UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008.

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     .

RENAISSANCE LEARNING, INC.

(Exact name of Registrant as specified in its charter)

Wisconsin		39-1559474
(State or other		(I.R.S. Employer
jurisdiction of incorporation)		Identification No.)

2911 Peach Street
P.O. Box 8036
Wisconsin Rapids, Wisconsin
(Address of principal executive offices)

54495-8036
(Zip Code)

(715) 424-3636
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller reporting company o
				(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class		Outstanding at October 31, 2008
Common Stock, $0.01 par value		29,172,587

 

 

RENAISSANCE LEARNING, INC.

INDEX TO FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008

		Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2008 and December 31, 2007			1
Condensed Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 2008 and 2007			2
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007			3
Notes to Condensed Consolidated Financial Statements			4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			7
Item 3. Quantitative and Qualitative Disclosures About Market Risk			12
Item 4. Controls and Procedures			13
PART II — OTHER INFORMATION
Item 1A. Risk Factors			13
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			13
Item 6. Exhibits			14
Exhibit 10.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

		September 30,				December 31,
		2008				2007
		(In Thousands, Except Share and Per
		Share Amounts)
ASSETS
Current assets:
Cash and cash equivalents		$	23,939			$	7,337
Investment securities			5,767				8,136
Accounts receivable, less allowance of $1,100			16,547				8,791
Inventories			5,646				6,273
Prepaid expenses			2,402				2,197
Income taxes receivable			2,853				1,450
Deferred tax asset			4,405				4,406
Other current assets			171				300
Total current assets			61,730				38,890
Investment securities			5,197				8,982
Property, plant and equipment, net			9,134				10,578
Deferred tax asset			1,460				1,587
Goodwill			47,233				47,065
Other intangibles, net			5,230				5,579
Capitalized software, net			229				452
Other non-current assets			174				167
Total assets		$	130,387			$	113,300
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	2,184			$	2,011
Deferred revenue			48,567				35,675
Payroll and employee benefits			4,701				4,184
Other current liabilities			4,306				3,563
Total current liabilities			59,758				45,433
Deferred revenue			2,935				2,707
Deferred compensation and other employee benefits			1,501				1,933
Income taxes payable			4,614				5,104
Other noncurrent liabilities			199				136
Total liabilities			69,007				55,313
Shareholders’ equity:
Common stock, $.01 par value; shares authorized: 150,000,000; issued: 34,736,647 shares at September 30, 2008 and December 31, 2007			347				347
Additional paid-in capital			52,074				52,683
Retained earnings			105,314				102,887
Treasury stock, at cost: 5,601,490 shares at September 30, 2008; 5,703,450 shares at December 31, 2007			(96,325	)			(98,123	)
Accumulated other comprehensive income			(30	)			193
Total shareholders’ equity			61,380				57,987
Total liabilities and shareholders’ equity		$	130,387			$	113,300

See accompanying notes to condensed consolidated financial statements.

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
		(In Thousands, Except Per Share Amounts)
Net sales:
Products		$	19,439			$	18,674			$	63,532			$	62,581
Services			8,761				7,135				22,100				17,093
Total net sales			28,200				25,809				85,632				79,674
Cost of sales:
Products			3,176				3,539				11,175				11,732
Services			3,664				3,301				9,993				8,612
Total cost of sales			6,840				6,840				21,168				20,344
Gross profit			21,360				18,969				64,464				59,330
Operating expenses:
Product development			4,521				4,410				12,822				14,111
Selling and marketing			8,953				8,852				27,230				27,093
General and administrative			4,226				3,809				11,783				11,263
Total operating expenses			17,700				17,071				51,835				52,467
Operating income			3,660				1,898				12,629				6,863
Other income, net			275				290				616				916
Income before taxes			3,935				2,188				13,245				7,779
Income taxes			1,365				821				4,722				2,917
Net income		$	2,570			$	1,367			$	8,523			$	4,862
Earnings per share:
Basic		$	0.09			$	0.05			$	0.30			$	0.17
Diluted		$	0.09			$	0.05			$	0.30			$	0.17
Cash dividends declared per share		$	0.07			$	0.82			$	0.21			$	0.92

See accompanying notes to condensed consolidated financial statements.

		For the Nine Months Ended
		September 30,
		2008				2007
		(In Thousands)
Reconciliation of net income to net cash provided by operating activities:
Net income		$	8,523			$	4,862
Adjustments to arrive at cash provided by operating activities:
Depreciation and amortization			2,861				2,874
Amortization of investment discounts/premiums			84				59
Share-based compensation expense			1,053				902
Deferred income taxes			127				(1,172	)
Excess tax benefits from share based payment arrangements			(36	)			—
Change in assets and liabilities, excluding the effects of acquisitions and divestitures:
Accounts receivable			(7,757	)			(5,171	)
Inventories			627				(1,559	)
Prepaid expenses			(205	)			(185	)
Income taxes			(1,858	)			2,941
Accounts payable and other liabilities			1,497				(251	)
Deferred revenue			13,119				13,906
Other			(304	)			191
Net cash provided by operating activities			17,731				17,397
Cash flows from investing activities:
Purchase of property, plant and equipment			(914	)			(1,993	)
Purchase of investment securities			—				(21,129	)
Maturities/sales of investment securities			5,680				33,746
Capitalized software development costs			(143	)			(167	)
Net proceeds from sale of property			113				567
Net cash provided by investing activities			4,736				11,024
Cash flows from financing activities:
Proceeds from exercise of stock options			348				30
Excess tax benefits from share based payment arrangements			36				—
Dividends paid			(6,096	)			(26,670	)
Purchase of treasury stock			(153	)			(1,433	)
Net cash used by financing activities			(5,865	)			(28,073	)
Net increase in cash and cash equivalents			16,602				348
Cash and cash equivalents, beginning of period			7,337				5,953
Cash and cash equivalents, end of period		$	23,939			$	6,301

See accompanying notes to condensed consolidated financial statements.

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

1. Consolidation

The condensed consolidated financial statements include the financial results of Renaissance Learning, Inc. and our subsidiaries.

2. Basis of Presentation

The condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in our opinion, necessary for a fair presentation of the results of the interim periods, and are presented on an unaudited basis. These financial statements should be read in conjunction with the financial information contained in our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Annual Report”), which is on file with the U.S. Securities and Exchange Commission (the “SEC”). The results of operations for the three and nine month periods ended September 30, 2008 and 2007 are not necessarily indicative of the results to be expected for the full year.

3. Earnings Per Common Share

Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Shares issued and shares reacquired during the period are weighted for the portion of the period they were outstanding. Diluted earnings per common share has been computed based on the weighted average number of common shares outstanding, increased by the number of additional common shares that would have been outstanding if the potentially dilutive stock option shares and restricted shares had been issued.

The weighted average shares outstanding are as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Basic weighted average shares outstanding			28,753,253				28,750,945				28,761,784				28,806,086
Dilutive effect of outstanding stock options			2,461				1,169				3,166				2,523
Dilutive effect of restricted shares			65,458				25,241				77,879				25,241
Diluted weighted average shares outstanding			28,821,172				28,777,355				28,842,829				28,833,850

For the three months ended September 30, 2008 and 2007, there were 769,781 and 849,989 shares subject to outstanding stock options, respectively, excluded from the calculation of diluted earnings per share because their effect was antidilutive. For the nine months ended September 30, 2008 and 2007, there were 769,266 and 849,989 shares subject to outstanding stock options, respectively, excluded from the calculation of diluted earnings per share because their effect was antidilutive. These options could be dilutive in the future.

4. Comprehensive Income

For the quarters ended September 30, 2008 and 2007, comprehensive income was $2.4 million and $1.4 million, respectively. Total comprehensive income was $8.3 million and $5.0 million in the first nine months of 2008 and 2007, respectively. Our comprehensive income includes net income and foreign currency translation adjustments.

5. Goodwill and Other Intangible Assets

In accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized and we are required to assess goodwill at least annually for impairment by applying a fair value-based test. Other intangibles consist of customer relationships and tradename, which were acquired in connection with the purchase of AlphaSmart, Inc. (“AlphaSmart”). The tradename has an indefinite life and therefore is not amortized. The customer relationships intangible is amortized over its useful life of ten years, on the declining balance method.

For the three months ended September 30, 2008 and 2007, we recognized amortization expense of $102,000 and $123,000, respectively. For the nine months ended September 30, 2008 and 2007, we recognized amortization expense of $349,000 and $422,000, respectively. Other intangibles consisted of the following:

		September 30, 2008												December 31, 2007
		Gross				Accumulated								Gross				Accumulated
		Amount				Amortization				Net				Amount				Amortization				Net
		(In Thousands)
Tradename		$	3,000			$	—			$	3,000			$	3,000			$	—			$	3,000
Customer relationships			4,150				1,920				2,230				4,150				1,571				2,579
		$	7,150			$	1,920			$	5,230			$	7,150			$	1,571			$	5,579

6. Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157 Fair Value Measurements (“SFAS 157”), to establish a consistent framework for measuring fair value and expand disclosures on fair value measurements. We adopted the provisions of SFAS 157, related to financial assets and financial liabilities on January 1, 2008. The adoption had no impact on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141R, Business Combinations, which replaces SFAS No. 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning January 1, 2009 and will apply prospectively to business combinations completed on or after that date. SFAS No. 141R is not expected to have a material effect on our consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position (“FSP”) 142-3, Determination of the Useful Life of Intangible Assets (FSP 142-3). FSP 142-3 intends to improve the consistency between the useful life of a recognized intangible asset under SFAS 142, Goodwill and Other Intangible Assets and the period of expected cash flows used to measure the fair value of the asset under SFAS 141 (revised 2007), Business Combinations (SFAS 141R) and other accounting principles generally accepted in the United States. FSP 142-3 is effective for us beginning January 1, 2009 and will apply prospectively to intangible assets acquired on or after that date. FSP 142-3 is not expected to have a material effect on our consolidated financial statements.

7. Share Based Compensation

There were no options to purchase our common stock granted during the nine months ended September 30, 2008. Options to purchase 11,551 shares of our common stock were granted in the nine months ended September 30, 2007. The exercise prices for all options are equal to the fair market value of our common stock on the date the options were granted.

Restricted stock awards, consisting of restricted shares and restricted share units, are granted to certain employees and our non-employee directors. For employees, restricted stock awards generally vest over a period of four years and for non-employee directors, upon termination of the individual’s tenure on our board. Restricted stock awards to employees are expensed over the vesting period, and those made to our non-employee directors are expensed when granted. We granted restricted stock awards for 93,179 shares during the nine months ended September 30, 2008, and granted restricted stock awards for 153,171 shares during the nine months ended September 30, 2007. We value restricted stock awards at the closing market price of our common stock on the date of grant.

A summary of restricted stock award activity for the nine months ended September 30, 2008 is as follows:

						Weighted Average				Aggregate
		Shares				Value Per Share				Intrinsic Value
		(In Thousands, Except Per Share Amounts)
Balance at January 1, 2008			250			$	14.16			$	3,498
Granted			93				13.06
Vested			(57	)			13.25
Balance at September 30, 2008			286			$	13.98			$	3,720

As of September 30, 2008, the total unearned compensation related to share-based compensation awards, net of estimated forfeitures, was $2.3 million, which will be amortized as expense over the weighted average remaining period of 2.7 years. Total share-based compensation was $1.1 million for the nine months ended September 30, 2008 and $0.9 million for the nine months ended September 30, 2007.

8. Dividends

On July 16, 2008, our Board of Directors declared a quarterly cash dividend of $0.07 per share, payable September 2, 2008 to shareholders of record as of August 8, 2008.

9. Subsequent Event

On October 22, 2008, our Board of Directors declared a special cash dividend of $0.75 per share and declared a quarterly cash dividend of $0.07 per share, both payable December 1, 2008 to shareholders of record as of November 7, 2008.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

Our results of operations can be affected by many factors including the general economic environment, state and federal budgetary decisions and the length and complexity of the sales cycle for school districts. Because of our dependence on educational institutions, the funding of which is largely dependent on government support, a decrease in government budgets or funding for educational software or technology could likely have an adverse effect on our business. National trends, federal and state legislation, Department of Education administrative policies and the way the foregoing align with our products and services can also impact our business.

An important component of our software product strategy is a transition to a subscription-based software sales model. We believe that a business model based on subscription-based software offers long-term advantages over traditional perpetual licensing, including: (i) improved product utilization leading to higher levels of customer satisfaction, (ii) product adoption by more schools, (iii) more lifetime revenue per customer and (iv) a more predictable and reliable revenue stream. This transition can significantly impact reported financial results and customer ordering patterns. During periods when high levels of customer orders are attributable to our subscription-based product and service offerings a significant portion of a period’s sales orders will be deferred and recognized as revenue in future periods over the subscription term, generally 12 months. Likewise, in periods when customer order levels for subscription-based products and services are seasonally lower, reported revenue may be higher than orders.

The transition to subscription-based products also affects customer ordering patterns. Compared to orders for non-subscription-based offerings, customer orders of our subscription-based offerings tend to more closely follow school budgeting patterns resulting in a more seasonal order pattern weighted to the second and third calendar quarters. Also, after customers transition to our subscription-based Enterprise products, they no longer order reading quizzes and math libraries since access to this content is included in their subscription. Historically, our customers have ordered more of this content in the first and fourth quarters. The combined effect is that a much greater proportion of a year’s orders is expected in the second quarter and to an even greater extent in the third quarter than we have experienced historically. Transitioning to subscription-based software can also adversely impact orders for expansions, add-on reading quizzes and math libraries by customers who own our software under perpetual license agreements, as they may delay purchases of expansions, reading quizzes and math libraries while they are contemplating a transition to subscription-based versions of our products. We believe these factors impacted order levels in the third quarter of 2008, while also causing reported revenue to be lower than order levels due to the deferral of revenue from orders we received this quarter.

In addition to the transition to subscription software and overall seasonal impacts, our order rates can also be affected by general economic factors such as the current economic downturn. Our laptops tend to be a more discretionary purchase than our software products and therefore tend to be more immediately impacted by school budgetary pressures than software. Our software orders levels can also be adversely affected by school budgetary pressures but generally to a lesser degree. We believe that order rates during the three-month and nine-month periods ended September 30, 2008 have been tempered somewhat by the downturn in the general economic environment and the resulting uncertainty about school funding levels.

We believe the percentage of customers using the subscription-based Enterprise version of our reading and math products is an important indicator of: (i) the progress of this strategic growth initiative, (ii) the magnitude of the growth opportunities still existing with regard to this strategy and (iii) the impact of the new seasonal patterns on our business. As of the end of the third quarter 2008, approximately 24% of our active reading product customers were using the Enterprise version. Worldwide, we currently have approximately 58,000 active Accelerated Reader customers, 19,000 active Accelerated Math customers and 41,000 active STAR Reading and STAR Math customers.

The following table sets forth certain consolidated income statement data as a percentage of net sales, except that individual components of costs of sales and gross profit are shown as a percentage of their corresponding component of net sales:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Net Sales:
Products			68.9	%			72.4	%			74.2	%			78.5	%
Services			31.1	%			27.6	%			25.8	%			21.5	%
Total net sales			100.0	%			100.0	%			100.0	%			100.0	%
Cost of sales:
Products			16.3	%			19.0	%			17.6	%			18.7	%
Services			41.8	%			46.3	%			45.2	%			50.4	%
Total cost of sales			24.3	%			26.5	%			24.7	%			25.5	%
Gross profit:
Products			83.7	%			81.0	%			82.4	%			81.3	%
Services			58.2	%			53.7	%			54.8	%			49.6	%
Total gross profit			75.7	%			73.5	%			75.3	%			74.5	%
Operating expenses:
Product development			16.0	%			17.1	%			15.0	%			17.7	%
Selling and marketing			31.8	%			34.3	%			31.8	%			34.0	%
General and administrative			15.0	%			14.7	%			13.8	%			14.1	%
Total operating expenses			62.8	%			66.1	%			60.6	%			65.8	%
Operating income			12.9	%			7.4	%			14.7	%			8.7	%
Other, net			1.0	%			1.1	%			0.8	%			1.1	%
Income before taxes			13.9	%			8.5	%			15.5	%			9.8	%
Income taxes			4.8	%			3.2	%			5.5	%			3.7	%
Net Income			9.1	%			5.3	%			10.0	%			6.1	%

Three Months Ended September 30, 2008 and 2007

Net Sales. Our net sales increased by $2.4 million, or 9.3%, to $28.2 million in the third quarter of 2008 from $25.8 million in the third quarter of 2007. Product revenues increased to $19.4 million in the third quarter of 2008 from $18.7 million in the third quarter of 2007 primarily due to the revenue recognized from prior period orders of software. Deferred revenue increased by $12.1 million in the third quarter of 2008, reaching a record level of $51.5 million, compared to an $8.9 million increase in the prior year’s third quarter. Increased sales of subscription based software and services was the main reason for the increase in deferred revenue. Service revenue increased to $8.8 million in the third quarter of 2008 from $7.1 million in the third quarter of 2007. Nearly all service categories achieved growth, with the largest increases occurring in our remote technical services, primarily hosting and installations.

Cost of Sales. The cost of sales of products decreased to $3.2 million in the third quarter of 2008 from $3.5 million in the third quarter of 2007. As a percentage of product sales, the cost of sales of products decreased to 16.3% in the third quarter of 2008 from 19.0% in the third quarter of 2007 primarily due to lower manufacturing costs of our scanner and a product mix shift in the laptop line to the more profitable Neos.

The cost of sales of services increased by $0.4 million, or 11.0%, to $3.7 million in the third quarter of 2008 from $3.3 million in the third quarter of 2007. As a percentage of sales of services, the cost of sales of services decreased to 41.8% in the third quarter of 2008 from 46.3% in the third quarter of 2007. The improvement resulted from growth of our more profitable technical service offerings, especially hosting, and better utilization of our fixed costs during the third quarter of 2008.

Product Development. Product development expenses of $4.5 million in the third quarter of 2008 were nearly unchanged with $4.4 million in the third quarter of 2007. As a percentage of net sales, product development expenses decreased to 16.0% in the third quarter of 2008 from 17.1% in the third quarter of 2007.

Selling and Marketing. Selling and marketing expenses of $9.0 million in the third quarter of 2008 were at similar levels with $8.9 million in the third quarter of 2007. As a percentage of net sales, selling and marketing expenses decreased to 31.8% in the third quarter of 2008 from 34.3% in the third quarter of 2007.

General and Administrative. General and administrative expenses increased by $0.4 million, or 11.0%, to $4.2 million in the third quarter of 2008 from $3.8 million in the third quarter of 2007. The increase was primarily due to a $0.6 million charge related to a 2004 lawsuit regarding defective parts from a supplier for which we received an unfavorable court decision. As a percentage of net sales, general and administrative expenses increased to 15.0% in the third quarter of 2008 from 14.7% in the third quarter of 2007.

Operating Income. Operating income increased by $1.8 million, or 92.8%, to $3.7 million in the third quarter of 2008 from $1.9 million in the third quarter of 2007. The increase was due to the higher revenue and gross profit margin improvements, partially offset by an increase in operating expenses as explained above. As a percentage of net sales, operating income increased to 12.9% in the third quarter of 2008 from 7.4% in the third quarter of 2007.

Income Tax Expense. Income tax expense of $1.4 million was recorded in the third quarter of 2008 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.1 million relating to the lapse of the statue of limitations on various tax positions. This compares to $0.8 million, or 37.5% of pre-tax income in the third quarter of 2007. The ongoing tax rate increased to 38.0% in 2008 from 37.5% in 2007 is a result of the expiration of the federal research and development tax credit. Congress extended the research and development tax credit on October 3, 2008. We will record the related tax benefit in the fourth quarter 2008. We do not expect this to have a material effect on our consolidated financial statements.

Nine Months Ended September 30, 2008 and 2007

Net Sales. Our net sales increased to $85.6 million in the first nine months of 2008 from $79.7 million in the first nine months of 2007. Product sales increased to $63.5 million in the first nine months of 2008 from $62.6 million in the first nine months of 2007. Deferred revenue increased by $13.1 million in the first nine months of 2008 versus an increase of $13.9 million in the first nine months of 2007. Service revenue increased by $5.0 million, or 29.3%, to $22.1 million in the first nine months of 2008 from $17.1 million in the first nine months of 2007. Nearly all service categories achieved growth, with the largest increases in our remote technical services, primarily hosting and installations. Service revenues also increased because we held a National Conference in the first quarter of 2008, but did not have a National Conference in 2007.

Cost of Sales. The cost of sales of products decreased to $11.2 million in the first nine months of 2008 from $11.7 million in the first nine months of 2007. As a percentage of product sales, the cost of sales of products decreased to 17.6% in the first nine months of 2008 from 18.7% in the first nine months of 2007 primarily due to lower manufacturing costs of our scanner and a product mix shift in the laptop line to the more profitable Neos.

The cost of sales of services increased by $1.4 million, or 16.0%, to $10.0 million in the first nine months of 2008 from $8.6 million in the first nine months of 2007. As a percentage of sales of services, the cost of sales of services decreased to 45.2% in the first nine months of 2008 from 50.4% in the first nine months of 2007. The improvement resulted from growth of our more profitable technical service offerings, especially hosting, and increased utilization of our fixed costs during the first nine months of 2008.

Product Development. Product development expenses decreased by $1.3 million, or 9.1%, to $12.8 million in the first nine months of 2008, compared to $14.1 million for the first nine months of 2007. The reduction in product development expenses is primarily due to: (i) ongoing savings from the restructuring of our product development group which occurred in the first quarter of 2007; (ii) a one-time charge of $0.5 million in the first quarter of 2007 for the restructuring; and (iii) research costs incurred in the prior year related to the expansion of the United Kingdom product offerings. As a percentage of net sales, product development costs decreased to 15.0% in the first nine months of 2008 from 17.7% in the first nine months of 2007.

Selling and Marketing. Selling and marketing expenses of $27.2 million in the first nine months of 2008 were essentially unchanged with $27.1 million in the first nine months of 2007. As a percentage of net sales, selling and marketing expenses decreased to 31.8% in the first nine months of 2008 from 34.0% in the first nine months of 2007.

General and Administrative. General and administrative expenses increased by $0.5 million, or 4.6%, to $11.8 million in the first nine months of 2008 from $11.3 million in the first nine months of 2007. The increase was primarily due to a $0.6 million charge related to a 2004 lawsuit regarding defective parts from a supplier for which we received an unfavorable court decision. As a percentage of net sales, general and administrative expenses decreased to 13.8% in the first nine months of 2008 from 14.1% in the first nine months of 2007.

Operating Income. Operating income increased to $12.6 million in the first nine months of 2008 from $6.9 million in the first nine months of 2007. As a percentage of net sales, operating income increased to 14.7% in the first nine months of 2008 from 8.7% in the first nine months of 2007. The increase was due to the increased revenue, gross profit margin improvements and lower operating expenses as explained above.

Income Tax Expense. Income tax expense of $4.7 million was recorded for the first nine months of 2008 at an effective income tax rate of 38.0% of pre-tax income, less a tax benefit of $0.3 million relating primarily to the lapse of the statue of limitations on various tax positions. This compares to $2.9 million, or 37.5% of pre-tax income in the first nine months of 2007. The ongoing tax rate increased to 38.0% in 2008 from 37.5% in 2007 as a result of the expiration of the federal research and development tax credit. Congress extended the research and development tax credit on October 3, 2008. We will record the related benefit in the fourth quarter 2008. We do not expect this to have a material effect on our consolidated financial statements.

Liquidity and Capital Resources

As of September 30, 2008, our cash, cash equivalents and investment securities were $34.9 million, up $10.4 million from the December 31, 2007 total of $24.5 million. The increase was primarily due to $17.7 million of cash flow provided by operations offset by $6.1 million used for dividends and $0.9 million used for property, plant and equipment purchases.

At September 30, 2008, we had cash and cash equivalents of $23.9 million. Our available cash and cash equivalents are held in bank deposits and money market funds. We monitor the depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. To date, we have experienced no material loss or lack of access to our cash or cash equivalents; however, we can provide no assurances that access to our cash and cash equivalents will not be impacted by adverse conditions in the financial markets. Our cash balances in the U.S. exceed the Federal Deposit Insurance Corporation (“FDIC”) insurance limits. While we monitor the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail or could be subject to other adverse conditions in the financial markets.

We have a $15.0 million secured revolving line of credit with a bank which is available until July 1, 2009. The line of credit bears interest at either a floating rate or a fixed rate for a period of up to 90 days based on LIBOR plus 1.5%. The rate is at our option and is determined at the time of borrowing. We also have a $2.0 million unsecured revolving line of credit with a bank available until April 30, 2009. The line of credit bears interest based on the prime rate less 1.0%. As of September 30, 2008, the lines of credit had not been used.

Our Board of Directors has approved a stock repurchase program under which we may purchase up to an aggregate total of 9.0 million shares of our common stock. During the quarter and nine months ended September 30, 2008, we repurchased approximately 5,400 and 11,500 shares, respectively, at a cost of approximately $67,000 and $153,000. As of September 30, 2008, the cumulative number of shares repurchased under this program was 7.8 million at an aggregate cost of $135.0 million. Depending on our stock valuation, cash availability and other factors, we may repurchase additional shares under this program.

On October 22, 2008, our Board of Directors declared a special cash dividend of $0.75 per share and declared a quarterly cash dividend of $0.07 per share, both payable December 1, 2008 to shareholders of record as of November 7, 2008. We believe our balance of cash, cash equivalents and investment securities coupled with cash flow from operations will be sufficient to meet both our near-term and long-term working capital requirements for the foreseeable future.

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

We do not have any off-balance sheet transactions, arrangements or obligations (including contingent obligations), that would have a material effect on our financial results.

Operating Leases. We enter into operating leases, primarily for facilities that we occupy in order to carry out our business operations. We utilize operating leases for some of our facilities to gain flexibility as compared to purchasing facilities outright and to limit our exposure to many of the risks of owning commercial property, particularly with regard to international operations. These agreements are generally for terms of one to five years and cannot be terminated by either the lessor or us for reasons other than breach of the lease agreement. We do not anticipate early termination of any of these agreements.

Purchase Obligations. We enter into commitments with certain suppliers to purchase components for our hardware products, such as AlphaSmart laptops, AccelScan scanners and the 2Know! response system. The majority of these obligations will be satisfied within one year.

Tax Audit Settlements and Deposits. Currently we do not anticipate making any significant cash payments related to the settlement of tax audits or deposits for unsettled audit issues during the next twelve months. Estimation of the amounts and timing of payments for periods further into the future are highly uncertain and therefore are not included in the table.

As of September 30, 2008, our approximate contractual obligations for operating leases and purchase obligations (by period due) were as follows:

		Payments Due by Period
						Less than												More than
Contractual Obligations		Total				1 year				1-3 years				3-5 years				5 years
(In Thousands)
Operating lease obligations		$	4,930			$	519			$	2,718			$	1,289			$	404
Purchase obligations			5,881				5,881				—				—				—
Total		$	10,811			$	6,400			$	2,718			$	1,289			$	404

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. There have been no significant changes to our critical accounting policies that were disclosed in our 2007 Annual Report.

Forward-Looking Statements

In accordance with the Private Securities Litigation Reform Act of 1995, we can obtain a “safe-harbor” for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements. Accordingly, the foregoing “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the following “Quantitative and Qualitative Disclosures About Market Risk” may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial results for 2008 and future periods. These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements. Factors which may cause such a difference to occur include: (i) the failure of Accelerated Reader Enterprise, Accelerated Math Enterprise and laptop orders to achieve expected growth targets, (ii) a decline in reading quiz and math library sales that exceeds our forecast, (iii) risks associated with our strategic growth initiative involving our transition to subscription-based products, (iv) dependence on educational institutions and government funding and (v) other risks affecting our business as described in our filings with the Securities and Exchange Commission, including our 2007 Annual Report and later filed quarterly reports on Form 10-Q and current reports on Form 8-K, which factors are incorporated herein by reference. We expressly disclaim a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk. Our exposure to market interest rate risk consists of: (i) the increase or decrease in the amount of interest income we can earn on our investment portfolio and (ii) the decrease or increase in the value of our investment security portfolio if market interest rates increase or decrease, respectively. We anticipate that we will have sufficient liquidity to hold our investments to maturity; therefore, we do not expect to recognize any material losses or gains related to an increase or decrease in market interest rates.

Market Risk. Our exposure to market risk relates to the quality of the holdings in our investment security portfolio. The fair market value of our investments is subject to increases or decreases in value resulting from the performance of the securities issuer, from upgrades or downgrades in the credit worthiness of the securities issuer and from changes in general market conditions.

We seek to manage exposure to market risk by investing in accordance with our corporate investment policy as established by our Board of Directors. The goals of the policy are: (i) preservation of capital, (ii) provision of adequate liquidity to meet projected cash requirements, (iii) minimization of risk of principal loss through diversified short and medium term investments and (iv) yields in relationship to the guidelines, risk, market conditions and tax considerations.

Our investment policy permits investments in obligations of the U.S. Treasury department and its agencies, money market funds and high quality investment-grade corporate and municipal interest-bearing obligations. The policy requires diversification to prevent excess concentration of issuer risk and requires the maintenance of minimum liquidity levels. The policy precludes investment in equity securities except for the specific purpose of funding the obligations related to our Supplemental Executive Retirement Plan. As of September 30, 2008, our investment securities had a market value of approximately $11.0 million and a carrying value of $11.0 million. Due to the type and duration of our investments, we do not expect to realize any material gains or losses related to market risk.

Foreign Currency Exchange Rate Risk. The financial position and results of operations of our foreign subsidiaries are measured using local currency. Revenues and expenses of such subsidiaries have been translated into U.S. dollars using average exchange rates prevailing during the period. Assets and liabilities have been translated at the rates of exchange at the balance sheet date. Translation gains or losses are deferred as a separate component of shareholders’ equity. Aggregate foreign currency transaction gains and losses are included in determining net income. As such, our operating results are affected by fluctuations in the value of the U.S. dollar compared to the British pound, Canadian dollar, Euro and Indian rupee. At this time, foreign exchange rate risk is not significant due to the relative size of our foreign operations and revenues derived from sales in foreign countries.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating our disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management was necessarily required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of September 30, 2008, an evaluation was performed under the supervision and with the participation of management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, management, including the CEO and CFO, concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the SEC.

There has been no change in our internal control over financial reporting that has occurred during the quarter ended September 30, 2008, that has materially affected, or is reasonably likely to materially affect, such internal control over financial reporting.

Part II — OTHER INFORMATION

Item 1A. Risk Factors

There have been no material changes from risk factors previously disclosed in our 2007 Annual Report in response to Item 1A to Part I of Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On April 17, 2002, our Board of Directors authorized the repurchase of up to 5.0 million shares of our common stock under our stock repurchase program. The repurchase of up to an additional 3.0 million shares was authorized by our Board of Directors on February 9, 2005. On February 6, 2008, our Board of Directors authorized the purchase of an additional 1.0 million shares under the stock repurchase program. No time limit was placed on the duration of the stock repurchase program, nor is there any dollar limit on the program. Repurchased shares become treasury shares and may be used for stock-based employee benefit plans, acquisitions and for other general corporate purposes.

The following table shows information relating to the repurchase of shares of our common stock during the three months ended September 30, 2008:

										Total Number of
										Shares Purchased as				Maximum Number of
		Total Number of								Part of Publicly				Shares that May Yet
		Shares				Average Price				Announced Plans or				Be Purchased Under
Period		Purchased				Paid per Share				Programs				the Plans or Programs
July 1-31, 2008			5,381			$	12.36				5,381				1,235,268
August 1-31, 2008			0				0				0				1,235,268
September 1-30, 2008			0				0				0				1,235,268
Total			5,381			$	12.36				5,381

Item 6. Exhibits

Exhibits.

Exhibit No.				Description
	10.1			First Amendment to Credit Agreement dated as of November 5, 2008 by and between Wells Fargo Bank, National Association and Registrant
	31.1			Section 302 certification by Terrance D. Paul
	31.2			Section 302 certification by Mary T. Minch
	32.1			Section 906 certification by Terrance D. Paul
	32.2			Section 906 certification by Mary T. Minch

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Index to Exhibits

Exhibit No.				Description
	10.1			First Amendment to Credit Agreement dated as of November 5, 2008 by and between Wells Fargo Bank, National Association and Registrant
	31.1			Section 302 certification by Terrance D. Paul
	31.2			Section 302 certification by Mary T. Minch
	32.1			Section 906 certification by Terrance D. Paul
	32.2			Section 906 certification by Mary T. Minch