Our results of operations can be affected by many factors including the general economic environment, state and federal government budgetary decisions, and the length and complexity of the sales cycle for school districts. 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.

We monitor several important issues which are significant to the evaluation of our financial condition, operating results, business challenges and strategic opportunities. Among the more important of these issues are:

(i) Our success and trends in maintaining and expanding our customer base, particularly with respect to the Accelerated Reader product which accounts for approximately 40% of our sales;
(ii) The general state of K-12 educational funding in the United States; and
(iii) The state of K-12 funding in certain large states, particularly California, Texas and Florida, which together make up about one-third of our total orders.

A key part of our business strategy for maintaining and expanding our customer base (and the related revenues) is to transition our traditional perpetual-license-based customers to our newer subscription-based software products. Our subscription-based products offer enhanced features which provide greater value to our customers, thereby contributing to increased customer satisfaction. Our most popular subscription-based products, the Enterpriseversions, include much greater access to product content. They also offer a hosting option which makes implementation of our software much easier and greatly reduces the costs both to our customers to implement and to us to develop and support the software. Customers who transition to our Accelerated Reader Enterprise subscription-based product to date have increased their average spending approximately $1,000 more per year, per school versus our customers using our perpetual-license products. Although this amount of incremental revenue could change due to customer mix and other factors including additional purchases of products and services, we expect that we will continue to see incremental revenue as our customers transition to Accelerated Reader Enterprise. We have also experienced an annual per customer revenue increase for our other subscription-based products, but the increase has been most significant with our Accelerated Reader Enterprise product.

We believe the percentage of customers using the subscription-based Enterprise versions of our reading and math products is an important indicator of the progress of this strategic growth initiative and the magnitude of the growth opportunities still existing with regard to this strategy. The percentage of customers using reading products is more critical since the Accelerated Readeris our most significant product and because we have experienced a greater increase in per customer revenues from Accelerated Reader Enterprisesubscription-based customers as compared to users of our other subscription-based products. As of the end of the second quarter of 2009, approximately 40% of our active reading product customers were using the Enterprise version as compared to approximately 25% at the end of the second quarter of 2008.

Our strategic transition to subscription-based software products has affected, and will continue to affect, our results of operations. We believe that this strategy has the potential to generate more lifetime revenue per customer than selling software under a perpetual-license model. Revenues from subscription-based software sales are not completely incremental to our results as customers who make the transition no longer purchase annual support plans for our perpetual-license products and those who purchase our most popular subscription-based product, the Enterpriseversion, also no longer purchase add-on content. Revenues under the subscription-based model are composed of both software and services. The gross profit margins from subscription-based software products are slightly higher than our historical gross profit margins on sales of perpetual-license software. In addition, the subscription-based software model tends to generate a sales mix somewhat more heavily weighted towards services. In addition, the services we sell with our subscription-based software products tend to have a somewhat higher gross profit margin than those sold with our perpetual-license software products.

The transition to subscription-based products has increased the seasonality of 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 cycles resulting in a more seasonal order pattern weighted to the second and, even more so, third calendar quarters. Also, after customers convert to our most popular subscription-based products, the Enterprise version, 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 are expected in the second quarter and to an even greater extent in the third quarter than we have experienced historically.

Transitioning our customer base to subscription-based software can adversely impact orders for add-on reading quizzes and math libraries by customers who own our software under perpetual-license agreements, as some may delay purchases of add-on content if they are contemplating converting to our Enterprise version subscription-based products. Additionally, our subscription based products are often sold at the school district level and district level sales tend to be more complex, have a longer sales cycle, and are typically for a larger dollar amount than sales made to individual schools. Orders from district sales are therefore more uneven and more difficult to accurately predict than individual school level sales and, therefore, the timing of large district sales can significantly impact quarterly order levels.

The transition to subscription-based products has increased the seasonality of customer ordering patterns for software. However, as the transition to subscription-based products has progressed, we have built substantial balances of deferred subscription revenue. Since this deferred revenue is recognized ratably over the subscription period (generally twelve months) it reduces the volatility of our reported revenue. This means that revenues in a given period are not necessarily indicative of the orders placed by our customers for our products and services during a given period.

Customer orders for our products decreased by approximately $3.9 million or 11%, in the second quarter of 2009 compared to the second quarter of 2008. In addition to the above factors, we believe that our second quarter 2009 orders were negatively affected by educational funding issues. We believe many customers delayed placing orders due to uncertainty about when federal funds from the American Recovery and Reinvestment Act of 2009 will be available to them. In addition, the extent of state budget shortfalls and the duration of the resulting effect on educational funding are not clear at this time and may also have affected order levels. Our customers in the states of California, Florida and Arizona have been particularly affected by state budget issues. These three states accounted for approximately 80% of the order decline we experienced in the second quarter of 2009.

We have implemented several cost savings initiatives including reducing laptop selling costs, implementing a general hiring freeze, reducing product development expenses related to some of our lower-performing product lines and implementing other general non-payroll cost constraints. There was minimal impact from these initiatives in the first quarter of 2009 because the savings were offset by one-time severance and other charges. Savings from these initiatives were approximately $0.8 million in the second quarter of 2009.

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       Six Months Ended
                                            June 30,                June 30,
                                        2009         2008        2009       2008
        Net Sales:
        Products                           74.5 %      78.0 %       73.0 %    76.8 %
        Services                           25.5 %      22.0 %       27.0 %    23.2 %
        Total net sales                   100.0 %     100.0 %      100.0 %   100.0 %
        Cost of sales:
        Products                           18.5 %      18.1 %       16.5 %    18.1 %
        Services                           33.7 %      41.7 %       34.6 %    47.4 %
        Total cost of sales                22.3 %      23.3 %       21.4 %    24.9 %
        Gross profit:
        Products                           81.5 %      81.9 %       83.5 %    81.9 %
        Services                           66.3 %      58.3 %       65.4 %    52.6 %
        Total gross profit                 77.7 %      76.7 %       78.6 %    75.1 %
        Operating expenses:
        Product development                13.8 %      15.2 %       14.6 %    14.5 %
        Selling and marketing              29.5 %      31.8 %       30.2 %    31.8 %
        General and administrative         11.2 %      12.2 %       11.6 %    13.2 %
        Total operating expenses           54.5 %      59.2 %       56.4 %    59.5 %
        Operating income                   23.2 %      17.5 %       22.2 %    15.6 %
        Other, net                          0.1 %       0.6 %        0.3 %     0.6 %
        Income before taxes                23.3 %      18.1 %       22.5 %    16.2 %
        Income taxes                        8.8 %       6.2 %        8.5 %     5.8 %
        Net Income                         14.5 %      11.9 %       14.0 %    10.4 %

Net Sales. Our net sales increased by $0.5 million, or 1.5%, to $28.5 million in the second quarter of 2009 from $28.0 million in the second quarter of 2008. Orders were $3.9 million lower in the second quarter 2009 than in the second quarter 2008; however, lower orders were offset by the recognition of $3.2 million more revenue from deferred revenue in 2009. The remainder of the difference in revenue is attributable to changes in the balance of our undelivered order backlog.

Product revenue decreased by $0.7 million, or 3.1%, to $21.2 million in the second quarter of 2009 from $21.9 million in the second quarter of 2008. Product revenue declined due to a $1.0 million decrease in hardware sales, partially offset by increases in revenue recognized from deferred revenue related to software orders we received in prior periods.

Service revenue increased by $1.1 million, or 17.8%, to $7.3 million in the second quarter of 2009 from $6.2 million in the second quarter of 2008. Nearly all categories of service revenue improved in the quarter. The most significant increases were in hosting and professional development which increased by $0.6 million and $0.3 million, respectively.

Cost of Sales. Costs of sales of products decreased by $0.1 million, or 1.3%, to $3.9 million in the second quarter of 2009 from $4.0 million in the second quarter of 2008. As a percentage of product sales, the cost of sales of products was relatively unchanged at 18.5% in the second quarter of 2009, compared to 18.1% for the second quarter of 2008. The cost of sales of services decreased to $2.4 million in the second quarter of 2009 from $2.6 million in the second quarter of 2008, a decrease of 4.8% due to cost efficiencies in our service business. As a percentage of sales of services, the cost of sales of services decreased to 33.7% in the second quarter of 2009 from 41.7% in the second quarter of 2008. Our cost of sales of services is relatively fixed, especially with respect to our technical services and software support. Therefore the increase in revenues combined with the relatively fixed nature of the related costs was the primary reason for the improvement in the cost of service sales as a percentage of sales.

Product Development. Product development expenses decreased to $3.9 million in the second quarter of 2009 from $4.3 million in the second quarter of 2008, a decrease of 8.0%. The decrease in product development expenses is due to the restructuring implemented earlier in the year. We closed our office in India and reduced our product development staff in other offices to better align our employee base with our product development needs and growth areas. As a percentage of net sales, product development expenses decreased to 13.8% in the second quarter of 2009 from 15.2% in the second quarter of 2008.

Selling and Marketing. Selling and marketing expenses decreased by $0.5 million, or 5.6%, to $8.4 million in the second quarter of 2009 from $8.9 million in the second quarter of 2008. Selling expenses decreased $0.3 million due to lower commissions caused by reduced order rates, and marketing expenses decreased $0.2 million due to cost efficiencies in our advertising programs. As a percentage of net sales, selling and marketing expenses decreased to 29.5% in the second quarter of 2009 from 31.8% in the second quarter of 2008.

General and Administrative. General and administrative expenses decreased to $3.2 million in the second quarter of 2009 from $3.4 million in the second quarter of 2008, a decrease of 7.5%. Approximately one-half of the decrease in general and administrative expenses was from lower salary and benefit costs due to our hiring freeze and personnel reductions with the remaining decrease due to non-payroll cost constraints. As a percentage of net sales, general and administrative expenses decreased to 11.2% in the second quarter of 2009 from 12.2% in the second quarter of 2008.

Operating Income. Operating income increased by $1.7 million, or 34.4%, to $6.6 million in the second quarter of 2009 from $4.9 million in the second quarter of 2008. The increase was due to the gross profit margin improvement and decreased operating expenses as explained in more detail above. As a percentage of net sales, operating income increased to 23.2% in the second quarter of 2009 from 17.5% in the second quarter of 2008.

Income Tax. Income tax expense of $2.5 million was recorded in the second quarter of 2009 at an effective income tax rate of 37.8% of pre-tax income, compared to $1.8 million that was recorded in the second quarter of 2008 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.2 million relating to the settlement of various state audit issues.

Net Sales. Our net sales decreased by $0.1 million, or 0.2%, to $57.3 million in the first six months of 2009 from $57.4 million in the first six months of 2008. Orders were $7.9 million lower in the first half of 2009 than in the first half of 2008; however, lower orders were offset by the recognition of $7.0 million more revenue from deferred revenue in 2009. The remainder of the difference in revenue is attributable to changes in the balance of our undelivered order backlog.

Product revenue decreased by $2.2 million, or 5.0%, to $41.9 million in the first six months of 2009 from $44.1 million in the same period in 2008. Product revenue declined due to a $2.8 million decrease in hardware sales, partially offset by increases in revenue recognized from deferred revenue related to software orders we received in prior periods.

Service revenue increased to $15.5 million in the first six months of 2009 from $13.3 million in the first six months of 2008, an increase of 15.9%. Nearly all categories of service revenue were up except for professional development which was relatively unchanged from the same period last year. The most significant increases were in hosting and other technical services which increased by $1.3 million and $0.7 million, respectively.

Cost of Sales. Cost of sales of products decreased by $1.1 million, or 13.6%, to $6.9 million in the first six months of 2009 from $8.0 million in the first six months in 2008. As a percentage of product sales, the cost of sales of products was 16.5% in the first six months of 2009, compared to 18.1% in the first six months of 2008. The reason for the improvement in product cost of sales was the higher proportion of software in the 2009 sales mix as compared to 2008, as our margins are higher on software than on hardware. The cost of sales of services decreased to $5.4 million in the first half of 2009 from $6.3 million in the first half of 2008, a decrease of 15.5%. About 80% of the dollar decrease was due to savings from not holding a National Conference in 2009 with the remainder attributable to cost efficiencies in our other services, the cost of which is relatively fixed, especially with respect to our technical services and software support. As a percentage of sales of services, the cost of sales of services decreased to 34.6% in the first half of 2009 from 47.4% in the first half of 2008. The increase in revenues from our hosting and technical services, explained above, which have higher margins than our National Conference was the reason for the improvement.

Product development. Product development expenses increased by $0.1 million, or 0.9%, to $8.4 million in the first six months of 2009, compared to $8.3 million for the first six months of 2008. As a percentage of net sales, product development expenses were 14.6% in the first six months of 2009, similar to 14.5% for the first six months of 2008. The change in product development expenses was primarily due to savings of approximately $0.3 million in the second quarter of 2009 from our restructuring, offset by $0.1 million less capitalized development expense in 2009 and the remainder mostly attributable to the additional costs we incurred in the first quarter of 2009 to effect the restructuring.

Selling and Marketing. Selling and marketing expenses decreased by $1.0 million, or 5.2%, to $17.3 million in the first six months of 2009, compared to $18.3 million for the first six months of 2008. Selling expenses decreased $0.6 million due to lower commissions caused by reduced order rates, and marketing expenses decreased $0.4 million due to cost efficiencies in our advertising programs. As a percentage of net sales, selling and marketing expenses decreased to 30.2% in the first six months of 2009 from 31.8% in the first six months of 2008.

General and Administrative. General and administrative expenses decreased to $6.6 million in the first six months of 2009 from $7.6 million in the first six months of 2008, a decrease of 12.2%. General and administrative expenses decreased primarily due to $0.4 million of fees incurred in the prior year to cancel some future professional development events, with the remainder primarily attributable to staffing reductions made in 2009. As a percentage of net sales, general and administrative expenses decreased to 11.6% in the first half of 2009 from 13.2% in the first half of 2008.

Operating Income. Operating income increased to $12.7 million in the first six months of 2009 from $9.0 million in the same period in 2008, an increase of 42.0%. As a percentage of net sales, operating income increased to 22.2% in the first half of 2009 from 15.6% in the first half of 2008. The increase was due to the gross profit margin improvement and decreased operating expenses as explained in more detail above.

Income Tax Expense. Income tax expense of $4.9 million was recorded in the first half of 2009 at an effective income tax rate of 37.8% of pre-tax income. This compares to income tax expense of $3.4 million that was recorded in the first half of 2008 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.2 million relating to the settlement of various state audit issues.

As of June 30, 2009, our cash, cash equivalents and investment securities were $19.2 million, up $1.4 million from $17.8 million at December 31, 2008. The increase was primarily due to $5.0 million of cash flow provided by operations offset by $4.1 million used to pay dividends.

As of June 30, 2009 we have a $15.0 million secured revolving line of credit with a bank which is available until July 1, 2010. 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, 2010 which bears interest at the prime rate. As of June 30, 2009, the lines of credit had not been used.

On April 17, 2002, our Board of Directors authorized the repurchase of up to 5,000,000 shares of our common stock; on February 9, 2005, our Board of Directors authorized the repurchase of an additional 3,000,000 shares and; on February 6, 2008, our Board of Directors authorized the repurchase of an additional 1,000,000 shares under the stock repurchase program. No time limit was placed on the duration of the repurchase program, nor is there any dollar limit on the program. We repurchase shares on the open market as well as from employees who elect to surrender shares at the time of vesting to pay their payroll withholding taxes. Repurchased shares will become treasury shares and may be used for stock-based employee benefit plans, equity compensation plans and, for other general corporate purposes. From January 1, 2009 through June 30, 2009, we repurchased approximately 12,600 shares at a cost of $111,000. Since the original authorization of the repurchase program in 2002, we have repurchased approximately 7.8 million shares at a cost of $135.1 million. Depending on our stock valuation, cash availability and other factors, we may repurchase additional shares as a beneficial use of our cash to enhance shareholder value.

We paid 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. In the first and second quarter of 2009 we paid a cash dividend of $0.07 per share. On July 22, 2009, our Board of Directors declared a quarterly cash dividend of $0.07 per share, payable September 1, 2009 to shareholders of record as of August 7, 2009.

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 sold and recorded as deferred revenue, the company's ability to provide the products and services underlying the 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 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. 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 do not anticipate the early termination of any significant lease agreement.

Purchase Obligations. We enter into commitments with certain suppliers to purchase our hardware products, such as Neo 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. Estimation of the amounts and timing of payments in periods after 2009 are highly uncertain and therefore are not included in the table.

As of June 30, 2009, our approximate contractual obligations for operating leases, tax audit payments and purchase obligations (by period due) were as follows:

     Contractual Obligations                           Payments Due by Period
     (In Thousands)                           Less than      1-3      3-5     More than
                                    Total      1 year       years    years     5 years
     Operating lease obligations   $ 3,680   $       773   $ 1,885   $  934   $       88
     Purchase obligations            4,781         4,768        13        -            -
     Total                         $ 8,461   $     5,541   $ 1,898   $  934   $       88

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 2008 Annual Report.

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 . . .