Renaissance Learning, Inc. is a leading provider of computer-based assessment technology for pre-K-12 schools. Our tools provide daily formative assessment and periodic progress-monitoring technology to enhance core curriculum, support differentiated instruction and personalize practice in reading, writing and math. Renaissance Learning products help educators make the practice component of their existing curriculum more effective by providing tools to personalize practice and easily manage the daily activities for students of all levels.

Our sales are derived primarily from the sale of software products, computerized hardware products and related services. Revenues are recorded net of an allowance for estimated returns. Allowances for bad debts are also recorded at the time of the sale.

Product revenue is derived primarily from the sale of educational software and hardware. Revenue from sales of hardware is generally recognized when the product is shipped to the customer. Revenue recognition from sales of our software depends on whether the software is: (i) off-the-shelf or customized and
(ii) whether it is licensed on a perpetual basis or as a subscription. We recognize revenue from off-the-shelf perpetually licensed software sales upon delivery to customers. Subscription-based software sales are recognized as revenue on a straight-line basis over the subscription period. Sales of software that require substantial modification or customization are recognized as revenue using the percentage-of-completion method of accounting. Revenues and deferred revenues from software that require substantial modification or customization are not significant in any of the years presented.

Service revenue is derived primarily from: (i) product support services,
(ii) professional development and product training seminars and conferences,
(iii) application hosting, (iv) technical services, (v) consulting and (vi) other remote services. Product support services included with sales of perpetually licensed software have a duration of 12 months or less and the associated revenue is recognized at the time the software is shipped with the related costs of providing the telephone support accrued for at the same time. Revenue from professional development and product training seminars and conferences is recognized when the seminar or conference is held. Revenue from other product support services and application hosting is initially recorded as deferred revenue and then recognized as revenue on a straight-line basis over the term of the agreement, typically 12 months. Revenue from technical services, consulting and other remote services is recognized as the services are performed or on a straight-line basis over the contractual period.

Deferred revenue includes: (i) amounts invoiced for products not yet delivered and services not yet performed, (ii) advance invoicing on contracts and (iii) that portion of product support agreements and subscription-based product sales that has not yet been recognized as revenue.

It is our practice to announce new products prior to when the products are ready for shipment to allow customers sufficient lead time for budgeting and curriculum purposes. This practice can result in fluctuations in backlog for orders of new products. These orders are generally filled within a relatively short period of time after the product is ready for shipment. Registrations for seminars and conferences are generally received from customers in advance of the events, resulting in a backlog for these services. Additionally, under district-wide implementations, customers commit to a comprehensive solution consisting of products and services in advance of delivery of the products and services. The delivery of backlogged products and services in certain periods can cause those periods to have higher revenue and higher revenue growth rates than other periods.

We expense all development costs associated with a software product until technological feasibility is established, after which time such costs are capitalized until the product is available for general release to customers. Capitalized product development costs are amortized into cost of sales, beginning when the product is available for general release, using the straight-line method over their estimated economic life, which is generally estimated to be 24 months.

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. National trends, federal and state legislation, Department of Education policies and, the way the foregoing align with our products and services can 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.

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 2008, approximately 32% of our active reading product customers were using the Enterprise version. Worldwide, we currently have approximately 55,000 active Accelerated Reader customers, 19,000 active Accelerated Math customers and, 47,000 active STAR Reading and STAR Mathcustomers. Customer counts have been adjusted from those previously reported as we refined our counting process with respect to various factors, including: the definition of an active customer school, how we count schools involved in a district implementation and, how to handle transfers of products and subscriptions between schools.

The transition to subscription-based products 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 Enterpriseproducts, 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.

This transition can also significantly affect reported financial results. Since our Renaissance Place product and service offerings are typically sold on a subscription basis with a term of 12 months, a large portion of our revenue is initially deferred and recognized into income over the subscription period. Driven primarily by sales of our subscription-based Enterprisesoftware packages, deferred revenue increased $8.5 million and $13.7 million, over the years ended December 31, 2008 and 2007, respectively. This timing difference between receipt of an order and revenue recognition, on subscription based products and services, can result in reported revenue being significantly lower or significantly higher than the amount of orders received in any given period and can also affect comparative results from one period to another.

Large infrequent charges are another factor that can significantly affect our results of operations. In 2008 we recorded: (i) a non-cash, non-recurring charge of $46.5 million (after tax) for impairment of goodwill and other intangible assets related to the 2005 acquisition of AlphaSmart, (ii) a charge of $0.6 million related to a lawsuit regarding defective parts from a supplier for which we received an unfavorable court decision and, (iii) a $0.4 million charge to terminate contracts for professional development events where we altered the timing or location of those events. In 2007 we took a charge of $0.5 million to reorganize our product development resources, reducing staff and assets related to the laptop line. Our 2006 net income and results of operations was impacted by a charge of $1.9 million in separation expense, primarily for former executives.

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

                                                     2008       2007      2006
       Net Sales:
       Products                                        73.4 %     78.4 %    81.4 %
       Services                                        26.6       21.6      18.6
       Total net sales                                100.0      100.0     100.0
       Cost of sales:
       Products                                        17.1       18.5      18.1
       Services                                        43.2       50.8      48.2
       Total cost of sales                             24.1       25.5      23.7
       Gross profit:
       Products                                        82.9       81.5      81.9
       Services                                        56.8       49.2      51.8
       Total gross profit                              75.9       74.5      76.3
       Operating expenses:
       Product development                             15.1       17.1      15.5
       Selling and marketing                           31.4       33.4      30.2
       General and administrative                      13.3       13.9      14.6
       Impairment of goodwill & intangible assets      41.6          -         -
       Operating income (loss)                        (25.5 )     10.1      16.0
       Other, net                                       0.7        1.1       1.1
       Income (loss) before taxes                     (24.8 )     11.2      17.1
       Income tax provision                             5.1        4.2       6.3
       Net Income (loss)                              (29.9 )%     7.0 %    10.8 %

Net Sales. Our net sales increased by $7.3 million, or 6.8%, to $115.2 million in 2008 from $107.9 million in 2007. Revenue in 2008 increased primarily due to recognition of deferred revenue from orders received in earlier periods and to a lesser extent by increased orders for our products and services received in the current year. Customer orders for our products and services increased by approximately $1.0 million, or 0.8%, in 2008 as compared to 2007. During 2008, deferred revenue increased by $8.5 million as compared to an increase of $13.7 million in 2007.

Product revenue decreased by $0.1 million, or 0.1%, to $84.5 million in 2008, essentially unchanged from $84.6 million in 2007.

Service revenue increased by $7.4 million, or 31.7%, to $30.7 million in 2008 from $23.3 million in 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 hold a National Conference in 2007.

Cost of Sales. The cost of sales of products decreased by $1.2 million, or 7.5%, to $14.5 million in 2008 from $15.7 million in 2007. As a percentage of product sales, the cost of sales of products decreased to 17.1% in 2008 from 18.5% in 2007 primarily due to lower manufacturing costs of our scanner and a product mix shift in the laptop line to the more profitable NEOs.

The cost of sales of services increased by $1.5 million, or 12.7%, to $13.3 million in 2008 from $11.8 million in 2007. As a percentage of sales of services, the cost of sales of services decreased to 43.2% in 2008 from 50.8% in 2007. The improvement resulted from growth of our more profitable technical service offerings, especially hosting, and increased utilization of our fixed costs during 2008.

Our overall gross profit margin percentage increased to 75.9% in 2008 from 74.5% in 2007. The improvement is attributable to the increased profitability on products and services explained above, tempered by an overall revenue mix weighted more heavily towards services in 2008.

Product Development. Product development expense, which excludes amounts capitalized, decreased by $1.1 million, or 6.0%, to $17.4 million in 2008 from $18.5 million in 2007. As a percentage of net sales, product development expenses decreased to 15.1% in 2008 from 17.1% in 2007. The reduction in product development expenses is primarily due to: (i) a charge of $0.5 million in 2007 to reorganize our product development resources, reducing staff and assets related to the laptop line, (ii) ongoing savings from the restructuring in 2008 and, (iii) research costs incurred in 2007 related to the expansion of the United Kingdom product offerings.

Selling and Marketing. Selling and marketing expenses increased by $0.3 million, or 0.1%, to $36.3 million in 2008 from $36.0 million in 2007. Selling and marketing expenses increased in 2008, partly due to increased commissions as a result of higher customer order levels and, higher promotional expenses related to the NEO; partially offset by lower spending on advertising and direct marketing. As a percentage of net sales, selling and marketing expenses were 31.4% in 2008 compared to 33.4% in 2007.

General and Administrative. General and administrative expenses increased by $0.3 million, or 2.2%, to $15.3 million in 2008 from $15.0 million in 2007. General and administrative expenses increased in 2008 primarily due to: a charge of $0.6 million related to a lawsuit regarding defective parts from a supplier for which we received an unfavorable court decision and, a $0.4 million charge to terminate contracts for professional development events where we altered the timing or location of those events; partially offset by other cost reductions. As a percentage of net sales, general and administrative costs decreased to 13.3% in 2008 from 13.9% in 2007.

Operating Income. An operating loss of $29.4 million occurred in 2008 compared to operating income of $10.9 million in 2007. The 2008 operating loss was primarily a result of the AlphaSmart impairment charges which were partially offset by earnings from ongoing operations. The impairment charges negatively impacted 2008 operating income by $47.9 million and net income after tax by $46.5 million.

Other Income. Other income, which is mainly interest income from our investment securities, decreased to $0.8 million in 2008 from $1.2 million in 2007 due to somewhat lower average cash balances in 2008 and to lower market rates of return on fixed income investments.

Income Tax Provision. In 2008 the annual effective rate of our provision for income taxes was -20.5%. Our annual effective income tax rate, excluding the tax effect of the impairment charge to goodwill and other intangibles, was 36.7% in 2008. Since the write down of the AlphaSmartgoodwill is not deductible for income tax purposes it does not generate a current tax benefit, resulting in tax expense of $5.8 million during 2008 in spite of the reported pre-tax loss. The tax accounting treatment of the goodwill write down is the primary reason in 2008 for the difference between the 37% rate and the actual rate of -20.5% reflected in the financial statements. This compares to income tax expense of $4.5 million that was recorded in 2007 at an effective income tax rate of 37.5% of pre-tax income.

Net Sales. Our net sales decreased by $3.6 million, or 3.2%, to $107.9 million in 2007 from $111.5 million in 2006. A significant portion of this decline was related to our customers purchasing more subscription-based products and services, particularly Accelerated Reader. Revenues from subscription-based products are initially deferred and then recognized ratably over the subscription period, generally one year, while the majority of revenues from non-subscription-based sales are recognized immediately upon delivery. During 2007, deferred revenue increased by $13.7 million as compared to an increase of $5.7 million in 2006. Customer orders for our products and services increased by approximately $5.2 million, or 4.3%, in 2007 as compared to 2006.

Product revenue decreased by $6.1 million, or 6.7 %, to $84.6 million in 2007 from $90.7 million in 2006. Product revenues decreased primarily due to the significant increase in deferred revenue and to a lesser extent due to lower laptop sales.

Service revenue increased by $2.5 million, or 12.2%, to $23.3 million in 2007 compared to $20.8 million in 2006. Service revenues increased primarily due to order improvements for technical services such as application hosting and installations, and in professional development services, both remote and onsite, partially offset by the impact of not holding a national conference in 2007.

Cost of Sales. The cost of sales of products decreased by $0.8 million, or 4.7%, to $15.7 million in 2007 from $16.5 million in 2006. As a percentage of product sales, the cost of sales of products was 18.5% in 2007, relatively unchanged from 18.1% in 2006.

The cost of sales of services increased by $1.8 million, or 18.2%, to $11.8 million in 2007 from $10.0 million in 2006. As a percentage of sales of services, the cost of sales of services increased to 50.8% in 2007 from 48.2% in 2006 primarily due to personnel and infrastructure additions that were required for some of our remote and technical services, and to price reductions in some of our on-site professional development service offerings.

Product Development. Product development expense, which excludes amounts capitalized, increased by $1.2 million, or 6.9%, to $18.5 million in 2007 from $17.3 million in 2006. As a percentage of net sales, product development expenses increased to 17.1% in 2007 from 15.5% in 2006. We capitalized product development expenses of $0.2 million in 2007 compared to $0.7 million in 2006. Product development expenses were higher in 2007 primarily due to: (i) a $0.5 million restructuring cost related to a partial reorganization of product development resources for the laptop line in 2007, (ii) the higher level of software development cost capitalized in 2006 than in 2007 and, (iii) a $0.3 million increase in research and development costs related to our United Kingdom products.

Selling and Marketing. Selling and marketing expenses increased by $2.4 million, or 7.1%, to $36.0 million in 2007 from $33.6 million in 2006. Selling and marketing expenses increased in 2007, partly due to increased commissions as a result of higher customer order levels and partly due to salaries as a result of our sales force expansion; partially offset by lower spending on advertising and direct marketing. As a percentage of net sales, selling and marketing expenses were 33.4% in 2007 compared to 30.2% in 2006.

General and Administrative. General and administrative expenses decreased by $1.4 million, or 8.4%, to $14.9 million in 2007 from $16.3 million in 2006. General and administrative expenses were lower in 2007 primarily due to the impact of an executive severance charge of $1.9 million taken in 2006. As a percentage of net sales, general and administrative expenses decreased to 13.9% in 2007 from 14.6% in 2006.

Operating Income. Operating income decreased by $6.9 million, or 38.6%, to $10.9 million in 2007 from $17.8 million in 2006. As a percentage of net sales, operating income decreased to 10.1% in 2007 from 16.0% in 2006 due to the combined effect of the factors discussed above.

Other Income. Other income, which is mainly interest income from our investment securities, was $1.2 million in 2007, unchanged from 2006.

Income Tax Provision. Income tax expense of $4.5 million, from continuing operations, was recorded in 2007 at an effective income tax rate of 37.5% of pre-tax income, compared to $7.0 million, or 37.0%, of pre-tax income for 2006. The higher tax rate in 2007 was primarily the result of the adoption of the new accounting standard for uncertain tax positions, Financial Interpretation No. 48 ("FIN 48"). The method for estimating, accruing and recognizing expenses and benefits of uncertain income tax positions under FIN 48 is substantially different than under the previous accounting standard.

As of December 31, 2008, our cash, cash equivalents and investment securities were $17.8 million, down $6.7 million from $24.5 million at December 31, 2007. During 2008, we generated operating cash flow of $24.9 million.

As of December 31, 2008 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 which bears interest at the prime rate less 1.0%. As of December 31, 2008, the lines of credit had not been used.

We declared quarterly cash dividends of: $0.05 per share in the first and second quarter of 2007 and $0.07 in the third and fourth quarter of 2007 along with a special dividend of $0.75 per share in the third quarter of 2007. We declared quarterly cash dividends of $0.07 per share in each of the four quarters of 2008 along with a special dividend of $0.75 per share in the fourth quarter of 2008.

We intend to continue to pay quarterly cash dividends, subject to capital availability and a determination that cash dividends continue to be in the best interests of the company and our shareholders. Our Board of Directors also considers several additional factors when declaring dividends, including: the company's financial statements as of the most recent practicable date, the expected cash costs to deliver the products and services recorded as deferred revenue, the company's ability to provide the products and services underlying amounts recorded as deferred revenue, the likelihood of recognizing amounts recorded as deferred revenue as net sales based on the company's historical experience and most recent projections and the short time period over which such recognition has historically occurred and is expected to occur and, other information, opinions, reports and statements prepared and presented by the company's officers and employees about the company's business, operations and financial condition.

We believe our strong cash position coupled with cash flow from operations will be sufficient to meet both our short-term and long-term working capital requirements.

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 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. Some of the leases have early termination clauses, but they generally cannot be terminated by either the lessor or us for reasons other than breach of the lease agreement. We plan to terminate the lease on a small office facility in early 2009 for which we have a 90-day no-penalty option to terminate. We do not anticipate the early termination of any other lease agreements. For each of the . . .