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SCIL > SEC Filings for SCIL > Form 10-Q on 14-May-2013All Recent SEC Filings

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Form 10-Q for SCIENTIFIC LEARNING CORP


14-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations

This report contains forward-looking statements. Forward-looking statements are not historical facts but rather are based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as "may," "will," "should," "expects," "intends," "plans," "anticipates," "believes," "estimates," "predicts," "potential," "continue" and variations and negatives of these words and similar expressions are used to identify forward-looking statements. Statements regarding our expectations for our future business results and financial position, our business strategies and objectives, and trends in our market are forward-looking statements. Forward-looking statements are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management's Discussion and in the Risk Factors section of our most recent Report on Form 10-K as amended by the Risk Factors sections contained in this Report on Form 10-Q. We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the Securities and Exchange Commission, or the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

Overview

We are an education company that accelerates learning by applying proven research on how the brain learns in online and on-premise software solutions. Our results show that learners who use our products can realize achievement gains of up to 2 years in as little as 3 months and maintain an accelerated rate of learning even after product use ends. We provide our learning solutions primarily to U.S. K-12 schools in traditional brick-and-mortar, virtual or blended learning settings and also to parents and learning centers, in approximately 45 countries around the world.

We are highly differentiated because of 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. At December 31, 2012, proof that our products produce substantial academic gains was demonstrated in 273 efficacy studies, including randomized controlled trials and longitudinal studies, representing results from approximately 130,000 aggregate participants. These studies show gains for students at all K-12 grade levels, for at-risk, special education, English language, Title I (low income, under achieving), and a variety of other students. Gains have been demonstrated throughout the United States and in ten other countries. The studies show that these gains endure over time.

In 2011, we began to transition to a software as a service (SaaS) model. Our easy-to-use and easy-to-access web-based platforms are able to effectively deliver individualized learning opportunities to a large number of students simultaneously. Our Fast ForWord and Reading Assistant educational software products are now available on our browser-based SciLEARN Enterprise software platform and our on-demand platform MySciLEARN On Demand. The SciLEARN Enterprise and MySciLEARN platforms meet the needs of institution and district-wide installations by providing scalability, remote access, centralized reporting, asynchronous online professional development, and ease of administration for multiple campuses. As of March 31, 2013, we had 136 full-time equivalent employees, compared to 231 at March 31, 2012.

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 (Individuals with Disabilities Education Act) 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 $645 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 the first three months of 2013compared to 2012, which we believe resulted from continued budget pressures on schools, lower number of sales employees compared to the first quarter of 2012 and two large transactions in the first quarter of 2012 that did not repeat in the same magnitude in 2013. According to the Center on Budget and


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Policy Priorities, in the 2012-2013 school year, elementary and high schools in 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 23% during the three months ended March 31, 2013, compared to the same period in 2012. Our total booked sales decreased 37% during the three months ended March 31, 2013, compared to the same period in 2012. Booked sales are not a generally accepted accounting principles ("GAAP") financial measure. (For more explanation on booked sales, see the discussion below.)

K-12 booked sales decreased by 41% to $1.9 million in the three months ended March 31, 2013 compared to the same period of 2012. Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, decreased by 28% to $1.0 million during the three months ended March 31, 2013 compared to the same period in 2012. We believe that the decline in booked sales reflects two large transactions in the first quarter of 2012 that did not repeat at the same size in the first quarter of 2013, continued budget pressures on schools as well as a decrease in the number of salespeople compared to the first quarter of 2012.

The weak environment and concerns about federal funding has also resulted in a lower average transaction value in 2013. In the first three months of 2013, we closed 4 transactions in excess of $100,000, compared to 5 transactions for the same period in 2012. 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.

Cost of revenues decreased 43% in the three months ended March 31, 2013, compared to 2012, primarily due to reduced headcount as a result of our fiscal year 2012 restructuring, resulting in lower revenue, lower royalties and lower amortization.

Operating expenses decreased by 50% in the three months ended March 31, 2013, compared to 2012, which is due primarily to a reduction in headcount compared to the same period in 2012. As of March 31, 2013, we had 136 full-time equivalent employees, compared to 231 at March 31, 2012. The decrease is also due to lower sales commissions, bonus accruals, consulting, audit and tax related expenses and other expense reductions.


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Consolidated Results of Operations



Revenues



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




                       Three Months Ended March 31,      2013-2012
                         2013               2012         % Change
Subscription         $       1,564      $         763      105%
License                        756              2,331      (68)%
Service and support          3,158              3,992      (21)%

Total revenues       $       5,478      $       7,086      (23)%

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.

For the three months ended March 31, 2013, total revenue decreased by $1.6 million or 23% compared to the same period in 2012. Booked sales decreased by $1.7 million or 37%, for the three months ended March 31, 2013 compared to the same period in 2012. For the three months ended March 31, 2013, subscription revenue increased by $0.8 million or 105% as we increased the number of subscription customers on our MySciLEARN platform, compared to the same period in 2012. Our K-12 transaction count decreased 24% in first three months of 2013 compared to 2012. License revenue declined $1.6 million or 68% for the three months ended March 31, 2013, compared to the same period in 2012, primarily due to the decline in booked sales and a smaller portion of customers purchasing perpetual licenses. Service and Support revenue declined $0.8 million or 21% for the three months ended March 31, 2013, compared to the same period in 2012 as we delivered fewer on-site training days compared to 2012.

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. As of March 31, 2013, the total number of active school sites increased 6% to 3,478 with 79% 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.


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Booked sales

Booked sales are a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is a useful metric for investors as well as management 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, and 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 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 for the three months ended March 31, 2013 and 2012 (dollar amounts in thousands):

                                        Three Months Ended March 31,       2013-2012
                                            2013               2012        % Change
 Total deferred revenue beginning of
 period                               $      13,484      $      17,322       (22)%
 Booked sales                                 2,897              4,615       (37)%
 Less: revenue recognized                    (5,478)            (7,086)      (23)%
 Adjustments                                     (1)                 8      (113)%

 Total deferred revenue end of
 period                               $      10,902      $      14,859       (27)%

For the three months ended March 31, 2013 and 2012, booked sales declined 37% to $2.9 million, compared to $4.6 million respectively. Booked sales is primarily composed of sales to the K-12 sector which decreased by 41% to $1.9 million in the three months ended March 31, 2013, compared to $3.3 million in the three months ended March 31, 2012. We believe that the decline in booked sales reflects two large transactions in the first quarter of 2012 that did not repeat at the same size in the first quarter of 2013, continued budget pressures on schools as well as a decrease in the number of salespeople compared to the first quarter of 2012.

Booked sales to the K-12 sector were 67% and 71% of total booked sales for the three months ended March 31, 2013 and 2012, respectively.

For the three months ended March 31, 2013 and 2012, booked sales to non-school customers declined 28% to $1.0 million, compared to $1.3 million, respectively, primarily due to a change in contract terms with some of our international VARs.

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 reaching our goal of increasing sales force productivity. For the three months ended March 31, 2013, we closed 4 transactions in excess of $100,000 compared to 5 in the three months ended March 31, 2012. School districts continue to struggle with current and anticipated budget shortfalls, making it especially difficult to close large deals in our pipeline. 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 the three months ended March 31, 2013, subscription booked sales represented 44% of total booked sales compared to 28% of total booked sales for the three months ended March 31, 2012. The following table sets forth information relating to our subscription booked sales (dollar amounts in thousands):


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                                          Three Months Ended March 31,        2013-2012
                                              2013                2012         % Change
Subscription booked sales               $       1,263       $       1,272        (1)%
Non-subscription booked sales                   1,634               3,343       (51)%

Total booked sales                      $       2,897       $       4,615       (37)%

Subscription booked sales as a % of
total booked sales                                44%                 28%
Non-subscription booked sales as a
% of total booked sales                           56%                 72%

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 create 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 $645 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 license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license 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 at any given time.


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Gross Profit and Cost of Revenues

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

                                         Three Months Ended March 31,        2013-2012
                                              2013               2012         % Change
Gross profit on subscriptions           $       1,246      $         500        149%
Gross profit on licenses                          691              2,087       (67)%
Gross profit on service and
support                                         2,197              2,156         2%

Total gross profit                      $       4,134      $       4,743       (13)%

Gross profit margin on
subscriptions                                     80%                66%        14%
Gross profit margin on licenses                   91%                90%         2%
Gross profit margin on service and
support                                           70%                54%        16%

Total gross profit margin                         75%                67%         9%

The overall gross profit margin increased by 9% for the three months ended March 31, 2013 compared to the same period in 2012, due primarily to improved margins in all three of our product areas, as a result of a 50% reduction in service and support headcount, lower royalties, reduced on-site training days and related travel expense, and lower amortization of intangibles.

Gross profit on subscriptions increased by 149% in the three months ended March 31, 2013 compared to the same period in 2012, commensurate with the 105% increase in subscription revenue and slower growth of SaaS infrastructure expenses.

Gross profit on licenses decreased by 67% in the three months ended March 31, 2013 compared to the same period in 2012, commensurate with 68% decrease in license revenue and associated lower royalties and lower amortization of intangibles.

Gross profit on service and support increased by 2% in the three months ended March 31, 2013, compared to the same periods in 2012, primarily due to a higher mix of support revenue as we delivered fewer on-site training days and associated lower travel related expenses, and a 50% reduction of service and support headcount as a result of our restructuring activities taken during the third quarter of 2012.


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Operating Expenses



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


                                      Three Months Ended March 31,      2013-2012
                                          2013               2012       % Change
      Sales and marketing           $       2,430      $       4,889      (50)%
      Research and development              1,073              2,570      (58)%
      General and administrative            1,377              2,218      (38)%

      Total operating expenses      $       4,880      $       9,677      (50)%

Sales and Marketing Expenses: 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. Sales and marketing decreased $2.5 million, for the three months ended March 31, 2013 compared to the same period in 2012 primarily due to a reduction in headcount and lower commissions. At March 31, 2013, we had 32 quota-bearing sales personnel compared to 50 at March 31, 2012.

Research and Development Expenses: Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs. Research and development expenses decreased $1.5 million in the three months ended March 31, 2013 compared to the same period in 2012 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.

General and Administrative Expenses: 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. General and administrative expenses decreased $0.8 million for the three months ended March 31, 2013, compared to the same periods in 2012. The decrease is primarily due to a reduction of headcount and lower spending in consulting and overall lower stock compensation expense compared to the same period as 2012.

Other Income and Expenses



The following table sets forth information relating to our interest and other
income and expenses (in thousands):


                                             Three Months Ended March 31,        2013-2012
                                                2013               2012          % Change
Change in fair value of warrants         $         (221)     $        (38)         482%
Interest and other income (expense),
net                                                 (23)              (21)          10%
Total interest and other income
(expense), net                           $         (244)     $        (59)         314%

The change in the fair value of the warrants relates to the change in fair value of our common stock warrants which were issued on March 28, 2012. The fair value was estimated using the Black-Scholes-Merton option pricing model, which requires the input of highly subjective assumptions as determined by the Company's management. To the extent these assumptions change in future periods, the fair value of the common stock warrants may increase or decrease and the change in fair value will be recorded in our results of operations. The increase in the fair value of the warrants during the three months ended March 31, 2013 is primarily due to the increase in the Company's stock price over that time period.

Interest and other income (expense) includes foreign exchange gains and losses as well as interest paid on amounts borrowed.


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Provision for Income Taxes

In the three months ended March 31, 2013, we recorded income tax expense of $14,000. The tax expense for the three months ended March 31, 2013 consists primarily of deferred tax expense relating to the amortization of acquired goodwill, current state tax expense and current foreign tax expense. The decrease in tax expense between 2013 and 2012 is due to lower forecasted . . .

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