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 38% 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 Enterprise versions, include much greater access to product content. The subscription-based products are offered with 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 Enterprisesubscription-based product from our perpetual-license products have increased their average spending on average by more than $1,000 per year, per school. 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 perpetual-license 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 Enterpriseproduct.

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 Reader is our most significant product and because we have experienced a greater increase in per customer revenues from Accelerated Reader Enterprise compared to our other subscription-based products. As of the end of the third quarter of 2009, approximately 40% of our active reading product customers were using the Enterprise version as compared to approximately 30% at the end of the third quarter of 2008. Worldwide, we currently have approximately 55,000 active Accelerated Reader customers, 18,000 active Accelerated Math customers and 47,000 active Star Reading and Star Math customers.

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. The subscription-based software business 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. Currently about 20% of our subscriptions have renewal dates in the second quarter and about 60% of our subscriptions have renewal dates in the third quarter. Also, after customers convert to the Enterpriseversion, they no longer order reading quizzes and math libraries, since access to this content is included in their subscription. 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. Historically, our customers have ordered more of this content in the first and fourth quarters. Currently approximately 40-50% of our orders occur in the third quarter.

Transitioning our customer base to subscription-based software can adversely impact orders for add-on reading quizzes and math libraries by causing customers who own our software under perpetual-license agreements to delay purchases of add-on content if they are contemplating converting to our Enterpriseversion subscription-based products. Additionally, our subscription-based products are often sold at the school district level. 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 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.

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 increased by approximately $13.4 million or 34%, in the third quarter of 2009 compared to the third quarter of 2008. In addition to the above factors, we believe that our third quarter 2009 orders were positively affected by educational funds provided by the American Recovery and Reinvestment Act which generally first became available to schools during the third quarter 2009. A recent survey by the Center on Budget and Policy Priorities indicates that nearly all states are still facing significant shortfalls in their fiscal year 2010 budget, and the majority of states already anticipate a deficit for fiscal year 2011. Therefore, it appears likely that once the federal stimulus funds are used up, many states may face budget challenges which could affect funding for education.

We have implemented several cost savings initiatives this year including 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 and $0.9 million in the second and third quarters of 2009, respectively.

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,
                                        2009         2008        2009        2008
        Net Sales:
        Products                           69.1 %      68.9 %       71.6 %     74.2 %
        Services                           30.9 %      31.1 %       28.4 %     25.8 %
        Total net sales                   100.0 %     100.0 %      100.0 %    100.0 %
        Cost of sales:
        Products                           16.8 %      16.3 %       16.6 %     17.6 %
        Services                           34.8 %      41.8 %       34.7 %     45.2 %
        Total cost of sales                22.4 %      24.3 %       21.7 %     24.7 %
        Gross profit:
        Products                           83.2 %      83.7 %       83.4 %     82.4 %
        Services                           65.2 %      58.2 %       65.3 %     54.8 %
        Total gross profit                 77.6 %      75.7 %       78.3 %     75.3 %
        Operating expenses:
        Product development                12.9 %      16.0 %       14.0 %     15.0 %
        Selling and marketing              30.1 %      31.8 %       30.2 %     31.8 %
        General and administrative         10.7 %      15.0 %       11.3 %     13.8 %
        Total operating expenses           53.7 %      62.8 %       55.5 %     60.6 %

        Operating income                   23.9 %      12.9 %       22.8 %     14.7 %
        Other, net                          0.7 %       1.0 %        0.5 %      0.8 %
        Income before taxes                24.6 %      13.9 %       23.3 %     15.5 %
        Income taxes                        8.2 %       4.8 %        8.4 %      5.5 %
        Net Income                         16.4 %       9.1 %       14.9 %     10.0 %

Net Sales. Our net sales increased by $3.6 million, or 12.6%, to $31.8 million in the third quarter of 2009 from $28.2 million in the third quarter of 2008. Orders were $13.4 million higher in the third quarter 2009 than in the third quarter 2008; however, higher orders were offset by a $9.4 million increase in the net amount of revenue deferred as compared to the same quarter last year.

Product revenue increased by $2.5 million, or 12.9%, to $21.9 million in the third quarter of 2009 from $19.4 million in the third quarter of 2008 due to increases in revenue across all product lines. The product revenue increase is the result of both strong orders in the period and from revenue recognized from prior period's subscription orders.

Service revenue increased by $1.0 million, or 12.0%, to $9.8 million in the third quarter of 2009 from $8.8 million in the third quarter of 2008. About half of the service revenue increase is a result of increased hosting revenue which is recognized ratably over the subscription period and is a direct result of the increasing number of customers who are utilizing our hosting services. The remainder of the increase is related to increased revenue for technical consulting services that we provide to help our customers to implement and get started using our products. These increases were somewhat offset by decreases in onsite professional development revenue.

Cost of Sales. Costs of sales of products increased by $0.5 million, or 16.3%, to $3.7 million in the third quarter of 2009 from $3.2 million in the third quarter of 2008. As a percentage of product sales, the cost of sales of products was relatively unchanged at 16.8% in the third quarter of 2009, compared to 16.3% for the third quarter of 2008. The cost of sales of services decreased to $3.4 million in the third quarter of 2009 from $3.7 million in the third quarter of 2008, a decrease of 6.7%. As a percentage of sales of services, the cost of sales of services decreased to 34.8% in the third quarter of 2009 from 41.8% in the third quarter of 2008. The improvement is due to growth of our higher margin services such as hosting and technical services, for which the cost of sales of services is relatively fixed.

Product Development. Product development expenses decreased by $0.4 million, or 9.1%, to $4.1 million in the third quarter of 2009 from $4.5 million in the third quarter of 2008. The decrease in product development expenses is primarily due to the restructuring and cost savings effort implemented earlier in the year. As a percentage of net sales, product development expenses decreased to 12.9% in the third quarter of 2009 from 16.0% in the third quarter of 2008.

Selling and Marketing. Selling and marketing expenses increased by $0.6 million, or 6.7%, to $9.6 million in the third quarter of 2009 from $9.0 million in the third quarter of 2008. Selling expenses increased primarily due to higher commissions associated with higher order levels this year. Marketing expenses were unchanged from the previous year. As a percentage of net sales, selling and marketing expenses decreased to 30.1% in the third quarter of 2009 from 31.8% in the third quarter of 2008.

General and Administrative. General and administrative expenses decreased by $0.8 million, or 19.6%, to $3.4 million in the third quarter of 2009 from $4.2 million in the third quarter of 2008. A $0.6 million charge taken in the prior year for a 2004 lawsuit settlement regarding defective parts from a supplier is the primary reason for the lower expense this year. The remainder of the decrease is attributable to staff reductions and other non-payroll cost constraints implemented earlier in 2009 as part of our cost reduction efforts. As a percentage of net sales, general and administrative expenses decreased to 10.7% in the third quarter of 2009 from 15.0% in the third quarter of 2008.

Operating Income. Operating income increased by $3.9 million, or 107.0%, to $7.6 million in the third quarter of 2009 from $3.7 million in the third quarter of 2008. The increase was due to the higher revenue, gross profit margin improvement, and decreased operating expenses as explained in more detail above. As a percentage of net sales, operating income increased to 23.9% in the third quarter of 2009 from 12.9% in the third quarter of 2008.

Income Tax. Income tax expense of $2.6 million was recorded in the third quarter of 2009 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.4 million relating to the lapse of the statue of limitations on various tax positions. This compares to $1.4 million that 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.

Net Sales. Our net sales increased by $3.5 million, or 4.0%, to $89.1 million in the first nine months of 2009 from $85.6 million in the first nine months of 2008. Orders were $5.5 million higher in the first nine months of 2009 than in the first nine months of 2008; however, higher orders were offset by a $2.4 million increase in the amount of revenue deferred as compared to the same quarter last year.

Product revenue increased by $0.3 million, or 0.4%, to $63.8 million in the first nine months of 2009 from $63.5 million in the same period in 2008. The product revenue increase is the result of both the increase in orders in the first nine months of 2009 and from revenue recognized from the prior year's subscription orders.

Service revenue increased by $3.2 million, or 14.4%, to $25.3 million in the first nine months of 2009 from $22.1 million in the first nine months of 2008. Nearly all categories of service revenue were up except for onsite professional development. The most significant increases were in hosting and other technical services which increased by $1.9 million and $1.2 million, respectively.

Cost of Sales. Cost of sales of products decreased by $0.6 million, or 5.1%, to $10.6 million in the first nine months of 2009 from $11.2 million in the first nine months in 2008. As a percentage of product sales, the cost of sales of products was 16.6% in the first nine months of 2009, compared to 17.6% in the first nine months of 2008. Product cost of sales improvement was due to the higher proportion of software in the 2009 sales mix as compared to 2008, as our margins are higher on software than on hardware, and to lower production costs for our responders and scanners. The cost of sales of services decreased by $1.2 million, or 12.2%, to $8.8 million in the first nine months of 2009 from $10.0 million in the first nine months of 2008. About 70% of the dollar decrease was due to savings from not holding a National Conference in 2009, with the remainder of the dollar decrease 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 34.7% in the first nine months of 2009 from 45.2% in the first nine months of 2008.

Product development. Product development expenses decreased by $0.3 million, or 2.6%, to $12.5 million in the first nine months of 2009, compared to $12.8 million for the first nine months of 2008. As a percentage of net sales, product development expenses decreased to 14.0% in the first nine months of 2009, from 15.0% for the first nine months of 2008. The change in product development expenses was primarily due to savings of approximately $0.6 million in the second and third quarters 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 $0.3 million, or 1.3%, to $26.9 million in the first nine months of 2009, compared to $27.2 million for the first nine months of 2008. Selling expenses were flat and marketing expenses decreased 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 nine months of 2009 from 31.8% in the first nine months of 2008.

General and Administrative. General and administrative expenses decreased by $1.8 million, or 14.9%, to $10.0 million in the first nine months of 2009 from $11.8 million in the first nine months of 2008. The decrease is due to a $0.6 million charge taken in the prior year for a 2004 lawsuit settlement regarding defective parts from a supplier, and $0.4 million of fees incurred in the prior year to cancel certain future professional development events. The remaining $1.0 million of the decrease is primarily attributable to staff reductions and other non-payroll cost constraints implemented earlier in 2009 as part of our cost reduction efforts. As a percentage of net sales, general and administrative expenses decreased to 11.3% in the first nine months of 2009 from 13.8% in the first nine months of 2008.

Operating Income. Operating income increased by $7.7 million, or 60.9%, to $20.3 million in the first nine months of 2009 from $12.6 million in the same period in 2008. As a percentage of net sales, operating income increased to 22.8% in the first nine months of 2009 from 14.7% in the first nine months of 2008. The increase was due to the higher revenues, gross profit margin improvement, and decreased operating expenses as explained in more detail above.

Income Tax Expense. Income tax expense of $7.5 million was recorded in the first nine months of 2009 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.4 million relating to the lapse of the statue of limitations on various tax positions. This compares to income tax expense of $4.7 million that was recorded in 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 to the settlement of various state audit issues and to the lapse of the statue of limitations on various tax positions.

As of September 30, 2009, our cash, cash equivalents and investment securities were $33.8 million, up $16.0 million from $17.8 million at December 31, 2008. The increase was primarily due to $21.7 million of cash flow provided by operations offset by $6.1 million used to pay dividends.

As of September 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 September 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 to pay their payroll withholding taxes associated with stock-based compensation. Repurchased shares 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 September 30, 2009, we repurchased approximately 20,000 shares at a cost of $182,000. 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.

In each of the first three quarters of 2009 we paid a cash dividend of $0.07 per share. 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. On October 21, 2009, our Board of Directors declared a quarterly cash dividend of $0.07 per share, payable December 1, 2009 to shareholders of record as of November 6, 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: (1) the company's financial statements as of the most recent practicable date; (2) the expected cash costs to deliver the products and services sold and recorded as deferred revenue; (3) the company's ability to provide the products and services underlying the amounts recorded as deferred revenue; (4) the likelihood of recognizing amounts recorded as deferred revenue as net sales based on the company's historical experience and most recent projections; (5) the short time period over which such recognition has historically occurred and is expected to occur; (6) seasonal cash flow; (7) general economic outlook; and (8) 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, AccelScanscanners 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 September 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   $ 3,783   $       395   $ 2,080   $ 1,157   $       151
Purchase obligations            3,766         3,753        13         -             -
Total                         $ 7,549   $     4,148   $ 2,093   $ 1,157   $       151

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 . . .