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SCIL > SEC Filings for SCIL > Form 10-K on 1-Apr-2013All Recent SEC Filings

Show all filings for SCIENTIFIC LEARNING CORP | Request a Trial to NEW EDGAR Online Pro

Form 10-K for SCIENTIFIC LEARNING CORP


1-Apr-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

Overview

We develop, distribute and license technology that accelerates learning by applying proven research on how the brain learns. We are differentiated by our continuous focus on the "science of learning" - combining advances in the field of brain research with standards-based learning objectives to achieve dramatic student gains. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through participation in our products. Our products are marketed primarily to K-12 schools in the U.S., to whom we sell through a direct sales force. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. As of December 31, 2012, 3,488 schools were licensed to use our products, a small fraction of the approximately 132,000 K-12 schools in the U.S. As of December 31, 2012, we had 140 full-time equivalent employees, compared to 240 at December 31, 2011.

Business Highlights

We market our products primarily as learning acceleration solutions, to be used in a blended model with existing teaching and curriculum materials, at both the elementary and secondary school levels. According to the U.S. Department of Education (USDE), in 2012, 67% of fourth graders in the United States were not "proficient" in reading and 33% performed below the "basic" level. Between 2009 and 2011, there was no change in average 4th grade reading scores.

States provide school districts with the majority of their funding, and those funds are also sometimes used to purchase our products. Additionally, federal education funds are a critical resource in helping school districts address the needs of the most challenged learners. We believe that a significant proportion of our sales are funded by federal sources, particularly Title I and IDEA (special education) grants. With respect to these sources, the National Education Association estimates that the federal sequestration that went into effect on March 1, 2013 will reduce Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year, but it is not yet clear what level of impact this will have on our sales.

We experienced a decline in revenue and booked sales in 2012 compared to 2011, which we believe resulted from state budget pressures, uncertainty about future education policies, and an increasing trend toward using federal funds wherever possible to save teacher jobs and core programs rather than on supplemental programs focused on struggling learners. According to the Center on Budget and Policy Priorities, in the 2012-2013 school year, elementary and high schools in at approximately half of the states are receiving less state funding than in the prior school year, and in approximately 35 states school funding now stands below 2008 levels.

Despite the recent attention school districts have paid to balancing their budgets, we believe our solutions will remain well-positioned for federal Title I, IDEA and competitive funding opportunities such as Race to the Top and School Improvement Grants, , to the extent they continue to be funded, due to the continued emphasis on achievement mandates and education reform.

Company Highlights

Our total revenue decreased by 31% during 2012 compared to 2011. Our total booked sales decreased 32% during 2012 compared to 2011. Booked sales are not a generally accepted accounting principles ("GAAP") financial measure. For more explanation on booked sales, see discussion below.) The change in booked sales is due primarily to a decline in K-12 booked sales of 35% compared to 2011. We believe that the decline in booked sales reflects continued budget pressures on schools and a change in our business model to increase the focus on selling lower priced subscription and per student licenses compared to perpetual licenses, as well as a decrease in the number of salespeople in the later part of the year.

This change in business model combined with a weak environment has also resulted in a lower average transaction value. In 2012, we closed 25 transactions in excess of $100,000 compared to 63 transactions over $100,000 in 2011.

Over time, we believe our On Demand MySciLEARN platform will enable us to significantly increase the number of smaller, more predictable transactions and recurring revenue. In 2012, subscription booked sales increased 53% and represented 27% of booked sales compared to 12% of total booked sales in the same period of 2011.

K-12 booked sales decreased by 35% to $20.2 million in 2012 compared to 2011. Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, decreased by 13% to $4.1 million in 2012 compared to 2011 due to changes in pricing and the timing of certain international transactions.


Cost of revenues decreased 27% in 2012 compared to 2011, primarily due to lower staffing associated with lower revenue, lower royalties and the reduction in materials shipped as we moved more customers to our On Demand platforms which do not require materials to be shipped.

Operating expenses decreased by 15% in 2012, compared to 2011, which is due primarily to a decrease in sales and marketing expenditures due to lower sales commissions and reduced headcount as a result of two reductions in force during the third quarter of 2012. In addition, the decrease is also due to lower expenditures in research and development due to the completion and release of our On Demand MySciLEARN platform in the prior year.

In the third quarter of 2012, we took action to reduce our ongoing expense structure which included the elimination of 65 positions and resulted in $1.5 million in severance charges. Excluding these charges, operating expenses would have decreased 19% in 2012 compared to 2011. These actions reduced our annualized expenses by approximately $6.0 million per year. As a result of these actions, we became cash flow positive in the fourth quarter of the year.

During the year, we had five key personnel changes. In April 2012, Linda L. Carloni, our Senior Vice President and General Counsel, announced that she would be retiring. On June 29, 2012, we hired Chris J. Brookhart as General Counsel and Mrs. Carloni's retirement date was July 26, 2012. On July 6, 2012, we received notification from Robert E. Feller, our Senior Vice President and Chief Financial Officer, that he was electing to resign. On July 11, 2012, our Board of Directors appointed Jane A. Freeman to be our CFO and Treasurer effective immediately. On July 8, 2012 our Board of Directors appointed Robert C. Bowen as our Chief Executive Officer effective immediately, in place of D. Andrew Myers. It was mutually agreed that Mr. Myers would step down from the CEO position and resign as a director of the Company. Mr. Bowen previously served as our CEO from 2002 to 2008 and Ms. Freeman previously served as our CFO and Treasurer from 2000 to 2008. On August 15, 2012, we announced that we were eliminating the position of Chief Technology Officer and had entered into a separation and release agreement with Ronald K. Park, our CTO, with respect to the elimination of his role. On November 6, 2012 we received notice from Jessica Lindl, the Company's Senior Vice President, Marketing & Inside Sales, that she was electing to resign.

Results of Operations

Revenues

The following table sets forth information relating to our revenues (dollar amounts in thousands):

                         Year Ended December 31,        2012-2011   2011-2010
                      2012        2011        2010      % Change    % Change
Subscription        $  4,524    $  2,407    $  1,476         88%         63%
License                8,770      20,002      21,030        (56)%        (5)%
Service and support   14,849      18,670      20,878        (20)%       (11)%

Total revenues      $ 28,143    $ 41,079    $ 43,384        (31)%        (5)%

As a result of the shift in our business model, beginning in 2012, we have presented revenues and cost of revenues for subscriptions, licenses, and services and support. We have reclassified all prior year amounts to reflect the current year presentation and the reclassification of prior year amounts did not have an impact on our total net revenues or results of operations.

Subscription revenue primarily includes revenue from annual or monthly customer subscriptions to our web-based applications, including Fast ForWord, Reading Assistant and BrainPro. We expect that subscription revenue will grow as we add new subscription customers, our existing subscription customers renew their licenses and some of our perpetual license customers choose to buy additional licenses as subscriptions.

License revenue includes primarily revenue from sales of perpetual licenses to our software applications, including Fast ForWord and Reading Assistant. We do not expect perpetual license revenue to return to its levels recorded in prior years as a result of our goal to convert to a SaaS-based subscription business model.

Service and support revenue is primarily derived from annual agreements for us to host software applications purchased by our customers as perpetual licenses and provide reporting services, support, and maintenance, as well as ad hoc trainings, professional development, consulting, and other technical service agreements. We expect service and support revenue to continue to decline as we do not expect the additions to support revenue from customers purchasing additional perpetual licenses to offset a decline in support


from existing licenses. In addition, we continue to expect customers to migrate toward our lower-priced web-based trainings from on-site service delivery.

2012 versus 2011: Total revenue decreased by $12.9 million or 31% in 2012 compared to 2011. Booked sales decreased by $11.6 million or 32%. Subscription revenue increased by $2.1 million or 88% as we increased the number of subscription customers on our MySciLEARN platform. Our K-12 transaction count increased 9% in 2012 when compared to 2011. License revenue declined $11.2 million or 56% due to the decline in booked sales and a smaller portion of customers purchasing perpetual licenses. Service and Support revenue declined $3.8 million or 20% primarily due to a lower level of on-site services delivered compared to 2011.

For 2012, our renewal rate decreased to 80% compared to 87% in 2011, primarily due to weak economic conditions which also impacted new business. Renewal rate is determined by dividing the number of school sites that renewed annual support and maintenance contract by the total number of sites whose contracts were expiring in the period. In 2013, we expect to begin reporting renewal rates on a dollar basis as it is a better representation of revenue potential. In addition, the increasing sales of per student licenses which can be moved from location to location make a site- based metric less useful.

2011 versus 2010: Total revenue declined $2.3 million or 5% in 2011 compared to 2010. Booked sales for the same period declined $5.9 million or14% for the same period. Subscription revenue increased by $0.9 million or 63% compared to 2010 as we increased the number of customers on our MySciLEARN platform. License revenue declined $1.0 million or 5% as booked sales of perpetual licenses declined in 2011 compared to 2010. Service and support revenue declined by $2.2 million in 2011 compared to 2010 as we delivered fewer on-site training days. For 2011, our renewal rate decreased to 87% from 88% in 2010.

We continue to focus on increasing the percentage of recurring, predictable revenue. In late 2010, we released the first version of our new SciLEARN platform, SciLEARN Enterprise, an on-premise solution that permits large customers to host our solutions on-premise and deploy from their own central server out to multiple school sites. In the second quarter of 2011, we released the second version of our SciLEARN platform, MySciLEARN On-Demand, which gives our customers the option to access our solutions online, via the SciLEARN platform hosted by us. At the end of 2012, the total number of active school sites increased 13% to 3,488 with 76% of those sites using the MySciLEARN On-Demand version of Fast ForWord and/ or Reading Assistant. Over time, we expect that the MySciLEARN platform will increase the portion of our revenue that is recurring. We also expect that MySciLEARN, together with new per student pricing options we introduced in the second quarter of 2011 and changes in our business model, will increase our volume of smaller transactions, shorten sales cycles, and increase our ability to drive predictable, recurring revenue.

Booked Sales

Booked sales are a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is useful because it is the most direct measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of subscriptions, licenses, services and support invoiced in the period. Revenue on a GAAP basis is recorded for booked sales when all four of the requirements for revenue recognition, as stated in our revenue recognition policy below, have been met; if any of the requirements to recognize revenue are not met, the sale is recorded as deferred revenue. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenue, and is not intended to represent a substitute measure of revenue or any other performance measure calculated under GAAP.

The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue (dollar amounts in thousands):

                                   Year Ended December 31,           2012-2011   2011-2010
                                2012          2011          2010     % Change    % Change
Total deferred revenue
beginning of period         $  17,322     $  21,871     $  22,230        (21)%        (2)%
Booked sales                   24,305        35,950        41,838        (32)%       (14)%
Less: revenue recognized      (28,143)      (41,079)      (43,384)       (31)%        (5)%
Adjustments                         1           580         1,187          n/a       (51)%

Total deferred revenue end
of period                   $  13,485     $  17,322     $  21,871        (22)%       (21)%

2012 versus 2011: Booked sales declined 32% in 2012 compared to 2011. Booked sales is primarily composed of sales to the K-12 sector which decreased by 35% to $20.2 million in 2012 compared to $31.3 million in 2011. During 2012, state budget pressures caused many school districts to focus on retaining teaching positions and continuing their core operations rather than purchasing supplemental programs. Federal stimulus funds which had benefited 2011 spending declined. Booked sales to non-school customers


decreased by 13% to $4.1 million in 2012 compared to 2011, primarily due to a change in contract terms with some of our international VARs.

2011 versus 2010: Booked sales declined 14% in 2011 compared to 2010. Booked sales to the K-12 sector decreased by 18% to $31.3 million in 2011 compared to $37.9 million in 2010. As described above, during 2011 state budget pressures again caused many school districts to focus on retaining teaching positions and continuing their core operations rather than purchasing supplemental programs. Booked sales to non-school customers increased by 20% to $4.7 million in 2011 as compared to 2010. The increase in 2011 reflects higher sales to international VARs, OEM's, consumers and virtual schools, partially offset by lower sales to private practice clinicians, who were more directly impacted by recent economic conditions.

Booked sales to the K-12 sector for 2012, 2011 and 2010 were 83%, 87% and 91%, respectively, of total booked sales. "Other adjustments" in 2011 consists primarily of the recognition of deferred revenue and the related receivable for 2010 booked sales with Free-On-Board ("FOB") destination delivery terms that were not delivered until 2010.

Historically, large booked sales, which we define as transactions totaling more than $100,000, have been an important indicator of mainstream education industry acceptance and an important factor in sales force productivity. In 2012, we closed 25 transactions in excess of $100,000 compared to 63 in 2011 and 84 in 2010. In 2012 and 2011, school districts struggled with current and anticipated budget shortfalls, making it especially difficult to close large deals in our pipeline. For the years ended December 31, 2012, 2011 and 2010, 26%, 41% and 47%, respectively, of our total booked sales arose from transactions over $100,000. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate. GAAP requires us to allocate discounts disproportionately to product licenses compared to service and support fees for non-subscription orders and accordingly, our product license revenues are disproportionately smaller than the related product booked sales. We cannot predict the size and number of large transactions in the future. MySciLEARN, together with new per student pricing options we introduced in the second quarter of 2011 and changes in our business model, are designed to decrease our dependence on large transactions by increasing our volume of smaller transactions and shortening sales cycles.

We continue to focus on increasing the percentage of subscription sales. In 2012, subscription booked sales increased 53% to $6.4 million. The following table sets forth information relating to our subscription booked sales (dollar amounts in thousands):

                                  Year Ended December 31,          2012-2011   2011-2010
                                2012         2011         2010     % Change    % Change
Subscription booked sales    $  6,449     $  4,213     $  3,608         53%         17%
Non-subscription booked
sales                          17,856       31,737       38,230        (44)%       (17)%

Total booked sales           $ 24,305     $ 35,950     $ 41,838        (32)%       (14)%

Subscription booked sales
as a % of total booked
sales                             27%          12%           9%
Non-subscription booked
sales as a % of total
booked sales                      73%          88%          91%

Non-subscription booked sales represents the sale of licenses, services and support for perpetual licenses and On Premise products.

Although the current economic and financial conditions, the expiration of federal stimulus funding, and federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 and non-school markets. However, achieving our growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products' ease of use, their fit with school requirements, and our connection with classroom teachers and administrators. Our K-12 growth prospects are also influenced by factors outside our control, including general economic conditions and the overall level, certainty and allocation of state, local and federal funding. As a result of the federal sequestration that went into effect on March 1, 2013, it is expected that funding for federal education programs will be cut by approximately 5.1% across-the-board unless Congress passes retroactive legislation reversing the impact of sequestration. The National Education Association estimates that these cuts will reduce Title I funding by $740 million and IDEA special education funding by $632 million in the 2013-14 school year. While federal funding for education remains significant, the current level of federal spending and the federal deficit are likely to put continued pressure on all areas in the federal budget, which could result in further cuts. States continue to experience severe budget pressure from the adverse conditions in the job, housing and credit markets although the outlook is improving. These conditions may continue to impact state education spending.


In addition, the revenue recognized from our booked sales can be unpredictable. Our various subscription, license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which package a customer will purchase, even when the amount and timing of a sale can be reasonably projected. In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue recognized in a period.

Gross Profit and Cost of Revenues

The following table sets forth information relating to our gross profits (dollar amounts in thousands):

                                      Year Ended December 31,            2012-2011    2011-2010
                                   2012          2011          2010      % Change     % Change
Gross profit on
subscriptions                   $  3,414      $  1,794      $  1,328          90%          35%
Gross profit on licenses           7,796        18,590        18,939         (58)%         (2)%
Gross profit on service and
support                            9,145        10,007        11,677          (9)%        (14)%

Total gross profit              $ 20,355      $ 30,391      $ 31,944         (33)%         (5)%

Gross profit margin on
subscriptions                        75%           75%           90%           0%         (15)%
Gross profit margin on
licenses                             89%           93%           90%          (4)%          3%
Gross profit margin on
service and support                  62%           54%           56%           8%          (2)%

Total gross profit margin            72%           74%           74%          (2)%          0%

2012 versus 2011: The overall gross profit margin decreased by 2% in 2012 compared to 2011 due primarily to a change in mix of revenues from higher margin license revenue to lower margin subscriptions and service and support.

Gross profit on subscriptions increased by 90% in 2012 compared to 2011, commensurate with the 88% increase in subscription revenue. The gross profit margin was unchanged.

Gross profit on licenses decreased by 58% in 2012 compared to 2011, commensurate with 56% decrease in license revenue. The gross profit margin decreased 4% primarily due to fixed costs, comprised primarily of amortization of purchased software, spread over a lower base of license revenue.

Gross profit on service and support decreased by 9% in 2012 compared to 2011 primarily due to 20% decline in service and support revenue during the year, mitigated by cost reductions as a result of a 52% reduction of headcount as a part of our restructuring activities taken during the third quarter of 2012. The gross profit margin increased 8% primarily due to the restructuring activities in 2012.

2011 versus 2010: The overall gross profit margin in 2011 was comparable to 2010 due to declines in the proportion of higher margin license revenue offset by decreasing license and service and support costs. Subscription margins decreased by 15% in 2011 over 2010, mainly due to implementation of the SaaS Operations department which was staffed up for revenue growth. License margins increased by 3% in 2011 over 2010 primarily due to lower royalty costs in 2011. Service and support margins decreased by 2% in 2011 compared to 2010, reflecting lower on-site services delivered in 2011.

Operating Expenses

The following table sets forth information relating to our expenses (dollar amounts in thousands):

                                  Year Ended December 31,        2012-2011   2011-2010
                                2012        2011        2010     % Change    % Change
Sales and marketing          $ 15,368    $ 17,979    $ 21,498        (15)%       (16)%
Research and development        6,998      10,324       7,933        (32)%        30%
General and administrative      7,549       8,413       8,129        (10)%         3%
Restructuring                   1,462            -           -       100%          n/a
Impairment                           -           -      3,890          n/a      (100)%

Total operating expenses     $ 31,377    $ 36,716    $ 41,450        (15)%       (11)%


Sales and Marketing: Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials. The $2.6 million decrease in sales and marketing expenses in 2012 as compared to 2011 was mainly due a reduction in headcount, lower marketing activities expense and lower commission and bonus expenses as we did not meet our sales quotas in 2012. The $3.5 million decrease in sales and marketing expenses in 2011 as compared to 2010 was mainly due to lower marketing activities expense and lower commission and bonus expenses as we did not meet our sales quotas in 2011. At December 31, 2012, we had 32 quota-bearing sales personnel compared to 50 and 51 at December 31, 2011 and 2010, respectively.

Research and Development: Research and development expenses principally consist of compensation paid to employees and consultants engaged in research, product development, product management and product testing activities, together with software and equipment costs. Research and development expenses decreased by $3.3 million in 2012 compared to 2011. The decrease in research and development costs in 2012 compared to 2011 was primarily due to a reduction in headcount and lower spending on development, as the second version of our On Demand offering was released early in 2012. Research and development expenses increased by $2.4 million in 2011 compared to 2010. In 2011, we continued to make critical investments in product development which resulted in increased headcount and consulting expenses related to the development of the new platform.

General and Administrative: General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees. The $0.9 million decrease in general and administrative expenses in 2012 compared to 2011 was primarily due to a reduction of headcount, lower spending in consulting and lower stock compensation expense. General and administrative expenses increased $0.3 million in 2011 as compared to 2010 primarily due to an increase in the use of consultants as well as an increase in depreciation expense due to the implementation of a new accounting system.

Restructuring: During the third quarter of 2012, as part of our strategy to better align our costs and organization structure with the current economic environment and improve our profitability, we implemented reductions in our workforce totaling approximately 30% as compared to staff levels at the end of the second quarter. The majority of the impact was on cost of service and . . .

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