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SCIL > SEC Filings for SCIL > Form 10-K on 28-Mar-2014All Recent SEC Filings

Show all filings for SCIENTIFIC LEARNING CORP

Form 10-K for SCIENTIFIC LEARNING CORP


28-Mar-2014

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, 2013, 3,109 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, 2013, we had 121 full-time equivalent employees, compared to 140 at December 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 2013, 65% of fourth graders in the United failed to achieve a "proficient" level in reading and 32% 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 (special education) grants. Both of these programs were severely impacted by the federal sequestration that went into effect on March 1, 2013. According to the National Education Association, sequestration was expected to reduce Title I funding by $740 million and IDEA special education funding by $645 million in the 2013-14 school year. Approximately, 80% of the cuts to these programs were restored in the spending bill passed in January, 2014.

We experienced a decline in revenue and booked sales in 2013 compared to 2012, which we believe resulted from continued budget pressures, on schools as well as a lower number of sales employees compared to the same period of 2012. According to the Center on Budget and Policy Priorities, in the 2013-2014 school year, elementary and high schools in approximately 60% of the states are expected to receive more funding per student compared to the prior school year. However, education funding remains under pressure; in approximately 34 states school funding remains below 2008 levels.

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, due to the continued emphasis on achievement mandates and education reform.

Company Highlights

Our total revenue decreased by 25% during 2013 compared to 2012. Our total booked sales decreased 25% during 2013 compared to 2012. 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 28% compared to 2012. We believe that the decline in booked sales reflects continued budget pressures on schools, the effect of sequestration on K-12 spending trends 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 predominantly new field sales team.

The weak environment and concerns about federal funding has also resulted in a lower average transaction value. In 2013, we closed 17 transactions in excess of $100,000 compared to 25 transactions over $100,000 in 2012.

We offer our customers both subscription and perpetual license options in a number of pricing configurations. Our goal is to increase our recurring revenue over time through a larger number of smaller and more predictable subscription transactions. In 2013, subscription booked sales represented 36% of booked sales compared to 27% of total booked sales in the same period of 2012.

K-12 booked sales decreased by 28% to $14.6 million in 2013 compared to 2012. Non-school booked sales, including private practice, international, direct to consumer, virtual schools and OEM customers, decreased by 13% to $3.5 million in 2013 compared to 2012 . We believe that the decline in booked sales primarily reflects continued budget pressures on schools including the effects of sequestration.


Cost of revenues decreased 37% in 2013 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 27% in 2013, compared to 2012, which is due primarily to a reduction in headcount compared to 2012, lower sales commissions, consulting, audit and tax related expenses and restructuring costs, partly offset by a $4.6 million impairment of goodwill. Excluding the goodwill impairment charge and restructuring costs in both years, operating expenses decreased by $11.7 million.

As a result of these expense reductions, we have reduced our operating loss during 2013 to $6.8 million from $11 million for 2012. Excluding restructuring costs and goodwill impairment, our operating loss in 2013 would have been $2.0 million compared to $9.6 million in 2012.

During the fourth quarter of 2013, as part of our strategy to improve the efficiency of our development operations, and to better align our costs and organizational structure with the current economic environment and improve our profitability, we implemented a plan to discontinue our development operations in China. The effected plan included a reduction in our workforce and closure of our China office and legal entity. We notified the employees affected by the workforce reduction on November 5, 2013. We expect to complete the exit plan by June 30, 2014. During the fourth quarter of 2013, we incurred a $0.2 million restructuring charge in connection with this exit activity. The charge included severance costs, contract termination costs and legal fees. Substantially all of the costs were cash expenditures and were paid through December 31, 2013.

We dissolved our Puerto Rico subsidiary as of December 31, 2013. This subsidiary did not have any employees during 2013 and had minimal operating expenses. This dissolution did not have a material effect on our results of operations.

On March 21, 2014, we entered into a patent purchase agreement pursuant to which we sold seven U.S. patents. See Note 19 to the consolidated financial statements for further discussion.

Results of Operations

Revenues

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

                         Year Ended December 31,        2013-2012   2012-2011
                      2013        2012        2011      % Change    % Change
Subscription        $  6,709    $  4,524    $  2,407       48%         88%
License                3,011       8,770      20,002      (66)%       (56)%
Service and support   11,342      14,849      18,670      (24)%       (20)%

Total revenues      $ 21,062    $ 28,143    $ 41,079      (25)%       (31)%

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.


2013 versus 2012: Total revenue decreased by $7.1 million or 25% in 2013 compared to 2012. Booked sales decreased by $6.1 million or 25%. Subscription revenue increased by $2.2 million or 48% as we increased the number of subscription customers on our MySciLEARN platform. License revenue declined $5.8 million or 66% due to the decline in booked sales and a smaller portion of customers purchasing perpetual licenses. Service and support revenue declined $3.5 million or 24% primarily due to a lower level of on-site services delivered compared to 2012, as on-site services are disproportionally related to large transactions.

For 2013, our K-12 renewal rate decreased to 83% compared to 93% in 2012, primarily due to weak economic conditions and a difficult back to school period in fall 2012. Renewal rate is determined by dividing renewals sales, plus additions of services or licenses made at the same time to renewing customers, divided by support and subscription licenses available for renewal. In 2013, we began reporting renewal rates on a dollar basis as it is a better representation of revenue potential. Prior to 2013, we reported on a per site basis. We believe the increasing sales of per student licenses which can be split between or combined in locations made a site- based metric less useful.

2012 versus 2011: Total revenue declined $12.9 million or 31% in 2012 compared to 2011. Booked sales for the same period declined $11.6 million or 32% for the same period. Subscription revenue increased by $2.1 million or 88% compared to 2011 as we increased the number of subscription customers on our MySciLEARN platform. 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% from 87% in 2011, on a site basis.

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 allows anytime, anywhere access to our Fast ForWord products. In the second quarter of 2012, we released Reading Assistant on the MySciLEARN platform. As of December 31, 2013, the total number of active schools was 3,109 with 89% of those sites using the MySciLEARN version of Fast ForWord and/or Reading Assistant. Over time, we expect that the increased availability of the MySciLEARN platform will help increase the portion of our revenue that is recurring.

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,              2013-2012   2012-2011
                          2013            2012            2011      % Change    % Change
Total deferred
revenue beginning of
period                $   13,485      $   17,322      $   21,871        (22)%       (21)%
Booked sales              18,162          24,305          35,950        (25)%       (32)%
Less: revenue
recognized               (21,062)        (28,143)        (41,079)       (25)%       (31)%
Adjustments                     -              1             580       (100)%      (100)%

Total deferred
revenue end of
period                $   10,585      $   13,485      $   17,322        (22)%       (22)%

2013 versus 2012: Booked sales declined 25% in 2013 compared to 2012. Booked sales is primarily composed of sales to the K-12 sector which decreased by 28% to $14.6 million in 2013 compared to $20.2 million in 2012. During 2013, reductions in federal spending due to sequestration more than offset slight improvements in state education budgets. School districts elected to focus on retaining teaching positions and continuing their core operations rather than purchasing supplemental programs. Booked sales to non-school customers decreased by 13% to $3.5 million in 2013 compared to 2012, primarily due to the termination of a large OEM contract and a change in contract terms with a significant licensee. Consumer and international sales increased in 2013 compared to 2012.


2012 versus 2011: Booked sales declined 32% in 2012 compared to 2011. Booked sales to the K-12 sector decreased by 35% to $20.2 million in 2012 compared to $31.3 million in 2011. As described above, during 2012, 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 decreased by 13% to $4.1 million in 2012 as compared to 2011, primarily due to a change in contract terms with some of our international VARs.

Booked sales to the K-12 sector for 2013, 2012 and 2011 were 80%, 83% and 87%, 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 2011.

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 2013 and 2012, school districts struggled with current and anticipated budget shortfalls, making it especially difficult to close large deals in our pipeline. In 2013, we closed 17 transactions in excess of $100,000 compared to 25 in 2012 and 63 in 2011. 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.

We continue to focus on increasing the percentage of subscription sales. In 2013, subscription booked sales increased 2% to $6.6 million. The following table sets forth information relating to our subscription booked sales (dollar amounts in thousands):

                                   Year Ended December 31,          2013-2012   2012-2011
                                2013          2012         2011     % Change    % Change
Subscription booked sales    $  6,576     $   6,449     $  4,213          2%         53%
Non-subscription booked
sales                          11,586        17,856       31,737        (35)%       (44)%

Total booked sales           $ 18,162     $  24,305     $ 35,950        (25)%       (32)%

Subscription booked sales
as a % of total booked
sales                             36%           27%          12%
Non-subscription booked
sales as a % of total
booked sales                      64%           73%          88%

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 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. Although both federal and state budgets and education spending are expected to improve in 2014, there is no guarantee that these improvements will be reflected in our booked sales.

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,            2013-2012    2012-2011
                               2013          2012          2011      % Change     % Change
Gross profit on
subscriptions               $  5,462      $  3,414      $  1,794          60%          90%
Gross profit on
licenses                       2,753         7,796        18,590         (65)%        (58)%
Gross profit on service
and support                    7,938         9,145        10,007         (13)%         (9)%

Total gross profit          $ 16,153      $ 20,355      $ 30,391         (21)%        (33)%

Gross profit margin on
subscriptions                    81%           75%           75%
Gross profit margin on
licenses                         91%           89%           93%
Gross profit margin on
service and support              70%           62%           54%

Total gross profit
margin                           77%           72%           74%

2013 versus 2012: The overall gross profit margin increased by five percentage points in 2013 compared to 2012 due primarily to improved gross margins in each revenue category.

Gross profit on subscriptions increased by 60% in 2013 compared to 2012, commensurate with the 48% increase in subscription revenue. The gross profit margin increased by six percentage points primarily due to the increase in subscription sales without a significant increase in variable spending.

Gross profit on licenses decreased by 65% in 2013 compared to 2012, commensurate with the 66% decrease in license revenue. The gross profit margin increased two percentage points primarily due to lower fixed costs, primarily of amortization of purchased software which declined.

Gross profit on service and support decreased by 13% in 2013 compared to 2012 primarily due to a 24% decline in service and support revenue during the year, mitigated by cost reductions as a result of a reduction of headcount as a part of our restructuring activities taken during the third quarter of 2012. The gross profit margin increased eight percentage points primarily due to the restructuring activities in 2012 and a lower proportion of onsite services which have a lower gross margin.

2012 versus 2011: The overall gross profit margin decreased by two percentage points 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 revenue.

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 four percentage points 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 eight percentage points primarily due to the restructuring activities in 2012.


Operating Expenses

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

                                  Year Ended December 31,        2013-2012   2012-2011
                                2013        2012        2011     % Change    % Change
Sales and marketing          $  9,105    $ 15,368    $ 17,979        (41)%       (15)%
Research and development        3,778       6,998      10,324        (46)%       (32)%
General and administrative      5,277       7,549       8,413        (30)%       (10)%
Impairment of goodwill          4,568            -           -       100%          n/a
Restructuring                     219       1,462            -       (85)%       100%

Total operating expenses     $ 22,947    $ 31,377    $ 36,716        (27)%       (15)%

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 $6.3 million decrease in sales and marketing expenses in 2013 as compared to 2012 was mainly due to a reduction in headcount, a move to lower cost virtual marketing activities and lower commission and bonus expenses. 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. At December 31, 2013, we had 32 quota-bearing sales personnel compared to 32 and 50 at December 31, 2012 and 2011, 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 $3.2 million in 2013 compared to 2012. The decrease in research and development costs in 2013 compared to 2012 was primarily due to a reduction in headcount and lower spending on product development, as we have now released on demand versions of all our products. Research and development expenses decreased by $3.3 million in 2012 compared to 2011, 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: 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 $2.3 million decrease in general and administrative expenses in 2013 compared to 2012 was primarily due to a reduction of headcount, lower spending in consulting, reduced audit and tax expenses, lower software maintenance costs, and lower depreciation. General and administrative expenses decreased $0.9 million in 2012 as compared to 2011, primarily due to a reduction of headcount, lower spending in consulting and lower stock compensation expense.

Impairment of goodwill: As part of our annual impairment test during the fourth quarter of 2013, we concluded that there were sufficient adverse indicators that triggered a goodwill impairment analysis. Among the indicators were (1) economic and budgetary challenges in our key K-12 market, (2) our continued transition from an on-premise, perpetual license model to a subscription driven, web-based SaaS business model and its short term impact on profitability, and (3) a significant decrease in our market capitalization as a result of a decrease in the trading price of our common stock during the fourth quarter of 2013. As a result of this analysis, we estimated the implied fair value of goodwill and compared the estimate to the carrying amount. The results of the analysis indicated that the carrying value exceeded the implied fair value of goodwill by approximately $5 million. Based on this, we concluded that a goodwill impairment existed as of December 31, 2013. During the fourth quarter of 2013, we wrote off the full goodwill balance in the amount of $4.6 million.

Restructuring: During the fourth quarter of 2013, as part of our strategy to improve the efficiency of our development operations, better align our costs and organizational structure with the current economic environment and improve our profitability, we implemented a plan to discontinue our development operations in China. The effected plan included a reduction in our workforce and closure of our China office and legal entity. We notified the employees affected by the . . .

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