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SCIL > SEC Filings for SCIL > Form 10-Q on 13-Aug-2013All Recent SEC Filings

Show all filings for SCIENTIFIC LEARNING CORP

Form 10-Q for SCIENTIFIC LEARNING CORP


13-Aug-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 Annual Report on Form 10-K as amended by the Risk Factors sections contained in our Report on Form 10-Q filed subsequent to the Annual Report on Form 10-K. 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. 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 June 30, 2013, we had 136 full-time equivalent employees, compared to 229 at June 30, 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 critical resources 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. Our Q2 sales were definitely impacted along with the US Department of Education providing states and districts with waivers to carryover unspent funds. This resulted in delayed decision as well as reduction in size of transactions.


We experienced a decline in revenue and booked sales in the first six months of 2013compared to 2012, which we believe resulted from continued budget pressures on schools as well as lower number of sales employees compared to the same period of 2012. According to the Center on Budget and 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. We have seen improved state level funding for the 2013-14 school year which should help offset the reduction in federal funding.

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 25% and 24% during the three and six months ended June 30, 2013, respectively, compared to the same period in 2012. Our total booked sales decreased 40% and 39% during the three and six months ended June 30, 2013, respectively, 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 46% and 44% to $3.2 million and $5.1 million in the three and six months ended June 30, 2013, respectively, 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 7% and 18% to $1.1 million and $2.1 million during the three and six months ended June 30, 2013, respectively, compared to the same period in 2012. We believe that the decline in booked sales reflects continued budget pressures on schools as well as a 34% decrease in the number of salespeople compared to the second 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 six months of 2013, we closed 7 transactions in excess of $100,000, compared to 13 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 41% and 42% in the three and six months ended June 30, 2013, respectively, compared to 2012, primarily due to reduced headcount as a result of our fiscal year 2012 restructuring and lower levels of on-site training. In addition, we have completed the amortization of purchased software and have lower royalty payments.

Operating expenses decreased by 47% and 48% in the three and six months ended June 30, 2013, respectively, compared to 2012, which is due primarily to a reduction in headcount compared to the same period in 2012. As of June 30, 2013, we had 136 full-time equivalent employees, compared to 229 at June 30, 2012. The decrease is also due to lower sales commissions, bonus accruals, consulting, audit and tax related expenses and other expense reductions.

As a result of these expense reductions, we have reduced our operating loss for the three months ended June 30, 2013 to $0.3 million from $3.2 million for the three months ended June 30, 2012 and we have reduced our operating loss for the six months ended June 30, 2013 to $1.1 million compared to an operating loss of $8.2 million for the six months ended June 30, 2012.

Consolidated Results of Operations



Revenues



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




                       Three Months Ended June 30,                      Six Months Ended June 30,
                         2013               2012         % Change        2013               2012         % Change
Subscription          $      1,659      $        921         80%      $      3,223      $      1,684       91%
License                        659             2,569        (74)%            1,415             4,900      (71)%
Service and support          3,012             3,658        (18)%            6,170             7,650      (19)%

Total revenues        $      5,330      $      7,148        (25)%     $     10,808      $     14,234      (24)%


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 primarily includes 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 addition of support revenue from customers purchasing additional perpetual licenses to offset a decline in support revenue 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 and six months ended June 30, 2013, total revenue decreased by $1.8 million and $3.4 million or 25% and 24%, respectively, compared to the same period in 2012. Booked sales decreased by $2.8 million and $4.6 million or 40% and 39%, for the three and six months ended June 30, 2013, respectively, compared to the same period in 2012. For the three and six months ended June 30, 2013, subscription revenue increased by $0.7 million and $1.5 million or 80% and 91%, respectively, compared to the same period in 2012, as we increased the number of subscription customers on our MySciLEARN platform. License revenue declined $1.9 million and $3.5 million or 74% and 71% for the three and six months ended June 30, 2013, respectively, 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 $0.6 million and $1.5 million or 18% and 19% for the three and six months ended June 30, 2013, respectively, compared to the same period in 2012, primarily because we delivered fewer on-site training days compared to 2012.

We continue to focus on increasing the percentage of recurring, predictable revenue. In the second quarter of 2011, we launched SciLEARN On Demand, a fully cloud-based platform. Hosted off-site by Scientific Learning, SciLEARN On Demand allowed anytime, anywhere access to our Fast ForWord products. In the first quarter of 2012, SciLEARN On Demand was re-branded as MySciLEARN with the introduction of additional services and capabilities that were added to the original SciLEARN On Demand environment to provide a more complete learning and management platform for our customers. In the second quarter of 2012, we released Reading Assistant on the MySciLEARN platform. As of June 30, 2013, the total number of active schools was 3,179 with 85% of those sites using the MySciLEARN 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 the 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 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 and six months ended June 30, 2013 and 2012 (dollar amounts in thousands):

                        Three Months Ended June 30,                    Six Months Ended June 30,
                            2013               2012       % Change         2013             2012     % Change
Total deferred        $      10,902      $      14,858       (27)%    $     13,485      $  17,322     (22)%
revenue beginning
of period
Booked sales                  4,296              7,128       (40)%           7,191         11,743     (39)%
Less: revenue                (5,330)            (7,148)      (25)%         (10,808)       (14,234)    (24)%
recognized
Adjustments                                         (5)     (100)%                              2     (100)%

Total deferred        $       9,868      $      14,833       (33)%    $      9,868      $  14,833     (33)%
revenue end of
period

For the three months ended June 30, 2013 and 2012, booked sales declined 40% to $4.3 million, compared to $7.1 million respectively. For the six months ended June 30, 2013 and 2012 booked sales declined 39% to $7.2 million, compared to $11.7 million respectively. Booked sales are primarily composed of sales to the K-12 sector which decreased by 46% and 44% to $3.2 million and $5.1 million for the three and six months ended June 30, 2013, respectively, compared to $6 million and $9.2 million in the three and six months ended June 30, 2012, respectively. We believe that the decline in booked sales reflects continued budget pressures on schools as well as a 34% decrease in the number of salespeople compared to the second quarter of 2012.

Booked sales to the K-12 sector were 74% and 84% of total booked sales for the three months ended June 30, 2013 and 2012, respectively. Booked sales to the K-12 sector were 71% and 79% of total booked sales for the six months ended June 30, 2013 and 2012, respectively.

For the three months ended June 30, 2013 and 2012, booked sales to non-school customers declined 7% to $1.1 million, compared to $1.2 million, respectively. For the six months ended June 30, 2013 and 2012, booked sales to non-school customers declined 18% to $2.1 million compared to $2.5 million, respectively. Growth in our consumer and international business was more than offset by declines in private practice and our OEM and virtual school activity.

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 and six months ended June 30, 2013, we closed three and seven transactions, respectively, in excess of $100,000 compared to eight and thirteen in the three and six months ended June 30, 2012, respectively. 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 and six months ended June 30, 2013, subscription booked sales represented 51% and 48%, respectively, of total booked sales compared to 29% and 28% of total booked sales for the three and six months ended June 30, 2012, respectively.


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

                           Three Months Ended June 30,                    Six Months Ended June 30,
                               2013              2012       % Change         2013             2012       % Change
Subscription booked
sales                     $      2,181      $      2,058         6%     $     3,444      $      3,330       3%
Non-subscription
booked sales                     2,115             5,070       (58)%          3,747             8,413     (55)%

Total booked sales        $      4,296      $      7,128       (40)%    $     7,191      $     11,743     (39)%

Subscription booked
sales as a % of total
booked sales                       51%               29%                        48%               28%
Non-subscription
booked sales as a % of
total booked sales                 49%               71%                        52%               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, but it is not yet clear what level of impact this will have on our sales.
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.


Gross Profit and Cost of Revenues

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

                       Three Months Ended June 30,                   Six Months Ended June 30,
                           2013              2012       % Change         2013             2012      % Change
Gross profit on       $      1,361      $        679       100%     $     2,607      $     1,179      121%
subscriptions
Gross profit on                588             2,314       (75)%          1,279            4,401     (71)%
licenses
Gross profit on              2,148             2,064         4%           4,345            4,220       3%
service and
support

Total gross profit    $      4,097      $      5,057       (19)%    $     8,231      $     9,800     (16)%
                                                         Change                                      Change
Gross profit                   82%               74%         8%             81%              71%      10%
margin on
subscriptions
Gross profit                   89%               90%        (1)%            90%              90%       0%
margin on licenses
Gross profit                   71%               56%        15%             70%              55%      15%
margin on service
and support

Total gross profit             77%               71%         6%             76%              69%       7%
margin

The overall gross profit margin increased by 9% and 7% for the three and six months ended June 30, 2013, respectively, 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 the elimination of amortization of intangibles in 2013.

Gross profit on subscriptions increased by 100% and 121% in the three and six months ended June 30, 2013, respectively, compared to the same period in 2012, commensurate with the 80% and 91% increase in subscription revenue and slower growth of SaaS infrastructure expenses for the same periods.

Gross profit on licenses decreased by 75% and 71% in the three and six months ended June 30, 2013, respectively, compared to the same period in 2012, commensurate with 74% and 71% decrease, respectively, in license revenue for the same period and associated lower royalties and the elimination of amortization of intangibles in 2013.

Gross profit on service and support increased by 4% and 3% in the three and six months ended June 30, 2013, respectively, 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.

Operating Expenses



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


                       Three Months Ended June 30,                    Six Months Ended June 30,
                           2013              2012       % Change         2013             2012       % Change
Sales and
marketing             $      2,211      $      4,378       (49)%    $     4,641      $      9,267     (50)%
Research and
development                    934             1,933       (52)%          2,007             4,503     (55)%
General and
administrative               1,286             1,971       (35)%          2,663             4,189     (36)%

Total operating
expenses              $      4,431      $      8,282       (46)%    $     9,311      $     17,959     (48)%


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 $2.2 million and $4.6 million, for the three and six months ended June 30, 2013, respectively compared to the same period in 2012, primarily due to a reduction in headcount and lower commissions. At June 30, 2013, we had 34 quota-bearing sales personnel compared to 48 at June 30, 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 million and $2.5 million in the three and six months ended June 30, 2013, respectively, 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 . . .

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