 

 

Sales of our products depend on the availability and extent 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 revenues 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.  

 

The funding for a substantial portion of our K-12 sales typically comes from federal sources, in particular IDEA (special education) and Title One funding.  The amount of this funding varies from time to time, as do the rules governing the use of this funding.  The federal budget deficit and competing federal priorities could adversely impact the ongoing level of federal education funding.  The temporary additional American Recovery and Reinvestment Act (ARRA) education funding expired in 2011. There has been much recent discussion, and the administration has granted 34 states and the District of Columbia waivers from certain requirements, but there has been no legislative agreement about changes to the No Child Left Behind Act of 2001.  A cutback in federal education funding or a change in the funding rules to allow general rather than restricted uses of federal funding could have a materially adverse impact on our revenue.  

 

In August 2011, President Obama signed the Budget Control Act of 2011, which provided for both an increase in the federal government's borrowing authority and reductions in spending.  Under the Budget Control Act of 2011, Congress must develop legislation to achieve further deficit reduction, and the outcome of this process is uncertain.  If Congress fails to achieve the required level of deficit reduction, automatic reductions in spending across-the-board (also known as “sequestration”) will begin in 2013.  If this sequestration occurs, funding for most federal education programs will be cut by up to 9% in mid-2013.   Any action or inaction by Congress that significantly reduces federal education funding, whether through across-the-board funding cuts or otherwise, would have a materially adverse effect on our financial condition, results of operations, and cash flows. 

 

State education funding continues to be significantly impacted by state budget difficulties. According to the Center on Budget and Policy Priorities, in the 2012-2013 school year, elementary and high schools in approximately half of the states are receiving less state funding than in the prior school year, and in approximately 35 states, school funding now stands below 2008 levels.  These reductions have resulted in teacher layoffs, program restrictions and overall expense reductions. While education spending remains an important priority for states, it faces competition from demands for, among other things, relief for the unemployed and homeowners and rising healthcare costs. Continued pressure on state budgets and state education funding could have a materially adverse impact on our revenue. 

 

Our cash flow is highly variable and may not be sufficient to meet all of our objectives. 

 

During 2010 and 2011, we used $4.2 million and $7.2 million of cash in operations and in 2009 we generated $14.5 million in cash from operations. In the first nine months of 2012, we used $10.8 million of cash in operations.  Over the next 12 months, we expect to fund our operations primarily through a combination of our current cash balances and cash available under our Comerica credit line. 

 

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On March 28, 2012, we closed our sale of 4,176,420 shares of company common stock at a price of $1.73 per share in a private transaction to several investors, which resulted in approximately $6.5 million in net proceeds to us.  As a part of the transaction, we issued warrants to the investors for an aggregate of 2,505,852 additional shares of Common Stock.  The warrants have an exercise price of $1.82 per share and are exercisable until 60 months after issuance.  As of March 31, 2012, we had approximately $8.1 million of cash on hand, including the approximately $6.5 million from the transaction.  As of September 30, 2012, we had approximately $2.6 million of cash on hand. 

 

In February 2012, we amended our credit line with Comerica, which has provided us with a line of credit since 2004. Our amended line of credit has a limit of $5.0 million, and expires December 31, 2013.  On July 9, 2012, we borrowed approximately $4.9 million under the line of credit.  

 

Borrowings under the line are subject to reporting covenants requiring the provision of financial statements to Comerica and ongoing compliance with certain financial covenants.  On August 14, 2012, we amended the financial covenants in order to bring our obligations more in line with our current operating plan in order to avoid an event of default.  The amended covenants require us to maintain a specified minimum adjusted quick ratio, to achieve certain levels of booked sales and to maintain a cash balance of at least $2.0 million. The required levels for the quick ratio vary over the term of the agreement. If we do not comply with the covenants, we risk being unable to borrow under the credit line. Even if we remain in compliance, a provision in the line of credit entitles Comerica to prevent us from borrowing or request that any outstanding borrowings be repaid at any time, regardless of whether covenants are met. 

 

On August 15, 2012, we repaid $3.5 million on the line of credit with Comerica.  As of September 30, 2012, we had $1.4 million outstanding on this line of credit.  During the month ending September 30, 2012, we did not achieve the required levels of booked sales on a three-month rolling basis and therefore we were not in compliance with the financial covenant under the terms of the agreement.  On October 16, 2012 we received a certificate from Comerica waiving the booked sales covenant violation for the month ending September 30, 2012. 

 

Historically, our cash from operations have generally been worse in the first half of the year than in the second half. This pattern results largely from our seasonally low sales in the first and fourth calendar quarters, which reflects our industry pattern, and the time needed to collect on sales.  Because of the seasonality of our booked sales we may have to borrow from our line of credit.  Our cash reserves and the cash available under the line of credit, if any, may be inadequate to meet our needs. 

 

Funding our liquidity needs to continue to operate our business will require us to achieve certain levels of booked sales and cash collections, and reduce operating expenses. If we are unable to achieve the required levels, or are unable to obtain waivers or amendments from Comerica in the event we do not comply with our covenants, we would be required to obtain additional debt or equity financing from other sources, to further reduce expenses, or to sell assets. Reducing our expenses could adversely affect our operations. We cannot assure you that we will be able to secure additional debt or equity financing or sell assets on acceptable terms, if at all, and failure to do so could cause us to cease operations. In addition, raising additional equity financing could result in substantial dilution of our current equity holders and in the net tangible book value per share of such holdings.

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 Our shares of common stock have been delisted from NASDAQ and we are not listed on any other national securities exchange.  It will likely be more difficult for stockholders and investors to sell our common stock or to obtain accurate quotations of the share price of our common stock. 

  

Effective October 18, 2012 our common stock was delisted from NASDAQ and our shares of common stock are currently quoted on the OTCbb, continuing under the trading symbol “SCIL.”  Stock traded on the over-the-counter markets are typically less liquid than stocks that trade on a national securities exchange.  Trading on the over-the-counter market  may also negatively impact the trading price of our common stock.  In addition, the liquidity of our common stock may be impaired, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and coverage by security analysts and the news media, if any, of our Company.  Stockholders may find it difficult to resell their shares of our common stock due to the delisting.  The delisting of our common stock from NASDAQ may also result in other negative implications, including the potential loss of confidence by customers, strategic partners and employees, the loss of institutional investor interest in our common stock and our inability to take advantage of certain exemptions available to listed securities under the Exchange Act and the 1940 Act. 

  

Additionally, as a result of the delisting of our shares of common stock from NASDAQ, we are no longer subject to the rules of  NASDAQ, including rules related to corporate governance matters such as the circumstances (including but not limited to certain issuances of our securities) in which stockholder approval is required, requirements regarding the independence of our directors and the existence of committees of our board of directors comprised of independent directors.  

  

We may not be able to be re-listed on NASDAQ, which could adversely affect trading and liquidity of our common stock. 

 

We intend to apply for the listing of our shares of common stock on NASDAQ as soon as practicable, assuming that the Company satisfies the applicable listing criteria.  However, there is no assurance that NASDAQ or any other national stock exchange will approve our common stock for listing, as there is no assurance that we will satisfy the criteria for listing or be approved for listing on NASDAQ or any other national stock exchange.  Failure to list our shares on a national stock exchange could result in a less liquid market for existing and potential stockholders in which to trade our common stock, which could depress the trading price of our common stock and adversely impact our ability to raise capital in the future. 

  

Our securities are subject to “penny stock” rules which may further reduce the liquidity and market price for our Common Stock. 

  

Certain securities that are not listed on a national securities exchange, have a trading price below $5.00 and satisfy certain other requirements, such as our common stock, are subject to the SEC’s “penny stock” rules.  Under the SEC’s penny stock rules, among other things, broker-dealers may not sell a penny stock to, or effect the purchase of a penny stock by an investor (other than an accredited investor or an “established customer” as defined in Rule 15g-9), unless, prior to executing the transaction, the broker-deal has determined that transactions in penny stocks are suitable for the purchaser (and delivers a written statement of such determination to the purchaser), obtained the purchaser’s written agreement to engage in the transaction, provided the purchaser with a written disclosure document regarding certain risks associated with investing in penny stocks and obtained written acknowledgement from the purchaser that the purchaser has receive the required disclosure documents.  Broker-dealers may find it difficult to execute transactions in our common stock as a result of the penny stock rules summarized above.  These requirements may further reduce the liquidity and trading price of our common stock. 

 

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 

 

None  

 

Item 3. Defaults Upon Senior Securities 

 

None  

 

Item 4. Mine Safety Disclosures 

 

Not applicable 

 

Item 5. Other Information 

 

None  

 

Item 6. Exhibits  

 

Refer to the Exhibit Index for a list of the exhibits being filed or furnished with or incorporated by reference into this Quarterly Report on Form 10-Q. 

 

 

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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 13, 2012

 

Scientific Learning Corporation 

(Registrant) 

 

/s/ Jane A. Freeman 

Jane A. Freeman 

Chief Financial Officer

 

 

 

 

 

 

 


 

 

 

 

Exhibit Index 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Incorporated by Reference

 

 

Exhibit Number

 

Description

 

Form

 

File Number

 

Date of First Filing

 

Exhibit Number

 

Filed Herewith

10.1

 

Lease Extension and Modification Agreement by and between Scientific Learning Corporateion and Rotunda Partners II, LLC, dated October 3, 2012

 

8-K

 

000-24547

 

10/5/2012

 

10.1

 

 

31.1

 

Certification of Chief Executive Officer (Section 302)

 

 

 

 

 

 

 

 

 

X

31.2

 

Certification of Chief Financial Officer (Section 302)

 

 

 

 

 

 

 

 

 

X

32.1

 

Certification of Chief Executive Officer (Section 906)

 

 

 

 

 

 

 

 

 

X

32.2

 

Certification of Chief Financial Officer (Section 906)

 

 

 

 

 

 

 

 

 

X

101**

 

The following materials from Scientific Learning Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012, formatted in XBRL (eXtensible Business Reporting Language): (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of 

Income; (iii) Condensed Consolidated Statements of Cash Flows; (iv) Condensed Consolidated Statements of Shareholders’ Equity; and (v) Notes 

to Condensed Consolidated Financial Statements, tagged as blocks of text

 

 

 

 

 

 

 

 

 

 

  

 

** In accordance with Rule 406T of Regulation S-T, the XBRL related information in Exhibit 10.1 to this Quarterly Report on Form 10-Q shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.