Overview

Franklin Electronic Publishers, Incorporated ("Franklin," "we", "us", or "our" or the "Company") designs, develops, publishes and distributes electronic information on handheld devices, memory media cards, and via internet downloads. We also design, develop, and license to third parties, linguistic technology, such as spelling error detection software in thirty-six languages, for use in application software, electronic products and on the internet.

For the year ended March 31, 2009, Franklin had a pretax loss of $4,289 compared with pretax income of $ $2,772 in the prior year. The decrease was primarily due to lower sales of $11,056 or 19% from $57,081 in the prior year to $46,025 in the current year. In addition the prior year benefited from other operating revenue of $3,500 received from two distribution partners, Seiko Instruments, Inc (SII) and Seiko UK Ltd, and was partially offset by $750 of other operating revenue received from Nuance Communications, Inc. (Nuance) in the current year following the settlement of pending litigation. Gross margin decreased to $22,816 from $31,921 in the prior year due to lower sales and other operating revenue of $11,056 and $2,750, respectively. The lower gross margin was partially offset by a decrease in operating expenses of $2,193.

The current year's pretax loss includes non-cash one-time charges of $1,419 as well as other one-time charges of $1,404. The non-cash charges related to impairment to the carrying value of goodwill allocated to the Company's data conversion subsidiary, Kreutzfeldt Electronic Publishing GmbH (KEP) in Germany, impairment of the value of Franklin's licensed Rolodex® Electronics trademark and inventory valuation adjustments related to the current economic climate. The other one-time charges related to severance accruals as a result of the reduction in the Company's global workforce and other operating cost reductions and costs related to the liquidation of the Company's subsidiary KEP. Excluding the impact of the one-time charges, the Company's pretax loss for the fiscal year 2009 would have been $1,466.

Sales in all business operations, with the exception of Other Domestic, have experienced declines primarily due to a slowdown in consumer spending from the current worldwide economic recession that affected sales in all of our global retail markets. Sales in Other Domestic operations increased by $717 primarily due to our Proximity Technology Division where sales increased by $683 due to the renewal of the Adobe Technology licensing agreement during our fiscal second quarter.

Sales of monolingual products in our North American business operation have been trending downward over the past several years primarily due to indirect competition from the internet, providing consumers with alternative solutions (often free) for their spell correction and reference needs. The downward trend has been partially offset by growth in our bilingual products in the North American market.

For the year ended March 31, 2008, we had an improvement in results of operations of $5,884 resulting in a pretax profit of $2,772 compared to a pretax loss of $3,112 in the prior year. The increase was primarily due to higher sales across the Company with strong gains in our European and Australian operations. In addition we recorded other operating revenue of $3,500 received from two distribution partners, SII and Seiko UK Ltd. Gross margin increased to $31,921 from $23,892 in the prior year due to an overall increase in sales of $4,868 and $3,500 of recorded other operating revenue. The higher gross margin was partially offset by an increase in operating expenses of $1,709 and other net of $345.

Results of Operations

The following table summarizes our historical results of operations as a percentage of sales for fiscal years 2009, 2008, and 2007 (in thousands):

                                                         Year Ended March 31,
                                                    2009          2008         2007
   Revenue:
   Domestic sales                                 $ 24,185      $ 31,605     $ 31,749
   International sales                              21,840        25,476       20,464
   Other operating revenue                             750         3,500           -

   Total revenue                                  $ 46,775      $ 60,581     $ 52,213

         As a Percentage of Total Revenue
   Revenue:
   Domestic sales                                     51.7 %        52.2 %       60.8 %
   International sales                                46.7          42.1         39.2
   Other operating revenue                             1.6           5.7           -

   Revenue                                           100.0         100.0        100.0
   Cost of Sales                                      51.2          47.3         54.2
   Gross Margin                                       48.8          52.7         45.8
   Expenses:
   Sales and Marketing                                32.4          27.8         30.4
   Research and Development                            9.3           5.9          8.4
   General and Administrative                         15.2          13.9         13.1

   Total operating expenses                           56.9 %        47.6 %       51.9 %

   Operating Income (Loss):                           (8.2 )         5.1         (6.2 )
   Interest expense, net                               (.8 )          .2           .4
   Other, net                                          (.2 )        (0.7 )       (0.2 )

   Income (Loss) Before Income Taxes                  (9.2 )         4.6         (6.0 )
   Income Tax (Benefit) Provision                      6.1           0.4          0.1

   Net (Loss) Income                                 (15.3 %)        4.2 %       (6.1 %)

   Net income (loss) applicable to common stock      (15.3 %)        4.2 %       (6.1 %)

Year Ended March 31, 2009 Compared With Year Ended March 31, 2008

Sales of $46,025 for the year ended March 31, 2009 decreased by $11,056 from sales of $57,081 in the prior year. The decrease was primarily due to lower sales in the retail markets across all of our business operations as a result of the worldwide economic recession and its impact on consumer spending. This, along with the absence of purchases by a significant customer in the current year, resulted in a decline of $8,349 or 26% in sales in our North American business operations, our largest retail market. Sales in our European business operations decreased by $2,606 or 14% with $2,457 attributable to lower sales and $149 as a result of exchange rates differences compared to the prior year. Our German operation accounted for $2,164 of the European decline primarily as a result of the worldwide recession and its impact on consumer spending and due to a promotional sale to a customer in the prior year period that did not purchase in the current year. The impact of the stronger U.S. dollar in the year ended March 31, 2009 contributed $611 to the decline in sales in our overseas operations as compared to the prior year.

Total revenue for the fiscal year ended March 31, 2009 of $46,775 included $750 reflected as "other operating revenue" that we received from Nuance following the settlement of pending litigation. Total revenue in the prior year period of $60,581 included $3,500 reflected as "other operating revenue" that we received from two distribution partners, Seiko Instruments, Inc. (SII) and Seiko U.K. Ltd. The payments were in consideration for the elimination of minimum purchase commitments in the agreement under which SII distributes Franklin products in Japan and we distribute SII products in the United States and Germany and for the extension of the distribution agreement under which Seiko U.K. Ltd. distributes Franklin products in the United Kingdom and Ireland.

Gross margin decreased by $9,105 primarily because of decreased sales of $11,056 resulting in lower gross margin of $5,505 and a decline in gross margin percentage, excluding other operating revenue, from 50% in the prior year to 48% in the current year, resulting in an additional decline of $850 in margin dollars. The decrease in gross margin percentage was primarily due to the impact of the stronger US dollar in the current year compared to the prior year and a one time inventory valuation adjustment. In addition, the decrease in other operating revenue negatively impacted the current year's gross margin by $2,750.

Total operating expenses decreased to $26,633 for the year ended March 31, 2009 from $28,826 in the same period last year. Sales and marketing expenses declined by $1,675 to $15,169 (33% of sales) from $16,844 (30% of sales) in the same period last year primarily due to decreased variable expenses for advertising, freight, and commission expenses by $963, $468, and $191 respectively. Personnel expense decreased by $392 primarily due to a net savings following a reduction in workforce in May 2008 partially offset by a one-time termination charge in March 2009 relating to an additional workforce reductions. Amortization increased due to a one-time impairment charge against the carrying value of the Rolodex®trademark of $386. Research and development expenses increased by $820 to $4,371 (10% of sales) from $3,551 (6% of sales) in the prior year. The increase is primarily due to a one-time charge relating to the liquidation of KEP in the amount of $732. Consulting and outsourced expenses also increased by $163, partially offset by decreased personnel costs of $96. General and administrative expenses decreased by $1,338 to $7,093 (15% of sales) from $8,431 (15% of sales) in the same period last year primarily due to approximately $600 of additional expenses related to the SII settlement agreement including an increase in incentive compensation accruals and associated legal and travel expenses in the prior year period. Personnel expense decreased by $345 primarily due to a net savings following a reduction in workforce in May 2008 partially offset by a one time termination charge in March 2009 relating to additional workforce reductions. Consulting, depreciation, bank fees, and doubtful accounts decreased by $230, $135, $94, and $301, respectively, partially offset by an increase in legal fees, accounting fees, and insurance of $294, $51, and $48, respectively.

For the year ended March 31, 2009 we had net interest income of $1 compared with net interest income of $116 in the same period in the prior year primarily due to lower interest income on investments.

Also for year ended March 31, 2009 there was a loss on investment of $370 resulting from the liquidation by its sponsor of a short-term fixed income fund.

Other, net was a loss of $103 for the year ended March 31, 2009 compared with a loss of $439 last year. For the year ended March 31, 2009 we recorded a gain on our program of selling euros at current rates for future settlement of $51 compared with a loss of $564 in the same period in the prior year.

At March 31, 2008, the Company had approximately $5.7 million of Deferred Tax Asset recorded on its Consolidated Balance Sheet which was established based on future projected taxable income. In view of the current year's loss and the uncertainty economic conditions may have on the future business operations, management has concluded that it is more likely than not that the full value of the deferred tax asset would not be realized and as a result has taken a partial write down of $2.7 million in the current fiscal year ended March 31, 2009.

We have operations in a number of foreign countries and record sales and incur expenses in various foreign currencies. As the value of these currencies fluctuate from year to year against the US dollar, our revenues, operating expenses and results of operations are impacted. For the year ended March 31, 2009, approximately 39% of our sales were denominated in currencies other than the US dollar. For the year ended March 31, 2009, our sales and gross margin decreased by approximately $597 from the year over year difference in exchange rates for the various currencies (primarily the euro) in which we operate, while our selling, general and administrative expenses were approximately $233 lower due to the fluctuations in exchange rates. The net effect of the year over year fluctuations in exchange rates on our results of operations for the year ended March 31, 2009 was an increase of approximately $365 in our net loss.

We enter into forward foreign exchange contracts from time to time to offset the impact of changes in the value of the euro on our revenue, operating expense and net income and to protect the cash flow from our existing assets valued in foreign currency. Although economic gains or losses on these contracts are generally offset by the gains or losses on underlying transactions, we seek to minimize our foreign currency exposure on a macro basis rather than at the transactional level. We only enter into contracts with major financial institutions that have an "A" (or equivalent) credit rating. All outstanding foreign exchange contracts are marked-to market at the end of each accounting period with unrealized gains and losses included in results of operations.

As of March 31, 2009, we had no outstanding foreign exchange contracts.

As of March 31, 2008, we had one outstanding foreign exchange contract in the amount of 1,500 euros (equivalent to US dollars of $2,368) with a duration of six months. An unrealized loss of $165 on the contract was included in results of operations under the Other, net caption with the offsetting balance recorded in the Accounts Payable and Accrued Expenses caption on our balance sheet.

Year Ended March 31, 2008 Compared With Year Ended March 31, 2007

Sales of $57,081 for the year ended March 31, 2008 increased by $4,868 from sales of $52,213 in the prior year. The increase was primarily from our European and Australian operations. Our European Operation reported an increase in sales of 33% or $4,608. A portion of the increase was the result of seasonal placements with two customers that did not purchase in the prior year. In addition, expanded business with several European distributors for various products accounted for the balance of the increase. These products included the 12 Language Speaking Global Translator (TGA-490), 12 Language Non-Speaking Global Translator (TGA-470), the Langenscheidt German-French Dictionary (LDF-1660), and the PONS German-English Professor PRO (DBD-1660). The Company's Australian operation also contributed higher sales year over year. Sales increased at key supporting dealers for several categories of products that outperformed last year's contribution, including: Collins Spellchecker (SPQ-109), Collins English Dictionary & Thesaurus (DMQ-119), Collins Bradfords Crossword Solver (CSB-1470U), 12 Language Non-Speaking Global Translator (TGA-470), 10 Language Speaking Translator (TG-480), and the Rolodex Organizer (RT-8212). The overseas operations sales benefited by $2,317 from a weaker US dollar.

Total revenue for the fiscal year ended March 31, 2008 of $60,581 included $3,500 reflected as "other operating revenue" that we received from two distribution partners, SII and Seiko U.K. Ltd. During the second quarter, we received $3,000 from SII in consideration for the elimination of minimum purchase commitments in the agreement under which SII distributes Franklin products in Japan and we distribute SII products in the United States and Germany. In March 2008, we entered into an agreement with Seiko U.K. Ltd. calling for a one-time payment of $500 to be made to us in consideration for the extension of the distribution agreement under which Seiko U.K. Ltd. distributes Franklin products in the United Kingdom and Ireland.

Gross margin increased by $8,029 primarily because of higher sales in the European business operation contributing $2,478 in gross margin dollars and $3,500 other operating revenue from the SII and Seiko UK agreements. The gross margin percentage, excluding the $3,500, increased by four percent from 46% in the 2007 fiscal year to 50% in the 2008 fiscal year, resulting in an additional increase of $2,283 in margin dollars. The lower gross margin percentage in the 2007 fiscal year resulted primarily from increased mark down and promotion allowances granted to certain customers in our North American operations, higher software amortization associated with release of certain new products in the 2008 fiscal year and inventory valuation provisions, primarily for one poorly performing product, in the 2008 fiscal year and the inclusion in the prior year of the higher margin technology licensing agreements. Excluding these agreements the gross margin percentage in the 2007 fiscal year would have been 49%.

Total operating expenses increased to $28,826 for the year ended March 31, 2008 from $27,117 in the same prior year period. Sales and marketing expenses increased by $964 to $16,844 (30% of sales) from $15,880 (30% of sales) in the same prior year period primarily due to increased spending of $371 for the Consumer Electronic Show and attendance at new shows in Europe and North America. Variable expenses for market development funds, freight, and commission increased by $267 due to higher sales. Personnel expense increased by $129 primarily due to corporate development expenses to establish strategic growth initiatives and operational efficiencies. Temporary labor increased by $111 primarily in the European business operation. Research and development expenses decreased by $850 to $3,551 (6% of sales) from $4,401 (8% of sales) in the prior year. The decrease is due to lower personnel and consultant costs related to lower fixed costs due to outsourced development of $495 and lower allocation of management information system (MIS) expense of $217. In addition, higher capitalization of software development work of $141 resulted in a decrease in net expense. General and administrative expenses increased by $1,595 to $8,431 (15% of sales) from $6,836 (13% of sales) in the prior year primarily due to approximately $720 of additional expenses related to the SII and Seiko UK agreements which included an increase in incentive compensation accruals and associated legal and travel expenses. Incremental expenses were incurred for corporate development of $616 to establish strategic growth initiatives and operating efficiencies. Doubtful account expense increased by $399 primarily due to a major customer declaring bankruptcy, partially offset by lower depreciation costs of $221.

For the year ended March 31, 2008 we had net interest income of $116 compared with net interest income of $207 in the same period last year. The decrease in interest income was primarily due to lower interest rates compared to the prior year.

Other, net was a loss of $439 for the year ended March 31, 2008 compared with a loss of $94 in the 2007 fiscal year. For the year ended March 31, 2008 we recorded a loss on our program of selling euros at current rates for future settlement of $564 compared with a loss of $213 in the same period in the prior year. In addition, the 2008 fiscal year included gains of $70 towards the settlement of patent claims compared to $195 in the prior year.

We have operations in a number of foreign countries and record sales and incur expenses in various foreign currencies. As the value of these currencies fluctuate from year to year against the US dollar, our revenues, operating expenses and results of operations are impacted. For the year ended March 31, 2008, approximately 38% of our sales were denominated in currencies other than the US dollar. For the year ended March 31, 2008, our sales and gross margin increased by approximately $2,317 from the year over year difference in exchange rates for the various currencies (primarily the euro) in which we operate, while our selling, general and administrative expenses were approximately $1,253 higher due to the fluctuations in exchange rates. The net effect of the year over year fluctuations in exchange rates on our results of operations for the year ended March 31, 2008 was an increase of approximately $1,064 in our net income.

As of March 31, 2008, we had one outstanding foreign exchange contract in the amount of 1,500 euros (equivalent to US dollars of $2,368) with a duration of six months. An unrealized loss of $165 on the contract was included in results of operations under the Other, net caption with the offsetting balance recorded in the Accounts Payable and Accrued Expenses caption on our balance sheet.

As of March 31, 2007, we had two outstanding foreign exchange contracts in the amounts of 1,500 and 1,000 euros (equivalent to US dollars of $2,004 and $1,336, respectively). The duration of these contracts was six months and three months. An unrealized loss of $154 on the contracts was included in results of operations under the Other, net caption with the offsetting balance recorded in the Accounts Payable and Accrued Expenses caption on our balance sheet.

Inflation and Currency Transactions

Inflation had no significant effect on our operations for the two years ended March 31, 2009. However, competitive pressures and market conditions in the future may limit our ability to increase prices to compensate for general inflation or increases in prices charged by suppliers.

Our operating results may be affected by fluctuations in currency exchange rates. During the years ended March 31, 2008 and 2009, we entered into several foreign exchange forward contracts with financial institutions to limit our exposure to currency fluctuation loss on sales made by our European subsidiaries.

Seasonality

The "back to school" season (August to mid-September) and the Christmas selling season (October, November and December) are the strongest selling periods at retail for our products.

The following table sets forth unaudited net sales for each of our last twelve fiscal quarters:

                    Quarter Ended     Quarter Ended     Quarter Ended     Quarter Ended
                       June 30        September 30       December 31        March 31
   Fiscal 2009*    $        11,993   $        12,434   $        13,535   $         8,063
   Fiscal 2008**   $        13,675   $        14,980   $        17,044   $        11,382
   Fiscal 2007     $        11,785   $        12,276   $        17,179   $        10,973

* Does not include settlement amounts paid by Nuance of $750.

** Does not include settlement amounts paid by SII and Seiko UK Ltd for $3,000 and $500, respectively.

Future Income Tax Benefits

We have income tax benefits of $18,527 which can be utilized against future earnings and have provided an income tax valuation allowance of $15,527 against these tax assets. The remaining $3,000 balance is based upon our estimate of taxes that would be due and offset against our net operating loss carried forward, based upon our estimate of future earnings.

Changes in Financial Condition

Accounts receivable decreased by $1,743 to $4,357 on March 31, 2009 from $6,100 on March 31, 2008 primarily because of lower sales. Inventory decreased by $1,667 to $7,595 on March 31, 2009 from $9,262 on March 31, 2008 primarily as a result of management's efforts to reduce inventory months on hand in Europe and the United States in line with the current sales levels. We had no outstanding borrowings under our credit facility at the end of each of our last two fiscal years.

Capital Expenditures

As of March 31, 2009 we had no material commitments for capital expenditures.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements.

Liquidity and Capital Resources

Cash and cash equivalents increased to $12,013 at March 31, 2009 from $11,824 at March 31, 2008. Cash provided by operating activities was approximately $2.6 million in fiscal 2009 compared to $4.8 million in fiscal 2008. Cash provided by operating activities included proceeds from a litigation settlement providing a net benefit of $600 in fiscal 2009. Cash provided by operating activities in fiscal 2008 included payments from Seiko Instruments, Inc and Seiko U.K. Ltd., providing $3.0 million and $500 respectively, in consideration for the elimination of minimum purchase commitments and of an extension of an existing distribution agreement.

Net cash used in investing activities for fiscal 2009 was approximately $1.3 million, compared to cash provided from investing activities of $300 in fiscal 2008. The increase in cash usage was primarily as a result of a decrease in short-term investments in the current fiscal year compared to the same period in the prior year. Current year investments are in short-term U.S. Treasuries which provide liquidity at minimum risk.

On March 31, 2009, we entered into an amendment (the "Amendment") to our Revolving Credit and Security Agreement (the "Credit Agreement") with PNC Bank, National Association ("PNC") dated December 7, 2004, as amended.

The Amendment modifies the Credit Agreement with PNC by providing for a $8,500 revolving credit facility with sublimits of $1,500 for Letters of Credit, $500 for foreign currency borrowings and subject to certain conditions $5,000 for acquisitions by the Company. The Amendment also modifies the Base Rate (as defined in the Credit Agreement) upon which the Revolving Interest Rate may be determined to be the greater of the Prime Rate, the sum of the Federal Funds Open Rate plus 50 basis points or the Daily LIBOR Rate plus 100 basis points and requires that any Advance made to the Company under the Agreement be fully secured by cash, money market funds and certificates of deposit held by or deposited with PNC. The minimum Fixed Charge Coverage Ratio was amended for the quarter ended March 31, 2009 to no less than .60x to 1.0 and permitted add-back of certain non-cash items to the Company's EBITDA calculation. The minimum Fixed Charge Coverage Ratio reverts back to 1.25x to 1.0 for the fiscal quarter ending June 30, 2009 and each quarter thereafter.

The Credit Agreement contains certain financial covenants and restrictions on indebtedness, business combinations and other related items. The Fixed Charge Coverage Ratio was amended for the March 31, 2009 quarter end, as indicated above, and for the December 31, 2008 quarter end, in both cases to ease the covenant requirement. However, at March 31, 2009, the Company was in breach of the Fixed Charge Coverage Ratio and the Funded Debt to EBITDA Ratio contained in the Amendment. As of March 31, 2009, we had no borrowings under the Credit Agreement. On June 22, 2009, the bank granted a waiver of the covenant breaches specified above.

We rely primarily on our operating cash flow to support our operations. Over the last three years we generated cash flow from operations of $7,728. We believe our cash flow from operations, and existing cash and short-term investment balances will be adequate to satisfy our cash needs for the next twelve months. The amount of credit available under the facility at any time is based upon a formula applied to our accounts receivable and inventory. As of March 31, 2009, we had credit available of $8,500 based on this formula. Our credit availability and borrowings under the facility fluctuate during the year because of the seasonal nature of