Summary of RENAISSANCE LEARNING INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Results of Operations Our results of operations can be affected by many factors including the general economic environment, state and federal budgetary decisions and the length and complexity of the sales cycle for school districts. Because of our dependence on educational institutions, the funding of which is largely dependent on government support, a decrease in government budgets or funding for educational software or technology could likely have an adverse effect on our business. National trends, federal and state legislation, Department of Education administrative policies and the way the foregoing align with our products and services can also impact our business.
An important component of our software product strategy is a transition to a subscription-based software sales model. We believe that a business model based on subscription-based software offers long-term advantages over traditional perpetual licensing, including: (i) improved product utilization leading to higher levels of customer satisfaction, (ii) product adoption by more schools,
(iii) more lifetime revenue per customer and (iv) a more predictable and reliable revenue stream. This transition can significantly impact reported financial results and customer ordering patterns. During periods when high levels of customer orders are attributable to our subscription-based product and service offerings a significant portion of a period's sales orders will be deferred and recognized as revenue in future periods over the subscription term, generally 12 months. Likewise, in periods when customer order levels for subscription-based products and services are seasonally lower, reported revenue may be higher than orders. The transition to subscription-based products also affects customer ordering patterns. Compared to orders for non-subscription-based offerings, customer orders of our subscription-based offerings tend to more closely follow school budgeting patterns resulting in a more seasonal order pattern weighted to the second and third calendar quarters. Also, after customers transition to our subscription-based Enterprise products, they no longer order reading quizzes and math libraries since access to this content is included in their subscription. Historically, our customers have ordered more of this content in the first and fourth quarters. The combined effect is that a much greater proportion of a year's orders is expected in the second quarter and to an even greater extent in the third quarter than we have experienced historically. Transitioning to subscription-based software can also adversely impact orders for expansions, add-on reading quizzes and math libraries by customers who own our software under perpetual license agreements, as they may delay purchases of expansions, reading quizzes and math libraries while they are contemplating a transition to subscription-based versions of our products. We believe these factors impacted order levels in the third quarter of 2008, while also causing reported revenue to be lower than order levels due to the deferral of revenue from orders we received this quarter. In addition to the transition to subscription software and overall seasonal impacts, our order rates can also be affected by general economic factors such as the current economic downturn. Our laptops tend to be a more discretionary purchase than our software products and therefore tend to be more immediately impacted by school budgetary pressures than software. Our software orders levels can also be adversely affected by school budgetary pressures but generally to a lesser degree. We believe that order rates during the three-month and nine-month periods ended September 30, 2008 have been tempered somewhat by the downturn in the general economic environment and the resulting uncertainty about school funding levels. We believe the percentage of customers using the subscription-based Enterprise version of our reading and math products is an important indicator of: (i) the progress of this strategic growth initiative, (ii) the magnitude of the growth opportunities still existing with regard to this strategy and (iii) the impact of the new seasonal patterns on our business. As of the end of the third quarter 2008, approximately 24% of our active reading product customers were using the Enterprise version. Worldwide, we currently have approximately 58,000 active Accelerated Reader customers, 19,000 active Accelerated Math customers and 41,000 active STAR Reading and STAR Math customers.

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The following table sets forth certain consolidated income statement data as a percentage of net sales, except that individual components of costs of sales and gross profit are shown as a percentage of their corresponding component of net sales:

                                      Three Months Ended          Nine Months Ended
                                         September 30,              September 30,
                                       2008          2007          2008         2007
       Net Sales:
       Products                           68.9 %       72.4 %         74.2 %      78.5 %
       Services                           31.1 %       27.6 %         25.8 %      21.5 %

       Total net sales                   100.0 %      100.0 %        100.0 %     100.0 %


       Cost of sales:
       Products                           16.3 %       19.0 %         17.6 %      18.7 %
       Services                           41.8 %       46.3 %         45.2 %      50.4 %

       Total cost of sales                24.3 %       26.5 %         24.7 %      25.5 %

       Gross profit:
       Products                           83.7 %       81.0 %         82.4 %      81.3 %
       Services                           58.2 %       53.7 %         54.8 %      49.6 %

       Total gross profit                 75.7 %       73.5 %         75.3 %      74.5 %


       Operating expenses:
       Product development                16.0 %       17.1 %         15.0 %      17.7 %
       Selling and marketing              31.8 %       34.3 %         31.8 %      34.0 %
       General and administrative         15.0 %       14.7 %         13.8 %      14.1 %

       Total operating expenses           62.8 %       66.1 %         60.6 %      65.8 %


       Operating income                   12.9 %        7.4 %         14.7 %       8.7 %
       Other, net                          1.0 %        1.1 %          0.8 %       1.1 %

       Income before taxes                13.9 %        8.5 %         15.5 %       9.8 %
       Income taxes                        4.8 %        3.2 %          5.5 %       3.7 %

       Net Income                          9.1 %        5.3 %         10.0 %       6.1 %

Three Months Ended September 30, 2008 and 2007 Net Sales. Our net sales increased by $2.4 million, or 9.3%, to $28.2 million in the third quarter of 2008 from $25.8 million in the third quarter of 2007. Product revenues increased to $19.4 million in the third quarter of 2008 from $18.7 million in the third quarter of 2007 primarily due to the revenue recognized from prior period orders of software. Deferred revenue increased by $12.1 million in the third quarter of 2008, reaching a record level of $51.5 million, compared to an $8.9 million increase in the prior year's third quarter. Increased sales of subscription based software and services was the main reason for the increase in deferred revenue. Service revenue increased to $8.8 million in the third quarter of 2008 from $7.1 million in the third quarter of 2007. Nearly all service categories achieved growth, with the largest increases occurring in our remote technical services, primarily hosting and installations.
Cost of Sales. The cost of sales of products decreased to $3.2 million in the third quarter of 2008 from $3.5 million in the third quarter of 2007. As a percentage of product sales, the cost of sales of products decreased to 16.3% in the third quarter of 2008 from 19.0% in the third quarter of 2007 primarily due to lower manufacturing costs of our scanner and a product mix shift in the laptop line to the more profitable Neos.

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The cost of sales of services increased by $0.4 million, or 11.0%, to $3.7 million in the third quarter of 2008 from $3.3 million in the third quarter of 2007. As a percentage of sales of services, the cost of sales of services decreased to 41.8% in the third quarter of 2008 from 46.3% in the third quarter of 2007. The improvement resulted from growth of our more profitable technical service offerings, especially hosting, and better utilization of our fixed costs during the third quarter of 2008.
Product Development. Product development expenses of $4.5 million in the third quarter of 2008 were nearly unchanged with $4.4 million in the third quarter of 2007. As a percentage of net sales, product development expenses decreased to 16.0% in the third quarter of 2008 from 17.1% in the third quarter of 2007. Selling and Marketing. Selling and marketing expenses of $9.0 million in the third quarter of 2008 were at similar levels with $8.9 million in the third quarter of 2007. As a percentage of net sales, selling and marketing expenses decreased to 31.8% in the third quarter of 2008 from 34.3% in the third quarter of 2007.
General and Administrative. General and administrative expenses increased by $0.4 million, or 11.0%, to $4.2 million in the third quarter of 2008 from $3.8 million in the third quarter of 2007. The increase was primarily due to a $0.6 million charge related to a 2004 lawsuit regarding defective parts from a supplier for which we received an unfavorable court decision. As a percentage of net sales, general and administrative expenses increased to 15.0% in the third quarter of 2008 from 14.7% in the third quarter of 2007.
Operating Income. Operating income increased by $1.8 million, or 92.8%, to $3.7 million in the third quarter of 2008 from $1.9 million in the third quarter of 2007. The increase was due to the higher revenue and gross profit margin improvements, partially offset by an increase in operating expenses as explained above. As a percentage of net sales, operating income increased to 12.9% in the third quarter of 2008 from 7.4% in the third quarter of 2007.
Income Tax Expense. Income tax expense of $1.4 million was recorded in the third quarter of 2008 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.1 million relating to the lapse of the statue of limitations on various tax positions. This compares to $0.8 million, or 37.5% of pre-tax income in the third quarter of 2007. The ongoing tax rate increased to 38.0% in 2008 from 37.5% in 2007 is a result of the expiration of the federal research and development tax credit. Congress extended the research and development tax credit on October 3, 2008. We will record the related tax benefit in the fourth quarter 2008. We do not expect this to have a material effect on our consolidated financial statements.
Nine Months Ended September 30, 2008 and 2007 Net Sales. Our net sales increased to $85.6 million in the first nine months of 2008 from $79.7 million in the first nine months of 2007. Product sales increased to $63.5 million in the first nine months of 2008 from $62.6 million in the first nine months of 2007. Deferred revenue increased by $13.1 million in the first nine months of 2008 versus an increase of $13.9 million in the first nine months of 2007. Service revenue increased by $5.0 million, or 29.3%, to $22.1 million in the first nine months of 2008 from $17.1 million in the first nine months of 2007. Nearly all service categories achieved growth, with the largest increases in our remote technical services, primarily hosting and installations. Service revenues also increased because we held a National Conference in the first quarter of 2008, but did not have a National Conference in 2007.
Cost of Sales. The cost of sales of products decreased to $11.2 million in the first nine months of 2008 from $11.7 million in the first nine months of 2007. As a percentage of product sales, the cost of sales of products decreased to 17.6% in the first nine months of 2008 from 18.7% in the first nine months of 2007 primarily due to lower manufacturing costs of our scanner and a product mix shift in the laptop line to the more profitable Neos.

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The cost of sales of services increased by $1.4 million, or 16.0%, to $10.0 million in the first nine months of 2008 from $8.6 million in the first nine months of 2007. As a percentage of sales of services, the cost of sales of services decreased to 45.2% in the first nine months of 2008 from 50.4% in the first nine months of 2007. The improvement resulted from growth of our more profitable technical service offerings, especially hosting, and increased utilization of our fixed costs during the first nine months of 2008. Product Development. Product development expenses decreased by $1.3 million, or 9.1%, to $12.8 million in the first nine months of 2008, compared to $14.1 million for the first nine months of 2007. The reduction in product development expenses is primarily due to: (i) ongoing savings from the restructuring of our product development group which occurred in the first quarter of 2007; (ii) a one-time charge of $0.5 million in the first quarter of 2007 for the restructuring; and (iii) research costs incurred in the prior year related to the expansion of the United Kingdom product offerings. As a percentage of net sales, product development costs decreased to 15.0% in the first nine months of 2008 from 17.7% in the first nine months of 2007. Selling and Marketing. Selling and marketing expenses of $27.2 million in the first nine months of 2008 were essentially unchanged with $27.1 million in the first nine months of 2007. As a percentage of net sales, selling and marketing expenses decreased to 31.8% in the first nine months of 2008 from 34.0% in the first nine months of 2007.
General and Administrative. General and administrative expenses increased by $0.5 million, or 4.6%, to $11.8 million in the first nine months of 2008 from $11.3 million in the first nine months of 2007. The increase was primarily due to a $0.6 million charge related to a 2004 lawsuit regarding defective parts from a supplier for which we received an unfavorable court decision. As a percentage of net sales, general and administrative expenses decreased to 13.8% in the first nine months of 2008 from 14.1% in the first nine months of 2007. Operating Income. Operating income increased to $12.6 million in the first nine months of 2008 from $6.9 million in the first nine months of 2007. As a percentage of net sales, operating income increased to 14.7% in the first nine months of 2008 from 8.7% in the first nine months of 2007. The increase was due to the increased revenue, gross profit margin improvements and lower operating expenses as explained above.
Income Tax Expense. Income tax expense of $4.7 million was recorded for the first nine months of 2008 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.3 million relating primarily to the lapse of the statue of limitations on various tax positions. This compares to $2.9 million, or 37.5% of pre-tax income in the first nine months of 2007. The ongoing tax rate increased to 38.0% in 2008 from 37.5% in 2007 as a result of the expiration of the federal research and development tax credit. Congress extended the research and development tax credit on October 3, 2008. We will record the related benefit in the fourth quarter 2008. We do not expect this to have a material effect on our consolidated financial statements.

Liquidity and Capital Resources As of September 30, 2008, our cash, cash equivalents and investment securities were $34.9 million, up $10.4 million from the December 31, 2007 total of $24.5 million. The increase was primarily due to $17.7 million of cash flow provided by operations offset by $6.1 million used for dividends and $0.9 million used for property, plant and equipment purchases.
At September 30, 2008, we had cash and cash equivalents of $23.9 million. Our available cash and cash equivalents are held in bank deposits and money market funds. We monitor the depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. To date, we have experienced no material loss or lack of access to our cash or cash equivalents; however, we can provide no assurances that access to our cash and cash equivalents will not be impacted by adverse conditions in the financial markets. Our cash balances in the U.S. exceed the Federal Deposit Insurance Corporation ("FDIC") insurance limits. While we monitor the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail or could be subject to other adverse conditions in the financial markets.

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We have a $15.0 million secured revolving line of credit with a bank which is available until July 1, 2009. The line of credit bears interest at either a floating rate or a fixed rate for a period of up to 90 days based on LIBOR plus 1.5%. The rate is at our option and is determined at the time of borrowing. We also have a $2.0 million unsecured revolving line of credit with a bank available until April 30, 2009. The line of credit bears interest based on the prime rate less 1.0%. As of September 30, 2008, the lines of credit had not been used.
Our Board of Directors has approved a stock repurchase program under which we may purchase up to an aggregate total of 9.0 million shares of our common stock. During the quarter and nine months ended September 30, 2008, we repurchased approximately 5,400 and 11,500 shares, respectively, at a cost of approximately $67,000 and $153,000. As of September 30, 2008, the cumulative number of shares repurchased under this program was 7.8 million at an aggregate cost of $135.0 million. Depending on our stock valuation, cash availability and other factors, we may repurchase additional shares under this program.
On October 22, 2008, our Board of Directors declared a special cash dividend of $0.75 per share and declared a quarterly cash dividend of $0.07 per share, both payable December 1, 2008 to shareholders of record as of November 7, 2008. We believe our balance of cash, cash equivalents and investment securities coupled with cash flow from operations will be sufficient to meet both our near-term and long-term working capital requirements for the foreseeable future.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations We do not have any off-balance sheet transactions, arrangements or obligations (including contingent obligations), that would have a material effect on our financial results.
Operating Leases. We enter into operating leases, primarily for facilities that we occupy in order to carry out our business operations. We utilize operating leases for some of our facilities to gain flexibility as compared to purchasing facilities outright and to limit our exposure to many of the risks of owning commercial property, particularly with regard to international operations. These agreements are generally for terms of one to five years and cannot be terminated by either the lessor or us for reasons other than breach of the lease agreement. We do not anticipate early termination of any of these agreements. Purchase Obligations. We enter into commitments with certain suppliers to purchase components for our hardware products, such as AlphaSmart laptops, AccelScan scanners and the 2Know! response system. The majority of these obligations will be satisfied within one year.
Tax Audit Settlements and Deposits. Currently we do not anticipate making any significant cash payments related to the settlement of tax audits or deposits for unsettled audit issues during the next twelve months. Estimation of the amounts and timing of payments for periods further into the future are highly uncertain and therefore are not included in the table.
As of September 30, 2008, our approximate contractual obligations for operating leases and purchase obligations (by period due) were as follows:

                                                          Payments Due by Period
                                               Less than                                          More than
Contractual Obligations          Total          1 year          1-3 years        3-5 years         5 years
(In Thousands)

Operating lease obligations    $   4,930      $       519      $     2,718      $     1,289      $       404
Purchase obligations               5,881            5,881                -                -                -

Total                          $  10,811      $     6,400      $     2,718      $     1,289      $       404

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Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. There have been no significant changes to our critical accounting policies that were disclosed in our 2007 Annual Report.

Forward-Looking Statements In accordance with the Private Securities Litigation Reform Act of 1995, we can obtain a "safe-harbor" for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements. Accordingly, the foregoing "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the following "Quantitative and Qualitative Disclosures About Market Risk" may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management's expectations regarding orders and financial results for 2008 and future periods. These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements. Factors which may cause such a difference to occur include: (i) the failure of Accelerated Reader Enterprise, Accelerated Math Enterprise and laptop orders to achieve expected growth targets, (ii) a decline in reading quiz and math library sales that exceeds our forecast, (iii) risks associated with our strategic growth initiative involving our transition to subscription-based products,
(iv) dependence on educational institutions and government funding and (v) other risks affecting our business as described in our filings with the Securities and Exchange Commission, including our 2007 Annual Report and later filed quarterly reports on Form 10-Q and current reports on Form 8-K, which factors are incorporated herein by reference. We expressly disclaim a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.
Item 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk. Our exposure to market interest rate risk consists of:
(i) the increase or decrease in the amount of interest income we can earn on our investment portfolio and (ii) the decrease or increase in the value of our investment security portfolio if market interest rates increase or decrease, respectively. We anticipate that we will have sufficient liquidity to hold our investments to maturity; therefore, we do not expect to recognize any material losses or gains related to an increase or decrease in market interest rates. Market Risk. Our exposure to market risk relates to the quality of the holdings in our investment security portfolio. The fair market value of our investments is subject to increases or decreases in value resulting from the performance of the securities issuer, from upgrades or downgrades in the credit worthiness of the securities issuer and from changes in general market conditions. We seek to manage exposure to market risk by investing in accordance with our corporate investment policy as established by our Board of Directors. The goals of the policy are: (i) preservation of capital, (ii) provision of adequate liquidity to meet projected cash requirements, (iii) minimization of risk of principal loss through diversified short and medium term investments and
(iv) yields in relationship to the guidelines, risk, market conditions and tax considerations. Our investment policy permits investments in obligations of the U.S. Treasury department and its agencies, money market funds and high quality investment-grade corporate and municipal interest-bearing obligations. The policy requires diversification to prevent excess concentration of issuer risk and requires the maintenance of minimum liquidity levels. The policy precludes investment in equity securities except for the specific purpose of funding the obligations related to our Supplemental Executive Retirement Plan. As of September 30, 2008, our investment securities had a market value of approximately $11.0 million and a carrying value of $11.0 million. Due to the type and duration of our investments, we do not expect to realize any material gains or losses related to market risk.

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Foreign Currency Exchange Rate Risk. The financial position and results of operations of our foreign subsidiaries are measured using local currency. Revenues and expenses of such subsidiaries have been translated into U.S. dollars using average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange at the balance sheet date. Translation gains or losses are deferred as a separate component of shareholders' equity. Aggregate foreign currency transaction gains and losses are included in determining net income. As such, our operating results are affected by fluctuations in the value of the U.S. dollar compared to the British pound, Canadian dollar, Euro and Indian rupee. At this time, foreign exchange rate risk is not significant due to the relative size of our foreign operations and revenues derived from sales in foreign countries. Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating our disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management was necessarily required to apply its . . .